Independent Financial Audits: An Overview for Nonprofits

What this is: A guide to the basics of nonprofit financial audits, including when nonprofits need to conduct audits, the benefits of financial audits, how to prepare for one and a general timeline. 

What this means: An independent nonprofit audit occurs when an external auditor reviews an organization’s financial records and internal controls to ensure compliance. Some nonprofits are required to conduct audits, while others choose to for financial management reasons.

In most situations, the term “audit” has a scary connotation. If an individual or company finds out that they’re being audited, they’re usually concerned about the IRS combing through their financial records and discovering mistakes. 

However, registered 501(c)(3) nonprofits don’t always need to feel this same fear regarding audits. Although the IRS sometimes audits tax-exempt organizations, many nonprofit financial audits are conducted independently instead. During an independent audit, an external auditor or auditing firm reviews your nonprofit’s financial statements, transaction records, accounting practices and internal controls to ensure compliance with the generally accepted accounting principles (GAAP). 

By undergoing an independent audit, your nonprofit might also find areas for improvement in your financial management strategy, which can help you fund your mission more effectively going forward. Let’s dive into an overview of nonprofit financial audits. 

When to Conduct an Independent Nonprofit Audit 

Not all nonprofits are required to undergo independent audits. Small and mid-sized organizations are generally less likely to have to conduct annual audits than enterprise-level nonprofits in more complex financial situations.  

Jitasa’s guide to nonprofit audits outlines 4 situations in which your organization would be required to conduct an independent audit: 

1. Audits are written into your nonprofit’s bylaws. Some nonprofit founders choose to include a requirement for regular audits in the organization’s bylaws to ensure financial security and accountability from the very beginning.
2. You receive more than $750,000 in federal funding each year. This includes federal funding passed through the state in which your organization operates.
3. Your state requires an audit for charitable solicitation registration or renewal. Most states have a threshold of revenue or contributions received annually that triggers their nonprofit audit requirement, and there are some exceptions to these rules. Make sure your organization follows the most up-to-date regulations for the state(s) where it’s registered.
4. A grant application requires you to conduct an audit. Many grantmakers need to see some proof of effective financial management before they consider awarding funding to your nonprofit. Some funders will accept a tax return or other financial statement, but others may specifically ask for an audit.  

Even if none of these situations apply to your nonprofit, it’s still worthwhile to examine your financial records and policies on a regular basis. Although you could conduct a less formal audit internally, hiring an external auditor can provide a new perspective on your organization’s financial health and help you determine the best path forward. 

Would you like to read more about building a foundation for your mission? Start with our Nonprofit Services Resource Center.

Benefits of Financial Audits 

The most obvious benefit of conducting a financial audit is ensuring compliance with federal and state regulations for nonprofit organizations, in addition to GAAP standards. However, your nonprofit can also benefit from audits in several other ways, which include: 

• Higher standards of accountability. If you conduct regular audits—whether you do so annually, every 2 years or even every 5 years—you’ll ensure that your organization is continuously held accountable for your financial activities. 
• Increased transparency. Communicating that your nonprofit has conducted audits and is making improvements over time demonstrates that you take financial management seriously, which can boost donor retention rates. 
• More effective risk management. Establishing sound policies and internal controls is useful in improving your nonprofit’s risk management strategy, since having the right procedures in place from the start can help prevent or mitigate a variety of risks. 

While many nonprofits experience one or more of these benefits, every organization has a different financial situation and can gain unique insights from an audit. As you conduct regular audits, you’ll likely find a variety of ways to improve your organization’s specific policies and procedures over time.

How to Prepare for an Audit 

To allow your external auditor to accurately and efficiently evaluate your organization’s financial position, you’ll need to put in some preparation work. Going through this checklist can help you pull together all of the essential information for your audit:

• Reconcile all bank accounts and check your account balances. 
• Review your accounts receivable and payable. 
• Address any uncleared transactions, outstanding payments or undeposited funds. 
• Remove inactive vendors from your list. 
• Update records on your nonprofit’s material and immaterial assets. 
• Compile all of the financial documents requested by your auditor, such as bank statements, details of grants received and payroll information. 

As you go through the checklist, review each aspect of your financial data for any coding errors. NPOInfo’s guide to nonprofit data hygiene recommends cleaning up ambiguous, duplicate, inconsistent, misplaced and missing information not only to make the auditing process easier but also to help your organization make data-driven financial decisions day to day. 

Nonprofit Financial Audit Timeline 

The financial audit timeline looks somewhat different for every nonprofit. If you’re completing the audit to fulfill federal, state or grant application requirements, make note of that organization’s audit completion deadline and work backwards from there. Here is a basic timeline that shows how long your nonprofit will likely spend on each part of the audit process: 

• Selecting an auditor: 4-12 weeks. The first step includes conducting research on various auditing firms, asking for recommendations from organizations similar to yours or your nonprofit accountant, issuing a Request for Proposals (RFP) and making your final decision. 
• Preparing for your audit: 2-4 weeks. This is where you’ll complete the checklist in the previous section and clean up your financial data. 
• Conducting the audit: 2-4 weeks. Ask your auditor about their expected timeline as you’re narrowing down the top candidates.
• Incorporating audit recommendations: It varies. Immediately after your audit, review the results and create a plan to implement any recommended changes. The timing of this step depends on how extensive your auditor’s suggestions are, but the earlier you can start, the better. 

If you’re conducting an audit to fulfill a requirement in your nonprofit’s bylaws, or simply choosing to undergo one to find opportunities for improvement, your timeline may not be as rigid as organizations that have a straightforward deadline to meet. However, it’s best to complete your audit well in advance of filing your annual Form 990 so you can incorporate any resulting changes into your tax return. Consider applying for an extension to give your organization as much time as possible to review your audit results, make changes and complete your Form 990. 

Especially if you’re conducting an independent financial audit for the first time, your nonprofit’s results may not be perfect and that’s okay! In addition to helping your organization maintain compliance, audits are a learning experience meant to improve your financial management strategy in the long run.

This article is provided for informational purposes only and should not be considered, or relied upon, as legal advice.