Tax Audit Explained
Accounting

The Tax Audit Explained: Process, Preparation, and Consequences

May 17, 2024 Jason Andrews

Audits are a challenging but necessary part of modern business, not least because of the role they play in building investor confidence and ensuring the integrity of capital markets. 

The tax audit process entails an examination of tax returns, accounting records, and other financial documents by a tax authority, with the broad goal of verifying the accuracy of a company’s tax payments. Accordingly, companies are expected to engage with the tax authority during the audit process and comply with a range of regulatory requirements – a process that can, without sufficient preparation, impose a significant drain on company time and resources. 

To help ensure as smooth and effective a tax audit as possible, it’s essential that the finance team understands the process, how to prepare for it, how to meet regulatory expectations, and how to implement its results. 

Tax Audits: The Basics

What Is a Tax Audit?

A tax audit refers to the process of a tax authority examining an organization’s tax returns to verify their completeness and accuracy. 

The process will vary by jurisdiction, and by supervisory tax authority: in the UK for example, tax audits are performed by HM Revenue and Customs (HMRC), in France by the Direction Générale des Finances Publiques (DGFiP), in Germany by the Bundeszentralamt für Steuern (BZSt) and in the US by the Internal Revenue Service (IRS). Tax audits are distinct from other types of statutory audit because they represent a direct intervention by the tax authority. Other types of audit, such as a company audit (see below) are initiated by the company itself as part of its regulatory obligations or out of a commercial need. 

As part of the tax audit process, the tax authority will attempt to establish that the company under audit has followed relevant tax regulations, and will highlight both areas of good practice, areas of noncompliance, and areas where improvement is necessary. The audit will also reveal discrepancies, such as undeclared liabilities or incidents of potential fraud. 

During the tax audit, auditors will request a range of documents and data from the audited company. These materials include:

  • Accounts 
  • Tax returns
  • Reported income and revenue
  • Payroll records
  • VAT records (if registered)

Why Are Tax Audits Important?

Tax audits ensure that companies are paying taxes correctly but also serve to protect the integrity, fairness and effectiveness of the economic system. With that in mind, audits also promote financial transparency and ethical business conduct, and help to maintain corporate reputations.

Audit issues may, if not addressed (or worse, ignored) expose companies (and their employees) to compliance risk, including financial and criminal penalties. It is critical that companies make the audit process as smooth as possible – for themselves and the tax authority – and ensure that auditor requests are fulfilled quickly and accurately. 

The Legal Framework for the Tax Audit Process

While regulatory details vary by jurisdiction, the tax audit process is governed by a legal framework which companies, and tax authorities, must follow. The framework imposes certain obligations, including requirements to:

  • Retain financial records for use in audits for a legally-prescribed duration. 
  • Prepare financial records for inspection by auditors during the audit. In the UK, for example, records must be retained for at least 5 years.
  • Disclose relevant information to auditors in compliance with regulations.
  • Cooperate with, and fulfill the requests of, auditors throughout the audit. 

Tax Audit vs Commercial Audit vs Company Audit

Tax audits are not the only type of audit that a company might have to deal with over a given period:

Company Audits

Most jurisdictions require companies to undergo an annual external audit in order to verify the accuracy of financial statements for that accounting period. The company audit, sometimes referred to as a financial audit, must be conducted by an independent third-party in accordance with relevant regulatory standards. The third-party auditor will request a range of materials from the company, including a range of historical financial statements. Like the tax audit, company accountants are required to cooperate with those requests to facilitate the audit process.

It is mandatory for public companies to undergo an annual company audit. The rule often also applies to larger private companies. Upon completion, the external auditor will submit a public audit report.

Commercial Audit

Commercial audits are internally-focused reviews of company systems, processes, and operations, and are conducted with the goal of  increasing commercial revenue or reducing costs. Companies may engage a third-party auditor to conduct their commercial audit: as part of that process, the third-party auditor will request a range of financial documents and materials to fulfill the objectives of the audit, and may also need to obtain materials from suppliers. 

The commercial auditor will prepare a report on their review findings, and communicate the results to the Board and to suppliers. 

Tax Audit Types

There are different types of tax audit, each of which entail a different approach by the tax authority 

Regular tax audits: Authorities may conduct tax audits on a regular basis to ensure a company is adhering to tax rules and paying the correct tax. Regular tax audits are typically not triggered by a particular event but follow a schedule of, for example, once every 5 years. This schedule may vary depending on factors such as business size or industry. Similarly, tax authorities may select a company at random to undergo a tax audit. 

Occasional tax audits: Not all tax audits are conducted according to a set schedule and authorities may conduct occasional audits in response to specific events – such as the discovery of discrepancies in a tax return or other unusual financial activity. In this context an occasional audit becomes a regulatory necessity which is intended to address a change in risk. 

Special tax audits: Where a specific regulatory or financial need arises, such as a company merger or a VAT deduction, or even an issue of criminal concern, authorities may conduct a special tax audit. Examining only a particular aspect of a company’s financial infrastructure, special tax audits are typically conducted within quite tightly-defined parameters. 

Tax Audit Preparation

Companies can reduce the burden of a tax audit by maintaining a state of preparedness throughout the financial year. To optimize preparation, and the outcome of the audit itself, it’s worth keeping the following key tax audit tips in mind:

Document Management

Tax authorities will make detailed requests for financial documents and records – potentially stretching back years and including tax returns, invoices, receipts, and previous communications with tax authorities. Companies must share these materials with auditors promptly – at the risk of potential penalties.

In preparation for document requests, companies should implement an effective document storage and management solution that enables accountants to find and share relevant materials quickly and simply. To optimize document management, companies should consider switching to a centralized cloud-based solution that can facilitate remote user access, faster search capabilities, and secure storage. 

Pre-audit Checks

Before tax authorities submit their requested document list, companies should run pre-audit checks to ensure the accuracy and completeness of the materials they may have to share, identify potential obstacles, and prevent unwelcome surprises. 

Accordingly, accounting teams should organize their pre-audit process around a checklist which can be shared with the relevant stakeholders. The audit checklist should include all the potential documents and materials that an auditor might request, and assign responsibility for performing any necessary pre-audit verification of those documents. 

Communication and Cooperation

Tax audits require accounting teams to interact frequently with auditors, team members from other departments, and third-parties such as lawyers and tax advisors. With that in mind, companies should seek to optimize their communication and collaboration infrastructure prior to the audit, with a focus on functionality and flexibility. 

In practice, this means moving away from long, inefficient email threads that leave stakeholders out of the loop and that bury important information. Instead companies should seek to integrate software solutions, including instant messaging apps, and cloud-based document management that can facilitate live collaboration and that offer secure remote access to documents for third-parties.

The Tax Audit Process

A tax audit will typically progress in the following way:

  1. Notification: The tax authority will contact you in writing with notice of the upcoming tax audit. The notice will include important information such as the scope of the audit, the information that the auditor might require, and how you should respond to the notification. 
  2. Opening meeting: After notice is received, the tax authority will assign an auditor, or a team of auditors, to oversee the process. The auditor will arrange an opening meeting during which they will explain the details of the audit, including its scope and goals, and request access to a list of financial documents. 
  3. Document review: The auditor will begin reviewing and examining requested financial documents in order to fulfill the objectives of the audit. During that process, auditors may make further requests for documents and resources from the accounting team. 
  4. Interviews: In addition to the document review, auditors may need to interview company employees, or even third parties, to collect the information that they need or to clarify information derived from financial records. 
  5. Adjustments and resolution: The auditor will use the findings of their review to suggest updates or adjustments to the company’s tax records and will work with the accounting team to resolve issues. 
  6. Audit report: With the review complete and finalized, the auditor will produce a written report setting out the audit’s findings and recommendations. The auditor will arrange a final meeting to discuss the report with the accounting team. The company will have the change to appeal report findings if it wishes. 
  7. Compliance or appeal: Following completion of the audit report, the company will work to comply with its recommendations, or appeal its findings to the tax authority. 

Dealing with Tax Audit Recommendations 

The tax authority’s final report will set out the adjustments and changes that a company must make to its financial records. Those adjustments may mean that the audited company receives a new amount of payable tax, while the tax authority may also impose penalties for violations of tax law. The audited company may provide an explanation for any discrepancies or compliance violations, and this may affect any action that the tax authority decides to take in response to the report. 

It will also be possible to dispute and appeal the results of the tax audit. Companies should seek to discuss any disagreements, and seek resolution, with the auditor prior to beginning an appeal. If it is not possible to reach a resolution, companies should ensure they understand the formal appeal process comprehensively and, if necessary, seek third-party advice on how to proceed.

It is important that every issue raised in the tax audit report is addressed. Companies should read through and discuss the report thoroughly in order to ensure that all stakeholders understand the results of the audit and the changes that need to be made. The changes set out in the report should be implemented promptly, and companies should document the actions they take in order to demonstrate compliance. 

Audit-Ready Accounting Efficiency

Tax audits, like all types of audit, can represent a significant administrative burden. The finance function doesn’t stop during an audit and accounting teams must be able to complete critical tasks, such as the month-end close, even as they fulfill their audit obligations. 

Fortunately, CFOs can ease that audit pressure by leaning-in to the possibilities of automation. FloQast accounting software, for example, helps accountants create an audit-ready work environment in which critical data can be accessed and retrieved in seconds, and shared securely with third-parties. Beyond that automated speed and efficiency, FloQast helps companies centralize their finance function, increasing visibility and accountability for critical audit tasks, and highlighting potential efficiency obstacles. 

Find out more about tax audit efficiency: get in touch with FloQast today.