All businesses are not audited in the same manner. The audit methodology for some are set by statute (in California, grocery stores reporting using the “Grocer’s Method” must be audited using the same method), while some industries have unique reporting requirements and must be audited accordingly.
A good example of an industry with unique reporting requirements is the construction contractor industry - these businesses generally owe tax on the cost of their materials rather than the selling price of their labor and materials. As a result, audits will focus on their purchases rather than their sales. But even your basic run-of-the-mill retailers and manufacturers can be audited in different ways and that determination is based on how they complete their sales and use tax returns.
Generally Accepted Reporting Methods
There are three broad variations for completing a sales and use tax return:
- Sales Down:In this method, recorded exempt sales are subtracted from recorded gross sales to arrive at recorded taxable sales. Tax due is then computed by applying the appropriate tax rates (based on ship to and ship from zip codes as applicable) to taxable sales. Tax due should equal tax recorded (accrued).
- Gross Sales – Exempt Sales = Taxable Sales
- Taxable Sales*Tax Rate(s) = Tax Due
- Pure Tax Up: In this method, sales tax charged is capitalized (divided by) the appropriate tax rate to compute taxable sales. Taxable sales are also reported as “total” or “gross” sales. In other words, all non-taxed sales are netted and only taxable sales are reported.
- Sales Tax / Tax Rate = Taxable Sales
- Gross Sales = Taxable Sales
- Modified Tax Up: This method computes taxable sales in the same way described above, but also provides recorded “total” or “gross” sales. Non-taxed sales become a “plug”* figure as the difference between recorded “gross sales” and computed “taxable sales.”
- Sales Tax / Tax Rate = Taxable Sales
- Gross Sales – Taxable Sales = Exempt Sales
An auditor should first establish which of these three methods has been employed during the audit period and plan the audit program accordingly.
Sales Down: Taxpayers using this method basically intend to report exactly what they have recorded. Unless there are clerical errors when entering numbers on the forms, all sales should reconcile. The only potential difference with sales tax due would occur if the taxpayer used tax rates that differ from the rates on the forms.
The audit program for this method will emphasize reconciling recorded amounts from the General Ledger and/or Financial Statements to the sales tax returns. Assuming there are no differences, the auditor is able to test the various areas (claimed exempt sales, tax rates applied to taxed sales, correct and complete posting of all sales invoices) directly to values on the sales tax returns to establish any additional liability.
Pure Tax Up: Taxpayers using this method are concerned with a single aspect of sales and use tax - reporting exactly the amount of tax accrued. Essentially, the form is completed from the bottom up - recorded tax amounts are entered on the form and then the taxable sales are computed based on the tax rates. Exempt sales are ignored entirely for reporting purposes. Here the auditor must establish both gross sales and total non-taxed sales before applying any tests to those sales categories.
Obviously there is no value in attempting a reconciliation of recorded sales amounts to reported amounts. Gross sales will never reconcile as long as there were any non-taxed sales and taxable sales will reconcile only if the exact same tax rates were applied to the invoices as appear on the forms. Here the auditor must establish both gross sales and total non-taxed sales before applying any tests to those sales categories. The audit findings will look a bit strange if the auditor finds problems with the non-taxed sales; the taxpayer will be assessed tax on disallowed exempt sales when none were ever reported/claimed. The tax accrual account is still reconciled and the applied tax rates are also tested.
NOTES: This method technically violates reporting requirements in most jurisdictions; taxing authorities want to have gross sales reported so they have a true picture of the scope of the taxpayer’s activities and so they can see how many sales are not being taxed. This method should never be used in “gross receipt” states such as Hawaii and Washington.
Modified Tax Up: This is the most common reporting method among businesses who outsource their sales tax compliance. The reason for this is that Modified Tax Up method assures tax reported will equal tax accrued. This could be a problem if the tax rates used by the taxpayer and the outsource provider are not the same; different rates applied to the same taxable amounts will result in tax being over- or under-reported. This method also assures gross sales are reported.
For this method, the auditor reconciles reported and recorded gross sales and total tax. However, the amount of non-taxed sales cannot be accepted as the basis for any tests; as explained above, exempt sales are merely a plug* figure. The auditor must establish the true recorded amount of non-taxed sales and apply any test results to that value.
Audits and Reporting Methods
While the concept of basing audit programs on the taxpayer’s reporting method may seem obvious, many auditors fall into the trap of applying a single approach to all audits. I have reviewed audits where the auditor applied percentages of error against reported non-taxed sales without recognizing those sales were not accurate to start with since the taxpayer used the Modified Tax Up method. Taxpayers need to be concerned with not only the tests auditors conduct but also to the base to which those test results are applied. They should also recognize nonsensical requests from an auditor - for example, auditor expects a total sales reconciliation when Pure Tax Up method was used to prepare returns.
* If the exempt sales amounts on the returns are a “plug” figure, there is no way to be certain those amounts equal what the true recorded exempt sales are. Thus the auditor cannot simply accept the reported amounts and must instead determine what the true base amount is for exempt sales. This will presumably be the recorded amount.
Other recent “Audits and Sales Tax” posts by Lloyd Geggatt:
- Software Audits for Buyers & Sellers – and the 3 Key Questions
- Luxury Audits: Empty Boxes Full of Champagne Wishes & Caviar Dreams
- Sales Tax Audits: Actual Basis Approach Can Result in "Win-Win".
- What Auditors Should Understand About Outsourced Sales Tax Returns
- Auditing Sales Tax Credits: An Auditor's Top 2 Considerations