Internal Revenue Manual 4231-582
During the course of the study, it was determined the audit guidelines established for gross receipts or sales in IRM 4231-582 along with the proper balance sheet analysis provided sufficient coverage in the income area. The IRM section is reprinted below for the reader's convenience with a few additional suggestions or observations. As stated previously, the applicability of the steps below should be considered in
conjunction with the evaluation of the taxpayer's internal controls.
(1) In the initial testing of the sales account, the following techniques may be considered:
(a) Test methods of handling cash to see if all receipts are included in income. Scan daily cash reconciliations and related book entries and bank deposits. Note any undeposited cash receipts on hand at the end of the year.
Note: Several errors were detected using this method whereby the original billing per the sales invoice did not match the subsequent cash receipts.
(b) Test reported gross receipts by the gross profit ratio method. * * *
(c) Note items unusual in origin, nature, or amount in the books of
original entry and test them by reference to original sales slips, contracts, job record book, bank deposits, etc. Also, check selected entries made at different times of the year, including some at the beginning of the year. Test check footings and postings to the general ledger.
Note: In one case, the sales journal was scanned and a one-time sale was made to a company with almost the exact same name as the taxpayer. The follow up to this entry revealed a separate company which was related by common ownership. The entry was traced to the separate company where it was determined the shareholders were allocating income and expenses between the two companies to affect the taxable incomes. In this particular case, one company was doing very well and the other operated at a small loss. Therefore, in this case, the reporting of income by one and the expense by the other did not result in an equal increase and decrease in tax.
(d) Review bank statements and deposit slips for unusual items. * * *
Note: This step was discussed in Chapter 4, Balance Sheet, under Cash section.
(e) Scan the sales account in the ledger for unusual entries. Test entries from the general journal and sales journal. Compare total receipts to total business income bank deposits and reconcile any differences.
Note: In one case, the taxpayer was making large and consistent debit entries to the sales accounts. The original explanation was that the entries were returns and allowances. However, upon subsequent examination it was determined the debit entries represented customer checks that could not be processed because of
insufficient funds. The bank would debit the taxpayer's account (credit entry on the taxpayer's books) and the taxpayer would debit sales rather than accounts receivables.
The taxpayer stated these entries were allowable under the bad debt provisions but could not refute the fact many of these accounts were collectible in the future.
(f) Be alert to the possibility of income which may be taxable even though not appearing on the books (dealer reserve income, constructive receipt, income from foreign sources, etc.).
(2) If the results of these initial tests compare favorably with gross receipts reported, further verification would generally be based on the particular circumstances of the case. For example, a high percentage of cash receipts which are not regularly deposited or properly accounted for would be a basis for further testing.
(3) If further verification is necessary, the following techniques should be considered:
(a) If original receipts and records are not too numerous, match up
invoices, contracts, or similar documents with any records kept by job or contract and reconcile any differences. If receipts and records are
numerous, test check at various intervals and also look for unusual items. If possible, test quantities of the principal product sold in comparison with production or purchases. * * *
Note: This step is especially pertinent with manufacturers who produce commercial products such as grocery counters, large shelves, or development projects. In most cases, the job must be bid for and a contract is drawn up. The examiner should be aware that supplemental contracts (also known as change orders) may be drawn up in special circumstances which should be included in income also.
(b) Check the receipts to the sales or general journal and reconcile any differences.
(c) Question any unusual sales discounts or allowances.
Note: See Chapter 5, for common discounts and allowances given. (d) Determine the extent to which receipts were used to pay operating expenses, liabilities, personal expenses, etc. * * *
(e) Determine the method and adequacy of accounting for
merchandise withdrawn for personal use. Withdrawals should be accounted for as the merchandise is withdrawn and not on an estimated basis.
Normally, purchases will be reduced by the cost of such merchandise; however, the amount may be credited to sales.
(f) If the taxpayer reports on the accrual basis, determine if all receivables are included in income.
documents for sales booked in the subsequent year. These sales were erroneously booked in the next year. The materiality, corporate tax rates, and potential interest received should be considered before proposing the adjustments.
(g) Scan sales agreements, contracts, and related correspondence for leads to unrecorded bonuses, awards, kickbacks, etc.
(h) If the records indicate contracts or sales may have been completed but corresponding income not reported, further inquiry should be made about the sales. If practical, check journal entries and bank deposits for the first few weeks of the following year to see if the amounts were taken into income at that time.
(i) Review work papers made for tax return purposes and make sure adjustments are appropriate. Reconcile receipts per books with receipts reported. Resolve any differences.
Note: In some cases, the taxpayer was on the cash method per the books and made adjusting journal entries at the end of the year to arrive at the accrual method. These journal entries should be scrutinized carefully (especially the receivables and payables for both the beginning and ending of the year).
(j) It may be necessary during the examination to secure additiona records, documents, or other clarifying evidence. If such additional data will resolve matters, advise taxpayers of what is in question and the information needed. They should then be given an opportunity to furnish the information.
Note: The examiner should not hesitate to utilize a summons if the records prove inadequate or the taxpayers unresponsive to requests. In one furniture case, it was necessary to summons not only the corporate bank records but the shareholders as well. The information revealed many unexplained deposits in the form of cashier checks and cash. Ninety percent of the cashier checks were under $10,000 thereby avoiding currency transaction reports. These records, along with other corporate records obtained with a summons, were the basis for a criminal fraud referral.
(k) Be alert to indications of:
1 Capital gain treatment of items which may constitute ordinary income.
2 Sales made or services rendered in exchange for other goods and services which were not included in income. [Bartering])
on the taxpayer's business premises. In some cases, there may be arrangements for operating concessions or businesses such as cafes, bars, candy counters, vending machines, and newsstands.
Other Recommended Income Probes
1. Commission expense comparison. The commission expense can be used to
extrapolate a sales figure for comparison with the sales reported on the return. For instance, if the majority of sales are generated through an independent sales force, the examiner can compute an average commission sales percentage. The
commission expense, per the return, can then be divided by this percentage to arrive at an estimated sales figure. If there is a large discrepancy between the two amounts in either direction, ascertain the reasons why.
2. Request IDRS/CBRS information. Presently, certain transcripts are available which show Form 1099 information issued to corporations. Even though not required, some brokerage firms will issue Forms 1099-INT or 1099-DIV to corporate taxpayers. Examination of these transcripts (BMF) may reveal bank accounts not indicated in the books and records. Currency Transaction Reports may also indicate cash transactions which would lead to further inquiries.