The Fear Behind a Financial Audit
Updated: Jun 21
Let's run an experiment...randomly say the word "Financial Audit" around a group of friends and watch them screech in terror! Well, maybe it's not that dramatic, but I guarantee the blood pressure spikes when just hearing those two words.
Why are people so fearful of an audit? There are two main reasons IMO;
*They freak out about dreamed up ramifications of something being found out in their financial audit (i.e. dragged off to a island by themselves in the middle of the Atlantic), or
*They are no where near prepared for any kind of audit. Specifically, I am talking about businesses that have no accounting platform driving the accuracy of the financial statements. Remember, you're not scared, if your prepared (nerd poem).
The first one is a fear based in nonsense, but the second one is grounded in reality. 1% to 2% of businesses are audited due to "IRS audit triggers". If you are a business that is not prepared for a financial audit, then keep reading so that you could withstand an audit if it happened.
Warning, it will get a bit geeky as you go.
First and foremost, your accounting records need to be reconciled for the period of time that the audit is looking at. In reality, your cash, credit cards, & loans need to be reconciled since the inception of the business to current. If your business has never had its accounting records reconciled, or has never filed tax returns, regardless of the reason, this is your first step in getting your financial history laid out to even be able to go through an audit. This step is considered a financial restatement.
Reconciliation of these accounts will ensure that the accounting records are "Complete" because all of these "proven" transactions are in the books.
Now, just having the reconciliations done doesn't mean your financial statements are correct.
Yes, we have all the transactions that hit a bank, credit card, or loan, in the books, but there may need to be adjusting journal entries created, records deleted, and/or changed.
Maybe you have had a "bookkeeper" doing your accounting. Believe me, the nightmare that can come because someone claimed to be an accountant, is ugly. I have spent thousands of hours that have been charged to my clients because their old bookkeeper completely jacked up the accounting records. Point being, there are many different ways that financial statements can have unfactual records in it. So, you need to have your financial statements fully correct before you start the process of backing up the information for an audit.
Once the financial statements are locked in and ready for filing and assuming that your business has not filed taxes before, or filed taxes that were incorrect, we begin to backup the transactions. This simply means proving that the transactions actually took place.
The base foundation of transactional proof are always the bank or credit card statements, loan documents, contracts, or any other documentation that would back up an entry in the financial statements. What this means is that, at a bare minimum, you need to be able to point to a transaction on one of these documents, that correlates to each transaction running through your books.
The next layer of proof is a 3rd party document such as an invoice. An invoice would back up the transaction that is seen on the statements mentioned above. A printed or emailed receipt would also be considered another source of proof.
From a financial audit perspective, the auditor wants to feel good, in his or her brain, that every transaction in the accounting records is substantiated by proof and actually belongs in the business's financial statements.
The best proof is a legal contract or an invoice. Think about how much money could be passed off as business expenses just because it passed through the business bank account. If you have an invoice from a 3rd party that matches the transaction, and are legitimate expenses/income for the business, then the auditor can feel defeated, which is what you want.
AUDIT SECRET: If the auditor initially is finding backup to the transactions that they are choosing, chances are the audit will become less and less as they understand that you have kept solid accounting records.
Preparing for an audit isn't that complicated if you have a good accounting department in place. This should mean that all the detailed work is being done correctly by following the accounting processes daily, monthly, and yearly. Secondly, maintaining highly organized backup information is what will lead you through any audit (unless you are a crook then they'll eventually figure you out).
If you need any help with a financial restatement and/or audit preparation, feel free to reach out.
Blue Collar CFO