Everything You Need to Know About the Small Nonprofit Audit

Blog > Everything You Need to Know About the Small Nonprofit Audit – A Complete Guide

For small nonprofits, financial audits are more than a regulatory requirement—they’re a cornerstone for trust and operational integrity. Regular nonprofit audits are generally recognized as beneficial practices that help organizations maintain financial integrity and transparency.

As a matter of fact, the Inflation Reduction Act provided the IRS with an additional $80 billion. This additional IRS funding may enhance enforcement capabilities, potentially increasing scrutiny of nonprofit audits. This heightened scrutiny underscores the necessity of audits to ensure compliance and financial health.

This blog post guides you through the nonprofit audit process, highlights its necessity and impact, and provides practical steps to prepare. By understanding these procedures, your nonprofit can fortify its operations and achieve long-term success.

What Is a Nonprofit Audit?

A nonprofit audit is an in-depth review of an organization’s financial records and internal control systems. This process involves examining financial statements, transactions, and procedures to ensure they are accurate and comply with laws and regulations.

By verifying financial practices, audits foster transparency and accountability, which are essential for maintaining donor trust and regulatory compliance.

Now that we know what a nonprofit audit is, let’s talk about why it’s so crucial.

Purpose of Nonprofit Audit

The primary purpose of a nonprofit audit is to ensure the organization operates transparently and adheres to legal and regulatory standards. This verification process is crucial for maintaining the nonprofit’s credibility and operational integrity. It ensures compliance with.

Laws: Verifies adherence to federal, state, and local legal requirements.
Regulations: Ensures compliance with specific industry and sector regulations.
Accounting Principles: Confirms that financial statements are prepared according to generally accepted accounting principles (GAAP).

Now that we have grasped the purpose of the audit, let’s understand its frequency for nonprofit organizations.

Frequency of Nonprofit Audit

Various requirements set forth by the IRS, federal and state laws, grant funders, and organizational bylaws determine the frequency of nonprofit audits. These audits ensure ongoing compliance and financial transparency.

IRS

As per IRS, nonprofits with gross receipts less than $200,000 and total assets less than $500,000 can choose to file Form 990-EZ instead of Form 990. Smaller nonprofits may also be subject to audits if they trigger certain IRS thresholds or if discrepancies arise in their tax filings.

Federal Law

According to Federal Law, organizations receiving federal awards exceeding $750,000 annually are required to undergo a Single Audit (formerly known as an A-133 audit). This audit assesses compliance with federal program requirements and the financial management of federal funds.

State Law

State requirements vary widely. Some states mandate annual audits for nonprofits with revenues or assets above specific thresholds. For example, in California, certain charities with gross revenues of $2 million or more are required to have an annual audit performed by an independent CPA.

Grant Funders

Both governmental and private grantors stipulate that recipients of their funds undergo regular audits. This ensures that the funds are being used appropriately and according to the grant’s terms. The frequency and scope of these audits can vary based on the grantor’s requirements.

Organizational Bylaws

Nonprofits often establish their audit requirements within their bylaws to maintain good governance practices. Internal policies may stipulate annual audits or reviews at specified intervals, regardless of external requirements, to ensure financial oversight and accountability.

Alright, we’ve covered the frequency; now, let’s discuss why audits are so critical.

Importance of Nonprofit Audits

Nonprofit audits play a crucial role in maintaining the integrity and trustworthiness of an organization. They not only ensure financial accuracy and compliance but also build stakeholder confidence and enhance overall accountability.

Consequences of Not Auditing

Failing to conduct regular audits can have severe repercussions for a nonprofit organization. These consequences include:

Fines: Noncompliance with federal, state, or local regulations can result in substantial penalties. These financial burdens can strain the organization’s resources and hinder its ability to fulfill its mission.
Penalties: Beyond monetary fines, nonprofits may face additional penalties, such as the revocation of tax-exempt status or disqualification from receiving grants. This loss of privileges can severely impact fundraising efforts and overall sustainability.
Sanctions: Noncompliant nonprofits may also be subject to sanctions, including increased scrutiny, mandatory corrective actions, or legal proceedings. Sanctions can damage the organization’s reputation and erode stakeholder trust.

Ready to get started with your audit? Let’s walk through the essential steps.

Steps in Auditing a Small Nonprofit Organization

You must follow several critical steps to conduct a thorough nonprofit audit for a small organization effectively and comprehensively. Each step plays a vital role in maintaining the organization’s financial integrity and compliance.

Step 1: Select an Auditor

Choosing the right auditor is crucial for a successful nonprofit audit. Here are the criteria for choosing an independent, qualified auditor:

Experience: Look for auditors with significant experience in nonprofit audits.
Certifications: Ensure they have relevant certifications, such as CPA.
Reputation: Check for a strong reputation and positive references.
Independence: The auditor should be free from any conflicts of interest.

Request for Proposal (RFP)

Before selecting an auditor, issuing a detailed RFP is essential. This document should provide a structured way to evaluate potential auditors.

Detailed Requirements: Clearly outline your audit needs and expectations. For example, specify if you need an audit of last year’s financial statements or a review of compliance with grant conditions.
Evaluation Criteria: Specify how proposals will be assessed. For example, outline criteria such as the auditor’s experience, cost, and familiarity with nonprofit accounting.
Submission Deadlines: Provide clear deadlines for proposal submission.

Specialization in the Nonprofit Sector

Selecting an auditor who specializes in the nonprofit sector ensures they understand the unique challenges and requirements of nonprofit organizations.

Relevant Knowledge: Ensure the auditor understands nonprofit accounting and compliance requirements.
Previous Clients: Preference for auditors with a portfolio of nonprofit clients.
Sector-Specific Issues: Ability to address common challenges faced by nonprofits. For example, the auditor should be familiar with managing restricted funds and compliance with various grant requirements.

Alright, once you’ve chosen your auditor, the next step is formalizing everything. Here’s how.

Step 2: Sign an Engagement Letter

Once an auditor is selected, the next step is to sign an engagement letter. This document formalizes the agreement between the nonprofit and the auditor. It should include the following.

Terms

The engagement letter clearly defines these terms between the nonprofit and the auditor.

Scope of Work: Defines the audit’s objectives and procedures.
Responsibilities: Details the roles of both parties.
Confidentiality: Ensures financial information remains private.

Cost

The engagement letter specifies the audit fees and payment terms, ensuring both parties agree on the financial aspects of the audit.

Timeline

The engagement letter provides a detailed timeline for the audit process. It should include:

Audit Schedule: Details the audit process timeline.
Deadlines: Set clear deadlines for each phase.
Reporting: Establishes dates for delivering the audit report and findings.

For Example:

Selecting an auditor takes around 4-12 weeks
Audit prep work takes around 2-4 weeks
Conduction the audit takes around 2-4 weeks

Now that the paperwork is sorted, it’s time to prepare for the audit itself.

Step 3: Begin the Audit Prep Work

Preparing for the audit is a crucial step that involves gathering all necessary documents and ensuring they are organized and ready for review. You must assemble various financial documents during the preparation phase to provide a comprehensive view of the organization’s finances.

Bank Reconciliations: Ensure all bank statements are reconciled with the organization’s records. This includes verifying balances and investigating any discrepancies to ensure accuracy.
Payroll Documents: Compile detailed payroll records, including employee timesheets, wage summaries, and tax withholdings. This ensures that all payroll expenses are accurately recorded and compliant with regulations.
Grant Details: Gather all documentation related to grants received, including grant agreements, expenditure reports, and correspondence with grantors. This helps verify that grant funds are used according to their specified purposes.
Other Financial Records: Include accounts payable and receivable, fixed asset schedules, expense receipts, and prior audit reports. These documents provide a complete picture of the nonprofit’s financial activities and compliance status.

Solutions like VComply make it easier to manage and organize these documents systematically.

All set with the prep work? Let’s move on to conducting the audit.

Step 4. Conduct the Audit

The audit process involves a thorough examination of the nonprofit’s financial activities to ensure accuracy and compliance. It includes the following.

Reviewing Financial Statements

The nonprofit’s financial statements, including balance sheets, income statements, and cash flow statements, will be scrutinized by the auditor. This review ensures that all financial data is accurately recorded and compliant with generally accepted accounting principles (GAAP).

For example, an auditor might identify discrepancies in reported donations, prompting a deeper investigation to ensure all contributions are properly documented.

Interviewing Staff

Auditors should interview key staff members to gain insights into the organization’s financial processes and controls. These interviews help auditors understand how financial transactions are managed and identify any potential areas of concern.

For instance, auditors interview the finance director about financial reporting processes, program managers regarding grant compliance, and the HR director about payroll and benefits management.

Examining Internal Controls

The auditor assesses the effectiveness of the nonprofit’s internal controls, which are procedures and policies designed to safeguard assets and ensure accurate financial reporting. Processes like authorization of expenditures, segregation of duties, and access controls are included in this examination.

For example, an auditor might review how purchase approvals are managed to ensure that no single individual has control over both the approval and payment processes, reducing the risk of fraud.

Conducting Analytical Procedures

Analytical procedures, which involve comparing financial data across different periods or against benchmarks, are also performed by auditors. This helps identify any unusual trends or variances that may indicate potential issues.

For example, if expenses for a specific program have significantly increased compared to previous years without a corresponding increase in activities, it may warrant further investigation.

Testing Compliance with Policies

The auditor tests the nonprofit’s adherence to its policies and procedures. This includes reviewing documentation to ensure that all transactions are properly authorized and recorded according to the organization’s policies.

For example, the auditor may check if all travel expenses have appropriate approvals and receipts as per the nonprofit’s travel policy.

With the audit done, it’s time to act on the findings. Here’s what you should do next.

Step 5: Implement the Findings

After the audit is completed, the next crucial step is to implement the findings. This involves reviewing the audit reports, updating policies, increasing controls, and instituting new processes to ensure ongoing compliance and improved financial management.

Reviewing Audit Findings

Carefully go through the audit report with key stakeholders to understand the identified issues and recommendations. Schedule a meeting with the board and relevant staff to discuss the findings and agree on action plans.

Updating Policies

Revise existing policies based on the audit findings. For example, if the audit highlights gaps in financial reporting, update the financial policy to include more rigorous documentation and review procedures.

Increasing Controls

Enhance internal controls to prevent future discrepancies. This might include implementing dual authorization for significant transactions or increasing oversight on expense approvals.

Instituting New Processes

Introduce new procedures to address the auditor’s recommendations. For instance, if the audit revealed issues with grant compliance, establish a more detailed tracking system for grant expenditures and reporting.

Software like VComply can aid in updating and implementing new processes identified in the audit findings.

To give you a real-world example, let’s look at Hollybush Academy’s audit experience.

Case Study: Hollybush Academy Nonprofit Audit

Hollybush Academy, a small private religious high school in New York, had never undergone a financial audit due to a lack of bank loans and exemption from filing Form 990. With new leadership in place, the Board mandated an audit for the fiscal year ending June 30, 2007, and selected Arthur Novak & Company, known for non-profit audit expertise, due to concerns over potential financial misstatements and fraud.

The audit revealed several deficiencies in the school’s accounting practices, including non-compliance with Financial Accounting Standards (FAS) #116, #117, and #157, and misclassification of assets and liabilities. As a result, Hollybush Academy improved its internal controls and financial reporting, enhancing transparency and accountability and aligning with best practices in the non-profit sector.

Now, let’s discuss some key areas you’ll want to pay attention to during an audit.

Areas of Focus in Auditing a Small Nonprofit Organization

Auditing a small nonprofit involves several critical areas to ensure a thorough evaluation. These focus areas help enhance the organization’s transparency, accountability, and efficiency by addressing various aspects of its operations and compliance. It includes the following:

External Audit

An external audit is conducted by an independent third party to provide an unbiased assessment of the nonprofit’s financial health and compliance. Key focus areas include verifying the accuracy of financial statements, evaluating internal controls, and ensuring adherence to relevant laws and regulations. This type of audit enhances transparency and builds stakeholder confidence.

Internal Audit

Internal audits are conducted by the nonprofit’s management to improve operational efficiency and ensure that internal controls are functioning effectively. These audits focus on evaluating operational processes, financial controls, compliance with internal policies, and risk management practices. The goal is to identify areas for improvement and implement best practices.

Financial Audits

The accuracy and completeness of the nonprofit’s financial statements are the specific focus of financial audits. Auditors review balance sheets, income statements, and cash flow statements to ensure they are prepared in accordance with generally accepted accounting principles (GAAP). This helps maintain financial integrity and accountability.

Compliance Audits

Compliance audits verify the nonprofit’s adherence to all relevant laws, regulations, and internal bylaws. These audits ensure that the organization meets federal, state, and local requirements, as well as any grant-specific conditions. Compliance audits are crucial for avoiding legal issues and maintaining good standing with regulators and funders.

Operational Audits

Operational audits assess the efficiency and effectiveness of the nonprofit’s operational systems and productivity. They involve reviewing key processes, employee management practices, and inventory control systems. The objective is to identify opportunities for operational improvements, enhance resource utilization, and support the organization’s mission effectively.

Sounds good? Let’s move on to some best practices for a smooth and effective audit.

Best Practices for Nonprofit Audit

Implementing best practices in auditing small nonprofit organizations is essential for maintaining financial health, compliance, and operational efficiency. A robust audit strategy has regular audits, risk identification, and operational improvements as key components.

Regular Audits: Schedule audits annually to ensure ongoing compliance and financial integrity. Utilize both internal and external audits to gain comprehensive insights.
Risk Identification: Continuously monitor for potential risks, including financial discrepancies and compliance issues. Develop a risk management plan to address identified risks promptly.
Operational Improvements: Regularly review and refine operational processes to enhance efficiency. Implement recommendations from audit findings to strengthen internal controls and optimize resource utilization.

Applications like VComply offer the tools needed to adopt and maintain these best practices effectively.

Alright, you’ve got the best practices down; let’s wrap it all up.

Wrapping Up

Auditing is vital for small nonprofits, ensuring compliance, preventing fraud, and maintaining financial health. Regular audits help identify and correct errors, providing transparency and accountability. By acting on audit insights, nonprofits can enhance their operations and achieve sustained success.

VComply stands out as an exceptional platform for managing audits, offering features like automated workflows, real-time dashboards, and comprehensive compliance management tools. These attributes simplify the audit process and ensure thorough and efficient reviews.

So, are you ready to streamline your nonprofit’s audit processes? Get started with VComply via a free demo today!

Everything You Need to Know About the Small Nonprofit Audit – A Complete Guide (2024)