Audit of Not-For-Profit Organisation (NPO)

This paper considers the practices applied in the auditing of NPOs and the improvements introduced in the standards and regulations. It also considers the implications of the audit and vulnerability of NPO to fraudulent activities. NAME: ADMIN:

Table of Contents
INTRODUCTION.3 Audit of Not-for-profit Organisation (NPO)...............................................................................4 Statistical Study - Increase in NPOs and Reasons behind Increase...........................................5 Statistical Study - Increase in fraudulent practices in NPOs .....................................................6 Objectives of NPO Audit.............................................................................................................7 DEVELOPMENT..........................................................................................................................8 Increase Scope and Diversity of Regulators...............................................................................8 Revised Audit & Accounting Framework....................................................................................8 Change in FASB Codification (ASC Section 958).....................................................................10 Internal Code of Ethics..............................................................................................................11 Training Arms ACAUS & ICAEW..........................................................................................11 Case Study 1 - Red Cross Scandal (September 11 & The Hurricane Katrina).........................12 Some improvements to eliminate American Red Cross existing weaknesses include having a proper whistle blower system in order to find out the specific individuals who meddle with the operations of the organization. Also, The American Red Cross should also put in place a supervisory department to protect documents of transactions and empower employees to act in order to ensure all documents are properly prepared and accounted for............................13 Furthermore, to ensure Auditors serve due diligence to The American Red Cross during an audit, they are encouraged to constantly improve their skills and knowledge through attending seminars and trainings conducted by the Training Arms ACAUS & ICAEW........................14 ..................................................................................................................................................14 Case Study 2 - The Salvation Army of Australia.......................................................................15

3 Conclusion....................................................................................................................................17 Future direction for Not-For-Profit Organisation....................................................................17

INTRODUCTION Audit of Not-for-profit Organisation (NPO) Not-for-Profit Organisations (NPOs) are charities or service organisations which do not run their operations on share capital, as they operate on funds and donations. Any surplus is not distributed to the organisation as dividend or any other incentives to its members. The purposes of settling up NPO is to support government in helping society by provision of education for poor children, support for senior citizens, sports facilities for athletes, or health services. Unlike for profit organisations, audit of NPO is not required by law, but considering the recent circumstances, most organisations have established a firm requirement for the audit of NPO. Moreover, with the revolution of NPOs changing into business-like entity, stronger emphasis is essential to comply with voluntary corporate governance policy. It is enforced by the Internal Revenue Service, if an NPO earns profit more than $25,000 it has to file an annual Form 990. Likewise, NPO need to have all the managerial activities such as having a budget to control costs, monitoring utilization of resources on activities, a risk management plan to counter any unforeseeable events besides conducting fundraising activities to generate and acquire funds to fuel their activities and services.

Statistical Study - Increase in NPOs and Reasons behind Increase The significant growth of NPOs can be inferred from the fact that, 1.5 million NPOs were registered with the Internal Revenue Service in 2007. There is a 60% increase in size of Public charities (Wing, 2009) under S501(C)(3) within time span of a mere 10 years, from 1997 to 2007. Alarmingly, the cumulative assets owned by NPOs increased by 70% in this decade.

(Source: Urban Institute, National Centre for Charities statistic, the IRS Business Master File) The growth in NPOs is a result of government granted benefits in the forms of tax exemption, limited liability, grants and donations, and the power to organise (IPC). Tax exemptions are provided to NPOs from local, state and federal taxes; which include property tax, income tax, and sales tax amongst others. Another benefit of an NPO is that no individual will be personally liable for debts and obligations. Government also assists registered non profit organisations. NPOs are being established on a too fast pace without need for them in various area. According to Broekhoven, donations run into billions which makes NPOs vulnerable to fraud.

Statistical Study - Increase in fraudulent practices in NPOs

Percent of Fraud Cases

20 15 Percent 10 5 0 2002 2004 2006 Years 2008 2010

(Source: Association of Certified Fraud Examiners) From the above data, it can be seen that the trend of fraud peaked in the year 2008. The increase in the cases of fraud are due to; economic downturn in the past years, ineffective internal controls and ineffective measures for transparency of operations in NPOs. That is the reason why rigorous requirements have been developed to conduct audit of NPO. A sharp drop in the cases of fraud was observed after 2008 and this can be attributed by; reestablishment of economic circumstances, stability in employment, and restrictions imposed by donors for accountability and transparency. According to Mueller, et al 2006 it is morally right for NPOs to be accountable as they receive money from government as well as volunteer donors; this step is important because it enhances accountability. Udochi, 2007 held that management failed because they followed traditional interpretation of accountability.

Objectives of NPO Audit The failure in compliance with the regulations and statutory requirements has led NPOs to engage themselves in unethical acts like corruption, fraudulent financial statements, and asset misappropriation. The American Red Cross is used to illustrate how it engaged in acts of corruption such as bribery, establishment of illegal gratuities to earn illegal profit and economic extortion. Fraudulent financial statements are also prepared that show excessive expenses or overcompensation and the amount covered under those false heads is utilized illegally. To address the increasing frauds and misappropriation of funds in NPOs, the objectives to inculcate development in auditing standards and regulations are: to enhance the accountability, transparency and integrity for NPOs; to improve regulations and standards that provide framework for the operations of NPOs; to provide a criteria which defines the credibility of NPOs; and to make the functions of NPOs even more effective.

DEVELOPMENT To achieve the objectives, steps taken by governments to ensure that NPOs act ethically are the establishment of the following: Increase Scope and Diversity of Regulators Initially there were no legal requirements for the checks on non profit organisations and audit of NPOs was not necessary. But keeping in view the statistics of cases of fraud as presented above, the scope of procedures in order to enhance the accountability of NPOs has been widened. The NPOs should be controlled by the government regulatory that have been created by the Non-Profit Organizations Act. To state a few, The Charity Commission is the regulator for charities in England and Wales (Charity Commission for UK and Wales, 2010); they ensure NPOs maintain the standards of governance, transparency and public accountability. While in the US, The American Institute of Philanthropy acts as a charity watchdog to ensure NPOs serve the public in an ethical manner. Revised Audit & Accounting Framework Not-for-profit organisations are required to comply with several standards as set by the American Institute of Public Accountants (AICPA) and contained in the General Accepted Accounting Principles (GAAP). SOP 98-2 accounting for cost of activities of Not-for-Profit Organisations and State Local Government Entities that include Fundraising provides guidelines on how an NPO should account for fundraising related activities, (Clark &Jordan, 2001). U.S. Federal Office of Management and Budget offers guidelines and circulars in costing and auditing for NPOs (Garfinkel, 2002).

9 SOX Act 2002 Whistle Blower Protection & Protection of documents The SOX Act 2002 provisions are mainly addressed to public companies. There are only two provisions that suitably apply to all organisations, the rest of SOX requirements regarding best practices on governance are not binding for NGOs. However, NPO is free to establish an internal audit function that will benefit the NPOs by improving financial reporting, minimising fraud cases, improved internal controls and increase credibility of the NPOs (AICPA, 2010). o Whistle blower protection (SOX Section 806) SOX Act requires an organization to develop, adopt and disclose a formal process to deal with the complaints from the employees of the organization. In order to protect retaliation against the complaints made by any employee, an organization is advised to develop procedures to protect the employee. An organization is required to execute a proper investigation on the basis of complaints made by the employees and to rectify the flaws in the system. o Protection of documents (Board Source, 2006) In order to ensure accountability, regulations require all NPOs to have a proper written record of its activities, along with electronic files and voicemails. The retention of documents is specifically important for any official investigation conducted on the basis of written documents therefore a complete record of documents needs to be maintained and all the documents need to be provided in order to avoid criminal obstruction.

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Change in FASB Codification (ASC Section 958) In US and UK, the NPOs should prepare the financial statements according to the International Financial Reporting Standards while auditing is guided by the International Auditing Standards. FASB No.116 deals with contribution made and received. This Statement requires NPOs to differ between contributions received that increase permanently restricted, temporarily restricted, and unrestricted net assets. It also requires NPOs to recognize the expiration of restrictions imposed by donor. FASB No. 117 provides guidelines for Financial Statements of Not-for-Profit Organisations (FASB, 2010). The recent changes made in the standards are: accounting for contributions and presentation of financial statements, investments, statement of cash flows, accounting of contributions received, gains or losses incurred on investment made by the organisation from contributions. Revised OMB Circular 122 &133 OMB Circular 122, Cost Principles for Non-Profit Organizations and OMB Circular 133, Audits of States, Local Governments and Non-Profit Organizations were enacted in May 2004 (revised) and June 2003 respectively. OMB Circular 122 establishes principles for determining costs of grants, contracts and other agreements with non-profit organizations. OMB 133 makes it a statutory requirement to conduct audits of non-profit organizations (WhiteHouse.gov).

11 Committee of Sponsoring Organizations Internal Control Integrated Framework COSO framework is a model which is used to evaluate risk within the internal controls of an entity. The internal control of an entity is a process that is affected by its board of directors, management and key personnel who possess an effective control over the operations of an organization. For an NPO, COSO model possesses high importance to establish and evaluate an effective internal control in NPOs, especially where risk of fraud is significant. COSO model also includes risk management principles which can be used to identify and mitigate risks. Internal Code of Ethics Internal code of ethics includes principles of honesty, truthfulness and commitment to task. This is an extremely important aspect because by application of code of ethics, a culture of honesty can be developed in a non profit organization. An example is represented by the Evangelical Council for Financial Accountability. This organisation is responsible for ensuring the accountability in protestant evangelical churches organisations in USA. They reviewed the standards to include adherence to the Biblical teachings in the management of NPOs. Theological beliefs have been used even with organisations that are not affiliated to any religion. Training Arms ACAUS & ICAEW There are some authorities that ensure the continuous development and effectiveness of auditors. Training arms in UK and US are the audit firms and professional educational institutions such as ICAEW. These entities ensure that the auditors acquire proper knowledge regarding their practice. Audit firms; such as PWC, Deloitte, Ernst & Young and KPMG, conduct training of their employees through seminars and professional development sessions.

12 In order to avoid or mitigate fraudulent practices, the developments discussed above can be strictly legalized. Thus the NPOs would be able to mitigate the frauds. CASE STUDIES Case Study 1 - Red Cross Scandal (September 11 & The Hurricane Katrina) Red Cross has been continuously reported in different cases of fraud in the past decade. Major frauds include; lack of proper documentation and misappropriation of donations executed at the time of the September 11 attacks and Hurricane Katrina disaster. The American Red Cross was accused of a failure to meet its own guidelines with the funds that had been received from well wishers. Donations of untold millions were never accounted for therefore the exact amount of donation misappropriated by Red Cross cannot be investigated. It has been estimated that the total donations amounted to US$561 million, but only US$154 million was given to the victims of the attacks, and it was said by Red Cross officials that the rest of the amount would be utilized on the war against terror. It was observed and brought up that there were loopholes in the manner in which the National Disaster Fund was being managed. This was true even when the Red Cross had its own auditors auditing its regulations and its accounts. The external firm KPMG was appointed by Red Cross to conduct its audit. One of the reasons that caused the situation was the lack of transparency. The American Red Cross had faced scandalous allegations and yet their books had been audited by one of the most internationally recognised audit firm (Holguin, 2002). The Red Cross pledges total transparency and yet the details of what each chapter had received from the National Disaster Fund were not available to the press (Holguin, 2002). The auditors of Red Cross admitted that money given to the Boston chapter was not traceable. This was the reason

13 why the auditors failed to detect the fraud, and clearly management is responsible for letting such loopholes exist. The question that arises at this point is who should take the responsibility for the fraud. From the above scenario, it can be rejoin from ISA 250, Consideration of Laws and Regulations in an Audit of Financial Statements; it is managements responsibility to ensure the effectiveness of the internal controls and due to management failure, some individuals find loopholes for the fraud. Besides, ISA 240, The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements state as well that an auditors duty is to provide reasonable assurance regarding the effectiveness of internal control, detecting material fraud and expressing opinion of the fairness of the financial statements. Therefore an auditor cannot be held responsible for the non compliance of the management, especially when corruption by creating bogus or destroying documents can cause detecting fraud impossible. The weakness in the system of the Red Cross is the failure of the organization to meet the requirements made by the regulations. The improvement in the system can be made if the organization establishes COSO Framework. If any complaint is made regarding any internal matters, the directors should execute a proper investigation and should ensure that the problem is resolved. Some improvements to eliminate American Red Cross existing weaknesses include having a proper whistle blower system in order to find out the specific individuals who meddle with the operations of the organization. Also, The American Red Cross should also put in place a supervisory department to protect documents of transactions and empower employees to act in order to ensure all documents are properly prepared and accounted for.

14 Furthermore, to ensure Auditors serve due diligence to The American Red Cross during an audit, they are encouraged to constantly improve their skills and knowledge through attending seminars and trainings conducted by the Training Arms ACAUS & ICAEW. Lastly, Corporate Governance practices should be strengthened by avoiding concentration of power in the hands of one person. Concentration of power can be hazardous for the organization if the person utilizes his power for unfair or unethical means. Red Cross should also provide complete authority to the auditors and have an Audit committee that are knowledgeable, independent, and empowered to act effectively.

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Case Study 2 - The Salvation Army of Australia The Salvation Army is one of the most well known and successful NPOs. It is an exemplary organisation and its example is given as arguably the best Not-For-Profit Organisation. The Salvation Army has managed to successfully apply corporate governance in all its matters. The trustees are active and they attend all or most of the meetings (Australia Salvation Army, 2010). There are separate councils and advisory boards which monitor each other to ensure accountability and transparency. These boards self police the controls to ensure compliance with the regulations set by the regional authorities for NPOs. In order to promote the culture of honesty among the staff members, there is a code of conduct which all employees are obliged to follow to enhance the principles of ethics in the organisation. The donations are utilized in a transparent manner, and the prominent results are enough to retain the trust from the public. The auditing of the Salvation Army is conducted by KPMG. The organizations collaboration with agencies such as Transparency International, GRI, FTSE Group and FEE are a clear indication that the organisation's core values include sustainability, transparency and the full accountability of the organisation. In order to ensure that the developments in regulations and statutory requirements are consistently applied by Salvation Army, it has established an internal control system with guidelines that assist the entire organisation in following the regulations. The best practice by the Salvation Army include providing holistic care that focuses on personal rights, choices and wishes, supporting and assisting victims to lead their lives to the fullest potential and enhancing end user active participation.

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There is no doubt in the fact that the record of Salvation Army has been clear when compared to other NPOs, but it cannot be denied that it became a victim of some fraud as well. Assets worth $1 million were misappropriated in 2005 and an accountant misappropriated funds of nearly US$166,000 in during the period Jul04-Sep05 in Manhattan New York City. The organization faced difficulty after the disclosure of these fraud but these fraud was recovered by the organization later by conducting formal investigations. The status obtained by Salvation Army is due to the continuous compliance of the organization with the regulations. The challenges encountered by Salvation Army when implementing new regulations were maintaining the effectiveness in the internal controls of the organization, maintaining the ethical practices by the employees and to establish new records and their retention under the new regulations. The Salvation Army has a Quality Assurance System developed by Booth House and SAHA, which is internally audited on a regular basis. It is the responsibility of any NPOs under CSR to fulfil their corporate social responsibilities.

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CONCLUSION From the above report, it can be inferred that the audit standards, regulations and the developments made in those regulations are helpful in maintaining a better environment for NPOs and they are helpful in reducing the misappropriation of funds and fraudulent practices. Despite being helpful, these developments are not enough. Therefore, in order to ensure the optimum level of accountability and transparency, strict regulations are required for NPOs. Future direction for Not-For-Profit Organisation After the analysis, there are various issues that must be made known and corrected; 1. Strict regulations should be imposed on all NPOs to review the roles and responsibilities of management of NPOs on a regular basis. 2. NPOs need to come up with very clear core values and adhere to them. 3. To emulate and modify best practices from other NPOs such as Salvation Army. 4. The authorities should conduct surprise audits without any formal prearrangements. 5. In order to eradicate employee fraud and collusion of management, NPOs should conduct employee and executive training. 6. NPOs should periodically evaluate their internal audit procedures. 7. NPO to ensure a proper code of conduct is implemented in the organisations.

18 8. NPOs should introduce rewards for staff who report fraudulent practices.

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REFERENCES INTERNET AICPA (2010). Benefits of Audit Committees and Audit Committee Charters for Not for Profit Organisations. http://www.corpgov.deloitte.com/binary/com.epicentric.contentmanagement.servlet.Cont entDeliveryServlet/CanEng/Documents/Public%20Sector/Corporate %20Governance/AC_Charter_NPO.pdf [Accessed 15th October 2010] Arnot, A. (2004). Triple Bottom Line: Accountants can Play a Key Role in Finding the Real Value in Corporate Social Responsibility Programs https://www.cgapdnet.org/Non_VerifiableProducts/ArticlePublication/EnvironmentalProtection/TripleBo ttomLine.pdf [Accessed 15th October 2010] Benefit Enjoyed by NPOs. http://www.ehow.com/facts_5067923_benefits-starting-non-profitorganization.html [Accessed 15th October 2010] Board Source. (2006). The Sarbanes Oxley Act and Implications for Non Profit Organisations. http://www.boardsource.org/clientfiles/sarbanes-oxley.pdf [Accessed 15th October 2010] Broekhoven, R.V. (2010). Perspectives in Charity Accountability. http://rvanbroekhoven.blogspot.com/2010/07/why-do-we-need-npo-accountability-ordo.html [Accessed 15th October 2010] Charity Commission of England and Wales (2010). The Regulator for Charities in England and Wales. http://www.charity-commission.gov.uk/ [Accessed 15th October 2010]

20 Clark, S.J. & Jordan, C. E. (2001). Accounting for Not-for-Profit Organisations Fundraising Costs. http://findarticles.com/p/articles/mi_m3257/is_2_55/ai_70657266/ [Accessed 15th October 2010] Conroy, D.K. (2005). Non Profit Organisations and Accountability: A comment on the Mulgan and Siclair Frameworks. http://eprints.qut.edu.au/9473/1/9473.pdf [Accessed 15th October 2010] FASB. FASB No. 116. http://www.fasb.org/pdf/fas116.pdf [Accessed November 2, 2010] FASB (2010). FAS117 Summary: Financial Statements for Not for Profit Organisations. http://www.fasb.org/cs/BlobServer? blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820923228&bl obheader=application%2Fpdf [Accessed 15th October 2010] Garfinkel, S. (2002). OMB Circular A-122Cost Principles for Non Profit Organisations Training. http://www.hud.gov/offices/adm/grants/training/a122atch1.pdf [Accessed 15th October 2010] Holguin, J. (2002). Disaster Strikes in Red Cross Backyard. http://www.cbsnews.com/stories/2002/07/29/eveningnews/main516700.shtml [Accessed 15th October 2010] Holguin, J. (2002). The Battle Inside the Red Cross Backyard. http://www.cbsnews.com/stories/2002/07/31/eveningnews/main517045.shtml? tag=contentMain;contentBody [Accessed 15th October 2010]

21 Mercer, E. (1999). Critical Issues in Financial Accounting Regulation for Non Profit Organisations. http://www.muridae.com/nporegulation/accounting.html#maintainer [Accessed 15th October 2010] Mueller, K, Rickman, J. & Wichman-Tau, N. (2006). Not for Profit Management System http://www.uabr.auckland.ac.nz/files/articles/Volume12/v12i2-not-for-profitmanagement-systems.pdf [Accessed 15th October 2010] National Audit Office (2010). The Value for Money Programme http://www.nao.org.uk/about_us/what_we_do/value_for_money_audit.aspx [Accessed 15th October 2010] The Salvation Army (2010). The 2009 Annual Report: A look at the Salvation Army Australian Southern Territory Year http://www.salvationarmy.org.au/salvwr/_assets/main/documents/reports/2009_salvation _army_annual_report.pdff [Accessed 15th October 2010] The Salvation Army. The Salvation Army: Quality Standards. http://www1.salvationarmy.org.uk/uki%5Cwww_uki.nsf/stc-vwsublinks/668CBFA01CFBEC2B8025738D007FA34C?openDocument [Accessed November 2, 2010] Udochi, F.O., (2007). Where was the Board? A Moves Based Approach to Improving NPO Accountability. http://weatherhead.case.edu/academics/doctorate/management/research/files/concept/Udo chi_Concept_Paper_Formatted_7_24_07_FINAL.pdf [Accessed 15th October 2010]

22 WhileHouse.gov. Circular No. A-122 Revised May 10, 2004. http://www.whitehouse.gov/omb/circulars_a122_2004/ [Accessed November 2, 2010] WhiteHouse.gov. Circular No. A-133. http://www.whitehouse.gov/sites/default/files/omb/assets/omb/circulars/a133/a133.pdf [Accessed November 2, 2010] Wong, C.M., Chua, V. & Vasoo, S. (1998). Contribution to Charitable Organisations in a Developing Country: the Case of Singapore http://www.accessmylibrary.com/article1G1-20531538/contributions-charitable-organizations-developing.html [Accessed 15th October 2010] ARTICLES Wing, Kennard T.; Roeger, Katie L.; Pollak, Thomas H. The Non Profit Sector in Brief. Urban Institute

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APPENDIX

http://nccsdataweb.urban.org/PubApps/nonprofit-overview.php (Accessed: 20 October 2010)

http://www.urban.org/uploadedpdf/412085-nonprofit-sector-brief.pdf (Accessed: 20 October 2010)

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16 14 12 10 8 6 4 2 0 2002 2004 2006 2008 2010

ACFE. (2010) 2008 Report to the nation on occupational fraud & abuse. Available at: http://www.acfe.com/documents/2008-rttn.pdf (Accessed: 20 October 2010)

http://www.rsmchiolim.com.sg/serv_NPOs.htm (Accessed: 15 October 2010)

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http://www.sox-online.com/coso_cobit_coso_framework.html (Accessed: 15 October 2010)

http://narcosphere.narconews.com/notebook/bill-conroy/2009/01/whistleblower-rightslegislation-signals-changing-guard (Accessed: 10 October 2010)