The Control Environment in a NFP

The Sarbanes Oxley Act (“SOX”) has brought a great deal of attention to internal controls in public companies.  SOX was passed in 2002 after corporate scandals such as Enron and Tyco.  The heart of SOX provides protection to investors’ funds by mandating a system of  internal controls for public companies. SOX places the responsibility of maintaining a system of internal controls squarely on the shoulders of the Board of Directors and its Audit Committee. Over the intervening years, most astute observers of the accounting and finance arenas would say SOX helped plug a large hole in corporate responsibility.

Unfortunately, this same level of attention to internal controls is often not seen at not-for-profit (“NFP”) entities.  Boards of directors or trustees are  not as diligent as they are when serving on  a public company board. There are many reasons for this.  Some of these are:

1. There are no investors per se and no personal investments in a NFP.  A donor often makes a charitable donation and often does not even think about the NFP until the next time a donation is required.
2. Some NFP organizations have members that elect a board of directors.  Some do not.  When there are no members, the directors nominate replacements for themselves. A level of organizational oversight is eliminated of necessity in NFPs without members.
3. Board members in NFPs are usually not paid, so their NFP board service becomes less of a priority.  They are usually very part-time directors at best.
4. State law can exacerbate the lack of director oversight. Many corporate bylaws provide a corporate director can be forced to give up their seat if they continually miss meeting. The board has a “hammer” to force participation. That is not always the case in a NFP. For instance, in New Jersey, a director of a charitable organization cannot be removed for missing meetings.  A person elected to a NFP board may never show up to another meeting for the rest of his term and face no real consequence for their lack of participation. A board member who is derelict in their fiduciary duty is bad enough in itself.  He also creates havoc with board quorums and unanimous consent resolutions, further weakening board oversight.
5. Smaller organizations may have difficulty attracting high caliber board members.

The list could go on and on but I think you already have the idea.

Good internal controls start at the top of the organization and should permeate down through the entire organization. A board attentive to internal controls sets the tone from the top.  This is called the control environment. The control environment is the foundation on which all internal control can be built   A good control environment makes the entire organization sensitive to the need for internal controls. Employees of the NFP will adhere to the required internal controls instead of ignoring them or finding work-arounds.  It is extremely difficult to establish a good control environment in an organization with very part time directors.  The lack of a good control environment is often compounded by a lack of segregation of duties in small organizations and the attention of the executive director to other, seemingly more pressing matters.  Nevertheless, it is a critical part of the board of directors function to make sure there is a functioning system of internal controls at their organization. A small investment of time by the directors can prevent embarrassing news such as embezzlements further down the line.