NFPA Textbook - Not-for-Profit Accounting - PDF

Not-for-Profit Accounting Version 2.0 David Annand Copyright © 2021 Athabasca University. All rights reserved. No part of this publication may be reproduced, distributed, stored, or transmitted in any form or by any means, including photocopying, recording, or other electronic or mechanical methods, without prior written permission of the copyright holder, except in the case of brief quotations for the purpose of critical reviews and certain other non- commercial uses permitted by copyright law. For permission requests, contact the copyright holder at the address below. Athabasca University Faculty of Business 201, 13220 St. Albert Trail NW Edmonton, Alberta, Canada T5L 4W1 Tel: 780-561-4650 Fax: 780-561-4550 Faculty of Business website: https://business.athabascau.ca/ Some of this material has been adapted from content originally published by CPA Canada. It is used with permission. ii Contents CHAPTER 1: Introduction to Not-for-Profit Organizations Learning Objectives....................................................................................... 1 A. Not-for-Profit Organizations in Canada........................................................ 2 The Process of Incorporation...................................................................... 3 Differences Between Registered Charities and Other NFPOs........................... 4 B. Financial Reporting Obligations.................................................................. 5 General Purpose Financial Statements......................................................... 6 Program- or Project-Specific Financial Statements........................................ 6 Internal Management Financial Statements.................................................. 6 Tax-Related Financial Reporting Obligations................................................. 6 External Accountant Involvement with Financial Information.......................... 7 Other Legislated Reporting Requirements.................................................... 8 C. Ethics and the Professional Accountant in the NFPO Sector.......................... 10 Competence, Truthfulness, and Reliability................................................. 10 Summary of Learning Objectives................................................................... 12 Concept Self-check...................................................................................... 14 Problems.................................................................................................... 15 CHAPTER 2: Governance Learning Objectives..................................................................................... 17 A. Overview of NFPO Governance................................................................. 18 B. Organizational Structure of NFPOs............................................................ 19 Members............................................................................................... 19 Board of Directors.................................................................................. 20 Executive Director.................................................................................. 21 Employees............................................................................................ 21 Service Volunteers................................................................................. 21 C. Board Policies........................................................................................ 22 Framework Policies................................................................................. 22 Board Self-Governance Policies................................................................ 23 Board and Staff Relation Policies.............................................................. 25 Operational Policies................................................................................ 26 Communications, Advocacy, and Public Relations Policies............................ 26 Tailoring Governance Policies to the Organization....................................... 27 D. Ethics................................................................................................... 27 E. Internal Controls.................................................................................... 28 Entity-Wide Controls............................................................................... 28 Specific Controls.................................................................................... 30 F. Budgets................................................................................................ 32 G. The Role of the External Auditor............................................................... 33 Reporting Obligations to the Board........................................................... 33 Reporting Obligations to Management....................................................... 34 Summary of Learning Objectives................................................................... 35 iii Concept Self-check...................................................................................... 37 Problems.................................................................................................... 39 CHAPTER 3: NFPO Financial Statement Concepts Learning Objectives..................................................................................... 43 A. Information Needs of NFPO Financial Statement Users................................ 44 Financial Statement Preparation............................................................... 44 Accounting Standards............................................................................. 45 The Users of Financial Statements............................................................ 45 The Objectives of NFPO Financial Statements............................................. 46 B. NFPO Financial Statements and Accounting Standards................................. 47 Applying the Accrual Basis of Accounting................................................... 48 Types of Contributions to an NFPO............................................................ 50 Accounting for Contributions and Capital Assets......................................... 51 Summary of Learning Objectives................................................................... 56 Concept Self-check...................................................................................... 58 Problems.................................................................................................... 62 CHAPTER 4: Fund Accounting Learning Objective....................................................................................... 67 A. Deferral and Restricted Fund Methods of Revenue Recognition..................... 68 Fund Accounting.................................................................................... 68 The Deferral Method of Revenue Recognition............................................. 72 Accounts Receivable............................................................................... 76 Restricted Contributions: Amortizable Capital Assets................................... 77 The Deferral Method and Amortization of Tangible Capital Assets.................. 83 Restricted Contributions: Land................................................................. 84 Restricted Contributions: Endowments...................................................... 85 Effects of Different Terms of Restricted Contributions: Deferral Method......... 89 Restricted Contributions to Pay Down Debt................................................ 90 Combining the Deferral Method with the Restricted Fund Method.................. 91 Summary of Learning Objective..................................................................... 92 Concept Self-check...................................................................................... 93 Problems.................................................................................................... 95 CHAPTER 5: Relevant Information for Decision Making Learning Objectives................................................................................... 105 A. Various Ways to Analyze Costs............................................................... 106 Direct and Indirect Costs....................................................................... 107 Cost Behaviours................................................................................... 109 B. Cost-Volume-Profit Relationships............................................................ 112 Segment Margin Analysis...................................................................... 115 C. Relevant Revenues and Costs................................................................ 117 Incremental Revenue Opportunities........................................................ 119 Special Orders..................................................................................... 121 iv Outsourcing Decisions........................................................................... 122 Maximizing Net Revenue Under Capacity Constraints................................ 123 Capital Asset Acquisition Decisions......................................................... 124 Conclusion.......................................................................................... 126 Summary of Learning Objectives................................................................. 127 Concept Self-check.................................................................................... 128 Problems.................................................................................................. 133 CHAPTER 6: Budgeting Learning Objectives................................................................................... 141 A. Performance Measures in NFPOs............................................................ 142 Measuring Performance Against Goals and Objectives............................... 142 Who Determines the Measurement Criteria?............................................ 143 B. Budgets as a Means of Measuring Performance........................................ 144 Authority for Spending.......................................................................... 145 Internal Control................................................................................... 145 Evaluation of Performance..................................................................... 145 C. Types of Budgets................................................................................. 145 The Traditional Budgeting Process.......................................................... 146 Alternative Budgeting Models................................................................. 148 Cash Flow Management........................................................................ 149 Zero-Based Budgeting.......................................................................... 149 D. The Budgeting Process.......................................................................... 150 Cash Flow Management........................................................................ 160 Interpreting the Results........................................................................ 162 Dealing with Cash Shortfalls.................................................................. 162 E. Variance Analysis................................................................................. 163 Flexible Budget Variances...................................................................... 164 Interpreting the Volume Variances......................................................... 167 Interpreting the Flexible Budget Variances............................................... 167 F. Conclusion.......................................................................................... 168 Summary of Learning Objectives................................................................. 169 Concept Self-check.................................................................................... 171 Problems.................................................................................................. 175 CHAPTER 7: Evaluating Strategy and Performance Learning Objectives................................................................................... 185 A. The Balanced Scorecard and Strategy Mapping........................................ 186 Developing a Strategy Map.................................................................... 188 Common Problems with the Balanced Scorecard Process........................... 190 B. Matrix Mapping.................................................................................... 191 C. Introduction to Ratio Analysis................................................................ 195 D. Liquidity Ratios: Analyzing Short-Term Cash Needs.................................. 200 Working Capital................................................................................... 201 Current Ratio....................................................................................... 201 Composition of Specific Items in Current Assets....................................... 202 v Acid-Test Ratio.................................................................................... 203 Operating Cash Flow Ratio..................................................................... 204 Analysis of MCC’s Liquidity.................................................................... 205 E. Profitability Ratios: Analyzing Operating Activities..................................... 205 Net Revenue Ratio............................................................................... 205 Revenue to Total Assets Ratio................................................................ 206 Return on Total Assets Ratio (ROA)........................................................ 207 F. Leverage Ratios: Analyzing Financial Structure......................................... 207 Debt-to Assets Ratio............................................................................. 208 G. Efficiency Ratios: Analyzing Ability to Control Costs.................................. 208 Fundraising Efficiency Ratio................................................................... 209 Charity Efficiency Ratio......................................................................... 210 Administration Efficiency Ratio............................................................... 212 H. Overall Analysis of MCC’s Financial Statements........................................ 212 I. Other Considerations Regarding Financial Statement Analysis.................... 213 J. Summary of Financial Ratios.................................................................. 215 Summary of Learning Objectives................................................................. 216 Concept Self-check.................................................................................... 219 Problems.................................................................................................. 222 CHAPTER 8: Registered Charities Learning Objectives................................................................................... 231 A. Characteristics of Registered Charities and Other NFPOs............................ 232 Advantages of Registered Charity Status................................................. 233 Categories of Registered Charities.......................................................... 234 Related Businesses............................................................................... 235 B. Disbursement Quotas........................................................................... 238 Transfers to Other Organizations............................................................ 240 Accumulation of Property...................................................................... 241 C. Gifts................................................................................................... 242 Defining Donations............................................................................... 243 Donated Materials and Services.............................................................. 245 Fundraising Events and Auctions............................................................ 245 D. Procedural Compliance.......................................................................... 247 Issuing Receipts................................................................................... 247 Improper Receipting and Replacement Receipts....................................... 249 The T3010 Registered Charity Information Return.................................... 250 A Note on GST and HST........................................................................ 250 Summary of Learning Objectives................................................................. 251 Concept Self-check.................................................................................... 253 Problems.................................................................................................. 257 GLOSSARY............................................................................................... 261 INDEX...................................................................................................... 277 vi CHAPTER 1: Introduction to Not-for-Profit Organizations In this chapter, you will learn the importance of the not-for-profit sector in Canada, what types of organizations are considered not-for-profit organizations (NFPOs), and how to distinguish between registered charities and other NFPOs. This chapter will then explain how an NFPO is created and when it may register as a charity. You will learn the most common financial reporting obligations of NFPOs. 1 Learning Objectives LO1 – Explain the relevance of not-for-profit organizations (NFPOs) in Canada. LO2 – Describe the process of incorporating an NFPO. LO3 – Describe the differences between an NFPO and a charity. LO4 – Describe the financial reporting obligations of NFPOs. LO5 – Explain the role of ethics in the not-for-profit sector for professional accountants. 1 Note: In this text, the term NFPO (not-for-profit organization) is generally used, but there may be references to other terms such as non-profit, nonprofit, or NFP (not-for- profit). These terms are synonymous and can be used interchangeably. CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 1 A. Not-for-Profit Organizations in Canada LO1 – Explain the relevance of not-for-profit organizations (NFPOs) in Canada. Ten percent of the economically active population in Canada is employed by the not-for-profit sector, even after excluding workers in hospitals, colleges, and universities. There are more than 1.5 million full-time equivalent workers in the not-for-profit sector, which is 2.5 times more than in the construction industry in Canada, twice as many as in the transportation industry, and almost as many as in manufacturing. When the public sector (government and government agencies) is included, the not-for-profit sector represents a significant proportion of Canada’s economic activity. In this respect, Canada has a more prominent not-for-profit sector than many other countries. In response, Canadian standard setters have developed accounting standards suitable for the specific needs of the not-for-profit sector. NFPOs meet a wide variety of needs. Some, such as food banks, lunch programs (in schools), hospices, and amateur theatre groups, provide products or services to a broad group of users. Such NFPOs are usually perceived to exist for the greater good of society. Other NFPOs serve specific user groups. Member-based organizations, such as provincial law societies, exist to serve their members on a cost-recovery basis. Other professional associations, sports groups, and many co- operatives follow this model as well. Some NFPOs are formed for a specific purpose to meet the needs of a defined group, such as the home-owners group for a condominium complex. Many NFPOs are hybrids: they start as special-interest groups (such as a local theatre group) but also meet the criterion of providing a perceived societal benefit. Whatever the specific purpose, all NFPOs share one common criterion: they cannot exist to provide personal financial benefit for the members or founders. In general, the following must be true for an organization to be considered an NFPO: All of the entity’s resources must be devoted to activities carried on by the organization itself. No part of the entity’s income is available for the personal benefit of any member. More than 50 percent of the directors or like officials must deal at arm’s length with one another and with others in the organization. Directors are generally not allowed to be paid for their role as directors (except for some expenses or for services rendered in a capacity other than as director). 2 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 Upon dissolution, any residual assets must be transferred to either another NFPO with similar purposes or to a government (details vary by legislation). In general, none of the residual assets may be transferred to the members or shareholders. NFPOs are generally exempt from paying income tax. The Process of Incorporation LO2 – Describe the process of incorporating an NFPO. NFPOs may be created in many ways and under different legislation. Each legislative act has slightly different requirements for information that an entity must submit to apply or register as an NFPO. If an NFPO operates in more than one jurisdiction and is not federally incorporated, the NFPO must register in all relevant provinces or territories. This is called extra-provincial registration. This course assumes that NFPOs are incorporated under federal legislation called the Canada Not-for-Profit Corporations Act (CNPCA). To incorporate a new NFPO, the founders must identify who the members of the organization will be, establish a board of directors, and draft articles of incorporation and bylaws. These are submitted to Corporations Canada for approval and registration as a not-for-profit corporation. The articles of incorporation include basic information, such as corporate name province or territory in Canada where the entity’s office is situated maximum and minimum number of directors purpose of the corporation or society restrictions on activities it may carry on classes of memberships a statement of how remaining property, if any, will be distributed upon liquidation additional provisions, if any The bylaws of an organization determine how the organization governs itself. For the most part, the organization develops its own bylaws. Examples of some areas that are covered by typical bylaws: majority required to pass a special resolution legal signing authority: who may sign contracts and execute other legal documents on behalf of the entity the financial year end of the entity CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 3 bank signing authority: who has the authority to make banking arrangements for the entity, who approves the opening or closing of accounts, and who determines the signing authorities how the entity provides financial statements to members: the Act permits a bylaw under which the board can publish a notice that the statements are available electronically or at the registered office of the organization rather than being mailed Once a review is completed, Corporations Canada will issue a certificate of incorporation providing evidence that the NFPO exists as a separate legal entity from its members or shareholders. Once the entity is incorporated and receives its certificate of incorporation, its articles may only be amended with the consent of the applicable regulatory body after a special resolution of the members of the organization. A special resolution means that classes of members that would otherwise be non-voting are allowed to vote. It requires a two-thirds majority rather than a simple (50 percent plus one) majority. There are many types of NFPOs. Only two types of NFPOs will be covered in this course: registered charities; and clubs, societies, or associations. Differences Between Registered Charities and Other NFPOs LO3 – Describe the differences between an NFPO and a charity. To become a registered charity, an incorporated NFPO must apply for this status and obtain approval of its charitable purposes. This requires approval as a registered charity by the charities directorate of the Canada Revenue Agency (CRA). Obtaining registered charity status results in certain tax advantages to the entity and brings certain obligations. Charitable purposes must include at least one of the following four categories of charitable activities identified by the courts in Canada: relief of poverty advancement of education advancement of religion certain other purposes that benefit the community in a way the courts have deemed charitable2 The primary advantages of registered charity status are that the entity is auto- matically exempt from taxation and that it can issue tax-creditable receipts to donors 2 See Government of Canada. (2016). What is the difference between a registered charity and a non-profit organization? https://www.canada.ca/en/revenue- agency/services/charities-giving/giving-charity-information-donors/about-registered- charities/what-difference-between-a-registered-charity-a-non-profit-organization.html 4 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 for their gifts. These donations can be claimed as non-refundable tax credits on the donors’ individual tax returns. On the other hand, registration creates additional obligations for the NFPO, including additional reporting requirements, restrictions on what activities it may undertake, and limitations on the use of its resources. In addition to the tax credit, contributors and donors may prefer to provide support to registered charities rather than non-registered NFPOs for the following reasons: Contributors can rely on the regulations and reporting requirements imposed on charities. For example, registered charities must provide information that is publicly available on the CRA website. The publication of this information provides a level of financial transparency that is not required of non- registered entities, which provides additional assurance to donors. Registering as a charity requires that the charity comply with its approved charitable purposes and use its resources for those purposes. The identities of directors and related charities are public, increasing donors’ confidence in the management and oversight of the organization. Many corporations have policies that permit gifts only to registered charities. Occasionally, a charitable organization may pursue charitable purposes such as those described above but choose not to obtain registered charity status. If the entity does not expect to depend on donations for a significant portion of its revenue, the ability to issue tax-creditable receipts may not be an advantage. In addition, founders of an NFPO might prefer not to obtain registered charity status for one of the following reasons: to avoid regulatory and reporting requirements. to avoid the mandatory publication of financial information that the entity would prefer to keep confidential. to have the option to undertake activities, such as political advocacy, that are not permitted for a registered charity. Because it is unusual for organizations providing charitable services not to register as such, in this text, charities will be used to refer only to registered charities. B. Financial Reporting Obligations LO4 – Describe the financial reporting obligations of NFPOs.. NFPOs are obliged to provide financial information to a variety of stakeholders. The different types of financial information that an NFPO may produce include general CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 5 purpose financial statements, program or project-specific financial statements, internal management financial statements, and tax-related statements. General Purpose Financial Statements An NFPO’s bylaws usually require that it issue general purpose financial statements. NFPOs are also usually required to prepare financial statements in accordance with Canadian accounting standards for not-for-profit organizations. These requirements will be discussed later in the course. Program- or Project-Specific Financial Statements Program or project-specific statements are most often prepared to meet the requirement of specific funding contracts. If a government agency provides funding for a specific purpose, it may require the NFPO to report back on the use of the funds it provided. Such reports may take many forms (often not standardized). Many require a single schedule of revenues and expenses (accrual basis); some require a statement of receipts and disbursements (cash basis); and others require only a report on expenses compared to budget. A statement of financial position (sometimes called a balance sheet) may be required in some cases. The contract may strictly specify the format of the report, or the funder may provide a more general description of the reporting parameters. Internal Management Financial Statements Such statements are prepared for management or the board, usually monthly or quarterly. No specific accounting standards guide their preparation. They provide the information that management requires for sound decision-making. For example, the statements may provide comparisons of actual results to budget or disclose revenues and expenses related to specific programs. Tax-Related Financial Reporting Obligations Registered charities: The Canadian Income Tax Act imposes additional reporting requirements for registered charities. They must file a Registered Charity Information Return (T3010) annually within six months of their year-end, even if the charity was not active during the fiscal year. If a charity does not file a return on time, it may be deregistered and its registered charity status revoked. Registered charities are eligible to claim a rebate of 50 percent of the goods and services tax (GST) paid. A charity must register for and collect GST in certain situation on certain types of revenue. These topics will be covered in greater detail in a later chapter. Other incorporated NFPOs: All incorporated NFPOs, other than registered charities, must file a Corporation Income Tax Return (T2). Though unusual, it is possible for NFPOs (other than registered charities) to have a combination of profit- oriented and not-for-profit activities. In addition to the T2, certain incorporated 6 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 NFPOs must also file a Non-Profit Organization Information Return (T1044) with the CRA. The T1044 is required when the NFPO has more than $10,000 in investment income, had assets of more than $200,000 in the prior year, or has filed a T1044 in a prior year. While non-taxable entities face no penalty for not filing a T2, they face significant penalties for late filing of the T1044. Unincorporated NFPOs: Unincorporated NFPOs are not required to file a Corporation Income Tax Return. Their primary tax obligations are to remit GST/HST (harmonized sales tax) and payroll taxes (if they have employees). However, if an unincorporated NFPO is deemed to be providing a financial benefit to its members, its income may be considered to be for-profit, and as an unincorporated entity, the profits may be deemed personally taxable in the hands of the members or other beneficiaries. All organizations: All NFPOs — registered charities, non-registered charities, incorporated, or unincorporated — will have tax-related filing obligations when they hire employees. The entity must remit income tax, Canada Pension Plan premiums, and Employment Insurance premiums to the CRA. It must also issue personal income tax slips to the employees and must assess and pay Workers’ Compensation premiums. The entity must be aware of and comply with applicable employment standards acts, human rights commissions, workplace safety legislation, and the like. If the entity does not make payroll remittances to the CRA, the directors of the organization may be personally assessed and liable for unremitted withholdings. This is the same for a profit-oriented corporation; however, because the directors of an NFPO are not compensated for participating in the organization, there is only a downside risk for this role. External Accountant Involvement with Financial Information Legislation, bylaws, or contracts determine whether an independent external audit is required in preparing financial information. The board may choose to engage an independent external public accountant to audit, review, or compile financial statements. Audit engagements provide the highest level of assurance to the users of the financial statements. In both profit-oriented organizations and NFPOs, the auditor must be independent of the organization. This means that management of the NFPO must be responsible for the contents of the financial statements and for preparing the financial statements. The auditor may assist with the final preparation but may only use information produced by the organization. If the auditor proposes adjustments, management must agree to them before the auditor may incorporate the adjustments into the financial statements and issue an unqualified audit report. An external accountant often performs a review of financial statements to provide negative assurance about an NFPO’s financial statements. The review report indicates that the financial statements do not appear to be materially misstated when judged according to appropriate accounting standards. In this scenario, CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 7 the accountant analyzes the statements and makes inquiries of management to ascertain whether the information in the financial statements appears plausible. These procedures reinforce the key relationships among certain numbers and offer some assurance about the reasonableness of the information presented. Because a review engagement is substantially narrower in scope than an audit, the accountant cannot express an opinion on the fairness of the financial statements taken as a whole. A compilation engagement provides no particular level of assurance since the external accountant simply assists management in preparing and presenting the financial information but does not perform audit or review procedures. The accountant does not comment on whether the financial statements are prepared in accordance with a particular set of accounting standards. Many NFPOs also engage external public accountants to complete required tax filings. These tax compliance services may be completed by the same external public accountant who performs the audit, review, or compilation engagement, without impinging on independence of action. Other Legislated Reporting Requirements In addition to the reporting requirements of the Income Tax Act (ITA), other regulations and acts may require an NFPO to provide financial or other information to a government agency periodically, or they may govern its financial reporting obligations in some other way. The Canada Not-for-Profit Corporations Act (CNPCA) requires incorporated NFPOs to prepare financial statements in accordance with generally accepted accounting principles (GAAP), which the Act equates with provisions of the CPA Canada Handbook. It also stipulates that the financial statements must be provided to members not more than 60 days and not less than 21 days before an annual general meeting (AGM) of members. Whether such financial statements must be submitted to Corporations Canada and whether they must be audited depends on whether the NFPO is classified as soliciting or non-soliciting under the Canada Not-for-Profit Corporations Act. A soliciting corporation is one that receives more than $10,000 in revenue from a public source in a single financial year, broadly defined as donations received from the public and government grants. All other corporations are non-soliciting corporations. The financial statements of a non-soliciting corporation do not need to be submitted to Corporations Canada. The financial statements of a soliciting corporation must be submitted to Corporations Canada within six months of the year end. 8 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 Reporting requirements under the Canada Not-for-Profit Corporations Act are shown below.3 Table 1.1 Reporting Requirements for Soliciting Corporations Does a public accountant (PA) Gross Type of report required need to be revenue appointed? $50,000 Yes, unless by A review is possible if members pass an or less unanimous resolution ordinary resolution; an audit is otherwise required; if no PA is appointed by members, then a compilation may be engaged. $50,000 Yes, must be appointed Audit, unless members pass a special to at AGM resolution opting for review $250,000 More than Yes, must be appointed Audit $250,000 at AGM Table 1.2 Reporting Requirements for Non-soliciting Corporations Does a public Gross accountant (PA) need to Type of report required revenue be appointed? $1 million Yes, unless waived by A review is possible if members pass an or less unanimous resolution ordinary resolution; an audit is otherwise required; if no PA is appointed by members, then a compilation may be engaged. More than Yes, must be appointed at Audit $1 million AGM Provincial corporations and societies acts have differing requirements for financial reporting. Some require external audits, with a provision for unanimous resolution waiving the audit, like that of the CNPCA. Some of the legislations allow 3 An ordinary resolution is one passed by 50 percent or more of the members present at a meeting. A special resolution must be passed by high majority (two-thirds, CNPCA) of the members voting at a meeting. A unanimous resolution must be in writing and must be approved by 100 percent of the members voting at a meeting. These definitions of resolutions are found in the CNPCA and are intended to protect the rights of members in various circumstances, including their right to financial information. CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 9 for an “internal” audit, in which two or more members who are independent of the board of directors examine the accounting records and approve the financial statements. Most, but not all, provincial legislation requires the filing of annual returns, normally with the financial statements attached. C. Ethics and the Professional Accountant in the NFPO Sector LO5 – Describe the role of ethics in the not-for-profit sector for professional accountants. The not-for-profit (NFP) sector is an important part of the Canadian economy that provides goods and services not generally available from the private, profit-oriented sector. Such goods and services are important to the well-being of Canadians. This category includes organizations that provide education, health, justice, research, culture, and recreation services, and organizations conveying social, humanitarian, and spiritual values. Accountants are employed in various roles in the NFP sector. These include working directly for an NFPO in accounting and finance. working for a Chartered Professional Accountant (CPA) firm that has NFPO clients. providing volunteer services in accounting and finance for an NFPO. serving as an executive member of an NFPO. serving as a member of the board of directors of an NFPO. In the NFP sector, an accounting professional is viewed as a person who has a good understanding of accounting and finance. For instance, an accountant may be asked about the differences between accounting standards in the profit-oriented and not- for-profit sector or whether a newly formed NFPO should seek status as a registered charity. Some of those who will seek such guidance will need assistance to translate accounting and finance standards into terms they can understand. In whatever role, a professional accountant generally gathers information, analyzes that information, communicates and interprets the analyzed information to stakeholders, and provides guidance about reporting requirements. Competence, Truthfulness, and Reliability Accountants are responsible to be competent, truthful, and reliable communicators. Competence requires knowing the relevant accounting standards and how they apply to the particular organization. Truthfulness involves providing information in 10 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 ways that are complete, clear to users, and free from perceived bias. Reliability means providing such services in a prompt, consistent manner. While competence, truthfulness, and reliability are universal characteristics, their practical application depends on one’s role. Accountants who are employees have a duty of loyalty to their employers and to their profession; managers have responsibilities to their superiors and, ultimately, to the board of an organization; and board members have a duty to an organization’s stakeholders. Accordingly, responsibilities will vary. An accountant-as-employee has the responsibility to report perceived issues to the relevant manager and make recommendations. In more urgent or difficult cases, this may involve reporting to a supervisor’s supervisor. Similarly, an accountant working in a public accounting firm should discuss ethical issues with the lead CPA or, in some cases, with the firm’s partners. Accountants who are board members will be required, under legislation and professional responsibility, to act ethically. Volunteers are also responsible to act ethically and to do their best to help the organization fulfill its mandated tasks. In all these roles, it is essential for the accountant to clearly understand the role and requirements of the NFPO sector in general and the NFPO with which the accountant is engaged as an employee, volunteer, board member, or other service provider. CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 11 Summary of Learning Objectives LO1 – Explain the relevance of not-for-profit organizations (NFPOs) in Canada. NFPOs meet a wide variety of needs and are usually perceived to exist for the greater good of society. Some provide products or services to a broad group of users. Other NFPOs serve specific user groups, like member-based organizations, including professional associations, sports groups, and co-operatives. Many NFPOs are hybrid organizations that represent a special-interest group but also provide a perceived societal benefit. NFPOs share one common criterion: they cannot exist to provide personal financial benefit for the members or founders. All resources must be devoted to activities carried on by the organization itself; no income can be made available for the personal benefit of any member; and more than 50 percent of the directors must deal at arm’s length with each other and with others in the organization. LO2 – Describe the process of incorporating an NFPO. To incorporate a new NFPO under the Canada Not-for profit Corporations Act (CNPCA), the founders must identify who the members of the organization will be, establish a board of directors, and draft articles of incorporation and bylaws. These are submitted to Corporations Canada for approval and registration as a not-for- profit corporation. Once a review is completed, Corporations Canada will issue a certificate of incorporation providing evidence that the NFPO exists as a separate legal entity from its members or shareholders. LO3 – Describe the differences between an NFPO and a charity. Registered charities are a subset of incorporated NFPOs that have been approved by the charities directorate of the Canada Revenue Agency (CRA). Obtaining registered charity status results in certain tax advantages to the entity but is accompanied by certain obligations. To become a registered charity, an NFPO must have at least one purpose that includes relief of poverty, advancement of education, advancement of religion, or certain other purposes that benefit the community in a way the courts deem charitable. The primary advantages of registered charity status are that the entity is automatically exempt from taxation and can issue tax-creditable receipts to donors for their gifts. The obligations that result include additional reporting requirements, restrictions on what activities they may undertake, and limitations on the use of the entity’s resources. 12 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 LO4 – Describe the financial reporting obligations of NFPOs.. NFPOs are obligated to provide financial information to a variety of stakeholders that may include general purpose financial statements program or project-specific financial statements internal management financial statements tax-related financial reporting obligations other legislated report requirements for soliciting and non-soliciting corporations LO5 – Describe the role of ethics in the not-for-profit sector for professional accountants. An NFP accounting professional is viewed as a person who has a good understanding of accounting and finance in the not-for-profit sector. In whatever role, professional accountants must be competent, truthful, and reliable communicators. While these characteristics are universal, their practical application depends on the accountant’s role. Accordingly, responsibilities will vary. In whatever role, it is essential for the accountant to clearly understand the role and requirements of the NFPO sector in general and the NFPO with which the accountant is engaged as an employee, volunteer, board member, or other service provider. CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 13 ASSIGNMENT MATERIALS Concept Self-check 1. What percentage of the economically active population in Canada is employed by the not-for-profit sector, even after excluding workers in hospitals, colleges, universities, and agriculture? 2. What kind of needs are met by Canadian NFPOs? 3. What overarching criterion is shared by Canadian NFPOs? 4. Describe five common characteristics of NFPOs. 5. Describe the process of incorporation for an NFPO registered under the Canada Not-for profit Corporations Act (CNPCA). 6. Describe four categories of charitable activities identified by the courts in Canada. 7. What are the primary advantages of registered charity status? 8. If an organization is a charity, why may its board choose not to seek registered charity status? 9. Contrast the role of general-purpose financial statements with program- specific financial statements. 10. Identify the main tax form that must be filed annually by each of the following: a registered charity, and an incorporated NFPO that is not a registered charity. 11. Assume that an NFPO is registered under the Canada Not-for profit Corporations Act (CNPCA). When must its annual financial statements be provided to members? 12. What distinguishes a soliciting, incorporated NFPO from a non-soliciting one? 13. Describe three main ethical requirements of public accountants. 14 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 Problems P 1–1 Which of the following is/are correct for an organization defined as a registered charity under the Income Tax Act? a. Official tax-creditable receipts may be issued to donors. b. The entity is exempt from taxation. c. The entity must incorporate. d. A Corporation Income Tax Return (T2) does not need to be filed with the CRA. e. All of the above are correct. f. a, b, and d. P 1–2 The directors of an NFPO incorporating under the Canada Not-for-profit Corporations Act (CNPCA) are responsible for drafting the initial bylaws. Assume that the drafted bylaws of a new NFPO include a provision defining a special resolution as one that requires a 60 percent majority vote to pass. Will this bylaw be enforceable under the CNPCA? P 1–3 The Board of Directors of a newly formed NFPO is deciding whether to incorporate under the CNPCA. Which of the following factors is least likely to be a significant consideration in this decision? a. Incorporating will require that the NFPO complete a Corporation Income Tax Return (T2) each year. b. The NFPO expects to receive donations and government grants of more than $50,000. c. The organization is likely to acquire real estate in the future. d. The organization may qualify for registered charity status. e. All of the above are significant considerations. f. a, b, and d. CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 15 P 1–4 Assuming that an NFPO is incorporated under the Canada Not-for profit Corporations Act (CNPCA), which of the following correctly applies the reporting requirements? a. The NFPO receives $9,000 in government grant revenue and $1,500,000 in member dues, and the members pass a special resolution waiving an audit. b. The NFPO receives $9,000 in government grant revenue and $200,000 in general donations, and the members pass a special resolution appointing a public accountant to complete a review engagement. c. The NFPO receives $260,000 in donations and no other revenue. The members pass a special resolution waiving an audit. d. The NFPO receives no grant or donation revenue. Member dues total $3,000,000, and the members pass a unanimous resolution appointing a public accountant to complete a review engagement. P 1–5 Assume an NFPO is created to establish a school program that will enable troubled teenagers to complete their high school diplomas. The NFPO must determine whether to organize under the Canada Not-for-profit Corporations Act (CNPCA) or under provincial legislation. Which of the following would be the least relevant factor for consideration? a. The NFPO expects that in the second year it will apply for registered charity status. b. The NFPO has no immediate plans to expand beyond the local city, although the board may set up a residential program once the program is established. For this, it would purchase a suitable building. c. Funding will be provided by one provincial mental health department, a provincial court-funded youth corrections agency, and the provincial education ministry. d. The funding contracts require audited financial statements to be prepared for the program being funded. Since each contributor will receive an individual audited set of financial reports, the board would like to avoid the cost of also having its general-purpose financial statements audited. e. a. and b. P 1–6 What are three types of financial statements that may be prepared by a public accountant? Under what circumstances may these statements be prepared, and what criteria would be used to prepare them? P 1–7 You have recently joined the board of an NFPO that has never had a public accountant involved in preparing its financial statements. Explain to the board the different ways a public accountant can be involved in the preparation of the external financial statements. 16 CHAPTER 1 / Introduction to Not-for-Profit Organizations v. 2.0 CHAPTER 2: Governance This chapter focuses on NFPO governance: the roles of stakeholders, the importance of policy development, the ethical and internal control considerations unique to NFPOs, how budgeting is used within NFPOs as an internal control mechanism, and the external auditor’s role and duties with respect to the board and senior management. Learning Objectives LO1 – Describe the nature of NFPO governance. LO2 – Describe the roles and responsibilities of members, the board of directors, employees, and volunteers in an NFPO. LO3 – Explain the role of the board in five key policy areas and describe the types of policies common to each area. LO4 – Describe appropriate ethical considerations in an NFPO context. LO5 – Explain the role of internal controls within an NFPO. LO6 – Describe the role of budgeting as a means of planning and internal control. LO7 – Describe the external auditor’s role and duties with respect to the board and senior management. CHAPTER 2 / Governance v. 2.0 17 A. Overview of NFPO Governance LO1 – Describe the nature of NFPO governance. One common characteristic of all NFPOs is that they cannot be owned by individuals for personal benefit, so ownership is not transferable. They are founded by members who do not expect to receive dividends or other forms of remuneration for themselves. Instead, their purpose is to contribute to the good of society or collaborate with others to accomplish mutual goals through the NFPO. Incorporated NFPOs may issue shares, but the purpose of these shares is to set up the corporate structure. The shares do not represent any vested interest in or ownership of the organization’s net assets, as would be the case in a profit-oriented corporation. Consider the following definition of NFPOs from the CPA Canada Handbook: “A not-for-profit organization is an entity, normally without transferable ownership interests, organized and operated exclusively for social, educational, professional, religious, health, charitable or any other not-for-profit purpose.”4 In NFPOs, the term member is often used to include those individuals who may have been named shareholders in incorporated NFPOs. The members jointly agree how the organization is to be governed by adopting bylaws. They also elect or appoint a board of directors to implement the organization’s purposes and oversee its operations on behalf of the members. For this reason, the board of directors and any committees that the board appoints to fulfill portions of its oversight duties are referred to as those charged with governance oversight. The board, on behalf of the members, ensures that the organization is well governed and operates ethically. To ensure that financial and other results are measured and reported accurately, the board liaises with the NFPO’s external accountant or auditor to establish an effective system of internal controls over operations and financial reporting. How the board fulfills its role is a critical component of the internal control system. This NPFO governance is the focus for this lesson. 4 CPA Canada. (2021). CPA Canada standards and guidance collection (CPSACHB). IFRS Foundation. https://0-edu-knotia- ca.aupac.lib.athabascau.ca/knowledge/Home.aspx?productid=1 18 CHAPTER 2 / Governance v. 2.0 B. Organizational Structure of NFPOs LO2 – Describe the roles and responsibilities of members, the board of directors, employees, and volunteers in an NFPO. A.typical NFPO is composed of members, the board of directors (who are also usually members), employees, and volunteers. Their respective roles and responsibilities are discussed below. Members All NFPOs consist of members with a common interest in a purpose other than self- interest. Membership in an NFPO is much like that of a typical organization that recruits members to join together for a common purpose. The following are some examples of such organizations: professional groups, such as provincial law societies whose members are lawyers. purchasing cooperatives whose members pool their purchasing power to buy in bulk and obtain better pricing for their members. community associations that organize sports or other activities for families living in a particular neighbourhood. Such entities serve a large number of members, but the majority of the members are not actively involved in leadership or governance of the entity. Alternatively, if a group of members unite to provide a service to society, the group may incorporate an NFPO to provide liability protection, allow fundraising, and establish a credible organization separate from themselves as individuals. In this type of NFPO, members may include the original founders, though new members may be invited to join after they demonstrate seriousness about becoming involved in the leadership of the organization. Many social service agencies and charities are organized in this way, with the number of members limited to the size of the board of directors. Accountability Regardless of the size of the membership, the members are the highest authority within an NFPO. The members determine and define the purpose of the organization. The purpose of the organization is stated in its articles of incorporation and usually repeated in the bylaws. The articles and bylaws cannot be amended without member approval. Figure 2.1 shows the typical accountability structure of an NFPO. CHAPTER 2 / Governance v. 2.0 19 Figure 2.1. A Typical Organizational Structure of an NFPO Members Board of Directors Executive Director Employee Volunteer s s Board of Directors The level of authority that comes after members within the NFPO is the board of directors. The name of this group may differ between organizations. For example, the board of directors of a law society may be referred to as benchers, and some professional organizations refer to their boards as a council or board of governors. Whatever the name, the board of directors is the entity elected or appointed to act on behalf of the members to govern the entity and to oversee its management. This course uses the term board of directors to refer to this group. Although some organizations may use the title director to refer to senior paid staff, in this course, it is used only to refer to volunteer elected board members. The board usually reports and is accountable directly to the members. In some very large organizations — often those in which the members are other organizations rather than individuals — the member organizations may appoint an intermediate body to appoint or elect the board of directors. This intermediate body might consist of a representative of each of the member organizations and may be referred to as a senate, a forum, or a similar descriptive term. Because this organizational structure is less common, this course assumes in all cases that the board of directors reports directly to the members. Even in large organizations, the organization exists to serve the interests of designated stakeholders. For example, the vision of the largest community foundation in Canada, the Vancouver Foundation, is “healthy, vibrant, and liveable communities across British Columbia.” To this end, it supports a variety of initiatives, from youth homelessness to Vancouver’s Greenest City Fund. The role of the board is to provide leadership and direction to ensure that the NFPO’s purposes are achieved. 20 CHAPTER 2 / Governance v. 2.0 to report to the members on the achievement of those purposes and on its stewardship of the organization’s resources. to appoint and oversee someone in a senior management position to implement the board’s direction and strategies. The management role is normally undertaken by a paid employee (executive director), but in very small organizations, volunteers may take on the management role. to fulfill or oversee the duties required by legislation or by the organization’s bylaws and policies. Executive Director The board of directors appoints a senior employee, often referred to as the executive director. Many larger Canadian NFPOs use the equivalent title chief executive officer (CEO), or in some sectors, general manager. In most cases, the executive director also holds an ex officio, non-voting seat on the board. Ex officio means “by virtue of one’s office.” In other words, the individual is not elected or appointed to the board but is automatically a non-voting board member based on the person’s position. Employees The board of directors effectively hires and holds only one employee accountable: the executive director. The executive director is responsible and accountable to the board of directors for the performance of all other employees. Service Volunteers Finally, the executive director is also responsible and accountable for appointing and supervising service volunteers. To understand the governance structure of an NFPO, it is important to distinguish between volunteers who serve in an oversight capacity as directors and volunteers who assist in implementing the NFPO’s programs and projects. For example, a charity may hold an annual fundraising gala. Planning and executing this event require more time and effort than staff can dedicate to a single event, so interested volunteers may assist with selling tickets, planning the entertainment, serving as ushers at the event, and so on. In a sporting organization, volunteers may coach and supervise teams, drive children to tournaments, or help with fundraising. Such volunteers are called service volunteers. Service volunteers are accountable to the executive director, perhaps indirectly through a department manager. Service volunteers do not report directly to the board of directors. Unlike the board of directors, which is also made up of volunteers, service volunteers hold no authority over the staff. It is common for board members to occupy both roles — they are elected to the board of directors but may help out in service capacities. In such a case, they must remember the difference between the two roles and remember which role they are playing — that CHAPTER 2 / Governance v. 2.0 21 of a board member or that of a service volunteer, ultimately accountable (in that role) to the executive director. Members hold the highest level of authority in the NFPO structure. Ultimately, if members are dissatisfied with the direction the board is providing, they have the authority to vote in new board members who will be able to change the direction of the organization through new policies. C. Board Policies LO3 – Explain the role of the board in five key policy areas and describe the types of policies common to each area. The board’s role is to develop and implement policies in five key areas. In very small organizations, these policies may be unwritten or may be documented in the minutes of past meetings. In the simplest terms, policy is “how we do things,” so even past practices or traditions may constitute policy. However, whether explicitly stated or not, the board is responsible to its members for developing and overseeing the following types of policies, each of which is discussed in detail below: framework policies board self-governance policies board/staff relation policies operational policies communications, advocacy, and public relations policies Framework Policies Framework policies can be thought of as commitment statements that are developed to direct the NFPO to achieve its intended purposes. These policies often use terms such as vision, mission, and values. A vision statement usually outlines the NFPO’s reason for existence. A mission statement focuses on the present and defines clients, critical processes, and desired level of performance. For instance, the vision statement of an NFPO dedicated to the eradication of poverty in inner-city Vancouver might be “an east-end Vancouver free of poverty.” Its mission statement might be “to help east-end Vancouver residents escape poverty and improve their quality of life.” Framework policies articulate the purpose of the NFPO, what the organization hopes to achieve, and the priorities and values by which it measures itself and its success. The board is responsible for ensuring that these policies are understood within the organization, and, more importantly, that they are consistent with the objectives stated in the NFPO’s articles of incorporation and with the purposes stated in the bylaws. If the NFPO is a registered charity, it is critical that the framework policies are consistent with and fall within the boundaries of the approved charitable purposes. 22 CHAPTER 2 / Governance v. 2.0 Framework policies may include mid- and long-range strategic priorities, which explain in measurable terms how the board expects to achieve the vision or mission. Policies related to strategic priorities should be reviewed every two to five years to ensure they are still relevant and achievable. For example, if the organization’s mission is “to increase opportunities for participation in organized sports for children in Smallville,” a strategic priority might be “to implement an after-school program offering one sports club for girls and one for boys at 50 percent of the city’s public elementary schools by 2022.” Organizations that regularly schedule strategic planning exercises often review and revise framework policies at these times. As the needs of the population served by the NFPO changes, the organization should update its mission and vision statements. Once the organization achieves the goals set out by the framework policies, it should develop new goals. Over time, the vision, mission, and strategic priorities of an entity will usually change and evolve (within the boundaries of the organizational purposes set out in the articles of incorporation and the charities application). Board Self-Governance Policies Board self-governance policies outline how the board itself operates. The board is not permitted to develop policies that contradict the bylaws, which always supersede board policy. Self-governance policies include the roles, responsibilities, and code of conduct of officers, and policies related to committees, meetings, and decision making. Many of self-governance policies may already be addressed in the NFPO’s bylaws. Most bylaws require the board to appoint, at a minimum, the following officers: chair5 one or more vice-chairs treasurer secretary The position of treasurer and secretary may be held by the same individual. The bylaws identify the officer positions, but rarely describe the responsibilities of the officers. Therefore, board policies usually include the duties and responsibilities of each officer, the length of the term of each office, and guidelines about whether a person may hold an office for multiple terms. The board code of conduct policy documents each director’s responsibility in areas such as confidentiality, avoidance of conflict of interest, participation in and support for board decisions, and adherence to the organization’s values and code of ethics. You can find an example of such a policy in Table 2.1. 5 This course uses the terms chair and vice-chair instead of president and vice-president to refer to the senior board officers. CHAPTER 2 / Governance v. 2.0 23 Table 2.1 Sample Code of Conduct The following code of conduct (“the code”) is designed to allow the Society to preserve its long tradition of integrity and credibility with the public and within the Society. This code applies to all direct service program volunteers and third- party service providers (those in face-to-face contact with the Society’s clients), board volunteers, and all employees (hereafter referred to as “personnel”). With respect to service, personnel shall 1. always act with fairness, honesty, integrity, and openness; respect the opinions of others and treat all with equality and dignity without regard to gender, race, colour, creed, ancestry, place of origin, political beliefs, religion, marital status, disability, age, and sexual orientation. 2. promote the mission and objectives of the Society in all dealings with the public on behalf of the Society. 3. provide a positive and valued experience for those receiving service within and outside the Society. With respect to accountability, personnel shall 1. act with honesty and integrity and in accordance with any professional standards or governing laws and legislation that apply to the responsibilities you perform for or on behalf of the Society. 2. comply with both the letter and the spirit of any training or orientation provided by the Society in connection with those responsibilities. 3. adhere to the policies and procedures of the Society and support the decisions and directions of the national board and its delegated authority. 4. take responsibility for actions and decisions. Follow reporting lines to facilitate the effective resolution of problems. Ensure that you do not exceed the authority of your position. Personnel shall not make themselves party to a conflict of interest. Conflict of interest arises when a person participates in a decision about a matter (including any contract or arrangement of employment, leasing, sale, or provision of goods and services) that may benefit or be seen to benefit that person because of their direct or indirect financial interests affected by or involved in that matter. Boards may appoint standing committees to fulfill some of the board’s oversight responsibilities, such as audit, finance, nominating, and compensation. Such committees have unlimited (or continuing) duration. The board may also appoint committees with a limited life to complete a particular project or advise the board on 24 CHAPTER 2 / Governance v. 2.0 a specific matter. These committees are referred to as ad hoc committees or task forces. The board provides both standing and ad hoc committees with committee terms of reference that state the purpose of the committee, its expected outcomes, its membership, and its reporting requirements (to whom the committee will report and when). If the board assigns the committee to make a decision on a matter, the terms of reference will indicate the extent of the committee’s authority. Board policy may determine the frequency of board meetings and decision-making procedures. The latter include typical agenda items, the rules of order, and the voting procedures to be followed at meetings. Board and Staff Relation Policies As described earlier, the board of directors directly oversees only one paid employee: the executive director. All other employees and service volunteers are accountable — directly or indirectly — to the executive director. Board and staff relation policies clarify this line of accountability and provide the board with guidance on the appointment, oversight, compensation, and replacement of the executive director. For example, the policies may describe the search process for a new executive director, they may require a committee to be appointed to evaluate the executive director’s performance, and they mat clarify that formal communications between the executive director and the board are the responsibility of the chair. Of course, because most executive directors also hold a seat on the board, formal communication is usually required only on specified matters such as performance evaluations. Board/staff relation policies may also indicate that the executive director’s primary performance measure is how well the organization’s strategies and mission are achieved. Board members and staff commonly misunderstand the accountability structure. Because staff members sometimes work closely with board members on specific projects, they may form close working relationships and forget the formal reporting arrangement. For example, a board member who is an accountant may contact the NFPO’s controller directly to suggest improvements in the presentation of the financial statements. This action is inappropriate because the controller reports to the executive director, not to the board of directors, and certainly not to an individual director. If a board member has concerns about the presentation of the financial statements, they should raise those concerns with the board treasurer, the finance committee (if there is one), or the executive director. If the concerns are significant, they should be discussed at a board meeting. A staff member may make the same type of mistake, for example, by taking a salary complaint directly to a board member rather than to a supervisor or the executive director. The only occasion in which it would be acceptable for an employee to approach a board member about human resource matters is if the employee has followed a formal grievance process and has been disregarded at the staff level. The next step in the process may be communication with a specified board member. For example, an NFPO board may have a whistle-blower policy that specifies that if an employee is aware of fraud or unethical actions by the executive director, the employee shall report this directly to the board chair. Other CHAPTER 2 / Governance v. 2.0 25 employee complaints should be taken up with the direct supervisor within the staff structure, not directly with the board. In the case of very small NFPOs that do not have an executive director, a board committee or volunteer may fulfill the senior management role. In such a case, the board/staff relation policies would be very different. However, they will still describe who is responsible for managing the operations and how they will be held accountable. Operational Policies The executive director implements and enforces operational policies and reports to the board on the results of these policies. Operational policies cover matters such as budgeting, financial controls, and operational controls: Budgeting: Who is responsible for preparing and approving the budget and identifying the parameters for developing an acceptable budget? How often and in what detail does actual-to-budget performance get reported to the board? What are the consequences of budget variances? Who has the authority to permit variances? Financial controls: Who can sign cheques, borrow on behalf of the organization, and select the organization’s bank? How often and in what form does the executive director report to the board on compliance with financial controls? To what extent, if any, does the board get involved in the pre- approval of transactions? Operational controls: These include parameters for developing new programs or changing existing programs, personnel policies requiring equitable treatment of all employees, and policies to protect against risk. Communications, Advocacy, and Public Relations Policies Communications, advocacy, and public relations policies identify who is responsible for speaking on behalf of the NFPO in particular circumstances. For example, in many cases, only the board chair or executive director may speak to the media on matters of public interest, and only when the board has articulated its position on the topic. In other cases, specific board members or senior employees may be assigned to meet with potential funders. Communications policies vary from one organization to the next, depending on whether the organization’s views are likely to be of interest to the public. Communications policies commonly designate a specific spokesperson for media interaction and limit board members from publicly expressing views contrary to the board’s agreed-upon positions. 26 CHAPTER 2 / Governance v. 2.0 Tailoring Governance Policies to the Organization The types of policies described in this chapter are those that generally support the governance of an NFPO. However, each organization is unique, and the policies developed must suit the size and nature of the organization. For some small, simple entities, the entire set of policies covering all five areas may be contained in several pages. In large organizations, board policies will be much longer and more complex. An NFPO board should thoughtfully consider each policy area to determine what is suitable for the particular organization and review and revise the policies in response to events and circumstances that reveal a need for change. Clearly documenting policies, so that there are neither gaps nor overlaps in responsibility, will increase both the effectiveness and efficiency of an organization. D. Ethics LO4 – Describe appropriate ethical considerations in an NFPO context. A code of ethics articulates a set of guiding principles to outline what types of behaviour and decisions are acceptable and expected in the organization. A code of ethics for an organization goes beyond the board code of conduct, which is specific to board members and how they carry out board activities. An organization’s code of ethics applies to all stakeholders in the NFPO, including staff, volunteers, and the board. The board of directors develops and approves the ethics policy, which is generally considered part of the framework policies. The code of ethics provides a detailed articulation of the organization’s values. It helps organization members, staff, and volunteers to make autonomous decisions that are nonetheless in line with organization values. An organization’s code of ethics will reflect the sector in which it operates and the types of risks to which it is exposed. An NFPO code of ethics may emphasize the importance of integrity in all dealings within the organization, with external stakeholders, and with the public. require that all staff, volunteers, and directors have a duty of confidentiality to the organization itself and a duty to respect the privacy of members and clients within the limits of the law. oblige adherents to look out for the best interests of the organization and to avoid conflicts of interest, and guide members on how to handle possible conflicts of interest. describe how differences of opinion are to be expressed and resolved within the organization. CHAPTER 2 / Governance v. 2.0 27 address the appropriate response to unethical behaviour when it is observed, including a safe process for reporting and rectifying it, with appropriate safeguards from retribution (e.g., a grievance or whistle-blower policy). emphasize the importance of maintaining absolute honesty and integrity in fundraising activities. require compliance with an applicable profession’s code of ethics (such as accounting, law, or health services) even though not all staff and volunteers may be members of that profession. E. Internal Controls LO5 – Explain the role of internal controls within an NFPO. Internal controls are procedures put in place by the management of an organization to ensure that its policies are followed and its goals achieved. Because the board of directors usually cannot directly oversee the NFPO’s operations and senior staff, effective internal controls are critical to the board’s ability to fulfill its fiduciary6 and oversight responsibilities. The board develops, implements, and monitors both board self-governance policies (discussed earlier) and internal control policies. It then directs the executive director to implement and monitor the internal control policies and procedures that assure the board that resources are being used as intended, assets are protected from loss, and the financial reporting system is reliable. Two broad categories of internal controls are entity-wide controls and specific controls. Entity-Wide Controls Entity-wide controls are often referred to as the control environment. Such policies apply to all members of an organization and demonstrate the general attitude of senior management (and in the case of NFPOs, the board of directors) toward compliance with specific controls. Entity-wide policies affect all aspects of operations and financial reporting. The extent to which the board and senior management take these controls seriously and adhere to them is referred to as the tone at the top. Operational staff and service volunteers are unlikely to believe that it is important to follow policies and procedures unless the board and senior management actively demonstrate that the controls are important. Entity-wide controls that are rigorously followed and are known throughout the organization enhance the effectiveness of the specific controls that affect day-to-day activities and transactions. The most common categories of entity-wide controls are as follows: 6 Fiduciary: to act honestly and in good faith, with a view toward the best interests of the organization. 28 CHAPTER 2 / Governance v. 2.0 statement of values and code of ethics human resources (HR) policies financial controls Information technology (IT) systems controls Statement of Values and Code of Ethics The statement of values and code of ethics form the basis of most of the other controls. Without a strong statement of ethical standards, staff and volunteers may view adherence to other policies and procedures as optional. The first step in emphasizing the importance of integrity within an organization is documenting the organization’s values and its code of ethics and making these available within the organization and to outside stakeholders. The organization must educate new staff and volunteers about the organization’s values and provide examples of how the organization interprets ethical behaviour. Without board and management emphasis on ethical behaviour, subordinates and volunteers cannot be expected to see it as important. For management, one aspect of ethical behaviour is to avoid overriding internal controls except in rare circumstances and, when overriding specific controls, to ensure that the reasons are clear and documented. Human Resource (HR) Policies Clear HR policies that are fair and applied consistently to all employees, including the executive director and service volunteers, are part of entity-wide controls. A commitment to an equitable hiring process and compensation, fair and transparent performance evaluation, and providing employees and volunteers with the training and tools needed to do their jobs will increase the likelihood that an organization will operate effectively and efficiently. Hiring competent, honest people for each position and placing volunteers in the roles to which they are best suited will reduce errors and omissions within the organization. Job descriptions for each role ensure that roles and responsibilities are well understood. Financial Controls Financial controls are the policies and procedures put in place to monitor and manage an organization’s resources. These controls include timely financial statements and operational reports, a budgeting process, and reliable accounting systems. In a for-profit enterprise, expenses are assessed in terms of revenue generated. Appropriate monitoring of the relationship between revenue and expenses tends to keep expenses under control. However, an NFPO often receives money from contributors or funding agencies. This revenue is then spent on providing services to a different group. Therefore, spending must be monitored directly. In other cases, funds received by an NFPO may be restricted to certain uses or purposes. Capital grants, for example, are funds generally distributed by governments to governmental units like school districts for the purpose of building or acquiring capital assets. For instance, a school district might receive a capital grant from the provincial government to build a new school. This grant may not be CHAPTER 2 / Governance v. 2.0 29 used for operating expenses. The school district might also receive a less restricted operating grant from the government to assist with the day-to-day expenses of providing educational services to students. Parents or patrons might donate money to buy library books. Contributors want assurance that funding was used as intended. Therefore, the internal control and financial statement reporting systems of an NFPO must be able to track expenditures and match them to appropriate revenues in a cost-effective manner. With respect to spending, a good budgeting process is both an entity-wide control and a specific control. Budgeting represents an entity-wide control in two ways. First, as part of short- and mid-term planning, the budgeting process allocates resources to the priorities the board has identified in its strategic planning. Allocating resources to the achievement of organizational priorities demonstrates that achieving the stated goals and objectives is important. Second if the budgeting process is completed thoughtfully and monitored throughout the year, it demonstrates that the board and management have committed to fiscal prudence and good oversight of the organization’s resources. Budgeting will be discussed more in a later chapter. Information Technology (IT) Systems Controls IT systems controls include access controls that limit who can access which parts of the IT system and change controls that limit who can change the IT system. Access controls ensure that unauthorized transactions are not recorded and that client and personnel confidentiality is maintained. They also reduce the likelihood that managers or others can override specific controls. Systems testing requires testing and documentation of all systems changes to reduce the possibility of unintended changes — for example, incorrect user settings causing systematic or multiple errors, or loopholes that allow unauthorized access. Specific Controls Specific controls affect only limited aspects of operations or finances, and there are many different types. Controls may govern a particular stream of transactions, such as approval processes for disbursements. Other controls may be directed at a particular type of activity, such as processes that tell an employee how to respond to requests for information from the general public. The main categories of specific controls are segregation of incompatible duties, instructions for information or transaction processing, and detection controls. Segregation of Incompatible Duties Segregation of incompatible duties involves separating the responsibility for initiating, approving, recording, and reporting transactions to the extent possible. Separating duties for custody and recording of assets like cash and inventory is also advisable. In very small NFPOs with few employees, it is common for the same 30 CHAPTER 2 / Governance v. 2.0 person to initiate and approve transactions, and for the same person to report and record transactions. In such cases, other checks and balances or review of work procedures become more critical. Instructions for Information or Transaction Processing Instructions for information or transaction processing are controls often documented in procedures manuals. Examples of such controls include the following: Adjusting journal entries must be supported by a specific type of documentation. The invoice backup for cheques must be provided to the persons signing the cheques and initialled by the signatory as evidence that the backup has been reviewed. Incoming cheques must be stamped “for deposit only” upon receipt and deposited the same day by someone other than the person recording the payment. Most of the above are prevention controls. By implementing such controls and encouraging all employees and volunteers to follow them, organizations can reduce the likelihood of errors or unauthorized transactions. However, not all errors can be prevented, and some prevention controls are not cost-effective. For this reason, management will also implement detection controls — that is, controls that are designed to catch and correct errors after they have occurred. Detection controls include checks and balances and review of one person’s work by another. In accounting, the most common checks and balances involve reconciling two items, as in the following examples: The person who opens the mail reconciles (or agrees) the bank statement to the list of cheques and cash deposited. A summary report of the electronic transactions is compared and reconciled to the amount credited to the bank account. Department managers must explain budget-to-actual variances. By investigating unexpected variances, the department managers may identify coding errors where another department’s costs have been coded to their programs. Even if an NFPO has few employees in the accounting department, a good control system will provide opportunities for a second person to review an employee’s work. The most critical and common of these is to have one person prepare the bank reconciliations and a second person review them. CHAPTER 2 / Governance v. 2.0 31 Summary Internal controls are critical for all organizations; however, those discussed above are more easily implemented by larger organizations. For small NFPOs with limited staff and volunteers, implementing internal controls can be difficult. There may not be adequate expertise available for areas such as finance, HR, and IT, nor access to timely information. Also, limited resources make segregation of duties particularly challenging. Where it is not possible to segregate duties, an alternative is to implement compensating controls such as increased oversight by the board. F. Budgets LO6 – Describe the role of budgeting as a means of planning and internal control. A budget is an implementation tool that managers of NFPOs use to plan and control the use of scarce resources. Budgets and their preparation and monitoring are an important entity-wide control for NFPOs. Budgeting permits management and the board to plan for good oversight of the organization’s resources. If monitored appropriately, the budget will identify potential financial problems and allow for timely corrections to plans before minor problems escalate. The board’s budget policy should clearly indicate how much authority the executive director has to deviate from the approved budget. For example, if one budget line is underspent, can those savings be applied to another area, or would that require board approval? If the executive director can find other sources of revenue, do they have the authority to allocate where the funds are spent, or would that decision require board approval? The executive director’s authority may be expressed in terms of either dollars or percentages. Even if discretion is permitted, budget variances above the amount permitted by policy must be explained so that the board understands why they are occurring. To provide budget-to-actual comparisons, the NFPO’s accounting system must be designed to provide the necessary information. For example, the chart of accounts must align with the budget lines. If separate reports are provided for different programs, the accounting system can be set up to classify revenue and expenses by program. With a carefully designed accounting structure, the reports themselves are not difficult to prepare, and management can focus on developing plans and projections rather than on the format and logistics of the reports themselves. The effective use of budgets is one of the most important planning and oversight tools for a board. Those responsible for finance play a critical role in coordinating the budget process and ensuring that budget reports are clear and meaningful for use in management and board decision-making. 32 CHAPTER 2 / Governance v. 2.0 G. The Role of the External Auditor LO7 – Describe the external auditor’s role and duties with respect to the board and senior management. As discussed in Chapter 1, many NFPOs are required by legislation, bylaws, or contract to appoint external independent auditors to examine their financial statements. Even when not explicitly required, many boards implement a policy to have the financial statements audited annually. Appointing auditors is a key component of both entity-wide and specific internal controls. Under Canadian Auditing Standards (CAS), the auditor has reporting obligations to both the board and to management. Reporting Obligations to the Board The auditor should work closely with the organization to co-ordinate and plan the audit and to obtain access to the books and records. CAS require that the auditor communicate before, during, and after the audit with those charged with oversight over financial reporting. This is ultimately the board of directors, although many boards appoint an audit committee to work with the auditor. The audit committee normally consists of board members who are independent of management and the board executive. In smaller organizations, the finance committee may also act as the audit committee. The auditor is required to communicate to those charged with governance about the following matters: areas of audit risk as assessed by the auditor and areas that the board considers at risk; these areas are used to plan the nature, extent, and timing of audit procedures. whether the board (or audit committee) has learned of any risks or allegations of fraud since the last audit, and if so, details of such information (in the context of the audit, fraud includes not only falsifying records, but also deliberate bias in reporting estimates and disclosures). the accounting policies chosen by management in preparing the general- purpose financial statements and the auditor’s assessment of the appropriateness of these policies. any entity-wide internal control deficiencies that affect the reliability of financial reporting or that are within the board’s area of responsibility and authority (for example, a lack of board oversight of management, which only the board itself can correct). any allegations or other information that the auditor may learn during the audit that suggest the possibility of fraud, and what the auditor did to follow up. CHAPTER 2 / Governance v. 2.0 33 a summary of adjustments to the financial statements that the auditor proposed to management and that were included in the statements. a summary of adjustments or additional disclosures proposed by the auditor that management declined to incorporate into the financial statements. a copy of the management representation letter — a form signed by senior management attesting that financial and other information submitted to the auditor is accurate and complete. Reporting Obligations to Management In addition to the matters the auditor is required to report to those charged with governance, the auditor is also required to communicate with management on the following matters: whether management is aware of any allegations of fraud since the last audit, including details and management’s response. certain written representations, including acknowledging

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