The Audit: What you need to know about external audits

The Internal Revenue Service (IRS), state and local tax au­thor­i­ties earn billions of dollars a year through external audits of company financial records. As a result, it is not sur­pris­ing that auditors take their jobs very seriously when it comes to in­spect­ing ques­tion­able financial records. In principle, nobody is exempt from being audited, whether they are a large company or a small free­lancer. Yet it is very unlikely for them to in­ves­ti­gate an entity that generates low revenues. Though it is possible, if there are anomalies, that a private household can be audited by the tax au­thor­i­ties if they get the im­pres­sion that a taxpayer has not submitted accurate ac­count­ing and tax returns.

If a tax office audit does occur, there’s no need to panic. Simply use the time after you are notified of the in­ves­ti­ga­tion to prepare as thor­ough­ly as possible, by finding out as much as you can about the general procedure and basic functions of an external audit. Once you have done your research, you can create an optimal starting position for your upcoming audit in­ves­ti­ga­tion. This won’t just calm your own nerves but will con­sid­er­ably simplify the external auditor’s work and speed up the process.

Tax au­thor­i­ties are permitted to in­ves­ti­gate the accounts of tax-paying in­di­vid­u­als and companies, even if they have submitted tax returns and annual accounts. This in­ves­ti­ga­tion consists of reg­is­tered visits to your company’s office or home. Tra­di­tion­al­ly, this type of ver­i­fi­ca­tion visit is referred to as an external audit. However, since tax au­thor­i­ties generally tend to pursue in­ves­ti­ga­tions against busi­ness­es more fre­quent­ly than against in­di­vid­u­als, the term audit is much more common, even if this term might give a false im­pres­sion that only companies and busi­ness­es can be audited.

Whether it’s the federal, state or local tax au­thor­i­ties who are in­ves­ti­gat­ing you, the tax au­thor­i­ties are always required to provide ample no­ti­fi­ca­tion to the persons/companies concerned either in writing or by telephone (often both) about the planned in­spec­tion and the date the in­ves­ti­ga­tion is due to commence. They will inform you what types of tax documents, tax al­lowances or premiums will be reviewed or for how long the audit period (typically three years) is scheduled. The tax office can also inform you which tax auditor will be re­spon­si­ble for the audit. However, this is not a mandatory dis­clo­sure.

All American citizens and in­di­vid­u­als who work and earn money in the USA are required to pay taxes. In order to comply with this oblig­a­tion, all tax-relevant matters are subject to the control of tax au­thor­i­ties at the federal level (IRS), as well as state and local level, depending on where you live. The necessary materials for this control and in­ves­ti­ga­tion are handed over to the relevant tax au­thor­i­ties in the form of an annual (or quarterly) tax return. These can be com­pli­cat­ed to file leading to avoidable mistakes, and an unclear tax status for many. The external audit can help clarify the tax status and li­a­bil­i­ties of a taxpayer.

As pre­vi­ous­ly mentioned, anyone can be in­ves­ti­gat­ed, whether it’s a private company, in­di­vid­ual trader or free­lancer. However, most in­ves­ti­ga­tions are audits on large companies, and the rule of thumb is that the larger a company, the more likely they are to be audited. In addition, there are several factors that increase the like­li­hood and frequency of an audit:

• Tax return seems im­plau­si­ble
• Tax return is filed too late
• Taxes are paid late on a regular basis
• Profits fluctuate wildly from previous year
• Turnover or profits are unusual for the size of the company/industry
• Labor costs are dis­pro­por­tion­ate­ly low
• A previous audit resulted in sig­nif­i­cant tax re­pay­ments

Audits can be divided into roughly three stages:

First and foremost, the tax office will register their audit. They will inform the party being in­ves­ti­gat­ed of the upcoming in­ves­ti­ga­tion and where it will take place. In general, audits take place either on the premises of the party concerned, or their tax adviser. However, if you cannot provide the auditor with a place of em­ploy­ment, for example, then the audit may take place at the tax office. Parties under in­ves­ti­ga­tion will receive an ap­point­ment for the start of the in­ves­ti­ga­tion, however, it can be postponed through con­sul­ta­tion with the tax office if your ac­coun­tant or tax adviser is on vacation at that time, or if you are busy pro­cess­ing a large order, for example.

At least two weeks before the audit begins, the tax au­thor­i­ties will send you the in­ves­ti­ga­tion order document, which defines, among other things, the relevant period being covered by the audit. In some cases, however, the ex­am­i­na­tion period may be more than three years – for example, in case the party being in­ves­ti­gat­ed is under suspicion of a criminal offense or ad­min­is­tra­tive offense. The order also tells you which taxes the auditor wants to consult during their visit, so that you can gather and arrange relevant documents in advance.

The second phase is the actual execution of the audit. This takes place at the agreed-upon location during normal business hours. You are obliged to grant the auditor access to your premises or property. Typically, the auditor visits your company first before the actual audit begins, re­gard­less of whether it takes place at your home/office, your tax adviser’s premises or at the tax office.

You must provide the auditor with one or more contact person(s) for the entire period of the audit. The auditor can contact them if they have any questions or want to consult certain books, business documents or other financial documents from the ac­count­ing de­part­ment. The duration of this op­er­a­tional review can vary wildly depending on the size of the company and the scope of the documents required: from one to two working days up to several weeks, anything is possible.

It is im­per­a­tive that you comply with requests for par­tic­i­pa­tion as soon as possible. If the auditor finds evidence of a criminal offense during their audit, they will im­me­di­ate­ly report it to the relevant au­thor­i­ties.

The final phase of the audit is the final meeting. The head of the tax au­thor­i­ties often par­tic­i­pates in this interview, alongside the auditor. In order to prepare for this meeting as thor­ough­ly as possible, you should ask the auditor for a written no­ti­fi­ca­tion in which they list their findings, including relevant ref­er­ences as well as the number of tax re­pay­ments. Together with your tax adviser, who is also permitted to attend this meeting, you can review the agenda for the meeting in advance and work out arguments against any po­ten­tial­ly un­fa­vor­able findings.

A tabular overview of the most important data during an audit:

One of the most important basic rules that you should always observe when it comes to an external audit is that your ac­count­ing must always be kept legally up to date. If there have been leg­isla­tive changes within the period being audited, your auditor will check whether you have im­me­di­ate­ly im­ple­ment­ed these changes in your ac­count­ing or tax return. Ad­di­tion­al­ly, there are several other areas that auditors pay attention to.

Any type of loan, company, rental or par­tic­u­lar­ly em­ploy­ment contract being awarded to a spouse, child or other family member are often the focus of auditing cases by the tax au­thor­i­ties. The main issue in this instance is whether the terms of the contract are ap­pro­pri­ate and in order. For example, the tax au­thor­i­ties will check whether salaries, profit shares, interest, voting rights or rental rates are within the normal range, or whether there is a glaring dis­crep­an­cy between other employee or business partner contracts. In addition, the auditor will ensure that family members are not being employed for bogus work by checking whether their position exists and whether a salary has been demon­stra­bly paid (i.e. transfer documents).

Costs incurred on business trips with private vehicles or company cars which are then deducted as tax write-offs are also closely monitored. If the vehicle or driver possesses a driver’s logbook, it will likely be reviewed during the audit. If the auditor finds in­con­sis­ten­cies, neg­li­gence or errors, the logbook will not be accepted as valid. The auditor will also check whether company cars are used solely for business purposes, or also for private trips. In this instance, ad­di­tion­al tax penalties may be incurred if in­fringe­ments are found.

If you have incurred losses during several con­sec­u­tive financial years, it will cause suspicion for the tax office. It will quickly become obvious that you have no intention of making a profit, but that the losses are due to de­lib­er­ate personal reasons or in­cli­na­tion. If you do not have a con­vinc­ing business plan ready to show the auditor to indicate that you intend to become prof­itable soon, the tax office could impose financial penalties.

Tax auditors also sometimes pay close attention to in­con­sis­ten­cies between quotes and sub­se­quent invoices. For example, if invoice amounts are sig­nif­i­cant­ly lower than the sums declared in the quote, the auditor will quickly become sus­pi­cious that un­de­clared work is being done. You should be able to explain the reason for any sig­nif­i­cant dis­crep­an­cies – prefer­ably with doc­u­men­ta­tion (post, email, etc.) with the customer in question. If the auditor’s sus­pi­cions are confirmed, there could be severe tax and even criminal penalties on the line.

Those who are required to keep accounts should also keep a cash register where all cash receipts and expenses are recorded daily. Ir­reg­u­lar­i­ties in the cash register roll are often the reason for com­plaints from the tax au­thor­i­ties.

If you are a business owner, such as a farmer, and you take less money from the farm as income than is credibly required for your liveli­hood (e.g. housing expenses, food, clothing, etc.) and you have no other sources of income, the tax office will check carefully whether or not you are engaged in un­de­clared work.

The most important aspect of preparing for an upcoming audit is to get all your accounts in order. Make sure you have all the necessary doc­u­men­ta­tion ready to be checked, as well as complete pre­sen­ta­tion of your business processes and any documents used for cal­cu­lat­ing sales, expenses etc. Sort through your invoices, tax and mis­cel­la­neous business documents in advance to allow the auditor to work as quickly and easily as possible. If you find that certain documents are missing, use the time before the in­ves­ti­ga­tion formally begins to fill in the gaps.

Try to an­tic­i­pate the needs of the auditor before they arrive. However, also bear in mind that as the main in­di­vid­ual re­spon­si­ble for a company, you are bound by your oblig­a­tion to provide in­for­ma­tion and cooperate. There is also a pos­si­bil­i­ty that the auditor may seek to interview employees who have not been des­ig­nat­ed as re­spon­dents. In order to avoid potential mis­un­der­stand­ings during these in­ter­ac­tions, you should also inform all other employees about the upcoming audit.

Of course, you must also ensure that your tax adviser is involved in all prepa­ra­tion for the audit. Clarify what tasks you want them to handle in advance during the audit and set a fee ceiling to avoid any nasty surprises when it is over.

As mentioned at the beginning, anyone can be subject to an audit. For large companies, audits are com­mon­place and often just a matter of time. However, you can increase your chances of avoiding an audit for as long as possible, as well as lay down the ground­work for a quick and painless in­ves­ti­ga­tion once it even­tu­al­ly happens. To do this, take the following things into account when book­keep­ing:

1. Always mail receipts im­me­di­ate­ly and store your copy right away afterward
2. Ensure care when book­keep­ing and make sure your practices are legally up to date
3. Always answer questions from the tax office ac­cu­rate­ly and on time
4. Inform the tax office in good time if you will be unable to meet a deadline, and politely ask for an extension
5. Hire a tax adviser to prepare your annual financial state­ments or tax returns, or at least have them double-check yours before sub­mit­ting
6. Always pay your taxes on time

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