What Is an Indirect Method of Testing in a Sales Tax Audit?

What Is an Indirect Method of Testing in a Sales Tax Audit? On it so in a prior video we talked about with the direct method of testing is direct method of testing involves testing actual source documents lining up and comparing them when you have a breakdown in the direct method then sales tax auditors will resort to what they call indirect methods a testament indirect methods of testing or is a fancy way of saying we're gonna guess play guessing games with statistics so one of the indirect methods of testing is audit path sales they look at current sales and they'll do statistical comparisons between past sales and current sales so one of the easiest ones they do is they do an observation test they'll send an auditor in a business for a couple of days to look at the sales that are being performed whether the employees are ringing everything up correctly whether they're charging tasks and then the auditor will sit there and literally record every single transaction and they'll compare that against the POS system reports to see if there are any discrepancies and then that's called an observation test so if there is an error within that test then they'll do certain things based on.

The error the other thing they can do is they can take the POS system reports in a current period and do a cash to credit card ratio so a lot of the times they'll take your credit card ratio which can be verified by your 1099 KS and they'll say okay here's the percentage of credit card sales based on current here's the amount of cash sales and we're just going to project that across the corner so the problem that we see with indirect math testing let's take the castor credit-card ratio for example auditor comes in and says I'm going to do two days of testing in a business I'm gonna do a restaurant and I'm gonna come in Tuesday at lunch time and I'm gonna come in Sunday afternoon so what the auditors saying is based on two days of testing that two days of testing is going to be used for a sample as a sample because they're taking two days so they're going to take that sample and they're going to apply it to a population population being a total data set I'm going to take a two days sample and they're going to apply it to a three-year period of a population so the three year pop population is over a thousand days they're going to take two days of sales they can say these two days of sales.

Tuesday at lunchtime Sunday afternoon or representative of this entire thousand days of sales hopefully you can see the problems with that some businesses do more credit card sales on the weekends some businesses are seasonal and will do sales more frequently at certain times and more frequently on others with restaurants you have families going out on Saturday nights for dinner those tend to be larger checks and so you tend to pay larger checks on credit cards unless you're walking around with a fistful of cash so depending on a little things and this is why indirect methods of testing are so dangerous little little hinges swing big doors so these little statistical changes can make a huge result as to the liability they could have massive impact and we've seen situations in the firm we have a client that they the CDT afaik came in and they said look we think that your client has underreported three million dollars in cash sales and just lifts out there and look at the agent I said if you really think they underreported three million dollars in cash sales.

Where's all the cash they didn't deposit three million dollars in cash in the bank so what you're telling me is they went home they stack the money under their mattress they got three million dollars in cash sitting room this giant brick under their mattress and they've just been warning it and where they've been going around and spending all this cash on his years which is not supported by any basis in reality and if you actually thought they were under reporting three by any cash you would have sent the guys with the windbreakers in the handcuffs to the flak jackets afternoon criminal people so that's why indirect methods are so dangerous and I use that as an absurd example because it was an absurd example but that's what happens when you have these statistical things so you need to be very very careful with indirect methods of testing and one of the reasons I advocate for you're gonna have somebody representing in a sales tax or they've gotta know about statistics is because of these situations we find so many statistical errors these auditors aren't statisticians so we find so many errors in the way that they're doing their statistical analysis the tightness of their control their procedures the way they're applying samples to populations I mean it's just a mess so that's the way than indirect methods of testing working that's frankly why they're so dangerous so whenever possible you want to avoid indirect methods of testing and focus on direct methods of testing because direct methods of testing are much more reliable than their indirect brother.


Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law