AUDITING SMALL AND MEDIUM SIZED ENTERPRISES 13.AUDIT TOOLS AND TECHNIQUES

1. AUDITING SMALL AND MEDIUM SIZED ENTERPRISES13.AUDIT TOOLS AND TECHNIQUES Ghana, 4 – 8 October 2010

2. Types of businesses • To know how to run a business is to know how to audit a business • Businesses can be divided into standard types • This typology is based on the internal controls and correlations • It will also suggest the tools and techniques that might be used to audit the revenues of the company • It is just a general framework: knowledge of the business at hand will lead to a concrete audit programme, depending on facts and circumstances • So the initial interview with the taxpayer is important to get to know the business • Even if this information is available on the internet or from an earlier audit it is necessary to have this interview: to update and to discuss any particular points

3. Direct and indirect methodsto establish the taxable income • The direct method: the total of all direct information - wages/salary - interests - rents from immovable property - sales of shares - deductible expenses - profits and losses • As this information is delivered by the tax payer or reliable third parties it will be used as correct information, there is a burden on the Tax Administration to proof incorrectness • Regarding expenses: the onus of proving that these are correct lies with the taxpayer

4. Existence checks • Stock-taking: • based on the taxpayer’s organisation of stock-taking • on site observation if the recorded goods/cash/ equipment exists • as the aim of a tax audit for assets seeks to find more goods than recorded ( completeness ) this technique is not that useful • However: if an asset can’t be found, it might have been sold and you have to account for the profit

5. Existence checks • Expiration checks: - on accounts payable: if they are paid after balance date, their existence at balance date is very likely - on accounts payable : if they are not paid: 3 possibilities: 1 they never existed> try to establish how they came on the balance sheet 2 they were paid before balance date>delete and adjust 3 the value is too high, as the taxpayer doesn’t want to pay or just a part of it ( perhaps he doesn’t agree with the price or quality)

6. Completeness • Auditing for completeness is difficult • Completeness of revenues/sales will be discussed elsewhere • Completeness of receivables: check payments and invoices in the year after balance sheet date: invoice or delivery of last year should be in the balance sheet • Completeness of stocks and/or other assets: - Invoices from suppliers in the year after balance date: if the date of delivery is before balance date, the goods should be in stock or (partly) sold before balance date - Look around in the accounts and at the premises: any goods forgotten? One might even discover goods (not mentioned in the selection of the business) that never have been recorded, not even the sales of these goods

7. Indirect methods • All these methods are used to establish the taxable income from secondary or linked information • Often used by the Tax Authority, so burden of proof on them • The use of estimates makes it necessary to use different indirect methods in the same audit

8. Indirect methods • Bank deposit method • Source and application of funds method • Net worth method • Capital comparison method • Percentage of mark-up method • Unit and volume method • Negative cash balance method • Chi-square test

9. Selecting an indirect method • Critical to effectively and efficiently determine the correct taxable income • Bank Deposits and Source and Application of Funds methods have their shortcomings if cash is not deposited or cash cannot be determined • Difficulty is identifying personal acquisition on expenditures if the taxpayer has taken steps to hide them • Issues could be overcome by using a method based on the taxpayer’s business activities, for example, mark-up or unit and volume methods

10. Auditing Small and Medium Size Enterprises 14. EDP Audit

11. Electronic Data processing (EDP) - audit • Rapid development - paper books, records and documents will be replaced by data transmitted electronically • These changes mean that it is necessary to make adjustments to examination methods • A different approach also opens up new opportunities • Number of specialists needed will increase

12. Products of EDP auditing • Preliminary investigation - taking stock of the information technology applied by the taxpayer in order to determine how information technology and the internal controls of the taxpayer interact • The relationship between risk analysis and the quality of the information technology - the assurance gained by a tax auditor can be increased through a systems audit by an EDP auditor

13. Products of EDP auditing (continued) • System audit of standard software - this standard software includes applications developed by software companies that are used by a lot of taxpayers • Data gathering and data conversion – in the preliminary investigation it has been established which electronic data of the taxpayer can be used in the EDP audit • Data analysis – which data to analyse and how, also follows from the planning stage

14. Products of EDP auditing (continued) • Sharing information gained while carrying out an audit (which may include the evaluation of this knowledge) via computer records – EDP auditing has an innovative and supporting role with the objective to transfer knowledge • Specific support of tax audits – making internal data available is part of this class of instruments and services

15. IT and EDP-auditing: OECD products • OECD Tax e-Audit Group products: • Guidance and Specifications for Tax Compliance of Business Accounting Software (2009). This document describes in general terms the standards that should be applied in the development of tax accounting software. • Record Keeping Guidance (2003 publication). The purpose of this paper is to set out guidance that will encourage appropriate standards for record keeping by businesses offering services or products via the Internet.

16. IT and EDP-auditing: OECD products • Guidance on Test procedures for tax audit assurance (2009). This paper contains a detailed inventory of compliance and substantive tests performed by tax auditors, which could also be performed by businesses to check the operation of their internal controls. • Standard Audit File-Tax (2009). This paper describes a standard audit file for tax purposes that also includes inventory data elements. SAF-T can be used for both internal and external test programmes.

17. IT and EDP-auditing • Via the GTCBAS Tax Authorities are encouraged to develop a regulatory framework regarding an automated accounting system • Auditors - not being an EDP-auditor - should have some basic knowledge of automated systems • They should be able to - work with Word, Excel, PowerPoint and special developed tax software - read computerized output - translate their audit questions into queries for EDP-auditors • When planning an audit it will be useful to consult the EDP-auditor • Special attention should be paid to tables with fixed data ( like VAT rates, inter company prices, etceteras )

18. Identifying records meeting specified criteria (exception reporting) • An exporter had not reported their employee tax correctly • Auditor identified a number of individuals who he suspected were employees • Analysis undertaken by Computer Assisted Verification by searching key fields and identifying payments made to the individuals in questions • Payments to individuals were identified • Computer analysis only took two days – manual analysis would have taken a lot longer

19. Test and make calculations • The auditor was reviewing a taxpayer as part of a project looking at disposal of assets to determine whether there was any GST/VAT risk • Taxpayer found to be claiming GST on purchases of plant and equipment upon importation and again where the same equipment was financed • Using computer assisted techniques the auditor was able to easily and quickly identify all incorrectly claimed GST credits

20. Compare data in separate fields or on separate files • Auditor was reviewing the taxpayers wages claim • She requested the taxpayers electronic payroll file • She then collected all the invoices relating to services supplied by the company and collated these in a spreadsheet • She then used computer assisted tools to run a check on wages paid versus services billed • An excessive claim for wages was identified

21. Summarise datafor example, summarise accounts receivable by age – one month, two month etc. • The taxpayer had upgraded their accounting software • The auditor wanted to check the integrity of this upgrade to insure there was no risk • Electronic data from an earlier back up was analysed using computer assisted techniques • Gaps were identified in the invoice numbering system • Missing transactions were identified

22. Specific testing • The auditor wanted to check to ensure all sales had been returned as income • He wanted to confirm that the taxpayers trading pattern matched sales returned in their cashbook • Taxpayer traded Monday to Saturday • Computer verification revealed there were no sales recorded for Saturday

23. Discovery test • Testing for data anomalies such as duplicated transactions • The auditor wanted to check the taxpayers accounting system to ensure there were no systemic errors • A number of duplicated transactions were identified by the computer assisted verification tools • Further testing of these transactions resulted in over claimed expenses being identified

24. Other examples in brief • EDP tools can be used to test for: • Negative transactions • Missing invoice numbers • GST/VAT credits claimed more then once • Highest and lowest transactions • Identify and review cash and blank transactions • Check general journal entries • Significant transactions • High value inventory items

25. Common elements in cases • Large amount of data to analyse • Analysis of voluminous transactions is critical in achieving the objectives of the audit • Usually no other alternative than to use computers due to the amount of data or time constraints

26. Auditing of Small and Medium Size Enterprises 15.Falsification / Fraud Cases

27. Falsification • Documents are just paper! • A perfect forgery looks like a normal document • Internet makes it much easier to forge or falsify a document • Tax authorities might have a specialized unit (labaratory) for research on suspicious invoices • Suspicious taxpayers on the internet use - amongst others: - www.companieshouse.go.uk - www.taxsites.com - www.dnb.com • OECD’s Guidance for ”Internet Search Tools”

28. False Documents: Indications ·Abnormal dates (constructing a roof before the walls) · Description of goods doesn’t fit in the line of products · Place of delivery (private address/ outside region) · Quantities · Invoice heading, lack of logo, or not the usual format · Lack of invoice number · The invoice looks like it has been copied, a blurred text • Use of different fonts within the same invoice

29. False Documents: Indicationscontinued • Once a suspicious document has been traced: the auditor might go along the audit trail to find missing documents or indications that things are not right: - no purchase invoice where there is a sale - different delivery address on the trucker’s note - no internal note for the reception of an important asset - no production order …

30. Auditing Small and Medium Size Enterprises 16. Capital Comparison

31. When to use • Taxpayers records are incomplete, inadequate or unreliable • Has significant cash transactions • Has accumulated substantial assets and returned income (if any) is inconsistent

32. Capital comparison method • Capital at start plus / minus adjustments to capital at start plus • Reported income minus • Capital at end minus • Known private expenditures for major investments should be enough to spend on • Household

33. Capital comparison method • Capital at the start is all the taxpayer’s assets minus his liabilities ( bank deposits, shares, cars, immovable property minus loans, etc.) • Adjustment to Capital at start is …… • Reported income stated in the tax return • Known private expenditures ( television, courses ) • Household money spent on food, clothes, sport, leisure, etc.)

34. Capital comparison method • If the amount for household is negative there must have been some unreported income to support this expenditure • This will also be the case if the amount for household is too low compared to families in the same economic and social position • An adjustment should be made up to a level where the amount for household is equal to that of families in the same economic and social position

35. CCM, an example • At the end of 2003 Mr. Bond owns a house he bought for $ 300,000 and there is still $ 50,000 in his bank account. He sold his old dwelling for $ 230,000, which was also the value at 1-1. • His reported income was $ 65,000 after a fictitious legal deduction of $ 5,000 for 3 children. • His bank account showed a deposit of $60,000 at the beginning of the year. • In his bank statements we also found expenditures for a new kitchen ($ 20,000). • The furniture in his new house looked rather new and during an interview he volunteered the information that he had paid $ 10,000 for it.

36. CCM, an example • Capital at start house 230 bank 60 290 • Reported income: 65 plus legal deduction in respect of children 5 70 ------ + 360 • Capital at end house 300 bank 50 350 ------ - 10 • Major private expenditures furniture 10 kitchen 20 30 ------ - • Household - 20 Conclusion? ====

37. More on the Capital Comparison Method It is an art to gather information that ’s not so obvious. In addition to a thorough initial interview, information can be gathered from numerous sources: • 3rd party information available? Investments abroad? Taxpayers travel patron? • Any reason to look into taxpayer ’s file at the bank ( any legal opposition? ) • Tour of business and residence ( Ownership of boats, cars, camper vans, etc? ) • Research the internet for organizations, assets, indicators of lifestyle

38. More on the Capital Comparison Method • Do you find any hints in the books or correspondence indicating large expenditures: such as a letter from a notary, a lawyer, insurance premium? • You might also find indications for the standard of living; a set of golf clubs might indicate that the taxpayer is a regular player, which will bring along a membership fee and other investments • When interviewing the taxpayer he might provide you with information about his lifestyle and in particular about the things he is proud of ( large garden: who is doing the maintenance work? )

39. More on the Capital Comparison Method • You might find other sources of income • Are they liable to taxes under your national legislation? • E.g. transactions at the stock-market • Depending on taxable or not taxable: adjust the comparison ( a win at the lottery ) • Some amounts in the taxpayer ’s return might not reflect a cash or bank income. ( amounts fixed by law or something of that kind: an adjustment has to be made ).

40. Issues to consider when finalising adjustments • Consider the reasonableness of the discrepancies • As far as possible reconcile any apparent understatement with known omission • Keep in mind that the CCM is not an exact science and be prepared to negotiate

41. Defending an adjustment • Provided the method is based on reliable estimates of the assets acquired by the taxpayer, the adjustment that results will have a good standing in court • The taxpayer would need to establish that the adjustments or the assessments are excessive

42. Defending an adjustment (continued) • To successfully attack the CCM a taxpayer will need to prove one or more of the following: • Capital at start is UNDER stated • Capital at end is OVER stated • Living expenses were LESS than alleged by the auditor • Non taxable amounts they received during the year such as betting wins, gifts, legacies, exempt income etc was GREATER than acknowledged by the auditor

43. Auditing Small and Medium Size Enterprises 17. Negative Cash Balance method

44. Negative cash balance method • This method is based on the fact that the cash balance should always indicate a positive amount • If the taxpayer’s cashbook shows a negative amount he registered a non existing expense or he did not register for some sales • So the object is to audit the original cashbook • The auditor might check on any date if the cash balance is still positive • The auditor may have to put the cash book entries into the correct date order, so that he can check the cash flow

45. Chi-square test • Proves that there are fictitious entries in the cashbook • Based on statistical procedures • Also based on psychology: everyone has a preference for certain digits • When producing an artificial list of numbers the preference numbers will appear more often than in a random made list • Statistical calculations will underpin the outcomes • The auditor need sufficient numbers ( minimum: 50 ) • This method will stand in court in some jurisdictions as an extra proof for unreliable records

46. Chi-square testCalculation and Evaluation • In a two, three or more digit number don’t use the first digit. It might often be the same ( 1 or 2 ), so not usable for the test. • Example: 304 daily postings re sales ( 365 minus Sun-, Satur- and holydays ) digit frequency theoretical difference difference frequency squared ----- --------- --------- ---------- --------- 0 17 30,4 13,4 - 179,6 1 20 30,4 10,4 - 108,2 2 59 30,4 28,6 + 818,0 et c et c et c --------- --------- ----------- --------- 304 304 0 1882,4 X SQUARE= 1882,4 DIVIDED BY 30,4 = 61,92

47. Chi-square testCalculation and EvaluationStatistically proven chance of coincidence:with x-quadrate > 60 it is almost impossible that the amounts in the cash book are not fictitious

48. Case study • Discussions on the next cases dealing with the capital comparison and the negative cash balance in the cashbook

49. Auditing Small and Medium Size Enterprises 18. Mark up methods

50. Percentage mark-up method • Also known as the Gross margin method • Used for trading companies and other businesses with a flow of goods ( restaurants, bars ) • Margins have to be fixed for a certain period of time • Can be applied to the total of sales/ product groups/ one product • Apply before going to the Unit and Volume Method • Most annual accounts and tax returns will show gross margins • Comparing Gross Margins is a very useful tool when looking at a large number of businesses as apart of a risk profile ( or mapping ) exercise • In quite a few OECD countries a standard profit and loss account is a legal obligation • This standard p&l should show gross margins