Five Minutes for Finance - The Annual Audit and IRS Form 990
Understanding Nonprofit Annual Audits and the IRS Form 990
In the previous article, The Board Treasurer, we mentioned that many nonprofits are required to have an annual audit conducted by an independent third-party, typically a Certified Public Accounting (CPA) firm, that assesses the reliability of the organization’s financial statements and its adherence to generally accepted accounting principles (GAAP).
While audits are not always legally required, many nonprofits choose to undergo one to build trust with donors, funders, and the public. In some states, larger nonprofits or those that receive federal funding may be mandated to conduct an audit as part of their regulatory requirements.
The audit process typically includes:
Reviewing financial statements: This includes the balance sheet, income statement, statement of functional expenses, and statement of cash flows.
Testing internal controls: Auditors evaluate the effectiveness of a nonprofit's internal control systems to prevent fraud or errors.
Assessing compliance: Auditors verify that the nonprofit is adhering to relevant laws, regulations, and tax-exempt status requirements.
Providing an opinion: At the end of the audit, the CPA firm issues an opinion, which may be unqualified (clean), qualified (with conditions), or adverse (indicating significant issues).
In addition to the Audited Financial Statements, the CPA firm may also prepare a Management Letter. Often, these supplementary documents summarize findings and recommendations for improving the organization’s financial operations. Although the CPA firm may provide an unqualified opinion in the Audited Financial Statements, it may identify significant deficiencies or material weaknesses that it encountered in the internal control environment, even if these were corrected during the audit process. The Management Letter is usually held in confidence by the Board of Directors and Senior Management.
Larger nonprofits may have an Audit Committee that is responsible for ensuring that the annual audit is performed. In the State of California, the Nonprofit Integrity Act provides rules on audits, the audit committee, and any overlap with the Treasurer and Finance Committee. For smaller nonprofits, the audit responsibility may be held by the Treasurer and/or Finance Committee.
While audits can be costly and time-consuming, they provide a high level of assurance to stakeholders about the financial health of the organization. Some organizations make their Audited Financial Statements public, by posting them on their website and/or Guidestar.
IRS Form 990: A Key Tool for Transparency
Form 990 is the informational tax return that most tax-exempt nonprofits must file annually with the Internal Revenue Service (IRS). The form provides a detailed account of the nonprofit’s financial activities, governance, and operations over the previous year. This helps ensure that nonprofit organizations are using their resources appropriately, in line with their mission, and in compliance with tax laws.
There are several key sections of Form 990 that nonprofits need to be aware of:
Part I – Summary: This section includes basic information about the organization, such as its name, address, mission statement, and financial data (e.g., revenue and expenses).
Pro Tip: The section for describing the organization and its mission Part I, Question 1) is limited - only 333 characters will appear on the first page, with the remainder shown on supplementary pages (Schedule O) at the end of the form. Because readers might not read to the end of the form, organizations should strive to limit the description such that it fits on the first page.
Part II – Signature Block: This section must be signed by an authorized individual, such as the organization’s executive director or board president.
Part III – Program Service Accomplishments: Nonprofits must describe their mission and how their activities align with their charitable purpose. This section is crucial for demonstrating that the organization is fulfilling its exempt purpose.
Part IV – Checklist of Required Schedules: Depending on the size and activities of the nonprofit, certain schedules (e.g., Schedule A for public charity status) may need to be attached.
Schedule B – Schedule of Donors: Nonprofits must report significant contributions from major donors (over $5,000), though donor names and addresses are generally not required for public disclosure.
Schedule G – Professional Fundraisers and Compensation: This section provides details on the compensation of key employees, contractors, and professional fundraisers.
Schedule O – Supplemental Information: This section allows the organization to provide additional context or clarifications about its operations or financials.
Form 990 serves as a public record, which means it is accessible to anyone, including potential donors, grantmakers, and the general public. The form is a critical tool for ensuring that nonprofits are held to high standards of financial transparency and governance. Many organizations post their Form 990 on their website and/or Guidestar.
How Audits and Form 990 Work Together
While Form 990 is a self-reported document, an audit can provide independent verification of the accuracy of the financial data presented. Many organizations choose to have their audit results incorporated into their Form 990 filing to further reassure stakeholders of their financial integrity. The IRS doesn't require an audit to accompany Form 990, but large organizations may include their audit reports as part of the filing process.
For nonprofits, an audit can also help ensure that they are fully compliant with IRS regulations, which can be complex and subject to change. Additionally, organizations with audits often present themselves as more trustworthy to potential donors, who may require independent verification of financial health before making contributions.
When is an Audit Required?
The IRS does not mandate audits for all nonprofits, but certain conditions may trigger this requirement. Common circumstances include:
Size of the Organization: In many states, nonprofits with gross annual receipts above a certain threshold (e.g., $500,000 or $1 million) must undergo an independent audit. The specific thresholds vary by state.
Federal Funding: Nonprofits that receive significant federal funding, particularly those involved in government contracts or grants, may be required to have an audit due to the rules set forth in the Uniform Guidance (2 CFR 200).
Public or Private Foundation Requirements: Some foundations or funding sources may require an independent audit for grant recipients, especially for large grants.
Even if a nonprofit is not required to conduct an audit, doing so can be an important best practice for maintaining financial transparency and credibility.
The Role of Donors and Stakeholders
Annual audits and Form 990 filings are particularly important for donors to nonprofit organizations. Donors want to ensure their contributions are being used effectively and that the nonprofit is operating efficiently. An audit can give donors confidence in the nonprofit’s ability to manage funds and carry out its mission.
Likewise, many foundations and government entities require financial audits and Form 990 submissions before awarding grants or making other funding decisions. These documents provide critical information to potential funders, allowing them to assess the financial health and management of the nonprofit.
Conclusion
Annual audits and IRS Form 990 are fundamental components of nonprofit financial management. They ensure transparency, build trust with donors, and help organizations comply with legal requirements. While audits can be expensive and time-consuming, they provide valuable insight into an organization's financial health and can significantly enhance its credibility. For nonprofits, prioritizing these processes is not only a best practice but a necessary step in building a sustainable and trustworthy organization.
By maintaining accurate financial records, undergoing regular audits, and filing Form 990 correctly, nonprofits can foster greater confidence among stakeholders and ensure that they are operating efficiently and in accordance with the law.
About this Series
Subsequent articles in this series will cover other topics related to nonprofit financial management. Here is a list of, with links to, previous articles:
About the Author
For over 30 years, Robert Pascual has been a leader in nonprofit financial management as a CFO, consultant, conference speaker and educator. He holds an MBA from the Haas School of Business at the University of California and is the founder and principal of Robert Pascual, MBA LLC. He has worked with small, mid-size, and large nonprofit organizations spanning the fields of education, workforce development, housing, health, philanthropy, social services, media, fiscal sponsorship, nature, and the environment. Each of these organizations has faced both unique and common challenges, some of which are probably similar to ones that you wrestle with.