Nonprofit Annual Financial Audits (Independent Audits): Definition, Process, and Tips

If you are new to nonprofit accounting or just starting your fund accounting career, you may be heading into your first nonprofit annual financial audit with some trepidation based on the horror stories you’ve heard from other people on your team.

But with modern fund accounting software and strong internal controls, audits shouldn’t be the subject of campfire stories to scare young nonprofit accountants. When you understand what an audit is, what is involved, and how to streamline it with the right systems, you turn audits into a valuable compliance tool—not something to fear.

An annual nonprofit financial audit, or independent audit, is an independent CPA’s comprehensive review of your organization’s financial records, internal controls, and accounting practices. During this examination, auditors verify that your financial statements accurately represent your organization’s financial position and that you’re following generally accepted accounting principles (GAAP).

Even though your nonprofit is exempt from federal income tax, you still need financial oversight. Some organizations are required to conduct annual audits to meet state laws, federal funding requirements, or grant conditions. Even if you don’t have those funding channels, these audits can demonstrate your financial accountability to donors and stakeholders, building credibility and trust.

Here’s what you need to know as you prepare for your first nonprofit financial audit.

Key Players in a Nonprofit Annual Financial Audit

Your audit will likely pull resources from your entire financial staff, including your leadership and board, as well as your outside audit firm. Here’s who plays a role:

Your Organization:

Making sure everyone on your team knows their role can help set expectations and streamline your audit process.

• Finance Director/CFO: Is the primary point of contact and coordinator
• Executive Director: Provides oversight and signs the management representation letter
• Board Treasurer: Reviews the audit findings and helps present the findings to full board
• Finance Staff: Gathers documentation and responds to auditor requests
• Program Managers: Needs to be available for questions about specific grants or programs
• Audit Committee (if you have one): Oversees the audit process and reviews results

External Audit Team:

Successfully completing an annual financial audit requires coordination between your auditing firm and your organization’s team. A strong relationship with your audit firm makes the process much easier.

• Lead Auditor: Oversees the entire audit process and signs off on the final report
• Staff Auditors: Conduct detailed testing and document review
• Audit Manager: Coordinates between your organization and the audit team
• Audit Partner: Reviews final work and presents to your board

Setting Expectations: An Overview of the Three Audit Phases

The annual financial audit consists of three phases: Planning, Fieldwork, and Reporting. Each phase builds on one another to ultimately verify the accuracy of your financial statements.

1. Planning Phase

Hopefully you are in regular contact with your auditor, sharing changes happening at your organization—like new fund accounting systems—and regulation changes that may affect you. But the formal audit process typically begins 3-4 months before your fiscal year end. Your auditor will send an engagement letter outlining the scope, timeline, and fees. The scope of an annual audit focuses on verifying that your financial statements fairly represent your organization’s financial position.

The scope should include examining your internal controls, testing significant transactions, and ensuring compliance with accounting standards. Most mid-sized nonprofits can expect to pay between $10,000 to $20,000 for their annual audit, though costs vary based on organizational complexity and location.

During initial planning meetings, your auditor will provide a list of required documents. Common requests include:

Core Financial Documents

• Statement of Financial Position (Balance Sheet)
• Statement of Activities (Income Statement)
• Statement of Cash Flows
• Statement of Functional Expenses
• Form 990 tax return
• Prior year audit report and management letter

Supporting Documentation

• Bank statements and reconciliations
• Grant agreements and documentation
• Board meeting minutes
• Financial policies and procedures
• Donor records and contribution documentation
• Payroll records and tax filings
• Expense documentation

This is also a good time to verify everyone on your audit team has view-only access to your fund accounting system so they can access these reports and documentation without going through a member of your team. If you have a new member of your audit team or new fund accounting software, make sure to set up training so everyone is comfortable with the system on day one of the audit.

2. Fieldwork

Once planning is complete, auditors begin their detailed examination of your financial records. This phase typically lasts one to two weeks and involves extensive testing and verification. Here’s what to expect:

Review Financial Statements: Auditors will dig into your Statement of Financial Position, Statement of Activities, and Statement of Cash Flows, comparing current year numbers to previous years and investigating any significant changes. They’ll trace transactions back to source documents and verify that your financial statements tell an accurate story.

Test Internal Control Systems: Auditors will examine how money flows through your organization, from initial receipt to final reporting. They’ll review who has access to financial systems and accounts, examine how duties are separated among staff, and test your approval processes and authority limits. This often involves observing your team handling transactions in real-time, like processing donations or paying bills.

Modern fund accounting systems like Blackbaud Financial Edge NXT streamline this process in several ways. With your auditor having view-only access to explore financial records independently, you no longer need to pull reports for them. Digital attachments linked directly to transactions make document review efficient, and drill-down capabilities let auditors trace any number from summary reports down to individual journal entries.

Staff Interviews: Auditors will talk with your team about their day-to-day financial responsibilities. These conversations help reveal whether written policies match actual practices and can highlight areas where processes might need strengthening.

3. Wrapping Up

The audit concludes with a draft report that details any findings—from minor suggestions to serious concerns that your organization needs to address.

Your team will meet with the auditors in an exit conference to discuss these findings and your plan to address them. This is your chance to clarify any misunderstandings or provide additional documentation before the final report.

The final audit report includes the auditor’s opinion on your financial statements and any significant findings. This report gets presented to your board, typically by the auditors themselves, who will explain their methodology, findings, and recommendations. The four opinion types are:

• Unqualified Opinion (Clean): This is what you are hoping for. Your financial statements fairly present your organization’s financial position and follow accounting standards.
• Qualified Opinion: The auditor found specific issues with your financial reporting, but they’re limited in scope. While concerning and should be addressed promptly, these issues don’t affect your overall financial position.
• Adverse Opinion: This indicates serious problems. The auditor believes your financial statements are materially misstated or don’t follow accounting standards.
• Disclaimer of Opinion: The auditor couldn’t complete their examination, often due to missing documentation or scope limitations. They cannot express an opinion on your financial statements.

Common Financial Audit Mistakes and Quick Tips

While the goal is to have a clean audit with no findings, you are likely to have a few issues pop up from time to time. Here are some of the common issues that auditors typically flag.

Internal Control Weaknesses

Many organizations struggle with proper segregation of duties, especially smaller nonprofits with limited staff. Having one person handle incompatible functions, like receiving money and reconciling bank statements, represents a significant control risk and potential for fraud.

Missing Documentation

Auditors often find expenses without proper support or donor restrictions that aren’t clearly documented. Grant expenses might lack proper authorization or time sheets might be incomplete. Always maintain clear documentation of approvals and support for transactions.

Tip: If you use a connected system like Blackbaud Raiser’s Edge NXT and Financial Edge NXT, the fundraising system will pass through any donor restrictions to your fund accounting system.

Classification Errors

Common classification mistakes include misclassifying restricted and unrestricted funds, incorrectly allocating functional expenses, and improperly recording in-kind donations. These errors can significantly impact your financial statements.

Revenue Recognition Timing

Organizations sometimes struggle with recording revenue in the proper period, especially for grants and pledges. You need to understand when to recognize revenue if you want accurate, GAAP-compliant financial reporting.

Getting ahead of these issues will dramatically improve your team’s audit experience. For more tips, check out these four proven strategies to reduce stress during your next audit.

Quick Tips to Help Prepare for Your Nonprofit Annual Financial Audit

With a few small changes to your standard financial processes, you can take a lot of the frustration out of the audit process.

1. Start Early and Stay Organized

Create a dedicated audit folder—physical or digital—at the start of your fiscal year. File important documents like contracts, lease agreements, and board minutes as you go rather than scrambling to find them later. Where applicable, attach those documents to the appropriate records in your fund accounting system. Attachments also help eliminate silos. If a different staff member manages the audit, they still have easy access to necessary documents.

2. Reconcile Monthly

Don’t wait until audit time to handle reconciliations. Keep your bank accounts, credit cards, and subsidiary ledgers reconciled monthly. This makes it easier to spot and fix issues before they compound.

3. Document Your Processes

Your internal control policies should be living documents and updated any time there is a change in personnel, systems, or processes. This includes how you handle cash receipts, approve expenses, and allocate costs. Auditors will want to see these, and you need good documentation for funding sources, like federal grants.

4. Maintain Clean Records

Regularly review your chart of accounts for inactive or duplicate accounts. Keep donor restrictions clearly documented. Make sure expenses are properly classified and supported with appropriate documentation.

5. Schedule Key Players

Ensure essential staff will be available during fieldwork. This includes your accountant, development director, and anyone responsible for grants or major programs. Their availability can significantly speed up the audit process.

Considering a remote audit? Here are 11 ways to ensure the process runs smoothly.

Better Financial Health Through Strong Audit Processes

A smooth audit process can streamline many aspects of your financial operations. Accurate and well-organized financial records make it easier to generate reliable reports, make informed decisions, and mitigate risk.

Clear documentation and strong internal controls can enhance your relationships with donors and grantors, showcasing your commitment to transparency and accountability. This builds trust and fosters long-term support.

Ultimately, a streamlined audit process paves the way for better financial health and sustainability. This enables your nonprofit to focus on its mission and achieve greater impact.

Learn how a fund accounting system built for nonprofits can help you streamline your annual financial audit.