Veterinary Medicine - Chapter 3, Examination Techniques
Publication Date - April, 2005
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- General Techniques
- Veterinary Office Procedures and Records
- Initial Interview/Internal Controls
- Examination Techniques - Balance Sheet
- Exhibit 3-1 - Form 4564, Information Document Request
- Exhibit 3-2 - Audit Plan
- Exhibit 3-3 - Initial Interview Questionnaire
Chapter 3, Examination Techniques
I. General Techniques
The application of the general techniques discussed in this section will depend on the type of entity (individual, corporate, etc.) and on the classification of the entity (practitioner, facility, group). Additional considerations may be the ownership structure (e.g., closely held) and the size of the entity.
Auditing a small to medium size veterinary corporate practice is much like an audit of any other type of corporation. The nature of the audit procedures selected and the extent of their application depends upon the degree of reliance that can be placed on the system of internal accounting controls.
Many veterinary practice corporations are closely held and may have related parties working within the corporation. Inquiries into the corporation's accounting procedure and staff are a factor in determining the depth and scope of the audit.
Before beginning the audit, the following may be helpful in planning the depth and scope of the audit:
- Articles of incorporation, bylaws, and stock certificate book
- Minutes of board meetings
- Organization chart
- Chart of accounts
- Contracts and agreements, such as leases
- Description of the accounting system and internal controls
- Loan agreements and other evidences of indebtedness and relationship to a debtor (education loans of shareholders)
- Copies of any prior audit reports by federal, state, or local agencies
- Copies of prior/subsequent returns and related returnsCopy of pension plan, letter of determination, and Form 5500s
Exhibit 3-1 is a sample Form 4564, Information Document Request, to assist you in obtaining these records.
It is important to keep track of where you are in an examination, including what you have seen and what you have requested. Exhibit 3 2 is an Audit Plan containing a list of audit steps that may be appropriate. The plan is not all-inclusive and should be modified for the taxpayer under examination.
A thorough understanding of the accounting systems is particularly important in the veterinary industry. The records created (hard copy or computer) by these types of systems may provide a valuable source of information in the examination of the veterinary practices. A complete explanation of the accounting system, both in theory and practice, should be obtained from the taxpayer prior to beginning the examination of the books and records.
A. General Procedures:
- The first record of customer visits to a veterinarian's office is the Appointment Book. This will reflect the customer’s name, and the date and time of visit. This information should link to the sign in sheet and individual customer account record. This record will be only as accurate as the office chooses to keep it. It may reflect appointments that were canceled, and no show appointments. It is not an exact record by itself.
- The Sign in Sheet will reflect the customer's name and the date of the office visit. It is merely a record of each customer coming into the office, as some customers have appointments while others could be walk ins. This record may not always link to the customer individual account record, as the amount charged each customer is not shown on it, and sometimes there may not be a charge for an office visit, such as for a surgery follow-up visit.
- The Day Sheet, usually completed for each day, will reflect the date, customer name, customer charges, payments received on the particular day, and the method of payment. Some collections on account may be for a charge prior to the current day. It may also contain a reconciliation of the day's receipts, bank deposits, and checks written as well as the amount of accounts receivable outstanding at the end of the day. Any charge or collection reflected on the day sheet should tie to a corresponding entry on the customer account card. Since the day sheet usually shows all receipts for a given day, it should also reconcile to daily deposits.
- A Statement of Procedures and Services, the bill prepared at the time of service, will show the charge for each procedure and service provided, and will include the date and customer's name. These charges should be directly reflected on the individual customer's account.
- The Customer Account Card or File will include all charges made to each customer, and all payments received on account. Receipts on account should be reflected in the income accounts of the books, and in bank deposits. Adjustments to the account, such as contractual allowances and discounts, should be reflected in the income or expense accounts of the books.
- The Bank Accounts will reflect daily deposits, and should include both cash and checks. Generally, deposit slips will reflect the source of the deposit, checks from clients, and credit card receipts. Deposits should be traceable back to a customer account, and collections posted to customer accounts should be traceable to a deposit.
Veterinarians may receive payments under a variety of different names:
For individuals - Dr. Jones, Dr. James Jones, Dr. J. Jones, etc.
For partnerships - Drs. Jones, Smith, & White, Main Street Clinic, etc.
For corporations - Dr. James Jones, P.C., Drs. Jones & Smith, P.C., Main Street Clinic, P.C., etc.
A. Initial Interview
The initial interview is an extremely important element of any examination. Information provided during the initial interview can save significant time and effort in unnecessary examination steps. In addition to the general items usually covered, specific questions relating to the practice of veterinary medicine should be included in the interview as well. As an audit aid, Exhibit 3 3 includes a listing of specific questions that may be appropriate. The list is not all-inclusive and some of the questions may not be pertinent in all examinations. The initial interview should be tailored to the taxpayer under examination.
B. Evaluating Internal Controls in a Small Business Environment
Internal controls are another area that must be explored during the initial interview in order to determine the accuracy and reliability of the taxpayer's books and records. Along with internal controls, consideration should be given to the taxpayer's financial status.
Control procedures in many small businesses are often weak or nonexistent. This may be due to cost factors, the lack of well-trained accounting staff or a lack of concern with this aspect of the business. Smaller businesses generally have a higher level of "control risk." Control risk is defined as the risk that a material misstatement could occur and it will not be prevented or detected on a timely basis by the business' internal control structure, policies, or procedures.
Evaluate the control structure of the business early in the examination process. The level of control risk should be assessed to determine the depth of the income probe. At a minimum, acquire knowledge of how the business operates on a day to day basis. Furthermore, the veterinarian's financial position must be understood to evaluate the likelihood that the profitability of the business supports the taxpayer's financial status.
Most of the knowledge needed to evaluate the control structure of the business is acquired through interviews of individuals having first hand knowledge of the business or thorough observations of the business operations.
The first area to explore is the control environment of the business. This is made up of many factors that affect the policies and procedures of the business. Such factors include management philosophy, management operating style, organizational structure, personnel policies, and external influences that can affect the business. A good first step is to draw up an overview of the business operations.
The second key area of internal control is the accounting system. Be familiar with the normal flow of each type of transaction, including the accounting records, which are involved in the processing and reporting of transactions. Generally, there are two significant elements to a transaction:
- The recording of the transaction from its initiation to its inclusion in the financial statements, and
- The flow of funds into or out of the business.
Control procedures are the last area. These are the policies and procedures established by management to achieve the objectives of the business. Separation of duties is the primary control procedure that should be documented. Many small businesses have one owner and no employees. Although no separation of duties can exist in this situation, other control procedures might be in place to assure accurate reporting of income and expenses. Formal control procedures are more likely to exist as the number of employees increases and the structure of the business becomes more complex.
In summary, a complete and thorough examination of the veterinary practice cannot be undertaken without an overview of the entire operation. An in depth review of the practice and the financial status of the owner/shareholder can only be accomplished through an evaluation and documentation of internal controls, including the control environment, the accounting system, and the control procedures.
General audit techniques for analyzing a balance sheet can be found at IRM 22.214.171.124. Guidance on reconciling a taxpayer’s books and records can be found at IRM 126.96.36.199.6, and IRM 188.8.131.52 details audit steps for analyzing Schedules M-1 and M-2. Industry-specific balance sheet issues are discussed below.
Cash may include cash on hand, money in checking and savings accounts, time deposits, and other cash investments. Multiple checking accounts may be maintained by veterinary practices. A main checking account may be used for depositing daily client receipts, paying expenses, and disbursing refunds to clients, while separate accounts are utilized for payroll or other purposes. Time deposits may be in the form of savings accounts, money market accounts, certificates of deposit, or similar accounts. Many times, transfers of funds occur among these accounts. Therefore, consider all accounts when analyzing the cash account.
B. Accounts Receivable
The method of reporting revenue must be determined when analyzing this account.
There are companies that will purchase the receivables of veterinary practices. Any sale of receivables should be reviewed to insure correct reporting of income based on the taxpayer's method of accounting.
In closely held situations, inclusion of loans to related parties in receivables should be reviewed.
Analyze accounts by the following categories: customer accounts, affiliated companies, shareholders, officers, and employees.
Veterinarians often hold stocks, bonds, real estate (for example, farms), or other types of investments through their corporations. Ensure that all income reporting (including sales of investments) has taken place when analyzing this account.
As previously discussed in Chapter 2, sales should be analyzed to determine whether the items purchased and their generation of income is material and should therefore be separately identified as inventory.
Remember that inventory items frequently include medicine, drugs, and feed supplements, as well as a large variety of pet items such as carriers, shampoos, and collars. Inventory versus supplies is a major issue in many situations. Also, as discussed in Chapter 2, certain court cases have held that the furnishing of pharmaceuticals by a medical treatment facility was so integrated in the rendering of the medical service that such drugs did not have to be inventoried. See Osteopathic Medical Oncology and Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999); Mid-Del Therapeutic Center, Inc. v. Commissioner, T.C. Memo. 2000-130.
Any medical supplies or drugs which are sold separately to the veterinarian's customers may still constitute inventory.
Form 4564, Information Document Request
Description of Documents Requested
In general, the records and documents that will be required to complete your examination include all of the records, journals, ledgers, logs, worksheets/schedules, third party statements, receipts, etc. that you used when preparing your ________ return.
For assistance, below is a list of specific items pertaining to your examination. Other documentation may be requested on an as needed basis.
- Copy of the following items for inspection:
- Prior and subsequent year Federal Income Tax Returns, including any amendments.
- State Income Tax and State Sales Tax returns.
- Officer/stockholders’ or partners’ Form 1040 for the year under examination, prior and subsequent years.
- Related corporate returns, that is, subsidiary, parent, and brother/sister.
- Related partnership returns.
- Payroll tax returns including Forms 940, 941, and State payroll tax records for all quarters encompassing the year under examination.
- Forms W-2 and 1099 issued for year under examination.
- Forms W-4 or W-9 for all workers.
- If previously examined, copy of prior Revenue Agent Report.
- Pension profits/sharing plan including determination letter and Form 5500 for the year under examination.
- Corporate Minute Book or Partnership Agreement.
- Working Trial Balance with a Chart of Accounts, including all adjusting/closing journal entries and accountant’s workpapers.
- Ledgers and Journals as follows:
- General Ledger.
- All subsidiary ledgers.
- General Journal - including payroll.
- Cash Disbursements.
- Cash Receipts.
- Voucher payables.
- Any other special journals maintained.
- All journals, records and workpapers for the year under examination pertaining to Business Gross Receipts, including but not limited to:
- Appointment books.
- Sign-in sheets.
- Day sheets.
- Bank statements for all accounts.
- Cancelled checks for all accounts.
- Money market, brokerage and investment statements for all accounts.
- Record of any loans and repayments during the year under examination.
- Detailed depreciation schedules.
- All journals, records and workpapers for the year under examination pertaining to Cost of Goods Sold including, but not limited to:
- Beginning and ending year inventory valuation, count, and dates of inventory verification.
- Inventory purchased.
- Removal of items for personal use.
- Cost of Labor.
- Purchase of materials and supplies.
- Other costs
Taxpayer Name: _________________ Form: _________________ Year: ______
|Date||Item||Document Request #|
1. Initial Interview
|2. Read Corporate Minute Book|
|3. Reconcile stock ownership|
|4. Complete 3-year analysis|
|5. Reconcile books to return|
|6. Reconcile cash to balance sheet|
|7. Review M-1 and M-2 schedules|
|8. Scrutinize adjusting entries|
|9. Scrutinize financial statements|
|10. Compare 941's to Wages and Taxes|
|11. Scrutinize related returns, sub years|
|12. Scrutinize pension/profit sharing plan|
|12a. Complete Form 4632 and 4632-A|
|13. Scrutinize Books|
|13a. General Journal|
|13b. Sales reversals|
|13c. Comparative Statements|
|14. Refine audit plan -- select items|
|15. Complete Gross Income Probe- Consider IRM 4.10.4.|
|16. Scrutinize canceled checks|
|16a. Additional banks|
|16b. Foreign activities|
|16c. Related transactions|
|17. Special Issues - Employment Tax|
|18. Related Party Transactions IRC §§ 7872, 461, and 267(a)|
Form: ________________________ Year: ______
Initial Interview Questionnaire
Every audit should include a tour of the taxpayer's facilities. Is the business still located at the address on the return? Are there any other locations?
If the Entity is a Corporation:
- Ask the taxpayer to explain the corporation's history.
Date incorporated: ______________ State:________
How did the business start?
Sole proprietorship, S-Corp, C-Corp, Partnership, purchase of stock from third party, IRC § 351 transfer?
Any changes in entity? (Possible built-in gains)
- Are the present officers-stockholders the incorporators?
- Who are the current officers-stockholders responsible for the corporation's management? (Executive, financial, sales, and services)
- What is the percentage of corporate ownership of each officer?
- What is the percentage of each officer's/stockholder's time devoted to the corporation's business?
- Have their ownership percentages and duties remained constant?
- How is compensation of officers-stockholders determined? (Salary plus bonus? Other fringe benefits?)
- Does the corporation own or lease passenger or recreational vehicles? If yes, to whom are these vehicles assigned? How are business purpose and expenses documented?
- Are immediate family members or close relatives employed by the corporation?
Explain the financial operations of the business, including the accounting system, types of records maintained, and internal controls.
- Is there an organizational chart? If not, describe in a general manner the organization of the accounting department, that is, the lines of responsibility.
- Who should be contacted to obtain books, records, documents needed during the examination? Isthere an office manager?
- What books and records are kept? Chart of accounts used? Double entry books used?
- Who keeps the books and records? Who adjusts and closes the books? Who reconciles bank accounts? Are proper cutoffs observed at month-end and year-end? Are adjusting and closing entries available?
- When are financial statements prepared (monthly, annually)? Who prepares them? What information is in the statements?
Have financial statements been given to others, such as banks, creditors, other businesses, etc.? Why? (Obtain copies)
Have the financial statements been restated for any reason?
Were the corporation's financial statements for the last 3 years audited by a public accountant?
If yes, were certified financial statements issued? (Obtain copies)
- Is the accounting software a commercial product?
Does the taxpayer receive technical support from the company for any problems encountered or are the problems fixed in-house? If in-house, by whom?
- Does the taxpayer use the services of an accounting firm? Does the accounting firm also provide management and consulting services?
How does the accounting firm bill (annual retainer fee, retainer plus specific items fee basis, or specific item fee only)?
Has the taxpayer changed CPA's? If so, why?
- Have there been any prior audits by any federal, state, or other governmental agency?
Describe the business operations during the year under exam, and what, if any, changes have occurred.
- Is the practice specialized? Does the practice experience seasonal fluctuations?
- Is the practice affiliated with any other veterinarians, clinics, emergency rooms, or hospitals?
- Does the practice have a combined purchasing arrangement for inventory or supplies?
- Who are the principal customers?
Has the business changed its means of producing income since incorporation?
How is new business obtained?
- Do all veterinarians in the practice provide the same type of medical care?
- Have there been any unusual or extraordinary events during the last three years (reorganizations, acquisitions, dispositions, or decline in income due to casualty, loss of prime client or supplier, or other economic or business conditions)?
- Has the taxpayer constructed or renovated any office, surgery, or animal holding facility? (Capitalize interest)
- Are there any plans in the future to expand or remodel?
- Does the practice own or rent the building?
Is any portion of the building leased to an independent contractor?
Is any portion of the building used for personal use?
- Are the assets used in the business owned or leased (tables, chairs, desks, x ray equipment)? Is there an option to purchase?
- How are appointments scheduled?
Is daily log or day sheet maintained?
- What are the billing practices (when services are rendered, monthly, or after insurance reimbursement)? Are all invoices pre-numbered, and are all numbers accounted for and used in sequence?
- What kind of inventories and supplies are kept on hand?
How are sales of inventory billed? Billed separately or as part of other services rendered? Is there a fee structure for high volume customers?
Are they inventoried for book and/or tax purposes?
If not, why not?
If so, what is included?
Are physical inventories conducted?
What records are available?
- Who opens the mail for the office or clinic?
- Is all cash received deposited?
If not, what is it used for and how is it accounted for?
Are any personal expenses paid by cash?
Are all checks deposited into the business account?
If not, what is procedure for check cashing?
How are non deposited checks accounted for?
Who cashes checks?
Where are they cashed (bank, check cashing business, other)?
What is the cash used for?
Who makes deposits?
How far away is the bank?
Are duplicate deposit slips kept?
- How is petty cash handled?
How are day accounts receivables handled?
How are credit card payments handled?
- Who authorizes the purchase of major items?
Who authorizes write offs?
- Are personal funds of shareholders and officers kept completely separate from business funds? Have the taxpayer/representative walk through a complete income transaction and a complete expense transaction. Prepare a flowchart as each is being described.
- Does the taxpayer have an Internet presence? (Website, web page, e-mail, banner for business purposes, how many websites are used by the business)
- Does the taxpayer conduct business transactions over the Internet? (Accept orders and/or payments over the Internet?)
Other Sources of Income
- Are any of the veterinarians involved in lecturing, teaching, or speaking engagements?
- Have any receivables been sold? If so, provide full explanation and documentation.
- Referral of patients to labs, clinics, emergency rooms, diagnostic centers (MRI, etc.), pharmacies?
Was any remuneration in the form of cash or other incentives received from the referral?
Is an interest owned in any operation to which referrals are made?
- Is there a pharmacy located in the facility?
- Is medication administered or prescribed by the veterinarian?
Cash payments or other incentives or benefits from drug companies?
- Contracts with zoos, government agencies, unions, schools, or other organizations to provide veterinary medical services?
- Payment to veterinarians by corporation for services other than veterinary services? (Directors' fees, etc?)
- Does the taxpayer perform surgery, etc. after hours?
- Does the company furnish services in exchange for goods or services?
- Have they ever received a cash payment of more than $10,000?
Were Forms 8300 filed? (Secure copies).
- How many employees?
Number and type of veterinarians on payroll: ____ Number and type of others: ____
- Number of assistants employed? Any student assistants?
- Any contract workers? If yes, determine if contract workers are employees or self employed.
For information concerning this subject, see "Independent Contractor or Employee?", Training 3320 102 (Rev. 10 96) TPDS 84238I.
- How are payrolls handled? Have all payroll returns been filed to date?
- Are 1099s issued to individuals for payments of $600 or more?
- When does the practice secure Social Security Numbers (W 4, W 9)?
Have they ever received a notification letter from the IRS regarding no/invalid SSN/EIN? If yes, what action was taken?
- Are any incentives (recruiting or other) provided to or received by veterinarians or other providers? If so, what type, who provided them and how are they reported?
(Examples: interest free loans; below market interest rate loans; loan forgiveness; rent, purchase, or other payment in excess of fair market value [to veterinarian/shareholder]; provision of office and staff rent free or below fair rental value; payment of personal expenses; repayment of student loans or other educational liabilities; income guarantees; bargain sales to veterinarians; payment of malpractice premiums; or malpractice payments not covered by insurance)
- Did the taxpayer (or shareholders) attend veterinary school on a scholarship?
If so, did they complete the required service? If the required service was not completed, has the scholarship been repaid with the required penalties?
Have any amounts been expensed through the corporation?
Did the taxpayer obtain a student loan (government or private) to attend undergraduate or veterinary school? Repayment history?
Have any amounts been expensed through the corporation?