Friday, June 22, 2012 - 8:55am

 

posted by
Pat Lewis,
Senior Professional
in Residence
ASU Lodestar Center


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

  • Conflict of interest policy
  • Whistle-blower protection policy*
  • Document preservation policy*
  • Annual (or biannual) external audit
  • Audit partner rotation after 5-7 years
  • Separation of audit and non-audit services
  • Audit committee of board
  • Dual leadership (defined as the position of board chair and CEO held by different persons)
  • Executive sessions held by board
  • Independent board members
  • Basic financial training for board members
  • Basic financial training for executive director
  • CEO formal certification of the accuracy of financial documents
  • Open public access to financial statements
  • Open public access to audit reports

*The whistle-blower protection policy and the document preservation policy are mandatory provisions relevant to all types of corporations, private and for-profit.
Source: Adapted from Nezhina and Brudney, 2010

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:

1. Sarbanes-Oxley Act and Implications for Nonprofits (http://www.independentsector.org/sarbanes_oxley)
2. Nezhina, Brudney, Unintended? The Effects of Adoption of the Sarbanes-Oxley Act on Nonprofit Organizations. Nonprofit Management & Leadership, Case Western Reserve University, Vol. 22, Number 3, Spring 2012
3. CFO Research Services, Virsa Systems, PricewaterhouseCoopers LLP as reported in Nezhina, Brudney, Unintended? The Effects of Adoption of the Sarbanes-Oxley Act on Nonprofit Organizations. Nonprofit Management & Leadership, Case Western Reserve University, Vol. 22, Number 3, Spring 2012. Pg. 323
4. Nezhina, Brudney, Unintended? The Effects of Adoption of the Sarbanes-Oxley Act on Nonprofit Organizations. Nonprofit Management & Leadership, Case Western Reserve University, Vol. 22, Number 3, Spring 2012. Pg. 325
5. Vermeer, T., Raghunandan, K., and Forgione, D. The Composition of Non-Profit Audit Committees. Accounting Horizons, 2007, 20(1). Pgs. 75-90.
6. Nezhina, Brudney, Unintended? The Effects of Adoption of the Sarbanes-Oxley Act on Nonprofit Organizations. Nonprofit Management & Leadership, Case Western Reserve University, Vol. 22, Number 3, Spring 2012. Pg. 327
7. Ibid. pg. 327
8. Ibid. Pg. 339
9. Ibid. Pg. 340
 

 

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Comments

Whenever policies such as SOX are created and passed, it many times frustrates me that there are so many provisions. Based off of this article, it is clear through the research, that this policy has helped more than hurt. The issue is that this summary is a brief peek or insight to what this policy contains and so it's impossible to fully understadn SOX with out an in depth look at every provision and how it affects non and for profit organizations. There are possibly certain provisions that have had clear negative impacts, however, the research that shows the improvment in boards,solid audit procedures, etc seem promising. I do hope that the time in which it takes to make financial contracts with the government and private donations speed up.

Speaking to the original question about if the results of SOX demonstrated the effectiveness of the policies, I would have to say yes on multiple levels. Especially the improvements to financial transparency, which in turn helps curb financial abuse. But I also believe that the consequence of increased overhead due to financial training expenses, increased knowledgeability and commitment of board members, and taking the time to build and train others on the structure of internal/external controls can be seen as a positive tradeoff. Though the use of the 80/20 rule for programming/administrative spending has been used to measure the efficiency of nonprofit organizations for years, it's not always the best way to show how well an entity is operating internally. Many times, sacrificing overhead costs and not properly training staff/volunteers results in other costs like high turnover and loss of time having to recruit and train new personnel. This also reduces the stability of relationships and development of the organization as a whole. So to me, I think overall that SOX was more successful than originally intended and the nonprofit world doubly benefitted by gaining opportunities to adapt and modify their approach to managing financials.

Also, I really like your closing statement about the responsibility of both nonprofit organizations and boards to keep up to date on public policies changes so they can make adequate adjustments to their operations/business plans prior to the execution of those new mandates. In a way, not planning ahead for how new conditions may potentially affect nonprofit work is like heading out to tan at the beach for 5 hours and not bringing sunscreen or a hat. There's a chance you'll be all right if there's clouds or you find some shade, but you'll most likely get burned if you don't change your strategy.

Thank you for your sharing your post. It's great to see that something that was implemented as checks and balances for major for-profit corporations can carry on to assisting nonprofits in their attemp to keep things as transparent as posible. I also liked how you showed the impact of implementing SOX on the nonprofit sector.

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