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When auditing a nonprofit entity, auditors must consider the limitations placed on the audit by

donors and other funding sources. These include:

* Audit restrictions imposed by funding sources that may affect GAAP and GAAS.

* Risks associated with the use of volunteer personnel,

in-kind services and volunteer board of trustees.


* Problems associated with comparison of budgets to actual results.

* Problems associated with accounting for multiple programs, grants or contracts that have year-
ends different from the fiscal year-end of the nonprofit organization.

* Risks caused by a detailed chart of accounts.

* Tax considerations resulting from unrelated business income.

The audit strategy should be reevaluated each year because resource inflow and outflow can
change significantly from year to year due to marked changes in business conditions. Audit
procedures should be designed to detect noncompliance with the restrictions or requirements
imposed by the funding source. All areas of noncompliance (no matter how small) should be
summarized by the auditors, evaluated for adjustment purposes, and brought to the attention of
management.

Accounting and auditing considerations for a nonprofit organization are similar to those of a profit-
making entity. However, there are a number of special challenges that face auditors of nonprofit
organizations. Auditing considerations for some of the key areas of the statement of financial
position and statement of activity are discussed below.

CASH

Auditing of cash for nonprofits is similar to auditing cash for business enterprises. The difference
is that nonprofit organizations have many more cash accounts.

Sometimes, accounts are set up for each program, some of which are temporary. In many cases,
the funding sources require a separate bank account. In addition, accounts are closed more
frequently than in the case of for-profit entities. Further, many nonprofits (in an effort to save bank
fees) will allow the bank to keep canceled checks. Some merely receive the monthly bank
statement with a photocopy of each check.
Auditors need to modify their audit program to make sure the cash is fairly presented. Moreover,
auditors should be aware of the possibility of restricted cash, cash overdrafts, and held checks.
The latter is a common practice in many nonprofits, due to funding constraints.

RECEIVABLES

Receivables for nonprofit entities usually are two types, namely (1) contributions and promises to
give and (2) receivables, such as tuition and fees for services performed.

Contributions and promises to give refer to unconditional, voluntary, and nonreciprocal transfers
of assets or settlement of liabilities. Assets transferred can be cash, property, securities, services,
pledges (unconditional promises to give in the future), etc. Usually, nonprofit organizations have a
separate development office. Of course, it is necessary to reconcile the records between the
development office and the accounting office.

Cash contributions present a major problem for nonprofit managers and auditors, as the objective
is to make sure that all cash contributions have been received and recorded. The key control
element is to separate access to the cash that the entity collected from the accounting for the
cash.

Contributions by check present a lesser problem--auditors have to be sure that the amount of the
gift was recorded properly, determine if there were any restrictions, the period in which the gift
may be used, payments during the period of audit, and any amounts receivable.

In most instances, auditors use confirmation procedures to verify both cash and check
contributions, In the case of pledges, estimation techniques have to be employed by the nonprofit
and verified by the auditors. That is, allocation of pledges over time has to be determined. Then a
discount rate has to be used to determine the present value of the future payments. Finally,
auditors have to agree with management's estimate of the amount of contributions that maybe
uncollectable and make a proper provision for such in the financial statements.

OTHER RECEIVABLES

Nonprofit organizations are involved in many exchange transactions. For example, private
schools charge tuition and fees; health and welfare organizations charge fees for counseling,
training, and other services; associations and clubs charge dues and other fees. Generally, these
transactions are not restricted in nature. Since these income items are exchange transactions
(defined in SFAS No. 116 as "reciprocal transfers in which each party receives and sacrifices
approximately equal value"), and not contributions, they are accounted for in the same manner as
in the profitmaking sector.

Usually, the most effective way to audit receivables is to confirm directly with the customer (in a
for-profit environment) and with the client, student, parent, patient, trainee, etc. (in a nonprofit
organization). Corresponding with a third party has a high degree of audit reliability because it is
external evidence versus internal evidence and is always superior to examining documents
prepared by the client.

Auditors have to consider, however, that the typical response rate is extremely low in the
nonprofit arena. Individuals who owe money to nonprofits are unfamiliar with the role of the
auditor, why the confirmation request is made, and the necessity for their cooperation. Auditors of
nonprofits generally have to use alternate procedures to verify the existence of receivables
because they usually cannot rely as much on confirmation work.

INVESTMENTS

The primary accounting pronouncement governing investments that concerns nonprofit


organizations is SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit
Organizations. Nonprofits must report equity and debt securities at fair value in the statement of
financial position and all realized and unrealized gains and losses in the statement of activities.

In addition, investment income should be reported as an increase in net assets, and unrealized
and realized gains and losses as increases or decreases in net assets. If there are no donor
restrictions, such should be included as increases or decreases in unrestricted net assets.
Otherwise, they should be included as increases or decreases in temporarily or permanently
restricted net assets, depending on the type of restrictions placed by donors.

PROPERTY AND EQUIPMENT

Accounting for and auditing of property and equipment is basically the same for both profit-
making and nonprofit entities. Prior to 1990, nonprofits did not have to depreciate their fixed
assets. Because many nonprofit organizations have never been audited, they have not
depreciated their long-lived tangible assets. For example, churches do not have to file a Form
990 with the IRS, are not audited, and do not depreciate their assets. If auditors were asked to
perform an audit for such an organization, SFAS No. 93 would have to be followed. However,
establishing the cost of the fixed assets and, thus, the value to be reflected in financial statements
present a challenge to the auditors. Guidance for such a situation is provided in the statement.

ACCOUNTS PAYABLE, ACCRUED EXPENSES, AND OTHER LIABILITIES

Accounting for and auditing these areas is very similar to that for profit-making enterprises. Both
nonprofit and for-profit organizations have accrued payroll expense, and liabilities for accrued
employee benefits, such as hospitalization and pensions. However, nonprofits, particularly private
schools, have to accrue a liability for payroll for the summer months.

Auditors should be aware of the contracts made with the teachers. Although the contract runs
from September to June, most teachers elect to be paid over 12 months instead of 10 months.
Most schools end their fiscal year on June Thus, teachers who are paid over a 12-month period
(i.e., those receiving pay during July and August) actually rendered the service from September
to June. The school must accrue the July and August salary for these 12-month teachers as of
June 30th in order to adhere properly to the matching principle and reflect the true expense
incurred for the year. This sometimes presents a problem in the first-time audit of a private
school. The situation also occurs in day-care centers, nursery schools, and agencies that have
contracts with their employees for fewer than 12 months, but pay over 12 months.

LOANS PAYABLE

Nonprofits that are affiliated typically give each other temporary advances. These advances are,
in effect, loans and should be treated on the financials as such. APB Opinion No. 21, Interest on
Receivables and Payables, states that "the interest rate used to determine the present value of a
loan should approximate the rate that an independent borrower and independent lender would
have negotiated in a similar transaction." Interest may not be reflected, thus making the financial
statements misleading.

When loans are interest-free or at below-market interest rates, auditors should refer to the AICPA
Technical Practice Aid. It provides guidance on how to account for the difference between the fair
value of the loan based on the market interest rate and the fair value of the loan at the below-
market rate (face value of loan in the case of interest-free loans).

REVENUES
Contributions, grants, and bequests constitute the major portion of the revenues for nonprofit
organizations. Some nonprofits may have income from sales of materials or services and related
fees. For example, a private school would have tuition income and related fees (admission,
registration, laboratory and transcript fees). Auditing these items can easily be accomplished by
applying analytical procedures, as detailed in SAS No. 56, Analytical Procedures. Analytical
procedures are used to determine whether information is consistent with their expectations.

An understanding of the relationships between certain financial information is necessary if the


auditors are to efficiently and effectively achieve substantive testing objectives. For example, if
the school had 800 students enrolled and the tuition was $5,000 per student, it is obvious that the
tuition revenues should be $4,000,000; if the registration fee was $50 per student, registration fee
revenues should be $40,000. Similarly, if seniors on average apply to 8 colleges (based on past
experience) and there are 180 seniors and each transcript fee is $4, then the transcript fee
revenues should be approximately $5,760 (180 seniors x 8 colleges x $4). Thus, much valuable
evidence can be obtained with simple calculations rather than testing details.

EXPENSES

Expenses of nonprofits should be broken down into two main categories, program service
expenses and supporting service expenses. Program service expenses pertain to direct and
indirect costs incurred to provide services in accordance with the nonprofit's mission and
objectives. These include salaries, employee benefits, occupancy, consumable supplies,
contractual services, and other costs. Supporting service expenses include management and
general (expenses incurred for supervision purposes and overall direction of the nonprofit entity)
and fund-raising (expenses incurred to solicit financial support for the organization).

Health and welfare organizations have to include a statement of functional expenses in their
audited reports. However, most of the nonprofits include such a breakdown also. This is a
classification of expenses by natural classes--such as salaries, fringe benefits,
consultants/contract services, telephone/fax, fund raising/special events, travel, advertising/public
relations, printing/publications, vehicle expenses, interest, depreciation, grants to others, and
other costs--with an allocation to the various programs, management and general, and fund
raising.

For control purposes, management is more interested in the object (natural) categories of
expenses. Funding sources, regulatory groups, and the board of directors/trustees are usually
more interested in the costs of providing the various types of services and compare such to the
amount of money spent on supervision and fund raising.

SALARIES, WAGES, AND EMPLOYEE BENEFITS

Payroll and fringe benefits are the most significant expenses of nonprofit organizations and
represent a key area of concern to auditors. Payroll is a common basis for allocating many
indirect costs to programs and other functions.

Usually, audit procedures depend on whether the workforce is relatively permanent (stable) or
changes from year to year. In the former case, the auditor can use analytical procedures, such as
comparison to prior periods and to budgeted amounts and reconciliation to Federal and State
payroll tax reports. When the workforce is somewhat unstable, it may be necessary to do more
detailed work, such as verification with personnel records, performing a payoff, and test checking
calculations and other details for a sample of employees.

Employee benefits include payroll taxes, hospitalization, vacation, bonuses, and pension costs.
The relation of the employee benefit expenses to the number of employees covered for the
current year should be compared to the same relationship the preceding year. It is important to
ensure that proper accruals exist for these items at year-end and, in particular, that the
accounting is proper for pension costs.

Regarding pension costs, auditors and nonprofit professionals should be familiar with two
pronouncements. One is SFAS No. 87, Employers' Accounting for Pensions, which provides
guidance for defined contribution and defined benefit pension plans. The second is SFAS No.
112, Employers' Accounting for Postretirement Benefits Other than Pensions, which provides
guidance for severance benefits, disability-related benefits, continuation of health care and life
insurance coverage, salary continuation, etc.

EXPENSES, OTHER THAN SALARIES, WAGES AND EMPLOYEE BENEFITS

Auditing of this area is similar to that for any business. The best approach is a combination of
analytical procedures (comparison to prior years and to budget) and detailed testing (vouching)
based on materiality limits set for individual accounts.

MATCHING COSTS

Some nonprofits, particularly those receiving grants or contracts from federal, state or local
governments, must provide matching funds, usually in the form of in-kind services. This is
expressed as a percentage of the total expenses. The auditor is presented with two challenges,
namely (1) ensuring that the donated materials or in-kind services qualify under the terms of the
grant or contract and were actually used for the program, and (2) determining valuation.

The funding source usually provides guidance regarding the amount accepted for donations of
materials and services. For example, the nonprofit may be instructed to value donated clothing at
thrift-shop value, and services, such as teacher aides, nurse, accountant, etc., at the prevailing
scale in the geographical area.

CONCLUSION

The accounting and auditing professions have experienced a flurry of bad publicity recently.
However, alleged audit deficiencies are not limited to profit-making institutions. Both nonprofit
professionals and auditors need to understand the challenges involved in auditing a nonprofit
organization and the ways in which these engagements differ from business audits.

Frank Grippo, MBA, CPA, is an Associate Professor of Accounting at William Paterson University,
Wayne, NJ. Joel Siegel, PhD, CPA, who has written several articles for the National Public
Accountant is a Professor of Accounting at Queens College, NY.

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