Auditing Nonprofits: Tips and Traps

• Chapter 0 - Roadmap and Introduction
  • A Roadmap for Today's Course
  • Introduction
• Chapter 1 - Unique Auditing for a Unique Entity - The Nonprofit
  • Learning Objectives
  • Introduction
  • Nonprofits: The Auditor's Perspective
    • Terminology
    • Independence
    • Unique Characteristics and Early Judgments
    • Other Differences: Nonprofits vs. For-Profits
    • Are You Ready to Undertake That Nonprofit Audit?
  • Summary
  • Questions
  • Appendix 1A - The FASB Accounting Standards Codification™
    • The FASB ASC: Who, What, and When
• Chapter 2 - Planning the Nonprofit Audit
  • Learning Objectives
  • Introduction
  • Assessing Risk
    • Why Assess Risk?
    • Planning Materiality and Risk
    • Specific Types of Risk
    • Auditor's Response to Risk Assessment
  • Audit Strategy
    • Getting Down to Business
    • A Pause that Refreshes
  • The Audit Plan
    • Getting Specific
    • Relevant Assertions
    • Plan Design
  • Other Planning Considerations
    • Timing
    • Assigning Staff
    • Documentation
  • Summary
  • Questions
• Chapter 3 - Auditing a Nonprofit's Resources
  • Learning Objectives
  • Introduction
  • Auditing a Nonprofit's Revenues
    • Resource Characteristics
    • Controls Over Revenues
    • Relating Controls to Audit Procedures
    • Relating Assertions to Resource Type
  • Summary
  • Questions
• Chapter 4 - Auditing a Nonprofit's Expenses
  • Learning Objectives
  • Introduction
  • The Unique Role of Expenses in the Nonprofit
    • The Statement of Activities
    • Expense Assertions
    • Presentation and Disclosure
    • Functional and Natural Classifications
    • The Right of Offset
    • Other Expense Classification and Understandability Assertions
  • Auditing Expenses for Occurrence, Completeness, and Accuracy
    • Analytical Procedures
  • Auditing Expenses for the Compliance Assertion
    • Compliance Issues
    • Audit Strategy
    • Compliance Audit Methodology
  • Other Expense Auditing Considerations
    • Expense Classification
    • Expense Allocation
  • Summary
  • Questions
• Chapter 5 - Auditing a Nonprofit's Assets
  • Learning Objectives
  • Introduction
  • Types and Characteristics of a Nonprofit's Assets
    • Asset Types
  • Summary
  • Questions
• Chapter 6 - Auditing a Nonprofit's Liabilities and Net Assets
  • Learning Objectives
  • Introduction
  • Liabilities
    • Liability Assertions
    • Types of Liabilities and Appropriate Auditing Techniques
  • Net Assets
    • What Are Net Assets?
    • Auditing Net Assets
  • Summary
  • Questions
• Chapter 7 - Nonprofit Audit Issues: A Potpourri
  • Learning Objectives
  • Introduction
  • Fraud, the Nonprofit, and the Auditor
    • What Is Fraud?
    • The Nonprofit's Susceptibility to Fraud
    • The Auditor's Approach to Fraud
  • Compliance and the Yellow Book
    • Compliance Auditing Defined
    • The Auditor's Approach
    • Governmental Audit Quality Center
  • Independence
    • Multiple Levels of Independence
  • Related-Party Issues
    • Definition of Related-Parties
    • Auditors' Responsibilities
    • The Auditor's Response
    • Reporting of Related Entities
  • Reporting and Communication
    • Financial Reporting
    • Auditor Communications
  • Summary
  • Questions
• Chapter 8 - Latest Developments
• Value Aid
• AICPA Audit and Accounting Guide - Not-for-Profit Organizations

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Chapter 2 - Planning the Nonprofit Audit

"We first survey the plot, then draw the model;" William Shakespeare – Henry IV, Part 2

Learning Objectives

Upon completion of this chapter you should be able to

• Comprehend the significance of planning the audit of a nonprofit.

• Appreciate the critical role of risk in every nonprofit audit.

• Develop an audit strategy for a particular nonprofit entity.

• Design or select an audit plan.

• Recognize the potential need to modify the nature, timing, and extent of audit tests.

Introduction

You have made the decision to accept the engagement to audit a nonprofit organization. The plot is a simple one. The auditor of a nonprofit must satisfy him/herself as to the reasonableness of the financial statements. The model is defined as a set of financial statements that are fairly stated in all material respects. Having surveyed the plot and envisioned the model, all that is left is to figure out how to fulfill the plot. The auditor accomplishes this phase of an audit by selecting, designing, or customizing the plan.

Since the advent of mandatory peer review/quality review in the accounting profession, survey results have repeatedly revealed a connection between lack of planning, audit failures, and deficiencies. Furthermore, there has been evidence of a clear relationship between the proportionately meager amount of time spent in planning activities and such failures and deficiencies. This characteristic of past audit performance is pointed out here, not in the light of critical disapproval, but from the standpoint of positive analysis.

The audit strategy and the audit plan must not only be effective in that they satisfy the demands of the plot, but they must also permit efficient execution. To that end this chapter is dedicated to the auditor or prospective auditor of a nonprofit organization. This chapter explores the allimportant audit planning process from the unique aspect of the nonprofit entity.

Proper planning is mental, can be very hard work, and many auditors do not consider it as the most rewarding part of the audit. However, there seems to be no end to the list of successful people who credit the importance of planning as a key to their success. How important is planning? According to Robert Montgomery Knight, the retired college basketball coach with the most career wins ever, "The will to win is not as important as the will to prepare to win."

Some auditors believe as much as 50% or more of the total time expended in an audit engagement should be in planning. There is no magic formula, either suggested in the standards or accepted in practice, as to the amount of time that should be devoted to planning; successful auditors will agree that it should be a significant amount. Famous flying ace and aviation executive, Eddie Rickenbacker, once said, "I can give you a six-word formula for success. Think it through, then follow through." Common sense bears that out.

SAS No. 108, Planning and Supervision, which superseded the long-standing SAS No. 22 of the same title, introduces the terms audit strategy and audit plan. Audit strategy was previously referred to as the audit approach but the newer term, in the author's opinion, appears to imply a strategy that is intended to prevail throughout the audit engagement, rather than just a method of getting started. The audit plan is more detailed than the audit strategy and is commonly referred to as the audit program. These terms offer more than just an exercise in semantics.

The audit strategy considers such factors as

• The overall scope of the audit to be conducted.

• Deadlines for performing the audit and issuing the report.

• Recent financial reporting developments.

The audit plan describes in detail the nature, timing, and extent of

• Risk assessment procedures.

• Further audit procedures.

Assessing Risk

Why Assess Risk?

Audit risk is defined as the risk, or chance, that an auditor would unknowingly fail to modify his/her audit opinion on financial statements that are materially misstated. Risk assessment is a two-edged sword, and a mighty sword at that! Assessing risk equally benefits the

• Financial statement user - The user receives the assurance, or confidence, that an independent auditor has done whatever he/she has considered necessary to locate and cause to be corrected or disclosed any misstatement from GAAP or OCBOA that the auditor perceived as material to a financial statement user. From the standpoint of the client and any third party user, an effective audit has much value; an ineffective audit has no value.

• Auditor - The auditor is granted the opportunity to be able to spend his/her time primarily on only the parts of the financial statements that are perceived to really matter to anyone. An inefficient audit does not directly affect the effectiveness of an audit, but it can place pressures upon the auditor, which, in turn, could lead to an ineffective audit.

Risk assessment is the key to an audit that is both effective and efficient.

Trap. The auditor of a small local charitable institution, as a result of initial inquiry of the Executive Director, has determined that the organization is understaffed and that there is a lack of sophistication in the bookkeeping and accounting functions. He has thus concluded to default to a maximum control risk, that a substantive procedure audit will need to be performed, and that no further attention be given to risk assessment.

Tip. The auditor's assumption that no further attention be given to risk assessment is not acceptable under the standards. First, SAS No. 109, Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement states that inquiry alone is not sufficient to evaluate the design of a control relevant to an audit and to determine whether it has been implemented. Secondly, SAS No. 107, Audit Risk and Materiality in Conducting an Audit, requires the auditor to consider audit risk and determine a materiality level for the financial statements taken as a whole for the purpose of determining the nature, timing, and extent of further audit procedures. The assessed risks and the basis for those assessments should be documented. Thus the auditor may not "default" to maximum control risk without having a basis for that assessment. There is more to risk assessment than internal control. For example, in planning a mostly-substantive audit, there are areas that are inherently more risky than others. In virtually every nonprofit audit, there are accounts and transactions over which the organization does not have in place, or does not exercise, control procedures, but where the risk of material misstatement in the financial statements is minimal or acceptable. Lacking any indication of specific concern, such as suspicion of fraud, the auditor may not need to plan substantive testing with regard to such accounts or transactions.

Furthermore, SAS No. 109, Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement requires a "brainstorming" session to discuss the risk of material misstatements. Such a session with the audit team is similar to, and can be conducted at the same time as, the SAS No. 99 brainstorming session dealing with fraud.

The auditor should, in accordance with SAS No. 109, assess the risk of material misstatement at both the financial statement and relevant assertion levels. SAS No. 109 also requires the auditor to evaluate the design of controls and to determine whether or not they have been implemented by the client. The SAS also introduces the concept of significant risks and suggests that such risks exist on most audit engagements. The auditor should gain an understanding of internal control and also perform substantive procedures for all identified significant risks because substantive analytical procedures alone are not sufficient to test significant risks.

Planning Materiality and Risk

Materiality and risk go hand-in-hand. That the consideration of materiality and risk affects planning audit procedures and evaluating audit findings is no different for a nonprofit organization than for any other audit. How an auditor actually determines materiality and how he/she assesses risk, however, may differ for a nonprofit entity as opposed to a for-profit business enterprise.

Trap. It is the policy of a particular audit firm to make a quantified preliminary materiality calculation, for all audit clients, based upon a percentage applied to the larger of total assets or total revenue of the business entity. In this scenario, the audit firm has been engaged to audit a large community service organization with multiple social programs and substantial endowments. Substituting total resources of the nonprofit for revenue and using the entity's total assets, our auditor proceeds to design, select, or modify audit programs based upon that calculation.

Tip. With multiple programs and a large amount of endowments this nonprofit's financial statement will, in all probability, display all three components of net assets, unrestricted, temporarily restricted, and permanently restricted. It is conceivable that, because of the different types of transactions one might find affecting each of the net asset classifications, and also because there will likely be a variety of types of stakeholders, each with a different focus toward the financial statements, one preliminary materiality amount might not be appropriate for the entire entity.

At a minimum, the audit planner should consider the different types of transactions affecting each net asset category, the sizes and types of social programs, and the potential needs of divergent financial statement users. Having done so, the auditor might conclude that more than one materiality amount is appropriate.

Typically, with audits of nonprofit organizations, one size materiality does not fit all, and furthermore total assets or total resources are not necessarily the best gauges of materiality. One suggested approach for nonprofits with multiple programs is to select a materiality amount based upon program expenditures rather than upon total resources or total assets. The AICPA's Audit and Accounting Guide, Not-for-Profit Organizations (The Audit Guide) also offers other suggested bases upon which planning materiality might be determined. Some of the suggestions include

• Total net assets.

• Various net asset classes.

• Changes in net assets.

• Revenues of each net asset class.

• The ratio of program expenses to total expenses.

• The ratio of fund-raising expenses to contributions.

Trap. A CPA has been engaged to audit the financial statements of a United Way-funded community service agency in a relatively small town. As a part of her audit planning, the CPA has determined that five of the agency's seven programs met her planning materiality threshold, which she had based upon program expenditures.

One day, while lunching in a local restaurant, the CPA overheard a heated conversation in which two gentlemen were discussing one of the programs of her nonprofit audit client. The gist of the conversation was that the organization was not doing a very good job, and that contributions solicited for that particular program were not being used appropriately. Both parties in the conversation seemed to conclude that they would no longer make any donations to the organization.

In keeping with her eternal vigilance as an auditor, upon returning to her office, she checked to see if the particular program discussed by the two gentlemen at the restaurant was one she had selected for audit testing. It was not. The particular program was one of the two that had not met her materiality threshold. Furthermore, the total expenses of the program were significantly less than what she had considered as material, and she concluded that in no way could there be, a misstatement that was material to the overall financial statements in this particular program. She decided that no modifications were necessary to her audit program.

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