Audit Committees.

An essential tool for stability

A prominent nonprofit organization that focuses on providing assistance to the homeless recently got three blasts of bad news, all within a two-week period.

First, a government funding agency raised questions about some of the information provided in the organization's annual filing. Then, a routine inquiry from a potential service provider revealed that a volunteer board member's employer, an insurance broker, was apparently providing insurance coverage to the organization at higher-than-market rates. Finally came the bombshell that the current controller may have misappropriated funds.

The first reaction of the organization's Board of Trustees was to call the independent auditors to ask why these problems had not been identified and brought to its attention. The accounting firm responded with copies of the past several years' management letters it had written' to the board, at the end of each annual audit of financial statements. Those letters contained the observations that:

A. The organization was often lax about the timeliness, quality and quantity of information it provided to government agencies;

B. The entity's lack of segregation of duties among its small accounting staff could be a cause for concern about the protection of its assets;

C. In light of the Internal Revenue Service's rules (and just as an element of sound management), a periodic conflict-of-interests statement by board members and senior management would be a good idea; and

D. The formation of an audit committee reporting to the board would provide a strengthening of the organization's internal-control systems.

The board members had a vague recollection of receiving and reading these auditors' letters, but their primary concerns had always been on fundraising and fulfilling the organization's mission. It had seemed that the board members were doing what they should be doing and that, all in all, the organization was functioning pretty well.

In fact, although the board was not at all a disinterested or neglectful body, it had not availed itself of a tool that might have kept those recent problems from arising: an active and competent audit committee.

Audit committees have long been an important part of corporate governance, and recent years have seen them become essential to the management of publicly held companies. Even though nonprofit organizations have increasingly been establishing audit committees in recent years, at least in name, it is important for the nonprofit community at large to overcome the inclination to view such a committee as primarily a tool for commercial enterprises.

Perhaps the most important aspect of an audit committee is that it concentrates the governing board's focus on various financial oversight areas, thus permitting the board to respond to situations on an ongoing basis, rather than to react to events when they occur. As a general rule, an audit committee consists of three to five members from the board, although it may be valuable to have interested, qualified persons from outside the organization as well.

Common sense and independent judgment are probably the most important committee qualifications, but, on the whole, members should also have a strong working knowledge of financial reports, basic business practices, and, hopefully, generally accepted accounting principles and auditing standards. However, to ensure the objectivity necessary for assessing the organization's internal decisions, compensated officers and staff' typically should not sit on the committee.

Moreover, it is important that audit-committee activities not be diluted by the governing board's other financial-oversight responsibilities. For example, the audit committee should not be an appendage to an entity's budgeting, finance, and/or investment committee - even though it may occasionally share a member or members with another committee. The audit committee has a unique role in an organization, and formally distinguishing it from other committees is an important practical and symbolic step. Then, regardless of whether it is establishing a new audit committee or reviewing the charge of an existing one, the nonprofit's board should clearly define in writing the committee's objectives, range of authority, and responsibilities.

There are a number of published sources in the marketplace that can provide guidance on how to establish and maintain an audit committee. While there are various ways to detail the committee's duties, as a general rule, its responsibilities fall within the areas of accounting and financial reporting, managing the auditing process, and overseeing the organization's adherence to ethical standards.

Accounting and Financial Reporting. Nonprofit organizations have many unique accounting and financial-reporting aspects. And, each entity's management and governing board has the ultimate responsibility for seeing that its financial statements - monthly, quarterly, or annual, as the case may be - properly 'reflect financial position and activities.

Accordingly, the board. needs to be able to dedicate a portion of its membership to that specific role, in the form of an audit committee, and then to rely on the conclusions that the committee reaches. In the end, the hoard must maintain an adequate and competent management, and, in turn, a capable accounting staff.

The audit committee is in the best position to evaluate the entity's financial and accounting skills, through an initial assessment of each period's financial statements and through discussions with external auditors.

Managing the Auditing Process. Most nonprofits engage independent accountants to conduct an "external" audit of the entity's annual financial statements. An audit will result in not only an opinion on the financial statements but also a level of assessment of the organization's internal controls as well.

In a nutshell, internal controls may be defined as those systems of policies, procedures, and practices that management puts in place to safeguard assets, produce reliable financial information and promote operational efficiency.

At the completion of the audit, the accountants frequently provide written or oral comments to management or the board on issues relating to the adequacy of internal controls (particularly internal accounting controls) or to other operations-related matters observed during the audit.

The audit committee should have the responsibility for essentially all of the board's interaction with the auditors (although the full board, at its discretion, may also choose to meet with the auditors). The committee should select the auditors, confirm their annual appointment and, if it chooses, discuss basic audit approaches and intentions prior to the audit field work.

After the audit is done, the committee should meet with the accountants to discuss the audit results, review the draft financial statements and consider any internal-control/management issues the auditors may have identified. The audit committee would then report the audit results to the board.

If the nonprofit has an internal-audit process, conducted throughout the year by the entity's employees, once again the audit committee is the logical place for the internal auditors to report. The process for conducting internal-audit projects (which are often operational in nature) is quite different from an external audit of financial statements, but the oversight and report processes are similar. Ultimately, the audit committee should periodically hear the results of internal-audit efforts and present them to the full board.

Overseeing Adherence to Ethical Standards. Every organization, whether commercial or nonprofit, must comply with a variety of laws and regulations, as well as assure its various constituencies (e.g., shareholders, contributors, lenders, regulators) that it has acted in accordance with fair practices and ethical standards. In this regard, the nonprofit audit committee should be responsible for identifying areas of compliance and establishing (or confirming previously established) conflict-of-interests policies and codes of conduct.

While such measures cannot guarantee proper behavior, they help to establish a control environment - a so-called "tone at the top" - that makes ethical departures or illegal acts easier to identify and, perhaps, to prevent. Of course, in the event an ethical problem is alleged, it should be the audit committee that initially addresses the circumstances on behalf of the board.

Audit committees require effort. They need to be staffed with the right people, and they frequently have to make difficult and sometimes unpopular decisions. Thus, it is an economic fact of life that receiving the essential support that an audit committee provides requires a nonprofit organization to expend significant energy and resources, both to structure the committee properly and to keep it functioning as it should.

Nonetheless, in this day and age, the costs of not having an efficient and effective audit committee - for a nonprofit organization of virtually any size and mission - are simply too high.

D. Edward Martin, MBA, CPA, is the partner-in-charge of the Not-for-Profit Industry Group at the accounting and consulting firm of Richard A. Eisner & Company, LLP. Julie L. Floch, CPA, is a partner and the Director of Not-for-Profit Services at Eisner. Martin is an adjunct professor at Pace University and Baruch College/CUNY. Floch is an adjunct faculty member at Baruch College and the New School University, is a member of several not-for-profit task forces of the American Institute of CPAs, and chairs the Not-for-Profit Committee of the New York State Society of CPAs.