The October 27, 2013, Washington Post headline was damning: “Millions Lost by Nonprofits, with Little Explanation.”

The recounting of this story of fraud among nonprofits started out by highlighting the case of the American Legacy Foundation, which for 14 years has been handling hundreds of millions of dollars from a historic tobacco company settlement.

A box checked “yes” on a federal disclosure form put this case in the public eye. After a little digging, the Post writer found that the nonprofit had lost $3.4 million due to fraud. The newspaper started looking further and discovered that more than 1,000 nonprofits had suffered significant losses to fraud and theft. And those were only the cases that totaled more than $250,000 in losses — the threshold for reporting to the government.

Danger to small nonprofits

That’s frightening information for those who lead nonprofits as well as for the donors who support them. However, as noteworthy as the scandal at the American Legacy Foundation is, it’s rather untypical, and perhaps the “typical” fraud should be an even more bracing wake-up call for U.S. nonprofits.

With more than $1 billion in assets, the American Legacy Foundation is huge compared to most U.S. nonprofit organizations. And, according to a “Strategic Finance” article by Thomas Buckhoff and Abbie Gail Parham entitled “Fraud in the Nonprofit sector? You bet,” it’s the smaller nonprofits that typically lack the institutional controls necessary to prevent and deter fraud.

Here are some numbers to put nonprofit fraud in perspective. They come from a number of surveys and give a sense of the magnitude of the problem.

• About 14% of all fraud cases occur in non-profits.
• U.S. nonprofits lose $40 billion a year to fraud, according to a Harvard estimate.
• 75% of nonprofits reported a loss to fraud in the previous year.
• Losses average $100,000 per fraud case, under the reporting threshold.

Corruption and altruism

The problem with fraud among nonprofits is somewhat unique. Along with the obvious loss of revenue, fraud creates a lack of trust and a strong sense of trust is a fundamental prerequisite for donor support. Further, because nonprofits are involved in works that seem altruistic — such as curing disease and addressing social issues — many believe that this sense of altruism carries over to the individuals working for the nonprofits.

This, however, seems to be quite contrary to the evidence. When the Ethics Resources Center surveyed business, government, and nonprofit sector employees, it found that they all had observed ethics problems in the workplace at shockingly similar rates: 56, 57, and 55 percent respectively.

Given the state of fraud in nonprofits, leadership has two challenges. The first is fraud prevention, and the second is convincing donors that any additional “overhead” invested in fraud prevention is a necessary and positive step for the organization.

We will first briefly look at various types of common fraud, pointing out some specific dangers and then suggest steps that can be taken to prevent fraud and create a more ethical workplace.

Corruption. For this scheme we associate corruption to higher-level fraud. It’s an area that has received much attention recently. In some notable New York cases, lawmakers have been found guilty of embezzling money from charities they set up and controlled. Corruption can also include filing fraudulent expense reports or billing schemes — charging the organization for bogus work or materials.

Check tampering. Checks can be stolen and then the act covered up by applying a later donation to the account. Also, groups that use acronyms are especially vulnerable. “ARC” can easily be changed to “A.R. Crosby,” for example. Along with skimming or tampering with donation checks, outgoing checks or blank checks can also be stolen and misused.

Cash theft. When donations are made in cash they are highly susceptible to theft. Charities and nonprofits that stage special events run a high risk of cash theft. Property theft is also a danger, especially items like valuables or collectables.

There are, of course, many variations on these crimes, so nonprofit leadership has to be vigilant and aware of the dangers at all times.

Top down ethics

An ethical climate starts at the top. Nonprofit leadership must put a code of conduct into place, review it each year, and use it to consistently and regularly train employees. Further, leadership, such as boards of directors, must be dedicated to its principles and implementation.

There must be independence on the board of directors and between committees. Many nonprofits are created by families, political allies, and by others who share a common bond. This creates an additional danger for favoritism, corruption, or fraud to occur, which may go unnoticed.

There must be separate finance and audit committees, and the audit committee must be independent of the finance committee. Further, board members must know enough about finance to recognize any suspicious activity. The finance committee should monitor income and expenses to budget projections throughout the year and look closely when targets are missed. A nonprofit should never automatically purge unpaid pledges from the system that can cause theft to be overlooked.

For employees there must be a way to independently report ethical violations. While nonprofits are not covered by most of the provisions of the Sarbanes-Oxley Act, they are covered by two: the whistleblower requirements and the maintenance of documents requirements.

As we see in the private sector, surveys show that nonprofit employees are reluctant to report ethics violations to their line supervisors; only 11% do so. Almost 50% choose to use hotlines when they are available. There is some good news for smaller and midsize nonprofits; their employees are more likely to report fraud than those who work for large nonprofits, according to the ERC survey.

Separation of duties

The importance of independence and segregation of duties carries throughout the nonprofit organization, especially in any operation that requires the handling of funds. The same person should not handle both the initial receipt and the later deposit of funds. Cash receipts should be made by someone who is independent of the accounts receivable bookkeeping. Two signatures, including one board member, should be required for larger checks.

Physical and electronic safeguards should be in place. Valuables and cash should be secure, and computer networks should have various user levels.

With all of this said, perhaps the single most important measure is to perform good background checks on everyone who works for the nonprofit. Many incidents have occurred where people with previous fraud and theft convictions have been hired in the nonprofit sector. When this happens, the outcome is virtually inevitable.

Some of the measures outlined above will add to overhead costs, and that’s a figure that many donors monitor closely. Regardless, it’s recommended that nonprofits take a proactive approach to putting these safeguards in place and communicate their action widely and often to their stakeholders.

While it may add marginally to an organization’s overhead, the cost of mitigating these risks will be more than offset by the renewed confidence supporters will have that their funds are receiving proper stewardship and benefiting the causes they support.