by Evie Alvarez
*adapted from The Tax Book - 2011 Tax Year

Executive Summary

An accountable employee reimbursement plan allows employers to reimburse their employees without having to add that amount to the employee’s income. It also allows the employer to expense the purchases, as allowable. However, certain guidelines must be followed in order to ensure that the reimbursements are allowable.

Why have an accountable plan?

The main benefit of an accountable plan (versus a nonaccountable plan) is that the reimbursement amounts are tax-exempt for the employee receiving the reimbursement. If the plan is nonaccountable, then the amounts are taxable income for the employee receiving the reimbursement.

Qualifications of an Accountable Plan

Employees must:
-          Have paid or incurred deductible expenses while performing services as an employee
-          Adequately account to the employer for these expenses within a reasonable period of time
-          Return any excess reimbursement or allowance within a reasonable period of time

Reasonable Period of Time

There is some variation, according the facts and circumstances of the situation, as to what qualifies as a reasonable period of time.  Following is a list of reasonable time frames:
-          The employer reimburses an expense within 30 days of the time the employee incurred the expense
-          The employee adequately accounts for the expense within 60 days after the expense was paid or incurred.
-          The employee returns an excess reimbursement within 120 days after the expense was paid or incurred.
-          The employer gives the employee a periodic statement, at least quarterly, that asks the employee to either return or adequately account for outstanding advances, and the employee complies within 120 days of the date of the statement.

Advanced Allowance

If the employer decides to pay the employer in advance of the employer actually incurring the expenses, the following requirements must also be met (in addition to the qualifications for an accountable plan):
-          Reasonable calculation of the allowance amount is done so as not to exceed the amount of anticipated expenses.
-          The employer makes the advance within a reasonable period of time.

Per Diem Option

Instead of an amount-specific reimbursement, an employer may choose to set-up a per diem allowance for travel, lodging, meals and incidentals. This could be based upon travel days, miles, or another fixed allowance. For rates, see: http://www.irs.gov/pub/irs-pdf/p1542.pdf

Please keep the following factors in mind:
-          Amount must not exceed the federal rates
-          Employees must substantiate the time, place, and business purpose of the trip
-          Employees are not required to submit receipts to the employer if using a per diem allowance

Practical Application

Within the above guidelines, there is flexibility as to exactly how your company sets up an accountable reimbursement plan. Following are a few examples of some practical applications.

Example 1

The employer requires the employee to submit reimburseable receipts within 2 weeks of the date the expense was incurred, along with an explanation of the expenses’ business purpose. The employer then writes a check to the employee for the amount of the expense. The employer retains records of the expenses and reimbursement.

Example 2

An employee travels out-of-town. The employee provides the employer with the time, place, and business purpose of the trip to be reimbursed. The employer writes a check for the employee, based upon the federal per diem rate for that location. For rates, see: http://www.irs.gov/pub/irs-pdf/p1542.pdf

Example 3

The employer assumes that the employee will have reimburseable expenses. After a reasonable calculation for the expected expenses, the employer pays money to the employee. At the end of the month, the employee provides the employer with receipts for the expenses and any excess allowance.

Corporate Policy

However your corporation structures employee reimbursement, it is important that the policy is part of the corporate documents. Having the policy on file will help in the case of any IRS scrutiny.

IRS audits of small business software files

Practitioners should balance risk for their clients.
BY JIM BUTTONOW, CPA/CITP
JANUARY 2012
 
Tax practitioners have always been cautious with the records they provide to the IRS in an audit to control the depth of an IRS inquiry. But IRS agents are starting to request client backup files from small business accounting software such as QuickBooks and Peachtree, and many practitioners are concerned about how much information the IRS is requesting and how it is using that information.
 
This article explores the IRS’ legal authority and long-standing use of electronic records in audits and takes a closer look into how the IRS requests and uses electronic files. It offers tips for CPA practitioners in responding to IRS requests for small business accounting files and for their clients in adjusting bookkeeping practices to minimize undue IRS inquiry during a small business audit.
 
In October 2010, partially at the request of tax practitioners during IRS focus groups, the IRS announced it was expanding its audit capabilities by training agents to be proficient in auditing information from files of accounting software commonly used by small businesses. According to the IRS, it has trained 1,100 revenue agents and has given them copies of the software to become proficient in using them and other programs in the future. It also encouraged agents to start requesting electronic files from taxpayers and practitioners. According to the IRS, the push to start using small business accounting files in audits originated with feedback from tax practitioners in 2008 focus groups. Practitioners indicated they wanted the IRS to be more efficient in examining records and reduce the volume of paper involved in audits. The IRS saw this as making audits more efficient for its agents as well.
 
IRS AUTHORITY TO REQUEST ELECTRONIC RECORDS
It’s clear in IRS regulations and precedent that electronic records can be requested and used in audits. Sec. 6001, Regs. Sec. 1.6001-1(a), Rev. Rul. 71-20 and Rev. Proc. 98-25 give the IRS broad authority to examine electronic records to establish the taxpayer’s correct tax liability. Regs. Sec. 1.6001-1(e) requires the taxpayer to make these records “at all times available for inspection by authorized internal revenue officers or employees, and shall be retained so long as the contents thereof may become material in the administration of any internal revenue law.” Rev. Proc. 98-25 clarified that the IRS has a right to electronic records.
 
The taxpayer must provide the electronic records upon request. If a taxpayer attempts to withhold them, the IRS may disallow all of the items that are unsubstantiated as a result of the decision to withhold the files—or it may summon the records.
 
SUMMONS POWER UPHELD
In June, the IRS prevailed in a summons enforcement case in U.S. District Court (Rouse, No. 8:11-MC-00046-T-24AEP (M.D. Fla. 6/27/11)). The IRS had requested the taxpayer’s QuickBooks backup files. The taxpayer refused to comply, and the IRS enforced the summons. The judge in the case summarily ordered the taxpayer to turn over the records to the IRS, citing Secs. 6001 (records required) and 7602(a) (IRS summons authority), and concluding the IRS had met the good-faith requirements for enforcing the summons under Powell, 379 U.S. 48 (1964). However, many facts of the case remain unclear, including whether the taxpayer offered alternative records to the IRS in lieu of the electronic files. In its decision, the Rouse court reiterated the right of the IRS to have original books and records: “A plain reading of § 7602 reveals that the I.R.S. may ‘examine books, papers, records, or other data which may be relevant or material to such inquiry …’ 26 U.S.C. § 7602(a)(1) (1998) (emphasis added). The Court finds that ‘other data’ under § 7602 includes the electronic backup files at issue, and thus, the summons is appropriate.”
 
IRS GUIDANCE
Although the courts are helping define this emerging issue, the IRS clearly has the largest stake in guiding agents and tax practitioners in how to comply. On Sept. 1, the IRS Small Business/Self-Employed (SB/SE) division issued a field directive memo (SBSE-04-0911-086) for agents and auditors about how to request, review and protect taxpayer backup files. It also updated a set of frequently asked questions (FAQs) at tinyurl.com/68gt5kb.
 
The memo instructs examiners to generally request a copy of the taxpayer’s original software backup file but to use professional judgment when determining which records to request. For example, agents would likely request files in larger-scope audits (such as when verifying gross income), but they probably wouldn’t request files in an audit of one expense item, according to the FAQs.
 
The IRS memo instructs agents to limit their review to information relevant to the year under examination. However, if the IRS is examining certain issues, such as accrual accounting or reconstruction of income, then it might review relevant data from other tax periods, according to the FAQs. Based on the results of an examination, the IRS also might expand the scope of an audit. In that case, the IRS would notify the taxpayer and use the available records. These updates leave room for IRS agents to determine when to examine prior- and subsequent-year data.
 
The IRS also mentioned that agents would not use the files for any purposes other than the examination and that the information is not disclosable to the public. The IRS stated that, if the file has “privileged information,” such as information protected under the Health Insurance Portability and Accountability Act of 1996, the representative should speak to the IRS agent about redaction. At this point, it appears that the IRS will not endorse any redaction. However, a discussion with the agent might be warranted to determine what could be redacted.
 
WHAT REVENUE AGENTS ARE LOOKING FOR
IRS auditors prefer reviewing and assessing the original books of entry—not translated or interpreted versions—to evaluate audit trails and the reliability of records.
 
Audit trails are critical in IRS examinations. The auditor can view dated transactions, subsequent changes, and the user name of the person who entered or changed a transaction. This information is directly relevant to the evaluation of the taxpayer’s accounting system and internal controls.
 
On May 27, the IRS modified its Internal Revenue Manual (IRM) to provide guidance and rules on how revenue agents should evaluate taxpayers’ electronic books and records. The IRS description of electronic books and records also includes taxpayer websites, e-commerce activities and Web marketing material, which the IRS finds useful for audit trails in tracing income, such as e-payments.
 
Some practitioners are concerned that taxpayer adjustments in business software files may raise red flags with the IRS unnecessarily, requiring more time and expense to explain them. They are concerned that the IRS will jump to conclusions by perceiving corrections of bookkeeping errors as attempts to manipulate books and records.
 
Practitioners face a dilemma. They want to supply the agent with the information needed, but many are concerned about turning over the entire backup file to the IRS.
 
FILE REDACTION
The IRS has commented publicly about taxpayers’ providing redacted prior-year files. On April 20, Chris Wagner, chief of the IRS Office of Appeals, addressed the redaction issue in a letter to the AICPA. In the letter (available at tinyurl.com/3rza5h6), Wagner confirmed the long-standing position of the IRS to have original documentation in an audit:
[I]t is important an exact copy of the original electronic data file be provided to the examiner and not an altered version. Only an exact copy of the original file includes the unaltered metadata which allows examiners to properly consider the integrity and veracity of the electronic files through use of such means as reports generated by the software program that may help to identify deleted or altered entries.
Wagner said that it’s acceptable for practitioners to “condense” prior-year information “as long as the condensed data does not include transactions created or changed for time periods under audit, or for transactions from prior years that have an effect on the years under audit.” The IRS published its approval of this position in its FAQs, where the Service also pointed out that, if the audit scope is expanded, the agent might request a backup file created before the file was condensed or a copy of the archive file created during the condensing process.
 
Wagner also noted a software limitation best solved by software companies—allowing single-year files in the backup process. Wagner suggested that, before a long-term solution is found, taxpayers should consider making their own backup files for individual years.
 
The AICPA hosted a meeting Sept. 8, with IRS officials and software developers about ways to minimize the amount of electronic data provided to the IRS during an audit. The AICPA discussed the need for software changes that would enable small business taxpayers to provide only information that is directly relevant to an IRS audit.      
 
On Sept. 1, the IRS director, examination, provided guidance on requesting backup files when taxpayers or practitioners assert they cannot comply because the backup file contains privileged communications. The memo (SBSE-04-0911-086) suggests in either case examiners contact their local IRS counsel for assistance. “Generally, a customer list would not be privileged but there may be unusual circumstances in a particular case that could possibly make the information, when combined with other information, privileged,” the memo stated.
 
Danny Snow, CPA, immediate past chair of the AICPA IRS Practice & Procedures Committee, is interested to see how the IRS will approach the issue of redacted files. “We are aware that CPAs are providing selective data,” he said. “We are waiting to see if the Service challenges the altered files because critical audit trails may be deleted when providing the selective data.” Snow said that the IRS has used restraint so far and that the new SB/SE commissioner, Faris Fink, appears to want to work closely with the AICPA on this issue.
 
THE IRS IN TRAINING
For most IRS revenue agents, using electronic records in small business audits is a relatively new approach, becoming increasingly prevalent since October 2010. The IRS has more than 14,000 agents, and only 1,100 have been trained in the use of QuickBooks and Peachtree. Clearly, this IRS audit technique is in its infancy. There’s evidence in current audits that the IRS is still learning how to use these electronic files and, as a result, has not established a standard operating procedure.
 
An IRS representative at the IRS Tax Forum Aug. 16–18 in Las Vegas commented on IRS procedure for requesting and reviewing electronic files in audits. In a seminar titled “Auditing with Electronic Accounting Software,” the representative detailed how the IRS requests records and how they should be supplied:
 
The IRS uses Form 4564, Information Document Request, to request software backup files (along with the administrator user name and password) from the taxpayer or representative.
The file must be provided by DVD, CD or flash drive—and not by email. If the practitioner mails the storage media, the IRS recommends that the file be encrypted and the password be sent separately.
The IRS will use the files to test the integrity and veracity of the accounting records—to test the business’s internal controls. This is always the first step for examiners, but they can do it more quickly and thoroughly using electronic records.
 
One tax forum participant asked how the IRS would proceed if a person other than the taxpayer or the representative had done the bookkeeping and refused to release the backup file as “proprietary” information. The IRS would summon the file, according to the IRS representative. The participant voiced concern that the IRS would have a copy of the file but the taxpayer would not—a situation the IRS representative characterized as a civil matter not involving the IRS.
 
As for reviewing the electronic files, the IRS representative echoed other IRS statements that the agent would review only data relevant to the years under audit, which could include data from other periods as long as they relate to the audit scope. The representative also said that the IRS examiner needs supervisor approval to expand the audit scope to additional years, and that the taxpayer would be notified in that case.
 
Some CPAs are optimistic that using electronic files could streamline the audit process. Other practitioners have experienced an IRS learning curve with their small business clients who have been audited.
 
REPRESENTING SMALL BUSINESS CLIENTS
Practitioners do not want to impede an examination and violate Circular 230, Section 10.20, by refusing to provide requested records to the IRS. However, practitioners have a duty to protect their clients by not providing more than what the IRS requests.
 
Here are some tips to protect clients from unnecessary inquiry and audit depth:
 
Keep audit trails on. Practitioners do not want the IRS to perceive that their client’s internal controls are weak. When the IRS requests records with associated audit trails, all of a taxpayer’s recording errors are exposed, and the agent can make conclusions based on entries that are reversed or corrected. Errors and corrections are common for many business owners who purchase programs such as QuickBooks to save on bookkeeping fees. If the IRS concludes that a taxpayer’s controls are weak, the IRS may expand the audit.
 
Some practitioners have suggested that their clients turn off the audit trail indicator on QuickBooks. Regardless of the reason, that approach is not advisable, because it will immediately raise the audit agent’s suspicion.
 
Keeping audit trails active also supports the IRS’ preference for contemporaneous recordkeeping. However, when there’s an error in an entry or account, the taxpayer or accountant should document several items: the erroneous entry, the correction and an explanation of the correction. The taxpayer should also include documentation to support the correction, especially for large and unusual items. When the IRS questions the corrected entries, the taxpayer can provide the documentation to demonstrate to the agent that he or she is an effective bookkeeper and that the records are trustworthy.
 
During tax preparation, create a new workpaper highlighting any large, unusual or frequently examined entries that have been corrected. Maintain the explanations in your client’s records to document your due diligence and reduce your risk.
 
Set limits, if possible. Be cautious when providing only the data for the year under audit by condensing transactions in nonaudit years. Discuss your concerns with the IRS agent or his or her manager before fulfilling the document request with the backup file. Explain in writing to the IRS exactly what you will be condensing. In the future, create separate backup files for each year. Be clear when responding to the IRS information document request about exactly what data you are providing and not providing.
 
You could also ask the IRS agent whether he or she will accept an alternative, such as printouts of accounts with detailed explanations. Before 2010, that was the method used in most SB/SE audits. Explain to the agent why it is a better approach; after all, it is how the return was prepared.
 
If your client has used QuickBooks utility programs such as QB or not QB to remove prior-year data, explain in writing to the agent exactly what was done when you provide the file. A word of caution: The IRS could view the use of these kinds of software products as the equivalent of not turning over the full software file. Warn your clients that providing less than the full file to the IRS might encourage the perception that they are attempting to hide something or have stripped out data that might be relevant to the audit.
 
If your client is a poor bookkeeper, request that he or she relinquish that duty to someone who is more qualified. You can encourage your client by explaining that the IRS may review every right or wrong keystroke in an audit. Encourage them to follow a good, old-fashioned cliché: “Measure the transaction twice, post the entry once.” This also makes the CPA year-end audit easier.
 
If possible, consider consolidating your client’s electronic systems into one complete system. Use of several systems confuses the IRS and adds complexity in an audit. Using one system to record revenue and another to record payables is confusing for everyone.
 
Be upfront with the IRS and your clients. Snow, the AICPA committee member, suggested that practitioners visit with the IRS group manager to discuss the need for the electronic files, and if your client is adamant about not turning over the complete files, meet with the territory manager. If your client authorizes providing the electronic files, Snow suggested noting the authorization in the engagement letter. “If you’re representing a client who does not want to turn software files over to the IRS, be sure you don’t violate Circular 230,” he said. 
 
THE OUTLOOK FOR ELECTRONIC FILES IN IRS AUDITS
It appears the IRS is advocating restraint in how its agents examine electronic files. However, the IRS has been clear that it expects full access.
 
Practitioners should always exercise caution in representing their clients. As audits of small businesses continue to increase, practitioners will need to closely monitor entries on their clients’ books and records to protect them from unnecessary inquiry by IRS agents. Practitioners should also carefully observe how the IRS uses these files as agents become more comfortable using electronic records.
 
When it comes to electronic files in small business audits, practitioners can take advantage of the tips provided in this article and continue to use the best practices they already know: Balance risk, follow professional judgment and look to the IRS for updates and guidance.
 
Editor’s note: Portions of this article originally appeared in the July/August 2011 edition of the Tennessee CPA Journal and are reprinted with permission from the Tennessee Society of CPAs.
 

EXECUTIVE SUMMARY
 
 In its examinations of the returns of small business taxpayers, the IRS is increasingly requesting electronic files of accounting programs such as QuickBooks and Peachtree. While taxpayers and their CPA tax preparers must be responsive to these requests, they must also take care to provide no more taxpayer data than a request reasonably covers.

  The IRS has instructed its examiners to generally request a copy of taxpayers’ original backup files for audits of such potentially wide ranging items as verifying gross income, although it has indicated a request may not be necessary with respect to a single expense item. Examiners also should limit their requests to the tax year under examination but will request records of other years when needed to verify a current-year item from prior- or subsequent-year accounting.

 Although the IRS has issued no specific guidelines regarding privileged information in a file, such as medical records, guidance indicates some redaction may be possible with the consent of the examiner.

Jim Buttonow (jbuttonow@newriverinnovation.com) is co-founder of tax technology company New River Innovation in Greensboro, N.C.

by Evie Alvarez

Business Expenses: Entertainment

We’re going to be posting a series of blogs about common business expenses. Hopefully this will give you an overview of what expenses are deducted from gross receipts in calculating taxable business income.

Executive Summary

Entertainment expenses are an area which the IRS often scrutinizes closely. Therefore, it is important to be able to support your deductions. Generally speaking, expenses to entertain a client, customer, or employee are deductible. There are guidelines regarding how this is defined by the IRS. There is also a list of entertainment expenses which are never deductible.

First Question

For any business expense to be deductible, it must be an ordinary and necessary expense for carrying on a trade or business. There are several types of expenses that will be ordinary and necessary to multiple businesses. Conversely, there are expenses which will be specifically with one type of business. This is the first question to ask when determining whether or not your entertainment expense will qualify for a business deduction.

Tests to be Met

Once you determine that the expense is ordinary and necessary for carrying on your trade or business, the entertainment (any activity generally considered to provide entertainment, amusement, or recreation, and includes meals provided to a customer or client) must be directly-related or associated.

To be directly-related it must:

• Take place in a clear business setting OR
• The main purpose of entertainment is the active conduct of business AND
• The taxpayer has more than a general expectation of getting income or some other specific business benefit

To be associated:

• Entertainment is associated with the taxpayer’s business AND
• Entertainment occurs directly before or after a substantial business discussion

No or Limited Deductions

The following expenses have limited deductions or are not allowable deductions:

·         Facility rental

·         Country club dues

·         Cruise ships

·         Luxury sky boxes

·         Hunting lodges

Documentation

Documentation is required. The expense may easily be disallowed if the following documentation is not available:

1.      Itemized bill (must show what has been purchased)
2.      Documentation of what the business purpose was of the meeting.

Amount

Only 50% of the cost is deductible when it comes to meals and entertainment. Keep that in mind!

Business Gifts

This isn't a meal or entertainment expense, but is such a short topic, that we decided to tack it on here. Simply put, your business may deduct gifts to employees, clients, or customers. The cost of the gift cannot exceed $25 per person per year. Incidental costs of wrapping or shipping are not added to the $25 limit. If the cost is $4 or less, it below de minimis, so does not need to be reported. Advertising items are not included as a business gift. So, if you send your clients a magnetic calendar with your business information on it, it is not considered a business gift, but an advertising expense.

Be on the look-out for the next posting about business expenses...

by Evie Alvarez

Executive Summary
This deduction is available to employees and business owners who have a space in their home that is regularly and exclusively used for business. Most expenses will be allotted according the percentage of the home which is used for business. Sole-proprietors and single-member LLCs, will report this as an expense on Schedule C. Employees will report this on Schedule A as an Unreimbursed Employee Expense. For employees, the amount of the deduction is the excess of 2% of gross income.

Eligibility Tests
Regularly and exclusively. Regularly and exclusively. You got that? Great!

Now, what does that mean? Any space in your home for which you are claiming business use of home must be regularly and exclusively used for business.

Let’s work through a few examples together and you can tell me whether it is REGULARLY and EXCLUSIVELY used for business.

- The kitchen table? Not likely. You probably have to push your piles of papers aside in order to fit your plate of pizza on the wood.
- A room set aside as an office? Possibly. If it looks like an office, then it should qualify. If it has a large bed that your mother-in-law sleeps on when she visits (every other weekend), it may be crossing the line when it comes to exclusivity. However, you may still be able to use the area of the room that is exclusively used for business.
- The coffee table in your living room where you sit and type on your laptop? Probably not. Again, that darned exclusivity test!
- The desk in your bedroom which you use to work from home twice a week? Sorry, but no. That’s not regular, so this doesn’t qualify as your principal place of business.

Now, of course, this wouldn’t be the Internal Revenue Code if there weren’t a few exceptions to the rule.

For the exclusivity test, there are exceptions if you use part of your home for storing inventory or product samples, or if you use part of your home as a daycare facility. These exceptions are somewhat beyond the scope of this blog, however.

Claiming the Deduction
Information you’ll need to know in order to claim the deduction:
- Area (square footage) of your home
- Area (square footage) of the space you use regularly and exclusively for business
- Length of time used for business (full- or partial-year)
- Direct Expenses: Those expenses which are only for the business part of the home. Examples include: painting or repairing the business room.
- Indirect Expenses: The expenses for keeping up and running the entire home. Examples include: insurance, utilities, general repairs, etc.

Direct expenses are fully deductible while the deductibility of indirect expenses is figured using the percentage of the home used for business.

Example

Area of office room: 50 square feet
Area of home: 2000 square feet
Percentage used for business: 3%
Cost of painting office: $100
Cost of utilities: $3,000

Deductible amount: $100 + 3% of  $3,000 = $190

There is also an opportunity to take depreciation on your home, if you own your home. Land is never depreciable. Depreciation is a topic for another day, so I’ll just let you know that you can take depreciation on your home if you have qualified business use.

Now, whether you’re an employee or a business owner, the guidelines for claiming Business Use of Home is the same. The difference is where that information then goes onto your return.

Sole-Proprietor or Single-Member LLC

You’ll need to fill out form 8829, which will then flow through your Schedule C as an expense. This amount will either lower your profit or increase your loss, which will then affect your gross income to be taxed. Awesome! Lowered profit = lower taxes.

Employee

This will come through your 1040 Schedule A, Unreimbursed Employee Expenses. Of course, as the name implies, if your employer reimburses you for these expenses, you will not be able to claim them on your tax return. The Schedule A is where you document your itemized deductions. Now, here’s the catch which lowers the overall effect of this deduction on your return. Only the excess of 2% of your gross income is actually deducted to determine your taxable income. (I’m assuming that your overall, itemized deductions are greater than the standard deduction. If the standard deduction is greater, the unreimbursed employee expenses won’t help you.)

So, taking our example from above into consideration, if I had gross income of $9,000, I’d only be able to deduct $10, since 2% of $9,000 is $180 and my overall expense is $190.  If I’m in the 15% tax bracket and only taking into consideration this deduction, my overall tax would change from $1,350 (15% of  $9,000) to $1,348.50 (15% of $8,990). Yep, that’s a whopping buck and a half. But, since we round to the whole dollar…only $1.

You may ask why I chose to use gross income of $9,000. That’s rather low. I totally recognize that and realize the limitations of my example. So, why $9,000? If I chose $10,000, you’d get absolutely no deduction WHATSOEVER. 2% of $10,000 is $200. Only the amount over $200 is deductible and our total was $190.

Now, of course, your circumstances will be different, but this does show you how this generous deduction really flows through to very little effect upon the amount of taxes you actually owe if you are an employee. If you own your own business, the net effect will be greater since you don’t have to worry about it being the excess of 2%.

I hope all of this confusing rambling has helped you come to appreciate the complexities of the tax code! Hopefully, it has also helped to give you some understanding of how your tax is determined so that you can make the most of the deductions available to you.

By Ivan Alvarez, CPA

Many small businesses, specially construction contractors, that require an audit maybe surprised by additional requirements CPA's must comply with when issuing an audit opinion. 

First, it seems that small entities, generally speaking, have much to be desired when it comes to internal controls. Many firms believe that internal controls is something that CPA's "do." This is incorrect. Management is responsible for internal controls. Further, your CPA auditor has to be independent, hence, auditors cannot be involved in the design and implementation of internal controls without losing their independence. Hence, the audit is not going to "fix" your internal control issues. Internal controls should be designed and operating effectively to prevent, detect, and correct a material misstatement before the audit begins. 

What if internal controls are not designed or operating effectively when the audit begins? Well, more than likely, material adjustments will be made by the auditor (see below, material adjustments discovered during an audit are not optional1). If such material adjustments are proposed by the auditor then these proposed adjustments are evidence that a deficiency in internal control exist since internal controls did not prevent, detect, or correct the material amount.  

Okay. A deficiency in internal control exist. So what? The big deal is that in addition to an audit opinion letter, the client (management and those charged with governance) will receive an internal control deficiency letter that must be shared with outsiders relying on the audit opinion. This deficiency letter can affect lenders decision to lend or surety companies from underwriting.

Now, what if you don't require an audit? Well, internal controls, when properly designed should be cost-effective and help your business reduce waste. According to a leading fraud reporting organization, fraud costs the typical organization about 5% of annual revenues. This 5% can be made up of employees doing personal errands on company time, employees padding expense reports with personal expenses, stealing supplies, etc.  

How do you fix internal controls if you have an issue or how do you design internal controls effectively? Well, the best equipped person to help you with is your local Certified Public Accountant or experienced business consultant. You can always try to do this on your own, but  internal controls do require some professional judgement. A CPA should help you prioritize which controls are essential and help you implement the right controls.  

1-If the adjustments proposed are material, the client must accept the adjustment or an alternative adjustment to prevent their financial statements from being "materially misstated." No auditor will sign an audit opinion if the financials are materially misstated.