Our Breakdown of Nonprofit Audits: Everything You Need To Know
It is extremely rare for the IRS to audit nonprofits. After all, they are not tax-paying entities. However, there are some scenarios that would incite government and private agencies to ask for one — so it is important to always have your finances ready.
There are two types of audits that your nonprofit’s accounting team should prepare for: an independent audit and an IRS review. Even when they are not legally required, they are necessary for defining the health of your organization. To help you prepare for these potential examinations, in this guide, we are going to cover:
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Understanding an Independent Audit
The IRS rarely requires nonprofit audits. However, depending on the size and spending of your organization, other government agencies may require you to conduct one. And, in any case, regular audits are a best practice to model transparency for stakeholders.
What Is an Independent Audit?
The "independent" in independent audit alludes to the fact that this type of audit is conducted by an agency outside of the government. The organization that calls for it hires a third party to review its business transactions, accounting practices, internal controls, and other financial records.
After reviewing these procedures, the auditor determines if the nonprofit is adhering to generally accepted accounting principles (GAAP). These principles are not lawful, but they are widely utilized, professional standards.
Independent audits can take up to two weeks to complete. Prior to the pandemic, audits happened in person; however, if the auditor is amenable and you digitally save all of your documents, your post-pandemic audit can take place remotely. This can be more efficient for both the auditor and your finance team.
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After the audit is complete, your auditor sends you a detailed report in which they share whether your nonprofit’s financial statements and records fairly represent its financial position. If the report does not mention issues, your record keeping is both well-organized and accurate. On the other hand, if the report notes some issues, follow the auditors recommendations to address them as quickly as possible.
When Is an Independent Audit Required?
While not all charitable organizations need an audit, there are a number of scenarios where one is legally required. These include the following:
Your nonprofit organization disburses $750,000 or more in federal funds per year.
A federal, state, or local government agency requests a copy of your nonprofit’s audited financial statements.
A private foundation requests one along with your grant proposal.
Your organization is located in a state that requires a copy of audited financial statements to register for charitable solicitation.
The bank you are working with requires one as a condition for a loan.
Why Would You Want an Independent Audit?
Whether any of the previous scenarios apply to your organization or not, it is best practice in the nonprofit world to conduct annual independent audits. Why? Well, there are several benefits to them.
Ensuring Stakeholder Transparency
Donors, members, and other supporters give their time and money to benefit your cause, and they want to know that their investment is doing what it is meant to do. Charity watchdog groups, such as the National Council of Nonprofits, even give you a higher rating if you conduct regular audits.
Pro Tip: Many people wonder, "can nonprofits make money?" The answer is that they can and do, but they have to funnel that money back into forwarding their goals. Audits determine where this money goes by evaluating, in part, how these nonprofit organizations account for donations, grants, and more.
Establishing Board Confidence
Part of your board’s fiduciary responsibilities is ensuring proper financial management. A regular audit confirms or denies that you have the right controls in place for this.
Securing Private Funding
Many private foundations and government entities require a nonprofit audit as part of the grant application process. Like individual donors, these bodies want to know that you are going to use the money that they are putting into your mission appropriately. Even if you are a new or small nonprofit, it is important to certify that financers can trust you.
Updating Financial Procedures
While you expend a lot of energy preparing for and conducting an audit, use this as an opportunity to also identify ways to improve your financial policies and procedures. That way, your finance department stays on top of the latest GAAP updates.
How Much Does an Independent Audit Cost?
The cost of an independent audit can vary depending on both the size and location of the nonprofit. Even a small nonprofit can end up paying $10,000 for an audit, while large organizations in major cities often pay over $50,000.
Some smaller organizations use another form of inspection — called a financial statement review — as an alternative. A review does not test your organization’s controls nor does it include a formal opinion, so you do not get a full examination. However, it is much cheaper than an independent audit, and it still gives you a basic evaluation of your financial situation.
A compilation is another substitute that is even cheaper and easier. The compilation process involves hiring a certified public accountant (CPA) to gather and organize your nonprofit’s financial statements. However, unlike with an audit or review, a compilation offers no formal assurance that your nonprofit remains compliant and honest.
The catch with these alternatives is that some third parties, such as a grantors, may not accept them in lieu of an audit. However, if your nonprofit is struggling with costs, it does not hurt to ask. If you can, conduct a full audit every two or three years, and complete reviews or compilations on the "off" years to save money.
Pro Tip: Do not use the same auditor every year. Every five years or so, complete an audit request for proposal (RFP) with a few new vendors. Getting different perspectives can ensure that you do not get stuck with one CPA’s point of view.
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Understanding an IRS Audit
Though a nonprofit audit is rare, the IRS does have a formal review process. Let’s get into how it compares to the independent audit process.
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Why Would the IRS Conduct an Audit?
There are several circumstances that may compel the IRS to conduct an audit of your nonprofit organization, including the following:
Either a government agency or a member of the public has complained of noncompliance.
The IRS has found an issue in the transactions between your nonprofit and the taxpayers who interact with you, such as donors and investors.
The IRS has found you to have inconsistent or incomplete filing of an IRS form, such as Form 990.
The IRS is looking at all nonprofits.
Essentially, if there is any hint that your organization’s financial house is not in order, the IRS may subject you to an audit.
Pro Tip: The IRS rarely audits a church, but when it does, it is because it has "reasonable belief" that the church does not qualify for tax exemption or that the church is not paying taxes on unrelated business or other taxable activity. Proper church accounting practices can help you avoid this scenario — or deal with it well if it does arise.
The Types of IRS Checks
The IRS conducts both full audits and compliance checks. Let’s take a closer look at both of these categories.
There are two types of IRS audits: a field audit and an office or correspondence audit. A field audit is when an IRS agent travels to the organization’s office to examine its books and records.
An office audit happens remotely through calls and letters. However, an office audit can evolve into a field audit if the agent finds serious issues or the organization does not respond to the agent’s requests.
A compliance check is not an audit. Its role is simply to determine whether or not your nonprofit has reported certain items properly. As with audits, compliance checks determine accountability on your organization’s parts. However, they are far less rigorous, invasive, and extensive in their evaluation.
What Does an IRS Audit Entail?
In any of these checks, the IRS may review a number of nonprofit tax filing requirements, including:
Whether your nonprofit’s activities are in line with your stated tax-exempt purpose
Any information found on your nonprofit’s 1099s
Whether you pay employment taxes and other taxes on time and correctly
Pro Tip: In the case of IRS audits, an ounce of prevention is worth a pound of cure. Keep a close watch on your nonprofit financial statements, and conduct annual independent audits to ensure that your nonprofit bookkeeping is compliant, accurate, and organized. You can even form a special audit committee within your board to further ensure compliance. Then, if the IRS does decide to audit you, you will be ready for it.
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Preparing for an Audit
Both an independent audit and an IRS audit require a great deal of preparation. Here is how your organization’s chief executives, board members, and other involved parties can get ready.
Prepare the Documentation
Your auditor typically sends you a list called a PBC (Pull By Client) that tells you what documentation they need. If your auditor does not send you a PBC, request one. This list usually includes:
Prepare the Board
After reading, Peter is feeling zen about his next nonprofit audit.
Once all of your financial paperwork is in order, it is time to bring your board of directors into the loop. Take the following steps to ensure that every board member knows what to expect from the process:
Schedule a meeting with your nonprofit treasurer and finance committee to review the audit protocol.
Schedule a meeting between the auditor and your treasurer and finance committee to review the audit findings.
Allot time in an upcoming board meeting for your treasurer to present the findings to the board.
Send the full audit report to every board member.
As soon as the audit is complete, the auditor will send you a report that outlines any issues as well as any recommendations to resolve or prevent those issues in the future. Take immediate action on implementing these changes. You spent a lot of time, effort, and resources on this audit. The last thing you want is to get the same report from your next audit because you did not follow through on the recommendations now.
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Audits are not pleasant, but a self-imposed, independent audit is one way to check in on the financial health of your organization. An annual independent audit is also insurance in case your organization ever undergoes an IRS audit.
If you keep on top of your financial housekeeping with strong nonprofit accounting basics, you will have no trouble getting through every audit with no or minimal issues!
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💡Are nonprofit audits required?
Nonprofit audits are not always required. However, even if a grantor or government agency does not request an audit, you should still conduct one once a year to make sure that your financial house is in order. Find out more.
🔑 How do I audit my nonprofit organization?
Your nonprofit organization can conduct an audit of itself by hiring a third-party accounting firm. Find out more.
📝 What does a nonprofit audit require?
The auditor will send you a list of the information that they need to examine. This list typically includes bank statements, investment statements, payroll information, donation information, and more. Find out more.