Nonprofit Finance & Strategy

Is It Time for an Audit?

Jeanne Bell — Fri, 15 Aug 2008 00:00:00 -0700

Blue Avocado reader Bill Mitchell writes: "As a board member of both a small ($400k/year) and a much larger ($1.8m/year) nonprofit, what are the criteria to determine whether or not to conduct a formal outside audit? I have worked on staffs, sat on boards and have been a foundation program officer and I have never had a clear set of guidelines. Thanks!"

Blue Avocado columnist Jeanne Bell replies:

Dear Bill: In these tough economic times it makes perfect sense that a board of directors would weigh the costs and benefits of spending $10,000 or more on this administrative expense. The short answer to your question is: "As soon as you have to."

The longer answer: A first tier for nonprofit audit requirements may be set by whether or not you receive federal funding. The federal government has not yet issued an across-the-board audit standard for nonprofits, although it could very well happen, given ongoing federal attention to charity regulation. Currently, nonprofits that expend $500,000 or more in federal contract dollars in a fiscal year must obtain what's called a ‘single audit' to test for compliance with federal grants management standards.

(See http://www.whitehouse.gov/omb/circulars/a133/a133.html for more information on these requirements.)

Things get a lot more complicated at the state level. State attorneys general, who regulate nonprofits at the state level, have wildly varying standards for nonprofits, ranging from $100,000 thresholds to no requirement at all. You can contact your state attorney general or any auditor for your state's requirements.

And, in 25 states, audited statements must be submitted if you solicit funds in their states, whether or not you are located there. For instance, if you are based in Seattle but raise funds from donors in all 50 states by mail, phone, or other means, you must not only register annually with the 25 states that require it, you must provide an audit with your registration.

However, the 25 states vary in the amount of annual revenue at which they require an audit. If you have donors residing in multiple states, check out the Multi-state Filer Project to research and potentially simplify this cumbersome annual registration process. (There are another 13 states that require fundraising registration but do not require audited statements to be attached.)

What else triggers an audit?

If you're not spending more than $500,000 in federal funds, nor raising money in states that require annual audits as part of state registration, what other factors should you consider? In many cases, foundation funders ask for an annual audit as part of their grant application process. If you are otherwise eligible for the grant, consider contacting a Program Officer or Grants Manager at the foundation and asking if submission of your IRS Form 990 in lieu of an audit will suffice.

The Form 990 actually provides more information about an organization than an audit does, although it lacks a CPA's sign-off attesting to the accuracy of account balances. Many foundations, sensitive to the fact that smaller organizations may not yet be auditing, will accept Form 990 during the application process, but may require a yearly audit after they have funded you.

You should also be aware that there are many groups that are establishing their own standards for when nonprofits should obtain audits. The Wise Giving Alliance has a $250,000 annual revenue threshold for audits, while the Standards of Excellence Institute's threshold is $300,000. The Independent Sector recommends a threshold of $1 million dollars. Remember, these are not regulating authorities but rather independent organizations attempting to influence nonprofit practice and how the general public evaluates potential donation recipients.

Benefits of audits

Aside from these specific funder and donor-related factors, it's helpful to recognize three inherent benefits that an audit provides to a nonprofit :

1. Donor and Community Confidence: An unqualified audit opinion is a universally accepted indicator that an organization is investing in its financial management and that its financial statements are likely to be accurate. Beyond donors, the audit is a symbol to an organization's broad constituency, including the media and watchdog groups, that the organization is committed to fiscal accountability.

2. Achieving Financial Best Practices: Board and staff leadership benefit from an audit performed by a CPA who's knowledgeable about current nonprofit accounting standards -- such CPAs can help move an organization towards best financial management practices. And even amongst experienced nonprofit finance staff, knowing that they will have to defend accounting judgments to an auditor at year-end encourages accounting discipline throughout the year.

3. Some Protection Against Fraud: An annual audit can bolster the soundness of internal controls. But caution: although the prospect of an audit may play a role in deterring malfeasance, a determined staff person or volunteer can find ways to steal that an auditor testing on-site for just two days each year may not detect.

Alternatives to audits

If your organization's leadership decides that it wants some of these benefits but cannot afford the $10,000+ price tag, it may elect to engage an outside CPA in a financial statement review rather than a full-blown audit. A review does not include on-site testing and therefore does not conclude with an auditor's "opinion" -- a technical term for the CPA's expert judgment -- as to whether the financial statements prepared by the organization were prepared in accordance with accepted accounting principles.

This report is based on limited document review and communications with staff and/or board, and gives limited assurance that the financial statements reflect an accurate picture. For roughly half the price of an audit, you could share a CPA-prepared document with constituents, albeit one with less "bite."

Another recent wrinkle to factor into your deliberation of when to begin auditing is something called, SAS-112: an accounting standard with the full name of "Communicating Internal Control Related Matters Identified in an Audit." As Kate Barr of the Nonprofits Assistance Fund recently wrote in The Nonprofit Quarterly, "At root, the new standards increase the likelihood that control deficiencies will be identified and reported."

In other words, if you are just beginning to professionalize your accounting and have yet to produce audit-like financial statements each month on your own, you will get very little slack from your auditor come audit time. As Barr concludes, "The new standards make clear that an auditor's role is to test and verify the information provided by an organization and issue an opinion?not to calculate and produce financial statements." (Read her full piece on SAS 112 online.)

Bottom line on audits

So what's the bottom line? In most cases, it makes sense for community nonprofit boards with operating budgets in excess of $250,000 to begin considering whether it's time to audit by evaluating their readiness in the context of SAS 112. And recognizing the potential benefits of an audit to build donor confidence and increase protection against fraud will also influence your decision. By the time you reach $500,000, the world at large will expect you to be making this annual investment and your accounting systems should be ready for the scrutiny.

Look for a future column taking up the question of screening, selecting and changing auditors.

Jeanne Bell is CEO of CompassPoint Nonprofit Services, and a frequent writer on nonprofit finance and strategy matters.

Nonprofit Budgets Have to Balance: False!

Jeanne Bell — Wed, 14 May 2008 18:01:43 -0700

As nonprofits serving people and communities in these difficult financial times, we don't expect things to turn around for our communities in the near future. Many of us are wondering: how can we achieve a balanced budget in these times? When is it okay not to have a balanced budget?

A potentially harmful habit practiced in many community nonprofits is presuming that a break-even budget is mandatory. Board members and staff may be under the influence of the false but persistent ‘nonprofits can't make money' myth as they develop the year's income and expense plan. Like other conventional wisdom, the balanced budget is based on sound concepts, but can become unnecessarily constricting. Instead of "How can we make the budget balance?" the annual budgeting cycle should begin with the question, "What financial outcome does our organization want or need this year?" Different scenarios lead to different decisions about what the budget's bottom line should look like:

1. We need to increase reserves or pay down debt: adopting a surplus budget. When the organization's leaders decide that its cash and other reserves are lower than ideal, the organization can plan to generate more income than expenses, creating surplus funds that can be used in future years. A surplus may also be needed to provide funds for paying down debt or for easing cash flow. The board should direct staff to develop the draft budget by determining realistic income targets that nonetheless outpace expenses. If the organization can deliver on a surplus budget, it will have higher net assets (net worth) at the end of the year, and enjoy a stronger financial position.

2. We can't gain ground now, but we can't lose ground either: the break-even budget. Typically, organizations choose break-even budgets by default and the skin of their teeth. A first cut on the budget shows expenses much higher than revenue, so the staff then tries to figure out how to increase the revenue number (but still stay close to reality) and decrease the expenses (but not damage programs). The staff and the Finance Committee tack their way towards a break-even budget, and hope that their cautiously optimistic projections work out.

3. There are three typical reasons for adopting deficit budgets. First and rarest, the organization's leadership decides that its cash and other reserves are more than sufficient, and so spending some of those reserves in the coming 12 months is a good idea. They may choose to make one-time purchases or expenditures, or to give the staff one-year, non-permanent raises. At the end of the year they will have more expenses than income for the year, and thus a deficit for the year.

A second reason for a deficit budget is a decision to invest. For example, the organization may invest funds in strengthening its fundraising capacity, or in new programming. Leadership believes that resources from previous surplus years can be risked as investments in future programmatic or financial paybacks.

An all-too-common third reason for adopting a deficit budget is a decision that ending the year in a worse financial situation is the lesser evil. For some organizations, simply cutting costs may not be the right financial decision. For example, in an organization that relies on earned income, cutting staff will result in lowering income. The leadership will need to re-work the way its services are structured--perhaps too complicated to do in just a month or two. Or an organization may be in executive transition, and the board believes that the dip in revenue is due to the absence of an executive director, and expects that income will go up again. They decide simply to "bite the bullet" this year--and they believe they can afford it.

At the end of a deficit budget year--assuming that reality matches the budget--there wil be a lower net worth and the organization will be in a financially weaker position. But "weaker" should be in quotes because a planned loss may, in fact, be a sound, strategic fiduciary decision by a board. For example, investing in a new website may mean a deficit this year, but could reap substantial gains in fundraising in coming years.

The core issue is intentionality. An unplanned deficit reflects an error in planning and/or execution, while a planned deficit is an investment of accumulated reserves for the benefit of the organization and its constituents.

Consulting to nonprofits, I've come to see that one of the reasons executives struggle to break the break-even habit is that foundation grants and government contracts are typically break-even contracts. We must prove that we spent exactly what we raised. But while grants and contracts are designed to break even, organizations are not. Healthy organizations require cash reserves, which means they must generate excess cash in at least some of the years.

The majority of community nonprofits with whom I work need to build reserves. But especially as we head into recession--which classically means fewer resources and higher demand for nonprofit services---developing a credible surplus budget may prove impossible. We may have to settle for break-even because we don't see opportunities for income growth or expense cuts. But we'll be settling for break-even, not aspiring to it.

Jeanne Bell, MNA, is CEO of CompassPoint Nonprofit Services, and consults to nonprofits in business planning, financial systems, and sustainability. She co-authored Financial Leadership for Nonprofit Executives (Fieldstone).

Five Ways to Let Government Money Run You Over

Jeanne Bell — Mon, 14 Apr 2008 19:00:22 -0700

Is government funding a way to expand what you do for important constituencies, whether they are families living with autism, low income people seeking legal help, or people attending your dance performances? Or is government funding a trap that will mire you in reporting nightmares, take you away from your values, and turn you into a heartless bureaucracy?

Let's start with a reality: local, state, and federal government agencies are major buyers of social services, education, health, and arts in the United States. In fact, government funding made up 52% of total income for social service nonprofits in 1997 (Lester Salamon in The Resilient Sector). For many organizations, the question is not whether to take government funding, but how to get more of it. Whether you are thinking about your first RFP (Request for Proposals) or are already knee-deep in existing grants and contracts, here are five ways to do it WRONG.

1. Don't assign anyone to oversee contracts management. Successful completion of a government contract requires not just doing the work well, but customized reporting of activities and finances. If no one is explicitly responsible for contracts management, some program directors may under-bid on costs, and you'll end up losing money on the contract. In other cases you may not pay attention to ensuring that the full amount of allowable costs is charged to the contract. Someone needs to make sure that budgets are appropriate prior to submission, that financial and programmatic performance is monitored, and that reports are done promptly and completely--these are not entry-level responsibilities!

2. Stay out of politics. Political engagement is an essential responsibility of government-funded organizations. It's not enough to help social service clients deal with the aftermath of our systems' inadequacies. Nonprofits need to take a seat at the budgeting and policy tables to inform policy direction and protect vital services. This might mean joining a local association of nonprofit contractors, or making sure that your board and staff leaders have the savvy to engage with government agencies and officials. Remember: endorsing a candidate for office isn't legal for nonprofits, but keeping officials informed is.

3. Blind yourself to the difference between what they're paying and what it's costing. A $1 million contract is a disaster if it ends up costing you $1.5 million to meet the deliverables. Because nonprofits have to track expenses to show they are in compliance with an approved contract budget, it's easy to post expenses only if they are at the level in the approved contract budget. In many cases, real costs that were not approved in the contract budget often get pushed somewhere else--to some nebulous "administrative" dumping zone--and the full cost of the program is lost forever. As a result, when it comes time to negotiate a renewal, the cost picture is inaccurate, and the nonprofit happily signs onto another money-losing year.

4. Let your organizational culture evolve organically. Because government funding often is a majority or even 90% of a nonprofit's budget, an implicit culture can grow that narrowly focuses on contract compliance and regards the government as the client (after all, the government is the client from a contract perspective). Culture means more than dress code or communication styles: it means a sense of nonprofit commitment to mission and to mission-identified constituencies (rather than contract-identified targets). Rather than let culture evolve on its own, devote attention keeping a nonprofit culture and a constituent-oriented outlook. Encourage cross-contract work groups and discussions. Demonstrate the same care with individual donors as you do with institutional donors. Engage your community in needs assessment, feedback, and be open to criticism and suggestions about your programs.

5. Now that you've got big money, don't sweat the little money. In CompassPoint's consulting practice, we often work with nonprofits--often those based in communities of color--whose early funding came from government agencies. Unlike nonprofits that established with large donations from their founding volunteers and board members, these groups often get started later on their individual, foundation, and corporate contacts. The result is too many 10-year-old organizations with $1 million programs but with fewer than 50 donors (who are listed in an outdated FileMaker database that nobody knows how to use!). Start to build the capacity for other kinds of funding, and set realistic goals for doing so. With even 10% of your budget coming from non-government sources, you'll enjoy the freedom to experiment, make a few mistakes, and do important work that would never be government-funded.

This article is adapted from "Government Funding: Use It Well," by Jeanne Bell, in Nonprofit Quarterly.