In May 2013, COSO issued its updated

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1 THE PPC NONPROFIT UPDATE, JANUARY 2014, VOLUME 21, NO. 1 THE PPC NONPROFIT UPDATE New COSO Framework Part 2 In May 2013, COSO issued its updated Internal Control Integrated Framework (2013 Framework). In the December 2013 issue of The PPC Nonprofit Update, we provided an overview of the 2013 Framework and the categories of objectives of internal control. Those three categories of objectives that allow organization to focus on different aspects of internal contol are operations, compliance, and reporting. This article addresses the relationship between components and principles, requirements for an effective system of internal control, and an overview of supporting COSO documents. Relationship between Components and Principles The 2013 Framework provides 17 principles representing the fundamental concepts associated with each component of internal control. An entity can achieve effective internal control by applying all of the principles because they are drawn directly from the components. The 17 prin- ciples relating to the five internal control components are as follows: Control Environment. 1. The organization demonstrates a commitment to integrity and ethical values. 2. The board is independent from management and exercises oversight of internal control. 3. Management establishes structure, reporting lines, authorities, and responsibilities for internal control. 4. The organization demonstrates a commitment to attracting, developing, and retaining competent individuals involved with internal control. 5. The organization holds individuals accountable for their internal control responsibilities. Risk Assessment. The organization 6. Specifies sufficiently clear objectives to enable the identification and assessment of internal control risks. 7. Identifies and analyzes internal control risks. 8. Assesses the potential for internal control fraud risks. In this Issue: New COSO Framework Part 2 ARSC Issues More Clarity EDs Website of Interest New Year s To Do List Tax Brief This newsletter is also available online. Please call (800) , or order online at ppc.thomsonreuters.com.

2 2 THE PPC NONPROFIT UPDATE, JANUARY 2014, VOLUME 21, NO Identifies and assesses significant changes that could impact internal control. Control Activities. The organization 10. Selects and develops control activities to mitigate risks. 11. Selects and develops IT general controls. 12. Establishes internal control policies and procedures and puts them into action. Information and Communication. The organization 13. Uses relevant, quality information to support internal control. 14. Internally communicates information to support internal control. 15. Externally communicates internal control matters. Monitoring. The organization 16. Selects, develops, and performs ongoing and/or separate internal control evaluations. 17. Evaluates and communicates deficiencies to responsible parties for corrective action. The principles are presumed to be suitable and relevant to all entities. However, there may be rare situations where management determines that a principle isn't relevant to an internal control component. The 2013 Framework also describes points of focus that are important characteristics of the principles. The points of focus can help management in designing, implementing, and conducting internal control, as well as in making assessments of whether relevant principles are present and functioning. Effective Internal Control The 2013 Framework provides a number of requirements for an effective system of internal control. According to the 2013 Framework, an effective system of internal control reduces to an acceptable level the risk of failing to achieve an organizational objective. In addition, it may relate to one, two, or all three categories of objectives. According to the 2013 Framework, in order to achieve effective internal control Each of the Five Components and the Relevant Principles Are Present and Functioning. Present means that the components and relevant principles have been designed and implemented to achieve specified objectives. Functioning means that the components and relevant principles are operating within the system of internal control to achieve specified objectives. The Five Components Operate in an Integrated Manner. Operating together means that all five components, taken together, reduce to an acceptable level the risk of failing to achieve an objective. Rather than discretely considering components, they're considered in terms of how they operate together as an integrated system. are present and functioning, and (b) internal control deficiencies combined across components don't result in a conclusion that one or more major deficiencies exist. When an organization determines that an internal control deficiency exists, the 2013 Framework requires management to use judgment in assessing the severity of that deficiency to determine whether each of the components and relevant principles are present and functioning, the five control components are operating together, and ultimately, the organization's system of internal control is effective. Overview of Supporting COSO Documents In addition to the 2013 Framework, COSO issued the following documents: Illustrative Tools for Assessing Effectiveness of a System of Internal Control. The Illustrative Tools include templates and scenarios that can help users apply the 2013 Framework. These tools concentrate on the various components of internal control and relevant principles, not on the underlying controls affecting the principles. They aren't an integral part of the framework and, accordingly, may not address all matters that need to be considered when evaluating an internal control system. Internal Control over External Financial Reporting: A Compendium of Approaches and Examples (the ICEFR Compendium). COSO developed approaches and examples for the ICEFR Compendium to assist users responsible for designing and implementing a system of internal control over external financial reporting. The approaches and examples within the ICEFR Compendium illustrate how organizations may apply the principles set forth in the 2013 Framework when preparing financial statements and other external financial reporting. Transition COSO believes that users should transition their applications and related documentation to the 2013 Framework as soon as it is feasible in their particular circumstances. Because COSO considers the key concepts and principles in the 1992 Framework still fundamentally sound and widely accepted, users may continue to use it until December 15, 2014, and COSO will continue to make the 1992 Framework available until that date. After that time, COSO has indicated that it will consider the 1992 Framework superseded by the 2013 Framework. Management can demonstrate that components operate in an integrated manner when (a) components Also, COSO has indicated that it will consider its 2006 Internal Control over Financial Reporting Guidance for

3 Smaller Public Companies superseded by the ICEFR Compendium after December 15, During the transition period (May 14, 2013, to December 15, 2014), COSO has stated that application of the COSO framework involving external reporting should clearly distinguish whether the 1992 or 2013 framework is used. ARSC Issues More Clarity EDs Due to the complexity of nonprofit financial statements compared with the fact that many nonprofit organizations have small accounting departments, many nonprofit organizations engage a CPA to prepare the organization s monthly financial statements. Under current standards, the CPA must then perform at least a compilation of those financial statements. Due to changes in the AICPA s ethics rules, the AICPA s Accounting and Review Services Committee (ARSC) is looking at changes to the compilation standards. That work is being done as part of the SSARS Clarity Project. ARSC s June 2012 exposure drafts (EDs) of proposed new standards for compilation engagements were unpopular and ARSC withdrew the EDs in January ARSC went back to the drawing board on its approach to compilation engagements and financial statement preparation services. The Result Three New EDs In October 2013, ARSC issued three exposure drafts: Preparation of Financial Statements, Compilation Engagements, and Association with Financial Statements. The preparation standard would apply when the accountant is engaged to prepare financial statements, but not to perform a compilation, review, or audit. The compilation standard would apply when the accountant is engaged to perform a compilation. Finally, the association standard would apply when the accountant agrees to permit the use of the accountant s name in a communication that also includes financial statements that the accountant may or may not have prepared and upon which the accountant may or may not have issued a report. Interested parties may submit comments to the AICPA until May 2, ARSC plans to deliberate the comments at its May 2014 meeting. THE PPC NONPROFIT UPDATE, JANUARY 2014, VOLUME 21, NO. 1 3 The EDs indicate a proposed effective date for periods ending on or after December 15, 2015, with early implementation permitted. More on the Clarity Project Work on the SSARS Clarity Project continues. At its November 2013 meeting, ARSC discussed the comments on the previously-issued exposure drafts of the clarified review engagement standards. ARSC also worked on drafts of a proposed SSARS for a framework for compilation and review engagements and proposed SSARSs on compilations of pro forma financial information and compilations of prospective financial information. The exposure draft related to the framework is expected to be released in late November or early December. ARSC has not indicated when the proposed SSARS on pro forma and prospective information will be released. The compilation EDs are available at org/research/exposuredrafts/compilationreview/ DownloadableDocuments/ a_SSARS_ED_ Prep_Comp_Assoc.pdf. Website of Interest The following website may be of interest to the nonprofit sector. This website is where you ll find Marc Pitman nonprofit consultant, fundraising trainer, blogger, and author of Ask Without Fear! Featured in respected publications and a guest on well-known television programs, The Atlantic magazine has put him on the list of top five philanthropic must-read blogs. His specialty is helping nonprofit board members get excited about asking for money. On his website, you ll find his blog, articles, training opportunities, relevant articles, case studies, a newsletter, and other tools to help fund more effectively.

4 4 THE PPC NONPROFIT UPDATE, JANUARY 2014, VOLUME 21, NO. 1 New Year s To Do List January is a good time for exempt organizations, whether calendar-year or fiscal-year, to address several matters that have tax and/or governance significance. Taking Care of Donors Contributions of cash or property of $250 or more require the donor to obtain a contemporaneous written acknowledgment (CWA) of the donation from the donee Section 501(c)(3) organization. At a minimum, the CWA must indicate the donee organization s name and address, contribution date, amount of cash contributed, and a description of any property contributed (a good-faith estimate of the value of any goods or services contributed must be provided by the donor). Most importantly, the CWA must include a statement as to whether any goods or services were provided (and their estimated value) in consideration for the contribution. A written acknowledgment is contemporaneous only if it is obtained by the donor on or before the earlier of (a) the date the donor s tax return (for the year the contribution was made) is filed, or (b) the due date (including extensions) of this return. Goods or Services Statement. Many charities, especially new ones, have deficient donor acknowledgments. Often, there is a failure to include a statement regarding any goods or services provided. The no goods or services required statement is being strictly enforced by both the IRS and the courts, which has resulted in deductions not being allowed if the statement is omitted. (Joyce A. Linzy, TC Memo ) Donations to private foundations are also subject to the strict donor acknowledgment rules. Unfortunately, foundation managers are often unaware of the rule and fail to provide an acknowledgment at all. Suggested Actions. Organizations should check for adequate content in their donor acknowledgment; confirm that their records adequately identify the name, address, and contributions of donors who should receive an acknowledgment; and furnish the acknowledgment as soon as possible to avoid the possibility that a donor files his/her tax return before receiving the acknowledgment. A tardy acknowledgment is legally no better than none at all. Who s Who Lists It is essential for an exempt organization to maintain complete lists of relationships for persons connected with it. Such lists can be critical for either tax or governance reasons. Disqualified Persons. Disqualified persons (DPs) who receive economic benefits from a Section 501(c)(3) public charity, (c)(4), or (c)(29) organization in excess of the value of the consideration for such benefits are subject to an excise tax of 25% of the excess benefit received [IRC Sec. 4958(a)(1)]. Under certain circumstances, organization managers are subject to a 10% tax. A DP is anyone who was, at any time during the five-year period ending on the date of the excess benefit transaction, in a position to exercise substantial influence over the organization s affairs (whether or not there is actual exercise). Also included are members of that person s family and any entity (corporation, partnership, LLC, trust, or estate) in which the DP and family members have more than a 35% ownership interest [IRC Secs. 4958(f)(1) and (f)(3)]. Family members are a person s spouse, siblings (whether by whole or half blood) and their spouses, ancestors, direct descendants through great-grandchildren, and spouses of these descendants [IRC Sec. 4958(f)(4)]. Ownership of an entity includes constructive ownership (i.e., the indirect holdings of family members are considered) [IRC Sec. 4958(f)(3)(B)]. The list of DPs for an organization that sponsors donor advised funds (DAFs) also includes anyone who provides investment advice regarding fund assets. In addition, if the organization is a supported organization under IRC Sec. 509(a)(3), the DPs of the supporting organization are also DPs for the supported organization. Note: The previous discussion is not a complete definition of a DP but is intended to indicate the complexity of identifying DPs. Conflict of Interest Persons. Persons who should be identified for conflict of interest purposes are basically the same as those who are DPs, as described previously, except that family members include both adopted and natural children. Related Organizations. Individuals are not the only persons of concern to an exempt organization. Transactions with related organizations require risk management to identify excess benefit transactions, and also to recognize potential unrelated business income and nonexempt activities. Therefore, an organization must identify all related organizations to ensure that all applicable transactions are properly documented and all required disclosures are made on Form 990.

5 THE PPC NONPROFIT UPDATE, JANUARY 2014, VOLUME 21, NO. 1 5 Related organizations (in addition to a parent or subsidiary) include 1. Brother/Sister an organization controlled by the same person or persons who control the filing organization. 2. Supporting/Supported an organization that is (or claims to be), at any time during the organization s tax year, (a) a supporting organization of the filing organization, or (b) a supported organization. Control can be established either through influencing the governing board or through ownership. Control may be either direct or indirect (e.g., the filing organization controls Entity A, which in turn controls Entity B; therefore, the filing organization is deemed to control Entity B). Donor Advised Funds. A distribution from a DAF that results in more than an incidental benefit to certain persons can trigger an excise tax on the recipient and, in certain instances, the fund manager [IRC Sec. 4967(a)]. Persons who cannot benefit include a donor or any person designated by the donor who has advisory privileges, family members of these persons, and entities in which the preceding persons have more than a 35% interest. In this instance, the definition of family members is the same as the definition for DP purposes. Observations. The greatest challenge in maintaining current lists of relationships is identifying changes in the identity of family members and their businesses and investments. Ideally, an organization should communicate at regular intervals (no less frequently than annually) with key persons to update the appropriate lists. Suggested Actions. Maintaining accurate lists is the best way to minimize the likelihood of undesirable tax consequences. Therefore, an organization that has not updated its lists in the last six months should do so. Conflict of Interest Oversight Business transactions of exempt organizations pose potential conflicts of interest when persons responsible for protecting the organization s financial interest stand to benefit personally from dealing with it. Some conflicts of interest are not automatically illegal or unethical. However, independent members of the organization s governing body should be made aware of a potential conflict of interest and evaluate the benefits and risks of conducting business with the related party. Although there is no statutory requirement that an organization adopt a written conflict of interest policy (CIP), the IRS believes that such a policy is required for prudent governance. Observations. Form 990, Part VI, requests information about an organization s CIP. Information requested includes whether the organization has a CIP and, if so, how it is monitored and enforced if a conflict arises. A policy must be adopted before the end of the filing year in order for the organization to affirmatively state that it has a CIP. If a CIP is adopted after the close of the year but before Form 990 is filed, answer No to the question in Part VI regarding the existence of a CIP, but disclose the post-year-end policy adoption in Schedule O of Form 990. Suggested Actions. An organization that has not adopted a CIP should strongly consider doing so. The larger the organization, the greater the potential benefit from having a written policy. Those organizations that have a CIP should monitor compliance by all persons who are covered by it. Monitoring procedures can vary, but typically would include having each person affirm in writing that he/she is unaware of having engaged in an impermissible transaction other than those, if any, disclosed previously for prospective transactions. The IRS may view having an unmonitored or unenforced CIP as worse than having no CIP. Compensation Review The compensation paid by an exempt organization to its trustees, directors, officers, and key employees (TDOKEs) and highly compensated employees (HCEs) is generally scrutinized during an IRS audit. The recipients of compensation [from Section 501(c)(3) public charities, (c)(4), and (c)(29) organizations] deemed excessive can be assessed an excise tax on the excess amount. Under certain circumstances, the organization s managers may also be assessed an excise tax. The organization typically bears the burden of demonstrating that compensation is reasonable. However, an organization can shift the burden of proving that compensation is unreasonable to the IRS if it satisfies certain safe harbor requirements. One of these requirements is that the governing body (or committee) that approves compensation arrangements do so while relying on appropriate data from comparable organizations. Consequently, compensation will generally be deemed reasonable if the amount is no more than what is ordinarily paid for similar services by comparable enterprises under like circumstances. Comparable data includes compensation paid by similarly situated organizations (both tax-exempt and taxable), the availability of similar services in the geographic area,

6 6 THE PPC NONPROFIT UPDATE, JANUARY 2014, VOLUME 21, NO. 1 The PPC Nonprofit Update is published monthly by Thomson Reuters/Tax & Accounting, P.O. Box 966, Fort Worth, Texas , (800) COPYRIGHT 2014 BY THOMSON REUTERS/ PPC. Reproduction is prohibited without written permission of the publisher. Not assignable without consent. This publication is designed to provide accurate information regarding the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, investment, or other professional advice. If such assistance is required, the services of a competent professional should be sought. Reports on products or services are intended to be informative and educational; no advertising or promotional fees are accepted. Tax & Accounting Research and Guidance P.O. Box 966 Fort Worth, Texas PRSRT STD U.S. POSTAGE PAID Thomson independent compensation surveys, and actual written offers from similar institutions seeking the services of the disqualified person [Regs (b)(1)(ii) and (c)(2)]. Observations. Satisfying the comparable data portion of the safe harbor rules can be difficult. For example, the IRS s final report on the College and University Project included a portion dealing with the reasonableness of compensation paid by the private schools examined. Although most of them attempted to meet the safe harbor standard, the IRS concluded that about 20% did not because their data was not comparable. Examples of the problems noted included relying on data from schools that were not similarly situated because of at least one of the following factors: location, endowment size, revenues, total net assets, number of students, or selectivity; using compensation studies that did not document the selection criteria for the other schools, nor explain why they were deemed comparable; and using compensation surveys that did not specify whether amounts reported included salary only or also included other types of required compensation. The IRS report is a reminder that relying on compensation data that is somewhat generic rather than specific will not satisfy the safe harbor test. Suggested Actions. An organization that plans to rely on the safe harbor rules in connection with 2014 salary reviews should begin now to identify specific criteria for data comparability and possible sources of comparable data. A sample CIP and RDP are available in PPC s Nonprofit Tax and Governance Guide: Helping Organizations Comply. In addition, this publication discusses the issues discussed in this article in greater detail. Tax Brief PROPOSED SECTION 501(c)(4) REGULATIONS RELEASED. The Treasury department and the IRS recently issued proposed guidance clarifying Section 501(c)(4) qualification requirements and seeks public input. The regulations will not be effective until they are published as final. The proposed guidance defines the term candidate-related political activity and would amend current regulations by not allowing this type of activity in the promotion of social welfare. Currently, the IRS applies a facts and circumstances test to determine whether an organization is engaged in political campaign activities that do not promote social welfare. The proposed regulations would reduce the need to conduct fact-intensive inquiries by providing more definitive rules. Comments and requests for a public hearing must be received by February 27, The guidance may be found at