The Ramifications of Fraud and How You Can Prevent it
Welcome to part two of our article on nonprofit fraud. If you missed our first installment, you can read it here.
You’ve just become aware of a fraud that has occurred at a nonprofit in your community. As someone who cares about the community and the nonprofit sector, you start to wonder, “What is going to happen to that organization”?
While the ramifications can differ in each case, they probably will include some, if not all, of the following:
- The board and management will want to understand how the fraud happened, and what management is doing to prevent it from ever happening again.
- The community is going to look to the board for answers, and wonder why the organization didn’t have controls in place to prevent the fraud.
- Management will be expected to explain to the board where the breakdown in controls occurred that allowed the employee to steal from the organization.
- The board knows it has a fiduciary duty to oversee the organization and its internal controls and assets. They aren’t sure what they should have done differently, given that they’re volunteers doing this community service in addition to their “day jobs.”
- The board and management will want to reach out to donors to assure them that their contributions to the organization are going to be recovered if possible, and that controls are being improved to help safeguard future gifts.
This organization could potentially lose major donors if they believe there are not enough controls in place to ensure their dollars are being spent according to their wishes. If enough donors are negatively affected by this event and choose not to support the organization, its very survival may be at stake, thus impacting those in the community the entity serves.
Management will now have to divert time and other resources not only to implement stronger internal controls to help ensure this does not happen again, but also to reassure the board and the public that the organization is well protected to prevent future fraud.
Fraud can be extremely costly to an organization, not only from a financial perspective, as often the organization will not recover the stolen funds, but also from the loss of an organization’s reputation as a trusted charity. This can be even more devastating. The organization may never recover in the public’s eye, risking their relationships with not only their long-time donors but also new and future donors.
What can you do?
So, what can you do to help prevent fraud from recurring, or to detect it quickly if it does? Here is a simple, yet effective three-step process:
- Consider the risks of fraud and determine where it is more likely to occur.
- Look closely at the internal controls the organization currently has in place and determine whether they address these risks sufficiently.
- Identify gaps where controls are inadequate, and identify controls to be put in place where they are most needed.
Organizations can also consult their auditors to seek advice and guidance on how to implement these very important internal controls. It may be prudent to review previous audits to see if auditors have brought risks to management’s and the board’s attention, and if they provided recommendations on how to improve their current control structure.
The silver lining? The board and management now have a keener sense of the risks of fraud in the nonprofit environment, which should contribute to an engaged dialogue among the board, management and the auditors about how to develop and implement cost-effective controls that protect the organization’s assets.
As part of the audit, the auditors may point out one or more shortcomings in controls that they believe constitute a “material weakness.” While that may sound ominous, it merely means (in auditing jargon) a situation involving a reasonable possibility of a material misstatement of the financial statements. Auditors tend to set the bar low when it comes to classifying deficiencies that create fraud risks as material weaknesses, for the simple fact that users of the financial statements (donors, lenders, other funders) tend to have a lower materiality threshold with respect to misstatements caused by theft.
It is also important to remember that control deficiencies noted in previous audits that may not have been considered material weaknesses in the past may be considered that way today, as expectations of management’s actions regarding fraud prevention and detection go up every time a nonprofit fraud incident hits the media.
Every organization that has more than one person (including board members) associated with it has the opportunity to segregate incompatible duties at some level to help protect assets. At times, organizations don’t have such segregation in place, but instead have implemented compensating controls, such as detailed review of monthly financial statements by the appropriate level of management and/or the board. If this is the case, the organization should ask itself the following questions in order to avoid over-relying on this compensating control:
- How does this compensating control work? Who reviews the financials, what is their experience level, and how do they document their review to confirm that it’s being done?
- How often do you question expenditures, and are these questions and their answers evaluated and documented? It is important to remember here that a fraudster would be working hard to escape detection by this compensating control.
- If the compensating control is a detailed review compared to budget:
- Who is involved in building the budget?
- What are the controls that would protect against a fraudster building their theft into budgeted expense line items?
Take a proactive fraud risk assessment and response like the one described here to give you reasonable comfort proper controls are in place to prevent and/or detect fraud. This isn’t about being paranoid – it’s simply a matter of prudently carrying out your fiduciary and management responsibilities to protect the organization you feel so strongly about.
Remember, the one characteristic that every financial theft in history shares—someone was trusted at some point.
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