Not all nonprofits are required to undergo a financial audit. Generally, a nonprofit is required to conduct an audit when it's mandated in their bylaws, required by state laws, when they receive more than $750,000 in federal funding, or when required to apply for a specific grant. Whether an audit is legally mandated depends on your organization's financial situation and the legal requirements in your state.
Even if your charitable organization isn't required to conduct an independent audit, it's good practice to perform regular audits. According to the National Council of Nonprofits, independent audits provide nonprofits with critical benefits:
- Increased financial transparency with funders and supporters
- Regular accountability for your organization's financial health
- Opportunities to improve internal controls, procedures, and policies
There's no shame in finding opportunities for improvement after your audit, but every nonprofit organization wants to pass their financial audit with flying colors. This nonprofit audit guide covers the necessary steps to pass an audit and addresses the common audit challenges that impede charitable nonprofits.
Meet with your auditor before the audit process begins
Before you embark on a nonprofit audit, your organization should host a meeting between staff members who will work with the independent auditor. This step helps the audit process go more smoothly. Preparing for the audit starts with addressing any questions from the team about what the process will look like.
Cover questions such as:
- Areas of the nonprofit that might present financial risk
- Planned changes in accounting practices or methodology
- Major operational changes from the fiscal year
Use this meeting as an opportunity to start identifying the documentation you'll need to pull for the audit and who will take responsibility for gathering that financial information. Many state laws require specific documentation, so confirm requirements with your accountant or CPA early.
The challenge grants present during a nonprofit audit
Meeting with your team is the first step in the auditing process, but it often surfaces a specific challenge: grants. Nonprofit grant allocations frequently present difficulties during audits due to uncertainty surrounding indirect costs.
When nonprofits undergo an audit, they need to prove where specific grant monies were spent. For indirect costs, it's much more challenging to create an audit trail and demonstrate proper cost allocation. While difficult, this task isn't impossible—and audits can help identify gaps in your tracking processes.
Consider this example: Your nonprofit receives a federal grant to help cover expenses for a program that feeds the homeless. Direct purchases such as food are easily attributed to this grant because you can immediately assign a monetary value. But you might also attribute staff time for serving food to this grant, meaning you'll need to maintain timesheets for employees being paid to serve.
In this case, your nonprofit will use time as the basis for cost accounting, meaning you'll need to present that time study to the nonprofit auditor as well. This is where many charitable organizations struggle—without accurate time records, your organization's financial statements may not hold up to scrutiny during an audit or compliance check.
Time studies for nonprofit audit success
Time studies are essential for grant compliance under 2 CFR 200 because your organization needs to accurately track time spent on various grant-related activities and projects. This allows you to designate grant monies to cover the payroll expense of those projects. Maintaining accurate financial records of time spent working on specific projects is an integral step in audit preparation.
Accurate time records make up the backbone of the cost allocation system for payroll expenses at nonprofits. This means your organization will need processes in place to ensure accuracy of financial statements before your audit begins. A nonprofit could face significant compliance issues without proper time documentation.
Make sure you have time tracking software that allows you to catch and correct human error. Your management team should look for obvious errors such as:
- Employees entering time during scheduled days off
- Identical time entries each day from team members whose schedules should vary
- Missing entries that create gaps in your financial records
While your team members should follow specific processes that encourage accurate time entry, human error happens. You'll need a system that allows leadership to correct mistakes while leaving a trail for the auditor to see when overrides occur. These best practices ensure your nonprofit's financial documentation remains audit-ready.
Creating an audit trail for your financial statements
The key to passing nonprofit audits is creating an audit trail throughout the year, rather than scrambling to resolve financial issues before the audit process begins. Consider your financial documentation and how you can establish an audit trail for each document. The purpose of an audit is to ensure your records accurately reflect your organization's financial position.
Your organization will need to prove that your accounting practices and methodology are correct for each aspect of your audit. An audit assesses whether the financial statements fairly represent your nonprofit's financial health. Here are two common areas where nonprofits need clear documentation:
Fundraising pledges
Development and nonprofit finance teams often disagree about fundraising pledges due to record-keeping differences. Development teams count pledges as revenue when captured in the CRM, while finance teams only count revenue once the pledge is paid in full.
This creates discrepancies between the two teams. Accurately track which fundraising monies come from pledges, then specifically track which funds have been paid and which remain outstanding. This ensures your audited financial statements match up, and you can identify any gaps between perceived and collected funds. A certified public accountant can help establish proper financial reporting procedures for pledge tracking.
Timesheet allocations
While your nonprofit can pull reports showing final allocations of time spent on various mission-related activities, the auditor will want to verify your work. The audit is conducted by examining both summary reports and source documentation. In addition to showing final calculations, present your raw timesheet data.
Before your audit begins, verify the calculations yourself using raw, unaltered data so you can catch any mistakes before handing paperwork to your auditor. All business transactions and financial equations have a data trail behind them—provide the complete set of unaltered data your nonprofit auditor needs to check your work and complete the audit efficiently.
Assemble necessary documentation for the audit
Up to this point, we've covered steps you'll need to conduct throughout the year to accurately capture data for auditing purposes. The best way to pass an audit is to avoid procrastination and implement strong financial management practices.
When you maintain accurate financial records throughout the year and implement processes to pull necessary data, you'll save significant time making last-minute fixes before the audit process begins. Smaller nonprofits especially benefit from establishing these routines early, while large nonprofits may require an audit on an annual basis.
In preparation, you'll need to assemble financial paperwork, financial statements, and reports from throughout the year. Once you've captured all information, reconciled accounts, and reviewed by an independent party internally, pull the documentation your auditor needs based on their Pulled By Client (PBC) list.
The PBC list typically consists of 40 to 120 items depending on your nonprofit's complexity and the type of audit being conducted. Common audit documentation includes:
- Bank statements and reconciliations
- Prepaid item lists
- Outstanding invoices
- Schedule of wages and accrued vacation
- Form 990s from prior years
- Issued 1099s
- Details of grants received and expenditures
- Payroll information and records
It usually takes two to four weeks to prepare for the audit and the same amount of time for the auditor to complete their evaluation. Conducting audits efficiently depends on having organized documentation ready.
Different types of audits and reviews for nonprofits
Understanding the different types of audits helps your nonprofit prepare appropriately. Each type of audit serves a different purpose and requires varying levels of documentation. Your state association of nonprofits can often provide guidance on which audits and reviews your organization may need.
Independent financial audit: A certified public accountant (CPA) examines your organization's financial statements to determine whether they fairly represent your financial position according to generally accepted accounting principles (GAAP). This is the most comprehensive type of audit. A nonprofit audit is a review conducted by an independent auditor who evaluates whether the financial statements fairly present your organization's financial situation.
Single Audit (A-133): Required for nonprofits that expend $750,000 or more in federal funding during a fiscal year. Nonprofits need to conduct an independent audit under these federal requirements. This audit focuses specifically on federal grant compliance and internal financial controls.
Program-specific audit: Focuses on a single federal program rather than the organization's overall financial statements. May be appropriate when most federal funding comes from one source. This approach to managing an independent audit can reduce audit cost while still meeting compliance requirements.
Operational audit: Evaluates the efficiency and effectiveness of your nonprofit's operations rather than focusing solely on financial statements. This common audit type examines internal controls and financial practices to identify improvement opportunities.
IRS audit: The IRS may audit exempt organizations to verify tax-exempt status and ensure compliance with regulations. An IRS audit can include a field audit where agents visit your location or a correspondence audit conducted through mail. These require thorough documentation of your organization's activities, and small nonprofits should be prepared just as larger organizations are.
Discuss the audit report with the board
You'll want clean audit results, but it might not always work out that way. You may have next steps to implement to ensure proper internal controls and financial reporting structure at your organization. The audit report summarizes the auditor's findings and provides an opinion on your financial statements.
Either way, add your financial audit results to your nonprofit board meeting agenda. When sharing audit results with board members, ensure they understand the purpose of each element. Many mistakenly think the audit opinion refers to internal controls when its actual purpose is to review management responsibility and accuracy of financial statements.
The board should participate in discussing the financial statements. These reports should paint a clear picture of the organization's financial health so board members understand your financial position. Whether you require an audit annually or periodically, board engagement is essential.
Ask a member of your finance team to discuss audit results with board members, explaining findings and answering questions. If there are next steps from the audit, explain why they're necessary and how they'll be implemented. Consistent communication about audit outcomes helps maintain accountability.
Make sure your nonprofit is prepared for any audit
Nonprofit auditors analyze your organization's funding sources to evaluate the health and legitimacy of your financial practices and internal controls. Audits require a paper trail to provide evidence for the different financial statements and conclusions you've drawn. Required by state or federal regulations, these reviews protect both your organization and its stakeholders.
Establish compliant and transparent processes that allow you to adequately track time, assemble necessary paperwork, and provide an auditable trail that offers proof to back up your financial statements. This is the foundation of passing every nonprofit audit. A nonprofit may face audits from multiple sources—funders, the IRS, or state regulators—so comprehensive preparation benefits every scenario.
With ClickTime, nonprofits can create an audit trail that captures digital signatures whenever a timesheet is submitted or overridden. Export this data in multiple formats for your auditor, or grant them direct access to review data within the platform—providing the audit-ready records your organization needs to conduct the audit efficiently.
