Audits can feel like the worst. No matter how you cut it, it’s never fun to be audited. When an audit is approaching, the organization goes into overdrive to review policies and procedures to make sure the audit goes smoothly. This can be extremely time-consuming and stressful on staff, particularly if they are not educated on audits. An audit may seem like a dark cloud looming over an organization, but I can assure you that is not necessarily the case! An audit is an opportunity to detect compliance and credibility issues in your organization, which helps nonprofits assess the effectiveness of their programs. Here are the reasons you may need to conduct an audit—and how to avoid issues. At the end of the article, I’ve provided a template to help you get started.
Some nonprofits may be required to be certified by different entities in order to become service providers and advertise recognition for their commitment to various standards. Accreditation entities have criteria that must be met, and therefore, the audits may be written and/or on-site audits conducted based on those criteria. The audit could encompass both financial standards as well as program/grant results and outcomes.
For example, the Commission on Accreditation of Rehabilitation Facilities, (CARF) International is an independent, nonprofit accreditor of health and human services in the following areas:
- Aging Services
- Behavioral Health
- Child and Youth Services
- Employment and Community Services
- Vision Rehabilitation Services
- Medical Rehabilitation
- DMEPOS (Durable Medical Equipment, Prosthetics, Orthotics, and Supplies)
- Opioid Treatment Program
Nonprofit schools may also have accreditation standards that can be obtained through various organizations, such as Cognia, which provides an explicit set of standards and criteria for accreditation and certification for schools.
The IRS also routinely audits exempt organizations to ensure compliance with federal tax requirements. Any organization can be randomly selected for an audit, but typically the IRS is looking for several common audit triggers, such as 990 noncompliance, fundraising discrepancies, unrelated business income, and political campaigning/lobbying activities.
The IRS audits exempt organizations, but any organization can be randomly selected for an audit. There are two types of audits the IRS may conduct:
- Field Audit – Initial contact letter is sent to the organization to schedule an appointment with an IRS agent to visit the organization’s premises.
- Office/Correspondence Audit – Initial contact letter directs organization to send documents to an IRS office by mail.
Key Ways to Avoid Potential Issues with the IRS:
- Submit your Form 990. This must be filed out in a timely manner with information that is compliant with the standards the IRS requires. Not only is this used for financial information, the form 990 is also used for governance issues. It serves as a checks and balance to the mission that is listed for the nonprofit. For example, if the mission of the nonprofit is to provide funds for educational activities for daycares in low income neighborhoods, but 70% of expenses are going towards marketing, then this would indicate problems with financial management and possibly mission drift.
- Avoid fundraising income/expense discrepancies. Fundraising income is usually paired with related fundraising expenses. If the IRS feels that this is not proportionate, an audit might be generated.
- Check compensation levels. Very low compensation amounts in relation to the size of the organization and excessively high compensation amounts in salaries and other benefits may open the door to an audit. The IRS requires that key employees (executive staff) who work for a nonprofit should be paid a reasonable amount but does not provide guidance on what is reasonable. Key employees are considered “disqualified persons” by the IRS and are subject to special restrictions because they have the ability to influence the organization. One way to check compensation levels is by researching comparable compensation data. Researching how much compensation is paid by similar organizations (similar size, budget, and mission) for people working in comparable positions helps provide a guideline.
- Pay taxes on Unrelated Business Income (UBI). Unrelated business income is income generated that has no bearing on the mission of the organization. For example, an educational nonprofit that makes money off of selling food to those participating in the programs. The revenue collected on the food is unrelated and therefore, subject to taxes.
- Comply with restrictions on political campaigning/lobbying activities. Lobbying is the attempt, through direct contact with legislators or creating grassroots calls to action to motivate others, to influence the passage or defeat of a piece of legislation. There are varying restrictions on the amount of lobbying and political activity nonprofits are allowed. Any and all lobbying must be reported on the Form 990. Most nonprofits cannot show any partisan preference and therefore, must be extremely careful in this regard. 501(c)(3) organizations may engage in limited lobbying but cannot participate in political intervention, which is an attempt to influence an election or defeat a candidate.
According to the IRS, a 501(c)(3) nonprofit cannot show a substantial amount of legislative lobbying; however, the definition of substantial or insubstantial is not clarified by the IRS or Congress. To avoid the uncertainty of a nonprofit’s lobbying activity being measured with this subjective test, nonprofits should consider filing the form 5786. This form simply allows the nonprofit to opt out of the vague “substantial” activity test and use the friendlier expenditure test.
501(c)(3) nonprofits can be involved with public education about the political process, voter registration, nonpartisan voter protection activities, educating candidates on issues relevant to the organization, and sponsoring debates with candidates. If the 501(c)(3) finds that it needs to do more lobbying, it can create a 501(c)(4) that allows for monetary and/or in-kind campaign contributions and establish and pay for the administrative and fundraising costs of a political organization.
Aside from the IRS, there are a number of other types of audits an organization can conduct.
With an independent audit, the organization communicates its commitment to financial transparency. By providing an independent audit report via the organization website or to those who request it, the organization demonstrates transparent practices that donors and the public have come to expect from charitable nonprofits.
External audits are usually conducted by hiring an independent auditor. Hiring an independent auditor might be expensive for many nonprofits, but something still recommended. Smaller nonprofits that lack funding can request accounting firms to donate their audit as an in-kind expense, to help offset the costs of an independent audit.
Key areas of focus for the independent audits should be on the financial statements that auditors use to submit data for IRS form 990. When independent audits are conducted, the organization communicates to its stakeholders and donors that it is doing its due diligence to preserve trust and accountability. Depending upon the state law, nonprofits may be required to provide a copy of their audited financial statements when they register with the state for charitable solicitation/fundraising purposes.
Internal Checks and Balances
Board members and/or staff should regularly audit the finances of the organization. This type of audit would be informal and a best practice measure. Ideally board members and/or staff should have a background in accounting to ensure best practices. Providing board, and executive leadership a true generally accepted accounting principles (GAAP) financial statement goes a long way. Accounting software provides an electronic version of the general ledger, revenues, expenses, assets, and liabilities—digital tracking that helps to maintain a complete picture of your nonprofit’s financial health.
Most federal, state, local and even private grants require some type of reporting requirements. Reports may include narratives, description of challenges, outcomes, and financials, which would include comparing the budget to actual expenditures.
Key ways to avoid potential issues with the grantors and/or credentialing criteria:
- Have a schedule of all reports due with indicators/criteria needed for collection.
- Keep regular checks on these reports. For example, if a quarterly report is due July 30, there should be a draft version with as much detail filled out, submitted to board or executive leadership no later than June 1.
- Board/staff must be well-versed and educated on the criteria of each grant in order to make sure organization is in compliance.
- Regular meetings on program goals, outcomes and compliance help in creating a more robust report and will help address any potential pitfalls. These steps will also help the organization determine if budget amendments are needed (if there is too much money or not enough).
The Silver Lining
Public trust is at the core of nonprofit organizations. Donations to 501(c)(3)s are tax deductible, and in turn, 501(c)(3)s are exempt from paying income tax and property tax. Use our template: Audit Template with Examples to help you empower your board and staff to focus on the audits as a fiduciary responsibility and a way to communicate trust, instead of a means to an end.
One of the best outcomes of any completed audit report is that the data collected can be used to highlight programmatic and financial results. Grant reporting bolsters the mission, purpose, and impact of the nonprofit. Audits educate the organization on how to improve processes as well as how to build relationships with the grantor. At the end of the day, audits may get a bad reputation, but if an organization takes the necessary steps with education and transparency, it takes a lot of the negativity away.
501(c)(3) budgets are dependent on donor contributions as well as arrangements with external entities to provide services for set fees. Subsequently, 501(c)(3) nonprofits are accountable to their donors and the federal government. Grantors giving money to nonprofit organizations also deserve to have confidence in the organizations’ accountability. Audits represent an opportunity, a silver lining, for nonprofits to boost their business and provide much-needed clarity on a variety of areas. Getting ahead of audits through proper planning and implementation will go a long way in protecting the organization and preserving public trust.
Suja Amir has a background in management, fiscal and forensic analyses, and general nonprofit consulting. She has years of experience in the nonprofit sector and in local government. She holds a B.S in Psychology and a Master of Public Administration from Virginia Commonwealth University. She is a founding board member of two nonprofit organizations, Asian & Latino Solidarity Alliance of Central Virginia, The Virginia Coalition on MOC Reform, and has served on many Boards, including Virginia School Readiness Committee; Virginia Complete Count Commission, Virginia Asian Advisory Board; and the Advisory Board Member of Practicing Physicians of America.