How To Ace An Audit


This is a guest post from a friend and colleague, Seth Peabody, CPA. Seth is the Director of the Tax and Accounting Division of DDS Financial. Speaking candidly, he is gifted in his abilities as a business person but above all has constructed the coolest accounting team that I have ever been around. Personally Seth is a Husband and Father but seems most inspired when you ask him about his missions work.

An audit seems like misery, and it is actually worse than that when it actually occurs to you. Our practice work with Doctors, Dentists and their associated practices; Seth is speaking as an authority on this subject, heed his advice from the article below which originally appeared in a 2012 issue of Medical Economics.

T. Seth Peabody, CPA

Organizing those bank statements and expense receipts now will save your practice headaches later

As a medical student, you didn’t prepare for the boards the night before. You spent countless hours reading, studying, and reviewing. So why, as a practice owner and decision-maker, would you prepare for an audit only days before the auditor arrives? Any doctor who has been practicing medicine for several years can expect to be audited, and proper recordkeeping prepares you for that day, just as studying and reviewing prepared you for your licensing exams.


Although the chances of a line-by-line Internal Revenue Service (IRS) audit are slim, the pain and suffering of an audit is immense. The IRS 2010 Data Book reports that roughly 70% of all small (corporations with $10 million in assets or less) corporate returns that the IRS audited or examined were changed.

The average recommended additional tax per return for a small corporation was about $30,000, and 62% of all partnership (including limited liability corporation) and S corporation returns under audit were changed. Data do not exist for the change of tax for partnership and S corporation returns, because these information returns are reported on the individual shareholder or stockholder returns. How many practices can sustain a $30,000 reduction to cash flow without making employment changes or accessing a line of credit? Proper record keeping, therefore, is not just essential. It’s critical.


Cost is a key component to recordkeeping for every medical practice, and you will need to consider numerous cost-related factors when preparing for an audit. For example, what are the costs associated with properly recording, organizing, and sorting your records now? On the other hand, what are the costs associated with gathering, recording, and organizing documentation that is several years old for the purpose of an audit?

Today, many records are readily available online. The trouble with online records, however, is that an item is usually posted only for a limited time. A gathering mission for old records in preparation for an audit can take hours or days, time that could be better used serving current patients and developing your practice.

Recently, a new client of ours received a letter informing him he would be audited by the IRS. To be thrifty, the practice owner thought he could handle the accounting and tax preparation function and audit defense alone. After the first meeting with the auditor, however, the doctor engaged our firm. He had not kept proper records for several years.

We were assigned the task of reconstructing the information and attempting to reconcile that information with the audited return. It cost $7,000 in accounting fees to reconstruct just 1 year of financial information, roughly $1,000 in check fees, and several hundred dollars for monthly credit card statements.

In all, we estimated it cost the practice $10,000 to reconstruct and gather that 1 year’s worth of transactions. In addition, the physician was forced to use countless hours of his personal time acquiring the necessary information and reports. Not only that, he had to spend additional hours with us recalling the transactions that were not originally documented. In short, his “thrift” wound up costing him time and money.

Keeping records up to date always is less costly than having to scramble to pull records together at the last minute with the auditor standing on your doorstep. The necessary records often are inaccessible, if not nonexistent, making it much more difficult to retrieve them several years after transactions occurred.

Unorganized and/or improperly stored records and the delayed recording of transactions may cost a practice additional taxes, penalties, and interest, as well as increased professional fees. Trying to prepare for an audit at the last minute can get expensive surprisingly quickly.


  • Keeping financial records current is easier than finding them later if you are audited.
  • Information is available from the IRS on what records you will need for an audit.
  • Reconcile financial statements regularly with bookkeeping software.
  • Keep tax returns and bank statements.


To record and store records properly, it is important to understand what an IRS auditor will review to substantiate information reported on a return. Auditors believe that a practice’s financial information should mirror, or easily be reconciled to, its tax returns. Those financial statements also should reconcile to bank statements and other financial records.

The next important information consideration is the documentation the auditor will request to substantiate a tax return. What the IRS is looking for is not a mystery. The U.S. Treasury Department has produced a video guide to an IRS audit that is available for downloading at The video clearly explains what an auditor will examine and the questions that will be asked during the audit process.

A wealth of additional useful information is available on the IRS Web site, including training and audit manuals for specific industries and professions that you can download for reference. The IRS also provides standard questionnaires for each type of audit. If you receive an audit letter, it will outline what specific information you will need to substantiate your return.

Below are a few examples of standard items you will probably be asked to produce during the course of an audit:

  • The auditor will request prior and subsequent federal, state, sales, payroll, and personal property returns to analyze whether your records agree with the auditor’s records. The goal is to compare what you reported originally with information in your practice’s records, and with information reported on returns you filed with any other agencies.
  • The auditor will review your personal tax returns to determine whether the information you reported on them reflects and reconciles with the return under audit.
  • The auditor will request the financial statements from your practice, including ledgers, journals, aged receivables and payables, trial balances, bank reconciliations, credit card statements, and other worksheets and schedules. Often these statements are difficult to produce without bookkeeping software and proper record storage.
  • The auditor may request W-2s, 1099s, and specific forms and schedules within the returns—for example, an in-house fixed asset listing or schedule, and the fixed asset schedules reported to another taxing authority.
  • The auditor will request schedules from the practice software showing the number of patients treated and the type of work performed on patients, to determine revenue. The auditor will analyze the information for any unreported income.



Several issues can prolong or increase the severity of an audit. More work is created to substantiate records when your audited return does not agree with your other financial records, even if you have submitted the return correctly. Other problems arise when the revenue reported on your income tax return is less than the revenue reported on your sales tax return. You will need to explain the discrepancies in detail and reconcile them.

Discrepancies create an immediate impression that your return probably is incorrect. Once this idea enters the auditor’s mind, it may be difficult to erase and get him or her back on the path of auditing and not looking for every minor error. This attitude almost certainly will wind up costing you additional time, and time is money.


Good records are critical, because not having them can lead to underpaying or overpaying taxes. In addition, well-kept records are essential during an audit to answer questions accurately and to the satisfaction of the auditor. Organized and controlled recordkeeping will minimize the tangible and intangible costs of an audit.

How can you achieve proper recordkeeping? By following these suggested procedures and examples on a weekly, monthly, or quarterly basis. In general, the frequency should be determined by the number of monthly transactions, but the number of monthly transactions should not be the overall determining factor. If you have a solo practice in a rural area, you may need only to perform the procedures quarterly. If, however, you are in a practice with several doctors in a metropolitan area, it may be necessary to perform the procedures on a weekly basis.

Below are a few tips to ensure proper recordkeeping:

  • Invest in appropriate accounting software for recording transactions.
  • An experienced bookkeeper should perform monthly reconciliations of credit card and bank statements, receivables, payables, inventory, and other accounts, using bookkeeping software.
  • Keep a record of all cleared checks, both physically and digitally. A digital format acts as insurance should the physical copy be lost.
  • Never use business accounts to pay for personal expenses, or vice versa.
  • The practice manager should place strict controls on all checks and credit cards. For example, a doctor’s spouse should not use a company credit card, even if the transactions are recorded against distributions or dividends.
  • Documentation is important for reported balances, expenses, income, and transactions. The audit may be conducted on a return filed 3 years earlier. Remembering what happened last year is difficult enough. Trying to remember specifics about something that happened 3 years ago is unimaginable.
  • Arrange for a certified third party, such as an accountant, to perform weekly, monthly, or quarterly bookkeeping services. The current market rate for an experienced bookkeeper is $50 to $100 per hour. Cutting corners is more harmful in the long run and leads to higher professional fees to defend an audit. The old saying “Don’t be penny-wise and pound-foolish” always comes to my mind when involved in an audit of a practice where the “bookkeeper” was a spouse or an office manager with no accounting experience.
  • Remember that just because the financial statements have been reconciled does not mean the transactions have been recorded properly. Reconciling means that the information is in the system, but it may not necessarily be recorded to the correct account. Periodically review the details of the transactions, general ledger, or detailed balance sheet and income (profit and loss) statement to ensure the accuracy of recorded transactions.
  • Review your accounts receivable, collections, and other reports (outside of the accounting software) to ensure that collections were deposited to the practice’s bank account. Even though the software and bank statement reconcile, it does not mean everything was entered. A difference could indicate fraud.


  • Keeping financial records current is easier than finding them later if you are audited.
  • Information is available from the IRS on what records you will need for an audit.
  • Reconcile financial statements regularly with bookkeeping software.
  • Keep tax returns and bank statements.


Most business owners do not know that an annual credit card statement is not sufficient to substantiate business expenses. It is important, therefore, to know what records to keep to minimize the impact of an audit and be able to substantiate business expenses. Credit card companies do not keep copies of receipts, so your practice is responsible for keeping receipts and documenting the business purpose of each transaction.

Document expenses by properly storing and notating the receipts, paying particular attention to meals and entertainment, travel, and related party transactions. For meals, entertainment, and travel expenses, record on the receipt itself who, what, when, the discussion topics, and the general purpose for the expense.

Additionally, transactions involving related parties, such as a consultation with a relative or rental payments to a building the practice owns, will receive detailed scrutiny. Related party transactions need to be documented as to the business purpose and fair market value of the transaction.

Bookkeeping software is vital for organizing your practice’s expenses, revenue, and other financial information. In addition, the development of online banking makes it easier than ever to record your practice’s financial information. Today it is possible to download your banking and credit card information in seconds rather than having to enter each transaction separately.

Keeping track of expense receipts is crucial for an audit. At a minimum, place receipts, bank statements, canceled checks, and other documentation together in a box marked for the tax year. Storing the information electronically and backing it up on at least a weekly basis is highly recommended.


The statute of limitations for an audit generally is 3 years, but tax returns, bank statements, and closing documentation should be stored indefinitely.

In 2011, I defended a client during the audit of a 2006 return. During that process, the auditor wanted my client to substantiate the purchase of land and the construction of a building that occurred in 2000. The land was purchased with cash, and to make matters more interesting, the client had no documentation for the construction of the building. When we contacted the builder, we learned he had no records, either. In this case, however, we were able to successfully and creatively argue the cost of the construction and improvements because the auditor was cooperative. We were extremely lucky not to have any change of tax for this particular audit. Do not expect auditors always to be so cooperative.

Proper recordkeeping is essential to operating any business. In addition, the owner of a successful medical practice understands the practice’s cash flow because he or she records the transactions and stores the documentation appropriately. Taking the aforementioned precautions will provide your practice with the weapons you need to defend your filed returns successfully against an audit.


My Summary – Todd Burkhalter

Hopefully you will never experience an audit from the Internal Revenue Service. However, they are cracking down and it is becoming more common. I would encourage you to follow the advice that Seth has provided above. Let us know if there is any way that we can serve you or your practice.

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