What Is an Audit?

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Andrea Miller
Andrea Miller
October 24, 2018

  • An audit is an examination of financial records to make sure they are accurate and follow best practices, including an IRS audit.
  • During the audit, a certified public accountant (CPA) will review records to detect errors or fraud while following established auditing standards of the profession.
  • You have the right to have professional representation if you are being audited by the IRS. 

Although the term audit is most often used when referring to the IRS, in more basic terms, an audit is the process of examining the financial records of a person or business to make sure they are accurate and in accordance with industry best practices.

A company may employ internal auditors who are responsible to make recommendations for streamlining systems and improving operations and controls based on their findings. External auditors provide an independent opinion about the accuracy of a business’s financial records. Publicly traded companies must be externally audited for the benefit of their shareholders.

Purpose of an Audit

An audit is designed to provide reasonable assurance that a business’s financial records are free of material misstatement, which is inaccurate information that could mislead an individual using the records in question to make a financial decision. During an audit, the auditor will look for ways to enhance internal controls and will assess the risk of fraud.

What Is an Audit?

Most companies have an audit at least once a year, though large companies may undergo a monthly audit. In addition, an audit is necessary when a company is planning a merger or a sale, seeking outside investors, or applying for a large loan or a credit line.

Auditing Standards

  • The Public Company Accounting Oversight Board (PCAOB) maintains and administers external auditing standards for public companies. Their 15 permanent standards have been approved by the Securities and Exchange Commission (SEC). Additional interim standards are designed to comply with the generally accepted auditing standards of the American Institute of CPAs (AICPA) Auditing Standards Board (ASB).
  • The ASB standards are designed for CPAs who are auditing companies that aren’t legally required to undergo an external audit. These guidelines include more than 60 active standards and are mandatory as part of the AICPA Code of Professional Conduct for members.
  • Internal audits are governed by the International Professional Practices Framework (IPPF), which the Institute of Internal Auditors established.

What Happens During an Audit?

The CPA conducting the audit will examine the business’s financial records to look for potential inaccuracies. In addition to direct examination, he or she may gather information through interviews, observation, inquiry, third-party information, and financial analysis.

Misstatements the CPA finds can be the result of either error or fraud. Usually, fraudulent misstatements are more difficult to detect because steps have been taken to cover them, including but not limited to forgery, collusion, or failure to record transactions.

After your business is audited, you’ll receive a formal report that provides the CPA’s independent opinion about whether its financial records are free of material misstatement. He or she will also indicate areas in which internal controls should be strengthened.

What to Do if the IRS Is Auditing You

Keep in mind that your chances of being audited are relatively low. The Wall Street Journal reported in 2017 that audits had declined for the sixth consecutive year. Americans have about a one in 160 chance of being audited by the IRS, compared to one in 90 odds in 2010.

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Although the IRS audits fewer than 1% of tax returns each year, some individual taxpayers will inevitably receive an audit notice. Keep in mind that you will receive an audit notice only in writing through postal mail, not in an email or over the phone. Although you may receive an adjustment notice from the IRS indicating you owe more taxes or are receiving a refund because of an error, this does not mean you are being audited.

If you do receive an audit notice, you should engage the services of a CPA or tax attorney who is certified as an enrolled agent (EA), which means he or she is eligible to represent you before the IRS. If you used tax preparation software to do your taxes yourself, you may be covered by an audit protection guarantee. This could include representation before the IRS or guidance about the correspondence you receive regarding the audit.

When you have a professional lined up to represent you during the audit, sign a power of attorney, so he or she can access the necessary information for the years in question. In most cases, an audit must be completed within three years of the tax filing date, so it’s important to save your tax records for at least that long. In fact, you are legally required to do so. The IRS may go back further if your audit involves understatement of income or fraud. In some cases, electronic documentation may be accepted during an audit.

You may be audited either through correspondence or in person with an IRS representative. In most cases, the process takes at least a few months. You have the right to request a delay while you gather the appropriate documents. Avoid providing tax and financial documents that do not relate directly to the audit.

If you disagree with the results of an audit, you have the right to file an appeal either through the IRS itself or in tax court. Your attorney can advise on which situation is the most advantageous.

Gathering Documents

Respond to the audit notice as quickly as possible, especially if a minor error or missing paperwork triggered the audit. In this case, provide the documentation requested, which may satisfy the IRS and eliminate the need for a full audit. Do not send documentation that does not directly relate to the audit, however. Remember that in about 80% of cases, the return is simply adjusted and errors corrected. This is known as a correspondence audit and does not require you to appear before the IRS.

When you mail documents to the IRS, make sure to request delivery confirmation from the U.S. Postal Service. This will provide a record that the agency received your paperwork. For correspondence audits, the address where you send your documentation will be included on the audit notice.

The notice will also provide instructions about how to organize your documents. Doing so correctly can expedite the audit process. For example, you should organize documents first by year, then by type of income or expense. Some of the documents the IRS might request as part of an audit include:

  • Receipts
  • Bills
  • Divorce settlements
  • Custody agreements
  • Canceled checks
  • Civil or criminal defense paperwork
  • Property acquisition paperwork
  • Tax preparation documents
  • Loan agreements
  • Schedules, diaries, or logs that corroborate travel dates and expenses, expenses associated with job hunting activity, and dates of gambling winnings
  • Travel tickets
  • Lottery tickets
  • Medical or dental records
  • Employment documents
  • Documents detailing insurance claims, loss, or theft
  • Schedule K-1
  • Schedule C questionnaire.

Preparing to Meet With a Tax Professional

If you’ve hired a CPA or tax attorney to represent you before the IRS during audit proceedings, he or she will need all the details of your tax situation. Before your first meeting with this individual, make sure you have gathered:

  • Your IRS audit letter.
  • All attached documentation requests (Form 4564 Information Document Request).
  • Copies of your tax return for the year for which you are being audited and for the two previous years, as well as your most recent tax return if it’s not the audited year.
  • Copies of all documents you provided to the person who prepared your taxes for the year in question.
  • The results of any previous audits if applicable.
  • All IRS notices and letters for the tax year in question..

This will provide your representative with a complete picture of your circumstances for the audit year, which will allow him or her to advocate on your behalf.

Avoiding an IRS Audit

Certain red flags on your tax return may increase your risk of an audit. According to Nerd Wallet, these include:

  • Submitting credit card statements for expenses in lieu of receipts.
  • Significant charitable contributions, especially noncash donations, that represent a disproportionate percentage of your income.
  • Substantial travel expenses.
  • Meal and entertainment expenses without documentation.
  • Claims that your tax records for the year are unavailable (because your hard drive crashed, for example).
  • Discrepancies between W-2 or 1099 income and reported income, which are easier than ever to detect.
  • Auto expenses without receipts.
  • Prevalent round numbers, which indicate you are estimating rather than providing real numbers.

When claiming large deductions, such as if you are affected by a natural disaster, provide as much proof as possible to support your numbers. This should include photos, canceled checks, reports from your insurance company, and repair receipts.

Even if none of these circumstances apply to your tax return, you can still be randomly selected for an audit by the IRS computer system. Receiving an audit notice doesn’t necessarily mean you’ve done anything wrong or that you have cause for concern. High-income households are also more likely to receive an audit notice than lower-income families are. If a business partner or co-investor has been chosen for an audit, you may be required to undergo a related examination.

However, most people who get audited do end up paying additional taxes. In fact, the Tax Foundation reported that the IRS collected an additional $12 billion from audited taxpayers in 2015 alone. You may be able to negotiate with the auditor to make a settlement for this additional amount by paying a lump sum if you can afford to do so. You can also request a payment plan to settle your taxes over time.

Fines Associated With an Audit

In some cases, an IRS audit can result in fines and penalties if you have underpaid your taxes. An erroneous claim that leads to a refund or credit will result in a fine of 20% of the refund or credit amount. If the IRS finds you have filed a frivolous tax return, which means you haven’t provided enough documentation to support the numbers you’ve provided, you could be subject to a penalty of $5,000.

Appealing an Audit Decision

When you disagree with the results of an IRS audit, you have the right to undergo mediation or to file an appeal. Mediation is a confidential but informal process in which an appeals officer who is trained in mediation techniques facilitates an alternative dispute resolution between a taxpayer and the IRS. Although this officer cannot make a decision or force either party to accept a decision, he or she can provide settlement proposals under the Fast Track Settlement Program.

The Fast Track program is available for small-business owners and self-employed individuals. The goal is a resolution of tax disputes within 120 days of initiation. If you disagree with the proposed adjustment after your audit, submit Form 14017, Application for Fast Track Settlement. This does not suspend your right to seek resolution through an appeal or other routes.

When you receive a notice or bill from the IRS that explains your right to an appeal, you can follow the instructions on this correspondence to request an appeal. The appeals system is designed for those who do not agree with an IRS decision and have not signed the form indicating their agreement. If you cannot afford to pay the amount you owe, but you do not have grounds to dispute the amount, you are not eligible for an appeal.

Keep in mind that you have 30 days to appeal from the day you receive the IRS audit decision. You may no longer appeal the decision after 30 days, but you will receive a Statutory Notice of Deficiency at that time. This allows you to petition the U.S. Tax Court if you have a dispute within 90 days. It also includes a statement of your calculated tax liability.

If you agree with this liability, you must sign a waiver to acknowledge the stated amount. The notice will also explain how the adjustment was calculated. The U.S. Tax Court is the only venue in which you can dispute your tax liability without first paying the disputed amount.

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