Why Should a Nonprofit Organization Consider Forming An Audit Committee?

Why Should a Nonprofit Organization Consider Forming An Audit Committee?

“It is imperative that audit committees develop strong organization ethics programs that clearly communicate expected behavior, promote candor with management, and require immediate attention to issues.”

- Wayne Berson, CEO, BDO USA, LLP

Many nonprofit organizations have formed audit committees in response to the Sarbanes-Oxley Act (the Act), and certain states require an audit committee if the organization solicits charitable donations. In addition, the Internal Revenue Service (IRS) now asks on the Federal Form 990 if an organization has an audit committee. Although not a requirement, this is noted as a best practice by the IRS, and if an organization does not have one, it has to answer “no” on the 990 which is a public document. Potential funders and others can see that it does not have an audit committee and can compare this to other organizations which raises the question about why an organization is not following a suggested best practice. The American Institute of Certified Public Accountants’ (AICPA) Audit Committee Toolkit: Not-for-Profit Organizations, 2nd Edition1 lists numerous reasons as to why a nonprofit organization should consider forming an audit committee, including providing better: financial results; decision-making in terms of accuracy and quality of financial reporting; ability to build stronger relationships with stakeholders; as well as facilitating transitions in leadership.

The NAC, an advisory group to the FASB, has made recommendations on changes to accounting rules that would improve reporting by nonprofit organizations so that they can better report and explain their financial picture to donors and other interested parties. The key recommendations that the NAC has put before FASB include:

  • Revisit the current net asset classifications to determine if there are ways that they could be relabeled or redefined to better portray liquidity on the statement of financial position and related notes.
  • Improve the statements of activities and cash flows to make them clearer so that the reader can understand the financial performance of the organization.
  • Create a framework for nonprofit organizations to provide commentary and analysis about the organization’s financial health and operations so that the readers receive the context behind the financial story. This would be similar to the “Management Discussion and Analysis” provided by publicly traded companies.
  • Streamline nonprofit specific disclosure requirements to improve their relevance and clarity.

Some of these recommendations relate to current FASB projects while others would require new projects be undertaken to address these issues.

First, let’s consider the application of U.S. Generally Accepted Accounting Principles (GAAP). While the debate over the appropriateness of one set of financial accounting standards used by organizations of all sizes and complexities has been going on for years, there is growing sentiment within the U.S. in support of a separate, stand-alone set of accounting standards for U.S. private organizations and nonprofit organizations alike. In October 2009, the Not-for-Profit Advisory Committee (NAC) was established to serve as a standing resource for the Financial Accounting Standards Board (FASB) in obtaining input from the nonprofit sector on existing guidance, current and proposed technical agenda projects, and longer-term issues affecting nonprofit organizations. In December 2009, a Blue Ribbon Panel charged with making recommendations on the future of standard setting for private organizations was launched by the AICPA and the Financial Accounting Foundation (FAF – the parent organization of the FASB. The Blue Ribbon Panel issued its report in January 2011, concluding that there are urgent and growing systemic issues that need to be addressed in the U.S. accounting standard setting system. While some stakeholders had suggested that the Blue Ribbon Panel’s work include nonprofit organizations, as well, the panel limited its work to private for-profit entities. The panel has acknowledged that many nonprofit organizations have a much broader and somewhat different set of users of their GAAP financial statements, either directly or indirectly, than do many private companies. The nonprofit organizations have to complete the Federal Form 990 which is public information. When there are federal funds involved, the GAAP financial statements are made part of the public information as well. Even though the current work of the panel does not include nonprofit organizations, those charged with governance should be aware of these issues and keep up to date on the status of the discussions of the potential shift in the accounting and disclosure models.

Second, let’s consider the inroads International Financial Reporting Standards (IFRS) are beginning to make on private organizations. In 2008, the AICPA recognized the International Accounting Standards Board (IASB) as an official standard-setter and thus, U.S. auditors are now permitted to issue opinions on private company financial statements filed using IFRS, as recognized by the IASB. More recently, in July 2009, the IASB published a 230-page condensed version of IFRS for small and medium-sized entities: IFRS for SMEs. The IASB defines SMEs as businesses that publish general-purpose financial statements for external users and do not have public accountability. IFRS for SMEs was developed for private companies and their financial statement users as a simplification to full IFRS. This did not address what the impact would be on nonprofit organizations. It is likely that there will be some customization of IFRS or IFRS for SMEs that would be utilized as a separate set of standards for nonprofit organizations. It should be an interesting next few years as this develops and it is determined what set of accounting rules will be followed.

Given this increased activity aimed at “simplification” of accounting standards for private companies and nonprofit organizations, encompassing both U.S. GAAP and international standards, it is easy to understand how having a focused oversight function by means of an audit committee in place to ensure that an entity’s decision-makers are remaining abreast of developments in financial reporting may be critical.

Finally, it’s all in the eye of the beholder. Consider perceptions of corporate governance and the potential effects on transactions involving a nonprofit organization. Simply, nonprofit organizations that are perceived to have solid governance structures and practices are looked upon more favorably than those that are not.

BDO Insight

Nonprofit organizations can benefit greatly from the assistance, guidance and oversight an audit committee can provide. Thus, absent specific requirements to maintain an audit committee, we encourage management and boards to weigh the benefits and costs of establishing audit committees within their organizations. In doing so, we recommend a thorough reading of this and other related guidance to understand what the decision to form and run an effective audit committee really means to the organization. An organization with an established governance body becomes even more attractive to potential donors.

GO BACK: Effective Audit Committee Guide

(1) Refer to the AICPA’s Audit Committee Toolkit: Not-for-Profit Organizations, 2nd Edition available for purchase at: https://www.aicpa-cima.com/home