Ep. 52: What You Need to Know About Audits

00:00:01

Erick O. Bell: Really what an audit is is someone testing the work that someone else has done. So for example, take financial statements. Management is proclaiming that these financial statements are accurate and so the auditor's job is just to go in and make sure that that assertion that management has made is correct. At its simple form, that's what an audit is.

00:00:21

Andrea Marquez: Audits can sometimes be associated with fear and it's a scary process to go through for some businesses. And if you're starting your own business, you might be wondering if you should even get an audit and what that process looks like. I'm Andrea Marquez and This Is Small Business, a podcast brought to you by Amazon. Today, we'll be digging into some things you need to know about audits with Erick O. Bell, an accounting professor at the Haas School of Business at UC Berkeley and an active certified public accountant. And yes, we'll touch on the scary IRS audits too.

00:00:54

Erick O. Bell: Most small businesses should not need an audit. And so a lot of times, small businesses will come to me and they'd say, “We're interested in getting a loan and the bank says that we need to have an audit done. Can you do an audit of our financial statements?” And my response is, “No, I won't. I don't think that's what the bank really means when they say they need an audit done.”

00:01:17

Andrea Marquez: Before getting into academia full-time, Erick worked at multiple auditing companies. And now, in addition to teaching, he also runs an accounting firm where he does accounting and bookkeeping services for small businesses.

00:01:30

Erick O. Bell: And I just think as a business owner, you push back on that and say, “We don't want to incur the cost of having two years of audited financial statements. What information on our financial statements are you most interested in and can we have an independent accountant come in and give an opinion on our assertion of either how much revenue we've earned over the last two years, our statement of cashflow over the last two years?” And so it would be much less in scope than an audit.

00:02:01

Andrea Marquez: Erick's referring to an audit that's done in accordance with the American Institute of Certified Public Accountant standards or AICPA standards. These audits can be pretty expensive, so it's great to hear that banks can be open to other ways to approve your loan. If you're a small business, you might not need an audit anytime soon if you're just starting out. But if you're planning on growing your business, then you might want to be prepared just in case.

00:02:26

Erick O. Bell: Once I'd say you've crossed maybe 5 million in revenues and now you're looking to get outside investors, you're looking to get multimillion dollar loans, it's at that point when you should be looking at hiring a auditor. And an auditor is an independent accountant and so these types of businesses will have their own accountants who's doing the work on a monthly, weekly basis. And then once a year or several times throughout the year, they will have a second set of accountants. The independent accountants come in and say, “Let's give an opinion on the work that's been done. Has it been done accurately?”

00:03:04

Andrea Marquez: So if you're trying to get an investor to grow your business or you're applying for a multimillion dollar loan, we'll dig into what the process looks like and how to do it. But first, let's talk about another type of audit, the IRS audit.

00:03:15

Erick O. Bell: An IRS audit is very scary and it happens very rarely. And so when the IRS is auditing companies, they're auditing their tax return. And the whole purpose of that audit is making sure that they've reported all the income that they've earned, so that they can apply the appropriate tax rate to receive the tax dollars that are due. So the IRS audit is separate. I think a lot of people have fear around it. As I was thinking about this yesterday, I was reminded of a time when I was at a barber shop.

This was probably 15 years ago and the barber said, “So Erick, what do you do? What's your job?” And I said, “Oh, I'm an auditor.” And the entire barber shop got quiet. Everyone was like, “Oh, man. We can't say anything around this guy.” And I said, “I'm not that type of auditor.” Most audits that are happening, they're not audits that are at odds with each other. An IRS audit, they are saying, “We believe you've under-reported your income and we're going to prove the opposite.” Whereas a typical audit generally is just you've made an assertion. Can we verify that that assertion is accurate?

00:04:27

Andrea Marquez: So when we're talking about the typical audit, it's not like they're here against you. They're just trying to be like, “These are the facts. We're just laying them out.” Versus the IRS audit is much more like, “Oh, you really have to have your stuff together.”

00:04:42

Erick O. Bell: Usually what happens in an audit is it was a mistake that was made and so there'll be additional taxes, there'll be interest that you have to pay for the unpaid tax and then if you've significantly underpaid, there'd be penalties associated with it. But in a normal audit, you get to pick who your auditors are. The company selects their auditors.

00:05:03

Andrea Marquez: And just to ease your mind a bit, in case you do end up getting an IRS audit, here's what the process might look like.

00:05:10

Erick O. Bell: I think that first, you get the letter from the IRS, is be responsive. And then at some point, you may consider hiring a tax attorney, someone who has experience with negotiating with the IRS.  

And again, when we use this term, IRS audit, it's really more like an IRS agreed upon procedures. They're looking at a very specific aspect of your tax return. We see that you had $300,000 in revenue and you spent $100,000 in travel. Can you give us the receipts for those travel expenses? And so it sounds scary, but the reality is you just go to your credit card statements and pull up the receipts and say, “Here are my receipts for the $100,000 of training.”  

Now, if $50,000 of that was trips back and forth to Vegas, they're going to ask some follow-up questions. And so to the extent that you did your best, it really isn't a overwhelming or scary process. It's just a back and forth asking for questions and you're providing responses.

00:06:13

Andrea Marquez: So now let's get back to talking about the typical audits. If you're planning on getting an audit, there's a few things you need to do. The first one is be organized.

00:06:23

Erick O. Bell: Hire an accountant or a bookkeeper, someone that can help you navigate the audit process. Small business owners are really good at doing what they do and you don't want to be distracted from your business's purpose by focusing on an audit.

00:06:39

Andrea Marquez: The second is be honest.

00:06:42

Erick O. Bell: Most auditors are not out looking for gotcha moments. That's not the goal. The goal is to be collaborative and to help you understand the accounting rules and this is when and how you should or could recognize revenue.

00:06:58

Andrea Marquez: And the third is know some key audit terms.

00:07:02

Erick O. Bell: So for example, one term is materiality. Auditors are testing for whether or not the financial statements are correct in all material respects, which means if you had a million dollars in revenue, it doesn't matter if there's the extra $1, 000 that did or did not make it on there. A million dollars in revenue is a million dollars in revenue. Different from $1. 2 million. Now that 0. 2 becomes a material number. And by materiality, it's what information in the financial statements would be significant enough to influence the decision making of a potential investor or creditor.  

And then another key term, for example, would be audit adjustments. And this is just very standard and so this goes back to being honest and just understanding an auditor is going to come in and look at your financials and say, “You should have recorded this expense or you should not have recorded this expense, so what we're going to do is present you with adjustments that you can make to your financial statements that they will be correct.”  

And so a lot of times, people get nervous, because they say, “We want zero audit adjustments.” And I always say, “That's not how it works. You're going to have audit adjustments. That's why you have a second set of eyes coming in and looking at it and not to get all worked up and not even make that a goal.”

00:08:22

Andrea Marquez: And the fourth and in my opinion, the most important thing to keep in mind when you're getting an audit is...

00:08:27

Erick O. Bell: Be nice to your auditors. Here's what I would explain to my clients. Say, “I need you to understand something. I just came from a place where they did not want me there and now I'm here and I know you don't want me here. And when I leave here, I'm going to go to another place where someone doesn't want me to be there, so let's just work together, make this as painless as possible. I'm going to send you a list of documents that I want to see and then I'm going to add to it based off of what I've seen. We'll just try and get through this as easy as possible.” That usually gets a chuckle out of them, but understand that we're just here to do our jobs and ultimately, it's to make your financial statements be reliable.  

The whole purpose of an audit of financial statements is you can put those out to potential investors and creditors and say, “This information is reliable, because we did it and then we had someone else come in and they gave an opinion that says, ‘Yes, they did it right.’ ”

00:09:21

Andrea Marquez: That was Erick O. Bell, an accounting professor at the Haas School of Business at UC Berkeley. This was such an informative conversation on audits. I love that Erick managed to make getting an audit less daunting. We covered a lot in this episode.  

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Until next time, this is Small Business. I'm your host, Andrea Marquez. Hasta luego and thanks for listening. This Is Small Business is brought to you by Amazon with technical and story production by JAR Audio.