Do you prepare internal financial statements for your board of directors on a monthly, quarterly or other periodic basis? Later, at year end, do your auditors always propose adjustments? What’s going on? Most likely, the differences are due to cash basis vs. accrual basis financial statements, as well as reasonable estimates proposed by your auditors during the year-end audit.

Simplicity of Cash
Under cash basis accounting, you recognize income when you receive payments and you recognize expenses when you pay them. The cash “ins” and “outs” are totaled by your accounting software to produce the internal financial statements and trial balance you use to prepare periodic statements. Cash basis financial statements are useful because they’re quick and easy to prepare and they can alert you to any immediate cash flow problems.

The simplicity of this accounting method comes at a price, however: Accounts receivable (income you’re owed but haven’t yet received, such as pledges) and accounts payable and accrued expenses (expenses you’ve incurred but haven’t yet paid) don’t exist.

Value of Accruals
With accrual accounting, accounts receivable, accounts payable and other accrued expenses are recognized, allowing your financial statements to be a truer picture of your organization at any point in time. If a donor pledges money to you this fiscal year, you recognize it when it is pledged rather than waiting until you receive the money.

Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting and recognition of contributions as income when promised. Often, year-end audited financial statements are prepared on the GAAP basis.

Need for Estimates
Internal and year-end statements also may differ because your auditors proposed adjusting certain entries for reasonable estimates. This could include a reserve for accounts receivable that may be ultimately uncollectible.

Another common estimate is for litigation settlement. Your organization may be the party or counterparty to a lawsuit for which there is a reasonable estimate of the amount to be received or paid.

Minimizing Differences
Ultimately, you want to try to minimize the differences between internal and year-end audited financial statements, which can be helped by, for example, maximizing your accounting software’s capabilities and improving the accuracy of estimates.

Annual financial statements that have been audited by a professional auditor can help assure funders and lenders that your not-for-profit is financially sound. Here are three critical audit issues to understand when preparing financial statements:

1. The auditor’s role

Auditors are responsible for expressing an opinion on financial statements. Beyond that, they’re responsible for obtaining reasonable assurance that financial statements are free of material misstatements — be it from error or fraud.

Your nonprofit and its advisors, on the other hand, are responsible for developing estimates adopting sound accounting policies and establishing, maintaining and monitoring internal controls. Although your auditor may make suggestions about these items, it isn’t his or her responsibility to institute them or to ensure they’re working properly. While management is strictly responsible for decision making, your auditor is required to evaluate whether internal controls, accounting policies, and estimates are adequate to prevent or detect errors or fraud that could result in material misstatements of the financial statements.

2. The board’s role

Sometimes a nonprofit board of directors’ role is overlooked in annual financial statement preparation, and that’s a mistake. Keep in mind that your board generally has a strategic and oversight role in the process, which is part of its overall fiduciary duty. Your board isn’t responsible for completing the job. However, board members can be a good resource for certain technical matters, depending on their professional background.

3. Financial analysis

Annual financial statements are designed to help you manage your organization. Financial statement metrics — such as debt ratios, program vs. administrative expense ratios and restricted vs. unrestricted resources — can be calculated to indicate how your organization is doing.

One of the best ways to see the big financial picture is to compare your budget, year-end internally generated financial statements and statements generated during the annual audit. This task can be completed more easily if the format of your audited statements is similar to that of your internal financial statements and budgets.

When reviewing internal vs. audited statements, look for large differences in individual accounts resulting from audit correcting adjustments. These can indicate an internal accounting deficiency. You’ll also be able to spot any significant discrepancies between what was budgeted for the year and the actual outcome.

Audited results demonstrate professionalism and provide assurance that your results are free from errors and fraud. For help preparing financial statements, contact us.