Clarifying Responsibilities of Audit Committee Members

California CPA magazine: May 2008

By David W. Tate, CPA, Esq.

To  satisfy their responsibilities and sleep well at night—nonprofit audit committee members need to be knowledgeable about their responsibilities. If you already serve, or are asked to serve on a nonprofit audit committee, do you know your responsibilities?

Committee responsibilities are generally spelled out in the California Nonprofit Integrity Act, the California Corporations Code (the business judgment standard), and, indirectly, in auditing pronouncements independent auditors are required to follow. From there, committee members must use their best judgment and diligence in meeting the requirement.

The California Nonprofit Integrity Act
The California Nonprofit Integrity Act  details the requirements nonprofit entities must meet; one of which is having an audit committee. The audit committee and related provisions apply to specified charitable corporations, unincorporated associations  and trustees that receive or accrue in any  fiscal year gross revenues of $2 million or more (exclusive of grants from, and contracts for services with, governmental entities for which the government requires an accounting of the funds received).

The Act also requires these nonprofits to have annual financial statements that are in accordance with generally accepted accounting principles and audited by an independent CPA. The California Office of the Attorney General has stated that the audited financial statements and notes to the statements must be released to the public.

Further, the board of directors must appoint the audit committee. Committee members may include people who are not members of the board, but may not include any of the nonprofit’s staff members.

The audit committee must be separate from the finance committee, if the nonprofit has one. Members of the finance committee may serve on the audit committee, but the chair of the audit committee may not be a member of the finance committee, and finance committee members must constitute less than half of the audit committee’s membership.

The attorney general’s office also has stated that there is no set number of members the audit committee must have. In theory, one member may be sufficient. However, in practice, three to five members generally allow for a sufficient variety of input without creating a committee that is too cumbersome.

The Act provides that audit committee members cannot receive any compensation from the charity in excess of the compensation, if any, received by board members, and may not have a material financial interest in any entity doing business with the charity.

The Act also provides that:

•    Subject to the supervision of the board, the audit committee shall recommend to the board the retention and termination of the outside auditor, and may negotiate the outside auditor’s compensation, on  behalf of the board; and

•     The audit committee shall confer  with the outside auditor to satisfy its members that the financial affairs of  the charity are in order, and shall determine whether to accept the  audit, ensure that any non-audit  services performed by the auditing  firm conform with standards for auditor independence and approve performance of non-audit services by the auditing firm.

The Business Judgment Standard
When it comes to information sources, the law is a bit more detailed, codifying a director’s entitlement to rely on the following people, who, the law implies, presumably know what they’re talking about:
•    Corporation officers or employees.

•    Counsel and independent accountants.

•    A committee of the board on which the director does not serve.

Once all the information is in, according to the statute, “the director acts in good faith, after reasonable inquiry when the need therefore is indicated by the circumstances and without knowledge that would cause such reliance to be unwarranted.”

For nonprofit religious corporations, Code Sec. 9241 contains similar language, but not identical conduct requirements.

Thus, the business judgment standard for a board member of a nonprofit requires the director, including a board member who serves as an audit committee member, to perform duties loyally, in good faith, without self interest, in a manner that the director believes to be in the best interests of the entity, and with the care, including reasonable inquiry, as an ordinary prudent person in a like position would use under similar circumstances.

Directors, having a duty to be proactive, may not close their eyes to what is going on with respect to the conduct of the entity’s business and finances. “In a like position … under similar circumstances” refers to the situation that exists at that time, including the individual director’s knowledge, experience and expertise.
Thus, cases have held that a director with specific expertise may be held to a higher standard and will be expected to use that expertise. In relying upon the opinion or reports of others, the director also must act in good faith, conduct reasonable inquiry and be free of any knowledge that would cause reliance upon data and reports received from others to be unwarranted.

Nonprofit directors should be mindful that they are susceptible to being second-guessed, such as by actual and potential donors, taxing authorities, employees and third-party individuals who have been injured, and, in rare circumstances, the state attorney general. Although this usually does not result in liability exposure in the nonprofit setting, it can when the issues relate to tax withholding or payment, employment/employee issues including discrimination and harassment, pension matters, and personal injury claims. 

The most likely penalty for having made a significantly erroneous decision, or from an omission to take action, is negative community publicity, lack of prestige and a resulting reduction in donations to the charity. Therefore, as the business judgment standard requires, nonprofit audit committee members should act only in the interest of the nonprofit, be knowledgeable about their responsibilities as an audit committee member and diligently perform those responsibilities to the best of his or her abilities.

The Nonprofit Integrity Act does not  regulate the standard of conduct that  applies to nonprofit audit committee  members and other nonprofit directors.  Those standards are broadly stated in the California Corporations Code.

Code Sec. 5231 (for nonprofit public benefit corporations) and Sec. 7231 (for nonprofit mutual benefit corporations) allows for some discretion, but requires directors to behave “in the best interests of the corporation and with such care … as an ordinarily prudent person in a like situation would use under similar circumstances.”

Auditing Pronouncements
Auditing pronouncements also, at least indirectly, require audit committee members to oversee the details of the nonprofit’s accounting and financial internal control functions, and to be prepared to respond to inquiries by, and communications from, the outside auditor. For example, applicable auditing standards may at least include the following Statements on Auditing Standards:

•     SAS 54 (illegal acts by clients);
•     SAS 99 (consideration of fraud in a financial statement);
•     SAS 100 (interim financial information);
•     SAS 109 (understanding the entity and its environment and assessing the risks of material misstatement);
•     SAS 112 (communicating internal control related matters identified in an audit); and
•     SAS 114 (the auditor’s communication with those charged with governance).

Additionally, a nonprofit that receives government source funding also may be subject to the enhanced OMB A-133, single audit, Yellow Book, auditing requirements.

It is beyond the scope of this article to discuss auditing pronouncements, audit processes and requirements, and the audit committee’s specific oversight of those matters. However, CPAs are uniquely educated and trained to understand, or become more familiar with, the technical aspects of the audit, the auditing standards and internal controls. It is that ability which makes CPAs valuable to serve as audit committee members.

Practical Comments and Conclusion
The Nonprofit Integrity Act and the business judgment standard state broad mandatory responsibilities of audit committee members. From that point forward, audit committee members best help the nonprofit and fulfill their function by being knowledgeable about their responsibilities and the activities of the nonprofit, as well as diligent in their inquiry and oversight of the significant accounting and audit functions.

Those significant accounting and auditing functions include (at a minimum):

1.     Retention and termination of the outside auditor;
2.     Consideration of the outside auditor’s independence;
3.     Oversight of the non-audit services performed, if any, by the outside auditor;
4.     Oversight of the audit planning and annual audit by the outside auditor;
5.     Review of the annual audit, the accounting and financial affairs, and the internal controls with the outside auditor;
6.     Consideration of whether to recommend that the board accept the annual audit;
7.     Oversight of the accounting and financial internal controls;
8.     Oversight of the accounting function, including staffing, qualifications and tone at the top; and
9.     Oversight of the (anonymous) whistle-blower process for accounting matters.

One final thought: there is no requirement that a nonprofit audit committee have a charter, though I recommend one be approved by the board to help create a common understanding about the activities that the audit committee will and will not perform.

Education and experience make CPAs uniquely qualified and valuable to serve  as nonprofit audit committee members.  But audit committee members also need  to be knowledgeable about their functions  and responsibilities.

Armed with this information, you will be better prepared to serve on a nonprofit audit committee, help the nonprofit ensure that its accounting function and annual audit are in order and satisfy your committee member functions and responsibilities.