A nonprofit’s viability may depend heavily on the organization’s financial credibility. Proper financial management is essential to the health of any nonprofit and may be pivotal to the protection of the organization’s mission and consequent effectiveness and efficiency. Independent audits and audit committees can help nonprofits make informed financial decisions that further the development and application of sound risk management strategies and compliance with applicable laws.
Independent audits are examinations of “financial records, accounts, business transactions, accounting practices, and internal controls of a charitable nonprofit by an “independent” auditor.” In this context, “independent” means that the auditor (a certified public accountant) is not an employee of the organization and is contracted only for certain limited purposes, including to determine whether the organization’s financial statements are prepared in accordance with the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP). These principles require for the issuance of “The Auditor’s Report” to the nonprofit’s board of directors expressing a professional opinion on whether the financial statements present fairly the financial position of the organization – which may affect the nonprofit’s acquisition of funds or its tax-exempt status.
An Audit Committee is a group (typically composed of 3-5 members) appointed and tasked by the board to oversee the nonprofit’s independent audit (not to be mistaken with the Finance Committee).
The board may adopt an Audit Committee Charter which outlines the committee’s authority and responsibilities, which may include:
- Selecting, retaining, setting the compensation of, and determining the scope of services to be provided by, the independent auditor
- Overseeing the audit process (which includes making sure that the organization is in compliance with any of the auditor’s recommendations)
- Addressing any complaints about financial mismanagement
- Identifying, communicating, and addressing risk management issues
Section XII of Form 990 asks if the “organization ha[s] a committee that assumes responsibility for oversight of the audit, review, or compilation of its financial statement and selection of an independent accountant” meaning members of the audit committee should satisfy certain requirements in order to be truly objective. The board of directors should also ensure that the audit committee is formed following state laws. These requirements may include:
- Staying independent of the Executive Committee (the Audit Committee cannot include the President or Treasurer)
- Not including anyone employed by the nonprofit organization or the audit firm
- Having at least one “financial expert” who is familiar with the audit process
- Avoiding conflicts of interest
California Audit Committee Rules for Nonprofit Public Benefit Corporations*
Here is a brief outline of governance provisions of the Nonprofit Integrity Act of 2004 (NIA), whose audit-related provisions generally exclude educational institutions, hospitals, and religious organizations:
- Mandatory independent audit of annual financial statements for organizations that receive gross revenues of over $2 million (generally excluding revenues from government grants)
- Mandatory audit committee for organizations that receive gross revenues of over $2 million
- Members of the audit committee must conform to the standards set by the California Law – Article 7 Section 12586.e.2
- Audits must be performed by an independent certified public accountant in accordance with GAAP
The NIA was passed following corporate scandals involving some of the country’s largest public companies and a few well-known nonprofits. Although the NIA excludes the majority of nonprofits with its $2 million threshold, there are several benefits of having an independent audit (see below) and many nonprofits opt to have an audit for such reasons.
*The NIA applies to nonprofits in California – the National Council of Nonprofits provides a 50 state chart which shows the audit requirements for each state. In addition to state laws, the IRS sets federal law requirements.
Benefits of Independent Audits
Though independent audits may not be required for all organizations on the basis of state and federal law requirements, a nonprofit may choose to have an independent audit and an audit committee for a few important reasons:
- Independent audits demonstrate financial transparency and integrity, maintaining donor and public confidence
- They help the board perform their fiduciary roles and reduce risk
- Audit Committees establish a solid governance structure to ensure accountability
- Some funders require audited financial statements to be eligible for funding
It is a common misconception that audits serve primarily to uncover fraudulent activities, like embezzlement. Audits rarely detect fraud, but auditors can provide nonprofits with information, tools, and strategies to better protect against such occurrences.
Expenses and Alternatives
It is not uncommon for audit fees to cost over $10,000 as audits require a significant contribution of resources. There is an increasing trend of smaller nonprofits to have a “remote audit” which is generally more time and cost efficient. There are also alternatives to an independent audit which include a financial statement review or compilation. Both are not conducted with an equivalent quantity of investigation and analysis; however, these alternatives may appeal to smaller organizations that want to responsibly manage their finances as they can be done at a substantially lower cost by a CPA. Reviews and compilations are not substitutes for an independent audit and will not meet any legal requirements of an independent audit.
Financial mismanagement can be damaging to an organization’s reputation, effectiveness, and sustainability. Since nonprofit organizations rely on public trust and tax-exemption that require truthful representations, even where not explicitly required by law, nonprofits should consider having an independent audit, audit committee, and/or some form of an audit or review process.