THE EXTERNAL AUDIT

PART 3—Forging the Auditor Relationship

The Auditor Relies on You for a Successful Audit

Nonprofits often feel apprehensive as they embark on the audit process the first time. Yes, it will take up a lot of your time and you will have to produce documents and answer questions. But I think it is helpful to know something about the challenges that the auditors face in providing this service.

As I discussed here, the CPA firm is a private company that charges you for their services. They usually quote a fixed fee and can lose their shirt if the hours spent on the job go over their budget, and there are a million ways that can happen. Some CPA firms prefer tax and consulting work even though they include audits in their product mix. The supply of auditors has been dwindling for years as fewer students seek degrees in accounting; in some parts of the country nonprofits have a difficult time finding an auditor at all.

Before choosing to engage with a nonprofit client, the CPA firm reviews the potential client’s recent financial statements to see if the nonprofit has received unqualified opinions in the past and if it is a “going concern,”—i.e., likely to maintain operations at a normal level over the next twelve months. Beyond that, firms are looking for clients with good reputations and well-run finance departments. In short, they select clients whose financial statements are likely to earn an unqualified opinion. If, during the audit, they find that your financial statements do not adhere to GAAP or your future is too uncertain, they will have to either withdraw from the engagement or give an opinion other than unqualified—an undesirable result for everyone.

At the conclusion of the audit both the ED and the CFO are required to sign a “management representation letter” stating that all relevant information has been provided. Their signatures mean that in addition to making all of the organization’s records available, the ED and CFO have provided all pertinent information about every circumstance that could potentially affect the organization’s financial position.

Here are examples of such information.

Subsequent Events

During the period between the end of the year and the release of the financial statements to the public anything significant that arises must be communicated; the auditors will decide if a disclosure in the audit report is necessary. A few examples: pending lawsuits, loss of property through fire or flood, prolonged disruption of a critical software system, or cancellation of a major contract.

Related Parties

Any transaction with a related party carries the risk that one party will exert undue influence over the other, so the auditor needs to know about it. GAAP requires that all business activity be conducted at “arms-length,” meaning that both parties are independent and acting in their own interest. A sale or lease between the ED and their friend or relative of real property to be used by the nonprofit is an example of related party activity which may or may not be conducted at arm’s-length. Any similar transaction made by anyone in a management role or any board member must be disclosed. (It is a best practice to require all board members to disclose any potential conflicts of interest annually.)

Related party transactions are not prohibited, but the auditor must be given the opportunity to evaluate each one. Some transactions may be advantageous to the organization. A relative may sell real property for less than the market value. In this case the auditor will review the transaction to ascertain that it was recorded as both a sale and a donation.

The auditor will verify that the related party transaction was of benefit to the organization and the price did not exceed market value. Use of a human service agency’s cash to purchase a warehouse full of batteries from the ED’s friend or brother-in-law most likely violates GAAP. Likewise for a sale of property above market value. In extreme cases, transactions such as these could put the organization at risk for an adverse opinion.

Related party transactions are difficult to spot when the names of the parties are not recognizable. The CPA relies heavily on the CFO and the ED to provide that information. If your ED would rather not disclose a related party transaction, your challenge is to convince them that you will not be able to sign the management representation letter if the disclosure is not made. You must inform the ED that you are prepared to make the disclosure without their permission, and/or to bring the matter to the attention of the board. These are, of course, highly undesirable options, but nothing is more important than your integrity and your reputation.

Negotiations

A newcomer to the world of nonprofit management may be surprised to learn that on occasion management and auditor are negotiating partners.

Negotiating Financial Statement Presentation

Because they have the specialized knowledge of GAAP, the auditors often prepare the drafts of the financial statements. The CPA’s desired outcome is financial statements that adhere to GAAP. Management’s perspective is a bit more nuanced. We want our statements to demonstrate that our organization is credit-worthy, but we also want to avoid the perception that our contributors’ hard-earned dollars are not needed.

Don’t make the mistake of thinking that the auditors are the authors of your financial statements. On the contrary, you are! You need to be aware of the power you wield in this relationship. GAAP gives us latitude in how certain items are reported. You have some discretion over how your assets and liabilities are grouped and labeled, and over the wording of the footnote disclosures. As an example, temporarily restricted net assets can be detailed on the face of the statements or in the footnotes—your choice. This may seem unimportant, but in fact, how the information is arranged and presented in the report can have a big impact on how the reader perceives it.

Another example: In recent years the “Liquidity and Availability of Financial Assets” footnote was added to the disclosures required by GAAP. Its purpose is to inform readers about the expected availability of cash to fund operations over the next twelve months. A more complete explanation can be found here. https://www.aicpa-cima.com/resources/article/demystifying-the-new-not-for-profit-liquidity-disclosures

Donors and potential funders might ask all sorts of questions depending on how this information is presented. I strongly recommend that you familiarize yourself with this standard and work closely with the auditors, the ED, and/or the board to present the information with honesty and clarity.

Negotiating Accounting Issues

In every audit engagement there is an understanding that the auditors are objective third parties whose role is to certify that the financial statements are fairly presented and adhere to GAAP. The potential exists for the auditors to overstep their boundaries in the advice they provide to the nonprofit. It is important to always remember that their responsibilities to advise you on the requirements of GAAP do not extend to participating in the financial management of your organization—this would be a conflict of interest. More on auditor independence can be found here.

Here are a couple of examples of how you can assert your role as the financial manager of your organization.

Auditors’ Journal Entries

As they review your records, the team will suggest journal entries to correct any errors they find; not all of these meet the threshold of materiality and will be “passed entries” if you do not record them in your books. Note that the auditors do not have GL data entry privileges; they can only propose entries and it is always your prerogative to accept or reject them. If an audit team member is eager for you to make an entry that you disagree with, make sure that their superior satisfies you as to why it is material to the financial statements.

Revenue Recognition

I have said many times that you should consult with the auditors about when and how to record grant revenue because the GAAP rules are complex. But to the extent that you understand the principles of GAAP revenue recognition and the provisions of the contract, you can participate in this decision. If you believe, for example, that the grant revenue is conditional, and the audit team thinks it is unconditional, you might have the option of contacting the funder to get the clarification that will support your position. And you can always make your case to the CPA who will be signing off on the opinion.

Cost Allocations and Bad Debts

You may be questioned about how you allocate costs across programs. For example, if you use FTEs rather than square footage to allocate building costs, be prepared to show with confidence why this method is reasonable and justifiable. Be confident and clear also in explaining how you arrived at your bad debt calculations.

My overriding point is that everyone involved needs to know that while you respect and appreciate the knowledge the auditors bring to the table, you are an active participant in this process. The auditors’ job is to ascertain that no material misstatements are present in your financial statements; your job is to run the finance department. In the vast majority of cases these concepts are meticulously observed. It is always a good idea, however, to keep them in mind.

Fieldwork Dynamics

Fieldwork is where your partnership with the auditors happens. Getting the work done quickly and efficiently is paramount; don’t forget that the firm is at risk of losing money on your job if it takes longer than expected. There are many things you can do to help the team achieve a smooth and efficient audit.

  • Provide them with a well-lit, private space near amenities where they can spread out, confer with each other, charge their devices, etc. Check in with them often to be sure that they have what they need.
  • If possible, give them access to the building so they can come and go on their own schedule.
  • Use this time to consult with the audit supervisor or partner on anything related to the job or other concerns. If you have any matters that you need advice on, fieldwork is an excellent time to ask your questions since the firm has set aside this time for your organization.
  • Make sure that the team has no idle time.
    • The first thing they are likely to do is upload your trial balance to their software. Be absolutely sure that it is in balance and ready to go before fieldwork starts. (More on that here.)
    • The supervisor will provide you in advance with a list of documents and schedules that they need. Work overtime if necessary to prepare these items and to have as many as possible ready and waiting on the first day of fieldwork. Strive to make the workpapers clear and well organized, and preferably in the format they need so no one has to spend time editing and cleaning up your work.
    • Clear your schedule so that you are available to answer questions as they arise. Show equal deference to every member of the team.

In Sum: There is More to the Auditor Relationship than We Sometimes Realize

As your rapport with all members of the audit team grows you will stand your ground when necessary but also show your appreciation for their expertise. And you will help them meet their deadlines with efficiency. In turn, they will give you the benefit of the doubt when disagreements arise; they will give you a good “report card” when they present their report to the board; and members of the firm will take the time to research the questions you ask about legal and accounting matters.

The time and effort you take to build a healthy, productive, relationship with your auditors—one based on mutual trust and respect—will surely pay off as you all work through this intricate but vital process together.