What to Expect from the Nonprofit Audit Process

Knowing what to expect from the nonprofit audit process can transform it from daunting to doable. There are clear steps to the audit process, with responsibilities for both the auditing team and the organization. Learn what to expect from each step–and what’s expected of your organization–to keep the process moving forward efficiently. You can also download the guide here. 

Jump to a section:

• What is a nonprofit organization?
• Why do nonprofit organizations matter?
• What financial statements are used by NFPs?
• What is a nonprofit audit?
• What is the process for a nonprofit audit?
• Step 1: Planning meeting
• Step 2: Items Required List
• Step 3: Preliminary fieldwork
• Step 4: Final fieldwork
• Step 5: Wrap-up
• Audit Considerations and Updates for 2022
• Preparing for an Audit with Aldrich

While a nonprofit organization (NFP) may center itself around humanitarian issues or rely on volunteers, the status is based on three specific factors defined by The Financial Accounting Standards Board (FASB).

These characteristics, which are typically not found in business enterprises, determine if an entity is a nonprofit organization:

1. The organization receives contributions from significant resource providers who do not expect a commensurate or proportionate monetary return.
2. The organization operates for purposes other than to make a profit.
3. There is an absence of ownership interest in the organization.

Nonprofit organizations provide many services and can have a huge impact on individuals, communities, and the larger environment. NFPs provide valuable programs to the community. They protect, feed, heal, shelter, educate, and nurture bodies and spirits. There are different types of NFP organizations, and they operate in a broad range of areas. Some NFPs exist to serve the public with services and resources; others focus solely on serving the members of the organization.

Among the millions of nonprofits across the country, there are public charities, religious organizations, labor unions, sports clubs, professional associations, advocacy and health services, art and education centers, and more.

To understand their positive economic impact, take a look at NFPs by the numbers:

• There are more than 1.8 million NFPs registered with the IRS.
• The NFP sector contributed $1.24 trillion to the US economy in 2020, 6 percent of the US gross domestic product (GDP).
• In 2018, private contributions to nonprofits exceeded $420 billion.
• An estimated 25% of US adults volunteered at an NFP, providing over 8 billion volunteer hours, in 2017.
• The NFP sector employs more than 12.3 million people.

Because of their unique organizational status, some financial statements used by NFPs are different from those used in for-profit organizations:

1. Statement of Financial Position: lists an organization’s assets, liabilities, and net assets on the report date. The NFP equivalent of a Balance Sheet.
2. Statement of Activities: reports revenues, expenses, and changes in net assets for the whole organization. The NFP equivalent of an Income Statement.
3. Statement of Functional Expenses: present the functional classification of expenses in three areas (program, management and general, and fundraising). Unique to NFP organizations.
4. Statement of Cash Flows: reports how the organization’s cash and cash equivalents changed over a given time. Same as a for-profit statement.

These financial statements are used by NFPs, donors and granting agencies, “watchdog” groups who monitor charitable organization activity, financial institutions, oversight agencies, and the media. NFP financial statements are a key part of the nonprofit audit process.

There are generally three levels of service that can be provided:

1. A compilation: provides the lowest level of assurance, relies on presented information.
2. A review: provides a higher level of assurance, relies on information provided with some corroboration.
3. An audit: provides the highest level of assurance, requires substantial effort, relies on a significant amount of corroboration from and collaboration with management.

Typically, a nonprofit independent audit refers to an examination of financial records, accounts, transactions, and internal controls by an independent auditor.

An NFP organization may be audited for a variety of reasons. The IRS may select an NFP for a tax audit, conducted as a field audit or a correspondence audit. An IRS agent will be onsite to conduct the audit in a field audit. For a correspondence audit, the NFP will be asked to send documents to the IRS office for review. Or, a nonprofit organization may undergo an independent audit. An independent audit might be required by state law, per certain government contracts, or because the NFP has reached or exceeded a certain level of expenditure in federal funds. Many NFPs will elect to undergo an independent audit even when not legally required for financial transparency or funding eligibility.

Here we’ll discuss what you can expect and how to prepare for an independent audit. If you have questions about tax or correspondence audits, reach out to our nonprofit team.

Regardless of where you are in the audit process, you should expect ongoing communication. Clear and timely communication between the auditor and the client (the NFP organization) helps the audit process proceed efficiently and smoothly.

Some circumstances may warrant particular interest:

• Merger with, acquisition of, or obtaining control of another organization
• Creating a new legal entity or controlled organization
• Pending or threatened litigation
• Actual or suspected fraud
• Infrequent or unusual transactions
• Uncertainty about how to record a transaction

If your NFP has experienced any of these issues, be prepared with relevant documentation and set aside time for specific conversations to address each one.

The planning meeting happens before the audit; it’s how everything gets started. The purpose is to discuss items that have or may have audit significance and set a timeline for the audit. Expect the auditor to explain the timeline clearly and identify the items of audit significance with no ambiguity. By the end of the planning meeting, you should know which items are required and when they must be made available to the auditor. Your responsibility is to answer questions, get clarification as needed, and specify any reasons that the proposed timeline is not feasible.

Items of audit significance may include the following:

• Starting, suspending, or closing a program or service
• Gaining or losing control of a consolidated organization
• Obtaining a significant new grant or contribution
• Starting a new fundraising appeal
• Obtaining new or additional federal funding
• Entering into new debt or lease agreements
• Changes in key personnel
• Converting to new accounting, payroll, or billing software

Efficiency tip: Have the right people in the room, including the executive director, department managers, and any staff members assigned to assist auditors during fieldwork. It may be helpful to have representatives from the board or audit committee present.

The audit is officially underway, but you can expect to receive the list of the required items prior to fieldwork. This step enables efficiency during fieldwork. The auditor will stipulate required items, with a date specified for when the items should be available. You should receive two lists: one for preliminary fieldwork and one for final fieldwork. The items and the dates will be based on the discussions from the planning meeting. If relevant, you should communicate with the auditor about any tasks or items you need assistance with or cannot have available by the specified date. However, remember that the auditors cannot make management decisions or be part of internal control systems.

Efficiency tip: Delegate items and tasks to the most relevant person in the organization. Stay organized by setting up a triage station where you can gather and check that all documentation for each item is complete and available. Create a computer folder to save all shortcuts that auditors need to access documentation.

This step is when the fieldwork begins. Expect the auditor to require time with key personnel. Auditors understand that your daily work continues and will attempt to minimize interruptions; however, fieldwork requires significant corroboration with key people in the NFP organization. Be prepared to explain substantial variances in assets, liabilities, revenue, and expenses from year to year.

Expect the auditor to focus on these areas:

• Obtaining an understanding of internal controls
• Performing walk-throughs of significant transaction cycles
• Reviewing interim financial information
• Conducting routine fraud inquiries
• Obtaining significant policies and procedures, as well as grant, lease, and debt agreements
• Obtaining audit confirmations
• Developing an audit plan

Efficiency tip: While you can’t pause the daily duties and work of the organization, it’s a good idea to reduce responsibilities for key personnel as much as possible. This might include delaying new projects, process changes, or other looming deadlines.

A small team often conducts audits onsite. You’ll need to provide adequate space for them to work. Additionally, auditors may wish to conduct private interviews with various organization members during this time—set aside an office or smaller meeting room for them. The auditors will request additional information during the audit. Designate staff members to be available for these requests and either fulfill them or carry the request to the appropriate person.

The first three steps of the audit process are set up to give NFP members adequate time to prepare needed items and be available for corroboration and interviews as the audit proceeds. The expectation is that you, the client, will be fully prepared. Books must be closed and all work papers ready for review—any delay on the client-side delays the entire audit process.

Efficiency tip: This step of the audit process is the most involved and intensive. If possible, pause any significant projects or initiatives until the audit is complete.

As the client, once you have met the requirements for each step, you can expect the auditors to honor the timeline too. At the agreed-upon date for delivery, auditors should provide the draft audit report and a letter to management, which recommends areas for improvement and notes deficiencies in internal controls. Before the findings are presented formally, there should be a discussion between the auditor, management, and the audit committee.

Efficiency tip: Effective auditor-client relationships are built on mutual respect and collaboration throughout the process. Don’t be afraid to communicate, and conversely, be available and open to communication from the auditors during this process.

The unique circumstances of the last two years may bring some special considerations to the audit process. Auditors may wish to examine operations in the current fiscal year and disrupted operations in the prior fiscal year. There may also be a particular emphasis on auditing more varied funding sources in the current year. As updates go into effect for both lease accounting standards and reporting standards for gifts-in-kind, these areas may become an area of focus during an audit. Be sure to make appropriate transitions to meet the new standards if you haven’t already done so.

New federal awards in the current year may require a “Single Audit.” A Single Audit is a compliance-based audit that must be completed by any entity or organization that expends $750,000 or more in federal funds in one year. So, new federal awards such as COVID-related funds and Shuttered Venue Operators Grant (SVOG) may have put your NFP organization in this category.

All in all, remember that while an audit process is involved–and can be intensive–the purpose is for greater financial transparency and effectiveness for NFP organizations. By being prepared, communicative, and collaborative, you and your staff can create a smoother and more efficient audit process. If you have questions about NFP audits or the auditing process, fill out the form below to contact the author and expert Bobby LaCour, CPA, or reach out to your Nonprofit Aldrich Advisor.