Eyeing nonprofits: the Charity Integrity Act & other pending governance, accountability rules.

You could see it coming--more transparent financial reporting, the restructuring of corporate governance--if it was good for public companies, it wouldn't be long until someone decided it also would be good for private companies and nonprofits.

What has come to be known as the trickle-down effect of Sarbanes-Oxley, along with California's own scandals involving nonprofit organizations, led to the Charity Integrity Act (SB 1262).

The act, sponsored by California's attorney general, took effect Jan. 1, 2005, and seeks to restore some of the lost confidence in nonprofits by creating certain standards for nonprofit governance.

The perceived need to strengthen nonprofit corporate governance has become so pervasive that even SEC Chairman William Donaldson--whose office has no jurisdiction over charitable organizations--recently stated that nonprofits were "behind the times" in this era of increasing expectations for corporate transparency. And, not surprisingly, proposed new federal standards loom in Congress.

However, as nonprofit organizations implement these new accountability standards--with help from their CPAs--they can create transparency and regain the confidence of their constituents, donors and the public.

APPLICABILITY

Under SB 1262, any nonprofit required to register and file an annual report with the attorney general must comply with the Charity Integrity Act. Most nonprofits that are exempt under IRS Sec. 501(c)(3) meet this requirement.

Some of the act's key features involving CPAs apply when the nonprofit's annual revenue exceeds $2 million. Government grants are excluded from the nonprofit's determination of gross revenue--so long as the governmental entity requires an accounting of those funds.

The attorney general initially sought a $500,000 threshold, which is comparable to other states with such regulations, but California nonprofits were successful in negotiating a more reasonable level.

AUDITS AND AUDIT COMMITTEES

For nonprofits that meet the $2 million threshold, SB 1262 requires an annual audit, as well as the adoption of an audit committee. This is where implementation of the act becomes challenging for some nonprofits that struggle to find qualified, financially literate volunteers.

The audit committee is required to be independent--even from the organization's own finance committee. While as few as one person may comprise the audit committee, the act requires that less than 50 percent of the audit committee members come from the nonprofit's finance committee, and also that the audit committee chair may not be a member of the finance committee.

Best practices suggest the audit committee should meet with its auditors at least twice a year. An initial meeting should occur during the planning stage of the audit to discuss new accounting, auditing or regulatory issues affecting the organization. Any particular concerns the audit committee may have regarding financial reporting or management integrity also can be addressed then.

A follow-up meeting at the conclusion of the audit should debrief the committee on the audit results.

A frequent practice is to provide a closed session--with management absent--to allow an open discussion of any ethical concerns or competency issues raised by the audit.

For CPAs, providing guidance regarding audit committee structure and a sample charter that provides direction and standards for the committee is a good way to add value and strength to your client relationship. Sample charters are available on the AICPA website, www.aicpa.org/audcommctr/toolkits/01.htm.

If your firm provides consulting services for nonprofit audit clients for which the act is applicable, you must conform to Yellow Book standards for auditor independence in serving those clients. Accordingly, the act limits certain non-audit services you may provide nonprofits.

EXECUTIVE COMPENSATION

The act also scrutinizes executive compensation. A nonprofit's board (or a designated committee) is required to review and approve the compensation, including benefits, of the CEO and CFO to determine that it is fair and reasonable.

This provision seemed superfluous since the IRS already has "intermediate sanctions" that carry substantial penalties for nonprofits and their directors for excessive compensation or improper benefits. The IRS also recently indicated its intent to increase its examinations of compensation practices for nonprofits.

However, many nonprofits lack a process to evaluate their executives' compensation and determine the market value.

Ideally, a board committee should conduct an annual performance evaluation, compile market data and provide a recommendation to the board.

By strengthening the executive review and compensation process, nonprofits can withstand scrutiny by their constituents and increase the executives' effectiveness by providing important feedback and improving the odds of their retention.

Providing guidance to directors regarding evaluation and compensation models is another area in which CPAs can help their nonprofit clients.

OTHER PROVISIONS

Other aspects of SB 1262 regulate a nonprofit's use of commercial fund-raisers. Some of these are for the protection of charities, and have little impact on services performed by CPAs. Briefly, the key elements are:

* A commercial fund-raiser must notify the attorney general before starting a solicitation campaign;

* The fund-raiser must have a written contract with charities;

* There are requirements for the fund-raiser to make timely deposits of contributions and delivery to the intended charity, and solicitation and ticket sale records must be maintained by the fund-raiser for 10 years; and

* Various prohibited acts are identified in the planning, conduct or execution of a charitable solicitation.

Answers to particular SB 1262 implementation questions may be found on the attorney general's website, http://caag.state.ca.us/.

POTENTIAL NEW FEDERAL STANDARDS

California's lawmakers are not alone in considering nonprofit accountability standards. At the federal level, the Senate Finance Committee and the House Ways and Means Committee recently have held hearings to evaluate the need for improving financial transparency and governance.

Meanwhile, a Johns Hopkins University survey of hundreds of charities found that substantial proportions of the country's nonprofits already are using some of the financial disclosure practices under review by the Senate Finance Committee.

Regardless of the likelihood of new legislation, two groups are taking the matter seriously. Independent Sector, a national, nonprofit organization representing thousands of charitable groups and causes, and the AICPA have provided responses to the Senate Finance Committee for its consideration.

The following are a few of the key issues addressed by Independent Sector and the AICPA, some of which run parallel to SB 1262 and some which suggest other potential regulations.

In recent testimony to the Senate Finance Committee, Diana Aviv, president and CEO of Independent Sector, suggested:

* All nonprofits with revenues exceeding $2 million that file IRS Form 990 (not just charities as defined under SB 1262) should be required to obtain an audit, while those with revenues between $500,000 and $2 million should be required to obtain a review from an independent CPA;

* Nonprofits should be required to file Form 990 electronically and the highest-ranking officer or trustee should have to attest to its accuracy and completeness; and

* Nonprofits should be required to develop a conflict-of-interest policy and have at least one individual with financial literacy on its board.

In March, the AICPA provided a written response to the Senate Finance Committee prepared by its Nonprofit Expert Panel and its Exempt Organization Taxation Technical Resource Panel. Among the AICPA's conclusions were:

* The audit threshold recommended by Independent Sector was reasonable;

* Mandatory audit firm or partner rotation is not recommended and has not proven to increase audit quality;

* The nonprofit's CEO and CFO should certify their financial statements in a manner similar to that required by Sec. 302 of the Sarbanes-Oxley Act;

* The audit committee could consist of board members, should have no less than three members and should establish a charter;

* A nonprofit's tax-exempt status should be reviewed by the IRS after the first five years of the nonprofit's existence; and

* Heightened standards of care for board members with special skills or expertise, as had been proposed by the Senate Finance Committee, would be a deterrent for professionals, such as accountants or lawyers, from serving on nonprofit boards because of the potential for increased exposure to liability. Independent Sector will deliver its final report to the Senate Finance Committee this summer, and the committee is expected to conclude its hearings shortly thereafter.

CONCLUSION

The days of legislative ambivalence regarding nonprofit governance and accountability are over. With the Senate and the House conducting hearings, and public scrutiny at an all-time high, the likelihood of increasing federal intervention in the nonprofit sector has never been greater.

The best course of action for California CPAs with nonprofit clients is to steer them through SB 1262, while advising and helping them prepare for possible new federal rules coming down the road.

BY DAVID LJUNG, CPA

David Ljung, CPA is a shareholder at Gilbert Associates, Inc., CPAs and Advisors, and director of the firm's services to nonprofit organizations. You can reach him at [e-mail].