Everything You Need to Know

About Church Audits (almost!)

Verne Hargrave MBA, CPA, CFE PSK LLP

3001 Medlin Drive Arlington, Texas (817) 664-3000

verne@pskcpa.com

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Table of Contents

Page What is an audit? 1 Audits come in all shapes and sizes! 1 What is a financial audit? 2 What will the auditors do to me? 3 What should you expect to receive from your auditor? 4 Why do my auditors’ statements look nothing like mine? 5 What are the benefits of a financial audit? 7 How do I know if I need an audit? 8 What’s the cost? 9 Are there any alternatives to a certified audit? 10 Appendix A – Sample Audited Financial Statements Appendix B – Sample Management Letter Appendix C – Sample Accountants’ Review Report

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What is an audit?

“An audit is an evaluation of an organization, system, process, project or product. It is performed by a competent, independent, objective, and unbiased person or persons, known as auditors. The purpose is to verify that the subject of the audit was completed or operates according to approved and accepted standards, statutes, regulations, or practices. It also evaluates controls to determine if conformance will continue, and recommends necessary changes in policies, procedures or controls”. AUDIT. (2006, MAY 25). IN WIKIPEDIA, THE FREE ENCYCLOPEDIA. RETRIEVED 19:30, JUNE 7, 2006, FROM

HTTP://EN.WIKIPEDIA.ORG/W/INDEX.PHP?TITLE=AUDIT&OLDID=55075337.

Audits come in all shapes and sizes!

IRS audits

Sales tax audits

Workers’ comp audits

Insurance audits

Energy usage audits

Environmental audits

Computer security audits

Internal audits

Performance audits

Fraud audits

Financial (Certified) audits

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What is a financial audit? A financial audit is an examination of an organization’s accounting records by an independent certified public accountant. The objective of an audit is to express an opinion on the fairness with which the financial statements present financial position, results of operations, and cash flows in accordance with generally accepted accounting principles (GAAP). Generally Accepted Accounting Principles:

Are the accepted body of accounting rules and policies established by the accounting profession

The purpose of GAAP is to promote consistency and fairness in financial reporting throughout the business community

GAAP also serves as a basis for providing comparability of financial information

The auditor must obtain reasonable assurance about whether the financial statements are free of material misstatement as a result of:

Errors

Fraud

Illegal acts

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What will the auditors do to me?

Through inquiries and questionnaires obtain an understanding of the church’s internal accounting control and processes

Through inquiries, questionnaires and tests of transactions the auditors will gain reasonable, but not absolute, assurance of the absence of fraud

Conduct tests of material “balance sheet” accounts to substantiate existence and accuracy of amount. In a church audit particular attention will be given to:

Cash accounts and bank reconciliation procedures Fixed assets and depreciation Accounts payable Notes, bonds and capital leases payable Net asset accounts, unrestricted, temporarily restricted and permanently restricted

Conduct tests of material “income statement” accounts to substantiate the legitimacy of the transactions. Specifically:

Tithes and offerings will be tested extensively to determine completeness and the presence of restrictions As the single largest expenditure of a church is generally personnel costs, extensive testing will be performed on salary amounts, housing allowance resolutions, benefits paid, accountable expense reimbursements, etc. A detailed analysis of cash disbursements will be performed including a computer sorting of transactions, followed by the selection of a sample of checks to be examined for accuracy, legitimacy and conformity to the church’s exempt purpose. Various analytical and statistical tests will be performed on the financial data to detect trends or other anomalies.

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What should you expect to receive from your auditors? A financial audit culminates in:

An opinion letter

A statement of financial position

A statement of activities

A statement of cash flows

Footnote disclosures

A management letter (Church specific)

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Why Do My Auditors’ Statements Look Nothing Like Mine?

Most church and ministry audits, even the best run organizations, require several large adjusting journal entries:

Causes some on finance committees or boards of directors to be alarmed and ask “Why?”

These “ajes” do not necessarily mean things are a mess!

There are two answers to the “Why?” question First, changes are needed because the users of a church’s internal statements are not the same as the users of its audited financial statements:

The monthly reports are directed to the church or ministry.

Audited financial statements are directed to the public

Internal reports are concerned with operational matters

Audited reports are concerned with economic condition, economic performance and comparability

Second, audited statements are required to follow prescribed rules such as:

Contribution reporting o Unrestricted o Temporarily restricted o Permanently restricted

Financial statement presentation for non-profit organizations o Statement of Financial Position o Statement of Activities (On a program basis) o Statement of Cash Flows

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Changes required in converting a ministry’s internal reports to audited financial statements:

Fixed assets included in expense line items in the budget and not capitalized

Loan principal payments included in expense line items in the budget

Fixed asset and loan principal payments included in temporarily restricted accounts

Church reserved funds intermingled among temporarily restricted accounts

Depreciation expense has to be recorded

Accounts payable and accrued expenses have to be added (Audited financial statements must be in accordance with generally accepted accounting principles (GAAP) which require the full accrual method of accounting)

Transfers among accounts and funds must be eliminated

Expenses classified directly to equity accounts must be reclassified

In certain cases pledges must be recorded as income when the pledge is received

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What are the benefits of a financial audit?

An audit gives a measure of comfort to the congregation when they realize the staff, finance committee, etc. are willing to let outsiders come in and inspect the books and records

An audit forces an annual clean-up of the books and records

An audit performed by a CPA firm that is familiar with churches assists the church in staying up-to-date on tax, accounting and some legal issues that affect churches

While not the overriding reason for conducting an audit, the certified audit may turn up fraudulent activity within the church

An annual audit will produce a management letter detailing areas of weakness in the accounting and management systems of the church and suggestions for improvements

An auditor can become a sounding board throughout the year for problems that may arise.

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How do I know if I need an audit? Many, if not most, churches do not have and may not need an annual audit. Before plunging into a costly and “life-altering” audit a church should assess its situation to see if an audit is even necessary. Some situations that require an audit are:

By-laws requirements

Denominational requirements

Loan covenants

Grants While not on the same level as the requirements above some circumstances dictate that a church should engage in an independent financial audit

In anticipation of a new building/fundraising campaign

When the church reaches a size that it has become a significant participant in the business community.

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What’s the cost? Audit cost is a function of several things:

Dollar amount of the budget Number of transactions Complexity of the accounts (i.e. numerous designated or special accounts) Geographic location Condition of the books and records

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Are there any alternatives to a certified audit?

Reviewed financial statements – A review engagement is less extensive in scope than an audit but does result in a set of financial statements and footnote disclosures. In place of an “Independent Auditors’ Report” the client receives an “Accountant’s Review Report” which provides limited assurance to the financial statements

Consulting or Agreed-Upon-Procedures engagement – If no certified audit is required and the church has concerns about certain aspects of their operations they can engage the accounting firm to address those specific areas

Fraud audit – If there are concerns of wrongdoing the best and most effective engagement is to conduct tests to determine the existence and extent of possible malfeasance