How a Nonprofit Can Prepare for an Audit

Your contribution revenue is increasing each year, and your organization is growing. You’re taking on bigger projects and eyeing bigger grants from bigger donors. As you examine the grant requirements to see if you could support taking on certain grants, you notice something new to your nonprofit: an annual audit. Now what? In this discussion, we’ll walk through what to expect, and how a nonprofit can prepare for an audit.

A nonprofit organization is not inherently required to have an audit, but may need to engage an auditor when:

Required by federal, state, or local government in connection with a grant or contract
Required by a state government in connection with a charitable solicitation registration (required by 40 states as of November 2022)
Required by a bank in connection with receiving a loan
Required by the federal government because the nonprofit expends $750,000 or more in federal funding in a year (known as a Single Audit or Program-specific Audit)
Required by the Board as a show of good faith to the public and potential donors

First, take a deep breath – it’s going to be fine! The first audit is always a little messy, but you’ll come out all the better for it. Second, know that the auditor is not “out to get you.” As a former auditor, I can assure you that they don’t want pervasive problems any more than you do! Audits are intended to keep things tidy and up-to-date, and help you identify and implement best practices for your organization.

Why a First-Year Audit Covers Two Years

As you prepare for an audit, be aware that your auditor will first need to substantiate or “audit” the beginning balances. To a degree, this means that the auditor needs to examine the prior year’s activity, and verify that there is no material misstatement in the statement of financial position or net income (or loss) of the year prior to that year under audit. This “double workload” is a big contributor to why first-year audits can be so long and arduous. So, if you know you’re going to need an audit in the next couple of years, start thinking about it now and work on getting your processes and controls in hand, if they aren’t already.

What Your Auditor Will Look For

Your auditor will focus on two things:

Compliance – have the transactions been recorded appropriately under US GAAP and per the organization’s accounting policies?
Documentation – information that substantiates transactions, events, and processes

Compliance

I’ll try to stay very high-level to avoid getting into audit jargon, but the verbiage gets technical pretty fast – and for a good reason. An audit is not intended to provide complete assurance that there is no fraud or misstatement, but to provide reasonable assurance. Auditors make this distinction because the cost of auditing a set of books to the point where there is complete assurance of 100% accuracy would far outweigh the benefit. The auditor is there to provide an objective evaluation of whether the financial statements are “fairly presented” and are “in accordance with the applicable accounting framework” (US GAAP for US entities; IFRS for non-US entities). The phrase “fairly presented” means that the auditor’s testing detects no material misstatement or indication of fraud. The phrase “in accordance with the applicable accounting framework” means that the financials are booked and presented correctly, per the accounting standards applicable to the country where the organization is headquartered. Basically, the auditor is just trying to ensure that the correct accounting treatments have been accurately and consistently applied.

Documentation

How does an auditor verify that an organization is compliant? Documentation!

One of the big requests presented to an organization under audit is documentation related to specific transactions. How an auditor selects these transactions is beyond the scope of this article, but you’ll need to provide documentation that sheds light on what a transaction is and substantiates how it was recorded. For expenses, this might be a receipt, or the invoice from an online order or monthly service. For depreciation, this would be the fixed assets and depreciation schedule – a listing of the fixed assets and their related depreciation per period. For revenue, this might be a report from your customer relationship management (CRM) software, a receipts report for tickets sold, or pledge agreements from donors.

During an audit, you’ll also be asked to provide documentation for non-financial information. This includes things like board meeting minutes, signed agreements like conflict-of-interest acknowledgements, and questionnaires. As you prepare for an audit, keep those documents in a physical or preferably an electronic format that you’ll be able to access and share easily with your auditor. Questionnaires are typically provided by the auditor to specific personnel at the nonprofit organization. The questionnaires will ask about the likelihood of fraud and potential misstatements, and about the respondent’s knowledge of the controls and procedures in place.

Controls Testing

While the auditor specifically will NOT provide an opinion on the nonprofit’s controls (and will say so right in their audit report, and is standard languge), they will perform certain tests of controls to see if there are any obvious breakdowns. This means that they will examine the accounting procedures documentation (which is why it’s a good idea to have the whole process mapped out in a document), and then do a walkthrough of sampled transactions to see if the procedures were followed, and if the controls were implemented and effective. The auditor will look for preparer and reviewer signatures, or the electronic audit logs if applicable. The auditor will also verify that team members cannot access functions which they are not supposed to be able to access, and that the appropriate segregation of duties are in place.

Review versus Audit

Besides making sure your controls and procedures are in place, and collecting and retaining appropriate documentation, the next best thing to undergoing a full audit is engaging a “baby audit,” or a review the year prior to the full audit. A review is just what it sounds like – an independent accountant/auditor examines the books, makes recommendations and notes adjustments as needed, then provides limited assurance that the financials are fairly stated. That is limited as opposed to a reasonable level of assurance, where a limited level of assurance is a notably lower standard of assurance. While a review of the financial statements does not satisfy a requirement for a full audit, having a review the year prior to the full audit will give you a head start on identifying any corrections that need to be made and give you a feel for how to handle audit requests. If you can engage the same firm to do a Yr 1 review as who will do your Yr 2 audit (which I do recommend, if you can), you get the added bonus of getting the firm familiar with your organization and procedures, reducing the number of “first year” questions you’ll experience during your audit, and reducing the beginning balance testing that the auditor will need to perform for the full audit. Under the right circumstances, you may be able to bundle both engagements for a reduced fee than if you engaged two separate firms.

Tips and Things to Know as You Prepare for an Audit

Engagement Pricing

I hope I don’t have to say this, but please don’t select your auditor on engagement price alone! Nonprofits are a particular challenge for auditors and accountants alike because they vary so widely from organization to organization, they typically have weak controls, may have little or no segregation of duties due to the limited number of employees, and are inherently under increased scrutiny and subjected to varying requirements by grantors and government agencies. To minimize the risk of these challenges, try to find an auditor who is experienced with nonprofits.

Advice and Independence

When getting to know us, potential clients have asked if RY CPAs can perform audits. While we’d love to offer our clients extra services, we cannot perform audits because an auditor must be completely independent of their clients in appearance and in fact. This means that the organization that does the accounting and prepares the financials cannot be the same organization that performs the audit. For the same reason, auditors are permitted (and are usually happy to) provide advice and guidance, but cannot make any entries, or regularly be involved in accounting. That said, an auditor can provide guidance on how to handle unusual transactions or point you in the right direction if you ask a question that is too involved. One of the easiest ways to prepare for an audit in any year is to ask questions! Most auditors prefer that you ask questions as they come up throughout the year, so that they can help you get the financials right the first time than for you to wait until the audit when the financials have to be corrected.

Materiality

Many organizations undergoing a first-year audit worry that the auditor will find tiny errors and give them a less-than-perfect report as a result. While your accountant shouldn’t focus on materiality, your auditor will. Small errors that do not cause material misstatements will not affect the audit opinion, and will rarely even make it into the proposed correcting audit journal entries or management letter (neither of which are public-facing, and only go to the organization’s management). For example, if your organization purchases a $30,000 van and expenses it rather than capitalizing it and depreciating it over its useful life, the auditor will recommend an adjustment to remove the expense and capitalize, then depreciate it. This is because the incorrect treatment of the purchase would understate assets and overstate expenses by about $30,000! If your organization purchases $30 in lightbulbs and they’re classified as supplies instead of repairs and maintenance, the auditor is highly unlikely to bother proposing an adjustment for two reasons: the amount is very small, such as to be immaterial; and because both expense types roll into Other Expenses on the statement of activity.

Final Opinion

The context above and a little legwork in your accounting will help your first audit go smoothly, and keep the anxiety of undergoing a first-year audit to a minimum. Again, remember that your auditor does not want to see you fail, and that each year gets better after the first audit! To find out how to get your books audit-ready, and how the RY CPAs team can provide audit support, fill out this form so that we can reach back to you, or schedule a call directly with one of our advisors!

By Anna Baumgardner, CPA | published 11/21/2022

How a Nonprofit Can Prepare for an Audit