Maintaining sufficient internal controls is important for all organizations, but it’s an area that’s particularly important for nonprofit organizations in the arts and culture industry.
As mission-focused organizations responsible for managing public and donor funds, embracing appropriate segregation of duties is vital. Added to this is the fact that nonprofit organizations are particularly vulnerable to fraud. One report from the Association of Certified Fraud Examiners found that nearly half of all nonprofit fraud cases occurred due to a lack of internal controls or an override of existing controls.
Of course, many nonprofit organizations do already have well-defined internal controls. But even when this is the case, it’s not uncommon for auditors to find small issues which should be addressed. Best practices change over time as new technologies and processes emerge. Failure to continuously improve internal processes can have severe consequences. In the worst-case scenarios, nonprofits can be the victim of fraud, lose critical funding and suffer lasting reputational damage.
With such high stakes, it’s important for every organization in the arts and culture space to embrace best practices for internal governance. Regardless of the size of the organization, implementing and maintaining a clear segregation of duties is an important step in ensuring that the nonprofit can continue to advance its mission.
The concept of segregation of duties is a fairly straightforward one. In a nutshell, segregation of duties is having multiple people complete important processes.
These important processes are often financial tasks, such as paying invoices or reconciling bank transactions. Below is a hypothetical example of segregation of duties functioning correctly at a nonprofit:
A nonprofit receives an invoice from a vendor for $500. The employee who receives this invoice enters it into the nonprofit’s accounting system but mistakenly inputs the invoice as a $5,000 invoice, rather than $500.
The invoice is routed to another employee responsible for reviewing and approving invoices. Upon review, this employee realizes their colleague’s error and re-routes the invoice back to them, thus preventing the nonprofit from overpaying the invoice.
While this sounds like a simple process, it’s a proven safeguard against both innocent errors as well as more nefarious fraudulent behavior.
In a nonprofit organization, the internal policies that govern segregation of duties tend to be set by financial and operational leaders, including CFOs and COOs. These processes are typically ratified by Executive Directors, CEOs, and Board Members and are scrutinized routinely as part of the external audit process.
As we noted earlier, the concept of segregation of duties applies to every nonprofit––regardless of size. And while nonprofits are not required to have internal controls as sophisticated as those public companies are required to have, there’s no reason not to aspire to similar internal governance standards.
Development departments play a crucial role in all arts and culture nonprofits––talking to donors and soliciting funds that enable the nonprofit to invest in program activities. However, there is often a disconnect between development teams and their colleagues in accounting.
One scenario: during a capital campaign, a donor makes a conditional agreement to invest $1 million to open a new gallery, provided the nonprofit independently raises another $1 million. The development department records a $1 million contribution, not accounting for the fact that this is conditional and should not yet be recognized as revenue.
With the correct segregation of duties, the accounting department reviews this contribution and corrects this mischaracterization. Without segregation of duties, the contribution would go unchecked, potentially leaving the nonprofit with a financial shortfall if they fail to meet the donor’s conditions.
Many nonprofits––even large ones with significant endowments––lack the staffing levels required to adopt sufficient segregation of duties. However, with the right approach, it’s possible to overcome these challenges.
Many mid-sized nonprofit organizations leverage their board members to enable more comprehensive internal controls. Invoices over a certain amount may be directed to the Board Treasurer to approve, or the Financial Committee may review bank statements on a monthly basis to verify there are no irregularities.
Establishing an ongoing relationship with a specialized nonprofit accounting firm exposes nonprofits to the latest best practices from across the industry.
Many nonprofits in the arts and culture space may be required to work with an auditor on an annual basis. Any nonprofit organization that expends $750,000 or more of federal funding annually is required to undertake a Single Audit performed by external auditors that assesses the organization’s internal controls, including segregation of duties.
At Smith + Howard, our audit team has extensive experience conducting these types of engagements. In the majority of instances, we encounter few serious internal controls issues. Nonprofit leaders charged with governance will receive a letter outlining these issues and recommendations to address them.
A comprehensive internal controls infrastructure is a vital step in ensuring that any nonprofit organization acts as a responsible steward of public and donor funds.
Clearly defined segregation of duties not only minimizes the prevalence of accounting errors, it dramatically diminishes the chances of fraud. By taking steps to avoid incidences of either material financial errors or misappropriation of funds, nonprofit organizations are insuring themselves against reputational, legal, and financial damages––all of which could jeopardize the organization’s ability to fulfill its mission.
Effectively defining and maintaining segregation of duties in a nonprofit organization can be challenging, which is why it’s important to seek the support of an experienced arts and culture nonprofit accounting firm.
At Smith + Howard, our nonprofit accounting team has significant experience both in conducting internal control audits and in providing advisory services to organizations aiming to improve their internal governance. With over fifty years of experience in the nonprofit space and a track record of serving hundreds of nonprofits across the nation, our team has true expertise in the realm of nonprofit financial controls.
To learn more about how Smith + Howard can support you in improving segregation of duties in your nonprofit organization, contact an advisor today.
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