Internal Controls and Financial Accountability for Not-for-Profit Boards Explained
Learn how not-for-profit boards can strengthen financial accountability through effective internal controls, transparent reporting, and sound governance practices.
Running a not-for-profit organization involves distinct financial responsibilities. Unlike businesses focused on shareholder returns, nonprofits are accountable to donors, grantmakers, and the public they serve. This accountability requires robust internal controls and diligent financial oversight by the board to maintain trust, ensure legal compliance, and safeguard resources dedicated to the organization’s mission. Effective financial stewardship is necessary for nonprofits to achieve their intended impact.
Purpose of Internal Controls in Not-for-Profit Boards
For not-for-profit boards, a system of internal controls serves several key purposes tied to the organization’s mission and public trust. Primarily, these controls are financial management practices designed to protect the organization’s assets from misuse, error, or theft.1National Council of Nonprofits. Internal Controls for Nonprofits Since nonprofits rely on external funding, ensuring these resources are secured and used appropriately is essential for operational stability and fulfilling fiduciary duties.
Internal controls also promote operational effectiveness. They help align the nonprofit’s activities with its mission, guiding the allocation of funds toward program services rather than excessive overhead. Clear procedures and defined responsibilities contribute to sound management, helping the organization achieve its goals efficiently. This structure supports the board’s oversight role, ensuring resources are directed toward community benefit.
Another purpose is ensuring the reliability of financial reporting. Accurate and timely financial reports are needed for informed decision-making by management and the board. Such reporting builds transparency and accountability, which helps maintain the confidence of stakeholders, including donors, foundations, and government agencies. Public filings, like the IRS Form 990, often require disclosure of governance practices, reflecting the importance of demonstrating financial stewardship.2The Tax Adviser. Revised Form 990: The Evolution of Governance and the Nonprofit World
Finally, internal controls help ensure compliance with laws, regulations, contracts, and grant requirements.3U.S. Government Accountability Office. Standards for Internal Control (The Green Book) Nonprofits navigate a complex regulatory landscape governing tax-exempt status, fundraising, and grant conditions. Strong control systems support adherence to these rules, helping nonprofits avoid legal penalties and reputational damage.
Financial Accountability Obligations for Board Members
Board members of not-for-profit organizations hold significant financial accountability, acting as fiduciaries entrusted with the organization’s resources and mission.4BoardSource. Nonprofit Fiduciary Duty and Responsibilities These responsibilities require board members to exercise reasonable care in overseeing the nonprofit’s financial health.
A central obligation is the duty of care, requiring board members to act diligently, as a prudent person would in similar circumstances. Financially, this involves active participation in oversight: attending meetings, reviewing financial reports and budgets, and asking pertinent questions. Board members should understand financial statements, monitor performance against budgets, and assess the organization’s overall financial condition. While committees may assist, ultimate responsibility rests with the full board.
The duty of loyalty mandates prioritizing the organization’s interests over personal gain. This means avoiding conflicts of interest where a board member might benefit from a transaction. Nonprofits typically require disclosure of potential conflicts and recusal from related decisions. This duty also guards against private inurement, where insiders improperly benefit from organizational resources, such as through excessive compensation.5National Council of Nonprofits. Can Board Members Be Paid?
The duty of obedience requires ensuring the organization adheres to applicable laws, regulations, its own bylaws, and its stated mission. This includes compliance with tax laws, state fundraising regulations, and donor restrictions. Board members oversee the timely filing of required reports, notably the annual IRS Form 990.6BoardSource. Form 990 IRS Instructions for Nonprofits Reviewing this form before filing is a common practice signifying board awareness of the information presented publicly.
Categories of Internal Controls
Not-for-profit boards utilize a system of internal controls often categorized by function: preventing problems, detecting them, and correcting them. This framework helps ensure comprehensive financial oversight.
Preventive
Preventive controls are proactive measures designed to stop errors or fraud before they happen. They build safeguards into processes, such as segregating duties so no single individual controls an entire financial transaction (e.g., separating invoice approval from check issuance). Requiring specific authorization levels for expenditures and using physical controls like locked storage for checks or password protection for financial software are other examples.
Detective
Detective controls identify problems after they occur, serving as a second line of defense. Regular reconciliation of bank accounts, comparing cash records to bank statements, is a common detective control. Periodic physical counts of assets compared to accounting records, and budget variance analysis comparing actual results to budgeted amounts, also help uncover discrepancies or inefficiencies needing investigation.
Corrective
When detective controls identify issues, corrective controls address them and aim to prevent recurrence. This involves actions like investigating discrepancies found during reconciliations and making necessary accounting adjustments. If an audit reveals weaknesses, such as poor expense documentation, corrective steps might include implementing stricter procedures or staff training. These actions refine the control system based on identified failures.
Documentation and Record-Keeping Parameters
Maintaining thorough and organized documentation is fundamental to financial accountability. These records provide evidence of activities, transactions, and compliance. The Internal Revenue Service requires exempt organizations to keep records sufficient to substantiate information reported on returns like the Form 990, clearly reflecting income and expenses.7Internal Revenue Service. Recordkeeping Requirements for Exempt Organizations
The scope of documentation includes foundational legal documents (articles of incorporation, bylaws, tax-exempt determination letter), governance records (board meeting minutes), and financial data. Board minutes document the decision-making process, showing fulfillment of fiduciary duties.8Nonprofit Risk Management Center. Fact Sheet on Board Minutes Financial records like annual statements, audit reports, and asset records often require permanent retention.
Specific retention periods apply to various documents, guided by statutes of limitations and regulations. Records supporting the Form 990 generally require retention for at least three years from the filing due date, potentially longer in cases like substantial income underreporting (six years). Employment tax records must be kept for at least four years. Records related to property should be kept until the limitation period expires for the year of disposal. Many organizations adopt a seven-year retention policy for tax-related records as a conservative practice.
Establishing a formal document retention and destruction policy is a recognized best practice.9National Council of Nonprofits. Document Retention Policies for Nonprofits Such a policy guides staff on retention schedules and ensures consistent handling of paper and electronic records, including secure storage and backup. The policy should also address suspending destruction for documents relevant to potential litigation, as required by laws like the Sarbanes-Oxley Act. Nonprofits must also consider state-specific requirements, which may mandate longer retention periods for certain records.
Ensuring Transparent Reporting
Transparent reporting involves the clear, accurate, and timely disclosure of financial performance, activities, and governance, helping to build and maintain public trust. For the board, ensuring transparency is part of fulfilling fiduciary responsibilities.
A primary tool for transparency is the annual information return, typically the IRS Form 990. This public document details a nonprofit’s finances, programs, governance, and compensation. Tax-exempt organizations are generally required to make their three most recent Form 990s and their application for tax exemption publicly available upon request.10Internal Revenue Service. Public Disclosure Overview for Exempt Organizations Many nonprofits post these documents on their websites proactively. Board review and approval of the Form 990 before filing helps ensure the accuracy of publicly reported information.
Adherence to Generally Accepted Accounting Principles (GAAP) provides a standardized framework for financial reporting. The Financial Accounting Standards Board (FASB) sets these standards for U.S. nonprofits. Updates, such as ASU 2016-14, aimed to improve the usefulness of nonprofit financial statements by enhancing disclosures about financial performance, liquidity, and resource management. Key changes included simplifying net asset classifications (to “with donor restrictions” and “without donor restrictions”) and requiring expense reporting by both natural (e.g., salaries, rent) and functional (program, administration, fundraising) classifications.11National Council of Nonprofits. Financial Transparency and Public Disclosure Requirements
Presenting expenses by function allows stakeholders to see how resources are allocated between mission activities and overhead. This analysis, often in a separate statement or notes, must disclose the cost allocation methods used. ASU 2016-14 also mandated enhanced disclosures about liquidity, giving readers a clearer view of resources available for near-term needs. GAAP-compliant statements, often independently audited, provide another layer of assurance.
Organizations can further enhance transparency by voluntarily sharing information beyond requirements. This can include publishing annual reports combining financial data with program impact narratives, making audited financials accessible online, and listing board members. Platforms like Candid allow nonprofits to share detailed information, increasing visibility and providing standardized data for evaluation. A culture of transparency, supported by the board, reinforces accountability and strengthens public trust.