Audits can be a headache, and in the worst cases, something to fear.
But before we talk about how to prepare for a nonprofit audit, allow us to suggest a reframe that will be valuable to your success:
Audits are an opportunity. Not an obstacle.
How so?
Because winning grant dollars, or persuading donors to support you, means combining compelling stories with compelling evidence. And a financial audit is the perfect opportunity to collect some impact evidence…
In this article, we’ll cover when nonprofits likely have to undergo an audit, what they’ll focus on, and best practices for success.
Let’s dive in.
If you prefer learning in a presentation-style environment, you can access the webinar replay link here.
The material covered in this article originally appeared in our Understanding Nonprofit Audits webinar, led by indinero’s Director of Nonprofit Services, Vanessa Brown.
The Money You Can’t Touch
You just received a $100,000 grant to expand your after-school program into two new neighborhoods. The money’s in the bank, and it feels like a win.
Three weeks later, your building’s HVAC system fails. The repair estimate: $40,000. You’ve got the cash sitting right there. It’s your organization’s money, isn’t it?
Not quite.
In the for-profit world, revenue is revenue. In the nonprofit world, revenue comes with instructions.
But as you know, that $100,000 is earmarked strictly for program expansion. Spend it on the repair, and you’ve violated the terms of the grant. And when auditors arrive, they’ll know.
Which Nonprofits Need an Audit?
There are a variety of scenarios that may compel a nonprofit to undergo an audit.
- State Law: If your nonprofit exceeds certain revenue or contribution thresholds (commonly $250,000+), your state may require you to file independently audited third-party financial reports. You can find your state’s requirements here.
- Federal Funding: If you receive over $1,000,000 in federal grant funding, you’re required to undergo an audit.
- Private Grant or Donor Stipulations: Foundations and major donors often require an audit, especially for restricted grants.
- Board Policy: Your board may require an annual audit as part of their governance framework.
- Loan Agreements: Lenders providing lines of credit or bridge funding may want to see audited financials.
Audited financial statements build donor confidence, improve transparency, and bring clarity to an organization’s finances. And if you’re above a certain size, it may be worthwhile to pursue an audit anyway.
Auditors often uncover valuable insights which, if acted on, could empower you to have even more impact.
How to Prepare
Audit firms will give you 2-3 months’ notice before they anticipate starting fieldwork, which gives you a significant window of time to prepare.
Then, before the auditors arrive, be sure to:
- Reconcile all bank accounts
- Review grant schedules
- Finalize supporting documentation
- Ensure board minutes are accurate and complete
- Confirm fixed asset records
Next, they designate an audit coordinator. Having a single internal point of contact who can receive requests and route them to the right people makes the process considerably less chaotic.
Lastly, once the time comes, don’t be surprised if you need to pull program managers in. They likely have intimate knowledge of how programs actually operate, and auditors will need that detail.
Potential Outcomes
There are four options, but most of the time, stakeholders expect an unmodified (clean) audit opinion.
- Unmodified (Clean): Your financial statements are fairly presented, and auditors uncovered no evidence of fraud, mismanagement, personal enrichment, or other financial malpractice.
- Qualified: Auditors uncovered a limited issue.
- Adverse: Financial statements were materially misstated, and potential evidence of malpractice uncovered.
- Disclaimer: Insufficient evidence for an opinion.
Where Auditors Focus
Auditors are ultimately trying to confirm that your financial statements are accurate and compliant. But a few areas get extra scrutiny in the nonprofit world.
Grant compliance is first. If you received earmarked funds, auditors want to see that those funds were used for that purpose and nothing else. The award letter is your compass here.
Functional expense allocation is where things can get uniquely complicated.
Staff at smaller organizations often wear multiple hats, but if they’re serving different purposes, how much of their salary do you allocate to “program services” vs. “management and general” vs. “fundraising”? Auditors want to see you’ve thought about it and that you can justify your position.
Revenue recognition, in accrual accounting terms, is next.
If you’re receiving a restricted grant, you can’t recognize that revenue until you’ve met the conditions attached to it. Auditors will check that you’re recording revenue when you’re entitled to it, and only then.
Internal controls are another key focus.
Who’s approving expenses? Who’s cutting the checks? If it’s the same person, auditors see a problem. They want segregation of duties, clear approval chains, and monthly bank reconciliations providing third-party verification of your reported cash balances. Additionally, donor-restricted funds need to be held separately until earned by purpose or time.
Finally, IT and cybersecurity controls are a growing focus. Auditors are requesting security certifications (SOC 1 and SOC 2 reports) from software providers, and are inquiring about protections for remote employees.
Common Issues Auditors Uncover
Even well-run organizations get caught off guard. Knowing what auditors commonly flag can help you anticipate challenges before they come up.
Missing documentation is the most frequent finding, and the easiest to prevent. Every expenditure needs a paper trail, every time, without exception. Nonprofits have been granted special treatment within the U.S. tax code, and the flip side of that treatment is a higher documentation standard.
Weak segregation of duties is another common flag, and one that small teams especially struggle with. When one person handles approving, reviewing, and paying, there are no checks and balances. The fix requires only separating who requests a payment from who authorizes it. Even a two-person review chain is better than none.
Improper donor restriction tracking trips up more organizations than you’d expect. If a donor gives you money earmarked for a specific purpose, those funds need to be tracked separately and spent according to the restriction. Errors here create more than audit findings. They erode trust with the people funding your mission, and they make the next grant application harder.
The prevention strategy is straightforward: build these into your monthly accounting process so they’re already handled when fieldwork begins.
Best Practices For a Smooth Audit
In addition to keeping documents organized, nonprofits with the smoothest audits share a few habits.
- Prompt Communication: When auditors reach out, respond promptly. Having open lines of communication with your auditors will help facilitate the process. It’s okay if you don’t immediately have an answer; a simple “hey, request received, it’ll take 2-3 days to pull this together” is perfectly acceptable.
- Regular Status Meetings: Every 2 weeks would be ideal, even if it’s simply a 15-minute call to make sure things are on track.
- Escalate Issues Early: It’s considerably more difficult to fix an error late in the process.
- Maintain Shared Request Lists: A common, shared platform with a comprehensive list of requested items will reduce the chance something falls through the cracks.
- Assign Clear Responsibilities: In addition to designating a single audit coordinator, make sure any delegated responsibilities are clear and time-bound.
Additionally, it’s worthwhile to think of an audit as a valuable exercise rather than a challenge to overcome.
Audit firms have seen the intimate financial details of hundreds of organizations. And recently, they’re often writing letters to management outside of their formal audit opinions, detailing practical recommendations which may improve your operations.
These letters didn’t used to be common, but they’ve become a valuable part of the process. Think of it as free consulting from people who’ve seen the inside of hundreds of organizations, and can recognize what good looks like.
Questions From the Webinar
How do you know when you have an unqualified auditor?
Qualified firms are peer-reviewed. If you’re not sure, ask if they undergo regular independent quality control reviews from organizations like the AICPA.
How much documentation and methodology do auditors expect organizations to maintain to support how expenses are allocated between programs, management, general, and fundraising?
You likely don’t have to get into nitty-gritty detail: “so-and-so spent 20 minutes doing this, and 40 minutes doing that.”
But you do need a documentation system that can confidently say: “so-and-so spends about 30% of their time on this program.”
I understood that the best practice is to avoid having finance committee members on an audit committee. So, why do finance committees often act as audit committees?
Nonprofits often operate with small boards and limited staff, so sometimes, it’s by necessity. It would be ideal to have a separate finance and audit committee — segregation of duties is important — but in reality, sometimes it’s not possible.
Does an audit management letter constitute a qualified audit?
We’re seeing this more often, where nonprofits will receive a “clean” audit opinion alongside a sidebar letter to management detailing ways they might improve.
What they’re talking about in those letters aren’t things that lead to an adverse opinion. Rather, they’re proactive ideas from the auditors for how a nonprofit could run more efficiently.
If a grant allocates a percentage of overhead, does the organization still have to track functional expense allocation?
That’s a good question. You’ll need to support your argument for the percentage of overhead you’re allocating.
Why are you doing that? Who’s considered overhead? Who’s considered direct services staff?
It’s a good place to think it through. Having a specific policy in place is good, and a management or board-approved policy is even better.
But at the end of the day, auditors want to understand your logic, and to be sure it makes sense.
Need Help Preparing for Your Audit?
Notably, we don’t perform third-party audits ourselves. But nonprofits are near and dear to us, and we can help you get prepared.
Book a free consultation with our Director of Nonprofit Services, Vanessa Brown. Bring your questions, and we’ll help you figure out where you stand, and what to tackle first.
