For-profit spillover: new regulation of independence. (Streetsmart Nonprofit Manager).

For nonprofit organizations, which are expected as a whole to adhere to a high standard of ethical behavior, the bar just went up two notches. One change will have a direct effect, the other an indirect impact.

The direct effect occurred when the General Accounting Office (GAO) issued new standards for nonprofits receiving federal dollars. The indirect effect will come from the new Sarbanes-Oxley Law, which governs only publicly held companies, but which will likely have a far-reaching, subtle impact on nonprofits.

When the federal government issues such items the law of unintended consequences often takes hold and is as powerful a force as anything in writing. But in this case it is likely that the new law and the new regulation will achieve for nonprofits exactly what was intended for all corporations: a restructured relationship between the entity and its auditors.

As readers may remember, the Sarbanes-Oxley Law was passed last summer in direct response to the wave of corporate accounting scandals and questioned financial practices that came to light during the previous 10 months.

Ironically the GAO revisions, which are the ones directly touching nonprofits, had been in the works much earlier. Philosophically, they owe their roots to the concerns about auditor independence that Arthur Levitt, a past chair of the Securities and Exchange Commission, had raised during the late 1990s. So both acts trace their origins to the same policy question: what is the best way to ensure that auditors remain truly independent of their clients?

Some may wonder why a nonprofit would ever use its accounting firm for consulting services as well. Those who do so may wonder why others do not. For many services, the institutional familiarity rooted in the annual audit helps many consulting projects, and vice versa.

Most large nonprofits already do this to some degree, and some small or rural organizations must do something similar when the only available CPA is also the only professional skilled in the accounting package the group uses. Other nonprofits use the auditing firm for general consulting as a type of quality control, since the consultant industry is not regulated while the typical auditing firm must maintain firm-wide quality standards.

The GAO regulation and Sarbanes have begun to change these relationships, largely because of what has happened in the for-profit sector. The rules are complicated documents with nuances and subtleties far more complex than can be covered in this space, but here is our summary of the key points:

The new GAO regulation:

* Deals with non-audit, or consulting services;

* Applies only to nonprofits receiving more than $300,000 in federal funds;

* Bases its policy on principles, not rules, as has often been the case in the past. For example, one of the GAO independence standards is as follows: "In all matters relating to the audit work, the audit organization and the individual auditor, whether government or public, should be free both in fact and in appearance from personal, external and organizational impairments to independence.";

It goes on to say that the independence standard is based on two fundamental principles: (1) Auditors should not perform management functions or make management decisions; (2) Auditors should not audit their own work or provide non-audit services in situations where the amounts or services involved are significant/material to the subject matter of the audit;

* It also stipulates that non-audit services must meet additional tests, such as the people performing the services should not work on the related audit, an audit organization's work must not be artificially reduced to make it look like less of a conflict, and the services must be documented and must meet certain quality assurance safeguards.

This GAO regulation will have a direct impact on nonprofits that get substantial federal dollars. Paradoxically, Sarbanes will probably have a more far-reaching impact, though it will be more indirect and subtle. Why? Because the for-profit executives who sit on nonprofit boards will soon be quite familiar with the more intricate and deeper Sarbanes-Oxley Law and may decide to apply its provisions to their nonprofit board responsibilities. Here are some of the highlights of the new law:

* Certain non-audit consulting services are prohibited from being performed for a client by its audit firm;

* All tax and consulting services must be pre-approved by the audit committee;

* Partners must rotate off an SEC engagement after five years (it used to be seven);

* Audit committees must disclose the name of at least one "financial expert" member;

* Most personal loans to the company's executives are prohibited;

* The auditor must report on the company's internal controls;

* Company executives must vouch for certain reports and controls.

The predictions

The provisions of the new regulation and the new law are clear enough, although not all of the operational details are fully defined, especially for Sarbanes. Nonetheless, you can bet the house that both documents will shape nonprofit operations in numerous ways. The law of unintended consequences aside, most of these impacts will proceed in a straight line from the changes described above.

For emphasis, the following are predictions, not recommendations. What nonprofits are likely to do is not necessarily the thing that should be done. Individual organization's decisions are always based on a mixture of predictable reactions and unpredictable assumptions and misunderstandings.

Moreover, the overall impact of the two new pieces of regulation is likely to be a second-guessing of previously acceptable relationships, which itself will lead to new ways of conducting business. So, with those caveats, here's a crystal-ball reading of where things will lead.

Audit/consulting split. The unavoidable conclusion one must draw at this point is that nonprofits will begin to use different firms for consulting services than used for audit services, although this is not necessarily required in the majority of cases. This split is what many advocates and federal officials intended for the for-profit corporation, of course, and now they sometimes explicitly prohibit it.

Where it is not prohibited, the step of getting audit committee pre-approval will discourage management from this course of action. Why would managers stir up a potential controversy on the board level if it's possible to get the same thing accomplished just by going to another provider?

There are two ironies in this probable outcome. The first is that nonprofits generally never engaged in the kinds of practices that in for-profits gave rise to serious concerns about auditor independence.

For instance, in the technology boom years of the last decade it was not unusual for the large accounting firms' consulting practices to have significant numbers of employees out-sourced to their clients' financial software implementation projects. The people looked like the client's employees, but in reality were on the payroll of the audit/consulting firm.

Most nonprofits simply don't have the scale of operations that make that kind of arrangement either necessary or financially feasible. Although, again, small or rural agencies have sometimes used their auditor for financial management consulting services even though that practice has always been very close to an automatic violation of auditor ethics.

The second irony is that this auditing/consulting split was, for different reasons, already in the works at the major accounting firms even before the events of the past 18 months. Most of the large firms had already spun off their technology implementation practices well before last year, and smaller firms usually didn't have consulting practices of a similar scope.

The rise of the "trophy" financial nonprofit board member. Nonprofit managers may read the Sarbanes requirement to have at least one "financial expert" on the audit committee with surprise. Weren't for-profit corporations' audit committees packed with financial experts?

That wasn't the case, it turns out. In any event, it will now be part of the culture that nonprofit boards of directors will be expected to have at least one bona fide financial expert. This means that CPAs, corporate internal auditors, and financial watchdogs will become the new class of trophy board member, as nonprofits feel compelled to reassure funders of their financial oversight capacity.

Good internal controls are part of board expectations. Nonprofits with a large amount of federal funding are already used to their auditors reporting on internal controls, but many other groups are not. As this becomes a requirement at for-profit firms, those same executives serving on nonprofit boards will want to make sure that the internal controls are in shape there, too. This means that cultural groups, advocacy organizations, and non-mainstream nonprofits will be pressed to concentrate some time and attention on strengthening internal controls.

Nonprofit CEOs will be held more accountable. Sarbanes requires the publicly held corporate CEO and other executives to sign off on the financial statements. While there is no comparable provision for nonprofits, the idea has now been implanted in executive culture that the CEO and other senior types have personal responsibility for what goes on in their organizations. Look for this to be translated to the nonprofit sector.

Consulting services fragmentation, firm alliances. With some consulting (non-audit) services explicitly prohibited and approval for others being made harder to get, the consulting/ auditing split described above will create more consulting sources for larger nonprofits.

There are only a handful of large nonprofit-oriented consulting practices in large national auditing firms, and those that have relied mostly on referrals from the audit side may shrink. At the same time, other practices in smaller firms may get more opportunities to grow. (For full disclosure: this columnist's consulting practice has always been largely separate from the audit practice. Call it early compliance or, more accurately, luck).

Some audit firms may form informal alliances in which they refer either consulting services or the audit to a competitor, depending on which service they want to keep.

The rise of principle-based auditing. The real sleeper development in all this may be that auditing becomes less rules-based and more principles-based. Many experts are trying to push it in that direction anyway, arguing that strict rules-based auditing encourages too narrow a focus which facilitates the kind of accounting scandals that arose recently. The GAO rules themselves can be read as a miniature experiment in regulation based on principles rather than rules.

Auditing and consulting relationships may not be the top item on most managers' radar screens. Even when they have been the matters have often been handled without a conscious policy. Because of the GAO and two legislators named Paul Sarbanes and Michael Oxley this will change, and nonprofits will become much more studied and deliberate about their choice of providers in both areas.

Thomas A. McLaughlin is a national nonprofit management consultant with Grant Thornton in Boston. He is also the author of Streetsmart Financial Basics for Nonprofit Managers (2nd edition.) and of Trade Secrets for Nonprofit Managers, both from John Wiley & Sons. His email address is [e-mail].