Audit. When you hear that five-letter word, do you get anxious? Although it may seem that your company doesn’t require an audit, they aren’t always a bad idea. Frequent audits don’t always mean you’ll face IRS fines—rather, they can be more like a regular maintenance check.

Find out more about audits, including their definition, types, and potential benefits for your company.

What is Auditing?

An audit examines your business’s financial records to verify they are accurate. This is done through a systematic review of your transactions. Audits look at things like your financial statements and accounting books for small businesses. Many businesses have routine audits once per year.

As a small business owner, you are responsible for maintaining clear accounting books that show your business’s income and expenses. If your records are disorganized or missing, audits will be especially drawn out and difficult.

Audits can help you spot problems within your business. They can find errors in your numbers, which can help you with decision-making. In the long term, a company audit can help you get your small business on track and boost your business’s bottom line.

When your small business is audited, you will generally receive an audit report. Auditors write audit reports to detail what they found during the process. The report states whether your records are accurate, missing, or inaccurate.

Types of Audits

Because different parties can audit a business, several types of audits can occur. Nine different types of audit include:

1. Internal audit: Someone in your business may conduct an audit to monitor process effectiveness, make sure you comply with laws, and evaluate risk management.
2. External audit: An accountant or other third party may audit your business for reporting accuracy. The auditor follows generally accepted auditing standards (GAAS).
3. IRS tax audit: The IRS audits your business to assess the accuracy of your business tax returns.
4. Financial audit: Generally, an external auditor analyzes your business’s financial statements for accuracy and releases an audit opinion to lenders, creditors, and investors.
5. Operational audit: Like in internal audits, this audit analyzes a business’s operations, goals, and results to look for areas of improvement. 
6. Compliance audit: An auditor examines your business’s policies and procedures to ensure they’re compliant (e.g., workers’ compensation compliance).
7. Information system audit: Software and IT companies may undergo an information system audit to ensure software development, data processing, and computer systems are running smoothly.
8. Payroll audit: An auditor (typically internal) analyzes your company’s payroll process to make sure there are no errors in your payroll process, like miscalculations. 
9. Pay audit: Not to be confused with payroll audit, a pay audit helps you identify pay discrepancies among employees. 

Some of the types of audits are internal, external, or both. The ones that you can do internally (e.g., internal audit, pay audit, etc.) are the ones you should know how to conduct. Of course, you can learn what happens when you get audited by the IRS for your own knowledge, too!

Read Also: How to Get a Mortgage in Your Business Name

Sure, conducting an audit can seem overwhelming. After all, it can be a lengthy process (sometimes lasting up to several months). But, regular audits are key to a healthy business. So before diving into the internal audit process, let’s review why you should conduct one. 

Conducting an audit can help you:

• Check for accuracy in your business finances or processes 
• Find errors in your books, processes, payroll, or pay rates
• Prevent IRS audits by helping you avoid incorrect reporting on tax returns 
• Implement new accounting or business processes
• Make more informed business decisions based on accurate information
• Ensure your business is compliant (e.g., payroll tax rules)

And, here’s another bit of good news: The more organized your business is and the more audits you conduct, the less time each may take.  

How to Prepare for a Business Audit

What to Do Before Your Audit

If you go it alone, before meeting the auditor, you should thoroughly review the tax returns being audited. Be ready to explain how you, or your tax return preparer, came up with the figures. If you can’t, then contact your tax preparer or another tax pro.

Find all records that substantiate your tax return. As discussed, the IRS has a right to look at any records used to prepare your tax return. Organize your records for the auditor in a logical fashion. Your pre-audit organization of receipts, checks, and other items will refresh your recollection for the audit meeting.

Neatness counts. Forget about dumping a pile of receipts before an auditor and telling him or her to go at it. Messy records mean more digging — and more digging, to the IRS, means more gold for them. Conversely, auditors frequently reward good recordkeepers by giving these folks the benefit of the doubt if any problems arise. Neatness builds your credibility with the auditor. Tidiness and order appeal to an accountant’s mentality, and most auditors are accountants.

Pinpoint problems backing up income sources or expense deductions. You’ll need to be able to show your right to take tax deductions or other tax benefits claimed on your return. Research tax law, if necessary.

What to Bring to an Audit of Your Small Business

Audit success means documenting your expenses. Proof should be in writing, though auditors are allowed to accept oral explanations. A list of items the auditor wants to see usually accompanies your audit notice.

At a minimum, the IRS will expect you to produce the following documents:

Bank statements, canceled checks, and receipts. The auditor will want to see bank records from all of your accounts, both personal and business. As a rule, don’t discard any business-related canceled checks, invoices, or sales slips. If you paid some expenses with cash, keep the paperwork (handwritten notes, notebooks, receipts, or petty cash vouchers) showing the payments.

Electronic records. Most banks don’t return canceled checks anymore, and many business expenses are charged on credit or debit cards. Bank and charge card (Visa, MasterCard, American Express) statements are accepted by the IRS as proof of payment. They must show the name, the date, the amount, and the address of the payee.

Because charges and statements don’t always show the business nature of the expense, you can’t rely on them as your only records.

Books and records. The auditor will ask to see your books. The tax code doesn’t require small businesses to keep a formal set of books; don’t let an auditor tell you otherwise. If you keep records with only a checkbook and cash register tapes, so be it. If you maintain more formal records such as ledgers and journals, the auditor is entitled to see them. If your data is on a computer, the auditor will want to see a printout.

Don’t make the IRS guess. If you don’t produce adequate records, the auditor can estimate your income and/or expenses and impose a separate penalty for your failure to keep records.

Appointment books, logs, and diaries. Businesses that offer services typically track activities and expenses using calendars, business diaries, appointment books, and logs. An entry in a business diary helps justify an expense to an auditor as long as it appears to be reasonable.

Records for certain equipment. Additionally, you must keep special records for certain equipment, called listed property, that is often used for both business and personal purposes. (IRC § 280F.) Cell phones and vehicles used for both business and pleasure are designated as listed property.

Purely business equipment is not in this category. For example, mechanic’s tools, a lathe, or a carpet loom are purely business tools, and no records of usage are required. But when assets are put to both business and personal use, the auditor can demand records of usage. For example, if you use a car for business and personal use, keep track of the business portion. There are apps or you can keep paper records.

If you haven’t kept usage records of listed properties, reconstruct them by memory or reference to projects that you worked on during the year.

Auto records. A vehicle can be listed as property if it’s used for personal purposes as well as business. So business use of your personal auto requires detailed records showing the work use portion. Here are some ways to do this:

• A log is the best way to keep track (and it’s easy to keep a little notebook in the glove compartment), although it’s not required by the tax code.
• Alternatively, you can keep all gas and repair receipts in an orderly fashion, with notations of trips showing how the car was used for business.
• A less accurate way to keep records is to add up the gas bills and divide by the number of miles per gallon that your car averages. Show the auditor your auto trip receipts and explain how they link up to sales trips by your business diary or calendar notations.

Travel and business-related meals. By law, out-of-town business travel requires greater record-keeping than most other expenses. You must have a written record of the specific business purpose of the travel and the costs incurred, as well as receipts. (IRC § 267.)

A good way to document travel expenses is with an appointment book or log, noting each time you incur a business expense, and the reason. Most people aren’t disciplined enough to write down every expense as it is incurred. It is okay to put together a log or diary after you have received an audit notice. But be up-front about it — don’t insult the auditor’s intelligence by trying to pass off wet-inked paper as an old record. Remember, it’s key to develop and maintain credibility with the auditor.

For business-related meals where you take a client or prospective client out to discuss business, you must have records showing the date of the meal, the cost (including tax and tip), the place of the meal, and the business relationship of the person you ate with. You don’t need an actual receipt if the cost of the meal is less than $75.

• Example 1:

Bianca, a self-employed designer, reconstructs a calendar book with the date and the following notation: “Round-trip cab fare to the office of John Johnson, prospective client, $24 (no receipt). Lunch at Circle Restaurant: Discuss proposal to decorate new offices at 333 Pine Street, $32 (Visa charge) plus cash tip of $6 (no receipt).” Bianca can also give the auditor details if asked. The auditor will probably be satisfied if it appears reasonable.

• Example 2:

Sam, the owner of a computer store went to an out-of-town computer retailers’ convention. He spent $1,800 and claimed it as business travel expenses on his tax return. On audit, Sam produces charge card statements to prove the $1,800 was spent for hotels, meals, and convention registration. The auditor wants more and asks Sam to justify the business purpose of this trip. Sam produces an ad for the convention, an agenda of events, and notes he took at programs. If it looks legitimate, and Sam’s explanation of why it was important for him to be there is convincing, the auditor should allow the deduction in full.

Expenses for renting or buying property. To prove business rental expenses, bring in a copy of your lease. If you purchased the property or equipment, have the purchase contract. This establishes grounds for claiming these expenses as well as a beginning tax basis of the property if you claim depreciation expenses.

Benefits of a Business Audit

There are many advantages of having an external or internal company audit.

The main function of an audit is to check for accuracy. As a result, an audit can help you find errors in your accounting books or processes. An audit might be able to spot a small mistake before it grows into a big one. And, non-IRS audits can catch errors before you file your business tax return, helping prevent IRS audits.

Audits can also motivate you to implement new accounting processes. If your auditor isn’t able to get a clear view of your records, they can help you improve records for the next audit. You can learn how to use accounting software to prevent disorganized and incomplete records.

Many business owners rely on financial statements to guide their business decisions. But, what if the number used to create the reports is incorrect? By verifying the accuracy of your financial records and finding errors, an audit can help straighten out your finances so you can make wise business decisions.

Embracing audits and recognizing their role in your business’s success might help prevent your heart from skipping a beat the next time one comes up.