March 17, 2000
REVENUE AUDIT MEMORANDUM ORDER NO. 1-00
SUBJECT : Updated Handbook on Audit
Procedures and Techniques Volume I (Revision —Year 2000)
TO : All Internal Revenue Officers and
Others Concerned
I. OBJECTIVE
This Order prescribes the use of the Updated Handbook on
Audit Procedures and Techniques (Volume I) in the audit of tax returns. The
Handbook is intended to provide revenue officers with minimum standard
procedures and a uniform guideline for the proper examination and/or
investigation of tax liabilities. This updated version was prepared in order to
conform with the provisions of the Tax Reform Act of 1997".
II. QUALITY
AUDIT
The purpose of auditing a tax return is to determine the
taxpayer's substantially correct tax liability. 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.
III. REPORTING
REQUIREMENTS
Revenue Officers are required to make a report after the
audit has been conducted. All reports should contain the minimum documentary
requirements specified under Chapter XVII of the Handbook.
IV. REPEALING
CLAUSE
This Order supersedes Revenue Audit Memorandum Order No.
2-95, all revenue issuances and portions thereof inconsistent herewith.
V. EFFECTIVITY
All revenue officers and other employees concerned are
hereby directed to refer to the aforesaid Handbook in the audit/investigation
of tax returns immediately after the approval of this Order. CTSHDI
(SGD.) DAKILA B. FONACIER
Commissioner of Internal Revenue
HANDBOOK ON AUDIT PROCEDURES AND TECHNIQUES
VOLUME I
(Revision - Year 2000)
PREFACE
The enactment of the National Internal Revenue Code of 1997
and its implementation effective January 1, 1998 marked significant changes in
Philippine taxation and the BIR's tax administration policies. Hence, it is
necessary to revise and update the existing revenue issuances and assessment
manuals in accordance with the new provisions of the Tax Code.
In order to utilize audit as an effective tool in the
enhancement of voluntary compliance, the first volume of the Handbook on Audit
Procedures and Techniques has been revised and updated to conform with the new
Tax Code. This volume discusses general procedures and techniques designed to
assist the Revenue Officer in the investigation of tax liabilities of
taxpayers. The audit procedures and techniques for the investigation of
Value-Added Tax liabilities are prescribed in a separate manual.
ACKNOWLEDGMENT
The updating of this Handbook on Audit Procedures and
Techniques — Volume I was completed under the leadership of Commissioner Dakila
B. Fonacier and Deputy Commissioners Romeo S. Panganiban, Estelita C. Aguirre,
Sixto S. Esquivias IV and Lilia C. Guillermo.
This Handbook is a project of the Assessment Service with
the Assessment Programs Division as the lead division which spearheaded the
project. Acknowledgment is also extended to Atty. Arnulfo B. Romero, Mr.
Rodolfo Mendoza and Mr. Manny B. Jimenez for their comments and invaluable
contribution to the project.
ASSESSMENT SERVICE
Nars P.
Tamayo Acting Assistant Commissioner
Elvira
R. Vera Acting Head Revenue Executive
Assistant
ASSESSMENT PROGRAMS DIVISION
Leticia
C. Batausa Officer-In-Charge
Ione S.
Alejo Section Chief
Elenita
V. Balonzo Section Chief
Cristina
T. Billones Section Chief
Urania
C. Salvacion Section Chief
Gladys
M. Aquino Revenue Officer III
Dessie
V. Garcia Revenue Officer
II
Elmira
C. Viray Revenue Officer I
Gean M.
Dienzo Computer Operator I
Cristina
V. Pangan Computer Operator I
Table of Contents
I. Introduction
Revenue Tax Administration
Purpose
Contents of the Handbook
II. Accounting
Methods
Cash Basis
Accrual Basis
Completion of Contract Basis
Percentage of Completion Basis
Installment Basis
Crop Year Basis
III. Bookkeeping
Systems
Single Entry System
Double Entry System
IV. Accounting
Records
Journal
Ledger
Subsidiary Book
Computerized Accounting System
V. Accounting
Period
Calendar Year
Fiscal Year
VI. Financial
Statements
Income Statement
Balance Sheet
VII. Purpose
and Standards of Audit
General Standards
Standards of Preliminary Planning
Standards of Field Work
Standards of Public Relations
VIII. Preliminary
Approach to Examination
Pre-audit Analysis of Tax Returns
Work Planning
Contact with Taxpayer
Preliminary Evaluation of Miscellaneous Records
Initial Examination Techniques
Evaluation of Internal Control
Sampling Techniques
IX. Balance
Sheet Approach to Examination
Cash on Hand and in Bank
Notes and Accounts Receivable
Allowance for Bad Debts
Inventories
Advances to Stockholders/Officers
Investments
Depreciable Assets
Allowances for Depreciation, Amortization and Other
Valuations
Reserves
Intangible Assets
Prepaid Expenses and Deferred Charges
Other Assets
Exchange, Clearing or Suspense Accounts
Current and Accrued Liabilities including Notes Payable
Fixed Liabilities
Deferred Credits
Loans From Shareholders/Officers/Owners
Capital Accounts
Capital or Owner's Equity
Partners' Capital
Stockholders' Equity
Capital Stock
Retained Earnings
X. Audit of
Income and Expenses
Audit of Income Accounts
Sales
Rent Income
Professional Fees
Income From Sale of Asset
Other Income
Audit of Expense Accounts
Purchases
Cost of Goods Sold
Salaries, Wages and Other Employees' Benefits
Fringe Benefits
Rents
Royalties
Interest
Taxes
Repairs
Bad Debts
Losses
Abandonment and Demolition
Casualty/Theft
Net Operating Loss Carry Over
Depreciation
Depletion
Contribution
Transportation and Travel, Representation and Entertainment
Stationery and Office Supplies
Professional Fees
Insurance Fees
Light and Power, Telephone and Telegraph
Miscellaneous Expenses
XI. Audit of
Minimum Corporate Income Tax and Improper Accumulation of Earnings Tax
XII. Auditing
Computer-Produced Records
Impact of Computer Records on Audit
Accounting Software Systems
Audit Techniques for Computer-Produced Records
XIII. Indirect
Approach
Percentage Method
Net Worth Method
Bank Deposit Method
Cash Expenditure Method
Unit and Value Method
Third Party Information (Access to Records) Method
XIV. Audit
Procedures on Other Kinds of Taxes
Withholding Taxes
Capital Gains Tax
Estate Tax
Donor's Tax
XV. General
Policies in the Investigation of Tax Fraud Cases
Jurisdiction
Procedures
Civil Fraud
XVI. Closing
Conference
XVII. Report
Making
Document Locator Form
Table of Contents
Narrative Report
Duly Accomplished Revenue Officer's Audit Report
Working Papers
Attachments to the Docket of the Case
Appendix
Revenue Memorandum Order No. 15-95
General Policies in the Investigation of Tax Fraud Cases
Revenue Memorandum Order No. 53-98
Checklist of Documents to be Submitted by a Taxpayer upon
Audit of his Tax Liabilities as well as of the Mandatory Reporting Requirements
to be Prepared by a Revenue Officer, all of which comprise a complete Tax
Docket
I. INTRODUCTION
A Revenue
Tax Administration
The function of the Bureau of Internal Revenue is to
administer the provisions of the National Internal Revenue Code. It is the duty
of the Bureau to implement the Tax Code and related laws enacted by Congress in
a fair and impartial manner.
The mission of the Bureau is to enforce internal revenue
laws with impartiality, consistency, collect the correct amount of taxes at the
least cost to the government and least inconvenience to the taxpayer and serve
the public honestly and efficiently in a manner that will elicit the highest
level of confidence in the Bureau of Internal Revenue.
Investigation supports the mission of the Bureau by
enhancing a high degree of compliance 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 returns and taxpayers that need to be
investigated; and
3. Conducting
quality audit of selected tax returns on a timely basis.
The purpose of auditing a tax return is to determine the
taxpayer's correct tax liability. 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 propriety of application
of tax laws.
B. Purpose
The updated Handbook on Audit Procedures and Techniques has
been prepared to equip all Revenue Officers who conduct field examinations
with-the necessary knowledge for the proper examination of tax returns and
provide them with confidence in carrying out the investigation. This Handbook
is designed to ensure that the Revenue Officer acquires useful auditing skills,
progresses from simple audit techniques to more sophisticated procedures, and
advances in examination procedures from a single proprietorship to a large
corporation and from a simple bookkeeping system to a highly computerized one.
The Revenue Officer's job is to familiarize himself with the
business activity and/or undertaking of the taxpayers assigned to him for
audit, to evaluate the various methods and procedures the taxpayers apply, to
be imaginative, observant and inquisitive in his examination, and above all, to
use common sense.
C. Contents
of the Handbook
The handbook contains guides, instructions and suggestions
in the conduct of audit for various 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 type of tax. This
does not preclude, however, the Revenue Officer from carrying out other audit
techniques which are deemed necessary in the circumstances surrounding a
particular case.
The Handbook is neither intended to provide a source of tax
law or procedural doctrine nor a substitute reference material of revenue
issuances. Each Revenue Officer is presumed to have a working knowledge of the
Tax Code, the latest amendments thereon, and an update of existing revenue
regulations, revenue rulings, revenue memorandum orders and other issuances.
The other contents of the handbook include documentary
requirements in the investigation process and proper report making.
II. Accounting
Methods
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 income
shall be made in such manner as in the opinion of the Commissioner of Internal
Revenue or his -duly authorized representative that clearly reflects such
income.
The methods of accounting recognized under the Tax Code 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 taxpayers 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. Completion
of Contract Basis is an accounting method applicable to contractors in the
construction of building, installation of equipment and other fixed assets, or
other construction work covering a period in excess of one year.
Under this method, gross income is to be reported in the
taxable year in which the contract is fully completed and accepted by the
contractee if the taxpayer elected it as a consistent practice to treat such
income, provided that such method clearly reflects the net income. Under this
method, all expenditures, are deducted from gross income during the life of the
contract which are properly allocated thereto, taking into consideration any
materials and supplies charged to the work under the contract but remaining on
hand at the time of the completion.
However, pursuant to Republic Act No. 8424 which took effect
on January 1, 1998, contractors are no longer allowed to adopt this method of
reporting their income derived in whole or in part from long-term contracts.
D. 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.
Beginning January 1, 1998 income from log-term contracts are
required to be reported using this method only.
E. 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 collected.
F. Crop Year
Basis is a method applicable only to farmers engaged in the production of crops
which take more than a year from the time of planting to the process of
gathering and disposal. Expenses paid or incurred are deductible in the year
the gross income from the sale of the crops are realized.
In relation to the foregoing accounting methods, the Tax
Code provides for a tax credit system in computing the tax payable by certain
taxpayers. While the tax credit system is not an accounting system, it is
discussed here for the proper understanding of the computation of taxes due
from taxpayers.
The tax credit system is a method used to account for the
creditable taxes deducted by the withholding agents from the income payments to
certain payees (as in the case of withholding tax at source pursuant to Revenue
Regulations (RR) No. 6-85, as amended by RR 2-98, or the creditable tax added
to the sales price (as in the case of value-added tax). The creditable taxes
should be clearly identified in the books of the taxpayer, such as:
1. Creditable
income tax (asset)
2. VAT input
tax (asset)
3. Withholding
tax payable-Compensation (liability)
4. Withholding
tax payable-Expanded Withholding Tax (EWT) (liability)
5. VAT
output tax (liability)
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.
Whenever a system of record keeping does not include equal
debit and credit to asset, liability, proprietorship, income and expense
accounts, it is referred to AA 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 deductions 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.
The accounting cycle starts with source documents (invoices,
bills, paid checks, loan documents, bank deposit slips, and bank statements)
proceeding to the cash receipts and cash disbursements journal, working paper
summary and ending with the tax return.
Reconciliation of the taxpayer's books, working paper
summary and records to the return is a very important audit step. In this way,
the Revenue Officer will become familiar with the taxpayer's accounting system,
policies and control procedures. If the records available are organized, this
will lend more credibility to the tax return, but if they are inadequate, then
the Revenue Officer should closely scrutinize the information on the income tax
return. Therefore, when encountered with the lack of formal books and records,
the Revenue Officer must use source documents and other available documents to
establish the taxpayer's financial position which shall be compared with the
taxpayer's standard of living and business activity for validation.
The following formulae for reconstruction of income and
expenses may be found useful:
1. Computation
of Sales
Cash Sales (cash book) xx
Add: Sales on account:
Collections
from customers (cash book) xx
Less:
Accounts receivable (beginning balance) xx
Collections
from sales for the period xx
Add:
Accounts receivable (ending balance) xx xx
— —
TOTAL SALES xx
==
2. Computation
of Purchases
Cash purchases (cash book) xx
Add: Purchases on account:
Payments
to creditors (cash book) xx
Less:
Accounts payable (beginning balance) xx
Payments
for purchases for the period xx
Add:
Accounts payable (ending balance) xx xx
— —
TOTAL PURCHASES xx
==
3. Computation
of Expenses
Cash payments for allowable expenses (cash book) xx
Add: Prepaid expenses (beginning balance) xx
Accrued
expenses (ending balance) xx xx
— —
Total xx
Less: Prepaid expenses (ending balance) xx
Accrued
expenses (beginning balance) xx xx
— —
TOTAL EXPENSES xx
==
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 + Capital
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
capital.
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.
