4.10.3  Examination Techniques

4.10.3.1  (03-01-2003)
Overview

  1. The purpose of this section is to provide guidelines for procedures and techniques that should be used in conducting an effective examination.

  2. Auditing includes the accumulation of evidence for evaluating the accuracy of the taxpayer’s tax return(s). Evidence takes many forms, including the taxpayer’s testimony, the taxpayer’s books and records, the examiner’s own observations and documents from third parties.

  3. It is important to obtain sufficient competent evidence to determine the accuracy of the taxpayer’s return. Every examiner must determine the appropriate amount of evidence to accumulate and establish the proper depth of the examination. This decision is a matter of judgment and important because of the prohibitive cost of examining and evaluating all available evidence. Factors to consider when establishing the depth of the examination include:

    1. The risk that the taxpayer has made errors that are individually or collectively material. The factors involved are addressed during the evaluation of the taxpayer’s internal controls.

    2. The risk that the audit tests will fail to uncover material errors. The factors involved are the depth of the examination, the examination techniques used, the nature of the errors (intentional or unintentional) and the reliability of available evidence.

  4. Methods for accumulating evidence include:

    1. Analytical Tests — such as analysis of Balance Sheet items to identify large, unusual, or questionable accounts. Analytical tests use comparisons and relationships to isolate accounts and transactions that should be further examined or determine that further inquiry is not needed.

    2. Documentation — such as examining the taxpayer’s books and records to determine the content, accuracy, and substantiate items claimed on the tax return.

    3. Inquiry — such as interviewing the taxpayer or third parties. Information from independent third parties can confirm or verify the accuracy of information presented by the taxpayer.

    4. Inspection — such as physically examining the taxpayer’s assets, e.g., inventory or securities.

    5. Observation — such as conducting a tour of the taxpayer’s business to observe the taxpayer’s daily business operations.

    6. Testing — such as tracing transactions to determine if they are correctly recorded and summarized in the taxpayer’s books and records.

  5. Factors to consider when choosing an examination technique are:

    1. Will the examination technique provide the needed evidence?

    2. Will the benefits derived from using a particular technique justify the associated costs to both the examiner and the taxpayer?

    3. Are there less expensive alternatives that will provide the same evidence?

  6. The following Examination techniques used to gather evidence are discussed in this section:

    1. Interviews, (3.2)

    2. Tours of Business Sites and Inspection of Residences, (3.3)

    3. Evaluation of the Taxpayer’s Internal Controls, (3.4)

    4. Examining the Taxpayer’s Books and Records, (3.5)

    5. Analyzing Schedules M–1 and M–2, (3.6)

    6. Bank Record Reconciliations, (3.7)

    7. Balance Sheet Analyses, (3.8)

    8. Testing Gross Receipts or Sales, (3.9)

    9. Testing Expenses: Cost of Goods Sold, (3.10)

    10. Testing Expenses: Operating Expenses, (3.11)

    11. Sampling Techniques, (3.12)

  7. Accounting systems and the organization of books and records are discussed in subsections 3.13 and 3.14, respectively.

4.10.3.2  (03-01-2003)
Interviews: Authority and Purpose

  1. An interview is defined as a meeting between two persons and usually includes holding a formal consultation for the purpose of resolving or exploring issues.

  2. Interviews are used to obtain leads, develop information, and establish evidence. The testimony of witnesses and the confessions or admissions of alleged violators are major factors in resolving tax cases. Cases are presented to a jury through the testimony of witnesses. Therefore, it is the agent's duty to interview the taxpayer and every witness connected with the case. The record of such interviews will usually take one of the following forms: Transcript of interview or question-and-answer statement, affidavit, memorandum of interview, or recording (wire, tape, wax, etc.).

  3. Internal Revenue Code Section 7602 authorizes the Secretary or a delegate to examine books and records and to take testimony under oath.

  4. Interviews provide information about the taxpayer’s financial history, business operations, and books and records. Interviews are used to obtain information needed to reach informed judgments about the scope/depth of an examination and the resolution of issues. Interviews are used to obtain leads, develop information, and establish evidence.

  5. Oral testimony is a significant factor in resolving tax cases. Oral testimony can:

    1. provide information not otherwise available from physical documentation,

    2. corroborate return information,

    3. provide relevant information not reflected on the return, and

    4. establish the taxpayer’s intent.

  6. At initial interviews, examiners should inform the taxpayer of the existence of the Taxpayer Bill of Rights II, as well as the examination and the appellate processes.

  7. See IRM 4.10.2.10.3, Advising Taxpayers of the Reason for their Examination, for guidance related to what information can be provided to taxpayers about the reason for the selection of their returns for examination.

4.10.3.2.1  (03-01-2003)
Who To Interview

  1. Interviews should always be held with the persons having the most knowledge concerning the total financial picture and history of the person or entity being examined.

  2. Internal Revenue Code Section 7521(c) states that an examiner cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence at the interview can be requested through the representative as a means to expedite the examination process.

4.10.3.2.1.1  (03-01-2003)
Powers of Attorney

  1. When a taxpayer obtains representation, the examiner will ensure that the authorization, Form 2848, Power of Attorney (POA), Form 8821, Tax Information Authorization (TIA), or a similar privately designed form, is properly executed. Service personnel are prohibited from disclosing tax information of a confidential nature to any unauthorized person. Upon receipt, the authorization must be date stamped and reviewed to ensure that it contains all required information. See IRM 4.10.11, Power of Attorney and Related Authorizations for complete instructions for reviewing and processing powers of attorney.

  2. Practice before the Service is restricted to persons recognized or qualified under provisions of Circular No. 230. If the taxpayer's representative impedes or delays the examination by failing to promptly submit the taxpayer's records or information requested by the examiner, failing to keep scheduled appointments, or failing to return telephone calls and written correspondence, the examiner may initiate procedures to bypass the representative and deal directly with the taxpayer, as outlined in IRM 4.10.11, Power of Attorney and Related Authorizations.

4.10.3.2.1.2  (03-01-2003)
Corporate, Partnership and S-Corp Examinations

  1. In corporate examinations, the current officers should be identified and questioned regarding the appropriate parties to interview.

  2. In TEFRA partnership and S corporation examinations, the Tax Matters Person (TMP) must be identified. The TMP should be asked to designate the company personnel or representative(s) who are most knowledgeable to be present at any interviews.

  3. In non-TEFRA partnership and S corporation examinations identify the member-manager of a LLC, general partner for a partnership or officer/shareholder most knowledgeable of the S corporation operations.

4.10.3.2.1.3  (03-01-2003)
Specialists

  1. Examiners should identify, in advance, all the persons the taxpayer will have present at an interview and ensure that appropriate Service personnel will be in attendance.

  2. For example, if issues of a technical nature and outside the examiner’s area of expertise will be discussed at the interview, the Service specialists should be at the meeting.

  3. Examiners should also determine if any specialist referrals will be made as early in the examination as possible. The field specialist referral requirements are available on the IRS Intranet and as of December 30, 2002, all referrals will be required to be input on-line (no paper referrals will be accepted after that date). The Intranet site is: http://lmsb.irs.gov/hq/fs/referrals.htm.

  4. If the return has been selected on classification as a mandatory referral to International, the examiner should make the referral during the preplanning phase of the examination. If complex international issues are discovered during the course of the examination, the case should be referred to International at that time.

4.10.3.2.1.4  (03-01-2003)
Third Party Interviews

  1. Internal Revenue Code Section 7602 allows examiners to obtain testimony from third parties who can provide relevant information to determine the correct liability for any taxpayer (see IRM 4.10.1 for a complete discussion of third party contact requirements based on the IRS Restructuring and Reform Act of 1998).

  2. The taxpayer’s right to privacy will be protected when contacting third parties for information.

    1. Information will be collected, to the greatest extent practicable, directly from the taxpayer to whom it relates.

    2. No information will be collected or used with respect to the taxpayer that is not necessary and relevant for tax administration or other legally mandated or authorized purposes.

    3. Information about taxpayers collected from third parties will be verified to the extent practicable with the taxpayer before action is taken.

  3. Caution should be taken to not disclose any tax information of a confidential nature when contacts are made with third parties.

  4. Definitions, duties, and procedures for third-party recordkeepers are listed in Treasury Regulation 301.7609–2.

  5. Tax Compliance Officers/Tax Auditors, under prescribed conditions, may contact taxpayers outside the Service office in the course of completing their examinations.

4.10.3.2.2  (03-01-2003)
Where to Conduct Interviews

  1. The time and place of interviews will be set by the Secretary as long as they are reasonably scheduled. The authority is provided in Internal Revenue Code section 7605(a) and the related regulations at 301.7605–1. In general, the Service will determine if an office or field examination is to be performed.

  2. Office examinations will be conducted at the Service office closest to the location of the taxpayer.

  3. Field examinations should be conducted at the taxpayer’s residence, place of business, or where the taxpayer’s books and records are kept.

  4. An exception to the rule for field examinations would be for some frivolous filers/nonfilers. Group Managers should consider the potential hazards to personal safety of examiners examining these returns. Meetings between the examiner and the non-compliant taxpayer should be held, where practical, in a government facility. The group manager may make other arrangements to facilitate the examination when it would not compromise the safety of the examiner.

4.10.3.2.3  (03-01-2003)
Preparation and Planning for Interviewing

  1. Timing - Proper timing of the interview is essential in obtaining information that is material in resolving a case.

  2. Review Available Information - Prior to any interview, the agent should review all the information and data he/she possesses relating to the case. Such information may then be divided into three general categories:

    1. information that can be documented, and need not be discussed,

    2. information that may be documented, but needs to be discussed, and

    3. information that must be developed by testimony.

  3. The interview file should contain only data or information arranged in the order it is to be discussed or covered in the interview. The less data the examiner has to cope with during the interview, the easier it will be for him/her to vary his/her line of questioning. It is very distracting and may even cause some confusion for the examiner to delay the interview to find a document or an item in a voluminous file. However, the files should contain sufficient data to cover all the matters under discussion, provided it isn't unwieldy.

  4. Prepare Outline - Before the interview, the examiner should determine the goal of, or purpose for, questioning the taxpayer. The topics that will enable the examiner to accomplish this goal should be outlined in more or less detail, depending upon his/her experience and the complexity of the case. The outline should contain only information that is relevant and material, including hearsay. Extraneous matter should be excluded because it may be confusing and may adversely affect the end desired. Important topics should be set off or underscored and related topics listed in their proper sequence. Specific questions should be kept to a minimum, since they tend to reduce the flexibility of the examiner. In addition to the topics to be discussed, the outline should include the following, if applicable:

    1. identification of the subject,

    2. information to be given the taxpayer about his/her constitutional rights,

    3. the purpose of the interview, and

4.10.3.2.4  (03-01-2003)
Types of Interviews

  1. Initial Interviews — The initial interview should be held as soon as possible after opening a case. The pre-audit analysis should include the preparation for the interview. See IRM 4.10.2 for details concerning the pre-contact analysis.

  2. Subsequent Interviews — Subsequent interviews with the taxpayer should be held if:

    1. The taxpayer does not provide all the information requested;

    2. More detailed explanations are needed; or

    3. A review of the examination’s progress is needed. The review should address information provided to date as well as outstanding information needed to complete the audit.

  3. Third Party Interviews — Third party interviews may be necessary when the taxpayer does not or cannot provide documentation regarding a transaction, a deduction, or an income item.

  4. Closing Interviews (Conferences) — Closing interviews should be held to solicit agreement to proposed adjustments. See IRM 4.10.7.5 for a detailed discussion.

4.10.3.2.5  (03-01-2003)
Documenting Interviews

  1. Interviews provide information not available from other sources. A properly planned and executed interview will provide an understanding of the taxpayer's financial history, business operations, and accounting records.

  2. The case file should reflect in-depth planned interviews throughout the examination. Sufficient questions should be asked to gain a clear understanding of the taxpayer, as well as the operations of the taxpayer.

  3. The elements of an adequately documented interview include:

    • Interview plan to address items specific to the taxpayer under examination. The type of return and relevant facts and circumstances are considered in the interview plan.

    • Sufficient depth to give a clear understanding of the nature of the taxpayer's financial history, business history and day-to-day operations.

    • Explanations of large, unusual or questionable (LUQ) items and whether such explanations resolve the potential issues.

    • Questions of financial status or overall assessment of return validity, when appropriate.

    • Description of books and records maintained and their availability.

    • Complete explanation of the taxpayer's accounting system and accounting methods, including any changes when appropriate. This may also include an explanation of the accounting method used for tax, if different from book accounting, and any adjustments that were made.

    • Explanation of the taxpayer's internal controls as discussed in subsection 3.4 below.

  4. Case files may be reviewed by many individuals after closing from the examiner, especially if the examination is unagreed. This includes the examiner, who may need to provide testimony during litigation. The interview(s) should be documented in sufficient detail that no unanswered questions remain.

  5. Examiners should take brief notes during the interview for significant responses to questions and note those areas which need additional development.

  6. After the interview, examiners should prepare a memorandum of the interview indicating the date, time, place and persons present, as well as, what transpired during the interview.

  7. It is not advisable to take extensive notes during the interview. It can be distracting and hinder the flow of the interview.

  8. As an alternative, questionnaires may be used to record taxpayer responses instead of a memorandum. If an interview questionnaire is used, the examiner should ask follow-up questions as needed. The original questions and responses should be included in the case file.

4.10.3.2.6  (03-01-2003)
Requests to Tape Record Interviews

  1. Internal Revenue Code Section 7521(a) addresses audio recording of interviews.

  2. Taxpayers — Taxpayers may request to tape record an interview proceeding as long as 10 calendar days advance notice of intent to record is provided to the Service. In addition, the taxpayer must supply his recording equipment. The Service has the right to simultaneously produce its own recording and has the right to reschedule the interview if the Service does not or will not have equipment in place.

  3. IRS — The Service can initiate an audio recording provided it notifies the taxpayer 10 calendar days in advance of the interview using Pattern Letter 2156 on Area Director letterhead. The Field Territory Manager must approve all Service initiated recordings. See Exhibit 4.10.3–1 for copy of pattern letter.

  4. All participants must consent to the recording of the interview.

  5. All recorded interviews will contain the following information:

    1. The date, time, and place of the interview,

    2. The taxpayer’s name and SSN/EIN,

    3. Identification of all participants on the recording, along with a statement of each participant’s respective role in the proceedings,

    4. The purpose of the proceeding,

    5. The tax year(s) under examination,

    6. A clear description of written documentation provided in support of the issues, and,

    7. At the conclusion, a statement indicating the total recording time for the interview (i.e., time tape was running), and that the interview has been completed and the recording is ended.

  6. The cassette will be labeled with the taxpayer’s name, SSN, year(s) examined, date of interview, total time of the recording and sealed in a manila envelope that should be stapled into the body of the workpapers. The Form 5344, Examination Closing Document will be marked at the top "RECORDED INTERVIEW CASSETTE ENCLOSED."

4.10.3.2.7  (03-01-2003)
Interview Techniques

  1. Interviews provide information about the taxpayer's financial history, business operations, and books and records that are not available from other sources. Interviews should be used to obtain information needed to make informed judgments about the scope and depth of the examination and correctly resolve issues. Interviews are used to obtain leads, develop information and establish evidence.

  2. It is important to create an environment where the taxpayer feels comfortable. Examiners should maintain a friendly and professional demeanor. Suggestions for establishing rapport include:

    1. Examiners should introduce themselves.

    2. Examiners should explain what will happen during the examination.

    3. Examiners should be prepared to explain return selection procedures, rights to representation, and appeal rights. See Publication 3498.

    4. Examiners should recognize that an IRS audit is often a once-in-a lifetime experience for the taxpayer and therefore the taxpayer may be tense or nervous.

    5. Examiners should exhibit openness, honesty and integrity and be calm and objective.

    6. Examiners should listen carefully to all details, be receptive to all information volunteered, regardless of its nature, and be patient and persistent in extracting the facts necessary to achieve the goals of the interview.

4.10.3.2.7.1  (03-01-2003)
Conducting the Interview

  1. Be Adaptable and Flexible - The examiner should keep an open mind. He/she should be receptive to all information provided, regardless of the nature, and should be prepared to develop it. If he/she is not flexible, he/she may waste a great deal of time and ask unnecessary questions, resulting in a voluminous statement of little or no value. Although the examiner may find it easier to adhere to a fixed pattern of interviewing, or to rely upon a series of questions or topics, rigid adherence to any notes or outline will seriously handicap his/her flexibility. The outline and data should serve only as aids and not as substitutes for original and spontaneous questioning. A carefully planned outline will provide enough leeway to allow the examiner to better cope with any situation that may occur and permit him/her to develop leads that may arise.

  2. Follow Through - Incomplete and unresponsive answers have little or no probative value. Any answer, apparently relative to a pertinent matter, that is not complete and to the point should be followed up by questioning the taxpayer about all knowledge he/she has concerning every facet of the topic. The examiner should follow through on every pertinent lead and incomplete answer. He/she should continue asking questions until all information which can reasonably be expected has been secured.

  3. The following suggestions will help the examiner to follow-through and obtain answers that are complete and accurate:

    1. Use short questions confined to one topic that can be clearly and easily understood.

    2. Ask questions that require narrative answers, avoiding " yes" and "no" answers, whenever possible.

    3. Whenever possible, avoid questions that suggest part of the answer i.e., leading questions).

    4. Question the taxpayer about how he/she learned what he/she states to be fact. The taxpayer should also be required to give the factual basis for any conclusions he/she states.

    5. Be alert so as to prevent the taxpayer from aimlessly wandering. Where possible, require a direct response.

    6. Prevent the taxpayer from leading the examiner far afield. He/she should not be allowed to confuse the issue and leave basic questions unanswered.

    7. Concentrate more on the answers of the witness than on the next question.

    8. To avoid an unrelated and incomplete chronology, the examiner should clearly understand each answer and ensure that any lack of clarity is eliminated before continuing.

    9. When all important points have been resolved, terminate the interview. If possible, leave the door open for further meetings with the subject.

  4. Maintain control of the interview; examiners should establish the pace and direction. Continually assess whether the taxpayer is leading to pertinent information or rambling.

  5. If at any time during the interview or any other phase of the examination process, the taxpayer indicates he/she wants to obtain representation, examination activity must be suspended and the taxpayer must be allowed a minimum of 10 business days to secure representation.

4.10.3.2.7.2  (03-01-2003)
Question Construction

  1. The areas to be addressed during the interview should be based on analyses completed prior to conducting the interview. Questions are the principal tools of interviewing.

  2. There are four types of questions: open-ended, closed-ended, probing, and leading. Each is described below:

    TYPE DESCRIPTION
    Open-Ended Questions Questions are framed to require a narrative answer. They are designed to obtain a history, a sequence of events, or a description. Ask open-ended questions about the taxpayer’s business, employment, education, and sources of income which may not be reflected on the return. The advantage of this type of question is that it provides a general overview of some aspect of the taxpayer’s history. The disadvantage is that this type of question can lead to rambling.
    Close-Ended Questions Questions are more appropriate for identifying definitive information such as dates, names, and amounts. These questions are specific and direct. Ask close-ended questions for personal background information such as the number of dependents or current address. Close-ended questions are useful when the taxpayer has difficulty giving a precise answer. They are also useful to clarify a response to an open-ended question. The disadvantage to close-ended questions is that the response is limited to exactly what is asked and can make the taxpayer uncomfortable.
    Probing Questions Questions combine the elements of open and close ended questions. They are used to pursue an issue more deeply. For example, when questioning a taxpayer’s travel expense, ask "How many miles is it from your residence to your practice and where do you first travel to in the morning?" The advantage of this type of question is that the taxpayer’s response is directed, but not restricted.
    Leading Questions Leading questions suggest that the interviewer has already drawn a conclusion or indicate what the interviewer wants to hear. Limit the use of leading questions. Use them when looking for confirmation, since the answer is stated in the form of a question. For example: "So you did not keep a log or other written record of your auto expenses?"

  3. Use the interview plan as a guide, not as an inflexible outline. Allow flexibility to respond to new information as it is received and to ask follow-up questions when clarification is needed.

  4. Vary the types of questions and pause between questions. This technique can help establish a more conversational atmosphere.

  5. Obtain as much information as possible during an interview. There may not be an opportunity to conduct another interview.

4.10.3.2.7.3  (03-01-2003)
Listening Skills

  1. The question, no matter how important, becomes irrelevant if the response is not accurately understood. Ways to enhance listening include:

    1. Making sure that non-verbal communication contributes to a comfortable atmosphere. If the examiner appears overly relaxed and is not looking at the taxpayer, the taxpayer may believe the examiner is not interested and will respond accordingly.

    2. Listening for the meaning of words. If the taxpayer’s response is unclear, try paraphrasing or repeating what was said.

    3. Not interrupting the taxpayer and allowing a brief pause at the end of the response. Use the time to analyze the response and, if appropriate, formulate a follow-up question.

    4. Maintaining eye contact with the taxpayer. This demonstrates interest and non-verbal responses can be observed.

4.10.3.3  (03-01-2003)
Tours of Business Sites

  1. The physical observation of the taxpayer’s operation, or tour of business site, is an integral part of the examination process. Viewing the taxpayer’s facilities and observing business activities is an opportunity to:

    1. Acquire an overview of the business operation,

    2. Establish that the books and records accurately reflect actual business operations,

    3. Observe and test internal controls,

    4. Clarify information obtained through interviews, and

    5. Identify potential audit issues.

4.10.3.3.1  (03-01-2003)
Authority to Conduct Tours of Business Sites

  1. Regulation 301.7605–1(d)(3)(iii) states: "regardless of where an examination takes place, the Service may visit the taxpayer’s place of business or residence to establish facts that can only be established by direct visit, such as inventory or asset verification. The Service generally will visit for these purposes on a normal workday of the Service during the Service’s normal tour of duty hours."

4.10.3.3.2  (03-01-2003)
Conducting Tours of Business Sites

  1. Tours of business sites should be conducted during examinations of all business entities. Generally, the principal location, and any locations acquired during the period under examination, should be visited. However, consideration should be given to the cost effectiveness and practicality of conducting the tour. When appropriate, alternatives should be considered.

    Example:

    A fish processing company owns more than a dozen vessels and several on-shore processing plants in three states. Rather than conducting tours of the different business sites, the agent reviewed video tapes the company had prepared for insurance purposes. The tapes helped the agent understand the taxpayer’s operation and how various pieces of heavy machinery were used.

  2. Tours should be conducted after the initial interview and early in the examination process. This clarifies what was said during the interview and provides a frame of reference when interpreting information in the books and records. This assists examiners to correctly determine the scope and depth of the examination and avoid unnecessary audit steps.

  3. Tours should be conducted with knowledgeable individuals. Taxpayers, or their representatives, can often explain business practices that appear unusual to the examiner.

  4. Tours should be planned to address large, unusual, or questionable items identified during the pre-contact analysis or interviews.

  5. Design the tour to fit the type of business. The Examination Specialization (ES, formerly MSSP) audit technique guides (ATG) include descriptions of business operations which can help determine what examiners should expect to see.

  6. Tours should not disrupt business operations or interfere with the taxpayer’s interactions with customers.

4.10.3.3.3  (03-01-2003)
Audit Techniques for Tours of Business Sites

  1. Observe and be alert to the physical surroundings. Confirm that assets identified on the tax return (and identified as having audit potential during the pre-contact analysis) are physically present and identify assets that are physically present but are not represented on the return.

  2. Ask questions to confirm understanding of what is observed and avoid confusion.

  3. Trace common business transactions through the system. Look for discrepancies between what the transactions "should" look like and what actually happens. Look for weaknesses in the internal controls such as a lack of separation of duties. This will help determine what degree of reliance can be placed on the books and records and what audit steps will be needed.

4.10.3.3.4  (03-01-2003)
Examples for Tours of Business Sites

  1. The following examples emphasize how tours of business sites can assist examiners to determine the correct scope and depth of examinations, identify significant issues, and avoid unnecessary and time consuming procedures.

    Example 1: An examination of an auto dealership was conducted at the representative’s office due to limited space at the business site. During the tour of the business, the examiner asked what was on the second floor above the work area and the POA stated that some obsolete parts were kept there. The examiner asked to take a look and found a well stocked inventory of parts used for repairs. The inventory, as represented on the return, included only the vehicles held for sale and not the parts used to complete repairs.
    Example 2: During the tour of a pharmacy, the agent noticed that a large billboard was mounted on the roof of the building. It was determined that the income from the rental of the billboard was omitted from the tax return.
    Example 3: Touring a new building included questions about a demolition loss claimed on the return. The examiner determined that the expense was for the demolition of the old building on the site of the new facility and was not properly accounted for on the tax return.
    Example 4 : During the tour of an auto repair shop, an examiner observed a new computerized alignment rack, an air conditioning evacuation and charging station, two brake lathes, and an elaborate engine analyzer. The depth of the depreciation issue, identified because of the expensive assets listed on the depreciation schedule, was limited because the existence and current use of the assets had been observed.

4.10.3.3.5  (03-01-2003)
Inspection of a Taxpayer’s Residence

  1. An examiner may consider inspecting the taxpayer’s residence. Due to privacy issues and the intrusiveness of such inspections, their use should be limited. The purpose of inspecting the taxpayer’s residence includes (but is not limited to):

    1. Determining the validity of deductions for an office or business located in the residence.

    2. Determining the taxpayer’s financial status.

4.10.3.3.5.1  (03-01-2003)
Inspection of a Business in the Home

  1. When determining the validity of office in the home deductions, the office or business should be toured as any other business site. In order for any portion of a personal residence to qualify, it must be used exclusively for business purposes. This can only be determined by inspecting the business portion of the residence.

4.10.3.3.5.2  (03-01-2003)
Other Inspections of the Taxpayer’s Residence

  1. When determining the taxpayer’s financial status, an inspection of the interior of the home is not required. The following techniques are suitable alternatives:

    1. Ownership, sales price and mortgage information can be obtained from public records.

    2. The examiner can drive through the taxpayer’s neighborhood to estimate the taxpayer’s standard of living.

  2. These activities should be completed early in the examination process. Coordination with the taxpayer is not necessary.

4.10.3.3.6  (03-01-2003)
Case File Documentation

  1. Examiners should document that a tour or inspection was completed and describe the results, including observations and resolution of any questions. The tour of the business site or inspection of the taxpayer’s residence should also be noted on the activity record.

  2. If a tour of the taxpayer’s business facilities is not conducted, the reason(s) should be documented in the workpapers.

4.10.3.4  (03-01-2003)
Evaluating the Taxpayer’s Internal Controls

  1. This section discusses examiner responsibility for evaluating internal control.

  2. Examiners are required to evaluate the existence and effectiveness of internal control for all types of business returns as described in IRM 4.10.4.

  3. Many of the businesses will be sole proprietorships or small, closely-held corporations. In this environment, the owner-managers usually control the entire operation through direct supervision of the business activities. It is not uncommon for one person or a small group of people to have the ability to override vital elements of a system of internal controls. Even in this environment, however, it is essential to evaluate internal controls to determine the appropriate audit techniques to be used during the examination.

  4. The evaluation of internal controls will assist examiners in determining the accuracy and reliability of the taxpayer’s books and records. Additionally, the evaluation of internal controls should be part of the decision making process used to select the appropriate method for the examination of income and expenses. Examiners should consider the type of business, the type of records maintained and the taxpayer’s financial status and not just the income and expenses reflected on the tax return.

4.10.3.4.1  (03-01-2003)
Purpose of Evaluating Internal Controls

  1. An evaluation of a taxpayer’s internal controls is necessary to determine the reliability of the books and records.

  2. It is essential to evaluate internal controls to determine the appropriate audit techniques to be used during the examination.

  3. The evaluation of internal controls gives examiners the opportunity to identify high risk accounts and eliminate verification of accounts that have little or no tax consequence.

  4. An evaluation of internal controls is used to determine the scope of an audit and the extent of audit procedures to be used.

  5. An evaluation of internal controls is used to assess the level of control risk and establish the depth of the examination. "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’s internal control structure, policies or procedures.

4.10.3.4.1.1  (03-01-2003)
Evaluation of Internal Controls in a Small Business Environment

  1. Internal controls areoften limited to the consideration of controls for segregation of duties and safeguarding assets. With this limited perspective, the evaluation of internal controls in small businesses are often viewed as unimportant because control procedures in such environments are often weak or non-existent. This may be due to cost factors, lack of staffing, or a lack of concern with this aspect of the business.

  2. The fact that internal controls may be weak in a small business environment does not preclude the necessity of determining the reliability of the books and records. Every taxpayer has a method of conducting business and safeguarding business operations.

4.10.3.4.2  (03-01-2003)
Internal Controls Defined

  1. Internal Controls are defined as the "taxpayer’s policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information."

  2. Examiners should obtain an understanding of three key elements of the taxpayer’s business:

    1. The control environment,

    2. The accounting system, and

    3. The control procedures.

4.10.3.4.3  (03-01-2003)
Key Steps for Evaluating Internal Controls

  1. The evaluation of internal controls can be described as an analysis completed by the examiner to understand and document the entire business operation. The key steps of the evaluation process are:

    1. Understanding the control environment,

    2. Understanding the accounting system, and

    3. Understanding the control procedures.

  2. Each of these steps is discussed in the following subsections. To add clarity, a flowchart of the process of evaluating internal controls is included as Exhibit 4.10.3–2. The flowchart identifies the minimum steps to be taken by the examiner to understand and document the entire business operation.

  3. While the flowchart appears to be a linear process, the evaluative process is not linear and the steps illustrated need not be followed in the order shown in the exhibit.

4.10.3.4.3.1  (03-01-2003)
Control Environment

  1. The first area examiners must understand is the control environment of the business. The control environment is made up of many factors that affect the policies and procedures of the business, including:

    • Management philosophy,

    • Management operating style,

    • Organizational structure,

    • Personnel policies, and

    • External influences that affect the business.

  2. To make an assessment of the control environment, examiners must understand, in detail, how the business operates. Therefore, the first step on the flowchart is to draw an overview of business operations. Interviewing the taxpayer and/or representative and touring the business are integral steps for completing the flowchart.

4.10.3.4.3.2  (03-01-2003)
Accounting System

  1. The second key area of internal control that examiners must understand is the taxpayer's accounting system. Gaining knowledge of the accounting system provides information about many of the taxpayer’s transactions.

  2. The examiner should become familiar with the normal flow of each type of transaction, including:

    1. The accounting records which are involved in the processing, and

    2. Reporting of transactions.

  3. Generally, there are two significant elements to a transaction:

    1. The recordation of the transaction from its initiation to its inclusion in the financial statement, and

    2. The flow of funds into or out of the business.

  4. Examiners must acquire knowledge of how the business operates on a day-to-day basis with respect to customers, suppliers, management, sales, work performed, pricing, location, employees, assets used, production and record keeping.

4.10.3.4.3.3  (03-01-2003)
Control Procedures

  1. Control procedures are the policies and procedures established by management to achieve the objectives of the business. The control procedures are the methods established to assure that the business operates as intended. Separation of duties is the primary control procedure that concerns the examiner. If properly executed, separation of duties will reduce the opportunity for any person to both perpetrate and conceal errors or irregularities in the normal course of their duties. Other specific procedures include:

    1. Documentation of procedures and transactions,

    2. Supervision of work and periodic review by independent third parties, and

    3. Timely recording of all transactions.

  2. 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. The greater the number of employees, and the more complex the structure of the business, the more likely some formal control procedures will exist.

4.10.3.4.4  (03-01-2003)
Industry Examples

  1. Not all businesses are susceptible to the same level of control risk. In some businesses, internal controls are required by third parties (such as when a franchise is involved) . Moreover, internal controls for businesses within the same industry may vary significantly.

4.10.3.4.4.1  (03-01-2003)
Franchises

  1. Internal controls are usually very good in franchise companies due to independent audits and verifications performed by the franchisor. Typically, the franchise fee is based on the gross revenue of the business. The franchisee usually must buy products from the franchisor to keep the franchise. The franchisor also requires that minimum records be kept. Regular audits, some announced and some unannounced, are performed by the franchisor. Franchise businesses may be operated in either corporate or non-corporate form.

4.10.3.4.4.2  (03-01-2003)
Cash Businesses

  1. Many small businesses that deal almost exclusively in cash are likely to have few internal controls. Practically all income is received in cash. No independent third parties review the operation. Many expenses are paid in cash and documentation for transactions is often lacking.

4.10.3.4.4.3  (03-01-2003)
Vertically Integrated Industries

  1. Generally, accounting methods and procedures are rigid in vertically integrated industries. Periodic checks are made to ensure compliance with the system. The majority of income is not generated by cash transactions. Most expenses are paid by check and are well documented. The new car market segment is a good example of an integrated industry.

  2. By contrast, few used car dealers are integrated or incorporated and most do not maintain double-entry books and records. Until recently, no third parties, other than law enforcement personnel looking for stolen cars, would review these operations. Since many buyers arrange their own financing, dealers often receive cash payments. It may also be difficult to trace the origin of the inventory.

4.10.3.4.5  (03-01-2003)
Summary of Internal Control Evaluations

  1. An examination of a taxpayer cannot be undertaken without an overview of the entire operation. An in-depth review of taxpayers’ financial status can only be accomplished through an evaluation and documentation of internal controls, including the control environment, the accounting system and the control procedures.

4.10.3.4.5.1  (03-01-2003)
Evaluation Methods and Tests

  1. The examiner’s role in evaluating internal controls must encompass a complete review of existing procedures. Adequate tests to validate the taxpayer’s records and testimony should be carried out as applicable.

  2. Information regarding internal controls may be obtained by interviewing the taxpayer and/or representative, inspecting the documents and records, and observing the taxpayer’s activities and operations.

  3. To complete a comprehensive evaluation of internal controls, the examiner should document the business operation and document the accounting system.

  4. Document the Business Operation — Draw-up an overview of the business operations. At a minimum, the information obtained should depict by whom, with what, how many, where, when and how business is transacted.

  5. Document the Accounting System — Identify what books and records are maintained. At a minimum examiners should determine:

    1. What the books of original entry are, whether they are automated, what types of subsidiary records (invoices, etc.) are maintained, what kinds of reports are prepared, how often they are prepared, and by whom.

    2. How income is received, how expenses are paid, and who is responsible for receiving and recording income and expenses.

    3. Who opens mail, deposits funds, writes checks, approves expenditures (both regular and extraordinary), signs checks, makes book entries, prepares invoices, matches invoices, has access to cash registers, and receives and reconciles bank statements.

  6. Document Assets — Identify the taxpayer’s business and personal assets, including capital acquisitions, bank accounts and cash. At a minimum, the taxpayer and/or representative should be questioned regarding capital asset transactions, cash in bank, cash on hand, bartering, number and location of bank accounts, non-taxable sources of funds, and total assets held.

  7. Document the Flow of Transactions — Outline the flow of receipts and expenditures through the books and records. Are there changes in the books? Is there a system of accounting for non-taxable receipts? Do the books and records have a system of accounting for cash receipts and expenditures? Does the taxpayer rely on information generated by third parties? Is the taxpayer’s mark-up identifiable? Does the taxpayer use the books and records for purposes other than tax? Do the books and records reflect regulatory or licensing requirements?

  8. Document Procedures Established to Safeguard Business Operations — Review procedures designed to safeguard the taxpayer’s business. Assets should be insured and employees who handle cash may be bonded.

4.10.3.4.5.2  (03-01-2003)
Interview Techniques

  1. 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 through observations of the business operations. An in-depth interview of the owner of the business who is usually involved with every facet of the business is an excellent way to gain insight into the control structure.

  2. While interviewing the business owner is ideal, examiners cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. Examiners should, however, request the taxpayer’s voluntary presence through the representative.

  3. When dealing with an individual who may be attempting to distort or conceal information, any information obtained through the interview process should be verified through tests of controls, such as the inspection of documents and reports or observations of the business operation.

4.10.3.4.5.3  (03-01-2003)
Compliance Testing

  1. The internal control system should be tested for compliance with the taxpayer’s (or representative’s) description. Observe or "walk through" sample transactions through the entire accounting process.

    • Select different types of transactions.

    • Look for consistency in recording similar or repetitive transactions.

    • Identify points where existing internal controls could be compromised.

4.10.3.4.6  (03-01-2003)
Setting the Scope and Depth of the Exam

  1. Once the steps are completed, the examiner can decide if the books and records adequately reflect business operations. Examiners can then select the appropriate depth and method of examining income and other issues based on the evaluation of internal control.

4.10.3.4.6.1  (03-01-2003)
Reliable Books and Records

  1. If it is determined that the taxpayer’s books are reliable, the examination of income can include direct testing of the taxpayer’s books and records. Some examples of audit procedures using books and records are:

    1. Tracing specific items to receipts,

    2. Testing sample receipts to books and records,

    3. Applying taxpayer’s mark-up to expenditures per records,

    4. Testing sample client accounts to receipts,

    5. Analyzing adjusting journal entries and differences between books and the tax return.

4.10.3.4.6.2  (03-01-2003)
Unreliable Books and Records

  1. If it is determined that the taxpayer’s books are not reliable, the examination of income should include indirect analyses. See 4.10.4 for audit techniques for determining income using Indirect Methods.


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