Welcome to Part Three in the CDTFA sales tax audit series. In Parts One and Two, we provided an overview of how an audit is conducted and how companies are selected for audit as well as audit procedures and techniques.
Now you will learn how to prepare for an audit, including how to work with an auditor and which records and documents to have ready. You will also read about audit testing and sampling as well as the PAPE program and cut-off techniques.
One note before you begin your preparations: be ready to comply with auditor requests but do not volunteer additional information. Do not sign anything without careful examination because the auditor is unlikely to explain the consequences or agreements; it is up to you to research and clarify what you do not understand.
Working with the Auditor
Like your parents told you, first impressions are important. Display your best manners and a helpful attitude. Respond promptly to meeting requests even if it is to negotiate a time better suited to your business. If you have been courteous the auditor will be more likely to be flexible.
Provide the auditor easy access to your facility. Include a tour to review the workflow, the types of controls you have in place, and to explain the use of any new machinery. If the auditor is on the premises for a while, offer a comfortable desk or office.
Being obstructive or offering an uncomfortable environment will only work against you. It can indicate guilt and antagonizes the auditor.
Help the auditor understand your specific business so records can be examined in the correct context. This is especially important if you have an unusual business or accounting methods.
Provide access to a staff member or employee that has a good understanding of the business and is capable of answering questions or locating documents in your absence. This saves time for both you and the auditor.
That being said, the auditor should not be conducting informal conversations with staff members who have incomplete knowledge of the business. The audit may become more extensive, or issues may occur due to the passing of inaccurate or incomplete information.
You will have received a list of records and documents in the audit engagement letter telling you what you must have ready and available. Providing these documents neatly and carefully and demonstrating transparency and a willingness to work with the auditor can make the process more comfortable.
If a request is unclear, ask the auditor to explain. Some requests are generic and may not apply to your particular business. Talk about any alternatives the auditor may want instead. If you are asked to prepare documents for a time period that is not representative of how your business normally operates you may be able to negotiate with the auditor, which will go more smoothly if you have been reasonable and open throughout the process.
Some examples of common records requested include:
- Accounts Payable (A/P)
- Accounts Receivable (A/R)
- General Ledger (G/L)
- Federal Income Tax Returns (FITR)
- Supporting documentation such as purchase orders, paid bills, invoices, contracts, and customer exemption certificates
The process is not meant to be inconvenient, but transactions can get lost, chargebacks occur, returns aren't accounted for clearly…things happen. If the auditor is unable to follow a trail or find all the documentation, be willing to cooperate. If you do not assist, the auditor may make an assessment based on a lack of information. Everyone will work harder, and the outcome may not be positive.
It is much better to keep a transaction out of an audit finding at the start than fight to have it removed from the findings later. If the information cannot be found, and if the CDTFA district administrator approves, CDTFA staff can request information directly from your financial institutions, either with your approval or by subpoena.
Tests and Sampling Methods
The California Department of Tax and Fee Administration tries to streamline the audit process whenever possible. One way audits can be performed more quickly is by using a short test at various points in the process.
The auditor will examine any record, supporting data, or other information to determine whether or not to proceed with the audit on that document or if it can be accepted as correct without further examination or investigation.
A short test can be expanded into a full examination anytime but saves time when a full examination is clearly not required to establish accuracy. In some instances, a short test is designed as a control test of documents over a short period to determine the most representative sample size for audit.
Testing is split into two categories: statistical and block sampling. Block sampling is used when statistical sampling is not possible. The auditor also looks into the conditions for employing the tests, especially when looking at the consistency of units sold or in business characteristics during the test period.
The size of the test period depends on what it takes to provide reasonable accuracy without excessive effort in comparison to the problem. Test periods are usually complete months or quarters. If daily or weekly controls are established, periods shorter than one month may be selected.
If your business has excellent controls, the test period will probably be a very small sample of the audit period.
PAPE Program and Cut-Off Techniques
The PAPE (Prior Audit Percentages of Error) program is another method of streamlining the audit process, but its use is limited to a particular set of circumstances. The program uses the percentage of error developed in a prior audit for the sales and accounts payable portion of the current audit.
To be eligible for PAPE, you must have been audited at least once before, and your business operations must meet certain standards of consistency during both the prior and current audit. PAPE cannot be used in two subsequent audits, only in the most current audit.
Cut-off techniques are methods of determining when to stop testing or examining data. Cut-offs can be used for the entire examination or a specific test or piece of data. The auditor has the discretion to accept test results, alter the audit approach, or to discontinue the audit on the strength of tests already completed.
The auditor’s biggest consideration when determining acceptance is the existence of errors. The auditor decides whether errors do exist, whether or not to keep testing, and whether to disregard the errors. If the test results are accepted, then the auditor has reached a cut-off.
One other time-saving technique is whole dollar auditing in which all transaction amounts are rounded to the nearest dollar to make calculations easier. It will not be used if you object or when markup form shelf orders are being calculated. It also will not be used if precise data is required.
The auditor generally tries to work with you and keep the inconvenience to a minimum as long as you do not create problems. Have records ready and remain cooperative for an efficient audit.
In Part Four, the final part of the series, we will take up what happens after the audit is complete.