Partners, Volume 14, Number 1, 2004
Partners, Volume 14, Number 1, 2004
|Sarbanes-Oxley: Guidance for Nonprofit Governance|
As employees of the companies under the leadership of these executives realized that their retirement funds had disappeared, Americans demanded swift action. In response, Congress passed the American Competitive and Corporate Accountability Act of 2002, commonly known as the Sarbanes-Oxley Act (“Sarbanes-Oxley”),1 hoping to rebuild Americans’ trust in corporate governance.
Initially, Sarbanes-Oxley focused on the for-profit sector, but recently, this focus has expanded to include the nonprofit community. Some nonprofit organizations raise millions of dollars each year, while others raise only tens of thousands of dollars or even less. Regardless of the size of a nonprofit’s budget, these organizations are often governed by volunteers who are not well-versed in methods of accounting and financial matters. The possibility that such volunteers may contribute to the appearance of impropriety is considerable. While many of the provisions of Sarbanes-Oxley do not apply to non-profits, voluntary adoption of some of the governance practices it recommends can significantly reduce the potential for inadvertent impropriety. Two of the provisions of the new legislation are binding for nonprofits, as well.
Drexel University, a nonprofit educational institution in Philadelphia, recognized the need to safeguard nonprofits and recently adopted many of the governance practices prescribed by Sarbanes-Oxley for profit-based entities.2 The State of New York is also considering legislation that will make nonprofit corporations subject to the requirements of Sarbanes-Oxley.3 What do the provisions recommend, and how might their voluntary adoption improve nonprofit governance?
Independent, competent audit committees
Sarbanes-Oxley requires an entity to maintain an audit committee comprised of members who are (1) part of the board of directors and (2) independent, insofar as they are not a part of the management4 team and not compensated as a consultant or for other professional services.5 The members may, however, be compensated for serving on the board of directors. Organizations must also disclose whether the audit committee includes a financial professional; if it does not, the corporation must explain the rationale for this omission.6
Although nonprofit entities are not yet required to comply with this provision, the legislation recommends that even small nonprofit organizations at the very least have their financial statements compiled by a professional accountant. Those nonprofits with minimal budgets usually can obtain the services of a professional accountant on a pro bono basis.
For nonprofit organizations with larger budgets ($500,000 or more) or those nonprofits receiving federal funding, the Act recommends formation of an audit committee separate from its finance committee, consisting of members who have expertise and knowledge in financial matters. This committee should conduct annual audits and obtain the services of a financial expert to guide its activities. Members of the audit committee should not be compensated specifically for serving on the committee and should be free of financial interests in the organization and of conflicts of interest that might result from relationships with any entity doing business with the nonprofit organization. Staff members should not serve on the audit committee; at most, they might serve as consultants to it.
Ensuring that auditors are responsible
Sarbanes-Oxley requires that the partner of the auditing firm hired to assess an organization’s accountability rotate off of the job every five years to provide a periodic check on the auditing process.7 The legislation expressly prohibits an auditing firm from performing other work for the organization, such as providing legal services, investment services, or management services.8 The auditing firm is required to report all accounting policies and practices used by the entity.9
Despite the fact that these provisions are not currently required of nonprofit organizations, those nonprofits performing annual audits should consider adopting them. It is especially important for nonprofit entities to refrain from requesting that their accountants and lawyers provide services beyond the preparation of financial documents and offering legal advice, respectively. Some nonprofit corporations may have to address this issue by employing independent management companies to assist in operating their organizations.
Attesting to financial statements
Under Sarbanes-Oxley provisions, a corporation’s chief executive officer and chief financial officer must certify the appropriateness of financial statements and represent accurately the financial condition of the entity.10 Sarbanes-Oxley also stipulates that the CEO, CFO, controller, and chief accounting officer should not have worked for the firm conducting the entity’s annual audit during the year preceding the audit.11
Although these provisions are not now binding for nonprofit organizations, these entities must nonetheless be conscientious about the integrity of their financial statements. Nonprofit organizations with gross receipts in excess of $25,000 are required to file Form 990, 990-EZ or 990-PF, and all nonprofits are advised to complete it.12 Many states additionally require organizations to register and file annual reports with the state in order to solicit funds.
Form 990 and the annual report typically must be signed by an officer of the organization who too often does not understand the statement or verify its accuracy. To ensure accountability, officers must take responsibility for fully understanding the financial information and verifying its accuracy. Ultimately, the board of directors has a fiduciary responsibility for approving the reports that are the basis for the information provided on Form 990 and the annual reports, and both the officers and the board of directors may be held responsible for false or inaccurate information.
Insider transactions and conflicts of interest
Sarbanes-Oxley prohibits loans to any directors or executives of a for-profit entity.13 While this prohibition is not currently applicable to nonprofit organizations, they too must be cautious of private benefit and self-dealing; these indiscretions could cause an organization to lose its tax-exempt status and subject both the entity and individuals to excise taxes. The Internal Revenue Service takes a firm stance on such practices: do not engage in them. In fact, the Internal Revenue Service recommends that nonprofit organizations develop and enforce policies regarding conflicts of interest.
Under the provisions of Sarbanes-Oxley, organizations must disclose internal control mechanisms, corrections to financial statements, adjustments to balance sheets, and material changes in operations or financial situations.14 The strict disclosure requirements do not yet apply to nonprofit organizations, but they indicate the importance of portraying financial conditions accurately.
Since Form 990 is a public document and must be provided to any person or entity who requests a copy,15 it is in a nonprofit organization’s best interest to attend to it conscientiously. Funding generated from public sources and individual donations could be jeopardized by misrepresentation of the organization’s financial condition in Form 990. Questionable financial practices not only threaten charitable giving, but they can also cause permanent damage to a nonprofit organization’s public image and thereby undermine its charitable activities.
Protection for whistle-blowers, documents
Protection for whistle-blowers and criminal penalties for retaliation against whistle-blowers stipulated by Sarbanes-Oxley extend to nonprofits.16 Nonprofits can comply with these requirements by adopting and publicizing confidential, anonymous formal processes to address complaints and by stressing that individuals will not be punished for reporting problems, however unfounded they might be.
Prohibitions against intentional destruction of litigation-related documents also apply to nonprofits. Criminal penalties exist for the altering, covering up, falsifying, or destroying any document to prevent its use in an official proceeding such as a federal investigation or bankruptcy proceeding. Liability also extends to individuals who persuade others to destroy documents.17
In order to comply with regulations concerning documents, nonprofit organizations need to retain appropriate records regarding their operations. Although the task is daunting for any type of organization, nonprofit entities are advised to develop written document retention policies that provide for the retention and periodic destruction of documents. Requirements vary depending on the type of document, so nonprofit organizations should seek the advice of an attorney when developing document policies.
Some analysts foresee complete application of Sarbanes-Oxley to nonprofit organizations. While their predictions have not yet materialized, nonprofit organizations would be wise to begin adopting measures to protect themselves from the appearance of impropriety. By responding to the concerns raised in the Sarbanes-Oxley legislation, nonprofit organizations can begin to reexamine their practices to ensure that they do not become the next centerpiece corporate scandal.
|By Sarah E. Gohl Isabel, Esq. and Timothy B. Phillips, Esq. with Troutman Sanders LLP. Sarah and Tim work extensively with nonprofit organizations from basic formation to com-plex joint venture arrangements. They can be reached via email at email@example.com or firstname.lastname@example.org.
1 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).
2 Drexel University, Drexel Trustees Adopt the Sarbanes-Oxley Act on Governance and Auditing Practices, Feb. 26, 2003. Press release available at http://www.drexel.edu/dateline/default.pl.
3 S. 4836A, 2003 Leg. Sess. (N.Y. 2003).
4 Sarbanes-Oxley Act § 301.
5 Sarbanes-Oxley Act § 301.
6 Id. at § 407(a).
7 Id. at § 203.
8 Id. at § 201(a).
9 Id. at § 202.
10 Id. at § 302(a).
11 Id. at § 206.
12 I.R.C. § 6033; Treas. Reg. § 1.6033-2(a); Instr. to Form 990.
13 Sarbanes-Oxley Act § 402.
14 Id. at § 401.
15 I.R.C. § 6104.
16 Sarbanes-Oxley Act § 301.
17 Id. at 802.