INTERNAL CONTROLS AND FRAUD PREVENTION IN NON-PROFIT ORGANIZATION

WRITTEN
BY

DAVID SANNI

Designed to provide information on key areas that can strengthen the internal control system of VI-MID-ISLAND SERVICE (VIMS)

Submitted To

VANESSA OLTMAN

Faculty of Management
Vancouver Island University
Nanaimo, BC, Canada

(Nov/15/2012)

Table of Content

1.0 INTRODUCTION 3 2.0 NATURE OF FRAUD IN CANADIAN NON PROFIT ORGANIZATION 3 2.1 TYPE OF FRAUD IN NON PROFIT ORGANIZATIONS 3 2.2 PERPETRATORS OF FRAUD IN NON PROFIT ORGANIZATION 4 2.3 IMPACT OF FRAUD TO NON PROFIT ORGANIZATION 4 3.0 COMPREHENSIVE APROACHE TO REDUCE FRAUD 5 3.1 UNDERSTANDING INTERNAL CONTROL 5 3.2 BENEFIT OF INTERNAL CONTROL 5 3.3 LIMITATIONS OF INTERNAL CONTROL 6 3.4 CONTROL MEARSURES IN PREVENTING FRAUD 6 3.5 SUMMARY AND CONCLUSION……………………….………………….8 4.0 REFERENCE…… ……………………………………………………………9

1.0 INTRODUCTION

The Canadian non profit sector has one of the largest populations in the world, accounting for over 7% GDP and creating 2 million full time jobs for Canadians. Further discoveries was made that 78% Canadians donates money to non profit Organization irrespective of all walks of life and income bracket. These donations are received to address core issues like youth, health, safer environment, crime prevention, poverty irradiation and to name a few.
Non profit organizations play an important role in Canada life and the increasing demand for accountability brings more attention to non profit organization fraud. Non profit organizations do not issue shares and the aim is not to maximize profit, they are only accountable to donors for source of capital. And if a non profit organization has an internal control problem donor may shift to other organizations where their capital is used efficiently. Internal control information does affect either directly or indirectly donors decision to contribute and the aim of this report is to identify the problems of internal control in non profit Organization, the effects of its weakness and the possible solutions to prevent fraud in VI-Mid-Island Service (VIB).

2.0 NATURE OF FRAUD IN CANADIAN NON PROFIT ORGANIZATION

Fraud is defined as a deliberate misrepresentation that causes a person or business to suffer damages, often in the form of monetary losses through deception or concealment. And Occupational Fraud as defined by the ACFE is the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets. Traditional fraud triangle theory by Donald Cressey explains that propensity of fraud occurring in an organization lies on three critical elements which are Pressure, Opportunity, and Rationalization. These elements are interrelated in order for fraud to be committed in an organization and every corporate executives needs to understand this theory to enable them know how and why employees perpetrate fraud. Diagram below describe the element and how they are interrelated.

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The fraud triangle construct explain these three elements as: • Pressure which is the driving forces behind a fraud committed. It is the circumstances that motivate an individual to commit fraud. There are many reasons that motivate fraud in an organization, but financial pressure is often the most common reason. • Opportunity is the favourable circumstances that enable fraud to be committed. The level of opportunity that a person has to commit fraud is based on there position in the organization. • Rationalization is the reason provided to justify an inappropriate act by a perpetrator rather than considering themselves as a criminal. Perpetrators always gives excuses for there act by either lack of good compensation, or misguided belief that they are entitled to borrow from the organizations funds for personal financial obligations. Non-profit median loss was $100,000 per fraud occurrence and represented 10.4% of the total organizations studied. How ever comparing to overall data else where we found out that losses in Canadian non profit organizations is low, but that could be misleading for some reasons. Much fraud goes unreported, while some organizations are reluctant in releasing information on fraud to protect the image of the organization. And also many fraud outcomes in Canadian media are not reported compared to other country.

2.1 TYPE OF FRAUD IN NON PROFIT ORGANIZATIONS

There are two categories of fraud that can be perpetrated against a non profit organization, which are internal and external fraud. Internal fraud is a fraud committed by an insider of the organization such as employees, directors and officers. While external fraud is committed by person outside the organization such as fundraisers, sub-recipients, programme participants and vendors.
Internal fraud can also be classified into two categories misappropriation of funds and fraudulent financial statement. Assets misappropriation appears to be the most common fraud in non profit organization such as: • Revenue and cash receipt scheme: Skimming which is known as stealing of cash before they are been recorded in the accounting record or Theft of merchandise which involves stealing items donated. • Purchase and disbursement scheme: Credit card abuse, which involves using organization credit card for personal use or coping donors card number for illegal usage and fictitious vendor scheme which involves issuing fake receipt to claim payment from the organization. • Payroll and employee expense scheme: This involves continued payment to terminated workers, overstating employees working hours, and fictitious expenditure fraud. The existence of external fraud is not as common as internal fraud but could be inform of: • Fraudulent billing by vendors: This involves double billing, failure to deliver purchases, or price gouging. • Financial assistant fraud: This involves financial aid granted to support non existing projects. This is discovered when donors visit the project to access it impact. • Sub recipient fraud: It involves reporting fraudulent data or program cost to the non profit organization that made the award for the original grant.

2.2 PERPETRATORS OF FRAUD IN NON PROFIT ORGANIZATION

Non profit Organization fraud can been committed at all levels from the CEO, managers, CFO, financial staffs, and fund raisers. The most frequently reported cases of fraud with high losses is from the CEO and other managers, followed by the CFO other financial officers and employees. Research discovered perpetrators at higher level have the tendency to commit fraud more frequently and mostly perpetrated individually, although median losses from fraud perpetrated by group could be higher.
Report by ACFE discovered a high percentage of fraud by accounting department with 22% above all other section, and weak internal control is the cause of most fraud cases.

2.3 IMPACT OF FRAUD TO NON PROFIT ORGANIZATION

The revenue loss is significant in fraud committed in non profit organizations but there are more severe impacts beyond financial losses like; • Negative publicity- which could damage organizations credibility for years to come. • Loss of Donors- An organization with publicized fraud will be less attractive to donors, and most contributors will not want to support an organization already tagged with a fraud record. • Loss of employees- In most situation of fraud the organization is forced to shut down due to bankruptcy or order by the government in most cases. • Low morale- There will definitely be a decline in employees and volunteer motivation because of the feeling the organization has failed them and there mission. • Cost of investigation and lawsuit- If fraud involving a substantial amount is uncovered in a non profit organization, cost of lawsuit and investigation could be tens of thousand or more.
In some cases the government may revoke the charity right of some organization, like the case of Biathlon Canada a government body for shoot and ski-sport which also provides support for the national team in 2010 was involved in a tax shelter scheme worth over $2 billion. Government revoked their charity right.
Far beyond the organizational damage done by the perpetrators the community and the beneficiaries of these donations also suffer when the organizations faces these problems. Also in the case of Newfoundland and Labrador brain injury association that was defrauded by former executive officer in 2010. The provincial office had to be shut down due to financial hardship.

3.0 COMPREHENSIVE APPROACHES TO REDUCE FRAUD

To minimize the opportunities for fraud and abuse in a non profit organization there is need for a strong board leadership and internal control system for adequate fraud prevention and risk management policies. This will enhance a well define control environment and allow management to stay focused on organization’s pursuit of its operation and financial performance goal.
Understanding the responsibilities of the internal control system in an organization reflects the effectiveness of this system as a necessity to archive a control environment.

3.1 UNDERSTANDING INTERNAL CONTROL

Every organization irrespective of size has a system and method of operation that safeguard there assets and promote the effective usage in accomplishing their goals. The system adopted is known as internal control, which is also defined by committee of supporting organization (COSO) as a process effected by the City Council, management, administration and individuals; designed to provide reasonable assurance regarding the achievement of objectives in the following areas: • Effectiveness and efficiency in its operation • Reliability of financial reporting • Compliance with applicable laws and regulations
This definition explains the fundamental concept of internal control as a means to an end not an end itself, and been effected by people to affect every level of an organization.
A sound internal control system promotes efficiency, reduces the risk of asset loss, and assist in the reliability of financial statement and compliance with law and regulation.

3.2 BENEFIT OF INTERNAL CONTROL

Internal control is divided into two categories: Administrative control and internal accounting control system. A good administrative control requires total commitment from top management and volunteers in adhering to principles of good control and direct oversight to their operation. Problems at the top management level can work down the organizational chart and that can cause disruption in operation. Therefore an active involvement by the top management and volunteer has a great impact in deterrent of fraud and in promoting operational efficiency while complying strictly with the stated policies of the organization.
A good internal accounting control system does not only safeguard the organizational assets but also ensure reliability on the financial record of the organization. The role of a sound financial record in a non profit organization is very important to prevent fraud. It also helps in other areas like insurance claim when adequate financial record is required for proof, and in budget preparation.
There are five main components to effective internal control system which are: • Control environment: This sets the overall controls tone of an organization and it is concerned with the action, policies and procedure that reflect the overall attitude of the top management, directors and owners of the organization. It is important that the organization makes it clear that unethical behaviours will not be tolerated in order to safeguard the trust given by there supporters and donors. • Risk assessment: This is the entity’s identification and analysis of risks in the achievement of its objectives. It important for management to identify their risk, determine the impact, and develops a plan to manage the risk. • Information and communication: This is a mean by which record report and process are sent across within and outside the organization. An effective communication is important to ensure roles and responsibilities are clearly defined. • Control activities: These are the processes, policies and procedures that help ensure that management directives are carried out. They consist of the controls over revenues, expenses and the financial statement close process. • Monitoring: This is an ongoing and periodic assessment of the internal control quality performance to ensure its effectiveness and modification when needed.

3.3 LIMITATIONS OF INTERNAL CONTROL

Regardless of how internal control system in non profit organization is been operated it can only provide reasonable assurance that a positive outcome can be achieved. The likelihood of these achievements are limited by the following factors: 1. Judgment- The effectiveness of controls will be limited by decisions made with human judgment under pressures to conduct business based on the information at hand.

2. Breakdowns- Employees sometimes misunderstand instructions or simply make mistakes causing breakdown. These errors may also result from new technology and the complexity of computerized information systems.

3. Management Override- High level personnel may override prescribed policies and procedures for personal gain or advantage. This should not be confused with management intervention, which represents management actions to depart from prescribed policies and procedures for legitimate purposes.

4. Collusion- Individuals acting collectively can alter financial data or other management information in a manner that cannot be identified by control systems.

3.4 MEASURES TO PREVENT FRAUD IN NON PROFIT ORGANIZATION

• Set the tone at the top: Fraud prevention is a measure that has to be initiated from the top management and donors. In order to ensure fair and honest practices, management including directors and officers need to “set the tone at the top” for good ethical behaviour. • Double signatures and authorization: Multiple layers of approval makes it difficult for frauds to be perpetrated. Huge expenditures involving check, cash and credit card requires two signatures and authorization. Having a board member or director as a secondary approval well definitely be helpful. • Backup documentation: Ensuring that all cash and check disbursement are accompanied by an invoice to justify the payment. And disbursement should not be authorized by the same manager signing the check. • Never pre-sign checks: Many non profit organizations executives pre-sign checks when going on vacation. All blank checks should be kept away or locked to avoid unauthorized usage. • Segregation of duties: Individual should not be responsible for entire incoming and outgoing transactions. If the organization is not having enough employees to segregate duties, the board or directors or officers should be responsible for reconciling bank and credit card statement. • Conducting background check: Background check on new employees and volunteers is important and can help reveal undisclosed criminal records and prior instance of fraud, helping to avoid bad hire. • Adequate training: Efficient training is required to employees to keep them up to date on change in technology, practice or operating environment. • Encourage whistle blowers: Employees may not have he courage to report theft or fraud if they feel their job is in jeopardy. Providing anonymous mean of communications like hotlines or drop box will be encouraging. • Fixed asset inventories: Fixed asset inventory review should be conducted at least once per year to ensure no equipment is missing and also recording the serial numbers of this equipment, if possible engraving identity mark on them in case of theft. • Audit and board level oversight: Regular audit will not catch every fraud; therefore there should be board review and oversight of the audit. SUMMARY AND CONCLUSION Some may find fraud in non profit organization unthinkable, but fraud has no discrimination to any organization. The VI-Mid-island Service board need to be aware of the magnitude of risk related to occupational fraud and needed steps to limit the frequency. Greed leads people to abuse there trusted positions in the organizations. And without the opportunity of internal control weakness available to capitalize on by perpetrators, fraud occurrence will be highly reduced and prevented. However, well established internal control system will not just prevent fraud in this organization but also ensure transparency in operation to convince the public that we have the right systems and policies in place that contribution and other resources are effectively managed, maintained and deployed. It is not necessarily about the money contributed but rather the primary responsibility to use the donated funds effectively and efficiently.

|TYPE |REFERENCE |IN-TEXT CITATION |
|E-Book |ACFE Report, (2012) Report to the nations on occupational fraud and abuse |ACFE 2012 |
|E-Book |COSO Framework, (2011) Internal control-integrated framework |COSO 2011 |
|Book with 1 |William A. Morehead, (2007) Internal Control and Governance in Non-governmental |William A. |
|author |Organizations Designed |Morehead 2007 |
| | | |
|Book with 2 |Martin T. Biegelman, Joel T. Bartow, 2nd Edition (2012) Executive Roadmap to Fraud |Biegelman and |
|authors |Prevention and Internal Control |Bartow 2012 |
|E-journal article|CBC news Ottawa, (2010) Biathlon Canada defends tax-shelter arrangement. Available link: |CBC 2010 |
| |http://www.cbc.ca/news/canada/ottawa/story/2010/11/02/ottawa-tax-shelter.html | |
|E-Book |CGA, (2011) Does Canada have problem with occupational fraud |CGA 2011 |
|E-journal article|CBC news, (2012) Defrauded charity still broke after crime. Available link: |CBC 2012 |
| |http://www.cbc.ca/news/canada/newfoundland-labrador/story/2012/11/06/nl-brain-injury-frau| |
| |d-1106.html | |
|E-Book |Andrew S. Lang, Tammy S. Ricciardella, (2001) Preventing fraud: How to safeguard your |Andrew Lang and |
| |Organization |Tammy Ricciardella|
| | |2001 |
|E-Book |Janice Moen CPA, (2010) Internal Controls |Janice Moen 2010 |