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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 phase.
  • 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 sheets laundered.

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?

Who knows?

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 Analysis.

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 income.

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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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:


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