Internal auditors are actively involved in volunteer organizations. Many serve as treasurers, on governing boards, and on finance, audit, and accounting committees of churches, civic agencies, and other Not-for-Profits (NFPs). They may have a professional role as well.

Effective systems of internal control are as essential to volunteer organizations as they are to business entities, yet the issue ranks low on the priority list of most NFP groups. Indeed it is often a sensitive issue. As a result, internal auditors who serve in such organizations have a special and essential role to play. Because internal auditors routinely deal with the examination and evaluation of systems of internal control, they can offer valuable knowledge and experience that can help volunteer organizations strengthen their governance practices and directors exercise due diligence.

THE STATE OF CONTROL

Many civic organizations or local chapters of large organizations can be quite small, with most of the oversight responsibility delegated to one individual, who usually has little, if any, training in business administration.

The need for effective governance is no less important in volunteer, NFP organizations than in profit organizations. NFPs often receive public funding and have a responsibility for care of these funds. The values held by volunteer NFPs may make them more subject to victimization. The structure of NFPs can contribute to their vulnerability. Many civic organizations or local chapters of large organizations can be quite small, with most of the oversight responsibility delegated to one individual, who usually has little, if any, training in business administration. Segregation of duties becomes difficult because of the limited number of personnel available to the NFP (either as staff or as volunteers). Some not-for-profits use volunteers to provide accounting and administrative functions. The level of the volunteer’s expertise has a significant impact on the effectiveness of the NFP’s internal controls. Lacking the proper training and awareness of issues affecting the financial operations can compromise the organization’s internal controls, and thus increase the risk of fraud. To compound the issue further, in some cases, volunteer boards lack an understanding of the financial and regulatory sides of the NFP’s operation. When and if the inexperienced board members review the financial data, they might not call into question information that is pivotal to identifying problem conditions. Consequently, board selection is an important issue that is often overlooked. Often, the board of directors consists of individuals committed to the beliefs of the organization, but who have little or no business aptitude.

The level of internal control often found in NFPs is illustrated by a 1990’s study that examined U.S. churches. Pastors at 1,200 churches received a questionnaire asking whether 40 basic internal controls were actually in place and operating. Although the study is based on churches, the results are equally applicable to most types of volunteer organizations.

The respondents indicated that some controls are in place, but many of the most important are missing. Approximately 70 percent of respondents stated that they had the recommended controls in place, and 90 percent said they maintain at least 10 of the 40 recommended control procedures. Yet 15 of the 40 were absent in more than 50 percent of the responding churches. Important steps such as limiting the financial secretary’s duties, establishing an audit committee, putting accounting procedures in writing, and requiring the finance committee to review supporting documentation for purchases were among the missing controls. A finding of great concern is that 70 percent of the churches didn’t have monthly bank reconciliations prepared by someone who wasn’t involved in the check writing process.

The study also reveals that the size of an organization makes a difference in the level of control. In general, the recommended control procedures were more common in larger churches than in smaller organizations.

BOARD EVOLUTION

Michael Burns, a board consultant, provided the following summary of board evolution. Each stage presents its own challenges. He noted that not all NFPs necessarily make these changes – some organizations recognize their niche and are effective as relatively small organizations.

Organizations at the “infancy” level, which may have few or no staff, usually have boards that are operationally focused. The board does the operational planning and board members are often key volunteers in implementing the plans. Boards in this stage develop few if any policies and evaluation programs are usually event- or activity-focused. Generally, NFPs at this stage lack resources for segregation of duties and are highly trusting of individuals.

Once an organization has grown to a certain level, the demands of keeping in touch with donors, issuing receipts, and performing regular administrative duties require paid staff. Boards in this “juvenile” stage of development often have a few staff who are focused on performing administrative tasks which board members are no longer prepared to do. Board interest in operations is reduced, and the board begins to examine the governance needs of the organization.

At the “adolescent” stage of board development, the NFP’s administration develops greater independence from the board. Staff have developed a deep understanding of the organization because of regular contact with members, financial sponsors and other interested parties. This understanding often leads to more vocal expression of opinions and ideas about how the organization should be run. At times, staff may undertake actions contrary to board direction. As staff assumes more control over daily functions, some board members may feel squeezed out and uncomfortable with the governance-focused role they now must take. It is also a time when internal conflicts among board members may occur as the board finds a balance between over-managing operational aspects and removing themselves from operations entirely. Finding this balance is critically important to the volunteer directors, as outlined in the “Volunteer Director Responsibility” section below.

If an organization makes it through the task of hammering out parameters for staff and board actions, it enters the “mature” stage of development. In this stage, staff are focused on operations and the board centers its efforts on the governance needs of the organization and its long-term goals. Still, each organization may be at a different place on the continuum, with some groups placing more directive power in the hands of staff and others reserving it for boards alone.

Although these stages appear as a linear progression, Burns notes that it is often necessary, and not always a setback, for organizations to move back to different stages, depending on their needs at the time. A mature organization that undergoes a major growth period – such as a capital campaign – may revert back to an operationally focused board (the juvenile stage) for the campaign period and pay only minimal attention to broader governance issues during that time. After the campaign, it will shift back into governance mode, often changing many board members at the same time.

VOLUNTEER DIRECTOR RESPONSIBILITY

Director duties/responsibility

Directors have a responsibility to ensure their “Nonprofit organizations carry out their activities through their officers, directors, staff and volunteers. The board of directors is accountable to ensure, among other things, that the organization carries out its mandate and does so in accordance with the law.”

Changing legal issues

Charitable and nonprofit organizations are facing a wide variety of legal issues. Sometimes, these issues are of the organization’s own making through inadvertence, negligence or misunderstanding, and they may, as a result, be involved in legal proceedings they could have avoided. In other situations, the law has changed affecting organizations that do not always know about the changes. A lack of knowledge can have serious and negative effects. For example, the enactment of lobbyist registration legislation in Ontario had significant impacts on charitable and nonprofit organizations.

Directors are accountable

Nonprofit organizations carry out their activities through their officers, directors, staff and volunteers. Sometimes the level of accountability and the due diligence expected of the members of the board of directors is very high, exposing the directors to potential personal liability for damages and to prosecution. The members of the board of directors are also where much of the action takes place – action that provides benefits to communities through charitable activities

All directors, whether of charitable or business corporations, in carrying out their functions must achieve a “standard of care.” In general, that standard of care for directors of charitable corporations is a subjective one, rather than objective. The subjective standard requires that a director exercise the degree of skill that may reasonably be expected from a person of his or her knowledge and experience. Under this subjective test, a lawyer or accountant would usually need to achieve a higher level of care than a person without similar training. By contrast, directors of business corporations under modern corporate legislation must meet an objective standard of care, i.e., exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

Standard of Care

In a 1999 case, the Canadian Federal Court of Appeal reviewed the issue of the standard of care for directors. This issue was important because directors could escape liability for unpaid taxes if they could demonstrate that they exercised the degree of care, diligence and skill that a reasonably prudent person would have exercised in comparable circumstances. The Justices found that the standard of care was not less rigorous for a director of a nonprofit corporation than for a director of a corporation run for profit and found the directors responsible for the unpaid amounts. The directors, said the Court, ought to have taken additional steps, such as setting up controls to account for remittances, asking for regular reports from the manager on the ongoing use of such controls and ensuring at regular intervals that the remittances have taken place. “It was not sufficient for the directors to delegate their authority, especially where there was clear evidence of repeated omissions and failures on the manager’s part. The delegation amounted to nothing less than abdication.”

The Court noted that:

As sad as it may be, especially with respect to respondents who acted as benevolent directors and gave their time, it is simply
not possible to find that they have exercised the degree of care and diligence expected to prevent a failure to withhold and
remit when such known failure was allowed to repeat itself uninterruptedly for one year. . . .

Duties similar to those of trustees

The common law has also established other duties for directors that are fiduciary in nature. These fiduciary duties require directors to act with a reasonable degree of prudence, to be diligent, to act in good faith and with honesty and loyally, and to avoid conflicts of interest. In the case of directors of charitable corporations, the duties have been described as being akin to those of trustees.

Charitable and nonprofit organizations operate in the community. There are other statutory and common law obligations and duties that arise from this reality. For example, if the organization has employees, then the directors may have liability for unpaid wages, vacation pay and source deductions. Similarly, if the organization owns property, it will be required to comply with the laws that are applicable to other property owners, including planning law, environmental protection and so forth. The directors have responsibilities and potential for liability under a wide spectrum of statutes. Depending upon the activities of the organization, the potential for liability is substantial.

AUDITOR GUIDANCE

As stated earlier, internal auditors can offer valuable knowledge and experience that can help volunteer organizations strengthen their governance practices and directors exercise due diligence. We have a body of knowledge that allows us to provide professional guidance to establish a control environment, a wealth of experience in risk management to focus the control practices and knowledge of proven framework for evaluation.

Referring to SAS No. 55, Consideration of Internal Control in a Financial Statement Audit (AICPA, Professional Standards, vol. 1, AU sec. 319):
The control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the following:

a. Integrity and ethical values
b. Commitment to competence
c. Board of directors committee participation
d. Management’s philosophy and operating style
e. Organizational structure
f. Assignment of authority and responsibility
g. Human resource policies and practices

Ways for NFP management to strengthen controls

To help strengthen internal control, NFPs may find these measures effective.

1. Financially competent board members should perform complete reviews, on a regular basis, of budget and operating results and immediately follow up on questionable situations.
2. The Board should:
   1. Confirm the NFP’s mission.
   2. Develop a basic statement of director duties and responsibilities.
   3. Provide director orientation.
   4. Create appropriate independent committees and establish a charter for each.
   5. Assure provision of timely and sufficient information.
3. At least one board member should be the check signer of all significant NFP expenditures.
4. Board members, managers, volunteers, and others must provide disclosures of any related-party issues involving their affiliation or knowledge of affiliations with the NFP.
5. A proper tone at the top should be maintained. If employees, managers, and volunteers witness the board and the executives bending the rules, for whatever reason, all other rules are subject to bending as well.
6. Since an adequate segregation is not often practical, the periodic redoing of the work of subordinates by supervisors may be used as a compensating control.
7. Properly prepared reconciliations should be completed to quickly highlight differences resulting from errors and other problems, including wrongdoing.

References:
Dale L. Flesher and John B. Duncan “Control in volunteer organizations,” Internal Auditor, December 1999. “Board Structure”, Canadian FundRaiser, July – 1997 (Based on remarks by Michael Burns at the conference of the Canadian Council for the Advancement of Education (CCAE) in Fredericton, NB.)

Don Bourgeois, “Potential for director’s liability substantial”, Canadian FundRaiser, August 1999.

Don Bourgeois, “Directors’ failure to meet the standard of care will result in personal liability”, Canadian FundRaiser, October 1999.

Lori A. West, “Not-for-Profits Often Suffer from Weak Controls” ViewPoint, AICPA Accounting and Auditing Publications, August 2004.

Karen Sandrick, “Avoiding conflict of interest. How boards can withstand close scrutiny. Trustee: The Journal For Hospital Governing Boards, July-August 2003.

M. W. Peregrine and James R. Schwartz, “Taking the prudent path. Best practices for not-for-profit boards.” Trustee: The Journal For Hospital Governing Boards, November-December 2003.