Welcome to Just Answer. I am here to help you resolve your tax and finance concerns. Please feel free to ask anytime you need extra help.
First I would offer that in my years of experience IRS rarely looks at inventory records since an understatement/overstatement one year just reverses itself in the next.
That said, I would recommend starting with a complete physical inventory asap. After that inventory should be tested periodically (monthly), with a full physical count and pricing at the end of each quarter and specially at year end.
To determine the areas of concern start by looking at cost of sales variances. Most business people are well aware of their cost of sales because it is such an important factor in profitability. Are the cost of sales variances explainable? If not, there could be either error or theft.
Since a reconstruction could be a huge project, start correctly now and teach all involved why it is important. Educated people are more likely to care and comply.
As to the audit, keep your fingers crossed. If it is a tax audit, you are probably fine. If an accounting audit, there is nothing you can do about the past. However, showing corrective action in place will go a long way.
Edited by Charles Greiner on 12/3/2010 at 2:16 PM EST