Nonprofit Audits: A Guide to Ensuring Financial Accountability
Nonprofit audits might sound intimidating, but they are far less scary than you think. For starters, the Internal Revenue Service (IRS) rarely has a reason to audit your organization—since you’re a nonprofit and don’t pay taxes.
This means you have more control over when, where, and how you conduct independent audits. Sometimes state and federal laws require you to audit your nonprofit, but that’s not always the case. And even if you don’t have a legal obligation to conduct an audit, a financial examination can still be a huge boost for your organization.
Below, we’ll walk you through everything you need to know about nonprofit audits. We’ll dive into what these are, why these are important, the different types of audits, how to choose the right auditor, and more.
What Are Independent Nonprofit Audits?
An independent nonprofit audit involves an examination of your organization’s financial records, accounting practices, internal controls, transactions, and financial statements. An auditor or auditing firm typically conducts this for your nonprofit.
Common reasons why you might conduct a nonprofit audit are to improve your charitable organization’s financial position, transparency, accountability, and bookkeeping practices. In short, it helps you keep track of your donations and expenses and ensures no malpractice behind closed doors.
Donors need to trust an organization before they contribute a one-off gift or recurring funding, and an independent audit provides them with that much-needed reassurance.
However, not all nonprofit audits are voluntary.
There are a few situations where your nonprofit organization may be required to conduct an audit. For example, your state might impose audit requirements if your income and spending exceed a certain threshold. And some nonprofit grants require a satisfactory audit before your nonprofit can receive funding.
Nonprofit Audit Terms to Know
Before we get too deep into auditing, let’s get on the same page about a few common auditing terms. You’ll likely see (or hear) these terms used when choosing and working with an auditor, so it’s best to come prepared before undergoing financial review:
- Bylaws: Nonprofit bylaws (also known as articles of organization) explain how your nonprofit operates. These are a collection of rules, processes, guidelines, and clauses.
- Reconcile: Reconcile means establishing an agreement between different sources of information, such as bank transactions with a financial statement.
- Internal controls: Internal controls are policies and procedures to ensure financial statements remain reliable and consistent, such as inventory observations, password control systems, and accounting software.
- Request for proposal (RFP): An RFP is a document you send to potential auditors and firms to determine the right fit for your charitable organization.
- Provided by client (PBC): A PBC is a list auditors send to your organization requesting access to certain documents and information.
- Pronouncements: Pronouncements are rules established by the Financial Accounting Standards Board (FASB) and Governmental Accounting Standards Board (GASB) that determine the rules for external reporting and disclosure.
- Generally Accepted Accounting Principles (GAAP): GAAP includes rules for determining cost, revenue, matching, and disclosure.
- Certified Public Accountant (CPA): A CPA is someone with a license to provide accounting services to the public.
- Unqualified: Unqualified is an auditing opinion that your financial statements conform with GAAP.
This isn’t a complete glossary of auditing and accounting terms, but it’s a good place to start. Terminology is critical in accounting, so don’t be afraid to check a term if you’re unsure what it means. When in doubt, look it up.
5 Types of Nonprofit Audits
You have a few options for obtaining an independent audit for your nonprofit organization. We’ll review the different types:
1. Internal Audit
Internal audits are better than nothing but don’t necessarily increase public transparency and accountability—since an internal team could be the root of the problem.
However, internal audits can be an effective way for your organization to identify opportunities for improvement. You might find better ways to do your financial reporting or identify valuable cost savings. An internal audit is a chance to step back, see the bigger picture, and look at your nonprofit’s history and trajectory.
Your organization’s development team assigns an audit committee to perform internal audits.
2. External Audit
External audits are typically the most reliable auditing option for nonprofits. Auditors or auditing firms will look at your financial statements, internal controls, and best practices to find areas for improvement.
Having a third-party perspective (someone paid to do the audit) means you’ll receive objective advice from someone less likely affected by relationships or emotions. They’ll provide you with actionable recommendations and let you know when you need to change a certain practice.
3. Compliance Audit
Compliance audits investigate your organization’s obedience to federal, state, and local laws. It’s less of a financial audit (though, it normally includes that to some extent) and more of a check on compliance requirements and adherence to established bylaws.
4. Financial Audit
Financial audits primarily look at your nonprofit’s financial statements to find opportunities for improvement. The auditor may suggest ways to cut costs or recommend changing certain internal controls.
For example, users on your accounting software might not follow password best practices, or there may be too loose of access privileges across your organization.
5. Operational Audit
Operational audits look at your nonprofit’s systems to find holes and opportunities. Here are a few functions auditors will typically examine:
- Human resources
- Information technology
- Operating systems
Auditors will make recommendations to boost your organization’s efficiency and help you reach your financial goals.
Why Are Nonprofit Audits Important?
Don’t have a legal obligation to audit your nonprofit? While that’s fine, you still might want to consider doing one. Audits provide benefits far beyond compliance and checkboxes.
Here are a few reasons to audit your nonprofit:
- Provide accountability: Regular audits encourage best practices and ongoing accountability. Those liable for your finances and business operations know they have a responsibility to stay on top of things and be honest.
- Improve nonprofit transparency: Donors, investors, lenders, and partners want to trust your nonprofit. Auditing your organization helps prove its legitimacy and reliability.
- Identify opportunities: Audits give you an opportunity to take a step back from the day-to-day minutiae and find options for improving your operations and financial health.
- Qualify for grants: Some grant funders require audits to ensure your nonprofit is trustworthy, lawful, and financially savvy.
- Comply with local laws: Some state and local governments require your organization to complete a financial audit if your revenue or expenses exceed a certain threshold.
While one-off single audits are a great start, get on a regular cadence with annual audits. Try to do them at year-end before you submit your tax returns.
The Nonprofit Auditing Process Explained
The audit process can differ slightly depending on your auditor, but here’s a rough overview of what the process tends to look like:
- Request for proposal: Send an RFP to auditors and auditing firms to understand their costs, availability, and timeline.
- Initial meeting: Meet with your auditor to discuss expectations, items of importance, and timelines. Your auditor will list files, documents, and personnel they’ll need access to start the audit.
- Item gathering: Gather the required financial statements and individuals your auditor will need to speak with during their audit. Double-check usernames and passwords to ensure your auditor can access your systems and accounting software.
- Fieldwork begins: Give the auditor room to investigate your organization, review key documents, and speak with personnel.
- Results and recommendations: Look for your auditor to compile their findings and recommendations into an audit report to present to your organization.
- Action: Take action immediately on the auditor’s recommendations.
How to Choose the Right Auditor for Your Nonprofit
The auditor you choose will have a big impact on the quality and actionability of your audit. So do your due diligence when choosing one—focus on finding the right firm to suit your use case.
Here are a few things you’ll want to look at:
- Fees: Learn about the expected costs and ensure these work with your budget.
- Timeline: Confirm that the auditor’s schedule can accommodate your timeline and availability.
- Expertise: Examine the auditor’s background to ensure they have experience and knowledge working with tax-exempt nonprofit organizations and charities.
- Relationships: Determine if you can establish an open line of communication with your auditor. If you don’t feel the relationship is a good fit, move on to a different candidate. You don’t need to be best friends, but you should be able to have positive, frank, and respectful conversations.
- Referrals: Ask for a list of other nonprofit organizations that have worked with the auditing firm. Contact them to learn more about their experiences and see if they’d recommend the auditors.
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