TLDR
Nonprofit audits test financial accuracy and internal controls, with particular scrutiny on restricted fund management, release-of-restriction documentation, and functional expense allocation. Bookkeepers who maintain audit-ready records throughout the year spend far less time preparing for fieldwork than those who reconstruct documentation when the auditors arrive. The most common nonprofit audit findings trace directly to fund accounting gaps.
The audit preparation paradox
The bookkeepers who spend the least time on audit preparation are the ones who maintained audit-ready records throughout the year. The ones who spend the most are the ones who relied on procedures they couldn’t verify until auditors asked.
This is the core argument for system controls over manual controls in nonprofit accounting. If fund assignment is enforced by the software, you don’t spend fieldwork prep time hunting unclassified transactions. If functional expense allocation is maintained at transaction entry, you don’t reconstruct it at year-end. If release-of-restriction entries are documented in the system, the audit trail is already there.
None of this makes audits trivial. It makes preparation proportional to organizational complexity rather than proportional to how manual your processes have been.
What auditors actually test on restricted funds
Understanding the audit program for restricted funds helps you prepare the right documentation.
Existence and completeness of restricted fund balances. Auditors trace the opening balance from the prior year, add contributions received during the year, subtract expenditures, and confirm the ending balance matches your general ledger. Any discrepancy requires explanation.
Restriction documentation. For each material restricted fund, auditors request the grant agreement or donor letter establishing the restriction. They confirm that the use of funds matches the stated restriction.
Release-of-restriction appropriateness. For each release entry, auditors confirm that the restriction was actually satisfied before the release was posted. A release posted before the program was completed or before the time period expired is a finding.
Expense eligibility. Auditors sample expenses charged to restricted grants and verify: (1) the expense was incurred within the budget period; (2) the expense type is permitted under the grant agreement; (3) the expense amount is supported by vendor invoices or payroll records.
Negative balances. Any restricted fund with a negative balance at any point during the year is tested. Auditors want to know whether an overspend occurred and how it was resolved.
The four material weakness domains auditors find most often
Research analyzing over 24,000 nonprofit audit engagements identified four recurring domains where material weaknesses concentrate. Understanding them helps bookkeepers know where to focus preparation.
Deficient board oversight. Boards that do not independently review financial statements, lack an audit committee, or rubber-stamp management recommendations cannot catch errors or misconduct before they become audit findings. Auditors look for signed minutes, evidence of substantive financial review, and a board that can articulate what they reviewed.
Commingled funds. Restricted and unrestricted balances that share a single ledger account (without sub-ledger or fund-level tracking) cannot be audited cleanly. Auditors test the restriction trail for every material restricted balance. A system that does not maintain fund-level separation produces findings by design.
Inadequate documentation. “If it isn’t documented, it didn’t happen” is the operating rule in audits. Eligibility verification for program participants, payroll allocations to grant-funded positions, and expense approvals for items charged to restricted funds all require documentation that survives beyond the memory of the person who made the decision.
Segregation of duties failures. A single person who authorizes payments, enters them into the accounting system, and reconciles the bank account has unchecked control over the organization’s assets. Full segregation requires three people minimum. Where that is not feasible, compensating controls must be documented and demonstrably operating.
What happens when findings go unresolved: the Aspira case
Audit findings that repeat without remediation signal systemic control failures, and grantors and regulators treat them as such. In Pennsylvania, Aspira-managed charter schools accumulated material weaknesses over multiple audit cycles. Management fees charged to the schools increased approximately 80% in a single year, reaching $13 million. The schools collectively ran $4.7 million in net deficits, and current ratios dropped to 0.2 — a level that indicates an organization cannot meet short-term obligations. Persistent findings and the absence of independent financial oversight allowed the conditions to develop over time without board intervention.
The lesson for bookkeepers is procedural: every finding in the management letter should generate a written remediation plan with a responsible party and a deadline. That plan should be reviewed by the board and referenced at the next audit. Auditors note whether prior-year findings were addressed.
How to document compensating controls
Most small nonprofits cannot fully segregate accounting duties. One bookkeeper does most of the accounting work. That’s a reality, not a failure.
Auditors understand this. What they look for is evidence that someone independent reviews the work — the executive director, the board treasurer, or a board finance committee.
Compensating controls that auditors consider meaningful:
- Board treasurer reviews and approves monthly bank reconciliations
- Executive director reviews and approves all journal entries over a threshold
- Board finance committee receives and reviews fund-level financial statements monthly
- Board approves the annual audit and reviews the management letter
These controls don’t eliminate the segregation of duties gap, but they demonstrate that the organization has oversight processes that catch errors the bookkeeper might miss. Document these controls in your internal control policy and make sure the documentation matches the actual practice — auditors will ask whether the controls operate as described.
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See plans & pricing- Prepared by Client (PBC) list
- The list of documents and schedules the audit firm requires your organization to prepare before and during audit fieldwork. Receiving and reviewing the PBC list early is the most important step in audit preparation. Each item should be assigned to a staff member with a due date.
DEFINITION
- Management letter
- The written communication from auditors to management and the board that describes internal control deficiencies noted during the audit. Findings are classified as material weaknesses (most severe), significant deficiencies (moderate), or other matters. Management letters often include recommendations for control improvements.
DEFINITION
- Segregation of duties
- The internal control practice of assigning different accounting functions to different staff: the person who authorizes transactions is different from the person who records them, who is different from the person who reconciles the accounts. Full segregation is often impractical for small nonprofits. Compensating controls (board review of bank statements, executive director approval of journal entries) partially address the gap.
DEFINITION
- Audit journal entries
- Adjusting entries proposed by auditors during fieldwork to correct errors or reclassifications found during testing. These entries must be reviewed and approved by management before being posted. Material audit journal entries may require restatement of previously issued financial statements.
DEFINITION
Q&A
How does fund accounting software affect nonprofit audit preparation?
Fund accounting software that enforces mandatory fund assignments eliminates one major category of audit findings — transactions without fund assignments. Software that maintains documented release-of-restriction entries provides the audit trail auditors request. Software that tracks functional expense allocation throughout the year produces Part IX data directly from accounting records rather than year-end reconstruction. Research covering over 24,000 nonprofit audit engagements found internal control deficiencies in 19% of audits; fund assignment and documentation gaps account for a large share of those findings. The practical effect of system-enforced controls is fewer hours of fieldwork prep and a lower risk of material findings.
Q&A
What should a nonprofit bookkeeper do if an auditor identifies a restricted fund balance error?
First, understand the nature of the error: is it a coding mistake (wrong fund), an unposted release-of-restriction, or an actual overspend? Coding errors can be corrected with a journal entry; document the correction and the approval. Actual overspends require identifying which unrestricted funds covered the shortfall and whether the restriction was violated. Document everything. If the overspend violated a grant restriction, the executive director and board must be notified — it may require a grantor conversation.
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