For many nonprofits, the fiscal year ends on June 30. With it comes the task of closing the year’s books and preparing for the year-end audit— a valuable but lengthy process that requires very specific preparation and documentation.
Year-end independent audits, in which all financial records, accounts, business transactions, accounting practices, and internal controls are examined and tested, are a crucial step in building a reputation of transparency and accountability. Independent audits help organizations maintain trust between donors and the public. They’re also an opportunity to determine what your organization is doing right and what needs work.
For some nonprofits, independent audits are required: for example, the federal Office of Management and Budget (OMB) requires any nonprofit that spends $750,000 or more in federal funds in a year to obtain a “single audit.” Additionally, some states require nonprofits to be audited if they solicit funds from state residents.
During an independent audit, an auditor will review your organization’s finances to determine if they adhere to a standard called “generally accepted accounting principles,” or GAAP.
Preparing for an audit can feel like a monumental task, but getting your ducks in a row ahead of time can make the process less intimidating, and ensure a healthy relationship with your auditor.
Here’s how to prepare:
Acquire a Pulled by Client List (PBC)
A PBC list details the information and documents that your auditor requires to complete your audit. You will likely receive two different PBC lists: one that lists the information needed to complete the “planning for audit” engagement, and another that requests documents needed to complete the audit fieldwork.
Nicole Loux, CPA, recommends the following tips to manage your PBC lists:
- Ask the auditor which items on the list should be prioritized, and start collecting those documents first
- Break the PBC list down by sections and enlist colleagues to pull the requested information
- Work with your auditor to set realistic deadlines for document procural
Prepare all financial documents
The most important preparation before an audit is ensuring that your organization’s accounting and personnel records are up-to-date and efficiently organized. Auditors will ask you to produce documentation that supports a range of financial transactions, and those documents need to be accurate and easily accessible.
The Council of Nonprofits recommends that all financial documents be organized into an electronic folder in order to ensure they can be easily accessed. However, you should ask the auditors in what format they want to receive documentation (electronic or otherwise) so that they can be prepared and stored in advance.
The Council of Nonprofits recommends that the following financial documents be assembled in one location:
- Journals that detail the organization’s business transactions
- Ledgers for the fiscal year
- Bank statements and canceled checks
- Payroll records and tax records showing employee withholding
- IRS Form 1099s for independent contractors
- Tax returns
- Invoice and paid bill receipts
- Receipts for credit card transactions
Additionally, auditors will commonly request to review the following items:
- Schedule of Federal Awards
- Year-end investment summary (showing year to date transactions and balance of investments)
- Documentation of marketable securities donate during the year (and documentation of their sale if applicable)
- Written pledges made by donors for a charitable contribution and documentation of verbal pledges
- Documentation of grant funds received and expected
- List of any physical items that the organization is intending to sell
- Fixed asset and depreciation schedule
- Listing of year-end accounts payable
- Reconciliation of net assets classifications
- All contracts, including leases
- Accounting manual or financial management policies
- Personnel manual
- Minutes of board meetings and committee
Document changes to Internal Control Procedures
Throughout the year, your organization may have experienced changes to its internal control structure. In particular, the COVID-19 pandemic forced many nonprofits to pivot to remote work environments and downsize staff. Consequently, any changes to internal controls must be documented in your organization’s accounting manual or handbook.
Your auditor may require your organization to complete a risk assessment as part of the audit process, which will help them identify weak spots in your internal control process and determine if there are gaps between risks and controls. To prepare for this, your organization must ensure that internal control procedures are up to date and ensure that residual risk is manageable.
Assess Information Technology (IT) risks
Remote and cloud-based work environments open a Pandora’s box of IT-related cybersecurity risks. Examples of these risks include:
- Vulnerability issues, especially from bad work habits like working outside the VPN
- Password management
- Insufficient insurance coverage
As remote and hybrid work environments become the norm, auditors are increasingly focused on these risks. For example, an auditor may inquire if your organization has reviewed the System and Organization Controls (SOC) of third-party vendors. SOC reports are a risk-management strategy that verifies that vendors have adequate controls in place to protect their systems. Make sure that these reports are readily available and that they do not raise any red flags.
Review all lease agreements and lease improvements
If your landlord has provided any tenant improvement allowances, these must be recorded in your organization’s accounting and amortized. Because these improvements are paid for by the landlord, they do not result in incurred costs and are often not recorded.
Conduct a physical inventory check
An auditor may ask to see physical pieces of equipment in addition to your inventory list. For this reason, a physical inventory check should be conducted before the audit, and asset lists should be appropriately updated to ensure that all inventory is accounted for.
Assess allowance for doubtful accounts
An allowance for doubtful accounts is a technique that shows the portion of the accounts receivable that an organization reasonably believes it may not collect—otherwise known as” bad debt” reserve. This allowance reflects management’s estimate of the account receivable that will not be paid for. For nonprofits, bad debt is often due to anticipating and recording pledges that do not come through.
Auditors use several techniques to test whether the allowance for doubtful accounts is reasonable, but organization managers can use similar strategies to assess their organization’s allowance before an audit.
“For outstanding receivable balances, you should look at collection history and subsequent collections to assist you in making assessments regarding your allowance for uncollectible accounts,” Christine Hall, CPA, writes for The Nonprofit Times.
When making an estimate, the Nonprofit Account Academy recommends that managers appraise the individuals behind each pledge, and consider if there is any indication that certain pledges will or will not be paid.
Following this, Hall recommends a liquidity analysis be performed to determine if the organization has enough financial assets to fund adequate reserves while enabling access to cash if needed.
Review accounts payable and accounts receivable
Before the audit, ensure that all AP/AR are up to date and confirm that outstanding checks on your bank reconciliations are current. Reach out to individuals who have yet to cash checks, and void and reissue old checks if necessary.
Don’t forget functional expense allocation
All nonprofit organizations are required to report functional expenses, which means categorizing expenses by “function” or purpose.
The goal of this report is to make it clear, to the organization’s stakeholders, that natural expenses are being used to support the organization’s programs and services. These expenses must be disclosed in either the statement of activities, statement of functional expenses, or within the notes of the financial statements.
Maintain open lines of communication
The simplest way to ensure a straightforward audit process is to maintain open communication with your auditor, during audit fieldwork and through the audit report date. Audit findings can go through multiple rounds of reviews, and it’s not uncommon for follow-up inquiries to be made. The audit isn’t over till it’s over, and maintaining communication with your auditor will help them finish the process faster.
(Alternative Reading: Does your nonprofit really need an annual audit?)
ABOUT THE AUTHOR
Lia Tabackman is a freelance journalist, copywriter, and social media strategist based in Richmond, Virginia. Her writing has appeared in the Washington Post, CBS 6 News, the Los Angeles Times, and Arlington Magazine, among others. She writes weekly nonprofit-specific content for 501c.com.