One of the main benefits of registering as a 501(c)(3) nonprofit is that your organization is exempt from paying most taxes. With this provision, you can reinvest all of your revenue back into your organization to help further your mission. However, it might lead you to wonder whether your nonprofit is also exempt from audits.
Although the answer to that question is no, nonprofit audits tend to work differently from audits of businesses’ or individuals’ finances, which are usually conducted by the IRS. While there are occasional exceptions, most nonprofit financial audits occur independently of the IRS and are instead conducted by third-party auditors.
To help you better understand nonprofit financial audits, this guide will answer the following five frequently asked questions about them:
- What is an independent financial audit?
- Do all nonprofits conduct audits?
- What are the benefits of auditing?
- What does the timeline for an audit look like?
- How should I prepare for my nonprofit’s upcoming audit?
1. What is an independent financial audit?
According to Jitasa, “An independent audit occurs when an auditor or auditing firm outside of your organization examines your nonprofit’s financial statements, records, transactions, accounting practices, and internal controls.”
This definition refers to external financial audits. It is possible to conduct an audit internally by having your own team review your organization’s data and procedures, but they don’t provide the benefit of an objective third-party perspective that external audits do.
There are also other types of audits your nonprofit might conduct, such as compliance, systems, or HR audits. However, financial audits tend to be popular because the way you manage funds determines whether your organization can effectively fulfill its mission. So, for the purposes of this article, we’ll focus on nonprofit financial audits conducted by external auditors.
2. Do all nonprofits conduct audits?
Not all nonprofits conduct financial audits, although any organization can. In general, there are four situations that would require your nonprofit to undergo audits:
- Audits are written into your organization’s bylaws. Upon starting your nonprofit, one of the founders may have stipulated that the organization would be required to conduct audits to ensure financial transparency.
- You receive more than $750,000 in federal funding each year. This includes federal funding passed through the state where your organization operates.
- Your state requires audits based on revenue generated. Nonprofits that bring in a certain amount of funding are required to conduct audits to maintain compliance with guidelines in their state, although that threshold varies.
- A grant application asks for an audit. Grantmakers often think of the funding they award as an investment, and they might ask your nonprofit to conduct an audit to make sure they’re investing in an organization that manages its finances effectively.
Even if your nonprofit isn’t required to undergo audits, you might still choose to conduct them on a regular basis, whether that’s every year, two years, or five years. It’s always beneficial to ensure your organization is being financially responsible, and audits are a helpful way to do just that.
3. What are the benefits of auditing?
In addition to assessing whether your organization is handling its finances responsibly, conducting regular audits benefits your nonprofit in several ways, including:
- Strengthening internal controls. Internal controls are policies and decisions that your nonprofit uses to prevent funds from being misappropriated. For instance, many organizations require two signatures on checks to catch any mistakes before they happen. Audits can help you discover times when funds were misappropriated in the past so you can develop strategies to avoid future problems.
- Improving your risk management strategy. Audits can also help your nonprofit identify a variety of potential risks, such as violations of cybersecurity, theft, or issues with financial compliance. This way, you can take more targeted actions to mitigate those risks.
- Increasing transparency with stakeholders. Letting your supporters know that you’re taking steps to consistently monitor and improve how you’re using your finances shows that your organization is trustworthy. This can lead to more donations and increased donor retention.
Additionally, conducting audits helps hold your nonprofit accountable to itself on a regular basis. Even as your organization grows and evolves, you can be confident that your finances will remain secure and be managed appropriately.
4. What does the timeline for an audit look like?
Your organization’s individual timeline will depend on the reason you’re conducting the audit. If you need to send your results to your state government or a grantmaking organization, check their deadline and work backward to figure out when you need to start.
Here is a basic outline of how long your organization can expect to spend on each of the activities involved in your audit:
- Selecting an auditor: 4-12 weeks. To choose the right auditing firm for your organization, conduct research online and ask for suggestions from other nonprofits. If you’ve previously worked with a nonprofit accountant, they may also be able to recommend auditors.
- Preparing for your audit: 2-4 weeks. This step will be covered in the next section.
- Conducting the audit: 2-4 weeks. Before you choose an auditor, ask them about their estimated timeframe for completing the audit to ensure you can make your deadline.
- Incorporating audit recommendations: it depends. Naturally, if your auditor makes more extensive recommendations, you’ll spend longer incorporating them. But the earlier you can start, the better! As you go, prepare some materials to communicate with donors about the improvements you’re making.
If you’re conducting your audit by choice or because your bylaws require it, try to complete it before your nonprofit files its annual tax return so you can incorporate your auditor’s recommendations. Consider filing for an extension on your Form 990 in case the audit takes longer than expected.
5. How should I prepare for my nonprofit’s upcoming audit?
Although your external auditor will do the work when it comes to actually conducting your financial audit, it’s still important to make the process as easy for them as possible. Some steps you should take to prepare for your audit include:
- Reconciling all bank accounts and checking account balances.
- Reviewing your accounts receivable and payable.
- Addressing any uncleared transactions, outstanding payments, or undeposited funds.
- Going through your list of vendors and removing any inactive ones.
- Updating the records on the assets your nonprofit owns.
- Compiling all of the financial documents your auditor requests, such as bank statements, payroll information, and details of grants received.
As you go through this process, check for coding errors or discrepancies in your financial data. NPOInfo’s guide to nonprofit data hygiene recommends cleaning up any ambiguous, duplicate, inconsistent, misplaced, or missing information in your database. Doing so not only ensures that your auditor has a clear picture of your organization’s financial position, but also allows you to proactively find opportunities for improvement.
Especially if your nonprofit is undergoing an independent financial audit for the first time, your results may not be perfect, and that’s okay! If you go into your audit with the expectation that it will provide a learning opportunity for your organization, you’ll be more receptive to your auditor’s recommendations. Then, you can make lasting changes that improve your organization’s day-to-day practices—and potentially the results of future audits as well.