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Avoiding Financial Fraud

Imagine that you wake up one morning to find your organization's name on the front page of the newspaper with a headline about fraud. It might be your worst nightmare as a board member.

It actually happened to the Woodruff Arts Center last November, when it admitted it had been defrauded of $1.438 million by an employee over a five-year period. Last month, the employee, Ralph Clark, admitted to embezzling $1.1 million by approving fictitious invoices for facilities-related services rendered to the arts center. He was able to approve invoices of up to $50,000 with little oversight, and the funds were then paid to his personal bank account. The fictitious invoices were for cleaning services from his wife's business that were never rendered ($780,000) and services he and students allegedly performed after hours ($153,000 and $41,000, respectively). He also received kickbacks ($165,000) from a maintenance service vendor in exchange for approving inflated invoices. (It is unclear why the difference in embezzlement amounts exists. Woodruff reported $1.438 million in fraud, but Clark admitted to only $1.1 million in embezzlement.)

The silver lining of the Woodruff's misfortune is that it gives nonprofit boards an excuse to reevaluate their own actions with respect to internal controls. Here are four tips to start the conversation.

Set the Right Tone at the Top

There is a reason "control environment" is the first and most important factor in establishing an entity's internal control framework, according to COSO, the Committee of Sponsoring Organizations of the Treadway Commission. The control environment, the entity's "tone at the top" conveyed by management, senior leaders, and, of course, a nonprofit's board of directors, affects employees' behavior.

Employees and those associated with an organization ascertain quickly whether management is happy to endorse—wink, wink—the occasional pocketing of supplies for personal use, or whether a lavish outing on the organization's dime is soft compensation (in lieu of higher salaries), a justified reward, or simply a nice excuse to try a hot restaurant's new spring menu.

The environment is set and felt in less obvious ways as well. Is merit rewarded above longevity? Are employees encouraged to engage in open dialogue with superiors and board members? Are there opportunities to engage in open dialogue (informal and otherwise) across divisions and departments, and even across leadership levels?

Such an environment—one that appreciates merit, encourages dialogue, and operates ethically—is the most effective complement to system-based internal controls and ongoing oversight activities from the auditor or the board.

Get Over the Denial Quickly

You may feel an entire gamut of emotions upon learning of employee fraud: anger, denial, embarrassment, or betrayal. Your instinct may be to act on any or all of those emotions rashly by firing the executive director, blaming a wayward employee, resigning from the board, or turning off your phone.

But as Katherine McLane, the vice president for communications and external affairs for the Livestrong Foundation, advised attendees of the Direct Marketing Association's annual nonprofit conference in Washington, D.C., last February, being prepared to make tough decisions and avoiding the paralysis boards sometimes feel when faced with unpalatable choices were two key factors that helped her organization navigate their own trying episode.

They acted swiftly and coherently, but not rashly or impulsively, to "tell [Lance Armstrong] to step away for the sake of preserving" the foundation's work. The board didn't linger over its denial; it wasn't paralyzed by the scandal. Individually, board members still had to process their emotions with respect to the incident, but as a group, as a leadership entity, as a board, the board acted.

Engage the Auditor

An annual audit and a strong relationship with an auditor can add tremendous value to an organization, in terms of accounting expertise, advice on internal controls, and knowledge about industry issues. Such value is often why some states and funders encourage (or mandate) the use of independent auditors for organizations that exceed certain size thresholds.

But if board members are simply relying on the auditor to ensure that the financial aspects of the organization are running smoothly, they may be caught unaware. An audit is not foolproof. An audit is not simply a stamp of approval that allows the board to consider programmatic challenges in lieu of financial ones.

An audit is an important aspect of maintaining the financial health of an organization, especially a larger organization, but it is not a panacea to prevent fraud.

Board members should view conversations with the auditor as an opportunity to discuss the organization's overall health and especially areas for improvement the auditor may have noticed. And the conversation should be just that: a conversation. If the auditor simply presents findings to the audit committee, whose members nod in approval, skim the management letter, and report briefly to the full board, the conversation is lacking engagement.

After all, it was an audit by Jones Day, a law firm retained by the Woodruff Arts Center, that gathered evidence and findings about the employee's fraud. Jones Day was retained when the employee's supervisor became suspicious, and I hope the conversations Jones Day continues to have with Woodruff's board continue to help the arts center resolve its challenges.

Review Finances Concisely, Consistently, and Creatively

I hope a review of financial information is an integral part of every board meeting, but simply reviewing the information is no guarantee that it is relevant, useful, or even accurate. Plus, if the financial review is buried as the final agenda item or if board members allow their eyes to glaze over as soon as numbers are placed before them, the review might not be all that helpful. And if too much attention is focused on the revenue side of the equation (How is our endowment doing? Have we met our year-to-date fundraising goal?), expense issues—including potentially fraudulent ones—may go unnoticed.

Instead, consider presenting the financial update in a concise, consistent, and creative way during each board meeting. Make as much information available to the board as it desires, but spend the meeting time discussing a few key metrics that board members should review on a regular basis. These vary by organization, but they usually involve a budget-to-actual report, a cash update, an administrative update (perhaps on the status of the audit or tax return), and an update on any other matters of importance to the board.

Spend the board meeting summarizing these key metrics (perhaps with graphs to illustrate the point in picture form), and allow the board to develop a baseline expectation of what the pictures should show. That way, deviations will be more apparent and pique the board's interest.

These four tips aren't guaranteed to prevent fraud or keep an organization's name off the front page of the paper, but by considering these and any other tips, board members might be able to sleep a bit easier, knowing their worst nightmares as board members are less likely to be realized.


avoiding-financial-fraud_Elaine-Grogan-Luttrull.jpgElaine Grogan Luttrull, CPA, Minerva Financial Arts
© 2013, Minerva Financial Arts

CPA Elaine Grogan Luttrull is the author of Arts & Numbers (Agate B2, 2013) and the founder of Minerva Financial Arts, a company devoted to bridging the gap between business and the arts. In addition, she teaches at the Ohio State University and the Columbus College of Art & Design, and she is the former director of financial analysis for The Julliard School.

Topics: Legal