A report on Sarbanes-Oxley and Nonprofit Organizations


The Sarbanes-Oxley Act (SOX) was created in 2002 after various accounting scandals came to light and led to a decline in investors' trust and confidence. A need for stronger regulations became necessary; SOX was created to help rebuild the trust. The regulations of SOX helps create a higher ethical responsibility of individuals, strengthens companies' governance, and requires stronger internal controls within a company (Alexander, Young, Weiner, & Hearld, 2008). Originally SOX was created for publicly traded entities and was not required for nonprofit organizations. However, in recent years the question has risen; Should nonprofit organization be held to the same standards as public companies? (Seaman, 2006)

The United States contains over one million nonprofit organizations which, in recent years, have reported revenues of over $1.5 trillion. Some nonprofit organizations, like public companies for example, have drifted from an ethical and moral path by participating in accounting manipulations and scandals. A few of the highly publicized accounting scandals in the nonprofit sector include organizations such as the Red Cross, The United Way, and the Nature Conservancy. This led to public dismay of the overall weakness and lax governance of nonprofits (Mead, 2008).

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A SOX reform article, located on EBSCOhost database, stated that over 90 percent of households donate to charities and make contributions (including time and money) to nonprofit organizations. The accounting scandals at the nonprofit level have created a poor public image making Americans believe that nonprofit organizations are corrupt or poorly managed (Mead, 2008). This negative image has caused a decline in donor confidence in nonprofit organizations resulting in an overall diminishing desire to commit time or money to these organizations.

Most donors, who are the investors in nonprofit organizations, are driven more by the overall mission and "do good" of the organization rather than the promise of profit, which is the expectation of investors in publicly traded companies. Donations are an act of volunteerism and when individuals perceive the nonprofit organization as untrustworthy or irresponsible with funds, the donors will pull away via lack of continued financial support. The deterioration of trust and confidence in nonprofit organizations as a result of the accounting scandals has created a need for reform (Seaman, 2006).

Donors to nonprofit organizations expect their donations to be used wisely and for their intended purpose. When donations to charities are wasted or misused it can be extremely damaging as the individual donors perception is that of being taken advantage of when the they were trying to do something good (Seaman, 2006). The recent misuse and manipulation of nonprofit organizations donations has led to steps being taken to improve accountability.

The passing of SOX legislation was originally created to regulate and hold accountable, publicly traded companies; it was not intended or required for nonprofit organizations; however, recent events have led to reconsideration. Since 2004, the U.S. Congress has held committee hearings to discuss whether Sarbanes-Oxley should be expanded to incorporate nonprofit and other tax-exempt organizations (Seaman, 2006). This debate about making Sarbanes-Oxley mandatory for nonprofit organization has driven some nonprofits to take steps towards complying with the legislation on their own.

The Sarbanes-Oxley Act is broken into different sections that help explain the necessary steps a company needs to take to successfully comply with the regulation. SOX requires that all financial statements are reliable, accurate, and contain full disclosure (SOX 302). This is certified in the auditors' opinion based on completion of SOX work as well as by formal management-officer approval before the release of financial statements.

The creation of an audit committee and general auditing requirements by independent auditors are also required to be in compliance with SOX. The creation and use of an audit committee is necessary "in proving oversight over and serving as a check and balance on a company's financial reporting system" (SEC Standards Relating to Listed Company Auditing Requirements, 68 Fed. Reg. at 18,789). An audit committee should consist of non-management trustees, with at least one trustee being a "financial expert." The oversight provided by the audit committee includes the institutions' accounting and audit practices, financial reporting, and compliance functions (Mattie, 2004).

Sarbanes-Oxley has included the need for public companies and nonprofit organizations complying with the legislation to maintain overall independence as a company (or organization) as well as between auditors. "Specifically, Sarbanes-Oxley tightens regulation of outside auditors, while at the same time seeking to bolster their independence from company management by, for example, restricting the non-audit services they may perform" (Dreier, 2005). These basic requirements of SOX are helping to eliminate the issue of mismanagement which previously led to accounting sandals. Further discussion about the sections of Sarbanes-Oxley will be discussed later in the paper.

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Protection for "whistleblowers" as well as the creation of "whistleblower" hotline programs has helped public companies obtain information regarding unethical behaviors or misconduct within a company. Many nonprofit organizations are following suit by implementing their own "whistleblower" hotlines to assist them in learning about unethical behavior (Seaman, 2006).

Implementation of Sarbanes-Oxley has proven to be successful for many publicly traded entities. However as the debate between mandating SOX for nonprofit entities continues, many argue that the overall costs and effort to comply outweigh the benefits. The article "What Works Best" discusses that SOX implementation does "soak-up" resources (money and time) and additional effort is needed to comply. However, the results of complying can help reveal a company or organizations need to re-engineer certain processes. Re-engineering can help streamline business operations, therefore save the company resources down the line. In most situations the implementation costs are offset by the benefits (Seaman, 2006). Initially the costs associated to implementation of SOX can be a burden, but the results of understanding the weaknesses of internal controls and being able to improve the organization can significantly outweigh any costs.

Positive and Negative aspects of SOX for Nonprofit Organizations, including Universities

Many challenges arise when trying to apply SOX to nonprofit organizations like universities. Unlike publicly traded companies the business processes and decision making involved with a university are drastically different. These differences make it challenging to effectively apply all aspects of Sarbanes-Oxley to a university. "The culture of many universities, which encourages highly decentralized decision making in the academic sphere, may be difficult to align fully with the Sarbanes-Oxley culture, which emphasizes top-down accountability" (Dreier, 2005). The need for a nonprofit specific version of SOX that is tailored to fit these types of the organizations would be necessary to assist in assuring the relevance and benefits of implementation.

Currently, nonprofit organizations that have opted to voluntarily comply with SOX, or the "spirit" of SOX, have experienced both the ups and downs of implementation. Substantial, and much needed, alterations to business practices and the exposure of a need to improve operations is one positive yet potentially costly result of compliance. On the other hand, Universities that have chosen to voluntarily comply have experienced a rise in overall credibility and respect through the increase of transparency and accountability due to SOX implementation. As donors become more confident and feel the university is reliable, the ability to recruit higher-quality board members and improve overall business practices continues to have a favorable effect on donor retention (Jackson & Fogarty, 2006).

Some critics argue that many nonprofit organizations and universities already have good internal controls in place without additional help from SOX. Organizations that have higher annual budgets tend to also have more procedures and controls, including whistleblower procedures and audit committees that include a financial expert (Williams, 2006).

These controls (whistleblower and audit committees) that are already in practice in many nonprofit organizations as well as the application of various other Sarbanes-Oxley principles continue to help improve donor confidence. Critical to the success of any nonprofit organization, the trust of benefactors, who provide vital financial resources, must be safeguarded.

"Sarbanes-Oxley, or any attempt at better governance, won't solve all problems, but it may lead to faster recognition and a better resolution" (Logue, 2007). Resolving issues and moving away from traditional neglect from nonprofit organizations continues to help improve the publics' image and faithfulness in nonprofits (Mulligan, 2007). In addition to creating stronger governance and polices, proper reprimand and punishments must be instilled to hold executives and board members responsible for their actions. Possible criminal penalties and monetary fines give executives amply warning of the consequences of unethical behavior. By creating these punitive penalties for a lack of ethical behavior, extra motivation is provided to individuals to stay on track, make appropriate decisions, and to act at the highest moral level (Jackson & Fogarty, 2006).

Future of Sarbanes-Oxley for Nonprofit Organizations

SOX influence has impacted higher education and other nonprofit organizations and has been determined to be considered the "best practice" (Dreier, 2005). Sarbanes-Oxley has helped public companies, and now many nonprofit organizations, to achieve higher accountability, responsibility, and transparency, which is why they will want to continue its success in the future (Mattie, 2004). Thanks to this success for nonprofits, implementing aspects of SOX has now become standard practice. In the upcoming years they will continue to implement it "as if it was part of routine business procedures to improve operations" (Hrywna 2006). The main focus for a base-line execution will continue to be about creating and improving a company's code of ethics, conflict of interest policy, and audit committee.

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Although a lot of nonprofit organizations already have a code of ethics and conflict of interest policy in place, the priority is to improve upon them to reflect the spirit of SOX. And along with that, making sure the audit committee is separate from the finance committee should be a major priority as well. According to Adam Shuster, the VP of finance and administration of Easter Seals of Massachusetts says, "Having a [separate] audit committee lets them sleep better" just knowing that there is another body looking over financial statements and asking necessary questions (Hrywna 2006).

The next big push for nonprofit organizations is going to be executing a successful whistle-blower policy, as discussed earlier, as well as setting up provisions on document destruction. These two steps are now the main provisions of SOX that are specified for nonprofits. The whistleblower policy has been the main priority of nonprofits, however in need of equal attention, SOX has now made it a federal crime to "destroy, alter, or falsify any document, including audit records, to prevent its use in an official proceeding such as a federal investigation or bankruptcy proceeding" (Gere 2005). So companies will be creating provisions to make sure this does not happen, and as more nonprofits begin to have audits, these provisions will be strictly overseen and checked regularly.

Another change that may be seen in the future of nonprofits will be compliance with the dreaded Section 404 of the Sarbanes Oxley Act. Section 404 requires an internal control report to be completed with the annual financial statements that; 1) states that management is responsible for establishing and maintaining an adequate internal control structure and procedure; and 2) must contain an assessment of the effectiveness of this internal control structure and procedure (SEC 2002). This section is so feared because it has become a huge expense for for-profit organizations whose cost-benefit ratio still hasn't been proven to those who are required to comply. Currently, this section is only required for publicly traded for-profit companies, but that is not to say it may not be required for all nonprofits in the future as well. To decrease what dramatic impact that could have on nonprofits, it is advised that companies start in small stages to satisfy the requirements. Small steps such as implementing software with segregation of duties or establishing a way that provides some sort of audit trail capabilities would be a smart start.

A lot of the future for nonprofit organizations dealing with SOX compliance relies on state legislations; California has been the most prevalent in passing legislation for this, but many other states are following suit. States including Connecticut, Kansas, Massachusetts, and New Hampshire now mandate that certain charities file audited financial statements with the state agency, and most states are trying to do the same (Gere 2005). According to Steve Hermes, the director of assurance services at an accounting firm in California, this is a good thing for the success of nonprofit organizations that states mandate this. He says, "Most nonprofits say an audit is a cost they would do without because they'd rather spend the money on programs, but by having audited statements, 'it gives you credibility to the public,' and potentially more contributions" (Hrywna 2006). Other state governance that is going to be widespread in the coming future involves specific standards being established for both conflict-of-interest and a boards conduct for related-party transactions and loans, as well as an increase in state's attorney general's oversight of all nonprofit organizations (Gere 2005).

A lot of the changes we will see in the future for nonprofits will mostly be improvement-based. They will continue the successful implementations that have already begun and progress into further compliance with the spirit of SOX. However the major overhauls we can expect to see will be coming from the state attorney general and legislation that will be passed. Whether SOX will prove to be a successful addition to for-profits and nonprofits alike is still to be determined, but regardless, it is here to stay.