Most people hear the word “audit”, think of the IRS, and shiver. But in the business and nonprofit worlds, a financial statement audit is simply a commonplace process used to provide information to various groups, including banks, investors, grantors and the state. Savvy business owners and nonprofit leaders know a well-kept secret: audits identify ways to improve internal controls, the bottom line and convey that information to all interested parties.

At Cray Kaiser, we say financial audits reveal blind spots. But we prefer the comparison a client recently made that equated audits to opportunities. He appreciated the chance to learn more about the financial operations of his company, specifically identifying ways to increase the financial reporting requirements, identify areas to reduce costs, and strategically identify opportunities that affect growth.

Financial Statement Audits Explained

Beyond the typical association of financial audits with the IRS, most people believe that an audit is being conducted any time they see professional accountants in their place of business. However, an audit is just one of three kinds of financial assurance procedures. From least expensive and least involved to most, financial assurance procedures include compilations, then a review and finally, an audit. An audit is the most detailed and involved financial assurance procedure, and it provides the most data to businesses that want to sharpen their financial reporting, identify internal control deficiencies and grow strategically. [Be sure to follow our blog to catch an upcoming post describing the differences between the three kinds of financial assurance procedures.]

Added Benefits of Financial Audits

Beyond meeting requirements from banks or potential investors, or as part of nonprofits annual tax filings, financial audits provide additional benefits and opportunities to create efficiency and influence strategy and growth.

1. Identifying blind spots. An audit can identify any deficiencies of internal controls, which open up the risk for fraudulent activities. A recent audit we conducted revealed exposure to fraud in accounts receivable processes. Sitting with the receivables clerk, something that would not have part of the process with another type of assurance procedure, the lack of internal controls quickly became apparent. A few quick and easy checks and balances suggested in the audit report greatly reduced this client’s risk of fraud with little added effort from the staff involved.

2. Ensure accuracy of financial statements. You use your financial statements to help you make decisions that are integral to the growth and success of your business. Yet simple errors can have a significant impact on your financial statements. Another recent audit we conducted uncovered improperly valued inventory. This error had a serious impact on our client’s financial statements which had already influenced decisions about the direction of the company. This client was grateful that he had requested an audit for the sole purpose of discovering inefficiencies in the financial reporting without any requirements for an audit by his bank or investors.

3. Provide accurate data for tax forms. Reducing the likelihood of errors in tax filings lessens the chances of being questioned by the IRS.

4. Reduce personal risk. Recently, a bank removed the requirement for personal guarantees from a line of credit for a client because the client went from having a reviewed financial statements to an audited financial statement.

5. Improve cash flow. Cash flow is often compromised by mismanaged accounts receivable timing. For example, if payments sit for a while before being deposited, there is a significant impact on cash flow. New procedures identified within the audit can create a more efficient method of deposits that improve cash flow.

6. Keep up with technology. New technology can impact existing processes and procedures. As the audit proceeds, checks and balances that may have been eliminated with new technology can be corrected.

7. Prepare for sale. A few years of financial audits improves credibility of a company when trying to position for a sale or a transaction of the business.

8. Ease bank loan process. Audited financial statements provide the information a bank needs to verify accuracy when a company is soliciting a loan for growth opportunities.

Is a Financial Audit Right for Your Business?

According to Cray Kaiser Principal, Deanna Salo, “Management cannot make the right decisions without accurate, timely financial statement reporting. Having a financial audit, even if not required by bankers, investors or shareholders, can be a good way of re-tooling the accounting department and streamlining procedures and processes.” She also notes that an audit helps companies be proactive instead of reactive. One of the by-products of an audit is a management letter which includes recommendations for management.  Audit recommendations always carefully balance the need for checks and balances with the cost of the employee time involved. Is an audit right for your business? Contact us to learn more.

In November of 2015, sponsors of audited employee benefit plans received a letter from the Department of Labor notifying them that over 40% of all audits submitted were not completed in accordance with auditing standards. Why is this concerning? Because audits that are not correctly performed create many issues for all those involved with employee benefit plans, including the plan sponsors, fiduciaries and participants.

Annual audits are an ERISA (Employee Retirement Income Security Act of 1974) requirement for plans with participants over a certain threshold and are attached to Form 5500. An audit verifies the assets of the plan and confirms the plan is operating according to the plan documents and in compliance with applicable laws and regulations. These audits have a filing deadline of October 15 each year.

Errors in plan administration can trigger issues with the IRS, including penalties, and can also cause legal problems for the plan’s fiduciary. More importantly, audits that are correctly done can detect a number of errors that, if not caught early, turn into major problems.  Commonly seen errors include: incorrectly calculated employee deferrals, employer matches, and deferrals for unique forms of compensation (like commissions or bonuses). Other common issues that may be uncovered with an audit include:

• Improper disposition or holding of forfeitures
• Failure by the plan of certain nondiscrimination testing, without adequate corrective action taken
• Top-heavy issues
• Other deviations from the Department of Labor and IRS requirements or from the plan document

The November Department of Labor letter communicates the results of the DOL’s audit of plan auditors. The intent of the letter was to encourage plan sponsors to confirm that they are using qualified, experienced auditors. Plan administrators are held responsible as fiduciaries of the plan, and can be held personally liable if they are not making reasonable choices with regard to their plan. This includes due diligence with selection of their plan’s auditor.

While many accounting firms are choosing not to continue to offer employee benefit plan audits as a service, Cray Kaiser assures clients that we are uniquely qualified for this work. In addition to our commitment to quality and continued education in this area, our staff has a great deal of experience understanding the nuances of these audits. Cray Kaiser is also a member of the American Institute of Certified Public Accountants’ EBPAQC (Employee Benefit Plan Audit Quality Center), a group created to improve quality of benefit plan audits with news alerts, training, webinars, audit quality center and other resources.

There’s nothing good about being selected for an IRS audit. At best it’s a time consuming nuisance, and at worst you’ll be poorer in the end. But you can reduce your likelihood of being audited, or if you are selected, of being billed.

There are three types of IRS audits. The simplest and most common is a correspondence audit, where the IRS mails you a request for further information about one or more items on your return. In most cases the issues can be resolved by responding with the appropriate documentation.

If you’re selected for an office audit, the IRS will schedule an appointment for you to meet with an auditor at their local facility. They’ll tell you in advance which specific areas of your return(s) will be addressed and what types of documentation you should bring in.

A field audit is more comprehensive. An IRS agent will travel to your home, business, or representative’s office, review the returns at issue, request documentation for questioned items, and ultimately issue a report either recommending a tax change or accepting the returns as filed.

The Selection Process

Correspondence audits are often triggered by information matching. The IRS receives W-2s, 1099s, and similar reports from businesses and financial institutions and matches the numbers to the tax returns filed by the individuals involved. If the returns don’t agree with reported figures, the individual will be asked for an explanation and/or simply mailed a bill.

The IRS also uses a computer scoring system to select audits. Based on past experience, the system assigns a score to each tax return indicating the likelihood that the tax was understated or certain income was not reported. Common red flags include the following:

• Disproportionately high charitable deductions in relation to income.
• Large deductions for travel, entertainment, and business meals.
• Unusually high ratios of business use claimed for automobiles.
• Unusually high home office deductions.
• Excessive and/or repeated business losses.
• Unreported foreign bank accounts.
• Frequent large cash purchases or deposits (reported by outside parties).
• It’s advisable to be conservative on your tax returns with respect to these “red flag “ areas, although you needn’t forgo claiming legitimate deductions. Be prepared to support your position by keeping meticulous records and retaining every relevant document.

2015 Audit Activity

In 2015, above-average audit activity may be expected for upper income individuals, sole business proprietors, partnerships, and S corporations. Cash-intensive enterprises (bars, restaurants, taxis, hair salons, etc.) are particularly apt to receive a higher rate of scrutiny, as are industry categories that tend to have high rates of deductions not independently reported to the IRS (such as construction and real estate rental businesses).

If you do happen to be selected for an audit, call us. We’re prepared to assist you with whatever is needed.

*This newsletter is issued quarterly to provide you with an informative summary of current business, financial, and tax planning news and opportunities. Do not apply this general information to your specific situation without additional details and/or professional assistance.