Examination Techniques Cont.

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Overview & Responsibilities
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Examination Techniques
Examination Techniques Cont.
Examination of Income
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Required Filing Checks
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Report Writing Cont.1
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Examination Techniques Cont.

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4.10.3  Examination Techniques (Cont. 2)

4.10.3.9  (03-01-2003)
Testing Gross Receipts or Sales

  1. The following techniques are used when testing gross receipts.
    1. Test the methods of handling cash to see if all receipts are included at end of year.
    2. Test the reported gross receipts by using the gross profit ratio method. See IRM 4.10.3.9.1 for additional instructions.
    3. Note items that are unusual in origin, nature, or amount.
    4. Test the books of original entry by tracing the entries back to the original sales slips, original cash register tapes, original contracts, job record book, or bank deposits.
    5. Check selected entries made at different times of the year, including some at the beginning of the year.
    6. Test check footings and postings to the general ledger.
    7. Review bank statements and deposit slips as described in subsection 3.7, above.
    8. Scan the sales account in the ledger for unusual entries.
    9. Test entries from the general and sales journals.
    10. Be alert for taxable income which may not appear on the books (high percentage of cash receipts which are not regularly deposited or properly accounted for, dealer reserve income, constructive receipt, foreign source income).
    11. Determine the extent the receipts were used to pay operating expenses. Question any unusual discounts or sales allowances.
    12. Determine the method and adequacy of the accounting for merchandise withdrawn for personal use.
    13. Determine if all receivables are included in income for accrual base taxpayers.
    14. Scan sales agreements, contracts, and related correspondence for leads to unrecorded bonuses, awards, kickbacks, etc.
    15. Review workpapers prepared for tax purposes and confirm that adjustments are appropriate.
    16. Be alert to indications of capital gains treatment of items which are ordinary income, sales made or services rendered in exchange for other goods and services, and unreported commissions or rentals from activities operated on the taxpayer’s business premises such as arrangements for operating concessions, such as cafes, bars, candy counters, vending machines, video games, etc.

     

  2. Each examination is unique. The above items are a suggested list, neither all inclusive or required in every situation. The examiner must use techniques which are effective in the conduct of their specific audit.

4.10.3.9.1  (03-01-2003)
Gross Profit Ratio Test

  1. When inventories are a material income producing factor, the gross profit test serves as an indicator of the reasonableness of gross receipts, inventories, purchases, and business net profit represented on the tax return.
  2. The term, "gross profit ratio" refers to the ratio:
    Gross Profit Realized on Sales
    Gross Receipts from the Sales

     

  3. It is the difference, or "margin" , between the cost of sales and gross receipts expressed as a percentage of sales.
  4. The margin is always computed based on the selling price.

    Example:

    An article is purchased for $1.20 and sold for $1.60.

     

    1. The margin would be 40 cents; ($1.60 – $1.20).
    2. The margin would be 25%; ($.40/$1.60).

     

  5. A related computation, "markup" , can be computed as either a percentage of cost or of selling price. Although many consider markup as a percentage of the selling price, computing the markup on the cost price is easier and less confusing to be used to compute the markup on the cost of goods and determine the correct sales.

    Note:

    The percentages of margin and markup on cost are not the same. Margin and markup in dollars are identical, however, the percentages are different. Both represent the differences between the cost of merchandise and the selling price.

     

  6. Exhibit 4.10.3–8 shows what the markup on cost must be to give the desired margin for common cases. To use this table, find the margin or gross profit percentage in the left column. Multiply the cost of the article by the corresponding percentage in the right or markup column. The result, added to the cost, gives the correct selling price.
  7. When the markup is computed based on the selling price, a different markup percentage must be used than when computing the markup on the cost price.

    Example:

    An article is purchased for $1.20 by a seller who then marks it up 25%.

     

    1. The markup of 25% of the cost ($1.20) equals 30 cents. Add 30 cents to the cost, and the selling price is $1.50 with a margin of 30 cents, or 20% gross profit margin.
    2. If a 25% margin is needed, then the percentage that will yield the desired margin when applied to the cost price must first be determined.
    3. From Exhibit 4.10.3–8, it can be determined that a 25% margin is equivalent to a 33.3% markup on cost.
    4. Multiplying 33.3% times the cost ($1.20) equals 40 cents. Adding 40 cents to the cost price gives a selling price of $1.60, and a margin of 40 cents, or 25%.
    5. A markup on cost of 25% gives a selling price of $1.50. If it were necessary to have a margin of 25% to cover the costs of operations and net profit, the taxpayer would be losing money by pricing merchandise on the basis of a 25% markup on cost. To realize a 25% margin, the taxpayer would need to use a 33.3% markup on the cost price.

     

  8. The following example illustrates the application of the gross profit ratio as a percentage of sales:
    Gross Sales $50,000
    Cost of Sales $40,000
    Gross Profit (Margin) $10,000

     

    1. The gross profit margin ratio is 20%. That is, 20% of $50,000 sales gives the margin of $10,000.
    2. From the markup table it is determined that a 20% gross profit ratio (margin) requires a 25% markup based on cost. The cost of sales in the amount of $40,000 must be increased by 25% or $10,000, to give the $50,000 gross sales.

     

  9. A change in the gross sales, in the example above, results in a change in the gross profit ratio and the markup:
    Gross Sales $60,000
    Cost of Sales $40,000
    Gross Profit (Margin) $20,000

     

    1. There has been an increase in gross sales of $10,000 ($50,000 to $60,000) or a 20% increase in gross sales. This results in a gross profit ratio of 33.3%. The markup (on cost) formerly is now 50%.

     

  10. After the ratio for the business under examination has been determined:
    1. Compare it with the prior years’ ratios for the same taxpayer, and
    2. Compare it with the ratios of similar businesses. In making the comparison, remember that the ratio will vary according to the size, sales volume and location.

     

  11. If the comparison indicates that there is a probable error in the reported gross profit amount, consider the reasons listed in items (12), (13), and (14) below, as possible reasons for the error.
  12. Possible errors in Reporting Gross Receipts:
    1. Inclusion of costs not subject to the gross profit ratio, i.e, rents, interest, dividends, etc.
    2. All accounts receivable were not reported when accrual basis accounting was used,
    3. All collected accounts receivable were not reported when the cash basis of accounting was used,
    4. Income constructively received was not reported,
    5. Installment sales were incorrectly reported,
    6. Sale of ending inventory was not included in gross receipts when the business was sold,
    7. Theft of inventory, or
    8. Unreported gross receipts from bartering.

     

  13. Possible errors in reporting Inventory:
    1. Inventory improperly valued or incorrect amount carried over from the prior year,
    2. Figures are estimates,
    3. Inventories are not used, even though inventory is a material income producing factor, or
    4. Ending inventory is understated.

     

  14. Possible errors in reporting Purchases:
    1. Included costs are not properly a part of the cost of sales,
    2. Personal withdrawals are not properly accounted for,
    3. Purchases are not reduced for returned merchandise, or
    4. Purchase discounts are not properly reflected.

     

4.10.3.10  (03-01-2003)
Testing Expenses: Cost of Goods Sold

  1. Testing the Cost of Goods Sold (COGS) may include the following techniques.
    1. Review inventory as provided in subsection 3.8.4.3, Inventories, above.
    2. If the taxpayer is a manufacturer, confirm they are in compliance with the full absorption rules in the regulations for IRC section 471.
    3. If the taxpayer is a producer or re-seller, as defined in IRC section 263A, confirm they are in compliance with the code and regulations of IRC section 263A.
    4. Review the cost of sales and examine the accounts that are material.
    5. Review the cost system and variance accounts.
    6. Compare the current year beginning inventory balance with the prior year ending inventory balance and resolve any discrepancies.

     

4.10.3.11  (03-01-2003)
Testing Expenses: Operating Costs

  1. The following techniques can be used to test operating expenses:
    1. Scan the expenses per the return and examine those which are large, unusual, or questionable.
    2. Trace the selected expenses back through the books to the original source documents.
    3. Verify the timing of the expense.
    4. Verify the amount of the expense.
    5. Be aware of the following possible technical issues:

     

     

    • Excess officers compensation
    • Expense versus capitalization in the areas of interest expense (IRC § 263A(f)), accounting and legal fees (inspect the billings the taxpayer received for itemized charges), organization costs, franchise costs, asset acquisition costs, and capital expenditures (IRC § 263).
    • Bad Debt Treatment
    • Fair Rental Value when dealing with rent expense to related parties or entities.
    • Lease-Purchase arrangements.
    • Passive loss limitations.
    • At risk limitations
    • Proper year end accruals of accrual basis taxpayers.
    • Personal use of business assets.
    • Net Operating Loss computations
    • Imputed interest expense.
    • Franchise expense and amortization
    • Expense vs. Credit vs. Capitalization

     

     

4.10.3.12  (03-01-2003)
Sampling Techniques

  1. The process of examining the taxpayer’s books and records can be substantially enhanced and improved through the appropriate use of sampling techniques.
  2. There are two basic types of sampling, judgment sampling and statistical sampling, as discussed in the following subsections.

4.10.3.12.1  (03-01-2003)
Judgment Sampling

  1. Judgment sampling requires examiners to use professional judgment in performing the sampling procedure and in evaluating the results of the sample.
  2. One type of judgment sampling is Block Sampling.
    1. Block sampling may use groups of continuous items selected from an account balance or class of transactions.

      Example:

      An examiner selects one month of travel expense to reach a conclusion about travel expense for the entire year.

       

    2. Block sampling may include selecting all items in a selected numerical or alphabetical sequence.

      Example:

      Gross Receipts is sampled by selecting customers with names beginning with certain letters such A, B, or C or by selecting the months of January, September and December.

       

     

  3. Another type of judgment sampling is Dollar Limitation Sampling (cut-off sampling).
    1. Dollar limitation sampling is a method which selects a minimum dollar amount and creates a sample by selecting all items exceeding that dollar amount.
    2. This type of sampling prevents the agent from wasting time examining small, insignificant amounts.
    3. This method is often combined with block sampling.

     

4.10.3.12.2  (03-01-2003)
Statistical Sampling

  1. Statistical sampling is a procedure used to choose a portion of the whole to make a statement about the entire body of information.
  2. Other terms applied to this type of sampling include probability sampling and random sampling.
  3. Using statistical sampling, there is no way for the person who is sampling to impose their judgement on the selection process.
  4. Examiners should not independently undertake a statistical sampling application. Examiners will discuss the facts and circumstances with their manager and determine if a request for a Computer Audit Specialist (CAS) is necessary. Refer to IRM 4.10.2, Referrals for Specialists, for instructions to request CAS assistance. Also refer to IRM 4.47, Computer Assisted Specialist Program - Computer Audit Specialist Program (CAS).

4.10.3.13  (03-01-2003)
Record Keeping Systems

  1. Taxpayers are required to maintain accounting records in sufficient detail to enable them to make a proper return of income (IRC section 6001). No particular form is required for keeping the records. They must, however, be accurate (Treas. Reg. 31.6001–1, 26 CFR 31.6001-1).
  2. This section provides descriptions of the common recordkeeping systems used by taxpayers.

4.10.3.13.1  (03-01-2003)
Double Entry System

  1. Double-entry recordkeeping is a system which is based on the " accounting equation" :
    Assets = Liabilities + Capital
  2. Every net increase or decrease in assets is accompanied by a corresponding increase or decrease in either liabilities or capital.
  3. Each transaction is recorded as a debit entry in one account and a credit entry in another. Therefore, a properly maintained set of double-entry books is always in balance.
  4. The double-entry system is comprised of journals and ledgers.
  5. See Exhibit 4.10.3–9 for a flowchart of accounting transactions in double entry accounting systems.

4.10.3.13.2  (03-01-2003)
Single Entry System

  1. The single entry system of recordkeeping does not include equal debits and credits to the balance sheet and income statement accounts. A single-entry accounting system is not self-balancing. Mathematical errors in the account totals are thus common. Reconciliation of the books and records to the return is an important audit step.
  2. A single-entry system may consist only of transactions posted in a notebook, daybook, or journal. However, it may include a complete set of journals and a ledger providing accounts for all important items.
  3. A single-entry system for a small business might include a business checkbook, check disbursements journal or register, daily/monthly summaries of cash receipts, a depreciation schedule, employee wages records, and ledgers showing debtor and creditor balances.
  4. See Exhibit 4.10.3–9 for a flowchart of accounting transactions in single entry accounting systems.

4.10.3.13.3  (03-01-2003)
Voucher System

  1. The voucher system is a recordkeeping system which uses a voucher register for recording expenditures that are to be paid for by check. The voucher register is similar to and replaces the purchases journal. The following steps are performed when this system is used:
    1. Each invoice (or group of invoices) which is paid by one check is entered in the voucher register on a single line.
    2. An identifying number is placed on both the voucher and the register.
    3. The voucher is placed in an unpaid voucher file until it is paid.
    4. When paid, the check number is placed in an appropriate box on the same line as the original entry in the voucher register.
    5. Postings are made periodically to appropriate cost or expense accounts (debits) and accounts payable (credits).

     

  2. Accounts Payable is the total of the items in the voucher register not having check numbers and invoices not posted in the register.

4.10.3.13.4  (03-01-2003)
Cost Accounting System

  1. A cost accounting system is a double entry system designed to show the cost of:
    1. Each completed job,
    2. Each completed process,
    3. Each completed product, and
    4. Work in process.

     

  2. Cost systems are used primarily by manufacturers and fabricators. They are also used by some smaller businesses, such as automobile dealers.
  3. There are three types of cost accounting systems in general use:
    1. Job Cost refers to the system used when goods are manufactured on specific orders only. Costs are accumulated on a departmental basis for each order or job.
    2. Process Cost refers to the system used when goods are manufactured continuously or in bulk and it is not desirable to distinguish between orders. Costs and quantities processed are determined by department and the average costs per unit are determined. The accumulated costs are transferred from department to department and inventories of work-in-process are valued on the basis of the accumulated costs.
    3. Standard Cost is sometimes used in conjunction with either job or process cost systems. Standard costs are the costs that are expected to be achieved in a particular production process under normal conditions. These costs are based on estimates and are used by management to determine how much a product should cost (standard), how much a product does cost (actual), and the causes of any difference (variance) between the two.

     

  4. Cost accounting systems include the following ledgers with related general ledger control accounts. Each of these accounts is debited for all additions and is credited for all deductions.
    1. Work-in-Process — journal entries are made, charging (debiting) Work-in-Process for material put in process, labor expended, and overhead applied to production.
    2. Materials — journal entries are made, charging Work-in-Process for materials put in process. If materials are allocated between direct and indirect costs, the indirect portion is charged to Factory Overhead.
    3. Payroll — journal entries are made, charging Work-in-Process for labor expended in manufacturing. If labor is allocated between direct and indirect costs, the indirect portion is charged to Factory Overhead.
    4. Factory Overhead — overhead expenses incurred are initially recorded as debits to the Factory Overhead account. Journal entries are then made, charging Work-in-Process for overhead applied to production. The overhead applied is an estimate based on experience. At year-end, the variance between the overhead applied and the actual overhead is closed to the income summary account.
    5. Finished Goods — The cost of goods or jobs completed during the month is removed from the Work-in-Process account and recorded in Finished Goods.

      Note:

      Some cost systems do not use a finished goods account. In that situation, the cost of goods or jobs completed is recorded in the Cost of Goods Sold account.

       

    6. Cost of Goods Sold — At year-end, the cost of finished products or jobs sold is removed from Finished Goods and charged to Cost of Goods Sold.

     

  5. Taxpayers using standard cost systems sometimes maintain a separate variance account. The variance is the difference between actual and standard costs. At year-end, the variance accounts are usually closed to the income summary account. If any of the products manufactured are still on hand, the variances should be allocated between the Work-in-Process, Finished Goods, and Cost of Goods Sold accounts. This year-end allocation is necessary to convert these account balances from standard cost to actual cost.

4.10.3.13.5  (03-01-2003)
Computerized Accounting Systems

  1. Rev. Proc. 98-25, 1998-1 C.B. 689, 1998-11 I.R.B. 7, provides requirements for taxpayers maintaining accounting records within Automatic Data Processing (ADP) systems. Per this revenue procedure, ADP systems include all accounting systems that process information "by other than manual methods. "
  2. Taxpayers who use computerized systems for recordkeeping must:
    1. Be able to produce legible records from the systems to provide the information needed to determine their correct tax liability.
    2. Keep all machine-sensible records and a complete description of the computerized portion of their accounting systems.

     

  3. The computer systems used by small businesses are usually less complex, consisting of microcomputers and purchased software packages which may be designed for their industry. In these situations, the examiner does not need specialized computer skills or knowledge to conduct the examination. The examiner should learn how the taxpayer’s computer is used, while obtaining an understanding of the accounting system.
  4. For examinations involving computerized accounting systems, the examiner should consider requesting the assistance of a computer audit specialist (CAS). See IRM 4.10.2.6.7.
  5. Examiners must request the assistance of a CAS:
    1. When Form 5546, Examination Return Chargeout, states "Record Retention Agreement on File."
    2. For all examinations of corporations with an activity code of 219 or above where the taxpayer has a computerized accounting system.

     

4.10.3.13.6  (03-01-2003)
Manual Accounting Systems

  1. There are many different types of manually prepared recordkeeping systems. Some are simple single-entry systems and others are sophisticated multi-journal, double-entry systems.

4.10.3.14  (03-01-2003)
Ledgers and Journals

  1. "Books of Entry" are classified as either "original" or "final" entry. The books of original entry are the journals because entries are made in chronological order from the primary records. The books of final entry are the ledgers because transactions are finally entered therein through posting from the books of original entry.
  2. The individual items on a tax return are usually groupings of similar items on the books. The taxpayer will have summaries and reconciliation records which give the detail of the combined items. These summaries and reconciliations must be obtained to reconcile the books to the return.
  3. When examining a consolidated group, each subsidiary and the parent will keep separate ledgers and journals. There are no consolidated ledgers or journals. Examiners should tie the separate general ledgers to the consolidating workpapers in order to compare these totals to the tax return.
  4. When a large corporation (assets in excess of $50,000,000) is under examination, the examiner should not ask for all of the records at one time because the records are voluminous and the audit is time consuming.
  5. There are unique features in some businesses which require the use of slightly different terminology, adaptation of journals, etc.; some examples of books and records maintained by the taxpayer may include:

     

    1. Primary Records —
      Invoices
      Bills
      Vouchers
      Cancelled checks
      Brokers’ statements
    2. Books of Original Entry —
      General Journal
      Voucher Register
      Special Journals
      Sales Journal
      Purchases Journal
      Checkbook
      Cash Receipts Journal
      Cash Disbursements Journal
      Payroll Register
    3. Books of Final Entry —
      General Ledger
      Subsidiary Ledgers
      Private Ledger
      Accounts Receivable Ledger
      Accounts Payable Ledger General Journal

     

     

4.10.3.14.1  (03-01-2003)
General Journal

  1. The general journal is used to record all transactions for which special journals have not been provided.
  2. Usually, the general journal has only a single pair of columns for the recording of debit and credit entries, but many variations of this basic design can be found. A third column may be included for entries to subsidiary ledgers, or various multi-column forms may be used.
  3. Entries can include:
    1. Routine monthly accruals.
    2. Standard journal entries (computations made the same way each month, on standardized journal entry forms).
    3. Reversals.
    4. Correcting Entries
      (Note: Not all entries necessarily flow through to the tax return.)

     

  4. Some companies maintain a system of journal vouchers. These are serially numbered documents, each containing a single, general journal entry, with full supporting details. In many cases the transaction numbering system used will indicate the source and type of each entry.
  5. Vouchers may be used in lieu of a general journal or a general journal, in traditional form, may be prepared from the journal vouchers.
  6. Companies having electronic data processing equipment generally enter journal vouchers to serve as one of the transaction sources for printouts of the ledger and the trial balance.
  7. Audit techniques for verifying journal entries include determining:
    1. That entries in the general journal were posted from authentic sources.
    2. That entries in the journal are properly supported by tracing a sample of journal entries back into the source documents. Sampling techniques may reveal transactions that are not supported, and possibly, not valid.
    3. Unusual entries by scanning.
    4. Material differences from prior and subsequent years.

     

4.10.3.14.2  (03-01-2003)
Special Journals

  1. A special journal is used to group similar types of transactions, such as all sales of merchandise on account, or all cash receipts. The types of special journals used depends largely on the types of transactions that occur frequently in its business.
  2. In each special journal, all transactions result in debits and credits to the same accounts.
  3. If the transaction cannot be recorded in a special journal, it is recorded in the general journal.

4.10.3.14.3  (03-01-2003)
Sales Journal

  1. The sales journal is a special journal designed to record only credit sales.
    1. Each sale is debited to Accounts Receivable and credited to Sales.
    2. Sales invoices are prepared for each sale.
    3. A copy of the sales invoice is used to make an entry in the sales journal.
    4. The sales journal entry usually includes the date, the customer’s name, an invoice number, the amount of the sales, and possibly the credit terms.

     

  2. Cash sales are entered in the cash receipts journal.
  3. The nature of a taxpayer’s business will determine whether other entries are included in the sales journal. An example is a retailer required to collect sales tax from its customers. In this case, an additional column in the sales journal is needed to record the necessary credit to Sales Tax Payable.
  4. Sales returns and allowances are frequently accounted for in the back of the sales journal. The daily activity is posted to the individual customers’ accounts in the Accounts Receivable subsidiary ledger. The returns and allowances are totalled periodically (usually monthly) and are posted to the sales returns and allowances (debit) and control accounts receivable (credit) accounts in the general ledger.

4.10.3.14.4  (03-01-2003)
Purchases Journal

  1. The purchases journal is a special journal designed to record all purchases on credit, including merchandise for resale or materials/supplies for incorporation into a finished product.
    1. Each purchase is debited to purchases and credited to accounts payable.
    2. Purchase invoices are prepared for each purchase.
    3. A copy of the purchase invoice is used to make an entry in the purchases journal.
    4. The purchases journal entry usually includes the date, the supplier’s name, the invoice number, the amount of the purchase, and possibly the credit terms.

     

  2. Cash purchases are recorded in the cash disbursements journal.
  3. The nature of a taxpayer’s business will determine whether other entries are included in the purchases journal. An example of this would be other expenses often bought on credit (e.g., Freight In, Supplies, etc.). In this case, an additional column in the purchases journal is needed to record the necessary debit to the appropriate expense account.
  4. Purchase returns and allowances are frequently accounted for in the same purchases journal. The daily activity is posted to the individual suppliers’ accounts in the Accounts Payable (subsidiary) ledger. The returns and allowances are totalled periodically (usually monthly) and are posted to the control accounts payable (debit) and the purchase returns and allowances (credit) accounts in the general ledger.

4.10.3.14.5  (03-01-2003)
Cash Receipts Journals

  1. The cash receipts journal is a special journal designed to handle all transactions involving receipts of cash.
  2. Unlike other special journals in which all transactions result in debits and credits to the same accounts, all transactions in the cash receipts journal result in debits to Cash, but require a variety of credit entries.
  3. Examples of transactions recorded in the cash receipts journal include cash sales, cash received from credit customers in payment of their accounts, or cash from other sources (such as a loan).
  4. The journal entry usually includes the date, the amount received, the payor, and the account credited with the cash receipt.
  5. In practice, almost all companies that sell to customers on credit keep an individual accounts receivable record for each customer in an Accounts Receivable (subsidiary) Ledger. The individual customer’s accounts are credited daily as receipts of cash occur.
  6. The cash receipts journal is totalled periodically and posted to the cash (debit) control accounts receivable (credit), cash sales (credit), and other (credit) accounts in the general ledger.
  7. The nature of a taxpayer’s business will determine the type and complexity of its cash receipts journal. It could be integrated with the cash disbursements in a checkbook or combined cash journal. Many taxpayers simply use bank records as a cash receipts journal. The bank statements or deposit slips are totalled and used for sales or gross receipts on the return. In this situation, failing to include non-deposited cash in gross receipts is a potential for an adjustment.

4.10.3.14.6  (03-01-2003)
Cash Disbursements Journal

  1. The cash disbursements journal is a special journal designed to handle all transactions involving payments of cash.
  2. Unlike other special journals in which all transactions result in debits and credits to the same accounts, all transactions in the cash disbursements journal result in credits to Cash, but require a variety of debit entries.
  3. Examples of transactions recorded in the cash disbursements journal include cash purchases, payments of obligations, resulting from earlier purchases on credit, or other cash payments.
  4. The journal entry usually includes the date, the amount paid, the payee, and the account charged with the disbursement for each check.
  5. In practice, almost all companies that purchase from suppliers on credit keep a separate accounts payable record for each supplier in an Accounts Payable (subsidiary) Ledger. The individual supplier’s accounts are debited daily as payments of cash occur.
  6. The cash disbursements journal is totalled periodically and is posted to the control accounts payable (debit), cash purchases (debit), other (debit) accounts, and cash (credit) in the general ledger.
  7. The nature of a taxpayer’s business will determine the type and complexity of its cash disbursements journal. It could be integrated with the cash receipts in a checkbook or combined cash journal. Many taxpayers simply use bank records, check stubs, or a check register as a cash disbursements journal. The bank statements or checks are totalled and used for various expense accounts.

4.10.3.14.7  (03-01-2003)
Payroll Register

  1. The payroll register is a special journal which includes a detailed listing of the company’s total payroll for each payday.
  2. The payroll register generally includes the name of the employee, hours worked, earnings, deductions, and net pay.
  3. The payroll register is totalled each payday to record the payroll journal entry, usually in the general journal.
  4. The journal entry results in a debit to the Salary Expense accounts, credits to FICA Tax Payable, Federal Income Tax Payable, and Other Payables (medical insurance, union dues, etc.) deducted from the employees’ earnings, and a credit to Salaries Payable for the net amounts due the employees.
  5. The nature and size of the taxpayer’s business will determine how the net amounts due the employee will be paid. Many companies use a separate payroll bank account against which payroll checks are drawn. Under this system, a check must first be drawn from a regular checking account for the net earnings due to employees and deposited into the payroll account.
  6. Besides the FICA Tax and Federal Income Tax deducted from the employees’ earnings discussed above, the employer must also pay FICA Tax equal to the amount paid by the employee, Federal Unemployment Insurance Tax (FUTA), and State Unemployment Insurance Tax (SUTA) . These three taxes on salaries paid by the employer are considered operating expenses. The journal entry results in a debit to Payroll Tax Expense and credits to FICA Tax Payable, FUTA Payable, and SUTA Payable.
  7. The FICA Taxes (both employees’ and employer’s shares) and the Federal Income Tax Withheld from the employees’ earnings are reported on the Form 941 and must be paid at least quarterly. Depending on the liability, payments may be required monthly or more frequently. The FUTA Taxes are reported on the Form 940 and must be paid at least yearly. Depending on the liability, payments may be required quarterly. The SUTA Taxes are reported on various state forms and payment dates among the states vary. Other payroll deductions (medical insurance, union dues, etc.) must be paid according to the particular contracts or agreements involved.

4.10.3.14.8  (03-01-2003)
General Ledger

  1. The general ledger is used to accumulate and classify the transaction data posted from the journals.
  2. The general ledger is self balancing and has an account for every balance sheet and profit and loss statement item.
  3. Periodic postings are made to these accounts. At the end of each accounting period:
    1. Proper adjustments are made to the accounts through the general journal.
    2. A balance sheet and profit and loss statement are prepared from the open accounts.
    3. Income and expense accounts are then closed.
    4. The net balances are transferred to the capital account.

     

  4. Some businesses include details of all entries in the general ledger, in effect combining the ledger and journal into one document. Others show only net debits and credits for each month, with the specifics recorded elsewhere.
  5. The mathematical accuracy of the account balances is tested by verifying the footings of some or all of the ledger accounts. Audit techniques include:
    1. The general ledger is scanned for entries that are unusual in amount, source, or nature. All significant entries are analyzed.
    2. Compare some or all of the account balances and entries recorded for the year under examination with the previous and/or subsequent year. This is an important task and can determine the depth and scope of your audit.
    3. Verify that entries in the general ledger were posted from authentic sources because the return is drawn from the general ledger balances. These balances can be falsified through the recording of unsupported debits or credits in the general ledger. Trace a sample of ledger entries back to the journals. Sampling techniques can reveal unsupported entries.
    4. Trace a sample of entries from the journal into the general ledger. An omitted transaction can be detected only by tracing from the source documents or the journals to the ledgers.
    5. Some errors, such as transposition errors in entering transactions and postings to the wrong account, may be discovered by tracing in either direction.

     

4.10.3.14.9  (03-01-2003)
Subsidiary Ledgers

  1. A subsidiary ledger contains the detail of a large general ledger account (i.e., accounts receivable detail). A taxpayer will maintain a controlling account in the general ledger that summarizes the totals in the subsidiary ledger.
  2. Subsidiary ledgers are not self-balancing.
  3. Subsidiary ledgers may be established for accounts such as:
    1. Accounts Receivable
    2. Accounts Payable
    3. Inventory
    4. Selling Expenses
    5. Property, Plant, and Equipment
    6. Investments
    7. General Expenses

     

  4. The general ledger control account balance must equal the composite balance of the individual accounts in the subsidiary ledger.
  5. The Accounts Receivable Ledger is a subsidiary ledger containing a chronological record of customer transactions. The customers’ accounts are usually filed in alphabetical order in the Accounts Receivable Ledger.
    1. Most taxpayers that sell to customers on credit keep an individual accounts receivable record for each customer. Including all of these accounts in the general ledger, with all other accounts, would be cumbersome. Credit sales are recorded as debits to the appropriate customer’s account and payments received from customers are recorded as credits to the accounts.
    2. When a taxpayer puts its individual customers’ accounts in an Accounts Receivable Ledger, there is still a need for an Accounts Receivable account in the general ledger to maintain its balance and to control the subsidiary ledger. It is a controlling account in that its balance should equal the total of the individual account balances in the subsidiary ledger. This is true because there must be postings to the individual subsidiary customer accounts every day and to the controlling account, in total, each month.
    3. The single controlling account in the general ledger takes the place of all the individual accounts in the subsidiary ledger and the trial balance can be prepared using only the general ledger accounts.

     

  6. The Accounts Payable Ledger is a subsidiary ledger containing a chronological record of supplier transactions. The suppliers’ accounts are usually filed in alphabetical order.
    1. Most taxpayers that purchase from suppliers on credit keep a separate accounts payable record for each supplier. Including all of these accounts in the general ledger, with all other accounts, would be cumbersome.
    2. Purchases of goods and services on account are recorded as credits to the appropriate supplier’s account and payments to the suppliers are recorded as debits to the accounts.
    3. When a taxpayer puts its individual suppliers’ accounts in an Accounts Payable Ledger, there is still a need for an Accounts Payable account in the general ledger to maintain its balance and to control the subsidiary ledger. It is a controlling account, in that its balance should equal the total of the individual account balances in the subsidiary ledger. This is true because there must be postings to the individual subsidiary supplier accounts every day and to the controlling account, in total, each month.
    4. The single controlling account in the general ledger takes the place of all the individual accounts in the subsidiary ledger and the trial balance can be prepared using only the general ledger accounts.

     

4.10.3.15  (03-01-2003)
IRS Enforcement Operations in High Assault Risk Areas (HARA)

  1. A High Assault Risk Area (HARA) is designated by the Area Director as one in which there appears to be hazardous conditions for Collection function personnel. All returns with a HARA Code assigned to Tax Compliance Officers/Tax Auditors are subject to the normal examination procedures. See IRM 4.1.1.8. However, due to the continuing problem of the security of Collection personnel in High Assault Risk Areas, the following steps should be stressed.
  2. If after the initial interview, a taxpayer is to furnish additional information, he/she should be encouraged to bring it in so that the adjustments may be processed at an interview and agreement secured. However, taxpayers should be accommodated if they prefer to submit additional information by mail.
  3. If the taxpayer agrees to a proposed deficiency, examiners will request and encourage payment of the tax due, together with any applicable penalty. The examiner will compute the interest and, when possible, include it in the payment from the taxpayer.
  4. If a taxpayer from a high assault risk area is unable or unwilling to pay the additional tax and/or interest, Collection function personnel will be contacted immediately on agreed interview cases. This contact could be made in person or by telephone. In offices where Collection personnel are not present, the examiner will prepare or have the taxpayer prepare Form 4966 (Current Collection Information). Completed Forms 4966 with a copy of the examination report will be accumulated and sent daily to the Collection function.

4.10.3.16  (03-01-2003)
Correspondence Examination Procedures

  1. Historically in a field office environment, correspondence examinations were normally conducted only when requested by the taxpayer. Over the years, correspondence examinations have increased significantly to include returns included in Nonfiler Strategies, Preparer Projects, and other local source inventory.
  2. Every attempt should be made to limit correspondence examinations at field locations. In addition, the use of Tax Compliance Officers, Tax Auditors and Revenue Agents to conduct correspondence examinations should be minimized, since cases commensurate with their grade level should normally require face-to-face interviews. Cases examined using the correspondence technique should only be assigned to Tax Compliance Officers, Tax Auditors or Revenue Agents when there are no qualified tax examiners or audit accounting aides available and a special compliance need exists.
  3. If there is a need to conduct correspondence examinations in field offices, every effort should be made to assign these examinations to tax examiners or audit accounting aides, but only those who have been adequately trained to conduct examinations.

4.10.3.16.1  (03-01-2003)
Correspondence Examinations Conducted by Tax Examiners and Audit Accounting Aides

  1. Management will ensure that tax examiners and audit accounting aides conducting correspondence examinations
    1. Receive the appropriate training (minimum Revenue Agent/Tax Compliance Officer Unit 1 Technical Training and Revenue Agent/Tax Compliance Officer Unit 2 Technical Training).
    2. Work only those cases suitable for their grade and experience level.
    3. Issue the appropriate initial contact letter for correspondence examinations (See Exhibit 4.10.3-10).
    4. Use Project Code