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What Is a Nonprofit Audit? Ultimate Guide + Checklist

Monday, April 8, 2024

In Depth Accounting Nonprofit Tax For Executive Directors For Nonprofit Accountants

If your nonprofit has valid 501(c)(3) status, it’s exempt from federal income tax, as well as many state taxes. However, being tax-exempt does not mean your nonprofit is exempt from financial audits!

The IRS will occasionally audit exempt organizations, but these make up a small percentage of the total. Instead, most nonprofit financial audits are conducted by independent auditors who can provide an objective perspective on your organization’s financial management practices.

In this guide, you’ll learn all you need to know about nonprofit financial audits, including:

Let’s get started by making sure we’re all on the same page about what exactly a nonprofit audit entails.

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What is a Nonprofit Audit?

A nonprofit audit is a comprehensive review of an organization’s records, reports, transactions, policies, and procedures. When a nonprofit audit is conducted by an independent auditor, its goal is to assess the organization’s overall health and ensure compliance with federal, state, and general financial regulations.

While the term “audit” is mostly used in a financial sense, there are several different types of audits your nonprofit could conduct. Here is an overview of the most common audit categories:

Mind map showing the five main types of nonprofit audits
  • Independent financial audit. This type of nonprofit audit occurs when a third-party auditor or auditing firm examines your organization’s financial statements, transactions, accounting practices, and internal controls. They provide an objective perspective on your organization’s financial health and compliance.
  • IRS financial audit. Since nonprofits don’t pay federal income tax like individuals and businesses do, the IRS doesn’t audit them often. However, that doesn’t mean a federal audit or compliance check is out of the question for your organization. In most cases, the IRS will audit nonprofits if they don’t file required forms or a reporting discrepancy is discovered, which is why it’s critical to complete your organization’s annual Form 990 and employer tax forms carefully and on time.
  • Internal financial audit. These audits are conducted by your organization’s management team. Although they can’t be completely objective, they allow your organization to take a step back from everyday tasks and consider opportunities for large-scale improvement in your financial strategy going forward.
  • Compliance audit. Financial audits are not the only types of audits your nonprofit may encounter. Compliance audits review your organization’s adherence to regulations and requirements set by federal, state, and local governments, as well as your organization’s bylaws and other policies.
  • Operational audit. This type of audit assesses your nonprofit’s internal systems, productivity, staffing, and management practices to determine strengths and areas for improvement. They can be holistic or specific to one area of your organization’s operations, such as technology or human resources.

For the purposes of this article, we’ll primarily focus on independent financial audits—just don’t be surprised if your nonprofit chooses or is required to undergo one of the other types.

Does My Nonprofit Need to Conduct a Financial Audit?

It depends. There are four main reasons why your nonprofit might be required to undergo an independent financial audit for compliance purposes, which are as follows:

Four reasons why your organization may have to conduct a nonprofit audit
  1. Audits are written into your organization’s bylaws. Upon establishing your nonprofit, the founders may have specified that the organization would need to conduct regular audits to ensure financial security and transparency from the start.
  2. Your nonprofit receives more than $750,000 in federal funding per year. This includes federal funding passed through the state in which your organization operates.
  3. State laws require your organization to conduct an audit. Most states stipulate that nonprofits whose total annual funding exceeds a certain threshold (often $500,000) must conduct an independent audit.
  4. A grant application asks for an audit report. Before they invest in your organization, most grantmakers want to see financial proof that you’ll manage the grant well. Some funders will accept copies of past tax returns or financial statements, but others will specifically request an independent audit.

Even if your nonprofit isn’t required to undergo an audit, it can still be worthwhile to conduct one just to get a better understanding of your organization’s financial situation. At the very least, establishing internal review procedures will help protect your nonprofit from risks and promote financial responsibility.

Benefits of Nonprofit Financial Audits

No matter why your nonprofit is conducting a financial audit, the process can provide several benefits, including:

  • Regular accountability. If you conduct recurring audits every year or every few years, your nonprofit will be held accountable to the same high standards for financial reporting and compliance. Even as your organization changes and expands, you can be confident that your finances are always secure and properly allocated.
  • Clear opportunities for improvement. Your nonprofit audit may not be perfect—which is completely fine! Audits can help your organization identify opportunities to improve its policies and procedures, leading to more efficient processes and sound management.
  • Increased transparency. You may decide to communicate that your nonprofit conducted an audit and even the recommended improvements you’re implementing with your supporters. This way, they’ll know that you take financial management seriously and will use their contributions as promised to further your mission.
  • Potential reputation boost. There are a number of charity watchdogs that provide information about charities to potential donors, and they may rank your organization higher if you’ve conducted an audit. This also promotes transparency with supporters who do their research before contributing.

These advantages are why your nonprofit should consider undergoing an audit even if you aren’t required to do so. Although you’ll need to put in effort to prepare beforehand and apply the auditor’s recommendations afterward, the benefits of financial auditing will likely outweigh the costs.

Nonprofit Audit Timeline

If your nonprofit is required to submit your audit results to a government agency or reporting organization, you should, of course, complete the audit well in advance of the deadline. However, preparing for an audit takes time, which you’ll need to factor into your decision for when to conduct it.

To help you plan more effectively, here is an estimated timeline of the independent financial audit process:

Table showing duration of audit steps
  1. Select an auditor: 4 to 12 weeks.
  2. Prepare for your audit: 2 to 4 weeks.
  3. Conduct the audit: 2 to 4 weeks.
  4. Incorporate audit recommendations: No specified time limit—but the sooner, the better!

Regardless of your nonprofit’s reporting deadline (or lack thereof), you should complete your financial audit before completing your annual tax return so that you can include the changes you’ve made as a result of the audit in it.

Your organization’s Form 990 filing deadline is the 15th day of the fifth month after your fiscal year ends (May 15 if your fiscal year follows the calendar year like most nonprofits). If you won’t have enough time to complete your audit, start incorporating the recommendations, and fill out the form by the deadline, you can file for an extension of up to six months via IRS Form 8868.

How to Choose a Nonprofit Auditor

If your nonprofit is required to submit your audit results to a government agency or reporting organization, you should, of

Your audit report will be most helpful to your nonprofit if you select an auditing firm with a strong track record that aligns with your needs and budget, which is why this part of the process can take up to three months. To find the right auditor for your organization, follow these steps:

  1. Begin your research online. A simple Google search is often the best way to start looking for nonprofit auditing firms. Browse their websites, note their fee structure and estimated timeline for conducting the audit, and read reviews from past clients.
  2. Ask for recommendations. In addition to searching online, reach out to other nonprofits in your network to see if they’ve conducted independent audits and if so, what they thought of their auditors. Your organization’s accountant might also be able to provide recommendations based on their knowledge of the nonprofit finance space.
  3. Issue a request for proposals (RFP). An RFP allows you to compare the top candidates you found through research and recommendations side by side. In addition to confirming the fees and timeline, request that your potential auditors provide a detailed statement of the work they will provide and several references.
  4. Make your final decision. After reviewing the proposals you receive and checking each auditing firm’s references, it’s time to approach your top choice and hammer out the final details of your contract for working together.

Once you’ve selected an auditor, they should provide you with information about preparing for the audit. This will usually come in the form of a Provided by Client (PBC) list to ensure you have all of the documentation that they’ll need to effectively assess your nonprofit’s finances.

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Nonprofit Audit Preparation Checklist

Naturally, the first step in preparing for your nonprofit audit is to pull all of the items on your auditor’s PBC list. These often include your organization’s:

  • Bank statements
  • Investment statements
  • Unpaid invoices
  • Details of grants received
  • Details of donations received
  • Payroll and staff compensation information
  • Board member names and meeting minutes
  • Tax documents
  • Fiscal policies and procedures handbook

There are also some other steps you should take to prepare for your audit, which we’ve compiled into a handy checklist for reference:

Nonprofit audit checklist
  1. Reconcile all bank accounts to see whether your statements match your internal financial records and whether your account balances are accurate.
  2. Identify and address uncleared transactions to determine why they occurred and how they have affected your organization’s cash balance.
  3. Review your nonprofit’s vendors and remove any inactive ones from your list.
  4. Check for unpaid membership dues if your nonprofit has a membership program.
  5. Deposit any undeposited funds to maximize your cash availability.
  6. Look for coding errors such as duplicate, missing, or incorrect data to keep your financial records clean.
  7. Check your capitalization to ensure your nonprofit’s assets are properly categorized.
  8. Review your accounts receivable and payable to confirm your outstanding cash obligations and resolve any discrepancies or disputes.

If you need help or have any questions about preparing for your nonprofit audit, don’t hesitate to reach out to financial professionals like the experts at Jitasa. Dedicated audit preparation comes with our standard bookkeeping and accounting services for mid-sized to large nonprofits and is available as an add-on for small organizations. Our years of experience working exclusively with nonprofits like yours will help you approach audits with confidence and make the most of them.

An independent financial audit is, at its core, an opportunity to learn about how your organization can improve its processes. These improvements may be simple actions that build over time to create a major impact, or they may be more complex changes that will take time and effort to implement. Either way, remember that even if your audit report isn’t flawless, your auditor has your organization’s best interests in mind.

For more information on nonprofit audits and their applications, check out these resources:

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