Getting Ready for an Audit
My last blog pointed out that any construction company may be subject to a sales and use tax audit by state tax authorities. However, the reality is that states have limited audit resources so, revenue agents typically focus their attention on companies more likely to produce the biggest revenue bang for the buck. I identified some red flags that might get the attention of the tax auditor both before and during the audit.
Today, I focus on red flags that often arise in the research (“pre-audit research”) that an auditor does before an in-person meeting between the taxpayer and the auditor. This research can uncover red flags, and, therefore, influence what is called the tax auditor’s pre-audit plan.
Even before an actual on-site audit begins, auditors do pre-audit research to get a handle on the industry and companies that may be targeted. Information obtained in this research may uncover “red flags” that influence the auditor’s pre-audit plan. It is, therefore, a good practice in planning for a sales and use tax audit to understand more about the pre-audit research before an actual in-person audit takes place.
Sources of Pre-audit Research
There are both internal and external resources that may be used in doing pre-audit research.
Prior Audits. The auditor will determine if there has been a prior audit on the taxpayer. Often, prior audit issues will still exist in a subsequent audit. Review of the prior audit will also assist the auditor in understanding the taxpayer’s operations.
Filing History. The tax auditor will also review federal and state tax records and transcripts to determine whether the taxpayer:
- Has been filing its sales tax returns regularly
- Has a pattern of filing sales tax returns late
- Has filed amended returns in the past few years
- Has made any large refund requests in the few years
- Has undergone recent federal income tax audits
Auditors frequently make extensive use of the Internet and public and other databases as research tools to get a better understanding of the construction company. For example, has the company been receiving media attention for recent growth both in revenue or M&A activity?
In addition to getting a general understanding of the business, auditors acquire certain financial and operational information about the construction industry in general. This industry information can be compared to the specifics of the taxpayer’s company. This is often called “benchmarking.” Where there are significant differences, that could be another “red flag” that you can expect the auditor to surface with you. Of course, such differences do not necessarily lead to proposed audit adjustments, but it is a good practice to be prepared to discuss them.
Construction Industry Financials and Key Operational Ratios. Some of the key construction industry financial and operational ratios would typically include:
- Liquidity Ratios
- Current Ratio
- Quick Ratio
- Leverage Ratios
- Debt to Equity
- Efficiency Ratios
- Working Capital Turnover
- Equity Turnover
- Profitability Ratios
- Net Profit/Gross Profit
- Gross Profit/Net sales
Other External Sources. There are a number of specific external sources that are often part of the auditor’s routine. For example, if the construction company is large, it may be required to file with the SEC. The auditor will ask you for a copy of the Annual Report and 10-K for each year under audit from. A thorough review of these documents assists the auditor in understanding your operations and industry.
Most taxpayers maintain a web page, and if one is available the auditor will visit the web page and research there. A great deal of information can be gleaned from your website about your business operations.
If you do not maintain a web page, the auditor is likely to research your business by doing a general search on the internet about your business and industry by using available search sites (e.g., Google, Yahoo, or others). And there are several construction-industry sources of information that may be relevant to the audit. For example, one such source might be the Construction Financial Management Association (CFMA), and its Construction Financial Benchmarker.
Finally, the auditor may also check social media outlets to gain any insights on your company.
Tax Audit: Better to be Prepared Than Surprised
The pre-audit plan prepared by the tax auditor is only the first stage of the audit process that might raise some red flags. Although the tax authorities of each state may differ in some of the specifics of their audit approach for different types of companies and industries, there are some steps common to all audits.
- Pre-Audit Research (industry ratios, audit history, etc.)
- Initial Audit Plan (based upon the pre-audit research)
- On-site Audit—Initial interview
- Audit & Verification Procedures (sampling, computer-aided, etc.)
- Use tax audit
- Current Tax Issues Raised During Audit and follow up Audit Procedures
- Proposed Adjustments and Appeals
Although the audit plan will change depending upon what the auditor learns from the on-site interviews and the actual audit of the books, it is a best practice to anticipate possible red flags that might emerge from both the internal and external research done before the in-person audit even starts. At a minimum, you and your team should be prepared to:
- explain major differences between a company’s specific financials and operations on the one hand and industry standards;
- provide reasonable explanations for any recent tax return filing problems, e.g., failures to file, late filings, etc.,
- demonstrate what remedial steps have been taken to correct any prior audit problems.
In future blogs, as I examine other possible red flags emerging at different stages of the above audit process, it is always important to keep in mind that the construction industry has many complex sales and use tax issues. Therefore, the more sophisticated the accounting and sales and use tax tools that you and your company use, the more likely that there will be a “good” audit result.