Is a Financial Audit Nothing More Than a Compliance Exercise?
Every year, thousands of nonprofits hire a CPA firm to audit their financial statements.
Some nonprofits do so to comply with regulation, as many states have made annual financial audits mandatory. Federal regulation also imposes financial audits on certain nonprofits that receive federal funding. In fact, many organizations were forced to obtain a financial audit for the first time because they received federal stimulus during the COVID-19 pandemic.
Yet, it is not uncommon for nonprofits to choose to undergo such a financial audit, despite not being required by law. This pattern suggests that some organizations determine that the benefits exceed the costs.
You might consider performing your own cost-benefit analysis, and decide whether retaining a CPA firm’s audit services is worth it for your organization. The main costs to consider are the fees and the time commitment.
Every dollar your organization hands out to a CPA firm is a dollar not spent on mission-related programs. Requesting quotes from multiple CPA firms is a good strategy to ensure you pay a reasonable price.
In addition, the time commitment that comes with the audit process is a nontrivial cost that can be easily overlooked. Finding the right CPA firm for your organization takes time. But most importantly, managers and staff will be expected to be available to provide documentation and answer questions from auditors.
On the other hand, the potential benefits of a financial audit include:
- becoming eligible for grants and bank loans
- attracting donations
- improving the organization’s governance practices
- establishing a relationship with a trusted professional
Grantmaking foundations and government agencies usually require their recipients, and sometimes applicants, to provide audited financial statements. These grantmakers demand a financial audit because it gives them assurance that an organization spends its money toward mission-related programs.
Similarly, banks often require audited financial statements from prospective nonprofit borrowers because it allows them to assess default risk. Incurring the fixed cost of a financial audit can make your organization eligible to an array of funding opportunities.
In a study published in the Journal of Accounting Research, I find that financial audits can also help nonprofit organizations attract donations. This is especially true for organizations that are not particularly well known by the public or that depend on contributions from a large pool of small donors.
Although small donors are unlikely to be aware of which nonprofits undergo a financial audit, they tend to be responsive to ratings by third-party evaluators, like Charity Navigator. It turns out that obtaining a financial audit influences these ratings.
However, this finding does not apply to nonprofits whose donors also happen to be beneficiaries, as they are less likely to care about ratings or financial reports. This pattern is a reminder that obtaining a financial audit is not a one-size-fits-all decision.
I also document in an ongoing study that financial audits can incidentally shape the governance practices of nonprofits. I find that organizations that undergo an audit are more likely to put in place measures like a conflict-of-interest policy, a whistleblower policy and a formal process to approve management’s compensation.
CPAs who specialize in nonprofit organizations often tell me the value proposition of their audit services goes beyond compliance. For example, they say the audit process can be an opportunity to inform organizations about best practices, which they believe can be especially helpful to people who might never have had formal training in business or management.
Finally, undergoing a financial audit implies opening your books and giving insider access to a professional. It is an opportunity to build a relationship with a CPA who knows the inner workings of your organization. This relationship can pay off when an unexpected event (like a pandemic) shakes your organization and you find yourself in need of advice.
The bottom line is that the decision to hire a CPA to perform a financial statement audit typically requires a cost-benefit analysis unique to each organization.
Nonprofits that are on the fence may consider a financial statement review as a compromise. A review engagement provides a lower level of assurance, but it is less expensive and time consuming than an audit.
Raphael Duguay is an assistant professor at the Yale School of Management. He studies the role of transparency in nonprofit organizations.