From The AICPA Audit Committee Toolkit. Copyright © 2005 by the American Institute of Certified Public Accountants, Inc., New York, New York.

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Independence implies one's ability to act with integrity and exercise objectivity and professional skepticism. Therefore, independence in not-for-profit governance is critical to promote ethical behavior and reliable financial reporting. With direct contacts to the management team and the auditing firm, the audit committee is quite possibly in the best position to monitor an organization's compliance with independence standards.

There are many groups that define and require independence from the auditor, the board, and management (see table). The AICPA's independence standards apply to CPAs in all situations requiring independence. In addition, Government Accountability Office (GAO) standards, which are generally more restrictive, apply to engagements involving federal entities and those organizations receiving federal funds. The GAO standards have been voluntarily adopted by many state and local governments and other entities both domestically and internationally. The IRS and most states also have prohibitions against self-dealing and conflicts of interest that have specific provisions and implications for not-for-profit organizations.

In addition, there are practices self-imposed by the board of directors. Many not-for-profit organizations include definitions of independence , ethics , and integrity in their policies and procedures. Others require that the board, staff, or both sign annual Statements of Independence or Conflict of Interest. It is recommended that senior management define, communicate, and exhibit these qualities to set a high standard throughout the organization. A sample conflict of interest policy for a not-for-profit organization is provided as a part of this tool.

AICPA: Auditor Independence

Independence shall be considered impaired by a variety of factors. Generally, CPAs are not independent if they are in a position to influence, make management decisions, provide accounting services, or have financial interests in an entity. A CPA is required to document any possible situations that might impair his or her independence on an engagement, inform his or her CPA firm, and inform the potential client if any such situations may exist.

Auditor independence requirements will be determined by state boards of accountancy; the GAO, if law, regulation, agreement, policy, or contract requires the member's report to be filed under GAO regulations; and any organization that issues or enforces standards of independence that would apply to the member's engagement. Such organizations may have independence requirements or rulings that differ from (for example, may be more restrictive than) those of the AICPA.

GAO Yellow Book: Auditor Independence

In 2003, the GAO enacted significant changes to the auditor independence requirements under Government Auditing Standards . Commonly referred to as the Yellow Book, this guide covers federal entities and those organizations receiving federal funds. Various laws require compliance with the comptroller general's auditing standards in connection with audits of federal entities and funds. Furthermore, many states, local governments, and other entities, both domestically and internationally, have voluntarily adopted these standards.

Although the standard deals with a range of auditor independence issues, the most significant change relates to the rules associated with nonaudit, or consulting, services. Auditors have the capability of performing a range of services for their clients. However, in some circumstances, it is not appropriate for them to perform both audit and certain nonaudit services for the same client. In these circumstances, the auditor, their client, or both will have to make a choice about which of these services they will provide.

The focus of the changes to the auditor independence standard is to better serve the public interest and to maintain a high degree of integrity, objectivity, and independence for audits of government entities. The standard includes a principle-based approach to addressing this issue, supplemented with certain safeguards. The new independence standard for nonaudit services is based on two overarching principles:

1. Auditors should not perform management functions or make management decisions.
   
2. Auditors should not audit their own work or provide nonaudit services in situations where the amounts or services involved are significant or material to the subject matter of the audit.

For nonaudit services that do not violate these above principles, certain supplemental safeguards have to be met, for example: (1) personnel who perform nonaudit services are precluded from performing any related audit work, (2) the auditor's work cannot be reduced beyond the level that would be appropriate if the nonaudit work was performed by another unrelated party; and (3) certain documentation and quality assurance requirements must be met.

The standard includes an express prohibition regarding auditors providing certain bookkeeping and recordkeeping services, and limits payroll processing and certain other services, all of which are presently permitted under AICPA auditing standards. At the same time, the standard recognizes that auditors can provide routine advice and answer technical questions without violating these two principles or having to comply with the supplemental safeguards. The standard also provides examples of how certain services are treated under the rules.

IRS: Inurement, Disqualified Persons, Excess Benefit, Excise Tax, Revocation

The IRS has a different set of rules and definitions to promote independence from not-for-profit boards and staff. A fundamental requirement for tax-exempt organizations under Internal Revenue Code (IRC) Section 501(c)3, 6, 7, 9, 10, 13, or 19 is that they must be organized and operated in a way that no part of their net earnings inure (accrue) to the benefit of any private shareholder or individual.

Inurement. Organizations have lost their exempt status because of private inurement from unreasonable compensation; unreasonable fringe benefits; improper (generally personal) use of an organization's assets; forgiveness of debts owed by insiders; personal expenses being paid by the entity; low-interest or unsecured loans to insiders; unreasonable housing allowances; and other-than-arm's-length fair-market-value purchases, sales, or property rental between the organization and insiders.

An organization is not prohibited from transacting business with members of its board of directors or paying competitive salaries. Certain guidelines and procedures must exist, however, to ensure that transactions do not unreasonably benefit the insider.

Disqualified Persons. In any transaction, a person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization at any time during a five-year period ending on the date of the transaction. Persons who hold certain powers, responsibilities, or interests are among those who are in a position to exercise substantial influence over the affairs of the organization. This would include, for example, voting members of the governing body, and persons holding the power of:

• Presidents, executive directors, or chief operating officers
  
• Treasurers and chief financial officers

A disqualified person also includes certain family members of a disqualified person, and 35 percent-controlled entities of a disqualified person.

Excess Benefit. An excess benefit transaction is a transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of any disqualified person, and the value of such economic benefit provided by the organization exceeds the value of the consideration (including the performance of services) received for providing such benefit.

Excise Tax Under Section 4958—Intermediate Sanctions. An excise tax equal to 25 percent of the excess benefit is imposed on each excess benefit transaction between an applicable tax-exempt organization and a disqualified person. The disqualified person who benefited from the transaction is liable for the tax. If the 25 percent tax is imposed and the excess benefit transaction is not corrected within the taxable period, an additional excise tax of 200 percent of the excess benefit is imposed.

Revocation.The IRS has indicated that the following four factors will be considered in determining whether to revoke an applicable tax-exempt organization's exemption status when an excess benefit transaction has occurred: repeated excess benefit transactions, size and scope of excess benefit transactions, whether organization implemented safeguards to prevent future recurrences, and whether there was compliance with applicable laws.

Conflict of Interest Policy*

[Organization Name]

Policy on Conflicts of Interest

and Disclosure of Certain Interests

This conflict of interest policy is designed to help directors, officers, and employees of the [ Organization Name ] identify situations that present potential conflicts of interest and to provide [ Organization Name ] with a procedure that, if observed, will allow a transaction to be treated as valid and binding even though a director, officer, or employee has or may have a conflict of interest with respect to the transaction. In the event there is an inconsistency between the requirements and procedures prescribed herein and those in federal or state law, the law shall control. All capitalized terms are defined in Part 2 of this policy.

1. Conflict of Interest Defined. For purposes of this policy, the following circumstances shall be deemed to create Conflicts of Interest:
    
   1. Outside Interests.

      (i) A Contract or Transaction between [Organization Name] and a Responsible Person or Family Member.
      (ii) A Contract or Transaction between [Organization Name] and an entity in which a Responsible Person or Family Member has a Material Financial Interest or of which such person is a director, officer, agent, partner, associate, trustee, personal representative, receiver, guardian, custodian, conservator, or other legal representative.

   2. Outside Activities.

      (i) A Responsible Person competing with [Organization Name] in the rendering of services or in any other Contract or Transaction with a third party.
      (ii) A Responsible Person's having a Material Financial Interest in; or serving as a director, officer, employee, agent, partner, associate, trustee, personal representative, receiver, guardian, custodian, conservator, or other legal representative of, or consultant to; an entity or individual that competes with [ Organization Name ] in the provision of services or in any other Contract or Transaction with a third party.

   3. Gifts, Gratuities and Entertainment. A Responsible Person accepting gifts, entertainment, or other favors from any individual or entity that:

      (i) does or is seeking to do business with, or is a competitor of [Organization Name]; or
      (ii) has received, is receiving, or is seeking to receive a loan or grant, or to secure other financial commitments from [Organization Name];
      (iii) is a charitable organization;

      under circumstances where it might be inferred that such action was intended to influence or possibly would influence the Responsible Person in the performance of his or her duties. This does not preclude the acceptance of items of nominal or insignificant value or entertainment of nominal or insignificant value that are not related to any particular transaction or activity of [ Organization Name ].

2. Definitions.
    
   1. A Conflict of Interest is any circumstance described in Part 1 of this Policy.
   
    
   2. A Responsible Person is any person serving as an officer, employee, or member of the board of directors of [Organization Name].
   
    
   3. A Family Member is a spouse, domestic partner, parent, child, or spouse of a child, brother, sister, or spouse of a brother or sister, of a Responsible Person.
   
    
   4. Material Financial Interest in an entity is a financial interest of any kind that, in view of all the circumstances, is substantial enough that it would, or reasonably could, affect a Responsible Person’s or Family Member’s judgment with respect to transactions to which the entity is a party. This includes all forms of compensation. (The board may wish to establish an amount that it would consider to be a “material financial interest.”)
   
    
   5. A Contract or Transaction is any agreement or relationship involving the sale or purchase of goods, services, or rights of any kind, the providing or receipt of a loan or grant, the establishment of any other type of pecuniary relationship, or review of a charitable organization by [Organization Name]. The making of a gift to [Organization Name] is not a Contract or Transaction.
   
    
3. Procedures.
    
   1. Before board or committee action on a Contract or Transaction involving a Conflict of Interest, a director or committee member having a Conflict of Interest and who is in attendance at the meeting shall disclose all facts material to the Conflict of Interest. Such disclosure shall be reflected in the minutes of the meeting.
   
    
   2. A director or committee member who plans not to attend a meeting at which he or she has reason to believe that the board or committee will act on a matter in which the person has a Conflict of Interest shall disclose to the chair of the meeting all facts material to the Conflict of Interest. The chair shall report the disclosure at the meeting and the disclosure shall be reflected in the minutes of the meeting.
       
   3. A person who has a Conflict of Interest shall not participate in or be permitted to hear the board’s or committee’s discussion of the matter except to disclose material facts and to respond to questions. Such person shall not attempt to exert his or her personal influence with respect to the matter, either at or outside the meeting.
       
   4. A person who has a Conflict of Interest with respect to a Contract or Transaction that will be voted on at a meeting shall not be counted in determining the presence of a quorum for purposes of the vote. The person having a conflict of interest may not vote on the Contract or Transaction and shall not be present in the meeting room when the vote is taken, unless the vote is by secret ballot. Such person’s ineligibility to vote shall be reflected in the minutes of the meeting. For purposes of this paragraph, a member of the board of directors of [Organization Name] has a Conflict of Interest when he or she stands for election as an officer or for re-election as a member of the board of directors.
       
   5. Responsible Persons who are not members of the board of directors of [Organization Name], or who have a Conflict of Interest with respect to a Contract or Transaction that is not the subject of board or committee action, shall disclose to the Chair or the Chair’s designee any Conflict of Interest that such Responsible Person has with respect to a Contract or Transaction. Such disclosure shall be made as soon as the Conflict of Interest is known to the Responsible Person. The Responsible Person shall refrain from any action that may affect [Organization Name]’s participation in such Contract or Transaction.

      In the event it is not entirely clear that a Conflict of Interest exists, the individual with the potential conflict shall disclose the circumstances to the Chair or the Chair’s designee, who shall determine whether there exists a Conflict of Interest that is subject to this policy.

4. Confidentiality. Each Responsible Person shall exercise care not to disclose confidential information acquired in connection with such status or information the disclosure of which might be adverse to the interests of [Organization Name]. Furthermore, a Responsible Person shall not disclose or use information relating to the business of [Organization Name] for the personal profit or advantage of the Responsible Person or a Family Member.
    
5. Review of Policy.
    
   1. Each new Responsible Person shall be required to review a copy of this Policy and to acknowledge in writing that he or she has done so.
       
   2. Each Responsible Person shall annually complete a disclosure form identifying any relationships, positions, or circumstances in which the Responsible Person is involved that he or she believes could contribute to a Conflict of Interest arising. Such relationships, positions, or circumstances might include service as a director of or consultant to a not-for-profit organization, or ownership of a business that might provide goods or services to [Organization Name]. Any such information regarding business interests of a Responsible Person or a Family Member shall be treated as confidential and shall generally be made available only to the Chair, the Executive Director, and any committee appointed to address Conflicts of Interest, except to the extent additional disclosure is necessary in connection with the implementation of this Policy.
       
   3. This policy shall be reviewed annually by each member of the board of directors. Any changes to the policy shall be communicated immediately to all Responsible Persons.

Signature: _________________________ Date: _____________________

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