Understanding Financial Audits: A Quick Guide for Nonprofits

The word “audit” tends to bring about anxiety and concern when the average person hears it. We picture horrible visions of the IRS combing through our personal information and telling us we did something wrong or owe money. While this may be the case for many individuals, there’s no need for nonprofits to have this same sense of stress and concern. 

Nonprofits don’t pay taxes, so there’s no reason for the IRS to come around, telling you that your organization owes money. However, audits can be incredibly useful for nonprofits to ensure donations are processed properly, tax forms are filed, and general accounting best practices are followed at your nonprofit. 

In this guide, we’ll cover the basics of nonprofit auditing so that you can better understand how your organization can use this important tool. We’ve pulled information from Jitasa’s comprehensive nonprofit auditing article, pared it down, and made it into this more digestible overview for the busy nonprofit professional. We’ll cover the following: 

Audits can be very useful for nonprofits to increase transparency for nonprofits, create regular financial accountability, and find new opportunities for improvement of financial practices. Let’s get started! 

Why Nonprofits Conduct Audits

Chances are, you don’t look forward to the IRS auditing your personal finances. There are not many people who jump up and down with excitement at the idea of the government double-checking their taxes. 

But nonprofits don’t pay federal income taxes. Sometimes their 501(C)(3) status means they don’t even have to pay state taxes! So, why should nonprofits need to go through a tedious auditing process? 

Some nonprofits are required to conduct regular, annual audits. Meanwhile, others simply volunteer to do so because they see the value in these comprehensive assessments of their nonprofit accounting systems. Your nonprofit might be a part of the former group if (required to conduct an audit) if: 

  • It’s written in your bylaws. Some organizations require annual or semi-annual audits in their bylaws to ensure financial compliance and effective accounting practices. 
  • Your state requires an audit. Some states also require audits from nonprofits—generally, if that organization accepts a certain amount of funding (usually more than $500,000) from the state government. 
  • Your federal funding exceeds $750,000. If your nonprofit accepts federal funding of over $750,000, you’re also required to conduct an audit.
  • Grant applications require an audit. Grant-makers want to be sure that your organization will use their funds wisely, so they sometimes ensure accountability by requiring financial audits. 

Even if you’re not required to conduct an audit, you may still find it a useful tool to ensure your organization has strong financial practices. Plus, you can communicate with supporters that you do conduct regular audits, increasing financial transparency and establishing trust in your organization’s financial practices. 

Internal vs. External Audits

While there are many types of audits out there, there are two main categories within the realm of financial audits: internal and external audits. These two differ primarily based on who conducts the audit: 

  • Internal audits are conducted by your team internally. The purpose of these audits is to discover potential opportunities to increase organization and streamline operations. 
  • External audits are conducted by a third-party auditor. Much like hiring a fundraising consultant, external audits are useful because they provide an outside perspective unclouded by attachment to your organization and mission. These audits are useful for ensuring financial controls and complying with accounting best practices. 

Solving financial discrepancies and ensuring accounting best practices not only keeps your finances organized, but also helps your organization with capacity-building initiatives. After all, it’s much easier to plan for growth when your finances are well-organized. 

Selecting a Financial Auditor

If you choose an external audit, your organization will need to select a financial auditing firm to conduct it. Start your research for an auditing firm by reaching out to your accountant and other organizations for referrals. Supplement this list of referrals with other firms you find through online search. 

Once you have an initial list of potential auditors, you can start narrowing your list to only the best candidates based on your organization’s needs and budget. Then, you should ask each firm specific questions that will help you further narrow your selection. These questions may include: 

  • What percentage of your clients are nonprofits? 
  • How long will the nonprofit auditing process take? 
  • What is your firm’s fee structure? 

Vet your top-choice auditors further by asking other organizations they’ve worked with for reviews. They should have experience, expertise, and the right technology to keep your information safe. This will help reduce risk at your organization as you’ll hand your auditor sensitive information to work with. 

Once you’ve vetted your preferred auditing firms, submit an RFP to solidify the agreement. Then, you can simply make your selection. The work isn’t over after you’ve found your auditing firm because you’ll still need to prepare for the audit. 

Preparing for an Audit 

To prepare, you’ll need to pull together all of the documents and reports that your auditor will review while conducting the audit. Much of this information will be available in your nonprofit accounting software, especially if you use a dedicated software solution rather than spreadsheets. 

Some of the steps you’ll take using this data will include:

  • Reconcile all bank accounts. 
  • Review uncleared transactions. 
  • Review your nonprofit’s vendors. 
  • Review customers’ or members’ payments. 
  • Review undeposited funds. 
  • Look for coding errors. 
  • Review your capitalization. 
  • Review your account balances. 
  • Review your accounts receivable and payable. 

When you’re reviewing all of this information, keep in mind that you’ll be reviewing both monetary and non-monetary transactions. Even if they don’t directly add to your bank account, in-kind donations should be recorded in your accounting system along with their approximate value to your organization. It’s easy to overlook donations of items and forget to include them in various accounting reports, but it’s a necessary step to keep up with GAAP standards and to have a successful audit. 

After the Audit

When the audit ends, you can breathe a sigh of relief, but only for a moment. You’ve made it to the other side of the process, but there’s still some work to be done. 

First, you’ll need to implement any recommendations made by your auditor. These changes should fix systemic issues by updating the financial processes at your organization so that you don’t run into similar concerns in future audits. 

Then, you’ll need to evaluate your experience with your auditor. You should ask questions such as: 

  • Are you satisfied with your chosen auditor? 
  • Did you notice any challenges or disputes among your staff members during the audit? 
  • Was the presence of the auditor disruptive to your regular organizational activities?

Chances are, this won’t be your nonprofit’s last financial audit. By asking these types of questions and considering your experiences now, you can improve your audit experience next time around. 

Financial audits may seem frightening in the beginning, especially if you’re comparing the experience of personal audits to those conducted at your nonprofit. However, nonprofit financial audits are ultimately a good thing! They can help you uncover mistakes or process discrepancies to improve your nonprofit’s accounting system over time, ensuring you always have the resources you need to further your mission. 

Author: Jon Osterberg
Jon Osterburg has spent the last nine years helping more than 100 nonprofits around the world with their finances as a leader at Jitasa, an accounting firm that offers bookkeeping and accounting services to not for profit organizations.

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