Running nonprofit organizations is fraught with all kinds of very complicated rules, exceptions to rules, and changes to those rules mandated at every level of government. However, one constant is only very rarely disrupted: the Internal Revenue Service (IRS) does not require an independent audit of nonprofit organizations. That said, there are other agencies that can and will impose nonprofit audit requirements if the size of the firm and its cash flow patterns warrant.
This article will cover when and why an independent auditor is necessary for a nonprofit organization as well as the generally accepted accounting principles that serve best when a financial audit is necessary. The Susan S. Lewis CPA firm performs audit services in Chicago and nationally.
When Is an Audit Required for a Nonprofit?
The national and state laws governing nonprofit organizations and their audited financial statements are myriad and sometimes confusing. A financial audit might be expected for many reasons such as organization size, the nature of its work, foundations e.g. the sources of its funding, or if it is a party to government contracts. However, nonprofit audits don't have to be complicated if you understand, more or less, how they work.
Federal Nonprofit Audit Requirements
An independent audit may be among the nonprofit audit requirements for those enterprises receiving federal funding. This is rooted in a law passed by the U.S. Congress to assure compliance with rules governing federal grant management standards and nonprofit organizations, particularly those that spend more than $750,000 of said funds annually. The same legislation advanced consistent procedures to conduct an independent audit of a nonprofit organization. Recipients of government contracts may also fall subject to financial review, i.e., they must submit audited financial statements upon request of the agency that awards the contract. Other firms that benefit from federal loans, food donations, real estate conveyance, and subsidies can likewise produce an independent nonprofit audit for government agencies.
Illinois State Nonprofit Audit Requirements
Audit requirements are mandatory for nonprofit organizations in Illinois. The one condition is that annual contributions must exceed $300,000 for the group to use an independent CPA to submit audited financial statements. If donations fall below this threshold, the nonprofit audit is only necessary if the charity employs a fundraising professional for solicitation. Yearly collections falling beneath $25,000 need not file any audited financial records. These provisions fall under the Solicitations for Charity Act passed by the Illinois state legislature.
Benefits of Independent Audits for Nonprofit Organizations
A nonprofit financial audit might be a legal demand or altogether unnecessary. Either way, retaining an independent auditor to perform a financial review of accounting records can only help your business. If you submit audited financial statements to donors and other sources, they will give your grant requests greater weight than those applications without such evidence of financial health. Nonprofit audits also burnish a firm’s reputation with the general public from which a new generation of contributors may come. Thirdly, making a habit of an annual audit creates a discipline of adhering to generally accepted accounting principles.
Yet another plus follows the regular adoption of an independent audit. Such a practice exposes areas and protocols where improvement is desirable. This sort of financial review serves as another set of eyes. After all, raising and disbursing funds is sometimes a tedious, monotonous business. Things might get missed to your financial and reputational detriment. Hiring a professional CPA to conduct an independent audit highlights points in the process where details fall through the cracks. So, an independent auditor serves as a means of quality control, helping to avoid backtracking and embarrassing admissions of errors later.
What Is an IRS Audit?
When the Internal Revenue Service (IRS) audits a nonprofit organization, this happens under a narrow set of circumstances. A nonprofit financial audit by the IRS is initiated if a return appears to be wanting in accuracy or completeness, unsupported by the organization’s financial records. Another trigger could be notification by any number of other government agencies that the nonprofit organization has failed to operate in accordance with their rules for grant recipients. Furthermore, the division within the IRS that takes responsibility for IRS-exempt organizations is itself under review, requiring financial review of organizations under its purview.
If the organization does business with other taxpayers and entities, the IRS audit of the latter might spill over to the former. Meanwhile, should the federal government discover discord between the organization’s financial records and the documentation submitted by employees or vendors, the audit process could very well kick in. Beyond these contingencies, any time nonprofit organizations seek abatement or money back from the IRS, an IRS agent may count these as red flags and invoke the audit process. So, while IRS audits are not frequent occurrences due to federal tax law requirements for a nonprofit organization, the modest possibility remains.
Looking at the criteria for an IRS audit as put forth above, there is good reason to suspect that a charity or foundation that undergoes an independent nonprofit audit ensures a less eventful and stressful time than would be the case otherwise. A nonprofit auditing firm can unearth the discrepancies, relationships, and transactions that activated the IRS audits in the first place. Remedying these things sooner rather than later can preclude unwelcome examination by the federal government.
Types of IRS Nonprofit Audits
IRS Field Audit
If a nonprofit’s financial position opens it up for an audit, one possible scenario is the field audit. This involves an on-site visit by an IRS agent to discover where and how financial information is maintained. The agent may also quiz staff as to the state of internal controls and other procedures that ensure accuracy and integrity. In fact, one or more IRS agents may participate, depending on the size of the nonprofit organization. Of all the IRS audits, this can be the most stressful.
Once the initial contact letter from the agency arrives, nonprofit executives should respond and move promptly. The IRS will indicate a time and date for the field audit but will nevertheless work with the organization to establish a mutually optimal day for the audit. In preparation, the financial compilation of pertinent documents is crucial as is the brevity and honesty of answers. Agents want to examine the organization’s finances closely so be proactive.
Office/Correspondent Audit
Less extensive than the field audit, the office or correspondence audit rarely includes a face-to-face encounter with an IRS representative. This sort of audit is more interested in completeness and timeliness of filings, the accuracy of financial information, operations conforming to a tax-exempt mission, submission of employee income data, returns related to 1099 vendors, excise taxes relative to private foundations that produce or manufacture goods, any outstanding unpaid tax liabilities, and if the application for exemption included all necessary disclosures, to name a few.
Most of these verifications and corrections are accomplished by telephone or in writing. However, if the audit process fails to resolve certain matters after a reasonable time period, the correspondent audit could possibly ramp up to a field audit. This potential occurrence is another good reason why accounting records should be consistently kept in order. It also makes the case for a regular independent audit to flush out issues in advance of an initial contact letter from the IRS.
Compliance Checks
Although not technically an audit, the compliance check aims to monitor an organization’s conformity to the federal law that has jurisdiction. Its aims are to determine if the nonprofit is reporting figures correctly; to obtain assurance that the firm is performing activities as directed by its charter, and to get feedback from the organization as to how to complete various forms, etc. These purposes are achieved through the compliance check questionnaire.
In brief, the IRS wants to confirm that the foundation, charity, or other nonprofit concern is following the prescribed rules of reporting and fulfilling the purpose upon which its tax exemption is based. This is the least intrusive of the IRS inquiries, and the most common. As with audits, the appropriate company officer will receive a written heads-up that a compliance check is coming. There are no sanctions or penalties if an organization passes on the compliance check questionnaire. All the same, too many refusals might invite a more comprehensive audit later.
What Is an Independent Nonprofit Audit?
Absent the curiosity of the IRS, nonprofit leaders may seek audited financial records for other reasons. A nonprofit audit might result from a judicial directive or another agency request, e.g., an agency granting federal funding. Alternatively, nonprofits impose their own nonprofit audit requirements.
Independent Audit vs. IRS Audit: What Is the Difference?
An independent nonprofit audit differs from one executed by the IRS in several areas. For one thing, there is no IRS personnel with whom to deal. The independent auditor is a professional CPA unrelated to the agency and is compensated by the audited firm. The audit is free of consultation with the IRS and devoted solely to evaluating internal controls and documentary accuracy. In the end, this accountant submits an audit report that details the investigative findings such as areas of strength, improvement, weakness, and danger.
Overall, the audit ideally confirms that the organization is operating in accordance with generally accepted accounting principles (GAAP). These embrace best practices recognized throughout the accounting profession. They include cost principle, revenue recognition, materiality principle, and full disclosure principle, among many others. The audit helps to hold the organization accountable to its directors, its investors, and its donors.
Independent Audit Process for Nonprofits
A financial audit by an independent CPA is performed methodically and according to rigorous criteria. One step leads to the next so the nonprofit firm has a full picture of its financial health.
Nonprofit Independent Audit Timeline
The duration of the independent audit can vary according to whom the audit is due, board members, for example. That party sets deadlines for benchmarks and the final audit report. While some expectations can appear generous, the amount of work demanded by the audit may find auditors sweating to make the finish line in time. This is why competent accountants invest their time efficiently. Selecting an independent certified public accountant with the right experience can take up to 12 months. This commences with extensive research and continues with winnowing the field of auditors with interviews and deeper questions, issuing a request for proposal (RFP) by an auditing firm, and making a final choice.
Subsequently, there is much preparation, two to four weeks’ worth, required by the final candidate: reconciling accounts, identifying coding errors, as well as evaluating undeposited monies and uncleared transactions. These are among the components of financial compilation. The audit itself can take up to a month and that is followed by filing a report with practical recommendations for improvements and efficiencies. This is called a “letter to management.” In total, an independent audit can consume six months. We now look at these steps in detail.
Step 1: Selecting a Nonprofit Auditing Firm
Initial Research
Starting from scratch in the procuring of a CPA for an independent audit can be as simple as a Google search. Other avenues of inquiry can include personal accountants for referrals, nonprofit peer firms that have utilized private auditors, or professional associations to which CPAs with audit experience might belong. Still, another avenue is obtainable through the U.S. Securities and Exchange Commission, which maintains an online database of corporate filings. This site includes the names of anyone associated with a financial audit. Important in this phase is to cast a wide net. There will be time to filter out the less ideal candidates. Initial research has the purpose of developing a list of prospects from which nonprofit organizations can glean.
Narrow Your Selection
With a large pool of candidates in hand, the next task is to take one step closer to the best nonprofit auditing firm available. This means interacting with professionals at each accounting firm. You want some details about their offerings and the manner in which they submit audited financial statements. Among the more important questions are those pertaining to how many nonprofits they have performed independent audit reviews for. Clearly, the ratio should reflect solid experience with not-for-profit groups and 501c3 audit requirements. Beyond this criterion, it is important to know the estimated length of the audit process and how the fee structure works. Explanations of these aspects are equally important.
Provide an RFP
An official request for proposal (RFP) is a way of further whittling the wheat from the chaff, so to speak. This invitation document should embrace the following components:
- A general overview of the accounting firm;
- Details on the personnel who will conduct the audit;
- Specific features that distinguish this firm from other nonprofit auditors;
- A plan for how they will carry out the audit;
- An explanation of the fee structure;
- A set of references who will attest to the firm’s competence and integrity with annual audits.
Sufficient written responses to these questions should allow the professional cream to rise to the top.
Step 2: Preparing for the Nonprofit Audit
In advance of the independent audit, a large amount of preliminary work must take place. To begin, the auditors send an itemized request list to the nonprofit client. This PBC (i.e., pull by client) request calls for all of the financial statements and financial records necessary to make a thorough evaluation and financial review of the nonprofit’s reporting and internal controls. The quicker the client provides these accounting records, the shorter the audit duration will be. The PBC commonly asks for:
- Statements from the financial institution or institutions
- Reconciliations from the bank
- Investment statements
- A schedule of prepaid items, upcoming expenses paid in advance and recognized as assets, e.g., rent or insurance premiums
- Unpaid bills such as utility payments or anything used but yet to be compensated for
- Employee wage/vacation day accruals
- Payroll data
- Record of grants and donations received
Keeping these documents updated and available throughout the year goes far toward making annual audits more efficient and less stressful. With them close at hand, proper preparation is easier. Bank statements are essential because each and every account must be reconciled in a way for which every penny is accounted. It follows from this that transactions not yet posted should be noted by auditors. To conduct an independent audit thoroughly, examiners must likewise analyze payments to the firm’s vendors, staffing agencies, office supply wholesalers, and maintenance services, for example. Furthermore, any undeposited funds that are held by the organization require identification and tabulation. Sound financial practices demand that the enterprise works from a sufficient base of capital, a reality that an independent audit will confirm or question. Never ignored is human error. Ledgers and financial statements are checked and re-checked in search of duplications, omissions, or mathematical miscalculations. These are some of the components of independent auditor reviews.
Accounting, confirming, following up, and ascertaining business patterns allow the auditors to create a narrative of where a nonprofit stands.
In its letter to management, the auditing firm approaches its evaluation from two directions. From an internal control perspective, the audit report identifies ongoing protocols and processes that deserve revision if efficiency and clarity are to be preserved. The other approach is narrower, focusing on “operating inefficiencies.” These are issues that could lead to more serious problems unless corrected.
Responsible officials will want to review the management letter for two reasons: 1) to ask deeper questions of the audit team and 2) to report the findings to company leadership. Questions for the auditors might look like these:
- What were the strengths and weaknesses of the internal controls?
- Do the issues raised affect the organization in terms of regulation and law?
- Was the staff accommodating to auditor questions and requests?
- Would any findings be of interest to the IRS?
- Were the recommendations from past audits incorporated into current procedures?
- Are there matters that require the attention of the firm’s board members?
Step 3: After the Nonprofit Audit
In its letter to management, the auditing firm approaches its evaluation from two directions. From an internal control perspective, the audit report identifies ongoing protocols and processes that deserve revision if efficiency and clarity are to be preserved. The other approach is narrower, focusing on “operating inefficiencies.” These are issues that could lead to more serious problems unless corrected. Operating inefficiencies could lead to, for instance, an IRS audit if management does not address them promptly.
Responsible officials will want to review the management letter for two reasons: 1) to ask deeper questions of the audit team and 2) to report the findings to company leadership. Questions for the auditors might look like these:
- What were the strengths and weaknesses of the internal controls?
- Do the issues raised affect the organization in terms of regulation and law?
- Was the staff accommodating to auditor questions and requests?
- Would any findings be of interest to the IRS?
- Were the recommendations from past audits incorporated into current procedures?
- Are there matters that require the attention of the firm’s board members?
Trust Your Nonprofit Audit to Lewis.cpa
Nonprofit groups do well to regularly authorize independent audits. It demonstrates to donors, members, directors, and regulators that the firm does its work transparently, comprehensively, and above board, and thus, the public has more confidence in the non-profit.
Lewis.cpa is well-versed in making these financial reviews an asset for nonprofit concerns. Reach out for an appointment today. We can walk you through the process for a nonprofit audit and ensure that you understand the entire process.
