Nonprofit Accounting Quick Guide: Financial Audits

Nonprofit organizations put significant emphasis on their fundraising initiatives, and for good reason! You need money and resources to fund your programs and work toward your mission. However, when organizations prioritize fundraising, they risk forgetting to consider what happens after the money hits their bank accounts. In short, they might not prioritize organizing their funds and maintaining best accounting practices. 

When you prioritize healthy financial practices at your organization, you’ll have more organized data and can more easily accomplish other financial activities like budgeting and allocating resources.

Auditing your nonprofit’s finances will help ensure your accounting practices are up-to-scratch, follow the generally accepted accounting principles (GAAP), and have impactful internal controls to protect sensitive financial information.

In this guide, we’ll discuss audits at length, covering the following topics:

1. Types of Financial Audits
2. When to Audit Your Nonprofit’s Finances
3. Timeline of Nonprofit Financial Audits 

Armed with the information in this quick nonprofit accounting guide, you’ll have what you need to understand audits and effectively prepare for your next one. Let’s get started! 

Types of Financial Audits

While there are many categories of audits that nonprofits may choose to conduct (compliance audits, operational audits, etc.), there are two main types of financial audits: internal audits and external audits. 

• Internal audits are conducted by your nonprofit’s team members. They’re used so that you can comb through your own financial information to determine any opportunities for improvement in your current management systems. 
• External audits are conducted by a third-party auditor to provide an outside perspective on your financial information. They’ll review your various documents, statements, and processes to ensure your internal controls and procedures follow financial management best practices. 

Both types of audits are useful, enabling your organization to better understand your revenue and expenses, improve your financial strategies, and help your various teams work better together.

The main advantage of hiring an external auditor is that they can bring in outside expertise and an unbiased perspective to review your nonprofit’s processes. Sometimes it’s challenging for nonprofits to recognize all of their own opportunities to improve because they’re caught up in the procedures they’re used to following. 

Every nonprofit has different needs, but most organizations can benefit from hiring an auditor on at least an occasional basis to review their financial information. 

When to Audit Your Nonprofit’s Finances

The word “audit” is often received with trepidation and even fear. No one wants their personal finances to be audited for fear that they may owe additional money to the IRS. However, nonprofits don’t need to have this concern. 

With the 501(c)(3) status, nonprofits are exempt from paying federal income taxes and even some state taxes. Therefore, you likely won’t discover that you need to pay additional taxes to the government as long as your status is valid. 

Nonprofit audits are instead focused on helping organizations maintain healthy financial management practices. They’re not required by all nonprofit organizations and are often voluntary unless your nonprofit meets certain specifications that would require an audit. Some of these specifications include if your organization: 

• Requires regular audits as a part of your bylaws. Some nonprofits require annual or bi-annual financial audits as a part of their bylaws for internal accountability. 
• Receives a certain amount of funding from the state government. Often, if nonprofits receive more than $500,000 in state funding (the actual amount may vary by state), they’re required to conduct an audit of their finances to ensure the funding is used appropriately. 
• Receives more than $750,000 in federal funding. Also to ensure funds are used appropriately, the federal government requires nonprofits to conduct financial audits if they’ve received more than $750,000 in federal funding throughout the year. 
• Is required to conduct an audit to receive grant funding. Some grantmakers require nonprofits to conduct audits to ensure sound financial practices before awarding grant monies. Therefore, as a part of good grant management practices, nonprofits should review grant requirements and determine whether they’ll need an audit. 

Understanding whether your organization is required to conduct an audit helps maintain compliance. But it can also be helpful in timing your auditing process. For example, if you’re required to conduct an audit by a grantmaker before you submit the grant proposal, you’ll need to time the auditing process accordingly. 

Similarly, if your bylaws require a financial audit, you may prefer to complete the audit before filing your annual Form 990. In this case, you may choose to file for an extension on your Form 990 to ensure you have time to complete the audit. 

Remember, though, that audits aren’t only helpful when they’re required of nonprofits. Many organizations voluntarily conduct audits as a helpful resource to ensure they’re following healthy financial practices and have strong internal controls. 

Timeline of Nonprofit Financial Audits

Audits take time! As mentioned in the last section, nonprofits often file a Form 8868 tax extension to ensure their financial audits are completed before filing their annual Form 990. This is because auditing can take anywhere from eight weeks to several months to complete. Often, the auditing timeline looks something like this: 

4 to 12 Weeks: Select an Auditor

If you’re conducting an external audit, your organization will need to select an auditing firm to conduct your audit. This process can take time as you’ll need to evaluate various firms to find the most suitable for your organization and needs. 

Look for recommendations from your accountant. Jitasa’s list of top outsourced accountants can also provide you with leads as you reach out to accountants, auditors, and more from many firms. You never know—you may even find the perfect accountant to meet your needs too!

Then, ask for more recommendations from other nonprofit organizations. Other local organizations with which your organization has built relationships may have undergone audits and have ideas for your organization. Finally, evaluate various options you find by Google search.

Narrow your selection by asking questions such as: 

• How many of your clients are nonprofits? 
• How long does the auditing process usually take?
• What is the fee structure? 

Once you’ve narrowed your selection, you can provide a request for proposals (RFP). Based on the proposals you receive, you can make your final choice!

2 to 4 Weeks: Prepare for Your Audit

In preparation for your audit, your nonprofit must ensure that all accounting tasks from the previous year are complete. This means you’ll need to: 

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

The best way to shorten this stage is to ensure your financial information is as hygienic as possible. Cleaning and correcting data in your accounting software will allow your organization to quickly pull necessary reports and information. 

You should also make sure to have a list of your vendors on hand, including your fundraising and CRM software solution vendors, event venue vendors, and other providers. Then, ensure you’ve taken a first pass at your various statements and reports, such as your statement of activities, statement of financial position, and statement of cash flows. 

2 to 4 Weeks: Conduct the Audit

During the audit itself, start considering how the process is going. This will help you determine whether to use the auditor again in the future. Consider if you’re satisfied overall with the process your auditor takes or if they’re disrupting your usual activities. Also, listen for any disputes among staff members regarding the audit process. 

Make notes of both positive and negative impacts the auditor has on your team during this time. This will help you evaluate their effectiveness after the audit is complete. 

After the Audit: Incorporate Recommendations

After the audit is complete, your auditor will write a “letter to management” outlining their recommendations for your financial processes coming out of the audit itself. This letter will be divided into two sections:

• Material control issues: These are the processes and procedures that need to be adjusted to ensure proper recording of financial information in the future. In terms of prioritization, these are the issues that you should address first when reviewing the outcome of your financial audit.
• Operating inefficiencies: These issues are less of a priority for your organization but should still be addressed after the audit. They’re essentially red flags that could indicate issues that could arise or inessential improvements that could create a more efficient financial management system.

Implement these recommendations immediately after your audit is complete and ensure you have the processes in place to maintain them long-term. For example, if a mistake is found in your chart of accounts, find out why that mistake occurred so that you can change up your data entry processes, ensuring it doesn’t happen again in the future.

While audits may evoke fear and trepidation for many individuals who hear the word, nonprofits have no reason to feel that same concern. Audits can be an incredibly helpful tool for nonprofits to improve their processes, create more efficient systems, and better approach their missions. Consider how your nonprofit would benefit from a financial audit and take the first step toward stronger finances! 

This blog is an original work of the attributed author and is shared with permission via Foundant Technologies' website for informative purposes only as part of our educational content in the philanthropic sector. The views, thoughts, and opinions expressed in this text belong solely to the author and do not necessarily reflect Foundant's stance on this topic. If you have questions or comments, please reach out to our team.