Qualified Audit Reports

Givewell MEDIA RELEASE
making a difference made easy

Qualified Audit Reports on a Charity's Financial Statements
a community confidence issue

The meaning of an audit qualification

Auditors play the significant role of attesting that the financial statements of an organisation are true and fair. They also review accounting controls and methods. Audit reports are usually short, filled with technical mumbo jumbo which basically says the financial statements are correct, interpretable and even comparable.

When an audit report is qualified this means the auditor has a material concern about one or more aspects of the financial statements and/or there is a material (or potentially material) shortcoming in accounting controls. It means that the auditor is unable to give an unqualified opinion that the accounts are true and fair. That is, there is something wrong.

Public companies go to great lengths to avoid a qualified audit report. Directors are understandably uncomfortable that their auditor cannot agree on the manner in which they report the state of the company. Senior management is most uncomfortable when auditors state there is a material shortcoming in accounting controls. Shareholders and regulators worry that if the company can't get its accounts right then what more should they be concerned about?

To users of financial statements a qualified audit report often signals a crisis of confidence in that organisation.

Community attitudes to charities

Charities enjoy community support for the work they do. When people give, most of all they want their money to help with that work. They want least that their money is absorbed in fundraising and administration costs, or even go astray. It is incorrect to assume that, as a whole, the community supports the fundraising practices adopted by charities. They are also concerned at the apparent lack of accounting controls that accompany those practices.

Research conducted by AGB McNair of 2000 adult Australians in October 1997 found that -

79% (net) would give more to charity if they could gain reassurance that most of their donation would get through to the cause.
19% (net) believe they get too many fundraising requests, particularly those who donate more.
20% (net) feel they are approached to give at inconvenient times.

To explore these issues further Givewell sponsored 4 Sydney based focus groups in July 1998, conducted by Eureka Strategic Research where many participants stated that -

There are "just so many charities" appealing for support these days.
There is mistrust that collectors could easily abscond with the funds, hence they give less.
When they make a donation to a new organisation they often quickly get requests from other organisations, leading to concerns that their personal details are not kept private.

Survey of charity audit reports

Last week Givewell reviewed its database of the audited financial statements of 148 major Australian charities with total fundraising income of $556m and found that 61 (41%) had qualified audit reports. In all except 4 of those cases (38% of the sample) the qualification was similar to the suggested wording in Auditing Statement AUS 802 relating to the internal controls over fundraising income prior to its initial entry in the accounting records.

Let's draw some inferences from the wording of this type of qualification -

Establishing accounting controls over fundraising income is not practical.
You can't audit internal controls that don't exist.
Therefore you can't determine the extent to which donations collected enters the accounting records.
The amount which could be collected and not entered into the accounting records may be material.
The amount of donations collected by or on behalf of the organisation which could go astray, due to a lack of internal controls, could be material.

While the last two points above are controversial, they are no less a correct inference from the qualification. If the amount which could go astray is not (at least potentially) material, then the audit should not be qualified. Remember that 59% of major charities have unqualified audit reports, many of which have very similar fundraising practices to those with qualified audit reports. The reasons for an unqualified report could include -

More comprehensive internal controls.
The amount of donations which are not subject to controls would not be material.
Their auditor is less cautious.

Givewell's argument on this audit issue is that an audit qualification is directly relevant to the community's prime concern about giving - it fails to provide reassurance that their donations actually get through to the cause - due to a lack of internal controls and the inability to audit such controls. While it may not indeed be practical to establish such controls, this is unlikely to gain sympathy from donors as many do not regard such fundraising methods highly in the first instance.

Now let's deal with a range of issues that have been brought up by charities and their auditors on this subject. As well as answer each issue I will briefly offer ideas on how to resolve them.

A charity has no control over a collector who misrepresents they are a fundraiser for the organisation.

While this is a matter of concern, it would not appear to be a matter for the auditor. Provided the organisation had followed legal requirements in the conduct of fundraising appeals, it should have no liability for the conduct of those who make appeals in its name without being authorised to fundraise. That said, its procedures should cover the detection and follow through of instances of fraudulent appeals.

It is not possible to establish controls over cash collections, particularly when volunteers are being used.

This argument follows from the assertion that controls are not feasible because a donation does not involve the provision of goods or services in return for the donation. This argument is not logical, as when consumers hand over cash for goods or services they have little interest in where it goes since they have satisfied their consumer need. However, in the case of a donation, their interest in the application of those funds persists until it gets through to the cause. So there is a greater, persisting economic interest.

As for controls, there is a large range of cash sale activities where unidentifiable consumers leave cash with businesses and have no further interest in what happens to those funds. These businesses establish controls to record and protect those funds at the point of the transaction. They cannot conduct audit confirmation tests, yet these controls are accepted by auditors and any inherent internal control weakness in cash sales activity undergoes a test for materiality in deciding whether an audit qualification is required.

Why should the fundraising appeals of a major charity be any different, particularly when donors have a continuing economic interest in the control and safeguarding of their donations?

The answer is to build internal controls similar to those used by commercial businesses with cash sales.

Charities cannot afford to establish complex internal controls.

While it is true that most commercial businesses use expensive technology such as electronic cash registers to maintain internal control over cash sales, other effective control systems pre-dated their use. Also, many fundraising appeals raise large amounts supported by a well-funded fundraising budget. This warrants attention to internal control systems with part of the budget allocated for that purpose. The charity should also consider allocating suitably qualified volunteers to supervise the recording and safeguarding of donations collected.
The question of where technology and resources are allocated in charities is really a matter of opinion. Consider the cost of technology and systems supporting donor acquisition and development compared to the level of systems and technology applied to accounting controls over fundraising income.
Some examples of the types of controls that could be implemented are -

A defined process of issuing pre numbered receipts for all cash donations with follow up checks to ensure receipts are always being issued.
Cash collections to be carried out by at least 2 persons who are not well known to each other. Proceeds to be taken from those collections by supervisors on an ad hoc basis.
Cash collections to be placed in a secured container, never in a paper box, bucket or unlocked box or tin.
Proceeds from appeals to be counted and recorded by at least 2 people.
If a charity receives cash donations in the mail, all mail should be redirected to a PO Box and mail collected each day by at least 2 people. This role should be rotated amongst office staff. All incoming mail to be recorded and opened under supervision with particular attention paid to recording cash and uncrossed cheques received.
Accounting entries for donations should refer to the appeal source to facilitate an audit trail to be established with the initial records.

The charity will lose volunteer support because of a signal that they are not being trusted.

The reality is that some people who volunteer as collectors do so for their own profit and that such people will be attracted to appeals which lack control. Also, less control provides more temptation. Therefore, it is in the interests of trustworthy volunteers, donors and the cause that controls are established which dissuade collectors who are not completely trustworthy. Volunteers encounter such controls as consumers every day. The challenge is to attract volunteers who are able to manage this control process in a subtle fashion.

This is a standard qualification used by auditors that shouldn't really cause concern.

While charities argue that auditors issue this qualification as a matter of policy, there is evidence to suggest this is not true in general. Of the 12 auditors recorded in the Givewell database who audit 2 or more charities, only 1 has given an qualified audit report in each instance, the remainder have a mixture of qualified and unqualified audit reports. Further, if the qualification were a standard then we should not expect to 59% of charities with unqualified reports.

There is also an inherent danger in seeing this qualification as standard communication. Let's imagine a charity with virtually no controls over the initial recording and safeguarding of cash donations, on which it relies for the bulk of its income. In this instance the wording of the audit qualification would not differ from the "standard" even though there are obvious concerns for donors in this instance.

Our belief is that the qualification should be taken seriously and that management and auditor need to work together to establish what is required to obtain an unqualified report.

Auditors are just not being consistent.

On the surface, there appears to be some truth in this. Different auditors reach different conclusions for organisations with similar fundraising profiles. This also appears to be so within an audit firm, due perhaps to different interpretations between audit partners.

Some suggestions on how to avoid inconsistencies follow -

Point out to your auditor instances (perhaps in the same firm) where similar organisations have gained an unqualified audit report.
Ask the auditor to suggest what level of controls need to be put in place to secure an unqualified audit report. Then ask his firm to help put them into place on a pro bono basis. If your auditor is uncooperative then consider a change to one that is prepared to help move your organisation towards improved controls evidenced by an unqualified audit report.
Point out that the audit qualification suggests that while implementing controls may not be practical it is possible.
Gain a commitment to such controls within your organisation, including branches. Point out that this will weed out undesirable practices and people.

The auditor can deal with this issue by releasing a limited scope audit report

This argument suggests it is possible for an auditor to note that the scope of the audit is limited so as not to include controls over fundraising income, thus avoiding the need for a qualification. While we have observed a couple of examples of this, it presents the possibility that the auditor has failed in their duty to audit. Such a report does not deal with whether the organisation has controls, and if not, the effect on the audit of not being able to review internal controls.

Auditors issue the qualification when there is a large potential liability

If this were true then we should find that larger organisations are much more likely to have qualified audit reports, even though they may be more likely to have effective controls. Analysis of our sample shows that audit qualifications were issued for 51% of above median (32% below median) and 40% above average (42% below average) - in order of fundraising income.

It has also been argued that large audit firms with higher PI cover are less likely to issue a qualification. However, the ratio of audit qualifications for the Big 6 (at that time) was 43%.

Conclusion

Givewell would simply like to see fewer charities with qualified audit reports. Our concern is the link with community concern over fundraising methods and controls. A lower qualification rate can be achieved by working with auditors to improve internal controls over fundraising income. It will also involve negotiation with auditors to establish consistency in interpretation. But first it requires charities to recognise that an unqualified audit report is essential.

Michael Walsh
Principal, Givewell