Welcome to Research Friday! As part of a continuing series, we invite a nonprofit scholar, student, or professional to highlight current research reports or studies and discuss how they can inform and improve day-to-day nonprofit practice.

It is not often that public policy intended for the publicly traded-corporate world directly impacts the nonprofit corporate world. So … when the Sarbanes-Oxley Act (SOX) was adopted by Congress in 2002, there just wasn’t much history to help nonprofits understand its impact – on them. A decade has now gone by, and, according to research by Tamara G. Nezhina of DePaul University and Jeffrey L. Brudney of Cleveland State University, a base for the future has been identified from this short period of history. Their study reviewed literature about the effect of SOX on nonprofits as well as surveys and other basic research implemented by the authors. The result of their work? The identification of intended – and unintended – outcomes that had both positive and negative impacts on nonprofits.

The goal of the Sarbanes-Oxley Act was to curb financial abuses among publicly-traded corporations. Further, it was intended to enhance transparency, which, for the nonprofit sector, is an imperative. Are these goals being achieved? And, at what price?

Two of several requirements were binding upon most corporations and nonprofits. These require policies covering whistle-blower protections and document preservation. However, Independent Sector and BoardSource recommend that nonprofits voluntarily incorporate certain other provisions of the Act that make good governance sense.1

Table 1: SOX Provisions Relevant to Nonprofit Organizations2

According to this very interesting and detailed research report, for-profit corporations anticipated that compliance with SOX would provide them a number of benefits: increased understanding, effectiveness and communication of business processes; revelation of internal control weaknesses potentially damaging to the corporation; more effective risk management; reduced fraud; and increased effectiveness of the board.3 On the other hand, the authors anticipated similar benefits for nonprofit organizations that adopted SOX recommendations (See Table 1) and subsequently revised financial procedures and internal controls. What did these studies find? The following are some highlights of the findings – and the overall impact.

Governance: “These studies found that greater board independence increased the governance costs for for-profit firms.”4 Board members of for-profit corporations are usually compensated for their service, thus these costs increased due to heavier expectations of duties – and thus of time – required of governing board members. These increased responsibilities and legal liabilities also increased insurance premiums for corporations and a variety of other costs.

Conversely, nonprofit board members typically do not receive compensation. Thus, material costs related to achieving greater board independence, such as those indicated above, are not experienced. However, some board members may demur from service due to the increased time commitment, responsibility, and legal liability.

Audit: SOX shifted the responsibility to hire, fire, and compensate the external auditor from staff to the board’s audit committee, which significantly increased the time and responsibility of those serving on this committee – either for-profit or nonprofit. For those nonprofits electing to establish audit committees with SOX requirements, indirect costs for that service increased and the authors suggest that it could be more difficult for nonprofits to attract people to board membership due to increased time and liability.5

Financial Controls: The most significant costs related to SOX compliance relate to the review of internal controls and further reviews by external auditors. Many for-profit corporations have experienced significant cost increases based upon documentation of processes, improved financial security systems – and the higher fees for external review.6 Similarly, nonprofits following these same processes would also incur higher costs due to increased audit fees and the potential need for additional staff.7

Impact: About half of those nonprofit organizations included in the random sample for this study adopted at least some of the SOX provisions, in addition to the two required ones. They reported:

• Better financial controls (27.3%)
• Reduced risk of accounting fraud (24.3%)
• Enhanced board effectiveness (21.1%)
• Increased fees for external audits (36.5%)
• Reallocation of resources from program to administrative expenses (14.8%)
• Increased financial training costs (13.8%)8

The overall result is that this research suggests that although compliance with SOX may increase operational costs for nonprofits, there are some gains: more private donations and government contracts (although at a slower rate than anticipated), and, for many, financial management improvements.

Are the primary purposes of SOX being achieved in nonprofit organizations? It appears from this study that internal controls, solid audit procedures and enhanced board effectiveness are occurring, thus lessening the risk of fraud. It also appears that increased transparency is a positive outcome.

But the authors share their concern about the unintended consequences of increased costs and decreased resources for programs. In their words, “Our findings highlight the effects of SOX – nonbinding legislation to nonprofit sector organizations – on board operations, financial risk management, audit fees, and ultimately mission attainment. We encourage greater attention to the unintended effects of public policies on nonprofit organizations by the practice and research communities.”9

I suggest the transparency and increased board effectiveness that is occurring resulting from SOX is a significant positive consequence of SOX. But it also reminds me that we – nonprofit organizations and their boards – need to be fully aware of public policy activity, participating in its development so as to minimize unintended consequences.


Patricia Lewis' role as Sr. Professional-in-Residence at the Lodestar Center is to help bridge academia and practice. She has a long career as a nonprofit executive and as a "pracademic," having previously served as President and CEO of the Association of Fundraising Professionals, Executive Director of Camp Fire Boys and Girls in Seattle-King County, Development Director of the Childrens' Home Society of Washington State, and as the Nonprofit Professional-in-Residence at George Mason University. She has written and lectured throughout the world about various leadership and management topics for the nonprofit sector.

Sources:

• Colorblindness: Implications for Youth Services
• Recruiting New Board Members? Here’s how our geographically-focused nonprofit does it!