Nonprofit Audit: Guide to Preparation and Requirements

13 min readApr 22, 2022

Proper nonprofit audit preparation builds donor trust, financial transparency and accountability. This guide steps you through preparation, requirements and standards.

What is a nonprofit audit?

An audit for nonprofits is the examination of the financial statements by an accounting professional to determine whether they conform to accounting standards. Independent audits are performed by a public accounting firm or an individual who is a certified public accountant (CPA).

What is the purpose of a nonprofit audit?

The audit is a vital part of the nonprofit’s accountability to donors, funders, and stakeholders. A common misconception about audits is that they are not necessary because government oversight provides enough protection for the public. Audits, however, provide a different type of oversight and validation than government regulators do.

This is because the purpose of an audit is to determine whether transactions are being handled correctly and whether the financial statements are being presented honestly and fairly. This is a different goal than governmental oversight, which determines whether laws and regulations are being followed.

Who performs a nonprofit audit?

Nonprofit financial audits are performed by outside public accounting firms to verify that nonprofits comply with federal tax laws and regulations. The IRS and the nonprofit’s board of directors also use financial audits to ensure that nonprofits are in compliance with all laws, regulations and their governing documents.

Nonprofit organizations must be prepared for an annual audit. The audit process begins with the selection of a public accounting firm. Nonprofits select an independent auditor by requesting proposals from several firms, reviewing fee structures and qualifications, and interviewing representatives from each firm to determine the best fit. The board of directors approves the auditor, and each organization must maintain documentation to support its decision.

Audits can be performed in-house or by a third party, but generally only nonprofits that have been around for at least three years and are grossing more than $500,000 annually hire an outside firm.

Proper nonprofit audit preparation and compliance is important for building donor trust, financial transparency and accountability.

Financial records.
Accounts and transactions.
Accounting practices.
Nonprofit internal controls

Do all nonprofits need to have an audit?

An audit is not required for small nonprofits but it is highly recommended because it provides a third-party assessment of the organization’s financial records and practices.

Nonprofit audits are required for all public charities, private foundations and supporting organizations that have annual gross receipts of more than $500,000 or total assets (net worth) of more than $250,000 at the end of a fiscal year.

Nonprofit organizations are audited for a number of reasons:

To ensure that the organization is operating in a legal and ethical manner
To verify the financial statements are accurate
To determine if the organization has complied with laws, regulations or its governing

Audits are required for the following conditions:

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Federal, state and local governments may request a copy of the nonprofit’s audited financial statements.
Charitable nonprofits who spend $750,000 or more in federal and state funds per year.
Some contracts with state and local governments to provide community services.
State laws require charitable nonprofits to submit a copy of their audited financial statements when they register with the state for fundraising purposes.
Private foundations may request a nonprofit to submit a copy of recent audited financial statement(s) when applying for a grant.

Alternatives to Audits

If a nonprofit is exempt from preparing an independent audit, they can opt for less expensive alternatives: such as a review or a compilation. This is much more cost-effective for smaller organizations.

Review: Certified Public Accountant examines specific financial statements. This is less thorough than a full audit. It does not include a formal written opinion about whether the financials are in accordance with Generally Accepted Accounting Principles (GAAP).
Compilation: Least expensive alternative. This involves an accountant to assemble financial statements from the information provided by the nonprofit. Financials are not subject to an audit or review. Transactions are not tested or analyzed. No opinion is provided regarding compliance with GAAP.

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When does my nonprofit organization need an audit?

An audit is not always necessary, but it may be required by law or contract.

The Board of Directors should determine which type and frequency of audits to conduct based on the organization’s circumstances.

Audits are not always necessary, but they may be required by law or contract. Nonprofit Organizations may need an audit to fulfill a legal requirement or as part of a contractual agreement. In these cases, the Board should determine which type and frequency of audits to conduct based on the organization’s circumstances.

How long do they anticipate the audit will take?

Nonprofit Audits are often used by donors, grantors and other stakeholders in an organization’s financial health. Nonprofits must provide a minimum of five years’ worth of documentation for the auditor to review. The audit will examine the organization’s financial statements, including income and expenses (including salaries), as well as any other relevant information that may be requested by the auditor.

The length of the audit will depend on the size and complexity of the nonprofit. The average length is three to four weeks, but if a nonprofit has not been audited in several years, it may take longer.

Auditors will also review the organization’s policies and procedures, including its operations and management. They will look at any documentation provided by the nonprofit to ensure that it is accurate and complete.

The auditor will also look at the nonprofit’s financial statements from previous years, if they are available.

The length of time required for an audit will depend on a number of factors including:

The size and complexity of the nonprofit organization
The effectiveness of internal control and management systems
The number and type of transactions being audited

Audits are not always required by law, but they are required by the IRS and other governmental agencies. Audits are also required by some donors to make sure their money is being used properly, and they may require a financial audit before any funds can be disbursed.

Other variables which determine how long an audit will take include:

What is your annual budget? What is the total value of your annual budget? (ie. $1,000,000). How much of your total budget was spent on administrative costs and how much was spent on program services? (ie. Program A- $10,000; Program B-$5,000; Program C-$8,000).
How many employees does the nonprofit have? What are their roles in the organization? (ie. President/CEO, Vice President, Secretary, Program Director, Program A- 1; Program B- 2). Do they receive any compensation for their service to the organization?
Are you a member of any other organizations that might require an audit? (ie. United Way, etc.)
How many volunteers do you have? Do they get paid or is it strictly a volunteer position? What are their roles in the organization? (ie. Board- 3; Program A- 2; Program B- 1; Program C- 4).
What kind of fundraising activities does your nonprofit participate in on an annual basis? These can include:
How many board members do you have? Do they receive any compensation for their service on the board?
How many programs do you offer, and what are the costs associated with each program? (ie. Program A- $10,000; Program B-$5,000; Program C-$8,000)
What is your total revenue for the last fiscal year?
What is the total value of your assets? (ie. building- $200,000; equipment- $100,000; cash- $50,000)
What is the total value of your liabilities? (ie. building- $200,000; equipment-$100,000; cash- $50,000)
What is the total value of your net assets? (ie. building-$200,000; equipment-$100,000; cash-$50,000)
What is the total value of your endowment?

Nonprofit Audit Report

The Financial Accounting Standards Board (FASB) principles require auditors to issue a report to the board of directors, presenting a professional opinion about the nonprofit’s financial practices. It will determine whether the financial statements represent the financial position of the organization without inaccuracies or material misrepresentations.

There are four types of reports:

Unqualified Opinion — Shows no red flags or misstatements of any financial position.
Qualified Opinion — Shows the auditors found one or two situations where the organization is not following GAAP. Overall, there are no misstatements of any financial positions.
Adverse Opinion — Shows auditors found a material misstatement. Overall, the organization is not conforming to GAAP.
Disclaimer of Opinion — Shows auditors found material misstatements. This can have a serious negative impact on obtaining funding.

How much does an audit cost?

Onsite audit fees can cost $20,000 or more for large nonprofits. There is a growing trend for smaller nonprofits to have “remote audits” where the auditors conduct the audit without a site visit. This can reduce fees.

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How to reduce audit costs?

Using a fund accounting software system like FastFund Accounting can help your organization improve tracking and compliance with reporting standards requirements. It can also help your organization prepare for your audit, eliminating preparation expenses with an auditor.

Key benefits of using a fund accounting system for nonprofit audit preparation:

Access to an auditable general ledger system.
Complete audit trail of transaction changes.
Generate Audit-ready financials for compliance.

Why conduct an audit even if you don’t have to?

Nonprofit auditing standards are designed to make it management’s responsibility, not the auditor, to establish and maintain proper internal controls. This is because nonprofit audit standards do not just look at financial statements and accounting records, but also evaluate the effectiveness of a nonprofit’s management and control systems.

What are Nonprofit Audit SAS Standards?

SAS 112 and nonprofit audit standards is an audit that redefines the types of internal control issues that will be reportable.

Nonprofit Audit Standards Pinpoint Internal Control Deficiencies

When the American Institute of Certified Public Accountants released its nonprofit audit standards (Statements of Audit Standards — SAS) in 2006, it has had a profound affect on nonprofit organizations and the software they use for their financial management. In the past, you may have seen the terms “reportable condition” and “material weakness” in your audit reports. The term “reportable condition” will no longer be used. Instead, the term “significant deficiency” will be used. The term “material weakness” will still be used, but its definition has changed.

According to the SAS, a control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. Control deficiencies are further categorized as deficiencies in design or deficiencies in operation.

What are control deficiencies?

In simple terms, according to the SAS, a control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. Control deficiencies are further categorized as deficiencies in design or deficiencies in operation.

For example, a deficiency in design exists when a control necessary to meet the control objectives is missing, or an existing control is not properly designed so that even if it operates as designed, the control objective is not always met. Off-the-shelf accounting software does not have the proper internal controls to meet this SAS requirement. For example, in QuickBooks, you can easily change a transaction even if it clears the bank, or is in closed accounting period. This would be classified in your audit report as a significant deficiency.

A deficiency in operation exists when a properly designed control does not operate as designed or when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively. This is a perfect example of the deficiency inherent in off-the-shelf accounting software in their inability to generate financial statements for your audit. Under these new audit guidelines, if your auditor has to create the financial statements for your audit, then it will be reported as a deficiency in operation on your audit report.

A deficiency in design exists when a control necessary to meet the control objectives is missing, or an existing control is not properly designed so that even if it operates as designed, the control objective is not always met. Off-the-shelf accounting software does not have the proper internal controls to meet this SAS requirement. For example, in QuickBooks, you can easily change a transaction even if it clears the bank, or is in closed accounting period. This would be classified in your audit report as a significant deficiency.
A deficiency in operation exists when a properly designed control does not operate as designed or when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively. This is a perfect example of the deficiency inherent in off-the-shelf accounting software in their inability to generate financial statements for your audit. Under these new audit guidelines, if your auditor has to create the financial statements for your audit, then it will be reported as a deficiency in operation on your audit report.
A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the entity’s ability to initiate, authorize, record, process, or report financial data reliably in accordance with GAAP such that there is more than a remote likelihood that a misstatement of the entity’s financial statements that is more than inconsequential will not be prevented or detected. Since most reports need to be created outside of the accounting software used by nonprofits, in programs like Excel, there is more of a risk that the audit will report a significant deficiency in their audit report.

Examples of Control Deficiencies

A poorly prepared financial report can lead to incorrect financial information being shared with management or board members and inaccurate reporting to the IRS. This can result in penalties, worse yet material fraud, including misappropriation of funds.

Financial Risk Management involves implementing procedures to prevent or detect misstatements of the nonprofit’s finances. Here are some examples of control deficiencies and consequences:

If there aren’t adequate systems in place that can help employees or management prevent or detect misstatements of the nonprofit’s financial position.

If the same employee opened the mail and logged-in checks received, processed deposits, approved expenses and reconciled bank statements.

If a nonprofit doesn’t not have staff members capable of preparing financial statements that conform with Generally Accepted Accounting Principles.

How true fund accounting software prevents audit misstatements

zation is using off the shelf accounting software, like QuickBooks for Nonprofits or Peachtree, even their nonprofit versions, it is likely that more audit findings will be reportable. The SAS clarifies that the significance of a control deficiency is dependent on the potential for a misstatement, not whether a misstatement actually occurred. Also, the potential misstatement does not have to be a material misstatement; it just has to be “more than inconsequential.” If more findings are reported, you will spend more time correcting and tracking the status of these findings. All of this translates into increased audit fees, the potential for negative reports in your audit and the risk of losing funding from your funding sources.

Using true fund accounting software, like FastFund Online will help to eliminate the potential internal control deficiencies inherent in off-the-shelf accounting software.

FastFund Nonprofit Accounting software includes the following features that are not available in off-the-shelf applications:

The ability to generate FASB compliant financial statements will benefit your organization by having more real time data available and eliminate the need to report a significant deficiency weakness.
Internal controls will help eliminate the potential for a significant or material weakness.
Security functions can create proper segregation of duties.

Schedule a FastFund Online Demo: Learn more about our unique software approach to nonprofit accounting, payroll and fundraising.

Bottom Line

An independent audit reviews financial statements, including your nonprofit’s statement of financial position, related statement of activities, cash flows and notes to the financial statements. With FastFund Accounting, you can generate all the required financial statements. An auditor can examine profit/loss segments so they can easily track expenses back to each donation or grant.

It also gives you the ability to classify net assets (with restrictions or without restrictions) and provide this information to the auditor to determine if restrictions were satisfied. This saves the auditor time reconciling activity.

Another benefit involves grant tracking by funding source, grouping them by state or federal grantors. This is helpful when an auditor requests grant-specific details for generating this information into a report.

A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.

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Originally published at https://www.araize.com/nonprofit-audit-preparation-and-requirements/