What Is an Audit?

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Staff Writer - Angela
October 24, 2018

What is an audit? 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

Instead of asking what is an audit, it may be better to ask why. 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.

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?

What is an audit and what happens during it? 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 You’re Being Audited by the IRS

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. The IRS may go back further if your audit involves understatement of income or fraud.

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.

Avoiding an IRS Audit

Certain red flags on your tax return may increase your risk of an audit. These include:

  • Submitting credit card statements for expenses in lieu of receipts.
  • Significant charitable contributions, especially noncash donations.
  • 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 income and reported income.
  • 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.

Most people who get audited do end up paying additional taxes. 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.

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