January 22, 2020

How to Prepare For A Financial Audit

It’s important to note that IRS audits aren’t the only type of business audit. In fact, there are several reasons you may need or even want to have a financial audit done. In addition, there are actually four types of IRS audits, a correspondence audit, an office audit, a field audit, and a random review. A field audit is by far the most serious, so we'll focus on how you can prepare for them in this post. 

Financial Audits Are Scary

Reviewing a financial audit checklist is overwhelming for anyone who’s not an audit specialist. Fortunately, like most overwhelming things, preparation and financial education can put you at ease.  Usually, an office or correspondence IRS audit will be resolved in one day. Generally, you’ll just have to pay or receive money to correct an error. In a correspondence audit, the IRS will ask you to mail them the financial information needed. An office audit is necessary when the IRS needs you to come in and answer questions. Again, these usually aren’t serious. The field audit is when the IRS comes to your office to verify that your business and expenses are legitimate. Even if everything’s in order, a government official poking around in your workplace is unnerving to say the least. The good news is, with healthy financial reporting and accounting habits, the audit procedures won't seem so scary. In fact, preparing for a financial statement audit can be a great opportunity to discover areas of improvement in your accounting and reporting systems. In the following section, we’ll discuss the accounting standards you should follow so you’re prepared for a financial audit.

How To Prepare For A Financial Audit

If your books are organized, you’ll need to coordinate with your auditor and compile your documents. Also, you should do an extra internal review of your books, including a financial statement audit, well ahead of your IRS audit to identify any issues. How long your internal review will take depends on how organized your business’s financial records. In the following paragraphs, we’ll outline what should be included in your internal review before an audit. Keep in mind that this list isn’t exhaustive and it’s a good idea to talk to a professional before undergoing an audit.

1. Align Reporting With Accounting

It’s not uncommon for a financial report to be inconsistent with accounting records. On a small scale, and in any other context but an audit, this generally isn't a big problem. However, it’s important to have everything as organized as possible for an audit. Generally, the more organized your books are, the easier it is for the auditor to do their job.  This is good for you because it means your audit report will be over faster, so you can get back to work. Plus, the auditor won’t have to do as much digging around in your private records.

2. Ensure Records Remain Organized

When you’re facing a financial audit, your single greatest asset is good organization. By having all your ducks in a row, you speed up the process significantly. That means less time wasted on the audit for you and an easier job for the auditor. Not to mention, if you’re more organized, you avoid forcing auditors to review more of your private information.  After all, if they can’t find the documents they need, they’ll go wherever they must to find the information they need. Worse, if you don’t have the information the IRS needs, you leave it up to them to decide what to believe. Ensure Things Remain Organized

3. Keep Digital Records Of Everything

The absence of records can cause serious problems for you in the IRS audit process. If you’re being audited, your books are probably not in the best shape. However, you should still be able to trace your records back to put most of the pieces of the puzzle back together.  One way to ensure that you have the bare minimum information you need is to keep digital records of everything. That means saving emails with transaction information, digitizing contracts, and more. Keeping everything digitized will make it possible to reconstruct the financial statements that your business should have.

4. Checking On Fixed Assets

In an IRS field audit, your fixed assets, and how they’re accounted for, will be looked at. Due to the blurred lines between expensing and capitalizing fixed assets, understanding your fixed assets is a priority for auditor reports. This is why it’s important to include fixed assets in your own internal audit. To avoid running afoul of IRS rules, you should review generally accepted accounting principles, as they relate to fixed assets. If you’re not a tax expert, it’s best to engage with a professional to do this.  By working with an expert, you can identify potentially problematic accounting procedures for your fixed assets.

5. Factoring in Deferred Rent

It’s become common for lessors to offer a period of free rent before starting to charge. In accounting and tax terms, the rent-free period is treated as what’s called deferred rent.  The way you expense lease costs will depend in part based on whether or not you entered a lease with deferred rent. So it’s important to factor this in when you’re organizing your books. To be clear, there’s nothing wrong with deferred rent. It’s just important to know that the accounting implications of deferred rent can get complicated. Work with an audit specialist to make sure you’re factoring in deferred rent.

6. Employee Paid Time Off (PTO)

Not all employee PTO is treated the same under the tax law. Standard PTO policies pay out when the employee takes time off, which is when the expense for PTO is taken as well. However, PTO policies often vary away from the standard. When they do, the proper accounting for PTO gets more complicated. This can lead to mistakes in accounting and underpayment of taxes. The more proactive you can be about fixing things like this, the better off you’ll be if you face an IRS audit. Check with a tax professional to ensure your accounting on PTO is all above board.

7. Close Your Books Monthly

As we’ve said, preparing for a financial audit is really about having good accounting habits. One of those habits is to close your books monthly. What this means is that, on the last day of your business month, you reconcile all your financial records. That means going through your transaction journal and attribute the amounts to the appropriate accounts. These are the records you use to create important financial statements like your balance sheet, income statement, and cash flow statement. These are also the records an auditor will be looking at, which is what makes closing the books so important.

8. Audit Your Team Regularly

The best athletes in the world practice by recreating the reality and pressure of competition. By doing so, they become comfortable competing, even under immense pressure. With a financial audit, the pressure itself is perhaps the hardest thing to deal with. However, by recreating that pressure and conducting stringent internal audits, an external audit becomes routine. Just remember that it’s important to not just go through the motions. When you find problems, create solutions that get implemented. Over time, your internal audits will get more and more effective and ingrained in your company culture.

Conclusion: Conquer The Financial Audit Process

We’ve demonized the audit process in popular culture. Yet, while it’s far from a cakewalk, an audit doesn’t have to be all that bad. That is, of course, only true if you’re prepared. Fortunately, now that you’ve read this post, you’re one step closer to conquering the financial audit process. If you’re facing an audit now, make sure you take it seriously. In fact, if you don’t have the time, expertise, or resources to prepare, you should hire a certified public accountant to help. If you’re not facing an audit, start incorporating good accounting habits into your organization now. It’ll more than pay for itself.  We make it easy to grow your business with our educational newsletters, so sign up today! [cta-newsletter]