IRS Audits - Part 4 Examining Process

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IRS Audits

Chapter 10. Examination of Returns

Section 3. Examination Techniques (Cont. 1)

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