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University of North Florida UNF Digital Commons

Accounting and Finance Faculty Publications Department of Accounting and Finance

1-2006

CPAs' Role in Fighting Fraud in Nonprofit Organization Andrea McNeal

Jeffrey E. Michelman University of North Florida, [email protected]

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Suggested Citation McNeal, Andrea and Michelman, Jeffrey E., "CPAs' Role in Fighting Fraud in Nonprofit Organization" (2006). Accounting and Finance Faculty Publications. Paper 8. http://digitalcommons.unf.edu/bacc_facpub/8

MA AGE M E T fra u d

CPAs' Role in Fighting Fraud in Nonprofit Organizations

By Andrea McNeal and j effrey Michelman

F raud in th e nonprofit sec tor ha been th e object of increas in g sc rutin y by th e U.S. Congress,

notably th e U.S. Senat e .... in ance Committee, a well a by ew York St ate Attorney General Eliot Spitzer. Recent studies indi- ca te that frauds occur in non - profits of all sizes and in every area of the counu'y with astound- ing frequency. Furthermore. the cost of the e fraud appears to be increa in g at an alarming rate (see Exhibit I ). With mall organization uffering the mo t ex treme losses from fraud and embezzlements, mall , co mmu- nity- based nonprofits mu st be e pec ially dili gent in enacting fraud prevention and detec tion meas ure s. Sp ec ifi ca lly , good board governan ce and internal co ntrol poli cies in these organi- za tion s are imperativ e to pre- ve nt or miti ga te th e nega ti ve impacts of fraudulent activity within the organization. Financial officer and CPAs advi in g no n profits al 0 ha ve a role to pl ay in facilitating and en uring effective internal controls.

Board Governance The implication of the Sarbane -Oxley

Act (SOA) for all organizations are far- rangi ng. T ypi ca ll y, th e boards of mall nonprofi t organizations tend to co mpri se a few vo lunteer community members th at kn ow each other well and ha ve es tab- Ii hed a l eve l of tru st and rapport. Additionally, non profi t boards freq uent- ly experience a high turnover of mem- ber , and individual that vo lunteer are

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often untrained or unqualified to proper- l y perfo rm the ove r si g ht function. Combined, these factors can re ult in a board that i unwilling or un abl e to a k the tou gh questions necessary to detect financial mi smanagement or fraud.

SOA req uires public companies to estab-

Ii h an independent audit committee with th e presence of at lea t one "financia l ex pert. " For nonprofits that undertake ex ternal audits, implementing this provi- sion represents an opportunity to enhance the overs ight function and strengthen the benefits received from the independent audit. Many mall non profits, however, lack the resources to conduct a full audit, and therefore do not need a fonnal audit

committee. The role of a CPA vo lunteer, even if

merely a an independent board member providing check-s igning oversight, may be critically impoltant in both substance and form. Small nonprofits should still con- sider retaining an independent accountant

to pelform a rev iew or compila- tion of th e entit y's f inan c i al record s to supplement any fraud detection activities. Furthermore, non profits that choose to forgo an ex ternal audit should at least establi h an independent finance committee to oversee the organi- zation 's financial employees and transaction .

Gi ve n th e hi gh turn over of board member and officers, a well as the vo lunteer nature of these position s. small nonprofits may ex peri ence difficulty find- in g vo luntee rs with adequate business and financial qualifica- tion . Furthermore, the turnover of the e indi viduals makes con- tinuity of oversight and fiscal ini- tiati ve more difficult.

onetheless, nonprofits hould attempt to engage "finan c i al ex pert ," or at lea t financially kno w ledgeabl e indi vidu al s, to serve on the finance co mmittee. Active in vo lvement of such indi - vi duals in the oversight function may provide additional scrutin y

and accountability for the financial offi- cer and employees and therefore aid in not only detecting, but also deterring, fraudulent activity. Although nonprofits may be stratifi ed into perhap three cat- egori e - those rece i ving no CPA ser- vices, those u ing CPA to comp lete a rev iew, and tho e u ing a CPA to com- plete a full audit - the ro le of the CPA remai n important in all three in tances.

JANUARY 2006 / THE CPA JOURNAL

Internal Control Issues Th e ci a ic fr aud tri ang le (Exhibit 2)

illu trates the three fac tor that are neces- sary fo r a fraud to occ ur : press ures o r incenti ves, rati onalization. and oppoltuni - ty. Although the convergence of these fac- to rs is what ult imate ly re ult in frauds, orga ni zati o ns ca n add ress the 0 ppOltunity co mpo ne nt , a nd thu s reduce the like li - hood of fra udulent acti vi ty, by establi shing adequate inte rn al contro ls.

Whil e every no nprofit faces its ow n set of co ntro l cha lle nges a nd weakn ess- es, sma ll community- based orga ni zati o ns h ave c h a rac te r is ti cs th a t m a ke th e m parti c ul a rl y uscepti ble to f ra ud . At the fo refro nt of the prob le mati c cha racte ri s- ti cs is the fac t th at th e e o rga ni za ti o ns a re no t o nl y ove rsee n , b ut ge ne ra ll y a lso run , o le ly o r la rge ly b y vo lun - teers. The indi viduals res po nsible fo r car- ry ing o ut exec uti ve and fin a nc ia l dutie ofte n ha ve se pa rate full -time j o bs and rece ive no co mpe nsati o n fo r ass umin g th e e additi o na l re po n ibiliti es. A s a result, the vo lunteers may not be as full y co mmitted to the ta ks at hand a they should be, and may therefore fa il to exer- c ise a n adequ ate leve l of ca re in pe r- formin g th e ir du tie . Additi o nall y, the e vo l unt ee rs m ay rece i ve littl e o r n o in struc ti o n o n the pro pe r pelfo rmance o f the ir res po ns ibiliti e .

These defic ie nc ies in dedi cation a nd trainin g can have di re conseq ue nces fo r an y o rga ni za ti o n, and ma ny good , hon- est vo lunteer may unknow in gly pelform th e ir duti es in co rrec tl y. Furth e rm o re, o me vo lunteers may neg li ge ntl y breeze

throu gh tas ks that deserve more attention, resulting in fi nanc ial losses o r admini s- trati ve diffi culties fo r the orga ni zati on. At the far end of the spectrum , un scrupulo us volunteers may ex pl o it these weakness- es to the ir ad va ntage, as exempli fie d in the First Coast Soccer Assoc iat io n case (di scus ed in Exhibit 3). Indi viduals look- ing fo r fra ud o ppOltuniti es w ill a lways choose orga ni zati o ns w ith the ex pl o itable co mbin a ti o n of hi g h po te nti a l rewa rd s and a poo rl y impl e me nted inte rn a l co n- trol tructure.

Because sma ll non profi t orga ni za ti ons re ly so heav il y on the integrity and a bil - ity of the ir vo lunteers, uc h e nti ties must o bta in bac kground check, both crimin a l and fin anc ia l, on all board me mbers and

JANUARY 2006 / THE CPA JOURNAL

EXHIBIT 1 Facts About Nonprofit Fraud

In a 2004 study of 508 occupational fraud cases*:

• 12.2% of the frauds occurred in the not-for-profit sector.

• The median loss of cases in not-for-profit organizations was $100,000, up from

$40,000 in a similar study in 2002.

• Billing schemes were the most frequent form of fraud in not-for-profit organi-

zations, accounting for 46.6% of the cases.

• 45.8% of the frauds occurred in organizations with fewer than 100 employees,

with a median loss of $98,000.

In a 2003 survey of more than 300 not-for-profit CEOs**:

• 62% said their board had not discussed the Sarbanes-Oxley Act.

• Only 20% indicated that their board had implemented any governance policy

changes as a result of the Sarbanes-Oxley Act.

• 77 % said they have a separate audit committee.

• Just 16% said they have a "whistle-blower" policy in place.

* Association of Certified Fraud Examiners, 2004 Report to the Nation on

Occupational Fraud and Abuse.

** Grant Thornton LLP, National Board Governance Survey for Not-far-Profit

Organizations (www.grantthornton.com).

EXHIBIT 2 The Fraud Triangle

Pressure/lncentive Pressure on employees to misappropriate cash or other organizational assets.

Rationalization Opportunity

Circumstances that allow an employe e to carry out the misappropriation of cash or other organizational assets.

A frame of mind or ethical character that allows employees to intentionally misappropriate cash or other organizational assets and justify their dishonest actions.

Sources: Occupational Fraud Abuse, by Joseph T. Wells, CPA, CFE (Obsidian Publishing Co., 1997);

Fraud Examination, by W. Steve Albrecht (Thomson South-Western Publishing, 2003).

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officer, or at least on anyone handling cash or other liquid asset. In many cases, mall nonprofits that have suffered at the

hands of fraud ters wou ld have uncovered previou s financial transgre sion s or pos- sibl e fraudu lent motivation s simply by conducting thorough background and ref- erence check on the perpetrators prior to hiring them.

Some organization may wish to go one tep further and obtain fidelity bond to

cover those volunteers that will handle cash. While fidelity bond coverage can mitigate financial losses suffered due to fraud , orga- nizations mu t be aware that mo t policies require the nonprofit to establish and main- tain sound accounting policies and proce- dures, and may refu e to pay indemnities if!hi requirement i not met Organization hould aI 0 con ider implementing a pro-

gram to provide a certain level of finan - cial-literacy education to board members and employee with financial re pon ibilities. Incorporating mandated training for indi-

Segregation of duties may be difficult in small organizations, but it is

especially crucial in combating embezzlement

and fraud when many transactions are

conducted in cash .

vidual with acce: to or oversight of the nonprofit' funds enhances the ability of the organization' volunteers to detect finan- cial mi management

In addition, mo t mall nonprofit are cash based, which can compound any i ues or weaknes es present in the control envi- ro nment. Marginally tempted employees may find the acces ibility of ca h too appealing and may engage in conduct that they otherwi e would not. Con equently, organization that receive much of their col-

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EXHIBIT 3 Case Study: First Coast Soccer Association

Over a period of 22 months, Karen Edenfield was able to steal more than

$80,000 from a community's children and their parents. As the volunteer treasurer

of a Jacksonville, Florida, youth soccer association, she managed the finances of

an organization that served more than 1,500 children and collected funds in

excess of $400,000 annually. In this role, Edenfield's stated responsibilities included

maintaining the records of the organization's funds, reconciling all of the associa-

tion's bank accounts, and paying the debts of the association in a timely manner.

During the last two years of her four years as treasurer, Edenfield wrote more

than 100 checks to herself, to cash, and to vendors for personal expenses.

Additionally, she set up a new "business" bank account for a fake company with

the same initials as a legitimate socce r association payee, in order to inconspicu-

ously siphon funds from the organization. She then transferred the money from

this account to her personal account

Like many other frauds, the start of this embezzlement was motivated by per-

sonal financial difficulties, resulting from the recent loss of her previous job and

her husband's previous businesses failures. A background check on Edenfield

would have revealed a history of financially questionable situations, including

numerous bad-check charges and a large tax lien levied against her husband

from a failed professional endeavor. However, the board of the association did not

undertake such an investigation. Furthermore, although Edenfield was required to

submit frequent budgetary and accounting reports to the assoc iation's finance

committee, the board members knew each other well and frequently exercised

only perfunctory oversight As a result, it took nearly two years for the board to

become suspicious enough to undertake a thorough examination of the organiza-

tion's finances .

Once under investigation, Edenfield admitted to the thefts, although the full

amount was never determined, due in large part to the organization's poorly kept

financial records. Additionally, Edenfield told the authorities that the association's

president had suggested that she make use of the organization's funds, and had

showed her how to do so without drawing attention. Very shortly after Edenfield's

sentencing, the president was charged with embezzling $5,000.

Discussions with board members revealed that the occurrence and duration of

the fraudulent activity were facilitated by a systemic failure in the board gover-

nance process, due to two primary factors. First, parents, particularly those serv-

ing as board members, were often afraid to ask pointed questions for fear of a

retaliatory effect on their child's soccer playing time. Second, cash payments to

many of the volunteers for the ir "service" had become an accepted form of prac-

tice within the organization.

JANUARY 2006 / THE CPA JOURNAL

lections and pay many vendors in cash need control in place to verify and oversee the cash recei pt and di sbursement .

egregation of duties may be difficult in small organizations, but it is especially cru- cial in combating embezzlement and fraud when many tran actions are conducted in cash. If nothing else, the duties of handling and reconciling fund hould al way be egregated, with one party re pon ible for

approving di bursements, another for phys- ically receiving and distributing fund, and a thi rd for receiv ing bank statements and performing the cash and bank reconcilia- tion . Furthermore, checks should never be igned in advance, and spec ial authoriza-

tion. such a dual signatures on checks, should be required for cash di bursement over a certai n dollar amount. While such controls may not prevent a determined fraudster. they decrease the opportunity for di honest individual to embezzle the orga- nization' s fund s, and may therefore deter many improprieties. Accordingly. organ i- zations mu t emphasize the importance of ad herence to uch control to emp loyee and board members. both during training and throughout their tenure.

Responsibilities of the Accounting Profession

Accounting profes ional s are in a unique position to help small nonprofits fight fraud (see Exhibit 4). Their ro le is threefold: • A community member s. CPA

• Volunteer to be treasurer.

hould get invol ved with the organiza- tion s they patronize and upport. By attending board mee tin g. becoming familiar with the organization's policie . and a king tough que tion s of those in charge, they can bring an outside ource of accountability to the individual responsib le for the organization' opera- tion s and finances. • B y vo lunteer in g to se rve as board member for small nonprofits. CPA ca n provide so me much - needed financial expertise to the board governance f un c- tion , and ca n faci litate the implementa- tion of proper governance and internal cont ro l policies throughout the organ i - zation. • e PAs hould give back to the nonprofit

ctor by acti ng in their professional capac- ity. They can offer to perform pro bono or reduced -fee as urance engagements, or volunteer their time and proficiency to pro- vide financial literacy and internal control traini ng to the organization' board mem- bers and emp loyee .

Andr ea McNeal, MAcc , CPA , is an accounting writer /e ditor with th e Association of Certified Fraud £mminers ill Austill, Texas. J effrey Michelmall, PhD, CPA , CMA , is an associate professor of accoullting and information systems at th e Ulliversity of North Florida ill Jacksoll ville, Fla .

EXHIBIT 4 ePAs' Role in Good Board Governance

• Volunteer to chair the finance committee .

• Make sure that the organization has purchased adequate directors' and officers' insurance.

• Require fidelity bonding for individuals handling cash.

• Require background checks on all employees handling cash or working with children .

• Help identify high -risk areas of the organization.

• Volunteer to perform pro bono or reduced-fee audits, reviews, or bookkeeping services.

• Volunteer to provide financial literacy and internal control training to the organization's board members and employees.

• Become involved in hiring full-time staff as appropriate, particularly those employees involved in the finance function .

JANUARY 2006 / THE CPA JOURNAL 63

  • University of North Florida
  • UNF Digital Commons
    • 1-2006
  • CPAs' Role in Fighting Fraud in Nonprofit Organization
    • Andrea McNeal
    • Jeffrey E. Michelman
      • Suggested Citation
  • Title
  • Board Governance
  • Internal Control Issues
  • EXHIBIT 1 Facts About Nonprofit Fraud
  • EXHIBIT 2 The Fraud Triangle
  • EXHIBIT 3 Case Study: First Coast Soccer Association
  • Responsibilities of the Accounting Profession
  • EXHIBIT 4 CPAs' Role in Good Board Governance