A financial audit (for all organizations with annual revenue over $500K) and memorandum on internal controls—more familiarly known as the management letter—should be available by request from the organization.
It may be helpful to request management letters over several years in order to evaluate whether the organization struggles with the same issues year after year.
The financial audit can be considered a “triage tool” that will help you to assess the organization’s financial security based on its cash situation. The audit includes footnotes prepared by the auditor to help the reader interpret the balance sheet, income statement, and cash flow statement. The footnotes pertain to significant accounting policies and often help to explain issues such as in-kind donations, the relative liquidity of assets, etc. (For example, a food bank may appear to have $3.5 million in revenue, when $3 million of that consists of in-kind food donations that cannot be used to support the organization’s infrastructure.)
An organization will receive a management letter if the auditor has comments for the board or financial management team. It is common for nonprofits to receive at least one comment. The comments are classified as “deficiency,” “serious deficiency,” and “material weakness,” and will give you a sense of the areas in which the organization can improve.
- “Deficiency” generally indicates that the organization has made minor mistakes in its financial processes. These comments signal areas for improvement or issues where the auditor has identified potential for error, even if no errors have occurred yet.
- “Significant deficiency” generally indicates that the organization has made more serious errors or has received more than one comment. It is important to note that the auditor has the right to increase all “deficiency” ratings to “significant deficiency” if the organization receives more than one comment of any kind. By asking neutral questions of the organization, try to understand if the comments add up to a larger issue with the organization, or if they note problems that are not related to each other.
- “Material weakness” generally indicates that the organization lacks financial capabilities. These comments are sometimes noted if an organization has to issue a restatement for an accounting error made in a previous year. A “material weakness” is a significant problem and it would be worth engaging the organization in an extensive discussion.