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:: Retail Industry Audit Technique Guide (ATG) - Chapter 2: General Issues in Retail   Table of Contents Chapter 2: General Issues in Retail Initial Interview Information Document Request Books and Records Income Issues Cash Records Indirect Methods Specific Items Methods of Determining Income: IRM 4.10.4.5.1 Bank Deposit Analysis: IRM 4.10.4.3.3.6 Source and Application or Cash T: IRM 4.10.4.6.4 Markup Method: IRM 4.10.4.6.5 Percentage Markup Method of Determining Income: IRM 4.10.4.6.6 Computations in the Percentage of Markup Method Net Worth Method: IRM 4.10.4.6.7 Analysis of Gross Receipts Sources of Receipts Vendor Rebates and Allowances Credit and Charge Backs Target Profit Percentage Deferred Income - Gift Certificates and Credit Vouchers Gift Certificate - Deferred Income - Balance Sheet Liabilities Other Retail Income Sources Cost of Goods Sold Retail Inventory: IRM 4.43.1 Personal Consumption of Inventory Retail Inventory Method (RIM): IRM 4.43.1.3.1 Last In, First Out (LIFO): IRM 4.43.1.3.1.3 Stock Ledger (INVENTORY): IRM 4.43.1.3.2.5.4 Point of Sale Perpetual Inventory Control System Valuation of an Acquired Retailers Inventory (Coordinated Issue) Purchases Expenses Excise Tax Issues Employment Tax Issues Initial Interview The initial interview is an important element of any examination, setting the stage for the rest of the examination. The primary purpose of the interview is to secure, by conversation with the taxpayer, sufficient facts which will present the overall financial picture, an understanding of the operations, and an overview of the recordkeeping practices. This is the examiner’s chance to learn exactly how the business works and how cash is handled. Information provided during the initial interview can save significant time and effort in unnecessary examination steps. Remember, the examiner is testing the accuracy of the taxpayer’s tax return and the sources of gross income. The interview is the best opportunity to allow the taxpayer to provide information not shown on the return. In addition to the general interview items usually covered, specific questions relating to the retail business should also be included. Some of the items to be developed in the initial interview: Business Operations Most “mom and pop” stores are cash intensive. Understanding how the taxpayer handles and accounts for the money is very important. Also secure a statement of how the inventories are valued and the method used. This is needed for calculations of markup and/or gross profit. Find out who actually takes the physical inventories and when they are performed.  Ask for the work paper that calculates the inventory value. Control procedures in many small businesses are often weak or nonexistent.  This may be due to cost factors, the lack of well-trained accounting staff or a lack of concern with this aspect of the business.  Smaller businesses generally have a higher level of "control risk,"  which is 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. Cash-on-Hand It is imperative that cash-on-hand is covered during the interview.  The examiner should probe for all funds the taxpayer had access to including funds available. Make sure the taxpayer understands that cash includes pocket money plus cash in a safe, safe deposit box or stored at home.   Personal Expenditures Many retail business owners use some of their inventory for personal purposes. This is especially noted in a restaurant or grocery business. The key here is to verify that the personal-use amount is properly accounted for and deducted from cost of goods sold or purchases. This list is not all-inclusive and some of the questions may not be pertinent in all examinations.  The initial interview should always be tailored to the taxpayer under examination. Back To Top Information Document Request Shown below are some documents examiners may want to consider when preparing an IDR for a retail case. Not all of these items should be requested in every case, but examiners should use this information as a guide and request the items that are appropriate and relevant for their specific case: All paid invoices for the year under examination, separated by vendor A listing of all purchases paid in cash Sales, Cash receipts, purchase, and general journal Adjustment entries to such items as Sales, excise Taxes paid All daily cash register tapes (including the summary tapes called ‘Z’ tapes) All bank statements for the year under examination, including deposit slips and checks written Work papers supporting the inventory computations List of vendors who offer vendor allowances such as rebates Documentation of any non taxable income Back To Top Books and Records Due to the diversity of the industry and the types of business organizations, a variety of books and records may be found during the examination.  Some taxpayers will have technologically sophisticated accounting systems that allow for very detailed records of sales and purchases.  They may describe the quantities purchased and the price paid each time.  Other taxpayers will not have a structured purchase journal, but may only have invoices and cancelled checks. Z Tapes - Most simple cash registers contain a “Z” key which can only be operated by the manager, owner or a key employee.  The Z key totals the entire history of activity on the cash register for a period of time, providing a summary total for (sales) taxable sales, non (sales) taxable sales, credit card sales, credit card tips, cash sales, lottery sales, coupons and discounts, etc.  Each day’s Z tape is used to record the daily sales in the sale journal.  These tapes must be retained by the owner and made available for the examination.  Without the Z tapes the examiner cannot know if all transactions are actually being recorded.  The examiner will conduct an audit test on the Z tapes, matching them to the entries in the sales journal and determining what sales are captured on the tapes. Point Of Sale (POS) - This is a computerized accounting system that records sales along with related items, such as employee’s time and tips received, or reductions to inventory and calculations of profit on each sale.  These machines can produce financial statements, periodic statements of profit and loss, profits per item, payroll checks, etc. When the examiner suspects that the computer program used by the taxpayer is not recording all sales properly, a referral should be made for an IRS computer examination specialist who will run an audit test of the computer program.  Inventory Reports - if maintained.  The retailer will usually take a physical inventory annually to determine if there is old merchandise that should be discounted for a quick sale. Cash Pay Outs - As discussed above, the accounting for cash is a primary focus for the examiner.  Many taxpayers keep daily envelopes with the cash paid out and the cash taken in recorded on the envelope.  Others maintain a separate file for receipts paid in cash. Back To Top Income Issues The examination of Income is a mandatory audit issue and minimum income probes will be conducted during every examination.  Please see IRM 4.10.4.3.3 (for individual business returns) and IRM 4.10.4.3.4 (for corporate and other business returns) for the Minimum Income Probes. If the minimum income probes and examination of gross receipts show all taxable income from known sources is reported, the examination may be limited at that point. If the results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, or if the books cannot be reconciled to the return, or if a material imbalance in the Financial Status Analysis cannot be reconciled, then a more in-depth examination of income is warranted.  The examiner will need to decide which techniques are best suited for each individual taxpayer. The following indirect methods have been used successfully in analyzing the sources of income: Back To Top Cash Records Retailers use different types of methods to collect and account for cash.  In some stores only the owner collects cash from customers and it is kept in a drawer or box.  In larger stores key employees collect and account for cash.  In more sophisticated systems a point of sale (POS) cash register may record sales and decrease inventory at the same time.  It is important to find out who collects the cash, where it is kept and who reconciles it to sales at the end of the day or shift.  When cash is used to pay vendors or make purchases, the examiner must know who is authorized to do this and what is the procedure?  It is also important to find out who takes the cash to the bank and what accounts it may be deposited into. A thorough understanding of how cash is handled is particularly important in the retail industry.  Even with weak internal controls, a taxpayer may be properly reporting income, but the only way for the examiner to know this is to gather detailed information about how the business is conducted, documenting cash inflows and outflows and thoroughly interviewing the owner regarding cash receipts and expenditures.  The records created (hard copy or magnetic media) by the accounting system will also provide a valuable source of information in the examination of the retail businesses.  A complete explanation of the accounting system, both in theory and business, should be obtained from the taxpayer prior to beginning the examination of the books and records. If the taxpayer has a computerized cash register system and cannot provide the requested financial records, the examiner can contact the cash register manufacturer for instructions on how to obtain the reports needed.  Most programs made within the last decade run the essential reports necessary to properly determine the correct tax liability and to comply with tip reporting. During the initial interview, the examiner should ask the taxpayer what percentage of sales is attributed to cash compared to credit or check payments.  When the examiner analyzes the bank deposits, this percentage can be verified and any discrepancies can be questioned.  During the tour of the business the examiner should be alert to the type of payments that are made and how they are handled. In spite of the modern record keeping systems available, many choose to report gross receipts according to amounts deposited to the business bank account.  When cash is not deposited in the bank, or when checks are cashed or deposited into an account other than the business account, this method of reporting income is not accurate. Interviews with return preparers who have been found to rely on the bank deposits to reconcile gross receipts (which in most cases understate income) indicated that they were unaware of the computerized record keeping systems.  These preparers provide only year-end compilation rather than complete income analysis of services rendered by the retailer business.  They have indicated that when they question their clients as to their deposit characteristics and are told that all gross receipts are deposited into the business bank account; the preparer confidently uses the bank statements to report income.  Rarely are any adjustments made to the gross deposits shown on the bank statements. For these reasons the examiner must check for unreported receipts.  A retail business is likely to receive many personal checks as payment for services.  If the owner is known at the business, whether it is a corporation or sole proprietorship, many of the checks will be made to the retailer personally.  It would not be difficult to cash these checks or divert them into personal bank accounts. Based on this discussion, the business income can easily be diverted from being deposited into the business bank account(s) and reported on the tax return.  Therefore, it is imperative that each examination includes alternative methods to verify gross receipts. Back To Top Indirect Methods When the taxpayers’ records are not available or are inadequate the examiner should consider the use of the following indirect methods:    Bank deposit analysis Fully developed cash T method  Source and application of funds Net worth method Percentage of markup method   Unit and volume method  The following is a synopsis of the indirect methods and the supporting court cases. The examiner needs to review the appropriate IRM sections for the proper application of these methods.  If any of these methods rely on estimates, they should be corroborated by other methods to establish a stronger position.  When tracing cash through a bank deposit analysis or using the source and application of funds method, several unique facets of the operations should be recognized.     Cash payouts are not deposited, but the money used to make the cash purchases originated from sales.  This is cash that would not be deposited into a bank account and must be added back to the bank deposit analysis.   In a restaurant business cash payment of employee credit card tips is money that is not deposited, but originated from sales.  Again, this cash must be added back to the bank deposit analysis.  Sales tax collected from customers for cash sales is money deposited that is not a source of income.  In many states the sales tax for restaurants and bars is higher than the sales tax for other retail businesses.    Cash collected from vending machines is cash that needs to be deposited and included in gross receipts.  If significant coin and currency deposits are not found on the deposit slips the examiner may need to determine the amount of income from this source and add it to the bank deposit analysis. Credit card payments from credit card companies for sales will include deposits of employee tips plus the sales taxes plus the sale.  Only the portion representing the sale is taxable.  Loans from shareholders are a non-taxable source of cash.  Proof of payment is necessary to establish facts.   Transfers between bank accounts are non-taxable.  The bank deposit analysis method assumes that the business owner deposits all income in a bank account.  In a cash-intensive business such as a bar or restaurant, this may not be the case.  For that reason, the bank deposits analysis should generally be supplemented with another indirect method when auditing a bar or restaurant.      To further support an indirect method another examination technique may be used such as having the examiner inspect the supply invoices to find the name of the company that prints the guest checks.  This printing company can provide the number of guest checks purchased by the restaurant in a year.  A projected income can then be determined from the average amount of the guest check times the number of checks.  If these methods are used in combination, they strengthen the case.     In examining a bar, it is possible that the bar owner may remove cash from his or her drawer, purchase liquor off the shelf of a store, sell the drinks in his or her establishment and pocket the profits.  (In most states this practice is illegal and bar owners cannot purchase liquor off the shelf or in discount stores.)  In such case, there may be no indication in the books that anything is wrong as neither the invoice nor the income touches the books.  An indirect method may uncover this. Back To Top Specific Items Method of Determining Income: IRM 4.10.4.5.1 Before we begin analysis of the retail indirect methods we should discuss the specific items methods. This method is preferable to an indirect method as it is based upon direct evidence of income.  For example, a restaurant owner may receive rebates from a supplier.  A copy of the supplier's invoices and cancelled checks establishes the amount of income from these rebates.  The specific items method relies on evidence gathered from source documents, rather than estimates.  If records cannot be obtained from the taxpayer, you may have to contact third parties.  If you do, be certain you correctly follow third party contact procedures.  The specific items method of establishing income, supplemented by the bank deposit method, is illustrated in Ketler v. Commissioner, T.C. Memo. 1999-68. During 1990 and 1991, Warren Ketler operated two sole proprietorships, including a catering operation doing business as California Barbecue.  Mr. Ketler failed to file Federal income tax returns for 1990 and 1991.  The Service determined Mr. Ketlers unreported income for these years by reference to Forms 1099 provided by payers.  Prior to trial, the Service obtained 1990 and 1991 bank records for all of Mr. Ketlers accounts and identified various nontaxable transfers and deductible business expenses.  Based on this analysis, the Service asked that the Tax Court find increased income tax deficiencies.  After trial, the Tax Court found that Mr. Ketler received the income reflected on the Forms 1099.  It also found that the Service had properly performed the bank deposits analysis, and, therefore, Mr. Ketler was also liable for increased income tax deficiencies.  Kikolos v. Commissioner, T.C. Memo 2004-82, involved liquor store owners, Nick and Helen Kikalos.  At the end of each day Mr. Kikalos would receive a bag from his store containing receipts which, among other things, included the cash register tapes (known as "Z tapes") from the store. The Z tapes from these store registers would have allowed for an accurate calculation of the Kikalos' gross income. However, after entering the information in his log books, Mr. Kikalos threw away all of the Z tapes. When IRS used a mark-up percentage to figure accurate gross receipts, the Kikaloses wanted to use a different indirect method and filed their petition in court.  The court said that arithmetic precision was originally and exclusively in the hands of the Kikaloses, who had simply to keep their papers and data. Having defaulted in this duty, they cannot, in essence, "frustrate the Commissioner's reasonable attempts by compelling investigation and re-computation under every means of income determination.”  The Court said that other indirect methods of estimating the Kikalos’ income are not relevant.   Quoting the Fifth Circuit, the court stated, “While the absence of adequate records "does not give the Commissioner carte blanche for imposing Draconian absolutes," such absence does weaken any critique of the Commissioner's methodology. Webb v. Commissioner, 394 F.2d 366, 373 (5th Cir. 1968).” The court said, “Indirect methods are by their very nature estimates and courts reject the notion that the IRS should have checked their calculations by other methods." Back To Top Bank Deposit Analysis: IRM 4.10.4.3.3.6. A bank deposit analysis (BDA) is used to identify deposits that may be taxable, to determine if business expenses were paid from other sources and to determine if business and personal accounts were co-mingled.  The deposited items will show whether cash is deposited. The examiner will analyze the deposits and reconcile non taxable deposit sources, comparing the total deposit with the reported gross income. If the retail business is cash intensive, where a significant amount of receipts are not deposited and there are many expenses paid with un-deposited cash, a bank deposit analysis would not be a good indirect method for proving income. However the total known deposits should be added to cash expenditures to show the total amount of funds used. This method is best for retailers whose books are unreliable, but who makes periodic bank deposits and pays expenses by check.   The bank deposits method of establishing income is illustrated in Ng v. Commissioner, T.C. Memo. 1997-248. From 1986 through 1990, Big Hong Ng owned interests in several business entities, including various restaurants.  Ms. Ng controlled several bank accounts in the United States and Hong Kong.  She commingled her personal funds with those of the business entities in which she had an interest.  The Service conducted a bank deposit analysis and determined that Ms. Ng failed to report significant amounts of taxable income during the years in issue.      In analyzing the bank deposits, the Service separated cash, checks, cashiers checks and wire transfers.  It examined the source of each deposit and separated items subject to self-employment tax from those not subject to such tax.  Further, to the extent possible, the Service eliminated those items that had been reported on Ms. Ng's income tax returns or that came from nontaxable sources (for example, transfers and refinancing proceeds).  The Service also analyzed Ms. Ng's cash expenditures.  The expenditures that could not be traced to a nontaxable source or reported income were considered unreported income. Back To Top Source and Application or Cash T: IRM 4.10.4.6.4. This method analyzes cash flows in comparison to all known expenditures, and shows that if there are excess expense items (applications) over income items (sources) an understatement of taxable income exists. These methods may be useful for a retail business that has unreported sources of income and when business and personal expenses can be verified. Back To Top Markup Method: IRM 4.10.4.6.5. This method reconstructs income based on the use of percentages or ratios for the type of retail business.  For example, the examiner would determine the industry markup for a particular type of retailer and apply that markup percentage to the verified cost of goods sold of the taxpayer under examination. Alternately, the examiner can use the taxpayer’s own markup percentages, if possible.  A ‘shelf test’ can be performed where the current sales prices can be compared to the cost of those items to determine the markup percentage.  This will be effective if there are only a few types of purchases or only a few suppliers of goods, such as for a gasoline retailer. This method works well for a business that is cash intensive or one that does not use bank accounts to deposit receipts, or for a taxpayer where total expenditures (such as personal expenses) cannot be determined.  This method is also recommended when inventories are present, but records are unreliable. Back To Top Percentage Markup Method of Determining Income: IRM 4.10.4.6.6  IRM 4.10.4.6.6.2 states that the percentage markup method is recommended in the following situations:  When inventories are a factor and the taxpayer has nonexistent or inadequate records  Where a taxpayer's cost of goods sold or merchandise purchased is from one or two sources and these sources can be ascertained with reasonable certainty and there is a reasonable degree of consistency as to sales prices.  Consider the following when applying the percentage of markup method:  Judgment should be exercised by examiners to make sure the comparisons are made to situations that are similar to those under examination  The availability of valid sources of information containing the necessary percentages and ratios  Complexity of the taxpayer's product mix and the availability of valid percentages and ratios for each product  Length of the period covered during the examination and the need to adjust the percentages and ratios to reflect those existing during the examination Back To Top Computations in the Percentage of Markup Method  Possible daily volume X Average check per seat = Daily sales   The possible daily volume would be the number of seats in the establishment X how many times in a day they are occupied.  The possible daily volume can be broken down into time periods in a day (breakfast, lunch, or dinner) to get a more accurate tally.  The average check per seat can be obtained from the taxpayer during the initial interview or from examining the sales tickets.        The daily sales can be extended to weekly and yearly sales based on the days open per week and the weeks open per year.   Daily sales X Days open in a week = Weekly sales     Weekly sales X Weeks open in a year = Yearly sales   These estimates should take into account the number of vacant seats and people who walk out before paying their bill.  The examiner should also look at the taxpayer’s advertising account to test the accuracy of reported income.  Are specials advertised?  How often?  Specials may refer to certain menu items or discounted prices or both.  Are the times during which specials are offered (for example, happy hour or weekly breakfast hours) reflected in the daily receipts ledger?  During the initial interview ask enough pertinent questions to determine if these or any other situations should be considered.     In addition to the above calculations, normal audit procedures should be followed, including tracing gross receipts to bank deposits, analyzing bank deposits of all business and personal accounts of the owner/manager, etc.  The examiner will review the interview responses regarding internal controls.  Does the same person who counts the daily receipts also make the bank deposit?  Are the meal orders taken on numbered tickets or would it be easy to simply not ring up a sale on the cash register for some orders?  The examiner must look closely at the supervision habits in the restaurant to evaluate how sales might be understated or how easily theft may occur and by whom. Back To Top Net Worth Method: IRM 4.10.4.6.7 This method measures the difference between a taxpayer’s net worth (total assets less total liabilities) at the beginning and at the end of the year.  An overall increase in net worth represents taxable income.  This method works when there is an entire business element missing, such as a retailer that does not report sales from an internet business, or a taxpayer who has additional income from an illegal source. The net worth method can also be used to corroborate other methods of proof or to test the accuracy of reported taxable income.   The net worth method of establishing income is illustrated in Michas v. Commissioner, T.C. Memo. 1992-161. During 1984, the taxpayers owned several sole-proprietorships, including a liquor store.  The Service determined that the books and records of these sole-proprietorships were inadequate and analyzed the taxpayer’s net worth to determine whether all taxable income had been reported.  The Service performed this analysis by determining the cost of the taxpayers business and personal assets at the beginning and end of 1984.  The Service then reduced these amounts by the taxpayer’s liabilities at the beginning and end of the year.  Then, the difference was adjusted by adding nondeductible expenditures (for example, living expenses) and by subtracting nontaxable sources of income (for example, gifts and loans).      The Court largely agreed with the Service, but found that certain adjustments to net worth were not proper.  Accordingly, the Court reduced the amount of unreported income determined by the Service. Back To Top Analysis of Gross Receipts Before an auditor reviews records for specific sources of receipts, he should do the following: Analyze the duplicate deposit slips.  If the business is cash intensive there should be frequent and significant cash deposits.  The examiner will calculate the percentage of cash to checks or credit card payments. Analyze the cash register tapes.  Cash registers print a daily total called ‘Z’ tapes.  A months worth of Z-tapes will usually be entered into a spreadsheet or handwritten on a monthly sales sheet.  Total the monthly sheets to compare with gross receipts on the tax return.  Use the monthly sheet for a sample month and verify the daily tape amounts were entered correctly. Analyze business cash pay outs.  Verify that the income was reported before it was paid out for business expenses. Sales taxes returns: The gross sales reported to a state sales tax agency will generally match the gross receipts reported on the income tax return.  If not, the examiner should reconcile any differences. It is also important to determine whether sales taxes were included in the total sales dollars.  The retailer should not include sales taxes in gross receipts and should not deduct state and local sales taxes collected and paid over to the state or local government. The examiner should be alert for double deductions in sales taxes paid for purchased items, such as taxes that are included in the cost of goods sold as well as a separate expense item.Sources of Receipts Back To Top Sources of Receipts Vendor Rebates and Allowances Many vendors offer a rebate or allowance to the retailer when they purchase certain items or quantities.  For example, a soft drink vendor may allow a discount on all diet soda purchased, if the retailer also purchases 5 cases of a new product, soda light.  Many times the vendor allowance will be a reduction of total purchases and will appear on the purchase invoice.   This way payment is made only for the net purchase amount and no income should be recognized. Some vendors, such as cigarette sellers, allow the retailer to purchase the product at discount or warehouse stores.  The vendor then issues a rebate check to allow the purchase for less than the retail amount.  There is no purchase invoice from the vendor in this transaction, since the purchase was made at another retail store.  This type of rebate should appear as an income item.  Income from rebates or credits is includible when received by a cash basis taxpayer, and when the right to receive it becomes fixed