4.10.3  Examination Techniques (Cont. 1)

4.10.3.5  (03-01-2003)
Examination of the Taxpayer’s Books and Records

  1. The examination of the taxpayer’s books and records serves two basic purposes:

    1. To analyze the likelihood that there are no material errors;

    2. To determine that individual transactions are valid (allowable), have not been omitted, are recorded at the correct dollar value, are properly classified, and are recorded in the correct time period.

  2. This section includes basics steps for analyzing and testing the taxpayer’s books and records.

4.10.3.5.1  (03-01-2003)
Step 1: Determination of Available Books and Records

  1. The first step is to determine what books and records are available for examination.

  2. Taxpayers may present receipts and cancelled checks as verification for items on the return. A business may use a single entry system with daily, weekly, or monthly entries and total, or a double-entry system. The routine bookkeeping may be accomplished through computerized or manual means.

  3. If the taxpayer is under a record retention agreement with the Service, they must maintain magnetic tapes, disks, or other machine sensible data or media used for recording, consolidating, and summarizing accounting transactions and records within the taxpayer’s processing system. See Rev. Proc. 91–38 for further information on Record Retention Agreements.

4.10.3.5.2  (03-01-2003)
Step 2: Taxpayer Explanation of Books and Records

  1. The second step is to have the taxpayer explain the books and records. The accounting and record keeping system should be explained by the person most knowledgeable of the system. The appropriate person may be the taxpayer, an employee of the taxpayer, or the taxpayer’s representative. The key is that the person must have knowledge of the taxpayer’s accounting system.

  2. The taxpayer’s explanation of the books and records should include:

    1. Explaining the flow of transactions or entries from the initial transaction, through all book entries and reconciliations to the tax return.

    2. Tracing specific income, expense, and, if applicable, balance sheet items through the accounting system (an accounting system includes all books of entry and all reconciliations).

    3. If applicable, tracing the flow of purchases and inventory through to Cost of Goods Sold.

    Note:

    These steps will also be used to evaluate the taxpayer's internal controls as described above.

4.10.3.5.3  (03-01-2003)
Step 3: Determination of Accounting Period

  1. The third step is to determine the taxpayer’s accounting period. "Annual Accounting Period" means the annual period regularly used by the taxpayer to compute income and maintain books and records (IRC section 441(c)).

  2. The term "taxable year" means:

    1. The taxpayer’s annual accounting period, if it is a calendar year or a fiscal year; or

    2. The period for which the return is made, if a return is made for a period of less than 12 months.

    3. See IRC section 441(b) for other taxable years.

  3. A tax year is adopted when a tax return for the taxpayer is filed by the due date (not including extensions) of the taxpayer’s first taxable year. Examples:

    1. A new corporate taxpayer, with a fiscal year ending August 30, has until November 15 of that same year to file its first tax return, to adopt this taxable year.

    2. A new individual taxpayer, with a calendar year, has until April 15 of the subsequent year to file his/her first tax return, to adopt this taxable year.

    3. A new corporate taxpayer, with a calendar year, has until March 15 of the subsequent year to file its first tax return, to adopt this taxable year.

  4. Allowable accounting periods include:

    1. Calendar year, ending December 31 — A calendar year is required if the taxpayer does not keep books, does not have an accounting period, or has an accounting period that does not qualify as a fiscal year.

    2. Fiscal year, ending on the last day of a month other than December.

      Note:

      If the taxpayer intends to choose a fiscal year, adequate books of account must be established before the end of the first accounting period.

    3. 52–53 week period.

  5. A short tax year is one of less than 12 months. The following two situations can result in a short tax year:

    1. When a taxable entity is not in existence for an entire tax year. Income, expenses, and tax are computed solely for the period of time the entity is in existence.

    2. When an existing taxable entity changes or is required to change its accounting period. In this case, income, expenses, and tax must be annualized.

      Example:

      A corporation files a tax return because of a change in accounting period for the 6 month short tax period ending June 30. The corporation has taxable income of $40,000 during the short tax year. Its annualized income is $80,000 ($40,000 x 12/6) . Its total tax (as annualized) is $15,450. The tax for the short year is $7,725 ($15,450 x 6/12).

  6. Generally, partnerships, S corporations, and personal service corporations must use a calendar year unless:

    1. A business purpose is established for another tax year, or

    2. A section 444 election is made.

  7. In general, the taxpayer must obtain the consent of the Commissioner to change the accounting period. Treas. Regs. 1.442-1(a)(1). The guidelines for obtaining this consent are contained in Rev. Proc. 92–13, 1992-1 C.B. 665, as modified by Rev. Proc. 92–13A, 1992-1 C.B. 668.

  8. Treas. Reg. 1.442-1(c) provides a special rule for certain corporations to change the annual accounting period without the prior approval of the Commissioner if all the following conditions are met:

    1. The corporation has not changed its annual accounting period within the 10 calendar year period ending with the calendar year that includes the beginning of the short period required to effect the change,

    2. The short period required to effect the accounting period change is not a taxable year in which the corporation has a net operating loss,

    3. The taxable income for the short period is, if placed on an annual basis, 80% or more of the taxable income for the tax year immediately preceding the short period,

    4. The corporation, if it had a special status (as defined in section 1.442-1(c)(2)(iv)) either for the short period or for the tax year immediately preceding the short period, must have the same special status for both the short period and the preceding tax year, and

    5. The corporation does not attempt to elect S corporation status for the tax year immediately following the short period.

4.10.3.5.4  (03-01-2003)
Step 4: Determination of the Taxpayer’s Method of Accounting

  1. The fourth step is determining the taxpayer’s method of accounting. An accounting method is a system for stating income, expenses, assets, liabilities, and financial position. Taxable income must be computed not only on the basis of a fixed accounting period, but also in accordance with a method of accounting regularly employed in keeping the taxpayer’s books.

  2. An accounting method is selected when the first tax return is filed.

  3. IRC Section 446(d) states a taxpayer may compute taxable income under any of the following methods of accounting:

    1. The cash receipts and disbursements method,

    2. An accrual method,

    3. Any other method permitted by this section, or any combination of the foregoing methods permitted under regulations prescribed by the Secretary (hybrid methods).

  4. There are special methods of accounting for the following income and expense items:

    1. Depreciation (IRC sections 167 and 168).

    2. Amortization (IRC sections 169, 178, 194, and 197).

    3. Depletion (IRC sections 611, 612, 613, and 613A).

    4. Deduction for Bad Debts (IRC sections 166 and 582).

    5. Installment Sales (IRC sections 453 and 453B).

    6. Long Term Contracts (IRC section 460).

  5. A taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.

  6. A reasonable (hybrid) method may be used, subject to the following restrictions:

    1. If inventories are present, the accrual method must be used for purchases and sales.

    2. If the cash method is used to compute income, the cash method must be used to compute expenses.

    3. If the accrual method is used for reporting expenses, the entire accounting method must be accrual.

  7. If the taxpayer selects an erroneous accounting method when the first return is filed, it can be corrected by filing an amended return before the filing of the next year’s return. All other accounting method changes can only be done with the permission of the Commissioner. See paragraph (9) below.

  8. The Service can prescribe a method of accounting that will " clearly reflect income" if, in the Service’s opinion, the taxpayer’s method does not clearly reflect income. A method does not clearly reflect income if all items of income and expense are not treated with reasonable consistency (see paragraph (9) below).

  9. Taxpayers may obtain the consent of the Commissioner to voluntarily change their method of accounting. In addition, an examiner may require a taxpayer to change from an improper method of accounting to a proper one. The Service has issued a series of revenue procedures to provide guidance and procedures for changes in method of accounting, whether voluntary or involuntary. Examiners must ensure that they are familiar with the applicable guidance in effect for the tax year under examination. The most recent guidance is available on the Change in Accounting Method (CAM) Technical Advisor web page located through the LMSB Intranet site.

  10. For additional details concerning Change in Accounting Method, please refer to IRM 4.10.13. Additionally, examiners are encouraged to consult with the Change in Accounting Method (CAM) Technical Advisor for additional assistance.

4.10.3.5.5  (03-01-2003)
Step 5: Determination of the Depth of the Examination of the Taxpayer’s Books and Records

  1. The fifth step is determining the depth of the examination of the taxpayer’s books and records.

  2. Factors that should be considered when determining the depth include:

    1. Type of Records — taxpayers use a variety of bookkeeping methods and maintain different types of records.

    2. Volume of Records — voluminous records may be encountered when auditing larger taxpayers or when the taxpayers records are unorganized.

      Note:

      When a taxpayer submits unorganized records, the burden is on the taxpayer to organize them and prepare summaries and reconciliations. This can be done with or without the examiner’s presence.

  3. The depth of the examination of the taxpayer’s books and records should be established after:

    1. Interviewing the taxpayer,

    2. Touring the business site (if applicable), and

    3. Evaluating the taxpayer’s internal controls.

  4. The depth may be expanded or contracted as the examination progresses, if warranted.

  5. The depth of the examination of the taxpayer’s books and records can be limited to the verification of specific items. This is appropriate for Office Audit examinations of wage earners and small Schedule C’s (where gross receipts have not been classified as an audit issue).

  6. The depth of the examination of the taxpayer’s books and records should include sampling techniques when there are voluminous records. This is an effective use of time in situations when it is impossible to review all records .

  7. Mechanical verification of particular accounts or journals should be kept to a minimum. If the degree of error is substantial, the taxpayer should be asked to make suitable verification and correction before the examination proceeds. Mechanical verification of the taxpayer’s books and records should be more extensive when indications of fraud are present.

  8. Taxpayers are required by law to maintain accounting records in sufficient detail to enable the preparation of an accurate tax return (IRC section 6001) . The appearance of the records is not important as long as the accuracy and orderliness are not affected.

  9. If the taxpayer’s records are lost, destroyed, or are not available due to circumstances beyond the taxpayer’s control, examiners may allow the taxpayer to present reconstructed records. The reconstructed records should be reviewed to determine the amounts are ordinary and necessary to the business activity.

  10. When records are incomplete, nonexistent, or suspect, the Examining Officer’s Activity Record (Form 9984) should document all attempts to obtain the taxpayer’s records and the group manager should be informed so delays can be kept to a minimum.

4.10.3.5.6  (03-01-2003)
Step 6: Reconciling the Taxpayer’s Books and Records to the Tax Return

  1. The sixth step is reconciling the taxpayer’s books and records to the tax return. The reconciliation traces the process the taxpayer used to prepare the return from the books and records.

  2. The records used for this reconciliation are:

    1. Taxpayer and/or accountant summaries, reconciliations, and account grouping papers — These will show the grouping of book accounts to the respective line items on the tax return.

    2. Profit and loss statement — The profit and loss statement is a financial report of an entity’s revenues and expenses for the accounting period. The report summarizes the net income or net loss for the period. The report is sometimes referred to as a "P&L " , income statement, or statement of operations.

    3. Compilations, audited and certified financial statements.

    4. Trial balance sheets — The trial balance is the listing of all accounts in the general ledger and their balances. A trial balance may be prepared at any time.

    5. Adjusted trial balance — A trial balance taken immediately after all year-end adjusting entries have been posted is called an adjusted trial balance. The adjusted trial balance is used to prepare financial statements. The balance taken immediately after closing entries have been posted is called a post-closing trial balance. Schedule M adjustments are calculated next, and then the tax return is prepared.

    6. Adjusting journal entries — Normally a taxpayer will need to correct, adjust or reclassify some original book entries by making adjusting journal entries. The adjusting journal entries are often recommended by persons conducting the year-end audit for financial reporting purposes.

    7. Tax reconciliation workpapers — The trial balances and adjusting (and consolidating, if applicable) entries are usually included in what the taxpayer may call the "tax reconciliation workpapers" or "grouping papers" . The tax reconciliation workpapers are requested at the beginning of an examination. These workpapers include the final balance which ties the tax return to the general ledger and other analyses necessary to complete the return.

  3. The following audit techniques should be used to reconcile the taxpayer's books and records to the tax return:

    1. Reconcile the profit or loss shown on the return to the taxpayer’s books.

    2. Compare prior and subsequent years P&L statements. Identify significant changes and adjust the scope/depth of the examination as needed.

    3. Review the adjusted trial balance, including the adjusting entries and explanations.

    4. Compare the current year’s trial balance to the prior and subsequent year’s balance. Note significant variations for further inquiry.

    5. Review the adjusting journal entries. Analyze the adjusting journal entries to verify the corrections or reclassifications are proper. Confirm the taxpayer’s explanations depict the true effect of the adjustments.

4.10.3.6  (03-01-2003)
Schedules M–1 & M–2

  1. The following section outlines procedures for analyzing Schedule M–1 and Schedule M–2.

4.10.3.6.1  (03-01-2003)
Schedule M–1

  1. Schedule M–1 is a critical schedule for identifying potential tax issues resulting from both temporary and permanent differences between financial and tax accounting.

  2. For a corporation, Schedule M–1 is the reconciliation between net income per the books and taxable income before the net operating loss deduction, dividends received, and the special deductions per Schedule C.

  3. For a partnership, Schedule M–1 is the reconciliation of net income per the books to the net income per Schedule K after taking into consideration all the separately stated income and expense items.

4.10.3.6.1.1  (03-01-2003)
Schedule M–1: Audit Techniques

  1. Use the following audit techniques to examine the entries on Schedule M–1.

    1. Verify that net income per the books agrees with net income per Schedule M–1, line 1. If not, obtain the taxpayer’s reconciliation of net income, per the books to net income, per Schedule M–1, line 1. The taxpayer is taking the Schedule M–1 adjustments off the return.

    2. Obtain the workpapers showing how all Schedule M–1 adjustments were calculated. Verify that large Schedule M–1 adjustments going in opposite directions (i.e., one increasing taxable income and the other decreasing taxable income) were not netted to arrive at what appears to be an immaterial amount not worthy of further review.

    3. Example of audit techniques

    Expense on return & not books:  
    Abandonment Loss $(100,000)
    Expense on books & not return:  
    Workman Compensation Loss $ 101,000
    Net Schedule M–1 Adjustment:  
    Expense on Books & not return $1,000

  2. Review legal authority supporting book vs. tax difference.

  3. Compare current year M–1 adjustments to prior and subsequent years’ Schedule M–1 adjustments:

    1. If a prior year’s Schedule M–1 adjustment is not made in the current year, determine the reason why.

    2. If a new Schedule M–1 adjustment is made in a subsequent year, determine if a similar Schedule M–1 adjustment should have been made in the year under examination.

    3. For book vs. tax temporary timing differences, verify that the applicable Schedule M–1 adjustments were made on the prior and subsequent year returns.

    4. Example:

      During 1994, the taxpayer received $30,000 for a three year agreement to buy a specific amount of raw materials from a supplier. For book purposes this $30,000 will be amortized into income at $10,000 per year over the three year term of the agreement. For tax purposes, the $30,000 will be recognized as income when received in 1994. The 1995 tax return is under audit. Review the 1994 return and verify the Schedule M–1 adjustment (income on return and not books of $20,000) was made. The following Schedule M–1 adjustments should have been made:

    1994 M–1: Income on return and not books
    $30,000 — $10,000 = $20,000
     
    1995 M–1: Income on books & not return
    ($10,000)
     
    1996 M–1: Income on books & not return
    ($10,000)

  4. Reconcile the total federal income tax expense per the books (including both current and deferred amounts) to the federal tax Schedule M–1 adjustment. Investigate any differences.

  5. Generally, for most reserves, a schedule should be prepared showing the beginning and ending balances. If the reserve increases during the year, a Schedule M–1 adjustment should have been made to increase taxable income. If the reserve decreases, taxable income would be decreased through a Schedule M–1 adjustment.

4.10.3.6.2  (03-01-2003)
Schedule M–2

  1. Analyze all changes in the retained earnings account per books during a given accounting period.

  2. Reconcile income per books with income per return. (Schedule M–2, line 2 equals Schedule M–1, line 1.)

  3. Reconcile opening balance with prior year’s ending balance. (Schedule M–2, lines 3, 5, and 6.)

  4. Verify that no deduction has been claimed for expenses related to stock dividends. (Schedule M–2, line 5b and line 6.)

  5. Determine that income items recorded as credits have been properly included in income.

  6. Consider imposition of IRC section 531 tax.

  7. Reconcile ending balance to book balance.

  8. Exhibit 4.10.3–4 is an example of a reconciliation of income and analysis of unappropriated retained earnings.

4.10.3.7  (03-01-2003)
Bank Record Reconciliations

  1. Bank records are third party source documents which support the taxpayer’s records. They provide an audit trail for transactions not disclosed in the taxpayer’s books and records.

  2. An examination of the bank records is necessary to determine:

    1. whether bank account transactions are being properly recorded;

    2. whether amounts deposited from any taxable source have not been reported;

    3. whether any improper entries were recorded during the year.

  3. The depth of the bank account analysis depends on the circumstances of each examination. The analysis is more important in an examination where the records are inadequate, nonexistent or possibly falsified. See IRM 4.10.4 for more details.

4.10.3.7.1  (03-01-2003)
Step 1: Review of Taxpayer’s Bank Account Reconciliation

  1. Review the year-end bank account reconciliations prepared by the taxpayer to determine how much audit work is required.

  2. If the bank accounts reconcile back to the books, then all transactions are probably recorded somewhere in the records. The transactions should be tested for proper recordation.

  3. If reconciliations do not exist or the bank accounts do not reconcile to the books, additional audit procedures are necessary.

  4. Reviewing the bank reconciliations involves the following steps:

    1. Trace the ending balance to the general ledger.

    2. Review any outstanding checks and investigate their status.

    3. Review outstanding deposits and determine if all are included in the reconciliation.

    4. Trace total deposits and disbursements per the reconciliation to the general ledger account entries.

4.10.3.7.2  (03-01-2003)
Step 2: Review of Monthly Bank Statements

  1. Review the monthly bank statements to:

    1. Gain an understanding of the frequency and typical amounts of deposits.

    2. Determine the average amount and volume of checks written.

    3. Establish the interaction between accounts.

    4. Compare the total deposits to the gross income of the taxpayer by considering non-taxable deposit sources such as loans, checks to cash, transfers between accounts, gifts and inheritances, and insurance proceeds and by identifying large, unusual, questionable (LUQ) deposits and withdrawals which warrant further audit action. Keep in mind that this is not a bank deposit indirect method of determining income, which is only appropriate for cash method taxpayers or taxpayers who have inadequate books and records.

    5. Trace these LUQ items through the ledger to determine their source and book treatment.

    6. Interview the appropriate person to determine the treatment of LUQ items.

4.10.3.7.3  (03-01-2003)
Step 3: Bank Deposit Analysis

  1. The purpose of the bank deposit analysis is to determine the source of the deposits. An analysis is time consuming and in many instances inappropriate, as in the case of a large corporation with a double entry accounting system. Therefore, the examiner must use judgment as to the extent and degree of this analysis.

  2. For testing the reporting of income, trace specific items of income from the source document through to the general ledger to determine whether all income transactions are reported properly and to detect unreported or improperly recorded items. A review of two or three months’ transactions postings should be sufficient.

  3. Large, unusual or questionable (LUQ) deposits deserve attention. Information from the initial interview should help determine what is LUQ.

  4. Some examples of LUQ deposits include:

    1. A large deposit when the normal is small,

    2. Even dollar amounts when most are not even,

    3. Cash deposit(s) by a non-cash business,

    4. Regular monthly deposits from unidentified source(s) (possible sources include unreported rental or installment sale income, and repayment of loans without reporting appropriate interest income),

    5. Any other deviations from a regular deposit pattern.

4.10.3.7.4  (03-01-2003)
Step 4: Reconciliation of Bank Deposits to Gross Receipts

  1. A useful audit procedure for small to medium-size taxpayers who deposit the majority of their gross receipts into a bank account is the reconciliation of bank deposits to gross receipts reported on the tax return.

  2. Non-taxable sources of income are critical to this computation and should be identified first.

  3. If the deposit analysis shows no material discrepancy between deposits and gross receipts, then a testing of income transactions may be all that is needed to complete the examination of income. See IRM 4.10.4, Material Understatements and Managerial Involvement for more information.

  4. If the deposit analysis shows a discrepancy between deposits and gross receipts, the audit steps are expanded to determine the cause of the discrepancy. See 4.10.4, Audit Techniques for In-Depth Examinations of Income: Corporations and Other Business Returns for more information.

  5. Exhibit 4.10.3–5 is a possible format for reconciling deposits to gross receipts.

4.10.3.7.5  (03-01-2003)
Step 5: Check Analysis

  1. A check analysis is conducted as a:

    1. Means of verifying the expenses and deductions claimed on the return.

    2. Source of information to determine the total disbursements, including nondeductible expenditures.

  2. A detailed analysis is time consuming and only necessary when there are inadequate records or when a potential for unreported income is present.

  3. If a review of the check disbursements is necessary, a quick scan of the cash disbursements journal can be made. Look for LUQ items and follow up as necessary.

  4. Checks should be analyzed to identify:

    1. Possible undisclosed income,

    2. Possible investments,

    3. Possible expenditures,

    4. Check endorsements

  5. When there are inadequate records or when the possibility of unreported income is present, an indirect method of determining income is indicated. IRM 4.10.4 contains guidelines and computational instructions for indirect methods.

4.10.3.8  (03-01-2003)
Balance Sheet Analysis: Introduction

  1. The preliminary analysis of corporation and partnership returns should also include consideration of the balance sheet.

  2. The balance sheet analysis is a useful technique to review the taxpayer’s financial position and identify adjustments to the profit and loss accounts.

4.10.3.8.1  (03-01-2003)
Balance Sheet Definitions

  1. A balance sheet, or statement of financial position, presents the financial position of a business entity on a specific date. The balance sheet provides a summary of the following elements:

    1. Assets — the financial resources the entity owns, future benefits obtained or controlled by the entity as result of past transactions or events.

    2. Liabilities — the debts the entity owes, the sacrifice of economic benefit, obligations to transfer assets or provide services to other entities.

    3. Equity — the remaining interest in the assets of the entity after deducting its liabilities. The equity represents the ownership interest.

  2. A balance sheet is a detailed expression of the equation:
    Assets = Liabilities + Equity

  3. Exhibit 4.10.3–6 demonstrates how transactions are posted to balance sheet and income statement accounts.

4.10.3.8.2  (03-01-2003)
Step 1: Determine Balance Sheet Basis

  1. The first step when analyzing a balance sheet is to determine whether the taxpayer’s balance sheet is tax based or book based.

  2. If the balance sheet is tax based, account balances are calculated based on the tax treatment of various income and expense items, as opposed to the book treatment of these items.

  3. In most instances where the balance sheet is tax based, the net income per the books will not agree to Schedule M–1, line 1 per the tax return. This means that all Schedule M–1 adjustments have not been disclosed. For example, balances on the tax return balance sheet do not agree to balances per books. Small differences may be the result of different account groupings for book and tax purposes.

  4. Use the following audit steps if the balance sheet is tax based:

    1. Verify net income per books agrees to net income per Schedule M–1, line 1. If it does not reconcile, obtain a schedule from the taxpayer reconciling the net income per the books to net income per Schedule M–1, line 1.

    2. Verify total assets and retained earnings per tax return balance sheet agrees to total assets and retained earnings per books. Any differences should be analyzed.

    3. Determine if the taxpayer’s accounting method clearly reflects income pursuant to IRC 446(c).

4.10.3.8.3  (03-01-2003)
Step 2: Identify Accounts for In-Depth Analysis

  1. The second step when analyzing a balance sheet is to identify accounts for in-depth analysis. See IRM 4.10.2, LUQ’s Defined.

  2. The analysis will include review of the books and records and consideration of:

    1. Accounts with unusual titles,

    2. Unusual entries within accounts,

    3. Accounts with large numbers of adjusting journal entries, and

    4. Accounts with large dollar amount entries in one month versus other months.

4.10.3.8.4  (03-01-2003)
Step 3: In-Depth Analysis

  1. The third step of a balance sheet analysis is the in-depth analysis of the balance sheet accounts selected in Step 2.

  2. The following subsections present specific techniques for analyzing individual balance sheet items. See Exhibit 4.10.3–7 for additional information.

4.10.3.8.4.1  (03-01-2003)
Cash on Hand in Bank

  1. Verify the book year-end balance reconciles to the bank statement year-end balances. Review reconciling items for propriety and test transactions as appropriate.

  2. Review cash disbursements journal for a representative period. Note any missing check numbers, checks drawn to the order of cash, bearer, etc.; large or unusual items; and determine propriety thereof, through a comparison with vouchers, journal entries, etc.

    1. In the case of a cash basis taxpayer, ascertain if checks were written and recorded which were issued after the close of the year under examination.

    2. Consider checks issued for cashier’s checks, checks payable to cash, etc., where the payee and nature are not clearly shown.

  3. Obtain bank statements and cancelled checks for each bank account for one or more months, including the last month of the period under examination.

    1. Compare deposits shown by the bank statement against entries in the cash book.

    2. Note year-end bank overdrafts in the case of a cash basis taxpayer. This may indicate expenses which are unallowable since funds were not available for payment.

    3. Determine if any checks have remained outstanding for an unreasonable time. This may indicate improper or duplication of disbursements. Old outstanding checks possibly could be restored to income.

    4. Determine whether voided checks have been properly handled.

    5. For a period, test sample check endorsements to see if they are the same as payee, noting any endorsements by owner, or questionable endorsements.

  4. Review cash receipts journal for items not associated with ordinary business sales, such as sales of assets, prepaid income, income received under claim of right, etc.

  5. Investigate entries in the general ledger cash account. Look for unusual items which do not originate from the cash receipts or disbursements journals. These entries may indicate unauthorized withdrawals or expenditures, sales of capital assets, omitted sales, undisclosed bank accounts, etc.

  6. Test check some cash sales with the cash receipts journal to ascertain if they have been correctly recorded. Also, check cash sales made at the beginning and end of the period under examination to determine if year-end sales have been recorded in the proper accounting period.

  7. Test check disbursements from petty cash to determine if there are any unallowable items included.

  8. Scrutinize cash overages and shortages, being alert to irregularities which may have cleared through accounts.

  9. Review the cash on hand account to determine if there are any credit balances during the period under examination. This may indicate unrecorded receipts.

4.10.3.8.4.2  (03-01-2003)
Notes and Accounts Receivable

  1. Check entries in the general ledger control accounts. Look for unusual items, especially those which do not originate from the sales or cash receipts journals.

  2. Obtain a detailed schedule of the notes and accounts receivable at year-end showing the customers name, invoices outstanding, and the balance due. Determine if the documentation agrees with the ending balance per books. Investigate any identified differences.

    1. Review detailed schedules of receivables for credit balances. This may indicate deposits, advance payments or overpayments which could be additional income or unrecorded sales.

    2. Review detailed schedules for related party loans. For accrual basis taxpayers, verify interest income is being accrued per IRC § 7872. For a cash basis taxpayer, determine if the loan is subject to the Original Issue Discount (OlD) provisions of IRC § 1273 and the current inclusion in income of OlD pursuant to IRC § 1272.

  3. Selected credit sales should be traced from the original invoices and postings through posting in the sales and accounts receivable journals.

  4. Determine whether accrued income on interest bearing notes or accounts (i.e., finance charges) has been included in income.

  5. Where the taxpayer reflects an accrual method by subtracting beginning receivables and adding ending receivables to cash collected, consider checking the detailed listing of receivables at the beginning of the period to the cash receipts journal. This may disclose diverting of funds, etc. Determine if beginning receivables used in the computation are the same as the ending receivables of the preceding year.

4.10.3.8.4.3  (03-01-2003)
Inventories

  1. Obtain year-end physical inventory sheets and review for the following:

    1. Verify, on a test basis, that all quantities and costs have been accurately extended.

    2. Reconcile total inventory per physical inventory sheets to amounts per books. Investigate any differences.

    3. Review for items on hand with a cost of $0.

    4. On a test basis, compare costs per physical inventory sheets to cost per purchase invoice, job cost reports, etc.

  2. Review the taxpayer’s method of inventory valuation for consistency and compliance with the applicable code and regulation sections; i.e., IRC § 471 & IRC § 472.

  3. Review the general ledger for inventory write downs, reserves for obsolescence or other decreases to inventory and test for propriety.

  4. Check for gross profit variations and investigate any significant differences.

  5. Verify year end purchases were included in the ending inventory.

  6. Verify direct costs have been allocated to ending inventory (i.e., freight in, duty taxes, packaging materials, etc.).

  7. Determine if taxpayer is subject to IRC § 263A. If applicable, determine whether all applicable indirect costs have been properly allocated to all items of ending inventory (i.e., raw materials, work-in-process, and finished goods).

  8. Verify that beginning inventory is the same as the prior year’s ending inventory.

  9. Verify that ending inventory is the same as the subsequent year’s beginning inventory.

  10. For taxpayers using the LIFO method of inventory valuation:

    1. Verify that the taxpayer made a proper LIFO election (Form 970) and that it has been consistently applied. Also verify there have been no unauthorized changes from the LIFO election.

    2. Verify LIFO index calculations are based on actual costs and that any writedowns to market value have been restored pursuant to 26 CFR 1.472–2(c).

    3. Verify LIFO inventory valuation method is used on all financial reports issued to shareholders, partners, and creditors, etc.

    4. Verify reasonableness of the taxpayer’s cumulative index by comparing the price increases per table 6 of the Producer Price Index published by the US Bureau of Labor Statistics. Investigate any material differences.

    5. Verify that the taxpayer has established an appropriate number of LIFO pools and that only substantially similar items are included in a particular pool.

    6. If the taxpayer is using sampling techniques to calculate a current year index, verify that no segment of the inventory has been excluded from the sample population and that the index sample is based on valid statistical sampling principles.

    7. Review ending inventory for "new items " . Verify base year cost is the current year cost of that item, unless the taxpayer is able to reconstruct or otherwise establish a different cost. If the taxpayer establishes a cost different from the current year cost, review calculations and supporting documentation for propriety.

4.10.3.8.4.4  (03-01-2003)
Investments

  1. Obtain a schedule of investments on hand at the beginning and end of the year. For investments acquired during the year, verify that the cost (including commissions and sales charges) has been accurately recorded in the general ledger.

  2. Review debit entries. Consider such items as:

    1. Nontaxable securities acquired with borrowed funds.

    2. Other acquisitions (transactions with related taxpayers, noncash acquisitions, creation, organization or reorganization of a foreign corporation, etc.)

  3. Analyze sales and other credit entries with regard to the following:

    1. Gains or losses (basis, wash sales, interest included in sales price, etc.).

    2. Other exchanges, write downs, write-offs, transactions with related taxpayers or controlled foreign entities, etc.

  4. Analyze the nature of investments using any records maintained by the taxpayer. Determine that related income such as dividends and interest has been properly reported.

  5. If stock is held in a foreign corporation, determine whether it is a foreign personal holding company.

  6. If the taxpayer is a dealer in securities, verify that all securities have been marked to market pursuant to IRC § 475 (i.e., treated as sold for the fair market value on the last day of the tax year and gain/loss recognized) . If the securities are either identified as "held for investment " or "not held for sale" , they are not subject to the mark to market rules. Generally the identification must be made before the close of the day on which the securities were acquired, originated or entered into.

4.10.3.8.4.5  (03-01-2003)
Loans to Stockholders

  1. For accrual basis taxpayers, verify that interest income is being accrued at a rate equal to at least the minimum Applicable Federal Rate pursuant to IRC § 7872.

  2. Determine whether the amounts advanced to the stockholder are bona fide loans or distributions of earnings and profits, which are taxable as dividends. This determination is based on the actions and intent of the parties at the time of the withdrawal and no single test or set formula can give a definite answer. Some of the factors to be considered include the following:

    1. Whether the amounts of the withdrawals are carried on the books as a loan receivable.

    2. Whether the withdrawals were secured (interest bearing note and or other collateral).

    3. Whether both the stockholder and the corporation treat the withdrawals as indebtedness.

    4. Whether interest is paid by the stockholder or charged by the corporation.

    5. Whether the corporation had sufficient surplus to cover the withdrawals when they were made.

    6. Whether the stockholder had the ability and intended to make repayment with interest at the time of the withdrawal.

    7. The presence or absence of a maturity date.

    8. The corporation, though prosperous, has not distributed dividends.

  3. If the amounts advanced to the stockholder are determined to be loans, a dividend can arise pursuant to IRC § 7872 if the stockholder is not obligated to pay interest or pays a below-market interest rate on the loan.

4.10.3.8.4.6  (03-01-2003)
Depreciable Assets

  1. Determine whether assets shown on the depreciation schedule, which have a prior year acquisition date, are the same as shown on the tax return for the immediately preceding period. If not, this would indicate depreciation being claimed for assets which have previously been expensed or fully depreciated.

  2. Review purchases of assets made during the tax year under audit. Review the transactions and associated documentation, giving consideration to the following:

    1. Note items which appear to have originated from unusual sources such as appraisal increases, transfers, exchanges, etc. and determine propriety thereof. Ascertain if prior earnings were adequate to cover acquisitions.

    2. Determine if costs relating to the acquisition and installation of assets, leasehold improvements, etc. have been capitalized with the appropriate useful life.

    3. Ascertain if assets include items of a personal nature.

    4. Where construction or any other work of a capital nature is performed with the taxpayer’s own equipment, labor, etc., for its own use, be certain that the basis of such assets includes the proper elements of material, labor and overhead, including depreciation.

    5. With regard to the basis of assets, consider such items as trade-ins, acquisitions from related taxpayers, allocations of costs between land and building, etc.

  3. For any construction in-progress, determine if IRC § 263A(f), capitalization of construction period interest is applicable. If so, verify that the proper amount of both direct and indirect interest on outstanding indebtedness during the construction period was capitalized.

  4. Decreases in the asset accounts during the year should be noted. The resulting gains or losses should be verified. Ascertain if the taxpayer has transferred assets to a related party for less than fair market value.

  5. Examiners should be alert for situations where accelerated deductions are being claimed in the following situations:

    1. Tangible property used predominately outside the U.S,

    2. Property leased to tax exempt entities,

    3. Property financed with tax exempt bonds.
      (Note: IRC § 168(g) requires straight line depreciation over an extended recovery period.)

4.10.3.8.4.7  (03-01-2003)
Depletable Assets

  1. Depletion allows the owner of a natural resource (such as minerals) to recover their basis in the minerals just as depreciation allows a manufacturer to recover the cost of equipment and buildings.

  2. IRC section 611 establishes the depletion allowance. IRC section 612 defines basis in the property. IRC section 613 defines the percentage depletion rates, gross income and taxable income from mining. IRC section 614 defines property and related rules. Associated regulation sections provide additional direction.

  3. Audit techniques are the same as those used for depreciation. See IRM 4.10.3.8.4.6 above.

4.10.3.8.4.8  (03-01-2003)
Valuation Reserves

  1. Review nature and sources of all accounts and ascertain whether they are being used as a means of diverting or understating income, or claiming unallowable deductions.

  2. For unallowable reserves which were created in a prior year and now closed by the statute of limitations, the beginning balance of the reserve for the year under audit should be brought into income through a " Change in Method of Accounting" adjustment pursuant to IRC § 481(a).

  3. Determine whether the depreciation, amortization, and depletion reserves are contingent reserves. Check for reasonableness of any addition.

4.10.3.8.4.9  (03-01-2003)
Intangible Assets

  1. Verify correctness of deductions claimed, such as amortization, write downs, write-offs, royalties, etc.

  2. Determine if there have been any transactions with related taxpayers, or controlled foreign entities. Consider arms-length transactions attributes.

  3. Determine if revenue derived from intangibles has been included in income. Be aware that it is not necessary for an intangible to have a basis or to appear on the records (e.g. subleases, overriding royalties, franchises, etc.).

  4. Analyze any transaction involving a transfer of foreign rights to any foreign entity for an equity interest or for nominal consideration.

  5. IRC § 197 Assets — acquisitions after (8/10/93). For asset or stock sales, verify per a review of the buyer’s return that the purchase price agrees to the sales price on the seller’s return. Be aware of "off" balance sheet contingent liabilities assumed by the buyer and included in the purchase price on the buyer’s return but not in the sales price per the seller’s return.

  6. Contingent liabilities, basis allocation issues:

    1. Analyze the adjusted grossed-up basis calculations to determine whether the buyer has, or should have, included contingent liabilities in arriving at the basis of acquired assets, including intangibles.
      (Note: The premature inclusion of contingent liabilities in arriving at asset basis may result in an incorrect amortization deduction. Conversely, exclusion of contingent liabilities assumed as part of the consideration paid may create the potential for bargain purchase treatment even though, economically, a premium may have been paid by the purchaser.)

    2. Determine whether contingent liabilities were assumed by the buyer or arose after the acquisition.
      (Note: While financial statement accruals are an indicator of the existence of a liability, the liabilities recorded on the seller’s financial statements should be distinguished from those entered on the buyer’s records. While it might appear that such items should be considered in the computation of asset basis, as they relate to conditions existing at the time of acquisition, this treatment would be incorrect since the decision to incur such expenditures is solely at the purchaser’s discretion.)

    3. Be alert to economic performance issues. A contingent liability becomes "fixed and determinable" when it meets the "all events test" under IRC Section 461(h). The purchase price should not include any contingent liabilities.

  7. Test check current additions to determine if the basis includes the proper elements of cost such as legal fees, appraisal fees, officers’ salaries, etc.

  8. Review allocation of purchase price between inventories, fixed assets with 3 to 7 year depreciable lives, and intangible assets with a 15 year life.

  9. Determine if "consulting" agreements, employment contracts, etc., entered into as a result of an asset acquisition are in substance, covenants not-to-compete (the cost should be amortized over 15 years).

  10. Verify no loss has been claimed on the disposition of an IRC § 197 asset if any other section 197 intangible asset acquired in the same transaction has been retained.

4.10.3.8.4.10  (03-01-2003)
Prepaid Expenses & Deferred Charges

  1. Review supporting schedules showing the specific prepaid expense capitalized at year end (i.e., insurance, real estate taxes, service contracts, etc.).

  2. Review documents such as invoices or policies on a test basis to verify the year-end prepaid expense balance is not understated.

  3. For accrual basis taxpayers, verify the prepaid expenses have not been expensed for tax purposes, via M–1 adjustments. If these prepaid amounts have been expensed for tax purposes, see proposed coordinated issue, "Accounting for Payment Liabilities" , issued by the Change in Accounting Method Technical Advisor.

4.10.3.8.4.11  (03-01-2003)
Other Assets

  1. The nature and classification of other asset accounts should be considered to determine if they have a bearing on tax liability.

4.10.3.8.4.12  (03-01-2003)
Deferred Tax Assets

  1. Review workpapers to determine the composition of the deferred tax asset. That is, income recognized for tax before book and expenses recognized for book prior to tax.

  2. The absence of a deferred tax asset may indicate the above noted timing differences have been treated the same for book and tax and thus taxable income has been understated.

4.10.3.8.4.13  (03-01-2003)
Liabilities: Accounts Payable

  1. Review any debit balances in the general ledger or subsidiary accounts. This may indicate diversion of funds, potential unreported income and/or understatement of sales.

  2. Review computation of year-end accruals for purchases. Purchases should be included in ending inventory. Determine if the taxpayer is accelerating subsequent year expense into the current year.

  3. Review any accounts which have long overdue balances. This may indicate contested liabilities or liabilities which no longer exist such as unclaimed wages. These items should be picked up as income or be disallowed as current expenses.

  4. Tie in trial balance amounts to general ledger. Check for adjusting entries or reclassifications and netting of related accounts receivable. This may indicate understatement of sales.

  5. Review for accruals to "related" cash basis taxpayers. Per IRC 267(a)(2), no deduction is allowable until the amount is includible in the gross income of the related payee.

4.10.3.8.4.14  (03-01-2003)
Mortgages, Notes, Bonds Payable In Less Than One Year

  1. Test interest expense and year-end accruals to reconcile interest expense. Test the mathematical accuracy of the analysis and trace to the general ledger.

  2. Obtain copies of debt agreements on a sample basis and review terms and conditions.

  3. Obtain loan amortization schedules, year-end statements, etc. to verify the accuracy of the year-end balance per the books.

4.10.3.8.4.15  (03-01-2003)
Other Current Liabilities

  1. Tie in trial balance amounts to the general ledger. Check for adjusting entries or reclassifications and netting of related accounts receivable. This may indicate an understatement of sales.

  2. Review computation of year-end accruals. Ensure actual expenses were incurred and that benefit has been received as of the balance sheet date.

  3. Review accrual amount to payments made subsequent to balance sheet date to ensure compliance with applicable code sections. (IRC § 267, IRC § 404 and IRC § 461).

  4. Review accruals for compensated absences (e.g. vacation pay, sick leave) to ensure only amounts paid within 21/2 months of year end are deducted.

  5. Review a copy of the employee benefit plan. Determine that the current period contribution has been timely paid by examining a copy of the cancelled check.

  6. Review year-end accruals to ascertain any amounts which must be paid prior to year end to be deductible under the economic performance rules (e.g., tort liabilities, retrospective workmen’s compensation, etc.).

4.10.3.8.4.16  (03-01-2003)
Income Taxes

  1. Review and analyze current and deferred income tax workpapers. Review detail of all temporary and permanent differences between income per books and the taxable income, including the following:

    1. Balances at the beginning of the period,

    2. Current period provisions for income taxes,

    3. Balances at the end of the period.

  2. Temporary differences are differences between income tax and financial reporting that have future tax consequences. Temporary differences arise as a result of the following:

    1. Revenues or gains that are taxable after they have been recognized for financial income (e.g., an installment sale).

    2. Expense or losses that are deductible after they have been recognized in financial income.

    3. Revenues or gains that are taxable before they have been recognized in financial income.

    4. Expenses or losses that are deductible before they have been recognized in financial income.

    5. A reduction in the tax basis of depreciation on assets because of tax credits.

    6. A business combination accounted for by the purchase method.

  3. Examples of temporary differences include:

    1. Marketable Securities — Unrealized gains and losses on securities held for investment that are reported as an adjustment to income or retained earnings in the financial statements based on the market value of the securities at the balance sheet but are not reported in the tax return until the securities are sold.

    2. Receivables — bad debts that are recognized using the allowance method for financial reporting and the direct charge-off method for tax.

    3. Gross profit on sales — gross profit that is recognized in different periods for financial and tax reporting such as gross profit recognized in the year of sale for financial reporting and on the installment method for tax reporting and gross profit recognized on the cost recovery method for financial reporting and the installment method for tax reporting.

    4. Sales returns and allowances — returns and allowances that are accrued for financial reporting but are not reported on the tax return until the goods are actually returned.

    5. Imputed interest — the imputed interest amount for financial reporting that differs from the amounts for tax reporting.

    6. Long-Term Construction Contracts — revenues on long-term construction contracts that are accounted for differently for financial and tax reporting. Examples include percentage-of-completion for financial reporting and completed contract for tax reporting and percentage of completion method for financial reporting and cash or accrual method for tax reporting.

    7. Inventories — inventories that are recorded at the lower of cost or market for financial reporting and at cost for tax reporting; reserves for obsolete inventory that are expensed for financial reporting and are not deductible for tax reporting, unless the inventory is actually scrapped or offered for sale at a reduced value; and related costs for retailers, wholesalers and manufacturers that are expensed for financial reporting and capitalized for tax reporting.

    8. Investments — investments accounted for by the equity method for financial reporting and the cost method for tax reporting and the excess of cash surrender value of life insurance over the cumulative premiums paid, which is taxable if the insurance is terminated for reasons other than death.

    9. Property and Equipment — depreciation for financial reporting using estimated useful lives or methods that differ from tax reporting; interest income that offsets capitalized interest income for financial reporting and is recognized as income for tax reporting; assets recorded at FMV for financial reporting and at a different basis for tax reporting; gains and losses on depreciable assets that are recognized for financial reporting and deferred for tax reporting because the assets are traded in on similar assets; gains on the appreciation of assets distributed as a part of a liquidation, that are recognized when liquidation is imminent for financial reporting and on distribution for tax reporting; leases that are capitalized for financial reporting and reported as operating leases for tax, amortizing capitalized leases over different periods for financial and tax reporting, and depletion based on historical cost of the asset (cost depletion) for financial reporting and on percentage rates (percentage depletion) for tax.

    10. Intangible Assets — intangible drilling costs that are capitalized for financial reporting and expensed for tax, amortization of intangible assets using periods or methods for book purposes which differ from tax, and organizational costs expensed for book and capitalized for tax.

    11. Liabilities — debt issue costs that are amortized using the interest method for financial reporting and straight-line for tax, expenses that are accrued for financial reporting but deductible for tax reporting only when paid (e.g., vacation pay, retrospective portion of workmen’s compensation, losses on discontinued operations) , and imputed interest for financial reporting that differs from amounts for tax reporting.

    12. Deferred Revenue — revenues received in advance, deferred for book, but recognized as income for tax.

4.10.3.8.4.17  (03-01-2003)
Loans From Shareholders

  1. Review loan agreements to determine if there is a true debtor-creditor relationship. Large liabilities in relation to capital stock may indicate a "thin capitalization" situation.

  2. Determine the source of funds advanced by shareholders to ensure no outright diversion of corporate receipts.

  3. Review the rates of interest and the scheduled dates of repayment to ensure transactions are at arms-length. If "loans" are "equity capital" then:

    1. Disallow interest expense; treat as dividends.

    2. Disallow bad debt deductions claimed by the shareholder.

    3. Treat the entire repayment as a dividend.

4.10.3.8.4.18  (03-01-2003)
Long Term Obligations

  1. Fixed Liabilities are usually found in the form of long-term bonds, notes, mortgages and debentures.

  2. Determine the source of funds advanced by reviewing registration statements, prospectus, and/or related documents in connection with any financing arrangement. Ensure all related costs (e.g. legal, professional, bond issuance) have been properly deferred and are being written-off over the life of the obligation.

  3. Review the transactions with related taxpayers and controlled foreign entities to ensure there is no mismatching of income and expenses and that the transactions are at arm’s-length.

  4. Review the tax-exempt securities on the books. The interest expense to carry tax-exempt securities is not deductible.

  5. Review the zero coupon bonds to ensure the correct allocation of the original issue discount.

  6. Test the interest and year-end accruals to reconcile interest expense.

  7. Determine whether any transactions are involved with no purpose, other than to create a tax deduction. Obtain copies of debt agreements on a sample basis and review terms and conditions. Obtain loan amortization schedules, year-end statements, etc. to verify the property of the year-end balance per the books.

4.10.3.8.4.19  (03-01-2003)
Stockholders Equity/Capital Stock

  1. Review all capital stock accounts and consider the following:

  2. If there were no changes during the period, consider the following:

    1. Subchapter S Corporations — review valid election, number and changes in stockholders’ loss limitations.

    2. Dealing in stock between shareholders — check gains or losses to individuals which involve the corporation and consider the possibility of distributions being equivalent to a taxable dividend.

    3. Closely-held corporations should be carefully reviewed for arms-length features, disguised dividends, etc.

  3. If there were new issues and additions during the period:

    1. Review the corporate minute book with items recorded on the books to determine if proper entries have been made.

    2. Verify all credit entries. Consider the tax implications of stock issued for services or properties, stock dividends, employee stock options, stock issued at less than fair market value.

    3. Determine if expenses relating to the issuance of stock have been properly handled, (e.g., legal fees, registration fees, etc.)

    4. Determine (in closely-held corporations) that if a recapitalization of stock occurs, then the fair market value of the stock received is equal to the fair market value of the stock surrendered. Significant differences indicate possible gift tax consequences.

  4. If there were reductions and cancellations during the period:

    1. Compare the corporate minute book with the items recorded on the books to determine if proper entries have been made.

    2. Verify all debit entries. Consider the tax implications of partial or complete liquidations, partial or complete redemptions, and distributions essentially equivalent to dividends.

4.10.3.8.4.20  (03-01-2003)
Treasury Stock

  1. Review any changes in the account. The acquisitions may be essentially equivalent to a dividend if an increase in treasury stock (redemption) or a decrease in treasury stock (bargain sale).

4.10.3.8.4.21  (03-01-2003)
Additional Paid-In Capital

  1. Review any changes to this account for the current period. This account normally results from stock purchased from the corporation in excess of the stated value.

  2. Reserves created by charges to income may no longer be needed. If a credit to Paid in Capital is made, it could escape taxation.

4.10.3.8.4.22  (03-01-2003)
Negative Goodwill

  1. For tax purposes, verify that the "bargain" element (difference between the FMV of assets and purchase price) has been allocated to all such assets on a pro-rata basis pursuant to IRC section 1060.

  2. For GAAP purposes, the bargain element is allocated to fixed assets first, then any remainder creates negative goodwill.

  3. For the bargain element allocated to current assets, verify income (i.e., bargain element) is recognized as the asset is consumed, sold, or collected.


More Internal Revenue Manual