Updated Handbook on Audit Procedures and Techniques

September 17, 2020 REVENUE AUDIT MEMORANDUM ORDER NO. 1-20 SUBJECT : Updated Handbook on Audit Procedures and Techniques TO : All Internal Officers, Employees and Others Concerned I. OBJECTIVES This Order prescribes the use of the Updated Handbook on Audit Procedures and Techniques in the audit of tax returns. The Handbook is intended to provide revenue officers with minimum standard procedures and uniform guidelines for the proper examination and/or investigation of tax liabilities. This updated version was prepared in order to conform with the provisions of the National Internal Revenue Code of 1997 (Tax Code), as amended, and existing revenue issuances. II. QUALITY AUDIT A quality audit is the examination of the taxpayer's books and records in sufficient depth for the purpose of ascertaining the correctness and validity of entries and the propriety of application of tax laws. To ensure quality audit of tax returns, revenue officers are enjoined to utilize their technical skill, training and experience, and follow the minimum audit procedures prescribed in the Handbook under Annex "A" hereof. The updated audit procedures and techniques for VAT liabilities and for Computer Assisted Audit Tools and Techniques will be prescribed in separate Revenue Audit Memorandum Orders. III. REPORTING REQUIREMENTS Revenue Officers are required to make a report after the audit has been conducted, with documentary requirements included in the docket. IV. REPEALING CLAUSE This Order supersedes Revenue Audit Memorandum Order No. 1-2000, all revenue issuances and portions thereof inconsistent herewith. CAIHTE V. EFFECTIVITY This Order shall take effect immediately. (SGD.) CAESAR R. DULAY Commissioner of Internal Revenue ANNEX A Updated Handbook on Audit Procedures and Techniques I. INTRODUCTION A. Revenue Tax Administration The function of the Bureau of Internal Revenue (Bureau) is to administer the provisions of the National Internal Revenue Code of 1997 (Tax Code), as amended. It is the duty of the Bureau to implement the Tax Code, related laws with tax implications enacted by Congress, as well as the revenue issuances, in a fair and impartial manner. The mission of the Bureau is to collect taxes for nation-building through excellent, efficient and transparent service, just and fair enforcement of tax laws, to be able to uplift the life of every Filipino. Investigation or audit supports the mission of the Bureau by enhancing a high degree of tax compliance from taxpayers and taxable persons, and encouraging the correct reporting of income, transfer, business and other taxes. This is accomplished by: 1. Measuring the degree of voluntary compliance as reflected on filed returns; 2. Reducing non-compliance by identifying and examining tax returns, taxpayers and transactions that need to be investigated based on a general audit program with audit selection criteria; and 3. Conducting quality audit of selected tax returns on a timely and regular basis. The purpose of auditing a tax return is to determine the taxpayer's correct tax liability and eventually, enhancing his/its tax compliance. A quality audit is the examination of a taxpayer's books and records in sufficient depth so as to ascertain the correctness and validity of entries thereon and the proper application of pertinent provisions of the Tax Code, tax laws and existing regulations. B. Purpose This Handbook on Audit Procedures and Techniques has been updated to equip all Revenue Officers (ROs) who conduct field examinations with the necessary knowledge for the proper examination of the tax returns and provide them with confidence in carrying out the investigation in the light of the Philippine Financial Reporting Standards (PFRS) and Philippine Accounting Standards (PAS). This handbook is designed to ensure that the ROs are provided with improved auditing skills and tax knowledge to be able to face the challenges of accounting and financial reporting the taxpayers apply. C. Contents of the Handbook This revised handbook contains guides, instructions and suggestions in the conduct of audit for various types/kinds of taxpayers. The discussions begin with the analysis of tax returns and financial statements, familiarization with accounting methods, bookkeeping systems, books of accounts and other related records. The audit procedures for balance sheet and income statement accounts are laid out together with investigation techniques for each tax type after taking into account the new standards of accounting and financial reporting. This does not preclude, however, the RO from carrying out other audit techniques which are deemed necessary in the circumstances surrounding a particular case. DETACa The handbook is neither intended to provide a source of tax law or procedural doctrine nor a substitute reference material of revenue issuances. Each RO is presumed to have a working knowledge of the Tax Code, the latest amendments thereon, and an update of applicable existing revenue regulations, revenue rulings, revenue memorandum orders and other issuances. Likewise, he should be familiar with the basic accounting principles, methods, chart of accounts and treatment of transactions taken up by taxpayers in their books of accounts and reflected in their financial statements. The other contents of this handbook include documentary requirements in the investigation process and proper making of reports. II. ACCOUNTING METHODS Pursuant to Section 43 of the Tax Code, as amended, the taxable income of a taxpayer shall be computed in accordance with the method of accounting he regularly employs in keeping his books. However, if the taxpayer does not regularly employ a method of accounting which reasonably shows his correct income, the computation of the income shall be made in such a manner as in the opinion of the Commissioner of Internal Revenue or his duly authorized representative clearly reflects such income. The methods of accounting recognized in Philippine Taxation are: A. Cash Basis is a method of accounting whereby all items of gross income received during the year shall be accounted for such taxable year and that only expenses actually paid for shall be claimed as deductions during the year. This method of accounting is generally used by taxpayers who do not keep regular books of accounts. Under this method, income is realized upon receipt of cash or its equivalent including those constructively received (such as deposits for the taxpayer's account by customers) but not including gifts or donations. Users of cash basis accounting are mostly individuals engaged in business and practice of profession, professional partnerships and professional service organizations. B. Accrual Basis is a method of accounting for income in the period it is earned regardless of whether it has been received or not. In the same manner, expenses are accounted for in the period they are incurred and not in the period they are paid. Under this method, net income is being measured by the excess of income earned during the period over the expenses incurred. Expenses not being claimed as deductions by taxpayers in the current year when they are incurred cannot be claimed as deduction from income for the succeeding year. Thus, a taxpayer who is authorized to deduct certain expenses and other allowable deductions for the current year but failed to do so cannot deduct the same for the next year. The accrual basis of accounting is being used by a taxpayer whose nature of business uses inventories since this method of accounting will correctly reflect income by matching purchases and expenses against sales. This method is being applied by most medium and large corporations. C. Percentage of Completion Basis is a method applicable in the case of a building, installation or construction contract covering a period in excess of one year whereby gross income derived from such contract may be reported upon the basis of percentage of completion. In determining the percentage of completion of a contract, generally one of the following methods is used: 1. The costs incurred under the contract as of the end of the tax year are compared with the estimated total contract costs; or 2. The work performed on the contract as of the end of the tax year is compared with the estimated work to be performed. In such case, the return should be accompanied by a certificate of the architect or engineer showing the percentage of completion during the taxable year of the entire work performed under contract. There should be deducted from such gross income all expenditures made during the taxable year on account of the contract, account being taken of the materials and supplies on hand at the beginning and end of the taxable period for use in connection with the work under the contract but not yet so applied. aDSIHc Beginning January 1, 1998 income from long-term contracts is required to be reported using this method only. D. Installment Basis is a method considered appropriate when collections extend over relatively long periods of time and there is a strong possibility that full collection will not be made. As customers make installment payments, the seller recognizes the gross profit on sale in proportion to the cash delivered. Moreover, Section 49 (B) of the Tax Code, as amended, states, "In the case (1) of a casual sale or other casual disposition of personal property (other than property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year), for a price exceeding One thousand pesos (P1,000), or (2) of a sale or other disposition of real property, if in either case the initial payments do not exceed twenty-five percent (25%) of the selling price, the income may, under the rules and regulations prescribed by the Secretary of Finance, upon recommendation of the Commissioner, be returned on the basis and in the manner above prescribed in this Section. As used in this Section, the term "initial payments" means the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable period in which the sale or other disposition is made." E. Crop Year Basis is a method applicable only to farmers and taxpayers engaged in agriculture, livestock, fishery and similar undertaking for business where the production of crops, livestock and other biological assets take more than a year from the time of planting or raising to the process of disposal. A farmer under this method shall include in his gross income for the taxable year: 1. The amount of cash or the value of merchandise or other property received from the sale of livestock, and produce which were raised during the taxable year or prior years 2. The profit from the sale of any livestock or any other items which were purchased 3. The amount of cash from the sale of crops produced during the crop year 4. Gross income from all other sources Expenses paid or incurred are deductible in the year the gross income from the sale of the crops/livestock and other biological assets are realized. Under the PFRS and PAS, the acceptable accounting methods are the cash and accrual basis. However, most non-individual taxpayers use the accrual method. Notwithstanding the accounting standard, the aforesaid accounting methods are acceptable for tax purposes as long as they are consistently applied. A taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner of Internal Revenue. Application for permission to change the accounting method and the basis upon which the return is made shall be filed within 90 days after the beginning of the taxable year to be covered by the return. The application shall be accompanied by a statement specifying all amounts which would be duplicated or entirely omitted as a result of the proposed change. Permission to change the accounting method shall not be granted unless the taxpayer and the Commissioner of Internal Revenue agree to the terms and conditions under which the change will be effected. III. BOOKKEEPING SYSTEMS Bookkeeping may be classified into two systems, namely, (1) the single entry and (2) the double entry. A. Single Entry System of bookkeeping is basically a type of "net worth" method of arriving at net income. It records only the debit or credit of each transaction, or an account with the debtor or creditor and a simple record of cash receipts and disbursements. ETHIDa Whenever a system of recordkeeping does not include equal debit and credit to asset, liability, proprietorship or net worth, income and expense accounts, it is referred to as a "single entry system." The single entry is often used by comparatively simple ventures such as small retail or commission merchants, professional firms, estates and trusts. In many cases, the only record of income and deduction consists of entries on the stubs of their checkbooks. Some taxpayers maintain an income tax folder in which they place documents to support their income tax deductions. A single entry system may be merely a chronological record of transactions posted in a notebook or journal. Sometimes, the records consist of a complete set of journals (cash, sales, purchases and general journal) and general ledger providing important accounts. B. Double Entry System Under this system of bookkeeping, accounting recognizes the two-fold effect of every recorded event, the debit and the credit or the object of the event and the equitable interest in that object. Every recorded event affecting one side must necessarily affect the other side. This can be presented in an equation: Assets = Liabilities + Equity This can be analyzed into its component elements which show that there are two distinct parties that have right in the assets of the business, the creditors and the owners. The rights of the creditors are the claims of such creditors on the assets of the business which are referred to as liabilities and the rights of the owners on the business are referred to as equity. In the double entry method, any net increase and net decrease in asset has a corresponding increase and decrease in either liabilities or capital. Audit of accounting records under this system shall be detailed as presented in the discussions of audit of real and nominal accounts. IV. ACCOUNTING RECORDS Pursuant to Section 235 of the Tax Code, as amended, taxpayers are required to preserve and maintain accounting records in sufficient detail to enable them to make a proper return of income and in order that all taxes due the government may readily and accurately be ascertained and determined anytime of the year. The Commissioner of Internal Revenue, under Section 5 of the Tax Code, as amended, is authorized to examine such records or other data which may be relevant in ascertaining the correctness of the tax returns. The books and records kept must be sufficient to establish the amount of the gross income and the deductions, credits and other matters required to be shown in the tax return. The primary records commonly used by all types of businesses, considering the different accounting systems and reporting methods of the business are invoices, vouchers, bills, receipts and other source documents which are also the supporting documents in the selling and buying of merchandise, services and other assets used in the business. For companies which require the use of inventories, the primary records include the detailed inventory list. Other primary records used in financial transactions are the cancelled checks, duplicate deposit slips, bank statements and notes. The secondary records, regardless of the accounting method used by the taxpayer, include permanent books of accounts and working papers which summarize and list the individual documents including adjustments, when necessary. These records are properly classified in such a way that the taxpayer will be able to determine the financial status of his business in a given period of time and the profit and loss for the period. cSEDTC All records required to be kept by the taxpayers should be preserved by them for proper administration of any internal revenue law. Under existing revenue issuances, all taxpayers are required to preserve their books of accounts, including subsidiary books and other accounting records, for a period of ten (10) years reckoned from the day following the deadline in filing a return, or if filed after the deadline, from the date of the filing of the return, for the taxable year when the last entry was made in the books of accounts, provided that, within the first five (5) years reckoned from the day following the deadline in filing a return, or if filed after the deadline, from the date of the filing of the return, for the taxable year when the last entry was made in the books of accounts, the taxpayer shall retain hardcopies of the books of accounts, including subsidiary books and other accounting records. Thereafter, the taxpayer may retain only an electronic copy of the hardcopy (paper) of the books of accounts, subsidiary books and other accounting records in an electronic storage system which complies with the requirements set forth in the regulations. Below are the regular accounting records being used by taxpayers: A. Journal is a book of original entry in which transactions affecting the business of a taxpayer are recorded consecutively and chronologically day by day as they occur: Journal consists (but not limited to) of the following: 1. Sales Journal is a book where all sales, whether cash or on account, are recorded, which are supported by sales invoices and are also the documents that will serve as the basis of recording the transactions in the books of accounts. Cash sales are usually recorded in the cash receipts book although it may be posted in both books representing a debit to cash in the cash book and a credit to sales in the sales book. Every entry in the sales journal pertaining to sales on account represents a debit to a customer's account and a credit to sales to be posted in the general ledger. Sales returns and allowances are also recorded in the sales book which represents a debit to Sales Returns and Allowances and a credit to Accounts Receivable to be posted in the general ledger. This would mean a decrease in Sales and eventually a decrease in an asset account. 2. Purchase Journal is a book whereby all transactions involving the purchase or acquisition of merchandise, whether cash or on account, are recorded which are supported by purchase invoice and are also the documents that will serve as the basis of recording the transactions in the books of accounts. Cash purchases are usually recorded in the cash disbursement book although it may be posted in both books representing a debit to cash in the cash book and a credit to purchases in the purchases book. An entry to record purchases on account is a debit to Purchases and a credit to Accounts Payable to be posted in the general ledger. Purchase returns and allowances are also recorded in this book and posted in the general ledger representing a debit to Accounts Payable and a credit to Purchase returns and allowances which would mean a decrease in the purchases account. SDAaTC In certain instances, where the volume of business is large and under the Value-Added Tax system, taxpayers maintain subsidiary sales and purchase journals where details of daily sales and purchases are recorded. 3. Cash book is a book whereby all transactions involving cash such as cash receipts or cash disbursements are recorded. Types of this book are the following: a. Cash receipts book a book whereby all transactions involving cash receipts of whatever source are recorded. b. Cash disbursements book a book whereby all transactions involving cash or check disbursements are recorded. B. Ledger is a book of final entry wherein the classified accounts or items of all transactions entered in the journal must be posted to the ledger and shall be classified accordingly so as to show the assets, liabilities, equity and the operating accounts. This will be the basis for the preparation of the trial balance and eventually the balance sheet and the profit and loss statement covering the operations of the business for a certain period. No entry shall be made in the ledger unless said entry originates from the journal. The accounts contained in the general ledger provide the RO with insight of the operations of the business. When pertinent, the chart of accounts and subsidiary ledgers, if any, should be requested from the taxpayer. If a private ledger is maintained, it should also be requested. As the RO goes through the ledger, unusual or non-recurring items should be noted and verified. Most of these items are classified as follows: 1. Unusual in amount The RO should be alert for month-end entries with significant amounts which may affect income and expenses. 2. Unusual by source Source means the books of accounts from where the entries to the ledger account originated. Hence, the expenses or adjustments to income which do not ordinarily originate from the cash journals, sales and purchase books should be investigated. Such adjustments originating from the general journal or journal vouchers should be thoroughly examined as to supporting documents and proper authorization. 3. Unusual by nature An entry in a ledger account may be unusual by nature as well as by the account itself. Accounts with abnormal balances such as receivable accounts with credit balances may indicate income which is credited to receivables instead of sales. Unusual accounts such as suspense, other receivables, due to stockholders, and such other unusual liability accounts should be analyzed as there may be some income components lodged into these accounts. C. Subsidiary Book . In the general ledger, accounts are usually transferred and grouped into certain accounts to a subsidiary book. This general ledger account is called control account. Control accounts in the general ledger contain summarized information that is recorded in detail in a subsidiary book or ledger. Thus, in order to relieve the general ledger of too many individual accounts, business concerns having numerous accounts with customers and creditors will transfer said accounts to separate ledgers one for customers and one for creditors. For example, the control account for the customer's subsidiar book will be called "Accounts Receivable," while the control account for the creditor's subsidiary book will be called "Accounts Payable." All corporations, companies, partnerships or persons required by law to pay internal revenue taxes have the option to keep this kind of book depending on the need of their business, provided that where such books are kept, they shall form part of the accounting records of the taxpayer and shall be subject to the same rules and regulations as to their keeping, translation, production and inspection as are applicable to the journal and the ledger. acEHCD D. Computerized Accounting System (CAS) . This method of accounting is now being used by most companies. It is a system whereby information is fed into the computer thus providing uniformity in the processing of transactions. All taxpayers engaged in business who have CAS or components thereof shall apply for permit prior to its use. Furthermore, taxpayers applying for e-invoicing system shall apply for a complete CAS provided the system is capable of generating hard copy of the invoice anytime. The RO should verify if the CAS or components thereof used by the taxpayer has been duly approved with a corresponding certificate of approval or permit to use. V. ACCOUNTING PERIODS Accounting periods are generally classified into two. They are: A. Calendar Year is an accounting period which starts from January 1 and ends on December 31. This is used by most taxpayers as their accounting period. However, the calendar year shall be the basis of computing the net income in the following cases: 1. When the taxpayer is an individual; 2. When the taxpayer does not keep books of accounts; and 3. When the taxpayer has no annual accounting period. B. Fiscal Year is an accounting period of twelve months ending on the last day of any month other than December 31. Corporations and duly registered general co-partnerships are allowed to use this type of accounting period. A corporation and a general co-partnership have the option to choose between the calendar year and the fiscal year. C. Change in Accounting Period If a taxpayer, other than an individual, changes his accounting period from fiscal year to calendar year, from calendar year to fiscal year, or from one fiscal year to another, the net income shall, with the approval of the Bureau of Internal Revenue (BIR), be computed on the basis of such new accounting period. Whenever a taxpayer changes its accounting period, the taxpayer is required to file with the BIR a separate final or adjustment return for the period between the close of the original accounting period and the date designated as the close of the new accounting period. A taxpayer can file an income tax return that has a taxable period of less than twelve (12) months only in the following cases: 1. When a corporation is newly organized and commenced operations on any day within the year; 2. When a corporation changes its accounting period; 3. When a corporation is dissolved; 4. When the Commissioner of Internal Revenue, by authority, terminates the taxable period of a taxpayer pursuant to Section 6 (D) of the Tax Code, as amended; and 5. In case of estate tax, when a decedent dies at any day within the year. The application for a change in accounting period should be filed with the Commissioner of Internal Revenue, through the Revenue District Office, where the business is registered sixty (60) days prior to the beginning of the proposed new accounting period. VI. FINANCIAL STATEMENTS Financial Statements are reports signifying the end result of the financial accounting process. Furthermore, they provide information about the financial position, financial performance, cash flows and management stewardship of resources. They also assist in predicting the entity's future cash flows and in particular their timing and certainty. The complete set of financial statements as prescribed in Philippine Accounting Standards (PAS) 1 are as follows: SDHTEC A. Statement of Comprehensive Income is a report that summarizes the business activities for a given period and reports the net income or loss resulting from operations and from certain other activities. It is variously called the Income/Earnings Statement, Statement of Profit and Loss, and Statement of Operations. It normally consists of the following sections or items: 1. Sales/Revenues reports the total sales to customers and fees received from clients for the period. All sales transactions should be recorded and issued corresponding sales invoice or official receipt (OR). 2. Cost of goods sold refers to cost of goods relating to sales when merchandise is acquired from outsiders. This is the sum of the beginning inventory, purchases, and all other buying, freight and storage costs relating to the acquisition of goods and subtracting the ending inventory thereof. When the goods are manufactured by the seller, the cost of goods manufactured must first be calculated. This is the sum of the cost of goods in process at the beginning, the cost of materials put into production, the cost of labor applied and factory overhead incurred. The total cost as thus obtained represents the cost of both completed work and uncompleted work still in production. The ending goods in process inventory, then must be subtracted from this total in arriving at the cost of the product completed and made available for sale. 3. Cost of services refers to all direct costs and expenses necessarily incurred to provide the services required by the customers and client, including: (1) salaries and employee benefits of personnel, consultants and specialists directly rendering the service; and (2) cost of facilities directly utilized in providing the service such as depreciation or rental of equipment used and cost of supplies. HSAcaE Except for banks and other financial institutions, cost of sales/services shall not include interest expense. 4. Operating expenses are expenses incurred or utilized in the course of business or pursuant to the practice of profession. They are generally reported in two categories: a. Selling expenses; and b. General and administrative expenses. The operating expenses as indicated in the Financial Statements of the taxpayer may not necessarily be considered allowable expenses for purposes of computing the taxable income. Section 34 of the Tax Code, as amended, provides items of allowable expenses that a certain taxpayer may deduct from the gross income. However, the taxpayer is allowed to elect a standard deduction of forty percent (40%) of the gross receipts/sales, in case of an individual subject to tax under Section 24 of the same Code, while it is forty percent (40%) of gross income as defined in Section 32 of the Tax Code, as amended, in the case of corporation subject to tax under Sections 27 (A) and 28 (A) (1), in lieu of the itemized allowable deductions. Unless the taxpayer signifies in his tax return his intention to elect the optional deduction, he shall be considered as having availed himself of the itemized deductions. 5. Other Income and Expenses include items identified with financial management and miscellaneous recurring activities. Other income includes interest and dividend income and income from rentals, royalties and service fees. Other expenses include interest expense and expenses related to the miscellaneous income items reported. B. Statement of Financial Position is a report that shows the financial position of the business unit as of a specified moment of time. It is a status report rather than a flow report. It is variously called Balance Sheet, Statement of Condition, Statement of Resources and Liabilities, and Statement of Net Worth. The Balance Sheet is the fundamental accounting statement in the sense that every accounting transaction can be analyzed in terms of its effect on the balance sheet. In order to understand the information a balance sheet conveys and how economic events affect the balance sheet, it is essential that the reader be absolutely clear as to the meaning of its two sides in the equation: Assets = Liabilities + Owner's Equity 1. Assets are economic benefits obtained or controlled by a particular entity as a result of past transactions or events. They include those costs that have not been matched with revenues in the past and are expected to afford economic utility in the production of revenue in the future. It includes both monetary assets, such as cash, marketable securities and receivables and non-monetary assets; those costs recognized as recoverable; and hence, properly assignable to revenues of future period, such as inventories, prepaid insurance, equipment and patents. 2. Liabilities measure the claims of creditors against entity resources. The method for settlement of liabilities varies. Liabilities may call for settlement by cash payment or settlement through goods to be delivered or services to be performed. 3. Owner's Equity/Stockholder's Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. It measures the interest of the ownership group in the total resources of the enterprise. Such equities originally arise as the result of contributions by the owners and the equities change with the change in net assets resulting from operations. C. Statement of Changes in Equity is a financial statement showing the equity at the beginning of the period, the changes that affect equity and the resulting equity at the end of the period. HESIcT Under PFRS for Small and Medium Enterprises, the statement of changes in equity should show all changes in equity including comprehensive income, owner's investments and dividends, owner's withdrawals of capital and treasury share transactions. However, they can omit the statement of changes in equity if the entity has no owner investments or withdrawals other than dividends and elects to present a combined statement of comprehensive income and retained earnings. D. Statement of Cash Flow is a financial statement that shows how the changes in balance sheet accounts and income affect cash and cash equivalents. It also reports the sources and uses of cash and break the analysis down to three activities, namely: 1. Cash flow from operating activities; 2. Cash flow from investing activities; and 3. Cash flow from financing activities. E. Notes to Financial Statements is an attachment with references to the aforementioned financial statements comprising a summary of the significant accounting policies and other explanatory notes and schedules. Generally, it will start with the general information/background followed by the basis of presentations. VII. PURPOSE AND STANDARDS OF AUDIT The basic purpose of tax examination is the determination of correct taxable income as defined by the Tax Code, as amended, and other internal revenue tax liabilities of the person or entity whose return is being examined. In conducting the examination, the RO's responsibility is two-fold: to the taxpayer and to the Philippine Government. Minimum standards of examination may be extended beyond the originally intended scope, or beyond minimum requirements because of situations or facts not apparent at the outset. The extent of verification to be done in any single tax examination is a matter of auditing judgment for which no rigid guide can be established. AcICHD The degree of checking or scope of a tax examination may be influenced by an analysis of the taxpayer's accounting procedures and the results achieved therefrom, for they measure the credibility of the records and the degree of the existing system of internal control of the taxpayer. Standard refers to the criteria by which the quality of performance of auditing examinations is measured. The following is the set of standards which should be observed by ROs in all aspects of the tax examination: A. General Standards 1. Independence, in fact and in faith, or having an impartial attitude must be maintained in all affairs relating to an examination in order to assure a fair application of tax laws, regulations and rulings. 2. Professional skill and ingenuity must be exercised in the performance of the examination and the preparation of the report. 3. Issues should be raised only when, in the RO's opinion, they have real merit and will contribute to the proper determination of tax liability. 4. The confidential nature of all information pertaining to any assignment must be strictly observed. 5. The RO must exercise due professional care and ethical behavior during the performance of the audit. B. Standards of Preliminary Planning 1. Sound judgment should be exercised in determining from assigned tax returns and financial statements those accounts which are most likely to contain areas of non-compliance and where the focus of the audit should be directed. 2. Advance planning of work schedules with reasonable accuracy is essential for the effective use of time. 3. A general audit plan should be formulated in each case prior to contacting the taxpayer, which includes the identification of possible risk areas, development of issues suggested by the return, financial statements, third party data and other information. The following steps may be included in the work plan: a. Prepare an audit plan and checklist of requirements. Secure documents/information available within the Bureau ( e.g. , tax returns, Third Party Information (TPI), etc.) b. Draw up a list of questions to be asked from the taxpayer. c. Identify other agencies or offices where the RO can have access to their records if the taxpayer cannot present the documents requested. C. Standards of Field Work 1. The RO assigned to the case shall serve a valid electronic Letter of Authority (eLA) in accordance with existing regulations. 2. Audits should normally be performed at the taxpayer's place of business because of the accessibility of the books and records and to permit actual observation of taxpayer's facilities and scope of operations. Otherwise, it should be performed in the office of the Bureau of Internal Revenue. 3. The use of accounting skills, tax knowledge and ingenuity should be directed toward recognizing risk areas including accounts that are prone to errors and misdeclaration. 4. Adequate evidential matter should be obtained through inspection, observation, inquiry, analysis, documentation and other audit procedures deemed necessary to afford a reasonable basis for the determination of the correct tax assessment of the taxpayer. TAIaHE D. Standards of Reporting 1. Reports shall be prepared in accordance with existing revenue issuances in a complete, clear, concise and legible manner in order that they may be easily read and understood. 2. Working papers should be used as a practical and professional tool to aid the RO in the discussion of issues and questions with the taxpayer or his authorized representative. It also generally provides a record of the findings that led to the tax assessment by the RO. Thus, they should be properly labeled, indexed, signed and arranged in a logical and orderly manner. 3. Reports shall be submitted within the prescribed period. E. Standards of Public Relations 1. Initial contact for audit arrangements should be made with the taxpayer and due care should be exercised in explaining the documents and records required to be examined. 2. ROs must be fully cognizant of the proper sources for gathering information and of the rights of the taxpayer and his representatives. 3. Time and patience should be devoted to a discussion of any proposed adjustments to ensure that the taxpayer has a proper understanding of the issues. 4. Tact and discretion are required in pointing out errors in books and records in order to avoid discrediting an employee or representative of the taxpayer. VIII. PRELIMINARY APPROACH TO EXAMINATION A. Pre-Audit Analysis of Tax Return Pre-audit analysis of the return is essential to an effective audit. Preliminary analysis is used to identify potential issues which will be developed further after contacting the taxpayer. All information contained in any attachment to the tax return should be thoroughly and completely scrutinized to ascertain whether or not all of the information is adequately reflected in the tax return. Before contacting the taxpayer, the RO should familiarize himself with the following: 1. The business organization of the taxpayer and whether it has business establishments other than its main or head office; 2. The location of the business and its branches as this has relation to the volume of business; 3. The industry in which the taxpayer is engaged in; 4. The accounting books and records that would ordinarily be kept; 5. The accounting methods and policies; 6. The overall composition of the tax return; 7. The types of income reported; 8. Mathematical computation of the tax due and its components; 9. Applicability of deductions claimed by the taxpayer; 10. Correct utilization of Tax Credit Certificates which shall be duly supported by approved Tax Debit Memo; 11. The reasonableness of expenses vis--vis the thresholds set by existing revenue issuances ( e.g. , representation & entertainment, charitable contributions, etc.); 12. Unusual or unfamiliar items; 13. Apparent questionable or unallowable items; 14. Gross profit and selling expense percentage as well as significant variations between prior and current years; 15. Inconsistencies in the treatment of bad debts, inventory valuation methods, depreciation rates and methods, etc.; 16. Correctness of the reconciliation of net income per books against taxable income; cDHAES 17. Applicability of Minimum Corporate Income Tax (MCIT) and Net Operating Loss Carry Over (NOLCO) applied in the current year; 18. Prior year's entries in the reconciliation schedules of retained earnings in a corporate return and of a partner's capital account in a partnership return which affect the year under examination; 19. The status of the retained earnings account as well as carrying value of assets; and 20. The report of the tax liabilities of the taxpayer for the immediately preceding period in order to be aware of the deficiencies that were reported. Review of prior year's examination records will clarify some doubts or questions in the RO's mind regarding certain items. B. Work Planning Works that are properly planned achieve good results. In order to avoid any situation where the RO will be faced with a situation of a cramped audit workload and schedule, he should prioritize the audit of the assigned cases in the following manner: 1. Mandatory cases as prescribed under the Audit Program for the taxable year covered 2. Returns or cases where the statute of limitations is about to prescribe. (Prescriptive period is three (3) years counted from the date prescribed by law for the filing of the return, provided that in case a return is filed beyond the prescribed period, the three-year period shall be counted from the day the return was filed.) 3. Cases assigned for reinvestigation 4. Returns which would be more productive in terms of revenues should be given precedence over the less productive ones In work planning, an Audit Plan should be prepared for every case. An Audit Plan contains relevant and significant information about the case and the taxpayer under audit. It also contains a checklist of the various auditing procedures to be undertaken, from preparation/planning to reporting, and the various books of accounts, records, documents and business forms to be verified in order to assess the correct tax due from a taxpayer. This checklist would serve as a guide for the RO to conduct a "quality audit" within the time frame allowed to conclude a tax audit. It is also a tool of the tax administrators to check on the progress of the tax audit and for proper evaluation of the performance of the RO. C. Contact with Taxpayer 1. Serving of eLA a. On the first opportunity of the RO to have a personal contact with the taxpayer, he should present the eLA together with the checklist of requirements. The eLA should only be served by the RO assigned to the case. He should have the proper identification card and should be in proper uniform. However, the service of eLA may likewise be done in other manners as prescribed in existing policies. b. An eLA authorizes or empowers a designated RO to examine, verify and scrutinize a taxpayer's books and records in relation to his internal revenue tax liabilities for a particular period. 2. Request for Accounting Records The initial request for accounting records shall be served with the eLA. In this request, the RO should clearly specify the records he desires to be assembled for his examination. Among the books and records that may be required are: a. receipts (official receipts, warehouse receipts, delivery receipts, etc.); b. invoices (sales and purchases invoices); c. vouchers; d. cancelled checks; e. bills and statements of accounts (utility bills, payment notices, etc.); ASEcHI f. contracts (sales/purchase contracts, loan contracts); g. journals (regular and subsidiary journals); and h. ledgers (regular and subsidiary ledgers). In case of failure of the taxpayer to comply with the initial request for accounting records within the prescribed period, a reminder letter shall be prepared by the RO assigned to the case. Further failure to comply with the reminder letter shall render the issuance of a Subpoena Duces Tecum (SDT). 3. Initial Interview The initial interview is an important part of the examination process and should be conducted in all audits. The interrogation should be conducted as to encourage the taxpayer to contribute willingly useful information which will assist in the proper determination of his tax liability. The information developed by this method may affect the eventual outcome of the case. The preliminary interview should, as far as practicable, cover the following: a. Discussion of sources of income this may uncover possible sources of income which have not been reported such as interests on investments and deposits, dividends, rents, sales of properties as well as information on the taxpayer's financial history and standard of living b. Records kept for each source of income c. Handling and recording of cash transactions d. Records of loans from banks and other creditors e. Real or personal properties bought or sold in the current year f. Other items that would be relevant in the examination, to wit: f.1 Responsible officers of the firm in order to facilitate acquisition of information/data; f.2 Place and time of audit; f.3 Ocular inspection of the factory, branches, outlets, etc.; f.4 Officers to whom the tax audit findings will be discussed; and f.5 Financial history and standard of living of the owner/s. D. Preliminary Evaluation of Relevant Records The investigation on the taxpayer's books of accounts may begin with miscellaneous records other than accounting ledgers and journals. More often than not, scrutiny of these records may reveal items which the RO should take into consideration as the examination progresses. The records and information to be obtained are the following: 1. Minute Book The review of the minute book should not be confined to the taxable year under audit but should cover at least some period immediately before or after. As the RO scans the minute book, he should note appropriate transactions and items of significance, such as contracts entered into by the taxpayer, stock issuance, dividend declaration and compensation of officers. ITAaHc 2. Stock Transfer Book This book contains the name of stockholders, past and present, with the number of shares cancelled and issued. This book is also vital in computing documentary stamp tax liabilities. A general knowledge of the names of large shareholders is also of value when checking the salary expense and fringe benefits. When the stock and transfer book is not available, the record of dividend payment is an alternative source of similar information. 3. Partnership Agreement A copy of the partnership agreement should be obtained and certain provisions affecting partner's salaries, profit and loss sharing, interest on capital, other allowances and other matters which may have tax consequences should be noted. 4. Audit Report of Independent Auditors The RO should read the auditor's report accompanying the financial statements. Sometimes, ROs fail to evaluate the auditor's report. However, there are cases when auditors do not issue an unqualified opinion. Any qualification or unusual comments in the auditor's report or certificate such as expression of opinion as to taxpayer's depreciation policy, inventory and cost valuation, adequacy of reserves, status of collectability of receivables and the like should be noted for consideration and should be related to the examination of accounts. In cases where the auditor issues two reports, one for management and the other for attachment to the tax return, the former should be studied and compared with the latter. Income and net worth in both reports may vary from income and net worth per books due to the auditor's adjusting entries not reflected in the books. Thus, the adjusting entries and supporting documents should be examined. If needed, the auditor's working papers should be looked into to explain these entries. 5. Auditor's Working Papers Audits, particularly of large companies, may frequently be simplified and facilitated, if the examining ROs are given access to the auditor's working papers. Where necessary, authorization from the taxpayer or requests for access to said working papers signed by duly authorized officials shall be secured to be able to scrutinize the working papers of auditors, particularly the year-end adjustments, intercompany transactions, nature of receivables and other peculiar accounts. 6. Statements and Schedules Filed with Government Regulatory Agencies Certain taxpayers are required to file financial statements and other reports with government bodies such as the Securities and Exchange Commission for corporate taxpayers, the Garments and Textile Export Board for garments exporters, the Board of Investments for exporters and other similar government offices. The RO should compare the statements filed with the Bureau of Internal Revenue against those filed with other government offices. Any discrepancy should be inquired into and material differences should undergo an in-depth investigation. 7. Appraisal Reports Appraisal reports, particularly real estate appraisals, are important in many cases such as for capital gains tax/withholding tax verification, as well as valuation of properties subject to estate/donor's tax. E. Initial Examination Techniques 1. Understanding the Taxpayer's Books and Records To have an understanding of the taxpayer's accounting system and records, one technique that should be commonly used is for the RO to interview the taxpayer or his representative and ask him to walk him through the accounting process of the taxpayer's business operation which includes journalizing different transactions and posting thereafter. CHTAIc 2. Reconciliation of Books and Returns Another step in understanding the records is to perform a reconciliation of the books with the tax return. The following procedures and actions are recommended to assist the RO in the reconciliation process: a. Request for a chart of accounts and identify account numbers and account titles. b. Identify unusual accounts. c. Scan the general ledger to discover unusual account entries. d. Ask the taxpayer for the tax working papers or any other type of working papers that were used to prepare the tax return. e. If the working papers are in the hands of the external auditor, the taxpayer should be advised to secure a copy thereof from their external auditor. f. If no working papers are available, request the taxpayer to prepare the reconciliation and supporting schedules used to arrive at the reconciliation of data as reflected in the books and the tax returns. g. Evaluate the Statement of Cash Flow to identify sales and purchases of fixed assets, investments made and disposed, loan and debt payments, capital contributions and other transactions that might not be readily apparent on the balance sheet and income statement. 3. Performance of Compliance Tests The RO should establish the level of reliance that can be placed on the books and records and determine whether the books show all the transactions which occurred. To accomplish this, a compliance test would be performed on some transactions through the backward and forward approaches in verification as follows: a. In the backward approach, the figures per tax return are traced to the trial balance, then to the general ledger, the various journals, and ultimately to the source documents such as sales invoice or official receipts. This approach is most commonly known as vouching which usually addresses all financial statements assertions except completeness. It is because testing for completeness requires the RO to search for evidence of unrecorded items. The backward approach is effective in checking unsupported expenses. b. In the forward approach also known as tracing, the RO should select a supporting document, say a sales invoice; and trace it through the sales journal, general ledger, trial balance and finally to the tax return. Tracing is often used as a test of the completeness assertion. Other assertions that are tested by this are the valuation and allocation and the presentation and disclosure assertions. The forward approach is usually used in uncovering unreported income. 4. Analysis of Adjusting Journal Entries It is important that the RO understands adjusting journal entries because tax issues are frequently discovered in the adjusting journal entries. These adjusting journal entries are usually accruals, deferrals, corrections or reclassifications of accounts. a. Accruals are normally entries to record certain known and fixed amount of obligations or liabilities. Accruals are also used to book uncertain, contingent liabilities. Contingent liabilities are not fixed in amount or date and are not deductible for tax purposes. EATCcI b. Deferrals are typically used to defer or postpone recognition of income or expenses. An inspection of the deferred income account may reflect amounts representing services already performed. It may also show goods already shipped and received by the customer. In both of these situations, a deferral of income is not proper. c. Corrections of prior year's earnings, other adjustments ( e.g. , recognition of allowance for bad debts and/or depreciation) and reclassifications are made through adjusting journal entries which are recorded in the general journal or in the journal vouchers. Usually, these entries are taken from the auditor's working papers. The examining RO should scrutinize these entries, especially those credited directly to retained earnings, analyze the tax issues involved and note down possible tax assessments. d. When scanning adjusting journal entries, the following should also be looked into closely: d.1 Unusual and-non-recurring entries; d.2 Entries reducing assets as there could possibly be unreported gain on sale, incorrectly computed gain on sale, incorrectly computed installment sale, non-taxable exchange, or withdrawal of goods by the owner; and d.3 Entries increasing liabilities as these could represent fictitious or contingent liabilities, fictitious expenses, invalid loans to shareholders, or undeclared income credited to liability accounts. F. Evaluation of Internal Control Internal Control is a system of procedures in place to ensure that all business transactions are properly recorded and assets are adequately safeguarded. It also consists of policies and procedures designed to provide management with reasonable assurance that the company achieves its objectives and goals including reliability of financial reporting, compliance with applicable laws and the effectiveness and efficiency of operations. ISHCcT It is mandatory for the RO to evaluate internal control for him to decide up to what extent the system can be relied upon. This will also determine the nature, extent and timing of audit tests to be applied in the examination and to plan subsequent audit procedures. Many classes of transactions of the taxpayer are very routinary. Accordingly, the taxpayer may establish strong internal controls over those transactions to ensure that misstatements are prevented or detected in a timely fashion. If the internal controls over a class of transactions are strong, the auditor may rely upon those controls. However, in order to rely, the auditor must perform: Tests of Design: Would the controls prevent/detect errors? Tests of Operational Effectiveness: Are the controls functioning as designed? 1. Principles of Internal Control Good internal control assures good record keeping and the liability of the employees and the owner from misappropriating the assets. Some broad principles of internal control are: a. Responsibilities should be clearly established. b. Adequate records should be maintained. c. Assets should be insured and employees bonded. d. Record keeping and custody should be separate. e. Responsibility for related transactions should be divided. f. Personnel should be rotated. g. Automation should be used whenever practical. h. Employees should be informed of prescribed procedures. i. The system should be under constant review. 2. Elements of Internal Control Internal Control can be divided into five elements: a. Control Environment This includes the entity's organizational structure, methods of assigning authority and responsibility, integrity and ethical values, commitment to competence, board of directors and audit committee participation in governance and oversight, management's philosophy and operating style and human resource policies and practices. b. Risk Assessment Risk assessment is the process of identifying, evaluating, and determining how to manage risks. It is also the taxpayer's identification and analysis of risks relevant to the preparation of the tax returns in accordance with the Tax Code and all applicable regulations are important in the design of internal controls. c. Information and Communication Methods used to initiate, record, process, and report an entity's transactions and to maintain accountability for related assets. d. Monitoring Taxpayer's ongoing and periodic assessment of the quality of internal control performance to determine whether controls are operating as intended and modified when needed. e. Control Procedures These include the adequate segregation of duties, proper authorization of transactions and activities, adequate documents and records, physical control over assets and records and independent checks on performance. These consist of the methods and records established to capture financial transactions such as sales, purchases, investments and payment of expenses and liabilities. This element is important to the RO for him to understand how transactions are initiated and recorded and to determine the degree of reliability to be placed in the taxpayer's books and records. 3. Standard Procedures in Evaluating Internal Control To establish the scope of the audit and degree of compliance tests to be performed, internal control should first be evaluated. There are five (5) basic steps in performing the assessment of the effectiveness of internals control over financial reporting. They are the following: a. Planning ROs should construct a plan prior to the start of the assessment of the effectiveness of internal control over financial planning. This includes review of the processes and sub-processes created by the taxpayer, specifically how these processes interact and controls that were put in place to mitigate known risks; b. Evaluating internal control at the entity level; c. Evaluating internal control at the process level; d. Testing control design and operating effectiveness at the transactional level; and e. Conclusion and findings. There is a variety of different techniques to evaluate and test internal controls. Below are just a few that may be considered in conducting tests of internal controls: a. Identify the personnel responsible for record keeping and determine their responsibilities and authority in the business operation. b. Identify the separation of duties and responsibilities. c. Reconcile the return with the books and records. Difficulty in reconciling the return with the books and records may be an indication of inadequate internal control in either financial or tax accounting. d. Interview responsible company personnel and observe business operations. Interviews may be in-person or in the form of questionnaires but is best conducted with an element of surprise. cEaSHC e. Review the chart of accounts and identify unusual accounts or note those accounts which should be included but not indicated. f. Secure and study copies of operating manuals or instructional booklets that may lead to an easy understanding of the taxpayer's business operations. There may also be a physical examination of documents deemed necessary for the evaluation. g. Determine if the taxpayer's personal transactions are segregated from business operations or if separate bank accounts are maintained by the owner and the business. h. Determine if bank accounts are reconciled monthly. i. Determine the books and records maintained and the frequency of recording transactions. j. Determine if pre-numbered documents are being used and check if said pre-numbered documents are properly accounted for through constant monitoring. k. Determine the extent of involvement of auditors and other third parties in the business. l. Determine if certified audits for any reason were conducted. If so, copies of documents in relation thereto should be secured. m. Determine if the income reported by the taxpayer reflects his lifestyle. n. Obtain confirmations of inventories at locations outside the entity. The effective evaluation of internal control is dependent upon a very good interview, inspection, observation of the business operation, and testing of the system. Internal controls that appear to be high-risk may lead to the conclusion that lower reliance be placed in its financial reporting and declarations as well. G. Sampling Techniques Sampling is a large and important part of the examination of a tax return. It is the application of examination procedures to less than 100% of the items in an account to evaluate its accuracy. 1. Two Basic Types of Sampling a. Statistical Sampling Statistical Sampling is the formal mathematical selection and examination of transactions, amounts or accounts based on the probability that moderately large number of items taken as samples will produce results, from which conclusion may be made. Statistical sampling techniques may include the following: a.1 Convenience sampling is a non-probability sampling technique where subjects are selected for convenience such as accessibility and proximity to the researcher. a.2 Random sampling is a popular probability sampling technique where each member of the population has an equal opportunity of being selected as subject. Subjects can be selected randomly with methods like lottery or computer-aided random selection. a.3 Systematic sampling is a technique where the RO first randomly picks the first item or subject from the population, then, he will select each nth subject from the list. CTIEac a.4 Stratified sampling is a probability sampling technique wherein the RO divides the population into different subgroups or strata; then he randomly selects the final subjects proportionally from the different subgroups or strata. b. Judgmental Sampling In selecting accounts and transactions to be tested, judgmental sampling should be applied as it involves the use of professional judgment in planning and performing the sampling and analyzing the results. Judgmental Sampling may include any or both of the following methods: b.1 Block sampling uses groups of continuous items selected from an account balance or class of transactions. An example is an RO's decision to sample one month of travel expense to reach a conclusion for the year. b.2 Peso limitation sampling or cut-off sampling selects a minimum peso amount and transactions in excess of the said amount are verified. 2. Factors to be considered in determining the sample size a. Internal Control The extent of sampling to be done is dependent on the degree of internal control. Thus, a small sample size is required if internal control can be greatly relied upon b. Accounting System Large errors or high frequency of errors in the accounting system may require a large sample size c. Materiality In choosing appropriate materiality thresholds, the absolute size of an item, the relative size and the nature of the business, and industry/business practice should be considered. Materiality of an item should be related to its tax consequence d. Analytical Review In analytical review, the following consideration should be studied: d.1 Taxpayer's standard of living; d.2 Interest in closely held companies; d.3 Transactions between related parties; d.4 Transactions involving questions of fraud; d.5 Significant increases or decreases in taxable income from year to year; and d.6 Significant adjustments on previous RO's reports. 3. Sampling Techniques to be applied in testing accounts and transactions There are many types of sampling techniques. The RO is not precluded from discovering and applying new techniques as may be necessary in each particular case. Listed below are the suggested sampling techniques in testing income statement and balance sheet items: a. Select the first and last months of sales to ensure that income was not deferred incorrectly to a different year. b. The last month of the period under examination should be tested because of the likelihood of errors and unallowable adjustments made before the end of the year. c. Selection of the largest three months' incurrence of an expense account may reveal expenses that should be capitalized, personal expenses or padded expenses. SaCIDT d. Scan the cash disbursements journal and general ledger for unusual or very large entries. This step also familiarizes the RO with the accounts payees, suppliers and clients of the taxpayer. e. Select at least one month's file of paid checks. Thoroughly analyze each check together with the endorsement at the back. This could lead to the discovery of fictitious payees, unusual transactions, personal items charged to expense and other possible disallowances. f. Inspection of the corporate minutes and the articles of incorporation could lead to an RO's determination to sample a particular account. g. Examine certain accounts in the income statement in relation to the balance sheet accounts. Thus, Accounts Receivable should be analyzed together with Sales. Bad Debts Expense should be verified together with the Allowance for Bad Debts. Likewise, Accounts Payable should be examined together with Purchases and other related expenses. h. Test check source documents and related transactions by considering the persons involved, nature of the contract, mode of payment and other important aspects. i. Rounded figures should be checked as they may be estimates. j. Utilize results of analytical review in selecting the sample. k. Limit the scope of the sample if the majority of the samples are so completed and there are still no discrepancies. 4. Examining the sample items The sample items, as selected, should be verified as follows: a. Analyze and determine the validity of the source documents. b. Examine all corroborating documents. c. Check with third parties. d. Inspect and observe inventory flow, fixed assets acquired, sales transaction and other transactions which may require ocular inspection. 5. Analyzing the Results Analyzing the result of a sample is an important yet commonly missed step. The sample taken should be evaluated and considered in relation to any peculiar situation, such as related-party transactions or economically unsound transactions. One example would be purchases made at unusually high or low prices. If the results of the sampling indicate potential tax assessment, an in-depth analysis should be conducted as follows: a. Verify the account showing the discrepancy or possible source of tax deficiency. b. Trace the audit trail involving the transaction. c. Perform a 100% verification of such account. d. Consider performing third-party checks to substantiate transactions. e. Take a close look at how the taxpayer handled the entire transaction. f. Consider the adjustments associated to other accounts. g. Discuss the problems or discrepancies with the taxpayer or his authorized representative. 6. Concluding the Sampling Results The audit samples should be clearly documented in working papers from which a conclusion shall be drawn. If a quality sample analysis has been performed, it will be easy to form a conclusion from the sample results. The conclusion reached should be clear, concise and final. cHECAS IX. BALANCE SHEET APPROACH TO EXAMINATION A series of suggestions on the procedures for commencing the examination of tax returns, as well as financial statements and appropriate accounting records, have already been presented. The initial phase includes a verification of the net income per books with the reconciling items reflected in the tax return. After the foregoing process, the RO should turn his attention primarily to the books and records, bearing in mind that there are some reconciling items which affect the net income per books. The following discussion offers guides and techniques in examining asset, liability and net worth accounts. The RO, however, is not precluded from applying other techniques which are deemed necessary in a particular case. A. Cash on Hand and in Bank 1. Compare deposits shown in the bank statement against entries in the cash receipts book and official receipts. Note down any unrecorded deposit and investigate the source. Also, review the bank reconciliation done by the company. 2. Test check cash sales with the cash receipts book if they have been correctly recorded. Also check cash sales made at the beginning and end of the period under examination to determine if year-end sales have been recorded in the proper accounting period. 3. Investigate other forms of sale using installment method and the like to check the accuracy of the tax treatment made by the company for such transactions. 4. Investigate entries in the general ledger cash account. Look for unusual items which do not originate from cash receipts or disbursements journals. These entries may indicate unauthorized withdrawals or expenditures, sales of capital assets, omitted sales, undisclosed bank accounts, etc. 5. Review cash receipts journal for items not identified with ordinary business sales, being alert to such items as sale of assets, miscellaneous income, sale of scrap, income received in advance, proceeds from issuance of capital stock and other taxable transactions. 6. Review cash on hand and cash in bank accounts to determine if there are any credit balances during the period under examination. The credit balances may indicate unrecorded receipts. 7. Review cash disbursements journal for a representative period. Note any missing check numbers, checks payable to cash, large or unusual items and determine propriety thereof through a comparison with vouchers, journal entries and other related accounting records. 8. If the taxpayer is on cash basis, ascertain if checks were written and recorded at the close of the period thereafter. Verify checks issued during the latter part of the year to check the authenticity of expenses claimed. 9. Give particular attention to checks issued for cashier's checks, sight drafts and other similar bank instruments where the payees and nature of the disbursement are already shown. 10. Obtain bank statements and paid checks for each bank account for one or more months, including the last month of the period under examination. 11. Note year-end bank overdrafts. These may indicate expenses which are fictitious or unallowable since funds were not available for payment. 12. Determine if there are checks which have remained outstanding for an unreasonable period of time. These may indicate improper, fictitious or duplication of disbursements. Old outstanding checks that are proven to be stale could possibly be restored to income. AHDacC 13. Determine whether voided checks have been properly adjusted in the books and credited to the appropriate expense accounts, if applicable. 14. For a test period, verify check endorsements to determine if they are the same as that of the payees' and if not, or in doubt, investigate further. 15. If records appear unreliable or have not been subjected to a competent independent audit, test of footings and postings should be made for a representative period. 16. Test check disbursements from petty cash to determine if there are any unallowable items included. 17. Scrutinize cash overages and shortages, being alert to occurrence of irregularities. 18. Tally debits and credits to the cash accounts per month against sales credit, debits to purchases and expense accounts and other sources and application of cash based on the worksheet of real and nominal accounts submitted by the taxpayer. Note down discrepancies and substantial accumulation of cash without reasonable credits. B. Notes and Accounts Receivable 1. Secure a breakdown of the receivables by class, whether notes or accounts and by debtors, such as customers, affiliated companies, officers, stockholders, employees and others. 2. Check entries in the general ledger control accounts. Look for unusual items, especially those which do not originate from the sales or cash receipts journals. 3. Determine if subsidiary ledgers are in agreement with control accounts, and if not, ascertain the reasons for any differences. 4. Compare the total of the period-end accounts receivable aging report to the total in the accounts receivable account in the general ledger. Investigate any discrepancies. 5. Note any credit balances in the general ledger or subsidiary accounts. These may indicate deposits or overpayments which could be considered as additional income or unrecorded sales. Also, credit balances may indicate a misapplied bad debt recovery or deposits received for so long a time that there is little likelihood that they will ever be refunded. Whatever the cause, the credits, if material, should be isolated for consideration. 6. Some credit sale invoices and postings should be test checked from the sales journal to the subsidiary and control account. 7. Compare balances of accounts receivable and sales for the current year with that of the preceding year. Investigate significant changes. 8. Investigate reconciling items and review justifications for the large and/or unusual balances and/or amounts classified as other accounts receivable. If justified, this should be fully documented. 9. In case of notes receivable, determine whether accrued income on interest bearing notes or accounts has been included in income. 10. Investigate the sources of notes receivable as there may be instances when the taxpayer has other sources of income other than his regular business. 11. Determine whether accrued income on interest bearing notes or accounts has been included in the income. IDSEAH 12. If needed, check the detailed listing of beginning receivables to cash collected as reflected in the cash receipts book. This may disclose diversion of funds and other irregularities. 13. If the company is using the direct write-off method in recording bad debts, there will be no account for "Allowance for Bad Debts." Thus, ascertain the reasonableness of the accounts written off in accordance with the Tax Code, as amended. Also, ensure its worthlessness by examining supporting documents. C. Allowance for Bad Debts 1. Ascertain the company's policy of providing allowance for bad debts by examining minutes of meetings and other documents. 2. Compare balances in the allowance account with that of the preceding years. Investigate significant changes. 3. Evaluate the reasonableness of the allowance by computing the ratio of the balance of allowance for bad debts to the trade accounts receivable balance. 4. Compute the ratio of bad debts expense over sales. Analyze if such is reasonable. 5. Compare prior estimates for bad debts with actual bad debt write-offs. For an accounting period, the ratio between the bad debt expenses to actual write-offs should be very close to one (1). Investigate if there is significant difference. 6. Analyze also the business exhaustion rate which is how long the beginning-of-year allowance will cover actual write-offs in order to know the sufficiency of the estimated allowance. If necessary, get the historical trend line of the exhaustion rate for the last three (3) years and investigate for any extraordinary rapid increase based on the said trend. 7. Review the aging schedule of accounts receivable to determine whether the allowance appears reasonable. 8. For accounts written off which were charged to expense, examine minute book for authorization to write off accounts. 9. Ascertain that accounts written off are worthless by examining supporting documents such as reports of collection agencies, correspondence with said customers, documents filed in court, and court decisions on collection cases. 10. If possible and necessary, check the financial status of the customers for which allowance for bad debts was provided. 11. Check entries to the allowance account for possible bad debts recoveries and trace if the same were declared as income at the time of recovery. D. Inventories 1. Determine the correct cost components to be included in the inventory. The costs used in determining inventory depend on whether the business is of a service, merchandising or manufacturing nature. Consigned goods should be segregated. 2. Test for lower of cost or net realizable value. 3. Review taxpayer's plan for performing inventory count. 4. Verify the inventory valuation method being applied if such is acceptable for tax purposes and consistently applied from year to year. 5. Compare inventory balances in the return under examination with the balances on the prior and subsequent year's returns and financial statement; then verify these with the taxpayer's records. 6. Check BIR authorization for changes in inventory valuation method and verify taxpayer's compliance with the requirements set forth under existing rules and regulations. 7. If necessary and possible, obtain the inventory count and reconcile the value to the general ledger balance. aCIHcD 8. If applicable, verify the shipment policies for receiving and delivering goods and supplies and test the last few receiving and shipping transactions prior to the physical count, as well as transactions immediately following it, to ascertain proper accounting for such transactions. Moreover, determine if year-end purchases were included in the closing inventory. 9. Check gross profit percentage variations. Conduct in-depth verification of items with substantial variations. 10. Determine the significance of any notes or qualifying statements on financial reports prepared by independent accounting firms. 11. Determine the taxpayer's computation of standard rates, if standard rates are applied. 12. Verify cost of production reports and test check certain costs reflected therein to supporting documents. 13. Analyze unusual entries to cost of sales account such as materials, labor and overhead charges not directly related to sales or transfers of finished goods, if applicable. 14. Determine if there have been write-downs for "excess" inventory to below cost. Verify authorization and supporting document/report for such write-downs. 15. Check the treatment for reversal of any write-down of inventories. 16. When items have been removed from inventory for the owners' or shareholders' use, check if these are properly recorded as part of sales. 17. These required minimum audit procedures, however, should not deter the RO from making a more detailed examination of the inventory account, when necessary. 18. Review freight costs. Ascertain that there should be a consistent treatment for freight in the books. 19. Ascertain if inventory losses claimed as tax deduction meets any of the following: AHCETa a. Losses from the sale of excess or obsolete raw materials; b. Losses from production of initial batches of new products; or c. Production losses from reprocessing of stocks returned for reconditioning. 20. All write-offs of inventories must be supported by a BIR Certificate of Destruction in order to be tax deductible. E. Advances to Stockholders/Officers This receivable account may represent an outright advance of money by the corporation to officers and/or stockholders. Usually, these advances vary in amounts over a period of time, consequently, building up the current amount. The following verification procedures on this account should be conducted, if warranted: 1. Verify authorization from Board of Directors for advances and loans to stockholders and officers by checking duly approved minutes of meetings. 2. Identify company officers and stockholders who are granted advances regularly. 3. Determine authenticity of advances and/or loans by verifying documents of the agreement or contract. 4. Check payments of advances to the company if such loan repayments earned interest for which no withholding tax was deducted. 5. Verify entries and supporting documents on cancellation of advances if the same do not originate from cash receipts. F. Investment The investments most commonly found on the books are stocks and bonds and, in some cases, real estate not used in actual business operations. The following procedures should be conducted in the examination of investments, if such are material assets of the taxpayer: 1. Familiarize with the nature of investments, utilizing any records maintained by the taxpayers such as the investment ledgers, worksheets showing the breakdown of investments and other investment records. 2. Analyze sales and other credit entries to the account. If stocks sold are listed in the stock market, test check selling price of stocks sold at the prevailing "close" price at the Philippine Stock Exchange during the date of the sale. Real properties sold should not fall below fair market value and/or zonal value where the zonal value has been established. The application of the "whichever is higher" rule shall be observed. 3. Verify cost and fair market value of the investment transactions from the monthly broker's statement, if there is any. 4. Verify journal entries to ascertain the selling price and gain on sale of investments. Vouch supporting documents such as deeds of sale, proof of remittance of taxes withheld, payment of documentary stamp tax and other relevant records. 5. Investigate sales to related parties and/or officers or stockholders below fair market value. 6. Cross-check all investments during the year to the interest, dividend or rental income accounts. 7. If investments or bonds were acquired at a premium or at a discount, determine whether the premium/discount is amortized over the life of the bond. 8. Ascertain if unrealized and realized gains and/or losses are recorded properly in the books. 9. Determine if investments are properly recognized and classified in their right accounts. G. Depreciable Assets This group includes tangible properties of relatively long life which are used in the operation of the business. However, natural resources such as oil or mineral lands are not included in this group of asset account. The following verification procedures should be undertaken on these accounts: 1. Check the appropriateness of the costs recognized in the initial measurement of the asset. Validate if there are costs included in the initial recognition which should not be allowed. 2. Compare the asset and related reserve amounts as they appear on the tax return, balance sheet, depreciation schedule, and taxpayer's books and other schedules. Compare the beginning and ending figures for the taxable year and reconcile differences or ask the taxpayer to make the necessary reconciliation. Verify the correctness of such reconciliation. 3. Review depreciation schedule of fixed assets and ascertain propriety of depreciation expense claimed. Watch out for depreciation that may have been taken on assets which are already fully depreciated or charged off to expense. 4. Review asset additions during the year by reference to invoices, contracts and other documents and determine if the proper cost basis was used. a. Note items which appear to have originated from unusual sources such as appraisal increases, transfers and exchanges, and determine propriety thereof. Ascertain if prior earnings were adequate to cover acquisitions. DACcIH b. Determine if acquisition and installation costs of fixed costs of fixed assets and leasehold improvements have been capitalized. c. Ascertain if assets include items of a personal nature. If the assets are used by the officers for their personal use, the depreciation should be disallowed. d. Where construction or any other work of a capital nature is performed with the taxpayer's own labor, equipment and other assets for its own use, be certain that the basis of such asset includes materials, labor and overhead including depreciation. e. With regard to the basis of recognition of costs of assets, consider such items as trade-ins, acquisitions from related taxpayers, allocation of cost between land and building and other basis. f. Determine if increases in assets used in operation resulted to increased production and/or revenue. 5. Note decrease in the asset accounts during the year. The accuracy of the gains or losses resulting therefrom should be verified and ascertained that the appropriate tax on the transaction such as value-added tax, if applicable, has been paid. 6. On sale of real properties and/or other material disposition of asset, verify the actual amount of consideration received and determine any undeclared proceeds of sale and any tax ( e.g. , CGT, EWT) shouldered by the buyer which should form part of the selling price. 7. Ascertain if the taxpayer has transferred assets to the owner, officers and stockholders or to a controlled domestic or foreign corporation for less than fair or adequate consideration. 8. Check the terms of the lease agreement particularly on who shall shoulder the repairs and maintenance costs as well as leasehold improvements. 9. Investigate if there are other affiliated companies who share in the usage of the leased property and estimate the allocable rent expense should have been charged to the affiliated companies. H. Allowances for Depreciation, Amortization and Other Valuation Reserves 1. Review the nature and source of all accounts and ascertain if they are being used to claim unallowable deductions. 2. With regard to depreciation, determine the correctness of the amount of asset being depreciated. No depreciation is allowable on the appraisal increase of fixed assets. Any foreseeable salvage value is to be deducted from the cost of the asset in determining the basis of depreciation. a. No depreciation is allowable on a building until it is completed or on a machine until it is installed. Expenditures which are properly includible as an element of cost are freight-in, installation cost, title cost, and legal or brokerage fees in connection with acquisition. b. Where land and building are acquired on lump sum, the following formula should be used in computing the building cost for depreciation computation: HSCATc FMV or Zonal Value of land FMV or Zonal Value of Land and Building x Total acquisition cost = COST OF LAND Total acquisition cost (land and building) XXX Less: Cost of land per above computation XXX COST OF BUILDING XXX ===== 3. Ascertain the taxpayer's depreciation and amortization policies and consider the following: a. Whether the methods applied by the taxpayer are in compliance with the Tax Code, as amended, and existing revenue regulations; b. Whether the depreciation rates used by the taxpayer are fair and reasonable; and c. Whether the taxpayer has applied the same method consistently from period to period. 4. Check authorization from minutes of meetings, fixed asset reports, or other supporting documents on credits for allowance for obsolescence and/or asset write-offs. If necessary, inspect assets claimed as obsolete and/or written off. 5. If revaluation method is used for subsequent measurement, ascertain the accuracy of the revaluation made and cross-check to the revaluation surplus in the equity account or expense, whichever is applicable. I. Intangible Assets 1. Investigate the nature of the intangible assets whether leases, patents, licenses, trademarks, goodwill, copyright, franchise and others. 2. Cost of acquiring the intangible should be capitalized when useful lives can be estimated. If not, no amortization is allowable for tax purposes. 3. Determine if the recorded cost and cost of current additions includes proper elements such as legal fees, application fees and other costs of acquisition. Examine contracts and other legal documents. 4. Verify correctness of deductions claimed as amortization of intangible assets as follows: a. Leasehold costs are subject to amortization over the term of the lease. b. Goodwill cannot be amortized if it is for an indefinite period of time. c. Research and Development expenditures may either be capitalized or treated as outright deductible expense. d. Patents sold with the exclusive right to make, use and sell an article constitute ordinary income. e. Organization expenses are subject to amortization and are not deductible in full on the year incurred. Check the reasonableness of the taxpayer's amortization policy on organization expense. 5. Determine if there have been transactions with related taxpayers. If so, verify if these are made at arms-length. 6. Determine if income applicable to intangibles has been included as income ( e.g. , subleases, overriding royalties, franchise and other sources). 7. Analyze any transaction involving transfer of foreign rights to any foreign entity for an equity interest or for nominal consideration. 8. Be alert to transactions which could have given rise to intangibles classifiable as asset account which may have been recorded as expense. IDTSEH 9. Test the details associated with valuation and impairment of intangible asset. J. Prepaid Expenses and Deferred Charges 1. Verify the nature and source of these assets and the manner in which they are charge off to expense. 2. When prepaid expenses are not reflected in the balance sheet, verify charges to expenses which entail advance payments such as insurance, rent, supplies, repairs and maintenance that are covered by contracts. K. Other Assets 1. Obtain a schedule of other assets account when material in amount. 2. Investigate sources of charges to the account. Verify entries and supporting documents to check if the other assets are results of income-generating activities not reported in the financial statements. L. Exchange, Clearing or Suspense Account 1. Obtain a schedule to determine the nature and purpose of the account if significant in amount. 2. Test check debit and credit entries, being aware of the possibility that such account may be used as a means for diverting sales, padding expenses, and concealing other irregularities. M. Current and Accrued Liabilities including Notes Payable These liabilities are found on business records under various titles such as accounts payable, vouchers payable, notes payable, accrued expenses and other current liabilities. The audit procedures are as follows: 1. Reconcile subsidiary ledgers with the control accounts. Request the taxpayer for explanation of any discrepancies noted. 2. Note existence of debit balances in the general ledger or subsidiary accounts. This may indicate diversion of funds and other underdeclaration of income. DaIAcC 3. Note accounts which have long overdue balances. These may indicate contested liabilities or accounts that no longer exist such as unclaimed wages or unclaimed deposits which should be reverted to income. 4. Review computation of year-end accruals with respect to their deductibility as expenses or purchases. 5. Examine legitimacy of accounts payable to affiliates or related taxpayers. Test check payments made by tracing the same to supporting documents. 6. Investigate entries in the general ledger control accounts. Check unusual items such as those that do not originate from the voucher register or disbursement book. This may disclose unreported income, improper claim or overstated expense. 7. Be aware of any contingent liability by reviewing minutes of meetings and annual reports. Although this is not reflected in the tax return, an accrual may have been made for the item. Any claim for an expense or deduction arising from a contingent transaction shall not be considered as a deductible expense. A deductible expense must be reasonably determinable in amount and the liability must be fixed. 8. If payables include liability on security deposits, secure a copy of the lease contract/agreement to determine provision on the application of lease deposits. These security deposits are taxable when received. 9. For payroll, perform the following: a. Observe payroll distributions; b. Examine payroll disbursements subsequent to year-end and compare with accrued payroll at the balance sheet date; c. Scrutinize the payroll registers for unusual items such as names of former employees, duplicate names and addresses, unusual pay rates, unusual number of hours and unusual bonuses and allowances; and d. Observe benefits that may be treated as "Fringe benefits expense." N. Fixed Liabilities 1. Review the Board of Directors' Minutes of the Meeting regarding whether new loan agreements or bond issuances are authorized. 2. Acquaint with the pertinent provisions of loan contracts, mortgage agreements, certificates of indebtedness, financing arrangements and consider possible adjustment areas as follows: a. Determination of expenses ( e.g. , interest and bank charges); b. Refunding of debt; and c. Legal, professional and other expense of issuance. Also, note the principal, rate and length for loans to make sure the balance sheet shows the correct outstanding balance for each loan. 3. Scrutinize any long term outstanding liability to the owner, shareholders and officers or to a related taxpayer as this may constitute accumulated unreported income. 4. Examine and trace any large cash disbursements made. 5. When the liability is secured by property pledged or mortgaged as collateral for the loan, determine if the property pledged/mortgaged is income producing. Review the terms and conditions stipulated on the loan agreement to determine if income derived therefrom remains to be reported by the taxpayer as the borrower. 6. Verify if funds were borrowed for use of affiliates as the interest expenses thereon shall not be deductible on the part of the borrowing taxpayer. There should be a reallocation of profits and the tax burden must be shifted to the affiliate in accordance with existing rules and regulations. 7. Determine whether the indebtedness will give rise to interest expense that is subject to limitations on deductibility under Section 34 (B) of the Tax Code, as amended. Determine if the loans were borrowed to finance acquisition of tax-exempt securities. If so, interest expense is not considered deductible for income tax purposes. TAacHE O. Deferred Credits 1. Check all payments received as recorded in the cash receipts books ( i.e. , date of receipt, source of collection and other entries) 2. Check if collections were included in the gross income during the year when the payments were actually received. Amounts are generally includible in gross income for tax purposes not later than the time of receipt if they are subject to free and unrestricted use by the taxpayer. Under this theory, collections, advance rentals, legal retainer and the like, advance sales of transportations tokens or communications tickets and other advances are income when received. 3. Look for credit balance of accounts which fall under deferred credits. They may be clearly labeled as advanced rentals, deferred service income or may be shown as a reserve account that is mixed with true liability accounts, or as a contra-balance in the receivables. 4. If the taxpayer used the completed contract method of accounting for contracts entered into and construction work that actually commenced prior to January 1, 1998, income and expenses attributable to a particular job or project are properly deferred until completion of the project. The contracts and progress reports should be inspected to determine whether the reporting of income has been delayed beyond the completion of the project. 5. When a taxpayer uses the installment method of reporting income, the unrecognized gain for tax purposes should be recorded as a deferred credit. This particular account should be checked to determine if the year-end balance remaining in the account reconciles with gross profit to be reported on the subsequent payments. Any difference would indicate erroneous computations of income from payments. 6. Obtain an understanding of the nature of the deferred income and other deferred credits' account, if material to overall financial statements, by conducting the following procedures: a. Test computations of the current year activity by examining supporting documents; b. Determine if the method of amortization is consistent with the prior year; and c. Determine if the deferred credit balance at the balance sheet date is reasonable. P. Loans from Shareholders/Officers/Owners 1. Determine whether there is a true debtor-creditor relationship. Excessively large liabilities in relation to capital stock (especially in the case of a new company) may indicate a thin capitalization situation. 2. Check the financial statements of the corporation as well as that of the shareholders. If there is an interest expense account on the part of the corporation from such loan, there should also be a corresponding interest income account on the part of the shareholder. There are certain tax advantages to the corporation or shareholder for an equity investment to be treated as a loan. Be sure that the taxpayer gets these benefits only when the facts of the case show that a "true loan" exists. If "loans" are found to be equity capital, the following procedures may be applied: a. Disallow claim for interest expense and treat payments during the year as dividends. b. Treat loan repayments as dividends. c. Disallow bad debts deductions by the shareholders. 3. Check supporting loan documents issued in favor of the shareholders, officers or owners. If unsupported or if support is doubtful, the unreported income may have been lodged in this account. 4. Verify certain payments of loans against check vouchers and cancelled checks. HDICSa 5. Verify the debit and credit entries in the general ledger account and watch out for unusual sources other than the cash receipts and disbursement book. 6. Examine adjustments, especially increases in the account, at the end of the year as this may constitute shifting of taxable income to this liability account. Verify journal entries, journal vouchers and related documents supporting the entries. Q. Capital Accounts 1. Capital or Owner's Equity for sole proprietorship a. Reconcile amount appearing on the books, tax return and financial statements. Verify discrepancies, if any. b. Review debits and credits to the account during the period under audit and check supporting entries to the account. Increases which originate from sources other than profit and loss may indicate omitted income. c. Relate the account balance and withdrawals with the owner's standard of living. Where owners report no other sources of income, and withdrawals appear insufficient to maintain personal living expenses, there may be underreporting or diversion of income. 2. Partners' Capital for Partnerships a. Review debits and credits to the account during the period under audit. Verify increases and decreases and check for unusual sources other than profit and loss. b. Reconcile amount appearing on the tax return, books and financial statements. Verify any differences noted. c. Examine pertinent provisions of partnership contract and check correctness of distribution of partnership income and expenses. d. Ascertain that the correct tax has been withheld on distribution of partnership profits. e. If the taxpayer claims that it is a general professional partnership, examine partnership contract and registration with the Securities and Exchange Commission. 3. Stockholders' Equity for Corporations a. Capital Stock a.1 Review entries in the capital stock account and verify increases and decreases thereto. Also, examine by-laws, articles of incorporation or other documents, such as benefit plan documentation, stock register and stock certificate book, in support of other transactions affecting capital stock. a.2 Examine stock register to gather information on the identity of shareholders, their contact information and the amount of shares each shareholder owns. a.3 Verify correctness of all items appearing on the return, books and financial statements. Investigate discrepancies, if any. In the process of verification: a.3.1 Make sure any unissued stock certificates per stock register are present and accounted for in the stock certificate book which should contain all unissued and cancelled stock certificates; a.3.2 Trace shares of stock issued per stock register to the stock certificate book; and a.3.3 Compare the number of shares issued to that reflected in the financial statements. IDaEHC a.4 Reconcile control account balance with subsidiary information on shareholders' capital in the stock register and transfer book and other related records. a.5 In case of additions to capital stock out of new issuance during the period under audit, ascertain that the correct amount of documentary stamp tax has been paid. Secure a photocopy of the proof of payment. a.6 Compare data from minute book and other records mentioned above with items recorded on the books of accounts to determine if entries have been made. a.7 Check the existence and valuation of treasury account by performing the following procedures: a.7.1 Check the minutes of the Board of Directors meeting if there is authorization to purchase the company's own stock; a.7.2 Check whether the company uses par-value method or cost method in accounting for purchase and resale of treasury stocks since it is significant in the valuation of the treasury stock as a reduction to stockholder's equity; a.7.3 Examine if the company has recognized any gains and/or losses in treasury stock transactions since per generally accepted accounting principles, recording any gains and/or losses on the said transactions is not appropriate; and a.7.4 To verify the existence of repurchased shares, check surrendered stock certificates which may be defaced by the company thru punched holes in the certificate, stamped "cancelled" or drawn with a big X across the certificate. a.8 Determine if expenses relating to stock issuance ( i.e. , legal fees, registration fees, broker's commission and other expenses) have been properly handled, recorded and reflected in the financial statements as well as in the tax returns. a.9 Determine during the examination of a recapitalization of the stock in a closely held company, if the fair market value of the stock or bond to be received by each exchanging stockholder is equal to the fair market value of the stock surrendered in the exchange. If there is a significant difference, consider the possibility of treating the difference as a donation subject to donor's tax to the corporation or to the stockholder, whoever received the lesser value. a.10 If a reorganization has taken place, examine the following documents: a.10.1 The reorganization plan; a.10.2 Journal entries giving effect to direct reorganization; DTCSHA a.10.3 Notes of all minute book referring to the transaction; and a.10.4 Notes of pertinent information from the correspondence file with other parties to the reorganization. a.11 Determine if the increase in capital stock is the direct consequence of an exchange of property under Section 40 (C) (2) of the Tax Code, as amended. If so, confirm compliance with the conditions set for the non-recognition of gain or loss by performing the following audit procedures: a.11.1 In case of merger or consolidation i. Verify if the plan of reorganization has been adopted by each of the parties to the reorganization. ii. Check if the income tax return filed for the taxable year in which the exchange took place incorporated all facts pertinent to the non-recognition of gain or loss upon such exchange, such as: o The historical cost or other basis of valuation of all properties, including all stocks or securities transferred incident to the plan; and o The nature and amount of liability assumed upon the exchange and the amount and nature of any liabilities to which any of the property acquired in the exchange is subject. iii. Verify Deed of Assignment of property for share of stocks; and iv. Check if the required documentary stamp tax has been paid. a.11.2 In case of transfer of property to a controlled corporation i. Verify if the transferor and the transferee filed an income tax return for the taxable year in which the exchange was consummated with a complete statement of all facts pertinent to the exchange. ii. Verify Deed of Assignment of the property. iii. Determine if transferor of the property gains control of said corporation, alone or together with others, not exceeding four (4) persons, pursuant to Section 40 (C) (2) of the NIRC. iv. Determine if the documentary stamp tax was paid. a.11.3 In both cases, ascertain if the following information have been annotated at the back of the Transfer Certificates of Title or certificates of stock: CScTED i. Date of execution of the deed of exchange; ii. The original or historical cost of property; and iii. The fact that no gain or loss was recognized as a result of such exchange. a.11.4 Retained Earnings The investigation of the retained earnings (or deficit, in case of accumulated losses) is a very important part of the audit process as this is related to the net worth method of investigation. It is the account to which the net income or net loss from operations is transferred and accumulated into. The minimum audit procedures that should be undertaken in analyzing this account are as follows: i. Compare the amount of earnings retained in the business as shown on the return, financial statements, books of accounts and the schedule of reconciliation of net income per books and per return. Verify differences, if any. ii. Verify correctness of all items, both increases and decreases, appearing on the books, financial statements or return. Trace beginning balance of retained earnings to the ending balance appearing in the balance sheet of the prior period. If possible, get a schedule or a reconciliation showing the changes from the beginning to ending retained earnings for the year under audit. iii. Check increases which do not originate from net income. Verify entries from the general journal/journal vouchers, especially those recorded other than as year-end adjustments as these may indicate sales or income directly posted to the retained earnings account. iv. Determine if declared and unpaid dividends are properly recorded. Compare paid dividends to the minutes of the Board of Directors meeting(s). v. Verify cash or stock dividends as well as any other type of dividends as to its existence as well as its proper recording in the books and imposition of withholding tax. vi. For taxpayer incurring continuous losses and deficit balance, investigate the real status of the business. Tour company premises, evaluate the volume of business, and compare the information gathered from external sources with the financial data reported. There may be underreporting of sales as there is very little reason for a business to exist if it is continuously incurring losses. vii. Examine supporting documents and authorization for all other debit and credit transactions in retained earnings to determine conformity with existing laws and regulations. viii. Examine documents relating to appropriations of retained earnings. Trace it to retained earnings account. ix. Investigate and confirm if prior-period adjustments are indeed errors that can be corrected by making an adjustment to retained earnings. Compute any effect of taxable income and corresponding taxes. x. Investigate a possible imposition of Improperly Accumulated Earnings Tax (IAET) by performing the following audit procedures: o Make sure that the company is not one of the following: Publicly-held corporations; Banks and other non-bank financial intermediaries; Insurance companies; Taxable partnerships; General professional partnerships; Tax-exempt joint ventures; Economic zones under special tax rate; and ISHaCD Philippine branch of a multinational company. The above mentioned corporations and/or partnerships are exempted from the imposition of 10% IAET. o Examine if the Retained Earnings account is more than 100% of its paid-up capitalization. However, do not include the additional paid-in capital as part of the paid-up capitalization in determining what is considered as unjustifiable accumulation of earnings beyond the reasonable needs of the business. o Inspect Board of Directors Minute Book to prove appropriations for future use in retained earnings account. X. AUDIT OF INCOME AND EXPENSES This chapter discusses the books of accounts, accounting records and documents used to record income and expense transactions. It enumerates the audit procedures and techniques for income and expenses. The audit of income or revenues is applicable to resident and non-resident individuals engaged in business and the practice of profession, estates and trusts engaged in trade or business, general professional and business partnerships and corporations. Expenses chargeable against income are allowable in their entirety only for business partnerships and corporations. Self-employed resident citizens and aliens engaged in business or the practice of profession, non-resident aliens engaged in business, estates and trusts engaged in trade or business and general professional partnerships as defined under Section 22 (B) of the Tax Code and their individual partners can claim expenses subject to the provisions of Section 34 of the Tax Code. The subsequent discussions on the procedures and techniques in the investigation of income and expense accounts are general audit guidelines. The RO should not be hindered in applying additional procedures and techniques, which he deems necessary, based on his initial findings, evaluation of internal control, reliability of accounting records, and analytical review of operations. A. Audit of Income Accounts 1. Sales a. Review the taxpayer's accounting method of revenue recognition if the same is acceptable and consistent with prior years. b. Determine if sales are properly recorded by checking the Cash Deposit Report (CDR). Check the date; compare the gross total of CDR against the gross total generated by the Point-of-Sale (POS) system. Verify footings. c. Determine if cash sales are deposited the next banking day based on deposit slip's validation and compare against the entries made per CDR. d. Ascertain that all sales were reported as of the cut-off date. Cut-off refers to the point at which entries from one accounting period stops and entries for the next period begin. This is usually the last day of a taxable year. If the last day of the taxable year is not used, the cut-off date must be the last day of the taxpayer's fiscal period. cDTACE e. Verify revenues/sales recorded and deposited near the end of the taxable year and immediately during the subsequent month to determine if these pertain to income earned for the taxable year under examination. f. Account for all sales invoices/official receipts issued. Check if there is any gap in the series used for the period. It is to be noted that cancelled invoices must also be presented to be proven cancelled. Match delivery receipts, gate passes, if any, against sales invoices issued. g. Review purchase orders, customer orders or bill of ladings to reconcile them with the sales invoices issued. Investigate discrepancies to uncover fraud and theft. h. Trace from shipping document entries to sales journal to reveal shipped items without sales recorded. i. Compute totals of sales invoices/official receipts, sales summary, entries in subsidiary sales journals and general ledger accounts. Inquire and investigate discrepancies between book entries and returns filed. j. Reconcile credits to sales with debits to accounts receivable and debit to cash receipts book. Test and check monthly entries. k. Research unusual and unfamiliar issuances of goods or goods which are not normally sold by the taxpayer. l. Conduct interviews to secure information regarding the taxpayer's business, financial history, number of employees and other information which may lead to sales information. m. Determine inventory method applied if acceptable and consistently followed. n. Determine if merchandise is being withdrawn for personal use or for any other purpose not in relation to normal sales process. o. Scan credit memo issued to customers and test check entries to Sales Returns & Allowances and Sales Discounts to ensure proper recording of credits. p. Verify, cancelled sales invoices by test checking deposits made and withdrawal of goods on the day of cancellation. q. Tour the business premises to obtain information on: q.1 sales volume; q.2 volume of sales return and method of handling sales returns; q.3 major products; q.4 other by-products and scrap sales, if any; q.5 equipment used in operation; cCHITA q.6 nature, quality and size of facilities; and q.7 inventory level. In touring the premises, be observant and ask questions that will disclose significant facts and information relative to the taxpayer's business operations. r. Review sales contracts, consignment agreements and other documents relative to sales. s. On installment sales, ascertain that collections have been properly segregated as to the year of sales and that the proper gross profit ratios have been applied. Review unearned or deferred income accounts for any uncollected balances which have been outstanding for an unreasonable period of time. t. Determine whether sales on consigned goods are taken up at the time of shipment or after sixty (60) days from the date goods were consigned. u. Where the internal control is weak and records are unreliable or inadequate, apply other approaches to audit revenue such as cash analysis, net worth analysis, third party verification, and other indirect approaches investigation. 2. Rent Income a. Obtain and review copies of lease contracts/agreements. b. Conduct ocular inspection of the premises under lease. Identify tenants and monthly or annual rentals. Conduct interview, if necessary. c. Relate real properties under lease agreement to assets declared in the balance sheet. Note inconsistencies between asset values and income generated. DETACa d. Where the rental income is based on a percentage of sales of the lessee, the sales of the lessee should be tested for a representative period, say one month, to get a proper approximation of the lessee's sales during the taxable year under audit and the rental income received by the lessor. In such cases, proper authorization from the lessee should be obtained before conducting the test verification. e. Obtain information on rental of neighboring properties and compare with rent income reported. f. Examine official receipts issued. Compare total collections per official receipts with entries in the cash receipts book and general ledger. Investigate discrepancies. g. Ascertain acceptability and consistency of accounting methods used. For cash-basis taxpayers, prepaid rent and rental deposits constitute income during the year of receipt. h. Take note of lease contracts which are actually conditional sales. i. When necessary, obtain copies of Transfer Certificates of Title, tax declarations, mayor's or municipal permits, and real property tax receipts to determine properties which may be undisclosed/unrecorded by the taxpayer. 3. Professional Fees a. Determine the taxpayer's accounting method of recognizing income, whether cash or accrual. Most professionals, however, adopt the cash basis of accounting. b. Examine contracts with clients and other correspondence/documents (logbooks, etc.) in relation to professional services rendered. c. Compare income reported on the tax return with the books of accounts, creditable withholding tax forms, financial statements and official receipts issued. Verify discrepancies, noted, if any. d. Account for official receipts issued. Note any missing receipt or break in the series and investigate the reasons therefore. If taxpayer claims it to be cancelled, request for the physical document. e. Analyze the reasonableness of expenses claimed in relation to income declared. f. Analyze the increase/decrease ratio of the sales for the year from previous year. g. Conduct interviews and third party verification, if necessary. h. Relate the income reported per tax return to the lifestyle and assets of the taxpayer. If the taxpayer's assets and estimated costs of living expenses are beyond the income earned, verify and compute for possible underdeclaration of income by using the net worth method of investigation. 4. Income from Sale of Asset a. Identify in the tax returns and financial statements any sale, exchange or disposal of assets other than inventories or stocks in trade. Sale or disposal can usually be assumed when there is a "Gain/loss on sale of property" or "Proceeds from sale of property" in the Statement of Cash Flows or in the Notes to Financial Statement. TaDCEc b. Obtain copies of deeds of sale and other documents relating to the sale, if there is any. c. Determine zonal values, fair market values or appraisal values and compare with the actual selling price. d. Compute any underdeclaration of sales by comparing the selling price with the existing fair market value, zonal value or value of similar properties sold. e. In case of disposal of capital assets, ascertain compliance with the provision of the Tax Code, as amended, on capital gains and losses. f. Verify sales of property reported on the installment basis and determine if all requirements pertaining thereto have been complied with. g. Determine if proper accounting for depreciation, book value and salvage value was correctly taken up. h. Inquire from certain company personnel on possible sales of assets which may not have been recorded in the books of accounts. i. If possible, tour the premises where properties and equipment are kept and inspect if there are properties still recognized as asset but are not physically in the location, which could signify disposal. 5. Other Income a. If not enumerated in the Notes to Financial Statements, request for a breakdown of the "Other Income." b. Scrutinize the entries in the general ledger and general journal for any other income or other receivables recorded thereto. c. Test check entries in inter-company accounts to determine whether shifting of income or management fees may have been made and charged to affiliates. d. Investigate suspense accounts and unusual liability accounts, such as due to affiliates/due to stockholders and other payables to uncover possible income not recorded in the income accounts. e. Clarify the nature of unusual items reported as Other Income. f. If there are investments, obtain a list of investments made by the company and test-check if the income on the said investments are verified and accrued on a timely basis. g. Test accrued interest and interests earned during the period on receivables and determine whether interest should be imputed on long-term receivables arising during the period. B. Audit of Expense Accounts 1. Purchases For taxpayers engaged in trading and manufacturing businesses, the purchase account is one of the largest accounts in the income statement. Thus, there is a possibility that taxpayers may hide a number of non-deductible expenditures in this account due to the volume of transactions posted to it. cDEHIC The following audit procedures should be followed in examining purchases: a. Account for all purchase invoices and receiving reports as of the cut-off date. Determine if year-end purchases have been recorded in the proper accounting period. b. Review purchase orders and match it to the invoices. Reconcile any discrepancies. c. Compare totals or purchases in the return, income statement, purchase book, subsidiary purchases book, if any, and general ledger. Determine any discrepancy and investigate its nature as well as the nature of year-end adjustments. d. Determine that the purchases declared are neither overstated nor understated by vouching the supporting documents, and test checking the footings of invoices, purchase books and ledger accounts. Understatement of purchases may also mean under declared sales. e. Upon vouching, check for purchases of items not related to the product manufactured as it may only be lodged in the purchase account. f. Tour the premises where inventory items are kept and correlate actual inventory level against purchases reported. Test check stock cards of major inventory items to evaluate accuracy of inventory reports. g. Scan the purchases book for possible unusual payees or unusual amount of purchases. Take note of suppliers not generally associated with the products or services handled by the taxpayer. h. Verify entries in the general ledger account which originate from unusual sources such as journal entries, debit and credit memoranda and other accounting records. i. Test check recorded purchases for a representative period with suppliers' invoices and cancelled checks. For efficiency, it may be best to vouch big ticket suppliers for it can represent the bulk purchase. Note if there are personal expenditures, withdrawals of merchandise by the owners, fictitious or duplicate invoices, cancelled purchase invoices, excessive rebates, discounts and allowances and purchases not received. j. Where there are only a few major suppliers, conduct third party verification to ascertain the correctness of purchases declared, if there is suspicion of fraud or if the RO believes that this is necessary. ISCDEA k. Obtain pre-processed data, such as the Summary Lists of Purchases and Importations by the taxpayer under audit and the Summary of Sales by the taxpayer's supplier and verify if the reported purchases of the taxpayer under audit match with those declared in the summary lists. In case of discrepancies, investigate secondary evidence such as paid checks, check vouchers or bank debit advice to prove payment for purchases. l. If purchases are from suppliers related to the owners or from affiliates, conduct a review of a number of transactions to uncover prices in excess of market value, excessive rebates and allowances, and other similar schemes. m. Identify variations in rates of items purchased over a period of time. Any rate variation must be properly justified. 2. Cost of Goods Sold a. Verify the inventory valuation method applied by the taxpayer whether first-in, first-out (FIFO), specific identification, weighted average or simple average. Last-in, first-out is not acceptable for income tax purposes. Determine consistency of application of the acceptable valuation method from year to year. b. Obtain an understanding of the production process thru familiarization with the taxpayer's business, tour of the premises, conducting interviews, and analyzing cost of production reports. c. Compare inventory balances in the return under examination with the balances for the prior and subsequent years' returns, and reconcile these with the general ledger and the physical inventory summary. d. Check unauthorized changes in inventory valuation method from period to period. Conduct test checking of inventory valuation of sample inventory items from the summary inventory sheets and determine if the taxpayer has not improperly valued any inventory item. e. Check gross profit variations. Any significant variation should be discussed with the taxpayer and a reasonable explanation in writing should be obtained. A material decrease in gross profit from one year to the next could be due to understated ending inventory. f. Determine the significance of notes or qualifying statements on financial reports prepared by external auditors. Any unusual comments or qualifying statements about the inventories or cost of sales that have a material tax effect should be discussed with the taxpayer and, if necessary, with a representative of the external auditor. g. If the taxpayer applies standard or predetermined cost in costing goods manufactured, inspect the working papers and production report used to calculate the cost per unit and ensure that expenses included are allowable. h. Analyze unusual entries to cost of sales. Account for labor, materials and overhead charges not directly related to sales or transfers of finished goods. Be alert on the possibility that the taxpayer may be trying to include a non-deductible item in the cost of sales account. i. Determine whether year-end purchases are included in closing inventory. Review purchase invoices at the last month of the taxable year under audit. Compare quantities on the inventory summary for classes of goods purchased with the quantity in the ending inventory list and quantity of sales recorded at year-end for such goods. Thus, if a specific item or a certain quantity of goods were purchased on the last day of the year, it should be included in the ending inventory unless sold that same day. EDCTIa j. Determine reductions in ending inventory values by reviewing authorization for write-downs and provision for obsolescence or decline in market values as well as theft and/or spoilage. Check minutes of meetings for such authorization. Analyze journal entries for the write-down or provision of allowance for obsolescence/decline in value. Check itemized inventory summary sheet and test-check the list with actual physical inventory. k. Review for gross profit variations. Compare and apply analytics to see if there are any significant variations either overall or by product line with prior and subsequent years. 3. Salaries, Wages and Other Employees' Benefits a. Evaluate the expense initially by comparing the ratio of salaries and wages to sales and the percentage of taxes withheld to total salaries, allowances, bonuses and other compensation. Low ratios might indicate that the company hires sub-contractors or an understatement of expenses which may be a lead to underdeclared sales. High ratios may also mean an understatement of sales or padded payroll with fictitious or terminated employees. b. Review payroll sheets. All expenses claimed having the semblance of a compensation payment should be verified together. c. Interview personnel assigned to prepare payroll and inquire if family members are included in the payroll. If so, check legitimacy of the work assignment and reasonableness of compensation paid. d. Compare payroll costs with industry standards and other independent data. Require explanations for significant deviations. e. Observe the actual number of employees and relate this to the declared sales. Inquire if independent contractors are hired in lieu of regular employees. f. To make sure no terminated employees are being paid, select a sample of taxpayer's terminated employees and trace them back to the payroll register. g. Check if there are proper cutoffs by testing accruals. h. Perform a comparative analysis of salaries, wages and other employee benefits with prior and subsequent years. Material changes may indicate a change in the volume of business or in the policy of classifying manpower employed. i. Determine if the taxpayer is properly withholding the correct amount of taxes on compensation by test checking actual pay slips against employee records and BIR Form 1604 CF (Annual Information Return of Taxes Withheld on Compensation and Withholding Taxes). ADCIca j. Reconcile totals of wages paid which were subjected to withholding tax and totals of compensation paid which were not subjected to withholding tax with payroll expense claimed. Consider the possibility of disallowing any noted discrepancy. k. Verify Social Security System Premium Remittance List to cross check the list of employees to whom compensation was paid. l. Verify if the 13th month pay, as well as all the benefits and bonuses paid or accrued exceeding the exempt threshold, were properly taxed. 4. Fringe Benefits Fringe benefits tax is a final withholding tax imposed on the grossed-up monetary value of fringe benefits furnished, granted or paid by the employer to the employee, except rank and file employees as defined in RR No. 11-2018. a. Obtain a list of managerial and supervisory employees from the Human Resource or Personnel Department of the company being audited with the following information per personnel: a.1 nationality; a.2 citizenship; a.3 number of years with the company; a.4 position/job designation; a.5 basic salary and allowances; and a.6 other compensation and benefits. b. Secure copies of employment contracts and/or appointment papers and examine these documents to verify the nature and amount of other compensation, allowances and benefits which may be subject to fringe benefits tax. ScaCEH c. Analyze expenses and other pertinent accounts where fringe benefits may have been lodged or recorded. Determine the amounts of benefits subject to tax. d. Include the value of the following items/services as taxable fringe benefits: d.1 Housing; d.2 Expense account; d.3 Vehicle of any kind; d.4 Household personnel, such as maid, driver and others; d.5 Interest on loan at less than market rate to the extent of the difference between the market rate and actual rate granted; d.6 Membership fees, dues and other expenses borne by the employer for the employee in social and athletic clubs or other similar organizations; d.7 Expenses for foreign travel; d.8 Holiday and vacation expenses; d.9 Educational assistance to the employee or his dependents; and d.10 Life or health insurance and other non-life insurance premiums or similar amounts in excess of allowable amount under the law. e . Exclude the following fringe benefits from the fringe benefits subject to Fringe Benefits Tax: e.1 Fringe benefits which are authorized and exempted from tax under the Tax Code, as amended, or under any special law; e.2 Contributions of the employer for the benefit of the employee to retirement, insurance and hospitalization benefit plans; e.3 Benefits given to the rank and file employees, whether or not granted under a collective bargaining agreement; e.4 If the grant of the fringe benefits is for the convenience of the employer; and e.5 De Minimis benefits, subject to prescribed thresholds, such as: e.5.1 Monetized unused vacation leave credits of private employees not exceeding ten (10) days during the year; TIEHDC e.5.2 Monetized value of vacation and sick leave credits paid to government officials and employees; e.5.3 Medical cash allowance to dependents of employees, not exceeding threshold provided in the existing regulations; e.5.4 Rice subsidy provided in the existing regulations; e.5.5 Uniform and clothing allowance not exceeding threshold provided in the existing regulations; e.5.6 Actual medical assistance, e.g. , medical allowance to cover medical and healthcare needs, annual medical/executive check-up, maternity assistance, and routine consultations allowed under existing regulations; e.5.7 Laundry allowance per month allowed under existing regulations; e.5.8 Employee achievement awards ( e.g. , for the length of service or safety achievement) which must be in the form of a tangible personal property other than cash or gift certificate, with an annual monetary value allowed under existing regulations; e.5.9 Gifts given during Christmas and major anniversary celebrations allowed under existing regulations; e.5.10 Daily meal allowance for overtime work and night/graveyard shift allowed under existing regulations; and e.5.11 Benefits received by an employee by virtue of a collective bargaining agreement (CBA) and productivity incentive schemes provided that the total monetary value received from both CBA and productivity incentive schemes combined do not exceed the threshold allowed under existing regulations. f. Determine the correct valuation of fringe benefits based on the provisions on valuation prescribed and illustrated in existing revenue issuances. g. Compute for the amount of taxable fringe benefits by dividing the monetary value of the fringe benefit by 68%. h. Compute for the correct final withholding tax on fringe benefits by multiplying the grossed up monetary value of the benefits with 35%. However, for a non-resident alien individual not engaged in trade or business within the Philippines, the grossed up monetary value shall be multiplied by 25%. i. Examine monthly final withholding tax returns with corresponding official receipts of payment to check if the correct final withholding tax on fringe benefits was paid. In case of non-withholding, non-remittance or late payment, compute the deficiency tax dues and/or penalties, where applicable. j. Compare the amount of fringe benefits per income tax return, audited financial statements and per books against withholding tax returns and official receipts. If the taxpayer is on accrual basis, examine the journal entry made in accruing expense at the end of the year. Verify if the tax has been paid on or before the due date on the first month of the following year. k. Disallow claims for fringe benefits in excess of supported amounts or where the payees are determined to be fictitious, or when the prescribed fringe benefits tax has not been paid. ACcaET 2. n Rents a. Check for the official receipts pertaining to the leased property. b. Verify pertinent provisions of the lease contract with the lessor and check if the terms are being properly followed. c. Verify the reasonableness of rentals paid by the lessee, particularly if the lessor is related directly to the taxpayer. d. Verify whether the taxpayer is renting property for which it has no actual business use. Any rentals in that case would be unreasonable and unnecessary; hence, the expense should be disallowed. e. Determine the terms of the lease. If the lessee may take or acquire title to the property, the claim for rental expense should be disallowed. f. Determine if there are any capital expenditures included in the accounts. g. Determine whether the proper amount of expanded withholding tax on rental payments has been withheld and remitted by verifying BIR Form 1604E and all the paid BIR Forms 1601E. h. In case the lessor is a non-resident foreign corporation or owner, the VAT on sale of services and use or lease of properties in the Philippines shall be based on the contract price agreed upon by the lessor and the lessee. The lessee shall be responsible for the payment of VAT on the said rental on behalf of the non-resident foreign corporation or owner. 3. Royalties a. Verify minute book and pertinent provisions of the contract stipulating the basis and the terms of royalty payments. b. Check correctness of the amount of the expense by computing the percentage of royalty or terms specified in the contract in relation to the reported sales. Disallow excess claim. c. Determine whether the proper amount of final withholding tax has been withheld and remitted. d. In case the licensor is a non-resident foreign corporation or owner, the VAT on sale of services and use or lease of properties in the Philippines shall be based on the contract price agreed upon by the licensor and the licensee. The licensee shall be responsible for the payment of VAT on the said royalties on behalf of the non-resident foreign corporation or owner. e. If the recipient is a non-resident alien or foreign entity, determine whether the proper amount of tax has been withheld and remitted. e.1 Check whether the recipient is a treaty country resident. If so, ask for a copy of a ruling issued for the use of the preferential tax rate. e.2 If a copy of a ruling has been produced, verify from the issuing BIR office the authenticity of such ruling. e.3 If the recipient is a non-treaty country resident, verify if the appropriate tax rate provided for in the Tax Code, as amended, is properly applied. SaIEcA 4. Interest a. Verify sources of interest expenses such as actual notes, loans, and mortgage or bonds instruments. Check whether the indebtedness is business related. b. Determine the accounting method used by the taxpayer for if it uses accrual basis, only the interest accruing during the taxable year is deductible. c . Perform vouching to bank advices by tracing the amount of interest reflected on bank advices to the amount stated in the General Ledger account. d. Determine if interest paid or accrued applies to obligations due to related taxpayers. Consider such items as: d.1 Arm's length features d.1.1 Bona fide obligations; and d.1.2 Interest in excess of the prevailing rates in unrelated transactions. d.2 Accrual of items payable to related taxpayers which are not paid within the prescribed time limit. IaHDcT e. Determine if deductions claimed relate to interest incurred in carrying tax free obligations. If so, then the interest claimed is not deductible. f. Disallow interest claimed in excess of interest income subject to final tax. g. Determine if the interest deduction includes any principal amount. h. If the recipient is a non-resident alien or other foreign entity, determine if the proper amount of tax has been withheld. (Follow procedures in item e.3 under item number 3 of royalties). i. Ascertain if the loans acquired were not utilized but were loaned out to affiliates. If so, disallow interest expense claimed. 5. Taxes a. Verify whether only the taxes properly paid or accrued during the year have been claimed. b. Determine that no protested taxes or reserves for deficiency taxes upon audit are claimed. c. Determine existence of claims for taxes not allowable as deduction such as: c.1 Income tax provided for under the Tax Code, as amended; c.2 Income, war profits and excess profits taxes imposed by authority of any foreign country; c.3 Estate and gift taxes; and c.4 Taxes assessed against local benefits of a kind tending to increase the value of the property assessed. d. Determine if the taxpayer is the owner of the real and personal property being taxed. e. Determine if there are any taxes on the purchase of capital assets that were already capitalized but also charged to expense account, which should be disallowed. 6. Repairs a. Determine depreciation policy of the taxpayer. A conservative depreciation policy often contemplates a high degree of current repair expenditures. b. Verify nature of expenditures. If the expenditure prolongs the life or enhances the value of the existing assets, then it is not deductible but should be capitalized and depreciated over the years of their estimated usefulness. c. Check repair accounts for the possibility that personal expenses of owners or other company officers and employees are included. Look for repair/maintenance tickets as issued by the company's division handling the repairs. 7. Bad debts a. Obtain and review list of charged-off or written-off accounts. b. Bad debts prior to being written off require approval must be sought and compared to actual written off accounts. DEIHAa c. Determine with a reasonable degree of certainty the uncollectibility of the debt. d. Determine if the charge-off or written-off is based on worthlessness of the debt within the year. e. Determine if there are repossessed merchandise. If so, verify if the value of the repossessed merchandise has been correctly assigned and deducted from the claimed amount of bad debts. f. Verify losses on installment receivable if consideration on any repossessed merchandise has been taken into account and if portion of the losses had been charged to the unrealized gross profit account. SDTIaE g. Determine if the method of deducting bad debts is acceptable and consistent with the method applied in the preceding year. h. Verify bad debts expense in relation to the examination of the allowance for doubtful accounts. i. Determine the reasonableness of the allowance for bad debts taking the allowance set for the previous years into consideration. 8. Losses a. Abandonment and Demolition Losses a.1 Verify if the amount of the abandonment loss is the adjusted basis of the abandoned asset. a.2 Determine if the loss really occurred within the taxable year. a.3 Determine if the retirement or abandonment loss is specifically allowable under the taxpayer's method of accounting for depreciable property. a.4 Determine the reason for the demolition of a building. If it was the taxpayer's intention to demolish the building when the property was first acquired, abandonment loss is not allowable. It should form part of the cost of the new building. b. Losses from Casualty or Theft Casualty loss refers to loss of property connected with trade or business. In the verification of casualty or theft losses, the following pointers should be observed: b.1 Ascertain that a loss has actually been incurred by examining supporting documents such as police report or report of the fire department. b.2 Ascertain that the loss is claimed in the proper year. Generally, casualty loss is claimed in the year incurred while losses from theft or embezzlement are claimed in the year discovered. b.3 Ascertain that insurance proceeds or claims, salvage proceeds, or salvage value have been properly taken into account. b.4 Ascertain that the adjusted basis of lost property has been properly computed. Consider reasonableness of values used in the computation and ascertain that the loss claimed does not exceed the adjusted basis. b.5 Ascertain that the rule as to the manner of deductibility have been complied with (type of asset, whether insured or not, time or period held, and other relevant factors.) b.6 In cases involving loss of cash, be alert on the possibility that the cash stolen may not have been previously included as income. b.7 Trace handling of losses involving inventory or stock in trade to preclude double claim of deduction. AacCIT b.8 Analyze any loss claimed for assets located in a foreign country. b.9 Verify police blotters, fire department records and other independent documents in support of the claim. c. Net Operating Loss Carry-Over (NOLCO) Pursuant to Section 34 (D) (3) of the Tax Code, as amended, "net operating loss" means the excess of allowable deduction over the gross income of the business in a taxable year. The validity of the claim for NOLCO may be determined through the following procedures: c.1 Secure copies of income tax returns and the applicable audited financial statements for the three (3) consecutive taxable years immediately preceding the year of claim. c.2 Verify audit reports, if any, covering the taxable years with net operating loss to ascertain correctness of amount claimed after audit. If the results of audit for prior years show a net income instead of a loss, disallow claim for NOLCO. c.3 Determine if the net loss was incurred during the taxable year in which the taxpayer was exempt from income tax. If so, the NOLCO should not be allowed as a deduction for the succeeding period. c.4 Examine the taxpayer's stock and transfer book and report submitted to the Securities and Exchange Commission to ascertain that there is no substantial change in the ownership of the business or enterprise in that: i. Not less than seventy-five percent (75%) in nominal value of outstanding issued shares, if the business is in the name of a corporation, is held by or on behalf of the same persons; or ii. Not less than seventy-five percent (75%) of the paid up capital of the corporation, if the business, is in the name of a corporation, is held by or on behalf of the same persons. c.5 For operators of mines, other than oil and gas wells, which did not avail of the Investments under E.O. 226, otherwise known as the Omnibus Investments n Code of 1987, as amended, verify correctness of claim for net operating loss as follows: i. Refer to audited financial statements and audit reports to check if the net loss was incurred during the first ten (10) years of operation; ii. Check if the period/taxable year when loss is claimed is within five (5) taxable years following the loss; and TIEHSA iii. Ensure that there is no substantial change in the ownership of the business or enterprise. 9. Depreciation a. Compare total depreciation as shown by the depreciation schedule with the deduction claimed on the return. Reconcile any differences. Be alert for duplication of claimed deductions. b. Review the rates of depreciation used to determine if they are reasonable. c. Test check a representative number of items listed on the depreciation schedule to determine if the accumulated depreciation at the end of the accounting period exceeds the depreciable basis of the asset. d. Test check extensions and footings to determine if current depreciation has been correctly computed. e. Determine if there is any personal use of cars and other depreciable assets. f. Ascertain if proper cost allocation has been made on bulk purchases of depreciable and non-depreciable assets. g. Observe and determine if the taxpayer's depreciation policy and computation conforms with the guidelines in Revenue Memorandum Circular (RMC) No. 70-2010 Circularizes the Revocation of BIR Ruling Nos. DA-413-04 and DA-436-04 and Clarifies the Basis in Computing Depreciation of Property, Plant and Equipment. 12. n Depletion a. Determine if the taxpayer has an economic interest in the property. b. Determine if the taxpayer has acquired, at least by investment, any control in oil, gas or mineral in a place, and secures, by any form of legal relationship, any income derived from the extraction of oil, gas or mineral. c. The following additional guidelines should be followed in the verification of the deduction for depletion: c.1 Ascertain that the sales reported in relation to a property do not include sales applicable to another property, sales of purchased minerals, non-minerals sales or other income items. TDAcCa c.2 Ascertain, where applicable, if mineral sales have been adjusted to "gross income from the property" by reduction of such factors as unallowable treatment cost, unallowable transportation costs, rents, royalties, including a proportionate part of lease bonuses, amounts paid to others in contract mining or similar operations where the other party has acquired an economic interest and is entitled to depletion, certain excise taxes, trade discounts allowed and other deductions. c.3 In situations where the basis for percentage of depletion is not the actual sales price of a finished product but a value of the mineral at the point at which has passed through the last allowable treatment process applicable thereto, determine if the value used is correct representative market or field price. c.4 Ascertain that mineral sales made to a business controlled by the taxpayer are not inflated to gain a tax advantage through depletion. c.5 Ascertain that all expenses applicable to a property have been charged including a proper allocation of general, administrative and overhead expenses. SDHacT c.6 Be alert on possible reduction of expenses by improper offsets such as income from scrap sales, cash discounts earned, sales of assets, and other income. 13. Contributions a. Determine if the done or recipient is the government or an accredited relief organization. b. Determine if the contribution is to be utilized for the rehabilitation of calamity stricken areas declared by the President. c. Verify if the claim is actually paid within the taxable year. Ascertain if the contribution can be deducted in full. If not, the amount should be within the threshold prescribed under existing regulations. 14. Transportation and Travel, Representation and Entertainment a. Determine if the expenditures have been incurred in relation to the business or practice of profession, not for personal use. b. For transportation and travel expenses, the following information are necessary to properly determine deductibility: b.1 Date of Travel b.2 Purpose of the travel and written authority for the travel b.3 The person or persons who incurred the expenditure b.4 Place or places travelled b.5 Amount of expenditure b.6 Means of transportation or travel c. Determine if taxpayer's travel and transportation and representation and entertainment expenses are recorded in a daily diary. If such expenses appear to be disproportionate to the taxpayer's income and business activities, the taxpayer should be required to support the book entries by furnishing documentary proofs and to establish the relevance of the expenses to the taxpayer's business. d. Determine the policy with respect to reimbursement or giving grants of allowances to employees. e. Ascertain the specific amounts recorded for these items. f. Prepare a summary of the total expenses posted to the accounts and compare the same with the deductions claimed per tax return. g. Select a representative test period or periods and test check entries in the ledger against supporting receipts and documents. h. Determine from the analysis and verification of supporting documents the reliability of the records. i. Determine company-owned vehicles and the expenses incurred in connection with these vehicles. ACETID j. Determine if entertainment facilities are used by the taxpayer primarily for the entertainment, amusement, or recreation of guests or employees. Facilities must be owned or form part of the taxpayer's trade, business or profession, or rented by such taxpayer, for which the taxpayer claims a depreciation or rental expense. k. Determine if representation expenses incurred by the taxpayer are not fixed representation allowances that are subject to withholding tax on wages pursuant to appropriate revenue regulations. l. For purposes of proving representation expense, the following information are necessary to properly determine deductibility: l.1 Amount of expense; l.2 Date and place of expense; l.3 Purpose of expense; l.4 Professional or business relationship of expense; and l.5 Name of person and company entertained with contact details. m. Look-out for possible double claim of expense, where supporting documents were used to support "transportation and travel" expense, as well as fringe benefit provided to managerial employees. n. Ascertain that representation and entertainment expenses are within the limitations allowed under existing regulations. 15. Stationery and Office Supplies a. Determine if the expenses claimed are not capitalizable office assets. TaDSCA b. Verify if personal purchases by the taxpayer/owner are included in the account. c. Determine the reasonableness of the expenditures. d. Compare receipts with the amounts claimed and investigate significant discrepancies. 16. Professional Fees a. Determine if the charges include amounts incurred for legal, accounting, engineering, appraisal, surveying and other similar services. b. Verify if the amounts are material and examine contracts to check the detailed description of the exact professional services rendered. c. Ascertain if the expenses do not constitute political contributions, bribes or kickbacks, which should be disallowed. d. Determine charges for research and experimental expenses which are lodged in professional fees. These items should form part of the cost of patents, trademarks and copyrights and other intangible assets subject to amortization. e. Verify if the corresponding taxes on the gross professional fees paid were withheld and remitted to the BIR. Otherwise, the expense should be disallowed. 17. Insurance Expenses a. Verify insurance policies. Premiums paid by employers on individual life insurance policies of their employees are not deductible if the employer is a direct or indirect beneficiary of such proceeds. b. Determine if the employee is the beneficiary of the insurance. Otherwise, the premiums paid shall be treated as an additional salary provided that it is reasonable. c. Check the account if it includes fire insurance, burglary insurance and other policies on officer's/stockholder's personal and real properties, which should be disallowed. 18. Light, Power, Telephone and Telecommunication Expenses a. Determine material amounts claimed as they may include capitalizable electrical equipment or purchases of capital items from utility companies. b. Examine the receipts issued by the utility companies. Compare the same with the amounts claimed per return. Investigate material discrepancies. c. Determine if there are personal expenses included in the expense account. d. Relate the expense consumption against sales and production to determine any possible under-declaration of sales. 19. Miscellaneous expenses a. Check the validity of the individual charges to the account. b. Determine if deductions claimed are adequately substantiated. c. Ascertain if the miscellaneous expenses claimed do not contain any personal items. EADSIa d. Scrutinize and vouch the supporting documents for material charges to this account since this is the spillover account of expenses. XI. AUDIT PROCEDURES ON WITHHOLDING TAXES The following audit procedures outline the steps to be performed by an RO in the determination of the correct amount of withholding taxes due from withholding agents by ascertaining the following: 1. The classification of the income payment and if the said income payments were subjected to withholding taxes. 2. The rate of tax and the amount of tax withheld is correct; and 3. The tax withheld is remitted within the prescribed dates mandated by regulations. 4. Compliance with the submission of necessary annual information returns on withholding taxes and issuance of corresponding certificates of tax withheld to payees. The audit procedures are classified according to the classification of withholding taxes, to wit: 1. Withholding Tax on Compensation 2. Expanded Withholding Tax 3. Final Withholding Tax 4. Withholding Tax on Government Money Payments Audit procedures for the different kinds of withholding taxes : A. Withholding Tax on Compensation 1. Verify the number and list of employees per payroll records and the list of employees submitted to the Social Security System and the Department of Labor and Employment as against the alpha list of employees from whom taxes have been withheld which is attached to the annual information return (BIR Form 1604CF). SETAcC 2. Examine payroll records, including confidential payroll, if any, employment contracts, supporting vouchers, receipts for advances/reimbursements of transportation and representation expenses, receipts for payment of compensation and reconcile amount of supported expenses with the figures per financial statements and withholding tax remittance returns. 3. Check the computation of the correct withholding tax per payroll period. Take note to segregate the taxable compensation income into regular and supplementary. 4. Examine monthly withholding tax remittance returns (BIR Form 1601C) and compare amounts remitted against the computed withholding tax on compensation per audit. 5. Reconcile the aggregate gross compensation income stated in the withholding certificate (BIR Form 2316) with the total amount indicated in the gross compensation income column of the alpha list. 6. Examine the salary expenses account and match it with basis of the withholding tax remitted per BIR Form No. 1604CF. Those expenses lodged in the salary expense without withholding shall not be deducted as expense. B. Expanded Withholding Tax (EWT) 1. Verify if the taxpayer is classified as "Top Withholding Agent" to determine which income payments are subject to EWT. 2. Check amount payable or paid per income statement and income tax returns against those declared in the monthly and annual returns. 3. Ascertain validity of payments by and to prime contractors, and subcontractors, professionals, brokers, sub-brokers, agents of entertainers, etc. by examining contracts, subcontracts, vouchers, receipts and billings. 4. Ascertain whether the correct percentage of tax is withheld for the income payments in accordance with existing regulations. 5. Determine the correctness of the amounts subject to withholding tax by comparing the total payments per supporting documents against the amount per withholding tax returns. 6. Verify the correctness of the payee classification and withholding tax rate applied. 7. Determine the dates of payment or the period when the obligation to pay the amount subject to the withholding tax is due. The time to withhold is fixed at the time the obligation is due irrespective of the actual payment. 8. Apply non-deductibility of related expense for those payments which were inadvertently not subjected to expanded withholding tax, unless the basic withholding tax plus penalties are remitted. 9. If necessary, gather third party information and documents for verification. 10. Reconcile the expenses accounts in comparison to those declared in the BIR Form No. 1604E. C. Final Withholding Taxes 1. Review the contracts for payment of certain items of income to resident and non-resident payees of interest and rent, Central Bank approval papers, employment contracts, contract for payment of royalties, records of prizes or winnings and financial statements. ITCcAD 2. Ascertain if the income payment was subjected to withholding tax in the year it was accrued, irrespective of whether the taxes withheld were remitted within ten (10) days following the month in which the payment was accrued. In the case of withholding tax on interest on bank deposits, the remittance shall be made quarterly within twenty (20) days after the end of each quarter. 3. Check the correctness of the basis and rate of withholding tax applied. If a preferential tax rate is being availed of, verify the correctness of the rate used from the ruling issued by the Bureau. 4. Ascertain the date of accrual of the income payment, to fix the time to withhold, irrespective of the actual remittance or non-remittance of the tax withheld by reason of official restriction. 5. Verify correctness of remittance against monthly remittance returns and annual information return. D. Withholding Tax on Government Money Payments 1. Examine government contracts with suppliers, purchase records, payment orders, billing records, receipts, vouchers, cash book and reports of Commission on Audit (COA) auditors. 2. Check money payments from vouchers, billing records, records of purchases, COA audit reports, etc. against monthly remittance returns (BIR Form 1600), books of accounts and other accounting records maintained. 3. Determine the correctness of bases and rates of tax applied. 4. Check whether the correct amount of tax has been withheld and remitted within the prescribed period. Otherwise, impose appropriate penalties for non-withholding or non-remittance of the tax, as the case may be. XII. AUDIT OF MINIMUM CORPORATE INCOME TAX AND IMPROPERLY ACCUMULATED EARNINGS TAX A. Minimum Corporate Income Tax Pursuant to Section 27 (E) (1) of the Tax Code, a minimum corporate income tax (MCIT) of two percent (2%) of the gross income as of the end of the taxable year is imposed on a corporation taxable under Title II of the Tax Code, beginning on the fourth taxable year immediately following the year in which such corporation commenced its business operations, when the minimum income tax is greater than the tax computed under Section 27 (A) of the Tax Code, as amended. Any excess of the MCIT over the normal income tax shall be carried forward and credited against the normal income tax for the three (3) immediately succeeding years. The verification of the MCIT may be conducted as follows: 1. Determine the taxability of the taxpayer to the MCIT. The MCIT shall apply to domestic and resident foreign corporations subject to the normal corporate income tax and shall not be imposed upon any of the following: a. Domestic corporations operating as proprietary educational institutions; b. Domestic corporations engaged in non-profit hospital operations; c. Domestic corporations engaged in business as depository banks under the expanded foreign currency deposit system, otherwise known as Foreign Currency Deposit Units (FCDUs), on their income from foreign currency transactions with local commercial banks, including branches of foreign banks, authorized by the Bangko Sentral ng Pilipinas (BSP) to transact business with foreign currency deposit system units and other depository banks under the foreign currency deposit system, including their interest income from foreign currency loans granted to residents of the Philippines under the expanded foreign currency deposit system; aHECST d. Resident foreign corporations engaged in business as international carrier; e. Resident foreign corporations engaged in business as Offshore Banking Units (OBUs) on their income from foreign currency transactions with local commercial banks, including branches of foreign banks, authorized by the Bangko Sentral ng Pilipinas to transact business with Offshore Banking Units, including interest income from foreign currency loans granted to residents of the Philippines; f. Resident Foreign corporations engaged in business as regional operating headquarters; and g. Firms that are taxed under a special income tax regime such as those in accordance with Republic Act (RA) Nos. 7916 and 7227. 2. Determine the gross income subject to MCIT a. Check the accuracy of the declaration of gross sales/receipts contributing to income taxable under Section 27 (A) of the Code. a.1 Ascertain the accounting method employed by the taxpayer and verify consistency in its application. In case of sales of services by taxpayers employing the accrual basis of accounting, the term "gross receipts" shall mean amounts earned as gross income and these shall include amounts actually or constructively received during the taxable year. a.2 Exclude items of sale specifically exempt from income tax and those passive incomes subject to special income tax rates. a.3 Ascertain legitimacy of deductions from gross sales such as sales returns, discounts and allowances. b. Verify correctness of the claim for cost of goods sold. Ensure that only business expenses directly incurred to produce the merchandise to bring them to their present location and use or to provide the contracted services are included in this account. b.1 For trading or merchandising concern, "cost of goods sold" means the invoice cost of the goods sold, plus import duties, freight in transporting the goods to the place where the goods are actually sold, including insurance while the goods are in transit. b.2 For manufacturing concern, "cost of goods manufactured and sold" means all costs of production of finished goods, such as raw materials used, direct labor and manufacturing overhead, freight cost, insurance premiums and other costs incurred to bring the raw materials to the factory or warehouse. b.3 For sales of services, "cost of services" means all direct costs and expenses necessarily incurred to provide the services required by the customers and client including (1) salaries and employee benefits of personnel, consultants and specialists directly rendering the service; and (2) cost of facilities directly utilized in providing the service such as depreciation or rental of equipment used and cost of supplies. Except for banks and other financial institutions, cost of sales/services shall not include interest expense. EHACcT 3. Determine the period when the taxpayer becomes subject to the MCIT. a. Verify from the BIR's Information System the year of taxpayer's registration with the BIR to ascertain whether or not it is subject to MCIT: a.1 Firms registered with BIR in 1994 and earlier years are covered by MCIT beginning January 1, 1998. a.2 Firms registered with BIR in any month in 1998 are covered three calendar years thereafter. For fiscal period taxpayer, taxable year 1998 shall mean any fiscal period ending any day from July 1, 1997 up to June 30, 1998. b. Ascertain whether the first taxable period under the MCIT of the taxpayer using fiscal year accounting covers month/s in 1997 prior to the imposition of MCIT. Be sure that the computed MCIT due for 1998 using the apportionment formula is correct. 4. Verify if the taxpayer is entitled to the relief from the imposition of the MCIT and secure documentary proof for the suspension of its imposition as approved by the Secretary of Finance. 5. Check accuracy of the amount of excess MCIT carried over and credited against the normal tax within three (3) years immediately succeeding years from payment thereof, if any. See to it that any excess MCIT are not claimed against MCIT itself or against any other losses. B. Improperly Accumulated Earnings Tax In accordance with the Section 29 (A) of the Tax Code, as amended, an Improperly Accumulated Earnings Tax (IAET) equal to ten percent (10%) of the improperly accumulated taxable income is imposed for each taxable year of each corporation identified under Section 27 (B) of the Tax Code. The IAET shall be determined as follows: 1. Ascertain the classification of the corporation and the business it is engaged in, to determine whether the imposition of the IAET shall apply. For this purpose, the fact that the corporation is a mere holding company or investment company is considered prima facie evidence of a purpose to avoid the tax upon its shareholders or members; hence, the 10% tax will automatically apply. However, the following corporations are not subject to the IAET: a. Publicly held corporations; b. Banks and other non-bank financial intermediaries; and c. Insurance companies. 2. Determine the reasonableness of the accumulation of profits or earnings and if the same is required for the purposes of the business, considering all the circumstances of the case. a. Look into the following factors to ascertain if the accumulated profits are reasonably needed in the business: a.1 Nature of the company's business; a.2 Financial condition of the corporation at the close of the taxable year; a.3 The dividend distribution history of the corporation; a.4 The stock of the corporation is widely held in small blocks; a.5 The use of the undistributed profits or earnings; a.6 Retention of cash, securities and other assets unrelated to the business operations; a.7 Advances or loss to stockholders, whether or not interest shall be paid; EacHCD a.8 Dealings between the corporation and its stockholders, such as withdrawals by the shareholders as personal loans or the expenditure of funds by the corporation for the personal benefit of the shareholders; a.9 The investment by the corporation of undistributed earnings in assets having no reasonable connection with the business; a.10 The need for business expansion; a.11 The earnings and expansion history of the taxpayer; a.12 Past savings effected by non-distribution of profits to stockholders; a.13 Past tax avoidance history of the corporation; a.14 Portion of shareholder's assets transferred to the corporation; a.15 Sudden shift in corporate or dividend policy of the company; a.16 The percentage of income distributed to shareholders during the taxable year; and a.17 Retirement of stocks, this being a capital transaction and should result in reduction of capital instead of reduction of earnings and profits. b. Secure copies of the board resolutions and verify therefrom any existence of undue accumulation of profits, correlating the findings with the plans per resolution as against the business activities and dealings made by the corporation. c. Require the taxpayer to submit documentary proof negating the clear preponderance of evidence that the profits were permitted to accumulate beyond the reasonable needs of the company's business. The accumulation of surplus for the reasonable needs of the business is not prevented if the purpose is not to prevent the imposition of the tax upon the shareholders. Undistributed income may be considered as properly accumulated in the following cases: c.1 The profit is retained for working capital needed by the business; c.2 The profit is invested in addition to plants, facilities and activities reasonably required by the business provided that the plans for expansion or improvement must be definite, concrete and capable of fulfillment and not what may be characterized as nebulous plans for future action. c.3 The accumulation of earnings is in accordance with contract obligations placed to the credit of a sinking fund for the purpose of retiring bonds. c.4 The profit is intended as reserves to meet competition, for anticipated losses or reverses in business and to meet business hazards and emergencies. d. Verify whether the company's increase in capitalization, if any, is necessary in the light of the existing circumstances surrounding the business. Ascertain whether declaration of stock dividends is from increased corporate capital since stock dividends are not taxable unless there is a change in interest, or unless they are disposed of by the holders. cIECaS 3. Determine the amount of improperly accumulated taxable income subject to tax and penalties as follows: a. Account for all the company's income during the year. b. Determine all the appropriate adjustments to the improperly accumulated taxable income. For purposes of imposing the tax, the taxable income shall be adjusted by the following items: b.1 Income exempt from tax; b.2 Income excluded from gross income; b.3 Income subject to final tax; and b.4 Amount of net operating loss carry-over deducted. c. Deduct dividends actually or constructively paid and income tax paid for the taxable year from the adjusted taxable income. d. Exclude the improperly accumulated income. e. Compute the 10% surtax based on the adjusted improperly accumulated taxable income. The computation of the surtax shall be made on a year-to-year basis depending on the thorough evaluation of the circumstances proving that the company has indeed permitted itself to accumulate earnings or profits beyond the reasonable needs of the business. XIII. INDIRECT APPROACH TO INVESTIGATION Reconstruction of income is generally employed where the taxpayer keeps no record or inadequate records, or where there is strong suspicion that the taxpayer has received income from undisclosed sources. Over the years, the Bureau has developed the following general methods for reconstructing a taxpayer's income. Benchmarking Percentage method Net worth method Bank deposits method Cash expenditure method Unit and value method Third party information or access to records method A. Benchmarking Benchmark is a point of reference for measurement or a set of standard to be used to measure the performance/compliance of taxpayers in a particular industry. Benchmarking of taxpayers refers to the process of setting a standard to determine the performance level of taxpayers in a given line of industry or sector. In this case, the ratios of Net VAT Due and Income Tax Due in relation to gross sales/receipt, vis--vis profit margin rate is to be used for the purpose of setting the industry standard for taxpayers' compliance. In this connection, performance benchmarking of taxpayers by line of industry where the best performers, among taxpayers within the same line of industry or business, will be identified using profit margin rate, Net VAT Due and Income Tax Due in relation to gross sales/receipts, could be an excellent tool in increasing taxpayers' voluntary compliance. SAHITC Monitoring and evaluation of tax payments through the use of performance benchmarking will determine/identify taxpayers within industry groups who are paying below the minimum amount or set benchmarks for tax compliance purposes. B. Percentage Method This method is the equivalent of a ratio analysis of percentages considered typical of the business under investigation to indicate potential areas of revenue adjustment in examination where revenue records do not exist. The computed amount of revenues based on the percentage computation is compared to the amount of revenues reflected on the return. The percentages used may be obtained from the taxpayer, industry publication, prior year's audit results, or third parties. The comparison will provide an indication on the possibility of revenue being understated. The extent of investigation required should be based on the degree of variance. It must, however, be emphasized that in comparing transactions of similarly situated business, the name of the particular taxpayer used as the model must not be divulged to the taxpayer under investigation or in the report as this would constitute a violation by an internal RO of the provisions of Section 270, National Internal Revenue Code (NIRC) on unlawful divulgence of trade secrets. Significant ratios and trends to be analyzed are as follows: 1. Percentage Mark-up This is effective on businesses whose purchases can be readily broken down in groups with approximately the same percentage of mark-up. The purchases should be grouped in items with the same percentage of mark-up. The appropriate percentage of mark-up would then be applied to each group of items to arrive at the gross receipts. The percentage of mark-up can be determined from selling prices obtained from the taxpayer. However, if cooperation from the taxpayer is lacking, the information should be obtained from competitive business establishments in the same industry. Once the gross receipts are determined, the taxpayer should be given the opportunity to explain the discrepancy noted between the reconstructed gross receipts and the amounts reflected in the books and in the tax returns. The taxpayer may argue that the percentage mark-up should not be applied to purchases which were stolen, broken or spoiled. cDCSET When reconstructing income using the mark-up method, possible unrecorded purchases should be considered. 2. Gross Profit Ratio or Gross Margin Percentage The gross profit is expressed as a percentage of sales. Gross Profit Ratio = (Net Sales Cost of Goods Sold) Net Sales Note: Net Sales should comprise of Zero-rated, Exempt and Vatable sales, net of sales discounts, returns and allowances. Analysis of said ratios to evaluate the taxpayer's performance during current in previous years should be done, or with other firms in the same industry to determine the normal gross profit ratio within the same industry. 3. Profit Margin Profit Margin = Net Income Net Sales If the profit margin is low, this will indicate that the firm's sales prices are relatively low or that its costs are relatively high or both. 4. Total Assets Turnover Total Assets Turnover = Sales Total Assets A high rate compared to the industry would signify sufficient volume of business and if a net loss is declared, questions must be raised or further investigation and analysis should be performed. Take note on the date the assets were increased, for they may not have been put into use due to limited time. 5. Inventory Turnover The inventory turnover is computed as follows: Inventory Turnover = Sales Average Inventory or Cost of Sales (Beginning Inventory + Ending Inventory)/2 If the turnover is low, the company could be holding damaged or obsolete materials not actually worth their stated volume. Average inventory at a given point x turnover rate = total estimated purchases during the year. C. Net Worth Method The fact that the taxpayer's books and records accurately reflect the figures on the income and business tax returns does not prevent the use of the net worth method of proof. The RO can still look beyond the taxpayer's books and records and use any evidences available to contravene their accuracy. However, this net worth method is most often used when one or more of the following conditions prevail: 1. The taxpayer maintains no books and records. 2. The taxpayer's books and records are not available. 3. The taxpayer's books and records are inadequate. 4. The taxpayer withholds books and records from investigation/verification by authorized RO(s). 5. The taxpayer maintains books and records; however, based on the assets known to be purchased by the taxpayer within the taxable year, it is conclusive that there is undeclared income. IAcDET This is a method of reconstructing income which is based on the theory that if the taxpayer's net worth has increased in a given year in an amount larger than his reported income, he had understated his income for that year. In applying this method, it is important to establish the net worth on a fixed starting date. This is to erase doubts that the increase in net worth or the excess of expenditures over reported income did not originate from prior accumulated funds ( i.e. , hoarded cash or undisclosed assets which do not represent income during the tax year.) In preparing a net worth statement or summary for use in a criminal investigation, the ROs should ensure that: 1. The taxpayer's method of accounting is used. 2. The cost of assets and actual amount of liabilities are used and that values other than cost, are not considered in the net worth computation. 3. Estimated non-deductible expenditures are eliminated from the computation. 4. Generally accepted accounting principles in conformity with the Tax Code, as amended, and regulations are followed. Net worth computation Assets xxx Less: Liabilities and Accumulated depreciation xxx Net Worth xxx Less: Prior Year's Net Worth xxx Increase (Decrease) in Net Worth xxx Add: Non-deductible items Personal, living and family Expenses xxx Income tax payments xxx Insurance premiums xxx Gifts xxx Non-deductible contributions xxx Net capital loss xxx Amnesty tax payments xxx Estate and donor's taxes xxx Other non-deductible items xxx Total Non-deductible items xxx Net Income before further adjustments xxx Less: Non-taxable items Gifts, donations and inheritance Received xxx Non-taxable stock dividends (if reflected in assets) xxx Retirement pay from SSS xxx Non-recognized gains from exchange of property under Sec. 40 of the Tax Code xxx Social Security benefits received from foreign government and institutions (PD220) xxx Other non-taxable items xxx Total Non-taxable items xxx NET INCOME SUBJECT TO TAX xxx ===== Burden of Proof The "Net Worth" method to be acceptable must establish with reasonable certainty an opening net worth, to serve as a starting point from which to compute future increases in the taxpayer's assets. It must also introduce evidence to support the inference that the taxpayer's net increases are attributable to currently taxable income. In computing the increase, the taxpayer's assets are totaled and net worth as determined at the close of the previous taxable year is subtracted from the total at the close of the taxable year in question. The remainder, if any, is the increase for the taxable year, and constitutes taxable income if no adjustments are required. However, where net worth increase is the income determinant the RO may, in making the final computation upon which to base the tax, add to the increase estimated living expenses incurred by the taxpayer since such expenditures are presumed to have come from income. The taxpayer, on the other hand, is entitled to reduce the reconstructed income by the amount of depreciation allowable on assets which are not considered in determining net worth. The factors to be considered in reconstructing net worth are variable, like availability of evidence. Generally, net worth has been computed on the basis of some, all or combination of the following: a. bank records; b. securities; c. financial statements; d. fixed assets; e. inventory; and f. all available records. D. Bank Deposit Method When the taxpayer's records are apparently inaccurate or manifestly incomplete, the RO may look at the bank deposits of the taxpayer as evidence income. Under the bank deposit method, the bank records of the taxpayer are analyzed and the RO estimates income on the basis of total bank deposits after eliminating non-income items. This method stands on the premise that deposits represent taxable income unless otherwise explained as being non-taxable items. This method can be used if the RO has been allowed access to the taxpayer's bank records or if the RO has obtained documented evidence from reliable sources as to the taxpayer's bank accounts. While the mere deposit of money does not prove the receipt of taxable income as alleged by the RO, the burden is on the taxpayer to prove that various deposits did not stem from the receipt of taxable income. The passage of time makes it difficult for the taxpayer to meet this burden but this does not relieve him from showing the non-taxable source to contradict the RO's determination. If the bank deposit method is used in support of findings of fraud, however, the burden of proof is on the RO. TSHEIc When computing taxable income under this method, it is appropriate to add to the amount of the bank deposit the amount of cash expenditures from undeposited funds for personal expenses which is non-deductible for tax purposes. Withdrawals which can be identified as deductible are allowed against the taxable income determined. In using this method, it is proper to prove the existence of a business and the practice of making deposit of business income into one or more bank accounts and then to adjust the total deposits for transfers, redeposits, deposits otherwise explained and finally to allow for ascertainable expenses, deductions and exemptions. 1. Analysis of Bank Deposits The RO's careful analysis of the taxpayer's bank deposits constitutes the most important phase of his investigation. A review of the taxpayer's personal and business bank records for several months should be made. The following questions should be answered in analyzing the taxpayer's deposits: a. Are deposits made on a basis consistent with the information secured during the initial interview? b. Are there any large or unusual deposits? c. Are there any deposits from sources not reflected on the tax return? d. Did the examination of the taxpayer's cancelled checks reveal additional bank accounts not previously disclosed by the taxpayer? e. Are there checks endorsed by the taxpayer and deposited into an account not previously disclosed? f. Are there checks for assets or personal expenses that affect the taxpayer's standard of living? 2. Computation of Gross Receipts Through Bank Deposit Method Total Reconciled Bank Deposits xxx Less: Non-taxable receipts deposited (sched. 1) xxx Net deposits that resulted from taxable receipts xxx Add: a. Business expenses paid in cash (sched. 2) xxx b. Capital items paid in cash xxx c. Personal expenses paid in cash (sched. 3) xxx d. Cash accumulated during the year from receipts xxx e. Increase in Accounts receivable xxx f. Decrease in accounts payable xxx xxx Total xxx Less: Non-taxable cash used in (a) thru (d) xxx Decrease in accounts receivable xxx Increase in accounts payable xxx xxx GROSS RECEIPTS xxx ===== Schedule 1 Non-taxable receipts include: Checks drawn to cash that were redeposited Second deposits of NSF checks Transfer between accounts Proceeds from loans, social security, exempt interest, etc. Schedule 2 Business expenses paid in cash Total business cash outlays per returns xxx Less: Total Checks written xxx Non-business expenses paid by check xxx Business expenses paid in check xxx Business expenses paid in cash xxx ==== Schedule 3 Personal Expenses Paid in Cash Total personal expenses xxx Less: Business expenses paid in cash xxx Personal expenses paid in cash xxx ==== Deposits may represent redeposited items and loans, in which case, taxable income as determined by the RO should be reduced by such amounts. Deposits may also be shown to represent amounts on hand at the start of the year in which they are deposited rather than income in that year. The bank deposit method, like the net worth method, encompasses an area of uncertainty. Though the taxpayer's records are inadequate for precise and complete verification of its return, a determination of income by the bank deposit method will be rejected if it is inconsistent with surrounding circumstances and gives an absurd result. aSIHcT E. Cash Expenditure Method An outgrowth of the net worth method of determining income is the "excess cash expenditure method." This method assumes that the excess of a taxpayer's expenditures during a tax period over his reported income for that period is taxable to the extent not approved otherwise. The taxpayer may show that this excess resulted from non-taxable items such as loans, gifts, inheritance or assets on hand at the beginning of the period. While it has been said that no opening worth is needed when the cash expenditure method is used, the more impressive authority is to the contrary. The two steps involved in the cash expenditure method are: a) valuation of the taxpayer's assets at the beginning of the taxable period in order to determine the taxpayer's funds available for expenditure during the ensuing taxable periods and b) determination of the amount by which expenditures exceed reported income for the taxable period. To show a failure to report the full amount of income by the use of this method, it must be demonstrated that the expenditures made during the taxable year were in excess of the available funds during the year which were reported on the tax return. Total expenditures may not include checks drawn to cash and items for which the taxpayer has paid in cash, unless the cash bank withdrawals were not used to pay for the cash expenditure. The burden is on the taxpayer to establish the relationship between cash withdrawal and individual items. Expenditures may not necessarily come from income, but very large expenditures for personal purposes each year may be interpreted as an indication that the income being reported was too small. Proof in cash expenditure case may be difficult, for it is highly unusual for anyone to keep accurate records of personal living expenses. However, once the RO has made a determination as to the amount of cash expenditures, the burden of proof to establish a different amount is on the taxpayer. Provided hereunder is the formula for the expenditures method, to wit: Expenditures (money spent or applied) xxx Less: Non-taxable Sources of funds xxx Corrected Adjusted Gross Income xxx Less: Reported Taxable Income xxx Additional Taxable Income (Unreported Income) xxx ==== F. Unit and Value Method This is not considered as a primary proof. The determination or verification of gross receipts may be computed by applying price and profit figures to the known ascertainable quality of business of the taxpayer. In addition, there are existing regulatory bodies to which the taxpayer reports units of production or service, some of which are: 1. Records of sugar milled by a sugar central 2. Records of fish production to the Bureau of Fishery and Aquatic Resources 3. Records of production by pioneer and non-pioneer industries to the Board of Investments Table 1. Examples Using Unit and Value Method Industry Item being tested Variables for estimate of item being tested Pizza Parlor Sales Pounds of flour used multiply by number of pizzas per pound multiply by average price per pizza Gas Station Gasoline Sales Number of liters sold per supplier's invoices multiply by average price per liter Exercise Patronage Membership statistics, club individual membership fees, or monthly dues Hotels Room Revenue Number of rooms multiply by rate multiply by average room rate Laundry Washer and Dryer Cost per machine load multiply by number of times machine was used during business hours and number of machines Real Estate Rental Revenue Number of rental units multiply by occupancy rate multiply by average rent Please refer to the formula of unit and value, to wit: Volume of merchandise (Manufacturer): Number of machines manufactured xxx Multiplied by: Average sales price xxx Computed total sales xxx Less: Sales Reported xxx Omitted Sales xxx ==== G. Third Party Information (TPI) Access to Records Method ROs must utilize the pre-processed data provided by the Audit Information, Tax Exemptions and Incentives Division for TPI. Moreover, ROs should determine when to make other third party inquiries. The decision to make a third party inquiry is shaped by the size of the peso amount involved and the volume of the transaction. Third party inquiry through access to records can be time consuming. ROs must weigh the benefits to be realized from work against the time required to make an access to records and the availability of the needed information through other methods. CSEHcT XIV. DISCUSSION OF DISCREPANCY Essential to an effective audit of internal revenue tax liabilities is the holding of a closing conference with a discussion of discrepancy with the taxpayer before the preparation of the final report of investigation by the RO assigned to the tax case. During this time, the RO and his supervisor explain to the taxpayer how the assessment of his tax liability was arrived at and the taxpayer is given an opportunity to present his side of the case. The discussion of discrepancy shall in no case extend beyond thirty (30) days from receipt of the Notice of Discrepancy. If it is found that the taxpayer is still liable for deficiency tax or taxes after presenting his side, and the taxpayer is not amenable, the head of the investigating office shall endorse the case with the report within seven (7) days from the discussion to the concerned reviewing and approving office for issuance of a deficiency tax assessment. XV. REPORT MAKING The RO is required to make a report after the investigation/audit has been conducted. Before starting to write a report, the Revenue Officer (RO) should have in mind a definite outline as to arrangement in which the facts and evidence may be presented in the most effective manner. A good general plan is to state the problem, present the results of the investigation and set forth the conclusions and recommendations. The report to be prepared by the RO in the conduct of his investigation shall contain the following: A. Narrative Report This is a memorandum report prepared and submitted by the RO. The narrative report shall contain the following: 1. A preliminary statement stating: a. the basis of the authority to investigate, specially the Letter of Authority or Tax Verification Notice, date issued/served and details of referrals or revalidations, if any; b. type of investigation/verification undertaken; and c. profile of the taxpayer, particularly the type of business organization, nature of business, product line, other sources of income, information of its registration with the SEC, BOI, PEZA, etc., identification of major owners/stockholders and subsidiaries/affiliates, if relevant, brief description of accounting system/method used, description of any extraordinary business activity and kinds and amounts of incentives availed of, if any. 2. A brief description of the approach in investigating stating, among others: a. the books of accounts; records and documents verified; b. the audit procedures adopted; c. access to records undertaken; d. the authorized representative of the taxpayer; and e. the dates and results of conferences. 3. Results of investigation summarizing: a. the audit findings; b. utilization of third party information; c. discrepancies discovered, disallowances made and other relevant facts uncovered during the examination; d. basis of computation of recommended deficiency taxes/tax credit or refund, if any; and 4. A recommendation for: a. the review/approval of the report of investigation and issuance of termination letter after collection of the deficiency tax; b. assessment of deficiency taxes indicating the prescription of the case; or AcSCaI c. such other recommendations as may be necessary under the circumstances. B. Duly Accomplished Revenue Officer's Audit Report These forms are required to be accomplished properly and accurately by the RO in reporting the results of investigation/verification. 1. BIR Form 0500 This form shall be accomplished by all RO in reporting results of investigation/verification of income tax liabilities of taxpayers. 2. BIR Form 0501 This form is to be used in reporting results of investigation on Capital Gains Tax on real property transactions. 3. BIR Form 0502 This form is to be used in reporting results of investigation/verification on Capital Gains Tax on stocks transactions not traded thru a Local Stock Exchange. 4. BIR Form 0503 This form is to be used in reporting results of investigation/verification on Donor's Tax. 5. BIR Form 0504 This form is to be used in reporting results of investigation/verification on Estate Tax. 6. BIR Form 0505 This form is to be used in reporting results of investigation/verification on Percentage Tax. 7. BIR Form 0506 This form is to be used in reporting results of investigation/verification on Documentary Stamp Taxes. 8. BIR Form 0507 This form is to be used in reporting results of investigation/verification on Value-Added Tax (VAT). 9. BIR Form 0508 This form is to be used in reporting results of investigation/verification on Withholding Taxes. 10. BIR Form 0509 This form is to be used in reporting results of investigation/verification on Expanded Withholding Taxes. 11. BIR Form 0510 This form is to be used in reporting results of investigation/verification on Final Withholding Taxes. 12. BIR Form 0511 This form is to be used in reporting results of investigation/verification on Specific Excise Tax. 13. BIR Form 0512 This form is to be used in reporting results of investigation/verification on Ad Valorem Excise Tax. 14. BIR Form 0514 This form is to be used in reporting results of investigation/verification on Excise Tax Credit/Refund. C. Working Papers Working papers form the most important portion of a report as they provide all the information on the investigation conducted. They are the best evidence of the scope of the investigation and the diligence with which it was completed. They further constitute the basis for the RO's determination of deficiency, liability and corresponding penalties. The working papers should include all notes made before, during, and after a tax investigation, which relates to his findings on a particular tax return and shall include items raised during the analysis of the return as possible issues. They should also include explanations on the various observations and analysis of pertinent schedules and information. Working papers prepared by the RO are used as sources of a more detailed information, which he may use later on as witness in court in case of litigation. The concluded examination should therefore be reflected by adequate working papers. Memory should not be relied upon in recounting the facts determined in the investigation. There is no better way to present the fact that an item or issue has been extensively explored on except by significant notes in working papers. Each of the working papers should be numbered and labeled clearly showing the name of the taxpayer, year of examination, date prepared and the signature of the RO should appear on each page. The pages should be numbered and prepared in the RO's own handwriting. SCEHaD The requirement is that the working papers should document whatever transpired during the examination. These may include summaries or transcripts of accounts analyzed, schedule of specific items checked, reconciliation of accounts, analysis of reserves and all other pertinent notes of the work performed. The basic working papers consist of, but are not limited to the following: 1. Working papers showing real and nominal accounts; 2. Working papers showing discrepancies, disallowances, adjustments and computation of deficiency taxes; 3. Reconciliation of net income per financial statements with the net income per income tax return; 4. Schedule of income producing property, if applicable; 5. Schedule of taxes and licenses; 6. Schedule of depreciation; 7. Schedule of loans/notes/accounts payable and interest expenses/advances from officers/stockholders, if applicable; 8. Schedule of miscellaneous income, if material; 9. Schedule of bad debts charged-off or written off, if applicable; 10. Schedule of accounts receivable and advances to officers/stockholders, if applicable; and 11. Schedule of miscellaneous expenses, if material. XVI. ATTACHMENTS TO THE DOCKET OF THE CASE Attachments consist of documents that are necessary to the proper understanding and substantiation of results of the investigation. The documents to be attached to the dockets are composed of but not limited to: A. General Requirements 1. Document Locator Form; 2. Table of Contents; 3. Duplicate copy of Letter of Authority or other correspondence such as Tax Verification Notice duly received by the taxpayer or his representative; 4. All tax returns with all the required attachments for the year/period under audit; 5. Audited financial statements with supporting schedules and reconciliation statements for the period under investigation; 6. Detailed lists of assets; 7. Proof of exemption under Special Law, if applicable; 8. Checklist of audit procedures undertaken; 9. Working paper showing computation of deficiency tax payment and all working papers prepared and initials signed by the RO; 10. Notice for discussion of discrepancy with the summary of findings; 11. Narrative memorandum report; 12. BIR Form 0500 series (Revenue Officer's Audit Report); 13. Duly signed Agreement Form, if applicable; and 14. Photocopy of Payment Form and Official Receipt as evidence of deficiency tax payment, if deficiency tax and penalties had been paid. B. Specific Requirements by Tax Type In addition to the general requirements above, the specific requirements are laid out below: 1. Income Tax/Withholding Tax a. Tax returns with proofs of payment (including tax debit memo or other forms of non-cash payment): a.1 Duly filed Income Tax Returns with all the required attachments (certified financial statements with Statement of cost of Goods sold); a.2 Duly filed Quarterly Income Tax Returns; and a.3 Duly validated Monthly and/or Quarterly Withholding Tax Returns. b. Duly filed Annual Information Return; c. Beginning and Ending Inventory List, if material/applicable; d. Notice of loss, proof of claimed losses, if applicable; e. Working papers showing computation of income and/or withholding taxes due duly signed by the RO; f. Comparative Report of Deficiency Tax Paid/Assessed, if applicable; g. Proof of claimed tax credit/s, if applicable; h. Proof of claimed "Interest Expense," if applicable; i. Proof of claimed Bad Debts/worthlessness of credits, if applicable; j. Certificate of Registration issued by the appropriate regulatory agency, together with the conditions attached to such registration, applicable; k. Other documents deemed necessary by the RO in the course of investigation; ScHAIT l. Reconciliation of the Financial Statements' figures with the Withholding Tax Returns' and Information Returns' figures, if applicable; m. Certification by the Revenue District Office, that he could not locate the BIR copy of the tax return etc., if applicable; and n. Result of Tax Compliance and Verification Drive (TCVD) and/or Third Party Information Program with Discrepancy Notice, if applicable. o. Delinquency Verification Report (For Claims for Refund/TCC); and p. Authority to Issue Refund/TCC (For Claims for Refund/TCC). 2. Other Percentage Taxes a. Form 0500 series (Audit Reports) with proofs of payment; b. Working papers showing the computation of the taxable receipts/sales (tax base) and percentage tax due duly signed; c. Reconciliation of Financial Statements' figures and Percentage Tax Returns' figures; d. Working papers on selected accounts related to the findings of investigation duly signed by the RO, if applicable; e. Comparative Report of Deficiency Tax Paid/Assessed, with proof of payment of deficiency tax, if applicable: e.1 Current year/period e.2 Previous year/period f. Proof of claimed tax credits, if applicable; g. Reports submitted to applicable regulatory agency that reflects the financial condition and result of operation of the taxpayer, if applicable. Examples are: g.1 Statement of Condition and Statement of Income and Expenses submitted to BSP, in case of banks; or g.2 Annual Statement submitted to the Insurance Commission, in case of insurance companies. h. Proof of entitlement to tax exemption/incentives, if applicable; i. Sample invoice for "Exempt Sales," if applicable; j. Other documents deemed necessary by the RO in the course of investigation; k. Delinquency Verification Report (For Claims for Refund/TCC); and l. Authority to Issue Refund/TCC (For Claims for Refund/TCC). 3. Documentary Stamp Tax a. Duly filed Documentary Stamp Tax Return; b. Duly Received Information Returns for Documentary Stamp Tax; IaECcH c. Working Papers showing details and computation of tax base duly signed by Tax Auditors/Revenue Officers; d. Working Papers showing computation of Documentary Stamp Tax Due duly signed by ROs; and e. Comparative Report of Deficiency Tax Paid/Assessed: e.1 Current year/period e.2 Previous year/period n Note from the Publisher: Copied verbatim from the official document. Irregular numerical sequence. n Note from the Publisher: Written as "Incentives" in the official document. n Note from the Publisher: Copied verbatim from the official document. Irregular numerical sequence.