Nonprofit Audits: A Complete Guide to Financial Auditing
Thursday, December 3, 2020
The IRS doesn’t require nonprofits to file taxes. You probably remember the forms and papers that you filled out when you first opened your doors to ensure you didn’t have to endure the annual burden of paying taxes on the revenue you receive. But does that mean your organization is also exempt from nonprofit audits?
Talk to a dedicated nonprofit accountant about your next nonprofit financial audit.Contact Jitasa
The answer is simple: no. While you may have escaped the need to pay taxes, you may still find that your organization should conduct an independent nonprofit audit. Let’s start with the basics:
What is an independent nonprofit audit?
An independent audit occurs when an auditor or auditing firm outside of your organization examines your nonprofit’s financial statements, records, transactions, accounting practices, and internal controls.
While the IRS doesn’t conduct nonprofit financial audits (you’re not paying taxes, so why should they audit you?), you may find that other entities do require audits to occur. For instance, some separate state or federal agencies may require an audit from your nonprofit depending on your size or spending habits. Or grant organizations may require one to prove your financial responsibility before providing funding.
Here at Jitasa, we help nonprofits determine if they need an audit, provide assistance preparing for it, and help organizations get the most out of the experience. With our ample experience in the field, we decided to put together this guide to help professionals in the sector gain a basic understanding of nonprofit audits. We’ll cover the following topics:
- To Audit or Not to Audit
- When to Conduct an Audit
- Selecting a Nonprofit Auditing Firm
- Nonprofit Audit Preparation
You’re welcome to use the navigation above to skip to the section that’s most intriguing to you. However, we recommend that you read with us from the top so you don’t miss anything important.
1. To Audit or Not to Audit
It’s not often that small to mid-sized organizations are required to conduct a nonprofit audit. And, luckily, the reasons you may be required to do so are fairly straightforward. When you’re deciding whether or not to conduct an audit at your organization, you should:
- Check your bylaws. At the onset of opening the doors to your organization, one of the founders may have written it into your bylaws that regular nonprofit audits should be conducted in order to ensure financial security and transparency.
- Check your state requirements. You may be required to conduct a nonprofit audit depending on the state you operate in and your dollars received. Nonprofits that spend or earn more than a certain amount (usually around $500,000) may be required to complete a financial audit.
- Check your federal funding. Organizations that receive more than $750,000 in federal funding or federal funding passed through the state are required to have an audit.
- Check grant application requirements. Some grant funders require nonprofits to conduct audits to ensure their financial systems are trustworthy, transparent, and well-managed. Even if granting institutions don’t require an audit, they may require other proof of financial management before they’ll be willing to provide funding.
These options all describe circumstances in which you may be required to conduct an audit. if you find that you’re not required to conduct an audit, that doesn’t mean you’re off the hook!
You’ll still want to practice financial responsibility and accountability by carefully reviewing your financial statements or hiring a nonprofit accountant to do it for you. Internal review procedures will help protect your nonprofit from scams, overspending, and other financial missteps you may encounter.
Even if you think you’re doing everything right (or if you’re new and don’t know if you’re doing everything right), it can still be worth conducting a nonprofit audit. There are plenty of benefits that result from conducting one.
The Purpose of Nonprofit Auditing
The purpose of a nonprofit audit, according to The Alliance for Nonprofit Management is, “for testing the accuracy and completeness of [the] information presented in an organization's financial statements. This testing process enables an independent certified public accountant (CPA) to issue what is referred to as an opinion on how fairly the agency's financial statements represent its financial position and whether they comply with generally accepted accounting principles (GAAP).”
Nonprofits who may not be required to conduct an audit may still consider doing so in order to make sure their financial records and internal controls are up-to-par and to find potential opportunities for improvement.
The benefits you’ll encounter when you conduct an audit include:
- Increased transparency. When you communicate the fact that a nonprofit audit took place and even the improvements that you’re making as a result of this deep financial analysis, your supporters will know that you take your funding and your financial management seriously.
- Regular accountability. If you conduct an audit of your finances regularly (whether that’s every year, two years, or even five), you’ll find that you are held accountable to the same high standards of controls and financial reporting over time.
- Find opportunities for improvement. Your independent audit may not be perfect, and that’s ok! One of the great things about auditing is that it can help identify opportunities for your organization to improve upon your policies and procedures.
In addition to all of the inherent benefits of conducting a nonprofit financial audit, there are also charity watchdogs who provide information about charities to potential donors. These watchdogs may rank your organization higher if you’ve conducted an audit. This also increases the element of transparency with your supporters who do their research before contributing, assuring them that you’re a trustworthy organization.
2. When to Conduct Your Nonprofit Financial Audit
The timing of your nonprofit audit heavily depends on the requirements of the organization to which you’re submitting the results. This should be the first place you look to see when it should be conducted.
Straightforward deadlines by which the audit needs to be completed are easy for nonprofit professionals to understand. However, what is less understood is the amount of time necessary to prepare, conduct, and incorporate recommended adjustments that come out of the audit process. This can put pressure on the date by which you will want to begin the audit process in order to meet your deadlines.
The below timeline is an example of the potential time that your organization can expect to spend on various activities.
- 4-12 weeks: - Selecting an auditor
- 2-4 weeks: Preparing for your audit
- 2-4 weeks: Conducting the audit
- Immediately after the audit: Incorporate the provided recommendations
One industry best practice is to make sure your audit is completed before you file your Form 990. Nonprofits need to incorporate the adjustments they make as a result of the audit on their Form 990. Here at Jitasa, we file our clients’ Form 990s after they’ve completed their financial audit.
If it doesn’t look like the audit will be completed before the Form 990 is due, we’ll file a Form 8868 with the IRS to request an extension for the Form 990 on behalf of the client to make sure this vital audit information can be included.
3. Selecting a Nonprofit Auditing Firm
If your organization has decided to (or is required to) conduct a financial audit, you’ll need to choose an auditing firm that will best suit your needs. You shouldn’t just pick the first auditing firm that you come across. This selection process is very important for your nonprofit to get the most out of the financial audit.
The stages that you’ll go through during the auditing firm selection process include: conducting initial research, narrowing your selection, sending an RFP, making a final decision.
To start your research, you may choose to conduct an initial Google search, ask your accounting firm for recommendations, or collect referrals from other nonprofits. This initial list can be as long as you feel is necessary. The next step will describe the process by which you can narrow your selections according to your organization’s needs and budget.
Narrow Your Selection
Once you’ve got your initial list of potential auditing firms, search the firm’s website or set up a call to ask them a few questions, digging deeper into their services. Some of the questions you’ll want answers to include:
- What percentage of the clients are nonprofits? Nonprofit finances differ dramatically from those of for-profits. Therefore, their auditing process also looks different. Make sure that the auditing firm you choose has an extensive background working with nonprofit organizations so that they can fulfill the specific requirements for 501(c)(3) organizations.
- How long will the nonprofit auditing process take? Can they give you deadlines for each of the activities? This is important to make sure that your organization can meet the deadlines for the audit itself. The last thing you want is for your auditing firm to miss a deadline and make your audit late.
- What is the fee structure? The fee structure of the auditing firm should be consistent with the scope of the audit activities required. Ask about the fee structure and see if firms will provide you with a quote.
The best way to compare the scope and price of different firms is to go through a formal RFP process with your shortlist of firms. We’ll cover that more in-depth next.
Provide an RFP
A formal request for proposal (RFP) helps your organization compare your short-list of auditing firms. This document allows you to request information about the firm and provide information about your organization to see if a partnership with specific firms will be a good fit for you both. When you put together your RFP for a nonprofit auditing firm, ask for items such as:
- A description of the firm
- Information on who will be working with your nonprofit to complete the audit
- An explanation of what sets that firm apart from other nonprofit auditing firms
- A statement of the work that will be performed by the firm
- The structure of the fees
- A list of references to other organizations who have worked with the firm
With an effective RFP, your organization will be able to decide if a firm is truly a good fit for your needs and budget. Call their references and double-check that they have a positive track record with past clients before you make your final choice.
Make a Final Decision
Congrats! You’ve decided who you’ll be working with for your nonprofit financial audit. You’ve put in the work and the research necessary to be sure you’re working with a reliable firm that understands your organization’s needs. You know what you’ll be receiving from them and can rest assured that everything is taken care of.
Now, you can start preparing for the audit.
4. Nonprofit Audit Prep Work
You’ll need to do some preparation before your nonprofit audit can take place. Usually, auditors will send a PCB (Pull by Client) list that tells your organization what information the auditor will be requesting.
This means you’ll need to pull together some documentation and reports that your auditor will be using during the auditing process. Having these ready to go will help them analyze quickly and find actionable information for improvements.
As you finish up the fiscal year, your organization should be sure that all of your bookkeeping and accounting activities are accomplished before you close up the books. Make sure that your organization has:
- Captured every transaction. Have you looked for unrecorded expenses? Recorded donations received at year end, but not deposited? Recorded pledges and grants?
- Reconciled all bank accounts. Be sure your checking, savings, and investment accounts are all reconciled and taken care of.
- Analyzed the adjustments for prepaid expenses. Look for the payments that your organization has made for goods and services that have not yet been delivered.
- Reviewed expenses for items that should be capitalized. Make sure all large-scale purchases that are being paid out over time have been recorded accurately and according to your capitalization policy.
- Taken a first pass at key financial reports. Schedules of your balance sheet accounts and temporarily restricted funds are two examples of reports you should pull together to the best of your knowledge.
As you’re going through this year-end financial data, keep in mind that if you find discrepancies, your auditor will also likely find the same ones. Do some work ahead of time to figure out what might be off. Assemble supporting documents for balance sheets, as well as clear and accurate records for payments, etc., which help prove that you’re adhering to organizational policy.
If you’ve had an audit before, you might already have access to a past Pulled by Client (PBC) list of items that your auditor will need from you. If you’re new to the audit process, you can request one of these documents from your auditing firm so that you can prepare the information your auditor needs.
PBCs can be anywhere between 40 and 120 items depending on the scope of the nonprofit audit and the complexity of your organization. Some of the items that are likely to be listed on your PBC include:
- Copies of bank reconciliations
- Bank statements
- Investment statements
- Schedule of prepaid items
- Invoices that have not yet been paid
- Schedule of accrued wages and vacation
- Details of grants received
- Details of fundraising contributions received
- Payroll information
The best thing your organization can do, if you know you’ll need a nonprofit financial audit, is to keep these items in mind throughout the year. You can keep your data organized and ready to pull into these reports. This way you’ll be able to pull them quickly and easily when it’s time to prepare for your upcoming audit.
Keep in mind that your nonprofit audit isn’t an opportunity for the auditor to sit back and accuse your organization of doing things incorrectly. Rather, it’s an opportunity to learn about how your organization can continue to improve your processes. These improvements may be simple actions that amplify to create a major impact, or they may be more complex changes that will take hard work and focus.
Either way, the purpose of conducting the nonprofit audit is to help your organization. Your auditor is in your corner to help you improve.
However, nonprofit audits aren’t the only way to improve your finances. The more you learn about them, the better you can strategize and enhance your operations. So, continue your research! We recommend continuing your reading with the following resources:
- Nonprofit Budgeting: Understanding the Basics [+Template]. Nonprofit budgeting is a difficult aspect of your organization’s financial plan. However, with the proper background knowledge and tips for success, you’ll create a concrete annual budget each time.
- Form 990 Filing: Your Essential Guide to Nonprofit Taxes. Tax season can be confusing even if you’re not conducting an audit. Learn about nonprofit Form 990s, why they’re necessary, and how to file one in this guide to nonprofit taxes.
- Top 10+ Outsourced Nonprofit Accounting Firms. If you think your organization could benefit from having an accountant on your side, consider outsourcing the services to professionals. These top 10+ firms will get your research started.