For many nonprofit organizations, an audit isn’t something that receives much attention—until it’s required. Sometimes the trigger is growth. Sometimes it’s a grantor requirement. In other cases, lenders, donors, or board members may request audited financial statements to provide additional confidence in the organization’s financial reporting.
Regardless of the reason, a first-time audit can feel intimidating. Questions about timelines, documentation, board responsibilities, and accounting requirements are common, especially for organizations that have never gone through the process before.
The good news is that understanding what to expect—and what makes nonprofit audits unique—can help make the process much smoother.
Why the $2 Million Threshold Matters
For many California nonprofits, the first audit is triggered by growth. Under California’s Nonprofit Integrity Act, charitable organizations with gross annual revenues of $2 million or more are generally required to obtain annual financial statements audited by an independent CPA. Organizations subject to these requirements must also provide board-level oversight of the audit process, generally through an audit committee that works with the auditors and reviews the audited financial statements.
Certain government grants are excluded from California’s $2 million calculation when the organization is required to provide an accounting of how the funds were used, so organizations should confirm which revenue sources count toward the threshold. California Attorney General guidance
Don’t Wait Until the Requirement Is Triggered
If this will be your organization’s first audit, the best time to begin preparing is before an audit is required. A significant private grant, major contribution, fundraising campaign, or other influx of revenue could move an organization across the applicable threshold more quickly than expected.
Monitoring revenue levels and upcoming funding opportunities gives the organization time to strengthen its accounting processes, organize supporting documentation, evaluate GAAP readiness, and establish the necessary board oversight before the funds are received. Preparing early can make the first audit significantly more manageable.
Audit Requirements Vary by State
California’s $2 million threshold does not apply nationwide. Audit and financial reporting requirements vary by state and may apply based on an organization’s revenue, contributions, fundraising activities, or registration status.
Organizations operating across state lines should review the requirements in every state where they are incorporated, registered, or conducting fundraising activities—not only the state where their primary office is located. Requirements and thresholds can differ considerably, so nonprofits should consult with their advisors to determine which rules apply to their specific circumstances.
Of course, a statutory revenue threshold isn’t the only reason an audit may be required. Nonprofits may also need an audit because of:
- Federal, state, or private grant requirements
- Lender requirements
- Major donor requests
- Foundation funding requirements
- Board governance initiatives
Whatever the reason, preparing for a first audit is an important milestone for an organization.
What Happens During a First-Year Nonprofit Audit?
While every audit follows a similar process, nonprofit organizations often encounter additional areas of focus related to grants, donor restrictions, functional expenses, and governance.
Planning and Information Gathering
The audit begins with discussions about your organization, funding sources, programs, and accounting processes. Auditors will request key documents and identify areas that may require additional attention.
For nonprofits, this often includes reviewing:
- Grant agreements
- Donor-restricted contributions
- Board and committee meeting minutes
- Organizational policies
- Major funding sources
Testing and Fieldwork
During fieldwork, auditors test transactions and account balances to determine whether the financial statements are fairly presented.
In addition to standard audit procedures, nonprofit organizations can expect additional focus on several areas unique to the sector:
Revenue and Contributions
- Donor-restricted contributions
- Conditional grants
- Government funding agreements
- In-kind contributions
- Special event revenue
Auditors evaluate whether revenue was recognized in the proper period and classified appropriately based on funding requirements.
Functional Expense Allocations
Unlike most for-profit organizations, nonprofits must report expenses by both natural classification and functional classification. Auditors often review how costs are allocated between:
- Program services
- Management and general
- Fundraising
Net Asset Classifications
Auditors review donor communications, grant agreements, and board actions to determine whether resources have been properly classified as:
- Net assets with donor restrictions
- Net assets without donor restrictions
Governance and Board Oversight
Auditors may also review:
- Board meeting minutes
- Conflict-of-interest policies
- Related-party transactions
- Executive compensation approvals
- Significant board decisions affecting financial reporting
Financial Statement Review and Issuance
Once testing is complete, auditors evaluate the presentation of the financial statements and required disclosures.
For first-time nonprofit audits, this often includes discussions around:
- Functional expense reporting
- Donor restrictions
- Net asset classifications
- Required nonprofit disclosures
- GAAP adjustments
Organizations that maintain their books on a cash basis often find this phase particularly educational as accrual-basis adjustments are identified and incorporated into the financial statements.
After completing their procedures, auditors communicate their findings to management and the board or audit committee before issuing the final audited financial statements.
Common Challenges First-Time Nonprofit Audit Clients Face
Every first-year audit comes with a learning curve. For nonprofits, a few challenges tend to appear more frequently than others.
Converting From Cash Basis to GAAP Financial Statements
Many smaller nonprofits maintain their books on a cash basis because it is simpler for day-to-day operations.
However, many audited financial statements are generally prepared in accordance with Generally Accepted Accounting Principles (GAAP), which requires accrual-basis reporting.
As a result, organizations may need to record adjustments for:
- Accounts receivable
- Accounts payable
- Accrued payroll and benefits
- Deferred revenue
- Grant receivables
For some organizations, the audit process is the first time these adjustments are formally identified and documented.
Functional Expense Reporting
Many nonprofits track expenses by account category but not by function.
Developing reasonable allocation methodologies for salaries, occupancy costs, technology expenses, insurance, and other shared costs can become one of the more time-consuming aspects of a first-year audit.
Tracking Donor Restrictions and Grant Requirements
Organizations often have the information needed to distinguish restricted and unrestricted funds but may not have maintained records in a way that easily supports financial statement reporting.
Auditors frequently spend time reviewing grant agreements, donor communications, and funding requirements to verify classifications and restrictions.
How to Prepare Before the Auditors Arrive
The most successful first-time audits typically begin long before fieldwork starts—and ideally before the audit requirement is triggered. If your organization is approaching an applicable revenue threshold, pursuing a significant grant, or anticipating a major contribution, early planning can help identify and address accounting or documentation gaps before they become audit issues. Before the auditors arrive, consider the following:
✓ Organize key financial records
- Reconcile bank and investment accounts
- Gather loan documents and supporting schedules
- Confirm account balances are supported
✓ Review revenue documentation
- Assemble grant agreements and donor communications
- Organize support for fundraising events and major contributions
- Verify funding restrictions and conditions are documented
✓ Evaluate functional expense reporting
- Review how expenses are allocated among program, management, and fundraising activities
- Document allocation methodologies for shared costs
✓ Assess donor restriction tracking
- Confirm restricted and unrestricted funds are being tracked appropriately
- Review documentation supporting releases from donor restrictions
✓ Update governance documentation
- Ensure board and committee meeting minutes are complete and current
- Verify significant financial decisions have been documented
✓ Designate an audit coordinator
- Identify a primary point of contact for auditor requests
✓ Meet with your auditors early
- Discuss expectations, timelines, and potential areas of focus before fieldwork begins
A little preparation upfront can significantly reduce stress and help the audit proceed more efficiently.
Bottom Line
While a first-time audit may feel like a compliance exercise, many nonprofit organizations discover that it provides benefits beyond satisfying a requirement.
When approached proactively, the audit process can do more than satisfy a requirement. The process often helps strengthen financial reporting practices, improve documentation, enhance governance procedures, and provide greater confidence to donors, grantors, lenders, and board members.
Rather than viewing the audit as an obstacle, organizations can use it as an opportunity to build a stronger financial foundation for future growth and mission success.
Whether your organization is preparing for its first audit, approaching California’s audit threshold, or evaluating its readiness for GAAP financial reporting, LSL can help you understand the process, prepare effectively, and navigate the requirements with confidence. Contact us today!
