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An independent audit is not the same as an IRS audit. Rather, it is an examination of your accounting records and financial statements by an independent auditor—normally, a certified professional accountant (CPA). The auditor is an independent professional hired and paid by your nonprofit. The auditor will do an independent investigation to test the accuracy of your accounting records and internal controls. At the conclusion of the audit, the auditor issues a report in the form of a letter stating whether, in the auditor's professional judgment, your accounting records and year-end financial statements fairly represent your nonprofit's financial position according to generally accepted accounting principles (GAAP). The auditor's letter is attached to the front of your financial statements. A clean bill of health from an auditor shows the world that you're keeping your books in a responsible manner. But do you need to do one?
Independent audits are mandatory for some nonprofits. The IRS does not require nonprofits to obtain audits, but other government agencies do. For example, the federal Office of Management and Budget (OMB) requires any nonprofit that spends $500,000 or more in federal funds in a year (whether directly or by passing the money on to other nonprofits) to obtain what is termed a "single audit" to test for compliance with federal grants management standards. In addition, approximately one-third of all states require nonprofits of a certain annual revenue size to be audited if they solicit funds from their state's residents. The revenue thresholds vary from state to state.
California requires annual audits for nonprofits registered with the state that have gross income of $2 million or more. Other states have lower income thresholds.
Finally, some funders, such as foundations, will not provide funding to a nonprofit unless they receive audited financial statements. The same holds true for many banks and other potential lenders.
Getting an audit sounds great in theory, but if it is not absolutely required by the government or an important funding source, it might not be worth the money, especially for nonprofits with smaller incomes. Think about it—if a nonprofit has an annual income of $100,000 or less, paying $5,000 to $10,000 for an audit would take up a substantial portion of its entire annual budget. Moreover, an audit is generally unnecessary for small nonprofits because they engage in a low number of financial transactions each year, and the veracity of their books can be checked in cheaper ways.
There are two cheaper alternatives to a full-blown independent audit. The first is called a review, which is like a mini-audit. A CPA examines your financial records, but much less thoroughly than in a full-blown audit. Unlike an audit, the CPA does not express an opinion as to whether your financial statements are in accordance with GAAP. Instead, the accountant merely states whether he or she is aware of any material modifications that should be made to the financial statements for them to be in conformity with GAAP. A review costs about half as much as an audit. Many funders will accept a review instead of an audit, but a review is not an audit and it may not be referred to as such.
The cheapest alternative to an audit is a compilation. This is where an accountant assembles your financial statements from the information you provide. The accountant does not subject your financial records to any audit or review and thus can express no opinion at all as to whether they comply with GAAP.
To learn more about tax issues with your nonprofit, see Nolo's book, Every Nonprofit's Tax Guide.