What Is a Business Audit & How Should You Prepare?

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Audit: This little five-letter word makes business owners across the United States cower in fear, but it doesn’t have to be that way. A business audit is no big deal if you’ve properly maintained your company’s financial records. In fact, there’s a world in which a business audit is a good thing that helps a company measure its financial health and catch errors, fraud, gaps and inefficiencies before there’s a massive problem.

TL;DR (Too Long; Didn't Read)

A business audit is when an individual or organization inspects various records and accounts belonging to a business. Most of the time, this term refers to a financial audit.

What Is an Audit?

In small business, an audit typically refers to a financial audit, which is an examination of a company’s financial statements to make sure they accurately and fairly represent a company’s financial position. There are three main types of business audits: internal audits, external audits and IRS audits. Each one has a different purpose.

Internal Audits

Most people think of the IRS when they hear the term "audit," but that’s just one type of business audit. Some business owners actually perform regular audits on their own small businesses by choice. That’s right: Audits aren’t always a bad, scary thing.

Internal audits happen when a company audits itself, usually to make sure that financial statements and bookkeeping records are accurate. This process basically serves as quality control, and records are not submitted to an outside organization. At a large company, an internal audit is typically done by an audit department, but at a small business, it’s typically done by one or two hires. This type of audit can be beneficial because it:

  • Ensures company policies and procedures are compliant with the law

  • Catches bookkeeping errors

  • Reveals employee theft or fraud

  • Reveals operating inefficiencies (i.e., it can help you make more money in the long run)

  • Makes tax time easier and prepares your company for potential IRS tax audits

  • Boosts investor confidence

  • Detects cybersecurity threats and potential data breaches

Typically, internal audits are done annually.

External Audits (or Independent Audits)

Unlike an internal audit, which a company conducts on itself, an external audit is conducted by someone outside of the company, typically a certified public accountant firm. This is usually done to ensure some sort of legal compliance. For example, a company seeking ISO 900 certification, a public company listed with the Securities and Exchange Commission and a nonprofit that’s spending more than $750,000 of federal funds all must undergo regular external audits. Companies may also be required to have an independent audit by certain business insurers.

Following an audit, external auditors will provide an audit report with one of four varying opinions:

  • Clean opinion: You passed the audit. Everything’s good.

  • Qualified opinion: The external auditor found some discrepancies, but the audit was not extensive enough to make a pass or fail conclusion.

  • Adverse opinion: You failed the audit. The auditor found financial statements that did not match the company’s actual financial position.

  • Disclaimer of opinion: This means the auditor is not giving any opinion on whether you passed or failed the audit. This could be because the auditor lacked access or was missing appropriate financial records and could not complete the audit.

If an audit does not come back with a clean opinion, a company may have to submit more paperwork or amend errors.

IRS Audit

This is what most people think of when they think of small-business audits. This type of audit is conducted by the IRS when they’ve found potential errors in your business’s tax returns. Generally, an IRS agent looks at three years of financial records unless there are egregious errors that require a deeper dive. IRS audits fall under two categories:

  • Correspondence audits: This audit is done through the mail. The IRS will send you an audit notice detailing any possible errors in your tax returns, and you must reply with supporting documentation that hopefully rectifies the errors.

  • Field audits: This type of audit is done at your place of business, a CPA’s office or a local IRS office. During this process, an IRS agent will look through all of your financial records to see if they match your business's tax returns and follow all current tax laws.

Small-business owners should hire a tax attorney, CPA or other tax professional to handle IRS audits. This is not something to take on by yourself.

What Are Auditors Looking For?

Auditors aren’t just looking at your whole financial picture — they’re looking at your lifestyle too. Generally, auditors are trying to determine the whole economic reality of your company (i.e., what is actually happening versus what’s written down on paper). To do this, they ask:

  • Did you report all your income? You’d be shocked at the number of people who forget income because they’re missing certain forms. This is particularly common with independent contractors.

  • Does your bank account activity match your business records? An auditor may look at both personal and business credit card and bank statements to make sure the records match.

  • Does your lifestyle match your reported income? If you drive a Maserati when your single-member LLC showed serious losses, that’s going to raise some eyebrows.

  • Does a lot of cash flow through your business? Cash businesses notoriously (and illegally) pocket money without declaring it because it’s much more difficult to trace. A cash-heavy business can raise red flags.

  • Have you written off personal expenses? Make sure you fully document travel, meals and other business expenses so there’s no question as to what was work or play.

  • Did you file paperwork for the proper business taxes? Some businesses are subject to additional taxes, such as sales taxes and payroll taxes. The IRS may also audit businesses they believe are misclassifying employees as independent contractors.

How to Avoid an Audit

Out of the nearly 154 million tax returns the IRS processes every year, only about 1 million people are audited. Generally, audits are triggered by some sort of mistake on a tax return, so the best way to avoid a potential audit is to make sure you properly file your tax returns. About 21% of paper returns contain errors, but your chance of an error dramatically decreases to 0.5% if you use accounting software and file electronically. To further protect yourself from an audit, you should:

  • Check your numbers: This is a common red flag you can eliminate if you just give your tax return a once-over (or twice-over) before you submit it.

  • Make realistic deductions: Losses for more than three years along with unusual and unrealistic deductions may raise red flags.

  • Don’t make too much or too little: The IRS scrutinizes businesses and individuals that make more than $1 million a year or are in the lowest tax bracket.

  • Be honest: Honesty is always the best policy. 

How to Prepare for an Audit

Different organizations have different audit standards, but you’re always going to need paperwork — and lots of it. The best way to prepare for an audit is to have all of your company's financial statements readily available and completely organized. This includes financial records like bank statements, credit card statements, receipts, invoices, journal entries, ledgers, cash-flow statements, profit-and-loss statements, notes, etc. The more information you provide, the better.

In the event of an external or internal audit, you may also need to provide an operating manual or employee handbook.

What Happens if I Fail?

What happens if you fail an audit depends on the type of audit. For internal and external audits, you’ll probably either have to submit more paperwork or rectify errors in your accounting. An IRS audit is a little trickier. If the IRS believes you’re missing a large amount of unreported income, they may hire a criminal investigation team, but otherwise, you’ll have to pay what you owe plus interest and a 20% penalty.