Keeping the Tax Man Happy

In "Climbing the Ladder to Nonprofit Success"* I try to emphasize that state and Federal laws governing nonprofits may not be the same. As tax season approaches, one of the areas that differs from state to state is whether or not you must have audited financial statements.

When deciding whether to accept a client requesting grant writing services, I pretty much have two iron-clad rules. You must be a 501(c)(3) and you must have formal accounting procedures in place that are at least capable of producing financial statements. My reasoning behind that is those are the two of the three things virtually every foundation or corporate sponsor requires, with the third being the 990. Without them, your application or entreaties for funding are going nowhere.

More importantly, not having at least the ability to produce audited financial statements can put you in violation of tax reporting laws.

The Council for Nonprofits has a list of states that will help you determine if your state requires audited financials. If you still have questions, the list also links to the specific regulatory reference for each state, or you can contact your state tax commission.

Income doesn't always predict the need for an audit.

While most small or new nonprofits will initially be under the income threshold that requires audited financials, several states require an independent audit if the organization employs "a professional solicitor", regardless of the revenue level, or if the organization receives a significant portion of their income from state funds. In general "professional solicitor" means any employee or paid professional that helps you raise funds, and can and usually does include everything from your CEO to your office manager, to contracted grant writers and  phone solicitors. Also, an independent auditor can't be the person who records or reviews your financial transactions on a regular basis.

Also noteworthy is that varying revenue levels may also require lower-level independent reviews such as an accountant's review or letter of compilation. For instance , Pennsylvania requires an independent auditors review of one form or another if your gross annual income exceeds $50,000, although the full-blown audit requirement doesn't kick in until receipts reach $300,000.

Audits aren't fun.

Last year, one of my former clients contacted me after her first-ever audit and was thoroughly incensed about the "intrusive behavior" of the auditors. The auditors had interviewed several of the staff members regarding how donations were recorded, and when the interviews indicated a somewhat chaotic system, they dinged the organization in their report. She was also angry that they "demanded every single receipt and every single phone message note" to back up expense records, including whether employees had called in or provided doctor's confirmations for sick pay. She wasn't complaining about having to provide the proof, as much as she was about the "inordinate waste of time" required to dig up the records  "to prove a $22.00 expense".

This is what an audit does. It isn't about whether you can add two and two. It's not even just about whether your books are in balance. It also evaluates whether you are exercising sound financial management. It can provide clues regarding the expertise of your staff. Perhaps you are recording expenses under the wrong category, or maybe you are reporting donations as unrestricted when they should have been applied to a specific program's income and spent only for that program. Maybe you are carelessly co-mingling personal and organization funds. It can uncover problems like embezzlement.

Audits should be learning opportunities.

Assuming that your audit problems stem from a lack of knowledge and not outright attempts to deceive, then your audit should be viewed as a chance to improve. You should want to have complete confidence that all the financial controls are in place, and that your financial position is exactly what it appears to be, good or bad. You should  be willing to either provide staff training or replace incompetent staff with people that know the rules and follow them.

Audits provide credibility with donors.

Being able to state that your financial dealings are honest and above-board as evidenced by your audit report reassures donors that their money will be used as they intended it to be when they gave it to you. That level of confidence can greatly impact growth in donations.

Good records mean smooth audits.

Depending on the type of audit or review, there are certain levels of sampling required under GAAP (Generally Accepted Accounting Principles). You are never going to get by without providing some selected source material, i.e. the invoice, receipt, purchase order, payroll check, deposit slip etc. that backs up the journal entry. Written procedures and even minutes of board meetings will also be on the request list.

However, if everything the auditor requests checks out the first time, there is usually no need for the auditor to keep digging. If the auditing firm has been hired on a total fee basis then they want to get done as soon as possible, but they are also required by law to investigate any irregularities. If they find something they don't feel is quite right, they have to keep digging until they have an explanation.

Hiring a proficient bookkeeper or retaining a bookkeeping firm to review your financial records monthly or at least quarterly might seem like an avoidable expense when you are first starting out, but in the long run, it will pay for itself in terms of smooth audits and happy donors. It is far better  to learn to do things properly now, before bad habits turn into bad audits!

© Rebecca L. Baisch 2013

* For your free copy, or to be on the subscriber-only newsletter list, email granthelp@ida.net