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Children's Voice Article, July/August, 2004

Better Governance for Nonprofits
Translating the Lessons of Enron and Sarbanes-Oxley

The Enron bankruptcy and other recent corporate financial scandals have resulted in a new federal law designed to increase corporate accountability, rebuild public trust, and restore investor confidence. Although the focus has been on public companies, attention is turning toward nonprofit organizations as well. The New York Times recently reported that several states have tightened regulation of charitable activities.

Nonprofit executives who want to stay ahead of the curve should understand the new corporate regulations and consider how the spirit behind those rules--desire for increased transparency, accountability, and a more ethical culture--can be translated and applied to nonprofit governance and management.

The Sarbanes-Oxley Act

Named for its primary sponsors, U.S. Senator Paul Sarbanes (D-MD) and Representative Michael Oxley (R-OH), the Sarbanes-Oxley Act (SOX) was approved by a nearly unanimous vote of Congress and signed by President Bush in July 2002.

SOX improves the accountability of key players in the financial reporting process, from management to boards of directors to external auditors. With few exceptions, these requirements apply only to publicly traded companies. Key provisions include:

Audit committee. Corporate boards must establish an independent, competent audit committee comprising members of the company's board of directors; they must not receive compensation from the company for anything other than board service.

Companies must disclose whether their audit committee includes at least one "financial expert" who has experience as a public accountant, auditor, or principal accounting officer. If an audit committee does not include a financial expert, the company must explain why. The audit committee hires the auditor and oversees the auditor's work.

Auditor responsibilities. Because one of the principal goals of SOX is ensuring auditor independence, accounting firms are prohibited from providing certain nonaudit services--bookkeeping, financial information systems, appraisal, actuarial, internal audit outsourcing, management or human resources, investment, and legal and expert services--to their audit clients. The audit committee must preapprove other nonaudit services, such as tax preparation and advice.

The lead audit partner must rotate every five years. To lessen the potential for conflicts, a company's chief executive officer (CEO), chief financial office (CFO), or controller cannot have worked for the auditing firm within the previous year.

Certified financial statements. The CEO and CFO must certify the accuracy of the company's financial statements.

Other financial disclosures. SOX requires companies to review and disclose management's assessment of the effectiveness of the company's internal controls, and requires other new disclosures designed to give investors a more complete picture of the company's financial condition.

Insider transactions and conflicts of interest. SOX strictly forbids companies from making personal loans to any director or executive officer. In a direct response to one of the problems that surfaced with the collapse of Enron, companies must disclose whether they have developed a code of ethics applicable to their senior financial officers and any changes to or waivers of that code.

Whistle-blower protections. SOX requires companies' audit committees to establish procedures for receiving confidential, anonymous submissions from employees regarding concerns about the company's accounting matters, and it protects employees of public companies who provide evidence of fraud. Companies may not take adverse employment actions against such employees based on their whistle-blowing; employees may challenge any such adverse action by initiating an admin- istrative proceeding before the U.S. Department of Labor.

Document destruction. SOX criminalizes the destruction or alteration of certain records of auditors and lengthens the time auditors must retain documentation of their audit work and related records. Certain of these provisions apply to all corporations, includ-ing nonprofits.

Why Should Nonprofits Pay Attention?

SOX was prompted by a series of spectacular failures of some of the nation's biggest companies--most notably Enron and WorldCom. Reflecting this background, most of SOX applies only to publicly traded companies and is based on a Fortune 500 model. Thus, some of the law's provisions cannot be strictly applied in the nonprofit context; others, like detailed internal control testing and reporting by management and audit of that testing, simply are not feasible for most nonprofits.

At the same time, recent legislative developments in several states suggest that attention is now turning toward charitable activities. In February 2004, California State Senator Byron Sher (D) introduced the Nonprofit Integrity Act of 2004. Sponsored by California Attorney General Bill Lockyer, the bill would expand reporting and disclosure requirements for charities, establish new audit requirements, and increase board accountability for fundraising relationships.

On his website, Lockyer says, "By providing more accurate, detailed, and useful information about nonprofits' finances, independent audits will enhance the ability of governing boards and the Attorney General's Office to assess charities' operations and flag potential problems."

Similar bills designed to extend SOX-like standards to the nonprofit sector are pending in New York and Massachusetts, and the IRS recently announced that it is considering comparable rules for tax-exempt organizations.

Nonprofit executives need to be aware of this trend toward increased regulation and consider how elements of SOX might be translated into best practices for nonprofit governance. Proactive organizations that have voluntarily worked to improve financial management and increase accountability will certainly be better prepared should they face later scrutiny from federal or state regulatory agencies.

Thanks to the media attention around Enron and SOX, issues of financial mismanagement are on many radar screens. Other nonprofit constituents, including corporate directors, members, funders, and donors, will begin to expect more-sophisticated financial management.

At this time of poor investment performance and funding shortfalls, it's more important than ever for nonprofits to increase public confidence and trust by renewing their commitment to be ethical, accountable, and transparent in corporate governance and financial reporting.

Contributied by CWLA General Counsel Cynthia Seymour.

What Should Nonprofits Do Now?

Proactive nonprofit executives should explore the following ideas:
  • Establish an independent audit committee that includes at least one board member with financial skills.

  • Train all board members in financial literacy.

  • Adopt a policy prohibiting loans to executives, and scrutinize other insider transactions.

  • Adopt or update a conflict of interest policy for board and staff.

  • Adopt measures to ensure that IRS Form 990 (Return of Organization Exempt from Income Tax) and other financial statements are prepared accurately and completely and filed in a timely fashion.

  • Establish or enhance policies and procedures to receive employee complaints and prevent retaliation.

  • Adopt or update a written document retention policy.

  • Consider adopting a code of ethics for directors and staff.

  • Keep an eye on legislative developments in your state, and watch for proposals to increase nonprofit accountability.

  • Consider other ways to enhance nonprofit governance. Daniel Kurtz, a non-profit expert in New York, has suggested that specific requirements of SOX have limited applicability for nonprofits and that the real lessons of SOX for non-profits should be about searching for ways to enhance governance. He offers several suggestions for increasing nonprofit efficiency and effectiveness:
    • Right-size the board. Consider whether your board has too many directors to make effective decisions and whether reducing board size--via such avenues as making some honorary directors or assigning some to serve on advisory groups--might increase the quality and effectiveness of decisionmaking.

    • Manage the flow of information to the board to ensure that board members' limited time can be devoted to significant decisionmaking and oversight.

    • Consider the issue of director independence in the nonprofit context. Kurtz suggests that in the nonprofit world, independence could be compromised by financial and nonfinancial considerations, including social and funding relationships and the desire to maintain collegiality.

Other Resources

Text of the Sarbanes-Oxley Act of 2002 (Public Law 107-204, 15 U.S.C. 7201)
Available online at www.pcaobus.org.

The Sarbanes-Oxley Act and Implications for Nonprofit Organizations
Available from BoardSource at www.boardsource.org and Independent Sector at www.IndependentSector.org.

Responding to the Sarbanes-Oxley Act of 2002: The Financial Reporting Practices of Nonprofits,
by Patrice Heinz
Available from the Alliance for Children and Families at www.alliance1.org.

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