A small business audit is an examination of a business’s accounting books and tax returns to make sure they are accurate and comply with relevant laws. Many businesses conduct an annual internal audit. An external auditor or IRS auditor might also audit your company.
When most business owners hear the word “audit,” their thoughts automatically jump to the Internal Revenue Service (IRS) auditing their business’s accounting for tax discrepancies. But an IRS tax audit isn’t the only type of audit that your business could face or should be prepared for.
Many businesses, particularly larger firms, conduct internal self-audits every year to ensure the accuracy of their books. External audits might be required if you’re applying for certain business certifications or programs. And yes, if your tax return has discrepancies, the IRS might select you for a tax audit.
In all cases, an audit is simply a quality control measure to ensure the accuracy of your financial records. We’ll cover the different types of small business audits here and explain why audits can be valuable to a company.
Most small business owners are intimidated at the thought of an audit, but an audit can actually help your business to be more productive and plan better for the future.
Here are some benefits of small business audits:
Ultimately, you should think of an audit as a quality control mechanism to improve your business’s efficiency. Business audits take time and money, but are often worth the boost to your business’s bottom line.
We’ll provide more information below about different types of small business audits, but all business audits share some things in common. The auditor, whether that’s someone within your business or an external auditor, will do a thorough evaluation of your accounting books and financial statements.
You can either provide a physical copy of your books or set up the auditor with login access to your accounting software. The auditor usually will check a year’s worth of financial data. Ideally, your financial records—whether kept in physical files or electronically—should be well organized by year and category of income or expenses. Otherwise, an audit might take much longer than necessary.
When an audit is finished, you should receive an audit report. The audit report will contain a statement about the auditor’s identity, the scope of the audit, and whether the auditor found the company’s financial records to be accurate or not. Audit reports generally follow a certain structure to comply with generally accepted accounting principles.
Certain types of businesses are required to undergo regular audits. For example, public companies that are listed with the Securities and Exchange Commission (SEC) must conduct independent audits. The federal Office of Management and Budget (OMB) requires nonprofits that spend more than $750,000 in federal funds to undergo an independent audit. Some business insurance companies also require their clients to undergo an audit each year to make sure they are paying the right amount of premiums.
An IRS audit might be the type that business owners are most familiar with, but it’s not the only type of audit.
You should be familiar with three main types of business audits:
An internal audit is a self-audit that’s scheduled and conducted by a representative of your own company. Many businesses do an internal audit once per year to ensure the accuracy of their books and financial statements. An internal audit is for your own purposes; you don’t submit the results to an external organization.
Larger companies usually have audit departments, but a smaller business might employ just one or two people to conduct audits. Internal auditors don’t just check a business’s finances. They also check company policies, procedures, and processes to check compliance with internal guidance and federal, state, and local laws.
Public companies generally conduct internal audits to update shareholders and investors on how a company is performing. Even if you’re not a public company, internal audits can be an important way to catch operational issues.
An external audit, also known an independent audit, is an audit that’s conducted by someone outside the organization. This is called an independent audit because the auditor has no loyalty or responsibility to the business that could create a conflict of interest.
Usually, businesses conduct independent external audits to comply with some kind of legal requirement. For example, the SEC and OMB require independent audits.
The external auditor will provide you with an audit report that follows generally accepted accounting principles. In their report, they’ll have to provide an opinion as to whether your company passed the audit. An auditor might take one of the following stances in a business audit:
If a company doesn’t receive a clean opinion, they might need to correct errors in their financial records and re-do the audit.
An IRS audit occurs when the IRS finds potential errors in your tax return. Usually, the IRS schedules audits for tax returns that were filed in the last three years. For substantial errors, the IRS might go further back.
Several factors can trigger an IRS audit. If you take several deductions, claim losses for multiple years in a row, or report high income levels, these are all risk factors for an IRS audit. If you’re chosen for an IRS audit, you’ll be notified in writing. There are two types of IRS audits—correspondence and field audits.
A correspondence audit—the more common kind—is when the IRS sends you a letter describing the possible errors in your tax return. You can reply with documentation to support your position. Field audits are when you meet an IRS examiner at your place of business, accountant’s office, or local IRS office. The examiner will look through your financial records and books to see if they match up with the tax return and comply with tax laws.
The chance of being selected for an IRS audit is extremely low—less than 1% for most types of businesses. However, if you are selected, you should have your accountant, tax professional, or business attorney present during the audit.
A small business audit is never fun, but there is no need to fear the possibility of one. In fact, an internal audit can be a welcome way to spot business inefficiencies and plan better for the future. Even external audits can help you stay on good terms with shareholders, investors, and lenders. As far as IRS audits go, they are nothing to fear either, as long as you are accurate about your income and deductions. At the end of the day, the best way to prepare for any business audit is to keep well organized financial records.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.