Economic Reality Audits
© by Greta P. Hicks, CPA
ARE you concerned that the in-depth interviews of your clients will
reveal issues that will later cause the auditor to make a fraud referral?
Are you concerned that your client may think that you did not properly
represent him/her? Are you concerned that the IRSí increased emphasis on
fraud enforcement could lead to a malpractice lawsuit?
The answer to all three questions should be "Yes."
The American Institute of Certified Public Accountants advises that
we should be concerned. Since our relationship is not protected by a privilege
as that of attorneys and their clients, certain questions raised during
an economic reality audit could place accountants in a difficult position.
Suggestions for protecting yourself include:
- Be prepared for the audit to the extent that you can answer relevant
questions. Preplan! Preplan! Preplan!
- Discuss potential problem areas with your client during the preplanning
- Advise client of new IRS procedures.
- Prior to allowing the IRS to interview the client, have the agent
explain why an interview is necessary. (Under current policy, initial interviews
are not mandatory.)
- At the first indication of potential fraud, recommend the client
seek the advice of an attorney.
Fraud Awareness Training is the old
title and Economic Reality Training is the
new term for the 1995 CPE program that IRS employees are attending this
spring. Employees will be studying ways to detect unreported income and
the mechanics of calculating income by using indirect methods. Traditionally
employees were trained in bank deposit analysis, net worth computations,
and determining the source and application of funds. The training has been
expanded to include the "sheet" method, the "suitcase"
method, and the "bottle" method.
The sheet method was used by a revenue agent to determine the income
that should have been reported by a motel. The agent summoned the laundry
records and counted the sheets and imputed a room rate for the number of
The suitcase method was used recently by the IRS to determine the
tip income of a bell man. The IRS person sat in his car across the street
from the hotel, and counted the number of bags the bell man carried into
the hotel. The agent imputed a dollar amount per bag to arrive at the bell
manís tip income. The court recognized this method as an accurate method
to use in determining unreported income.
The income from clubs and bars is tested by using the bottle method.
The agent secures copies of all invoices for purchases and imputes a number
of drinks per bottle and price per drink to arrive at an estimate of income.
Detecting Under Reported Income - IRS Style
The IRS calls it economic reality audits or financial status audits.
The name it went under when I worked for the IRS was probe for unreported
income. "Fraud Awareness" training or training in indirect methods
of determining the amount of under reported income are the old names. By
what ever name you call it , the IRS focus is back to the basics of auditing
what is not on the return rather than what is on the return.
In 1979, I was in charge of the Austin District training program
and for a while monitored the classroom training in the Southwest Region.
My duties took me to New Orleans, Austin, Dallas, and Oklahoma City. Back
then I was telling the new Revenue Agents to audit the taxpayer and not
the tax return. It was a hard sell because they were under time pressure
to complete the audit. More often than not they would slip back into asking
for information to support what was on the return.
Whatís happening now?
Economic reality audits are the same song but second verse. Is it
a fad that will pass?
If the statistics show high time on cases and low dollar of return,
the emphasis will change and the agents will again be under pressure to
produce dollars or cut time. Letís face it, economic reality or financial
status audits take more time. If the agents donít produce accordingly,
either the agent or the program will be out.
Agents have been told that the financial status of the taxpayer is
to be considered on ALL AUDITS.
During the pre-planning phase most auditors will perform a Cash T
The Cash T is a method of reconstructing income where the IRS compares
all known expenditures during the particular year at issue with all known
sources of receipts for the same year.
The theory of the Cash T is that if a taxpayerís expenditures during
a given year exceed reported income, and the source of the funds for such
expenditures is unexplained, the excess expenditures represent unreported
income. Page 2 gives you an example of the Cash T method of determining
You may be called to explain that any excess income of expenses over
income are loans, gifts, inheritances, or other nontaxable sources of cash..
Is The IRS Getting Personal?
The IRS calls it economic reality audits. The practitioner community
calls it an invasion of privacy. Agents and auditors have attended training
to perform audits on the taxpayer rather than verify the amounts on the
tax return. They are charged with answering the questions, "Does the
tax return make sense? Is the taxpayerís lifestyle consistent with the
tax return?" What kinds of questions do they ask?
- Did you buy a boat, car, four-wheeler, motorcycle this year?
- Did you take a vacation? If so how much did you spend?
- Do you have children in college? If so, how much is the tuition?
How much do you spend on books and room and board?
- How much were your gambling losses?
- How much did you spend on jewelry?
- Were there any major illnesses? If so, were they covered by insurance?
What portion did you pay?
- How much did you pay in rent, groceries, utilities, clothing, and
other personal living expenses?
- Did you receive any gifts or inheritances?
- Did you borrow any money? If so, how much?
- How much cash do you keep on hand?
Whatís In IRS Audit Files?
Beginning immediately the IRS is developing case files prior to the
cases being assigned to auditors and revenue agents. The case files MAY
include the following:
- Department of Motor Vehicle report.
- Credit Bureau report.
- Property tax report from Appraisal District
- Print out of Information Return data, 1099s, W-2s.
- State Sales Tax information.
- Secretary of State information.
- Specialized industry instructions.
- Accounts Receivable transcript.
- Other data available through public records and third parties.
ECONOMIC REALITY AUDITS ARE now a reality. Last spring the IRS trained
its agents to determine whether the income and deductions on the tax return
made economic sense. Most all audits now include an in-depth investigation
of the personal lives of taxpayers.
Prior to beginning audits, the agents will have available in the
taxpayers file such information as:
- Credit reports
- Court House records.
- Department of Motor Vehicle Reports.
- Other 3rd party source data.
Agents are insisting upon an 2 to 6 hour interview with the taxpayer
that includes personal questions, such as:
- Did you take a vacation? If so, how much did you spend.
- Did you buy a new boat, motor cycle, personal auto, motor home,
or other major purchase?
- What were you gambling losses? Winnings?
- Do you have children in college?
The AICPA and other professional organizations are attempting to
negotiate a modification of this latest of IRS probes in to the personal
lives of taxpayers.
As of 1-1-98 some IRS Districts have discontinued these types of
audits as a standard practice.
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List of Articles by Greta P. Hicks, CPA
GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies
and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing
educational materials and programs on solutions to IRS problems and is
a nationally known speaker and writer on solutions to IRS problems. To
arrange for consultation contact:
Greta's web site: http://www.gretahicks.com
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