On the Effectiveness of the External Audit Process

Make the most of your annual audit.

It is important that the audit committee has an independent point of view on audit quality; assessing the effectiveness is a natural extension of the audit committee's activities.

That said, what is an effective audit?

Whilst the auditor is in large part responsible for the effectiveness of the audit process, management and the audit committee have an important influence. Their contributions should also be considered in the overall assessment of effectiveness. An effective audit truly challenges and tests the contents of the financial statements in order to form an opinion on whether they present a true and fair view. An audit must, of course, comply with all relevant auditing and ethical standards. Fundamentally, an effective audit must deliver the right audit opinion, in which shareholders have confidence. Other characteristics of an effective audit include:

• Communications and reports to those charged with governance that reflect the audit team’s thought processes and rationale for conclusions. These should discuss management’s approach, alternatives considered, relevant comparators and a clear articulation of the final conclusion. 
• Effective interaction with management and the audit committee throughout its performance — everyone must understand what the ‘audit issues’ are, why they are ‘issues’ and how they will be resolved.

Assessing the effectiveness of the audit process is broader than assessing the auditor. Management have a role too and their contribution should also be included in the overall assessment. With this in mind, let us explore ways to assess the effectiveness of the external audit:

*On TEAM-STRUCTURE AND LEADERSHIP demonstrated by external auditor:

• Does the partner demonstrate leadership of the team and provide effective ownership and oversight of the audit? 
• Do the partner(s) and manager(s) commit an appropriate amount of time to undertake the audit, to supervise staff and to meet directly with management and the audit committee? 
• Do you agree with the audit team’s assessment of significant risk areas? 
• Are appropriate specialists (e.g., tax, pensions, valuations etc.) involved in the audit commensurate with the complexity of issues?

*Possible sources of evidence; Indicators:

• Feedback from management on whether the partner and key team members are available and responsive, based on interactions throughout the audit. 
• Feedback from members of executive management most involved in the audit process, on whether the lead audit partner is actively engaged in the audit process and audit decisions and is not over-reliant on his/her team. 
• Evidence that changes are made to the audit team in response to changing business needs as well as performance issues e.g., team strengthened to deal with a major corporate transaction. 
• Direct experience of the audit committee and the board based on interactions with the auditor. 
• Information from the auditor on the proportion of senior to junior time and the absolute amount of hours budgeted to be spent on the audit by senior team members. 
• Information from the auditor on the proportion of audit effort spent addressing risk areas. 
• Feedback and insights received by the audit committee and executive management from the involvement of specialists.

*On HOW WELL THE EXTERNAL AUDIT IS TAILORED TO THE BUSINESS:

• Is the audit team’s understanding of the business and its structure, the sector and the regulatory environment appropriately reflected in the audit approach? 
• Is the audit approach responsive to changes in the business over time? 
• Has the approach been challenged in the current year and if so, what has changed? 
• Have business risks been properly considered when assessing audit risks?

*Possible sources of evidence; Indicators:

• Evidence that senior audit team members demonstrate a good understanding of the group’s business and industry sector (e.g., from their discussions with executive and non-executive management). 
• Communication of planning matters by the auditor to the audit committee shows scope changes that are responsive to changes in the size, risk and nature of the business. 
• Communication of planning matters by the auditor to the audit committee shows clear understanding of the business and the risks that matter most. 
• Audit committee’s consideration as to whether the external audit scope makes sense in the context of the areas of the business that it is concerned about. 
• Audit approach is clearly modified year on year as appropriate. 
• Commerciality, flexibility and innovation are apparent from the discussions with the audit team.

*On PROFESSIONAL SKEPTICISM in execution of external audit:

• To what extent does the team demonstrate professional integrity and objectivity? Would the audit partner say ‘no’ when needed and stand by their view? 
• Is there an appropriate degree of challenge throughout the audit? 
• In areas of significant accounting and audit judgement, does the audit team demonstrate the robustness of their approach including the evidence considered and the rationale for the conclusions reached?

*Possible sources of evidence; Indicators:

• Feedback from management and the audit committee on whether senior audit team members were robust when dealing with key judgments, errors, etc., whether they had conviction, were able to clearly articulate the rationale behind their position and did not unduly rely on management representations. 
• The auditor’s communications about their independence clearly articulate the safeguards considered and applied to maintain independence and objectivity. 
• Results of external quality reviews. 
• Evidence from audit committee and other meetings that the audit partner challenges executive management’s view and does not just accept explanations received without corroboration. 
• Quality and clarity of the articulation of the key audit and accounting issues. The basis for the auditor’s view is clearly explained and the audit committee understands the auditor’s thinking.

*On TECHNICAL EXCELLENCE in execution of external audit:

• Is technical excellence visible within the team and is this appropriately demonstrated alongside commercial application? 
• Are management and the audit committee provided with accounting, corporate governance and other technical and regulatory insights to allow them to operate effectively in a changing environment? 
• Do the partner(s) take ownership of technical judgments and are they able to clearly articulate their point of view and reasoning behind them? 
• To what extent are specialist technical resources used and effectively deployed in order to address difficult or unusual technical issues?

*Possible sources of evidence; Indicators:

• Quality of analysis in communication and reports from the auditor. 
• Feedback from members of executive management who are best placed to assess technical competence. 
• Experience from audit committee briefings and formal meetings. 
• Results of external quality reviews. 
• No late surprises coming through communications. 
• Feedback and insights received from the specialists where involved. 
• Number of restatements and prior year adjustments.

*On COMMUNICATION AND REPORTING by the external auditor:

• Are communications from the auditor clear and concise and does the auditor communicate a point of view where relevant? 
• Are the communications and reports from the auditor timely so as to allow appropriate action to be taken to prevent as well as detect material misstatements in financial reporting? 
• Are communications from the auditor specific and relevant to your company and its circumstances?

*Possible sources of evidence; Indicators:

• Clarity and timing of reports to management and the audit committee and whether they provide insight into broader governance matters, the company’s financial reporting process and control environment rather than just accounting technical matters. 
• Use of interim and ‘early warning’ reports in addition to communication of planning matters and findings from the audit. Feedback from management regarding communications throughout the year. 
• No late surprises coming through communications.

*On THE ROLE OF MANAGEMENT in the external audit process:

• Are key personnel available and accessible to the auditor when needed? 
• Is information requested by the auditor prepared on a timely basis, complete and accurate? 
• Are management’s papers to the auditor and audit committee on key judgments, estimates and uncertainties well researched and written i.e., articulate the issue, approach used by management and rationale, alternatives considered and a clear final conclusion and recommendation? 
• Where possible, is management proactive in seeking early input from the auditor e.g., on complex, unusual or sensitive transactions? 
• Does the audit timetable allow sufficient time for robust quality control and review processes to be applied by both management and the auditor? 
• Do management act on feedback provided by the auditor on financial reporting processes, and controls?

*Possible sources of evidence; Indicators:

• Delays in the audit process beyond the control of the auditor. 
• Feedback from the auditor on availability and flexibility of key management personnel and timeliness and quality of information received. 
• Feedback from the auditor and audit committee on quality of management’s papers on judgments, estimates and uncertainties and timeliness of involving the auditor. 
• Number of audit adjustments as a result of errors in information provided. 
• Auditor’s feedback on whether management implemented agreed upon actions from prior year management letters, assessments of the audit process or post audit debrief meetings.

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READ MORE>> www.EY.com: Assessing the Effectiveness of the External Audit Process

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Sample Questions for Evaluating an External Auditor

Maximize the effectiveness of your
annual external audit by interaction.

Each year, audit committees should evaluate the external auditor in fulfilling their duty to make an informed recommendation to the Board whether to retain the auditor.

The evaluation should encompass an assessment of the qualifications and performance of the auditor; the quality and candor of the auditor’s communications with the audit committee and the company; and the auditor’s independence, objectivity and professional skepticism.

FOLLOWING IS A LIST OF SUGGESTED SAMPLE QUESTIONS, AND ALSO A LIST OF ATTRIBUTES FOR COMPANY PERSONNEL TO RATE:

*Q1
Did the lead engagement partner and audit team have the necessary knowledge and skills (company-specific, industry, accounting, auditing) to meet the company’s audit requirements? Were the right resources dedicated to the audit? Did the auditor seek feedback on the quality of the services provided? How did the auditor respond to feedback? Was the lead engagement partner accessible to the audit committee and company management? Did he/she devote sufficient attention and leadership to the audit?

*Q2
Did the lead engagement partner discuss the audit plan and how it addressed company/industry-specific areas of accounting and audit risk (including fraud risk) with the audit committee? Did the lead engagement partner identify the appropriate risks in planning the audit? Did the lead engagement partner discuss any risks of fraud in the financial statement that were factored into the audit plan?

*Q3
If portions of the audit were performed by other teams in various domestic locations, or abroad by the firm’s global network or other audit firms, did the lead engagement partner provide information about the technical skills, experience and professional objectivity of those auditors? Did the lead engagement partner explain how he/she exercises quality control over those auditors?

*Q4
During the audit, did the auditor meet the agreed upon performance criteria, such as the engagement letter and audit scope? Did the auditor adjust the audit plan to respond to changing risks and circumstances? Did the audit committee understand the changes and agree that they were appropriate?

*Q5
Did the lead engagement partner advise the audit committee of the results of consultations with the firm’s national professional practice office or other technical resources on accounting or auditing matters? Were such consultations executed in a timely and transparent manner?

*Q6
If the company’s audit was subject to inspection by the PCAOB or other regulators, did the auditor advise the audit committee of the selection of the audit, findings, and the impact, if any, on the audit results in a timely manner? Did the auditor communicate the results of the firm’s inspection more generally, such as findings regarding companies in similar industries with similar accounting/audit issues that may be pertinent to the company? Did the auditor explain how the firm planned to respond to the inspection findings and to internal findings regarding its quality control program?

*Q7
Was the cost of the audit reasonable and sufficient for the size, complexity and risks of the company? Were the reasons for any changes to cost (e.g., change in scope of work) communicated to the audit committee? Did the audit committee agree with the reasons?

*Q8
Does the audit firm have the necessary industry experience, specialized expertise in the company’s critical accounting policies, and geographical reach required to continue to serve the company?

*Q9
Did the audit engagement team have sufficient access to specialized expertise during the audit? Were additional resources dedicated to the audit as necessary to complete work in a timely manner?

*Q10
Did the audit engagement partner maintain a professional and open dialogue with the audit committee and audit committee chair? Were discussions frank and complete? Was the audit engagement partner able to explain accounting and auditing issues in an understandable manner?

*Q11
Did the auditor adequately discuss the quality of the company’s financial reporting, including the reasonableness of accounting estimates and judgments? Did the auditor discuss how the company’s accounting policies compare with industry trends and leading practices?

*Q12
In executive sessions, did the auditor discuss sensitive issues candidly and professionally (e.g., his/her views on, including any concerns about, management’s reporting processes; internal control over financial reporting (e.g., internal whistle blower policy); the quality of the company’s financial management team)? Did the audit engagement partner promptly alert the audit committee if he/she did not receive sufficient cooperation?

*Q13
Did the auditor ensure that the audit committee was informed of current developments in accounting principles and auditing standards relevant to the company’s financial statements and the potential impact on the audit?

*Q14
Did the audit firm report to the audit committee all matters that might reasonably be thought to bear on the firm’s independence, including exceptions to its compliance with independence requirements? Did the audit firm discuss safeguards in place to detect independence issues?

*Q15
Were there any significant differences in views between management and the auditor? If so, did the auditor present a clear point of view on accounting issues where management's initial perspective differed? Was the process of reconciling views achieved in a timely and professional manner?

*Q16
If the auditor is placing reliance on management and internal audit testing, did the audit committee agree with the extent of such reliance? Were there any significant differences in views between the internal auditors and the auditor? If so, were they resolved in a professional manner?

*Q17
In obtaining pre-approval from the audit committee for all non-audit services, did the lead engagement partner discuss safeguards in place to protect the independence, objectivity and professional skepticism of the auditor?

Furthermore, another good way to get well-rounded feedback is to provide a simple questionnaire to the rest of the company staff in order for them to rate their experience. 

Here therefore, is a guide, divided into sections, to help:

OBTAINING INPUT ON THE EXTERNAL AUDITOR FROM COMPANY PERSONNEL 

QUALITY OF SERVICES PROVIDED BY THE EXTERNAL AUDITOR RATING

• Meets commitments e.g., by meeting agreed upon performance delivery dates, being available and accessible to management and the audit committee.
• Is responsive and communicative e.g., by soliciting input relative to business risks or issues that might impact the audit plan, identifying and resolving issues in a timely fashion, and adapting to changing risks quickly.
• Proactively identifies opportunities and risks e.g., by anticipating and providing insights and approaches for potential business issues, bringing appropriate expertise to bear, and by identifying meaningful alternatives and discussing their impacts.
• Delivers value for money e.g., by charging fees that fairly reflect the cost of the services provided, and being thoughtful about ways to achieve a cost-effective quality audit.

SUFFICIENCY OF AUDIT FIRM RESOURCES RATING

• Is technically competent and able to translate knowledge into practice e.g., by delivering quality services within the scope of the engagement, using technical knowledge and independent judgment to provide realistic analysis of issues, and providing appropriate levels of competence across the team.
• Understands our business and our industry e.g., by demonstrating an understanding of our specific business risks, processes, systems and operations, by sharing relevant industry experience, and by providing access to firm experts on industry and technical matters.
• Assigned sufficient resources to complete work in a timely manner e.g., by providing access to specialized expertise during the audit and assigning additional resources to the audit as necessary to complete work in a timely manner.

COMMUNICATION AND INTERACTION RATING

• Communicates effectively e.g., by maintaining appropriate levels of contact/dialogue throughout the year, effectively communicating verbally and in writing, being constructive and respectful in all interactions, and providing timely and informative communications about accounting and other relevant developments.
• Communicates about matters affecting the firm or its reputation e.g., by advising us on significant matters pertaining to the firm while respecting the confidentiality of other clients’ information, and complying with professional standards and legal requirements, including informing us when the company’s audit is subject to inspection by the PCAOB or other regulatory review and sharing the results of the review that are pertinent to the company’s accounting or auditing issues.

INDEPENDENCE, OBJECTIVITY AND PROFESSIONAL SKEPTICISM RATING

• Demonstrates integrity and objectivity e.g., by maintaining a respectful but questioning approach throughout the audit, proactively raising important issues to appropriate levels of the organization until resolution is reached, and articulating a point of view on issues.
• Demonstrates independence e.g., by proactively discussing independence matters and reporting exceptions to its compliance with independence requirements.
• Is forthright in dealing with difficult situations e.g., by proactively identifying, communicating and resolving technical issues, raising important issues to appropriate levels in the organization, and by handling sensitive issues constructively.

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READ MORE>> www.thecaq.org: Audit Committee Annual Evaluation of the External Auditor

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Help the Success of the External Audit by Educating Your Professional Team on the Characteristics of Skepticism.

Expect your external auditors to
embrace a professional level of
skepticism in order to succeed.

Skepticism is integral to the conduct of external auditors. But the exercise of skepticism should not be limited to external auditors. Even if not codified in law or regulation, deterrence and detection of financial reporting fraud requires all participants in the financial reporting supply chain to exercise skepticism.

Skepticism is a questioning mindset, and it requires an understanding that even the best organizations can be susceptible to fraud. Management, audit committees, and internal auditors, at a minimum, should take a “trust but verify” approach with systems, methods, and communications rather than accept critical information at face value.

Skepticism is not an end in itself and is not meant to encourage a hostile atmosphere or micromanagement. The word skepticism, in fact, comes from the Greek word skeptikos, which means “inquiring” or “reflective.”

Is skepticism a set of personality traits, or is it a learned skill? The short answer is both. We will consider skepticism as an individual characteristic, albeit with multiple dimensions, listed as follows:

• Questioning mind—A disposition to inquiry, with some sense of doubt
• Suspension of judgment—Withholding judgment until appropriate evidence is obtained
• Search for knowledge—A desire to investigate beyond the obvious, with a desire to corroborate
• Interpersonal understanding— Recognition that people’s motivations and perceptions can lead them to provide biased or misleading information
• Autonomy—The self-direction, moral independence, and conviction to decide for oneself, rather than accepting the claims of others
• Self-esteem—The self-confidence to resist persuasion and to challenge assumptions or conclusions

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READ MORE>> www.thecaq.org: The Fraud-Resistant Organization

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Creating a Fraud-Resistant Culture in Your Business; the Importance of Skepticism

Skepticism is discouraged in some
cultures around the globe,
 particularly when it means
 challenging superiors within an
 organization. When dealing
internationally, training and
education can lessen the
gravity of this reluctance.

In an age of complex accounting in an increasingly global economy, the entire financial reporting supply chain must participate in deterring and detecting financial reporting fraud.

The effort begins with a tone at the top that promotes an ethical culture, a tone set by the CEO and management, reinforced by boards, audit committees, and internal auditors, and enhanced with the knowledge and presence of external auditors. 

The effort requires the exercise of healthy skepticism up and down the financial reporting supply chain. Ultimately, it is the responsibility of all the players in an organization to know their roles in delivering high-quality financial reporting, to be part of the financial reporting supply chain’s “deep defense” in deterring and detecting financial reporting fraud, and to perform those roles to the best of their abilities.

To effectively conduct an audit of an organization’s financial statements, an external auditor should have a thorough understanding of an organization and its industry to evaluate whether the results suggest that a fraud risk exists. The external auditor should know how to assess fraud risk, including the risk of management override of controls, and how to respond to identified risks. In accounts or assertions with lower risk of material misstatement, less evidence and documentation may be required, while accounts or assertions where higher risk factors are present demand more rigorous examination of evidence.

What is most helpful to aid the external audit is to train staff to use characteristics of skepticism. While some individuals are more naturally disposed toward skepticism, research shows that individuals can be trained to employ professional skepticism.

What is skepticism?

Throughout the audit process, auditing standards call for external auditors to exercise professional skepticism, defined by the auditing standards as “an attitude that includes a questioning mind and a critical assessment of audit evidence.” External auditors are required by professional standards to be alert for information that suggests material errors in the financial misstatements, and must exercise skepticism when considering the possibility that there may be a material misstatement of the financials due to fraud. External auditors must also apply professional skepticism when they consider the risk that management may override internal controls, and take that risk into account when formulating judgments about the nature and extent of audit testing.

PCAOB’s Practice Alert No. 10 Maintaining and Applying Professional Skepticism in Audits, reminds auditors of their obligation to exercise professional skepticism throughout the audit, and suggests skepticism is “particularly important” in the following circumstances:

• Significant management judgments 
• Transactions outside the normal course of business, such as nonrecurring reserves, financing transactions, and related-party transactions that might be motivated solely, or in large measure, by an expected or desired accounting outcome 
• The auditor’s consideration of fraud 

To properly exercise skepticism, in addition to diligently pursuing sufficient appropriate audit evidence, an external auditor can employ effective interview and inquiry techniques, including how to evaluate nonverbal communications. 

External auditors also should be familiar with judgment biases and other threats to skepticism. 

Cognitive biases have their place. Without them, decisions can fall victim to the inefficiency of “analysis paralysis.” However, when not kept in check, judgment biases can lead to bad decisions and to overlooking possible indications of fraud. A delicate balance is required. The first step in striking that balance is awareness.


What are some common threats to skepticism?

There is research that identifies threats to professional skepticism and ways in which such threats can be mitigated. One threat is a lack of vigilance about possible sources of bias in judgment. While everyone uses shortcuts to facilitate forming judgments or making decisions, it is important to be aware of the potential for cognitive shortcuts that can lead to poor decisions. When an individual fails to notice financial reporting irregularities, it could be because he or she fell into one of the several common judgment traps. Following is a list of 4 most common judgment tendencies with strategies suggested to help avoid these and mitigate bias:

1. Confirmation: The tendency to put more weight on information that is consistent with initial beliefs or preferences.
   Solution: *Make the opposing case and consider alternative explanations. *Consider potentially disconfirming or conflicting information.
2. Overconfidence: The tendency to overestimate one’s own ability to perform tasks or to make accurate assessments of risks or other judgments and decisions.
   Solution: *Challenge opinions and experts. *Challenge underlying assumptions.
3. Anchoring: The tendency to make assessments by starting from an initial value and then adjusting insufficiently away from that initial value.
   Solution: *Solicit input from others. *Consider management bias, including the potential for fraud or material misstatements.
4. Availability: The tendency to consider information that is easily retrievable or what’s easily accessible as being more likely or more relevant.
   Solution: *Consider why something comes to mind. *Obtain and consider objective data. *Consult with others and make the opposing case. 

Judgment biases are not the only threat to the exercise of skepticism. Threats exist at every level of the financial reporting supply chain. For example, the individual might face deadline pressure, pressure to please one’s boss or client, or lack of experience in significant accounting estimates. These threats can be mitigated, but the first step is clear-eyed acknowledgment that the threats exist. Understanding the importance of skepticism is a vital part of ensure the success of both the internal and external audits.

The role and responsibility of the external auditor defined:

The primary responsibility of the independent external auditor is to provide an opinion on an organization’s annual financial statements. The opinion is intended to provide reasonable assurance that the financial statements are presented fairly in all material respects. Most large companies (i.e., those with over $75 million in public float), are also required to have their external auditor report on the effectiveness of the company’s internal control over financial reporting. External auditors are engaged by, and report directly to, the audit committee, but they often have contact across many parts of an organization’s operations, and can garner valuable insights not only about controls, but also about an organization’s culture. In addition, their work across multiple companies endows external auditors with useful perspectives.

Professional standards require the external auditor in a financial statement audit to understand the company’s system of internal control as part of the audit planning process. This understanding includes consideration of the tone at the top and overall corporate culture, and incentives or pressures that may impel fraudulent financial reporting. The auditor considers factors such as management’s philosophy and operating style (including the integrity and ethical values practiced by management), the company’s commitment to competence, the effectiveness of the board and audit committee’s oversight, and the company’s human resource policies and practices (including compensation arrangements). All of these factors contribute to the auditor’s risk assessment of the company.

Communications

The more an external auditor engages, and engages effectively, with various members of management throughout an organization, the better the audit design and results. In obtaining information, face-to-face meetings encourage open discussion and the opportunity to assess nonverbal communications. Early in the engagement, auditing standards require the external auditor to brainstorm about possible fraud risks. Topics for brainstorming include:

• How and where the engagement team believes a company’s financial statements could be susceptible to material misstatement due to fraud
• How management could perpetrate and conceal fraudulent financial reporting
• How assets of the company could be misappropriated
• The importance of maintaining the proper state of mind throughout the audit regarding the potential for material misstatement due to fraud

Other factors that the external auditor may consider as part of its risk assessment include the following:

• Communications and training programs, including the tools that help each level of management reinforce the desired messages with its direct reports
• Incentives or pressures that may exist for management to engage in fraudulent financial reporting
• Management’s fraud risk assessment and results of testing of internal controls

The board and audit committee can leverage the external auditor’s fraud risk assessment to ask questions of management.

Transparent, open, two-way communications between the external auditor and the audit committee are vital, and is it is necessary for all parties involved to employ an attitude of skepticism.

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READ MORE>> thecaq.org: The Fraud-Resistant Organization

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Who Gets Audited by the IRS?

Get an External Audit!

Believe it or not, it’s the big fish that get audited more often.

If a Schedule C shows more than $1 million in sales, the odds of being audited rise to 12.1%. If you are in this situation, I would suggest discussing incorporating your business with your attorney and tax professional. This move doesn’t just minimize your audit risk but it also allows you to take advantage of potentially lower tax rates and limits liability.

Here is some IRS data that show the frequency of audits performed in 2012 by return type:

First of all, in 2012 there were more than 143 million individual income tax returns filed, and 1% of these returns were audited that year.

• When it comes to business returns however, the odds of being audited increase. Many of those 2012 individual returns contained a Schedule C, Income and Expenses for sole proprietors.  Audit risk also rises depending on how much income your business generates. For example, if your Schedule C lists gross receipts under $25,000, your odds of being audited are 1.2%, just a little bit higher than those for individual returns without business income. The odds double to 2.4% when gross receipts exceed $25,000 up to $100,000. Once small business owners bring in more than $100,000 and up to $1 million in gross revenue, their odds of landing in the hot seat increase by 3.6%.
  
• When it comes to corporate returns, during 2012, 17.8% of large corporations with more than $10 million in assets were audited. And once assets exceed $20 billion, you can pretty much be guaranteed that you will be audited. In 2012, 415 out of the 446 corporations in this category were audited--that’s 93%.
  
• SELF-PREPARED RETURNS ARE TARGETED. There are more than 75,000 pages of tax code. Even tax professionals specialize in certain fields and refuse to take on tax returns or certain types of transactions because of the complexity involved. Once you become self-employed, the ante goes up; there is so much more to know about the tax code, more than can be dealt with through a Q & A session with tax preparation software designed for the individual filer. The IRS knows that there will likely be a lot of mistakes on self-prepared income tax returns that include a Schedule C. Therefore, many of those are pulled for examination.

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READ MORE>> SmallBusiness.FoxBusiness.com: Will Your Business Return be Audited

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What the IRS Looks for to Flag for an Audit

Contact GBC Audit Services today.

"The IRS examined 1.1 percent of all individual tax returns in 2010 and 2011, so the chances that your tax return will be audited are only about 1 in 90." -Moneywatch.

That is the good news, but nevertheless it's wise to be prepared, since being chosen for this is an unpleasant experience. Hire external auditors to come and evaluate your company for you and ensure you are taking care of business. Here is a brief summary of how the IRS looks for returns to audit:

The IRS uses a computerized process to check all tax returns for math and clerical errors, such as incorrect Social Security numbers and addresses, and also runs tax returns through a process that compares the information you report from your bank, employer, and W-2, 1099 and other forms and documents. If you omit an item from your tax return, it's very likely to be picked up by the IRS's computers.

A few newer items that can trip up some taxpayers include payments received by businesses from credit and debit cards and investors who report the sale of their investments. These amounts are reported by banks etc and it's important the amounts be accurate. Also, individuals who report gains from the sale of their investments should also take note that the securities industry is now reporting to the IRS the cost basis of investments that were sold as the gross proceeds from the sale.

Meanwhile, the IRS assigns numerical weights to certain tax return characteristics. These weights are added together to obtain a national composite score for all tax returns. When the total score of all selected items on your tax return exceeds the national average score set by the IRS, the agency will flag the return for a possible audit. The exact items the IRS zeroes in on and scoring method is a closely guarded secret, but some of the things the agency is believed to scrutinize include:

• Large amounts of income not subject to tax withholding 
• Unusually large amounts of deductions claimed than seem unreasonable when compared to your income 
• A large number of dependent exemptions claimed that doesn't square wtih reported SSNs, tax withholding allowances and so forth 
• Large deductions for charitable contributions, casualty losses, home office expenses, and travel and entertainment expenses 
• Indicating a change of address when not reporting a sale of your residence and not changing your home related deductions

While an IRS audit is not something most sane folks want to go through, it also isn't something to be feared. If you have kept complete and accurate records of all of your deductions and have reported all of your income, you should be fine. In fact, in about a quarter of audits, the IRS makes no changes or issues a refund. Contact GBC Audit Services today to arrange for smooth-sailing this tax season.

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READ MORE>> www.CBSNews.com: "What Triggers an IRS Tax Audit?"

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