A. Initial Examination Techniques
One technique that should be commonly used is for the Revenue Officer to interview the taxpayer or his representative and ask him to walk him through the book recording of a sale, purchase and expense transaction in order to have a thorough understanding of the taxpayer’s accounting system and records.
B. Reconciliation of Books and Returns
Another step in understanding the records is to perform a reconciliation of the books with the return. The following actions are recommended to assist the Revenue Officer in the reconciliation process:
- Request for a Chart of Accounts and identify account numbers and account titles.
- Identify unusual accounts.
- Scan the general ledger to discover unusual account entries.
- Ask the taxpayer for the tax working papers or any other type of working papers that were used to prepare the return.
- If the working papers are in the hands of the external auditor, the taxpayer should be advised to secure a copy thereof from their auditor.
- If no working papers are available, request the taxpayer to prepare the reconciliation and supporting schedules used to arrive at the reconciliation of data as reflected in the books and the tax returns.
C. Performance of Compliance Tests
The Revenue Officer should establish the level of reliance that can be placed on the books and records and determine whether the books show all the transactions which occurred.
To accomplish this, a compliance test should be performed on some transactions through the backward and forward approaches in verification as follows:
- In the backward approach, the figures per tax return are traced to the trial balance, then to the general ledger, the various journals, and ultimately to the source documents such as sales invoice or official receipts.
- In the forward approach, the Revenue Officer should select a supporting document, say a sales invoice, and trace it through the sales journal, general ledger, trial balance and finally to the tax return.
- The backward approach is effective in checking unsupported expenses while the forward approach is used in uncovering unreported income.
D. Analysis of Adjusting Journal Entries
It is important that the Revenue Officer understands adjusting journal entries because tax issues are frequently discovered in the adjusting journal entries. These adjusting journal entries are usually accruals, deferrals, corrections or classifications of accounts.
- Accruals are normally entries to record certain known and fixed amount of obligations or liabilities. Accruals are also used to book uncertain, contingent liabilities. Contingent liabilities are not fixed in amount or date and are not deductible for tax purposes.
- Deferrals are typically used to defer or postpone recognition of income or expenses. An inspection of the deferred income account may reflect amounts representing services already performed. It may also show goods already shipped and received by the customer. In both of these situations, a deferral of income is not proper.
- Corrections of prior year’s earnings, other adjustments and classifications are made through adjusting journal entries which are recorded in the general journal or in the journal vouchers. Usually, these entries are taken from the auditor’s working papers. The examining Revenue Officer should scrutinize these entries, specially those credited directly to retained earnings, analyze the tax issues involved, and note down possible tax assessments.
- When scanning adjusting journal entries, the following should also be looked into closely:
- Unusual and nonrecurring entries;
- Entries reducing assets as there could possibly be unreported gain on sale, incorrectly computed gain on sale, incorrectly computed installment sale, non-taxable exchange, or withdrawal of goods by the owner; and