Sales tax auditors are happiest when the amounts on sales tax returns reconcile exactly with the amounts in the taxpayer’s books and records. This allows them to accept the returns at face value and move on to other areas of the audit. But when there is not a perfect reconciliation, they must do some analysis.
It is not uncommon for some of the amounts on the sales tax returns not to reconcile with what is reflected in your accounting records. Purely processing errors aside, the primary reason for these differences is the method used by the preparer to complete the tax return. When returns are prepared in-house, you have access to all the source data, accounting reports, etc and can prepare the return from top to bottom in what I would call the Sales Down Method. Outside providers on the other hand generally work from data sets with limited content. But even if they had the complete data set, they will almost certainly use tax rates that differ from the ones used for the original calculations. This is no one’s fault; it is simply the result of tax regions being defined with different identifiers in different systems. Some systems rely on zip codes to determine which tax region an address is in; others use some type of geo-code; still others attempt to apply latitude/longitude co-ordinates. Whatever the identifier, unless you and your provider utilize the same one there will inevitably be some transactions where you charged one rate and the provider’s system uses a different one.
This difference in tax rates prevents the provider from using the same Sales Down Method as you would have used. Totals for gross sales, taxable sales and exempt sales would agree with the values recorded in your books but the tax due will differ because different tax rates will be applied. The return will indicate you owe either more or less tax than you charged/collected so you must pay out of pocket or appear to be collecting excess tax.
To overcome the problems caused by different tax rates, most providers will apply a Modified Tax Up Method when preparing sales tax returns. The basic premise is to enter both gross sales and total tax from your records. The tax is capitalized by the applicable tax rate(s) to arrive at taxable sales. Taxable sales are subtracted from gross sales to arrive at exempt sales. This method insures that both reported total sales and tax will reconcile to the recorded total sales and tax. This method will result in reported taxable and exempt sales being different from recorded sales anytime there are differences in tax rates between the two systems. But differences in these two numbers are a mathematical function that should have no adverse impact at time of audit.
But won’t an auditor question why the exempt sales on your return are different than the amount in your books? Probably. But remember two things
- A tax return is simply a vehicle for sending information and money to the taxing authorities. And yes, it makes life much easier for everyone when a return is a mirror image of the books and records. But it is those books and records that are of primary importance, not the tax returns.
- The taxable sales on the return will differ from recorded sales by the amount that the exempt sales differ from their recorded counterparts but in the opposite direction. If exempt sales on return are $1,000 less than recorded, then taxable sales are $1,000 higher than recorded. Does this mean you have over reported taxable sales? Should the auditor give you a refund? Not likely when the amount of tax reported reconciles to the tax recorded. Or do you owe more tax if exempt is greater than recorded and therefore taxable sales are too low? Again, you have reported the same amount of tax as was recorded.
This is the point at which the auditor should turn his attention to the books and records to arrive at the correct values for audited total sales and tax due. It is irrelevant what is on a tax return; the real question is what should have been on the tax return. And an auditor only knows that by auditing the underlying books and records
When auditing sales transactions, the auditor needs to
- Assure all sales are accounted for
- Assure correct tax rate(s) were applied to the taxable sales
- Assure non-taxed sales are properly supported
- Assure all tax charged/collected was reported.
For this discussion, we’ll assume your recorded amounts pass those four tests and those recorded amounts become the “audited” amounts. Those audited amounts yield the exact same amount of tax as was reported on the return. Therefore there is nothing to assess! (It will certainly be helpful if the tax returns are backed by an audit trail to show that the same set of transactions were submitted to the provider as were included in the recorded values reviewed by the auditor).
Any auditor worthy of that title should be able to identify the above situation and focus on what is important rather than pursuing differences that simply represent different reporting methods and not additional tax. The good news is even if the auditor doesn’t see this on his own, you now know how to put them on the proper path.
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