income taxes program

7/27/2019 Income Taxes Program

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AP-11: Audit Program for IncomeTaxes

Company Balance Sheet Date

The company has the following general ledger accounts related to income taxes.

General Ledger Number Description of the Account

AuditObjectives

Audit Procedures for Consideration

N/APerformedby

WorkpapIndex

FINANCIAL STATEMENT ASSERTIONS

E/O Existence or occurrence. V/A Valuation orallocation.

C Completeness. P/D Presentationand disclosure.R/O Rights and obligations.

AUDIT OBJECTIVES

A. Tax laws and regulations have been properly applied, andno items are improperly excluded in the determination of taxes
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estimated to be currently payable, and the related current taxliability is adequate but not excessive (assertions E/O, C, R/O, andV/A).

B. The provision for income taxes and related balance sheet

amounts, if any, for deferred taxes are properly stated inaccordance with applicable accounting principles (assertions E/O,C, R/O, and V/A).

C. The valuation account for deferred tax assets is adequate

but not excessive (assertions V/A and P/D).

D. Income taxes payable, deferred tax assets (and relatedvaluation allowances) and liabilities, income tax expense, andrelated note disclosures are properly described and disclosed in the

financial statements (assertion P/D).

IDENTIFICATION CODES

The letters preceding each of the above audit objectives, i.e., A, B,etc., serve as identification codes. These codes are presented in theleft column labeled Audit Objectives when a procedureaccomplishes an objective. If the alpha code appears in a bracket,e.g., [A], [B], etc., the audit procedure only secondarilyaccomplishes the objective. If an asterisk precedes a procedure, it isa preliminary step or a follow-up step that does not accomplish an

objective.

BASIC AUDIT PROCEDURES

* 1. Obtain or prepare an analysis of income tax relatedaccounts and related tax return information. Perform the followingprocedures:

a. Scan the accounts and compare opening balances to theprior years workpapers.

b. Review the prior years tax return and the results of anyIRS examinations completed during the period.

c. Inspect supporting documents for significant transactionsduring the period, i.e., estimated tax payments, refunds, etc.Document the items tested.


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Practical Considerations:

SAS No. 96, Audit Documentation, requires documentation of

substantive tests of details involving inspection of documents toinclude identification of the items tested. The authors believe items

tested can be identified by listing the items; by including a detailschedule in the workpapers, such as an income tax accountanalysis, on which the items are identified; or by documenting inthe workpapers the source and selection criteria. For example:

For tests of significant items, documentation may describe the

auditors scope and the source of the items (for example, alltransactions greater than $5,000 from the 20X2 income tax payableaccount detail).

SAS No. 96 is effective for audits of financial statements forperiods beginning on or after May 15, 2002, with early applicationpermitted.

Some small businesses may operate in several states, and theauditor should consider the taxing jurisdictions the client is subjectto. In some cases, state and local taxes on income may besignificant.

In many small businesses, income taxes are recognized to theextent of the amounts paid or received only. Liability, receivable,or deferred accounts may not be used during the year. The auditorwill be expected to adjust the accounts during the course of theaudit. Under such circumstances, the analyses may be prepared asthe auditor determines the appropriate adjustments.

B 2. Calculate the current year provision for income taxes bypreparing a draft of the tax return or a tax calculation workpaper.

a. Reconcile income before taxes per the financial statementsto taxable income per the tax return.

b. Explain the nature of all permanent and temporarydifferences.

c. Compute the current tax provision by considering taxescomputed under both the regular tax system and the alternativeminimum tax system.


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Practical Consideration:

The auditor should obtain all information needed for the tax

return during the conduct of the audit for more efficient completionof the tax return. Some of the more common types of information

needed are: (See also Chapter 12, EXHIBIT 12-2.)

Reconciliation of financial statement captions to descriptions

required by the income tax return.

Depreciation schedule in accordance with tax methods and

using tax bases for assets.

Calculations of investment tax credit recapture arising from

dispositions of property, if applicable.

Identification and computation of all applicable taxpreference items.

List of dividends by source.

Property acquisitions or dispositions identified as to specific

assets, dates acquired or sold, cost, depreciation method, life,amount of accumulated depreciation, gain or loss involved.

Details of officers compensation, including time devoted to

business, percent ownership, addresses, social security number, andexpense account allowances.

Detail of noncash contributions, including a description of

property and method of determining fair market value.

Listing of amounts and dates of income tax prepayments.

Necessary pension or profit sharing plan information.

A 3. Evaluate the adequacy of the amount for income taxespayable in the balance sheet. Perform the following procedures:

a. Discuss the status of any IRS examination in progress withclient personnel.
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b. Assess the adequacy of the balance of taxes payable in

light of possible assessments for disputable items in this yearsreturn and any open prior years, including possible penalties andinterest.

c. Consider vouching current year tax payments to paidchecks. Document any items tested.


Some small businesses will have no, or insignificant,

disputable items, and this step will be little more than a routineaccrual calculation.

If there is a tax cushion beyond a minor allowance for matters

that might arise between the audit date and the actual filing of thereturn, the accrual should be evaluated in light of the requirementsof SFAS No. 5. (Seeparagraph 1202.8.)

B 4. Calculate the deferred tax asset or liability and the relateddeferred tax provision.


The additional audit procedures section provides more detailedprocedures for calculating deferred taxes.

The MACRS methods are acceptable GAAP methods unlesssalvage value would be material. The recovery periods for realestate and for 3-year and 5-year property closely approximateGAAP. However, large acquisitions in the other classes should beevaluated to determine whether different depreciable lives shouldbe used for financial reporting. Similarly, the allowance forSection 179 property may cause material departures for whichdeferred taxes should be provided.

C 5. Evaluate whether it is more likely than not that deferred taxassets will be realized.


The additional audit procedures section provides more detailed

procedures for evaluating the realizability of deferred tax assets.

B 6. Evaluate items for which there has not been an accrual (or
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which have been partially accrued) underAPB Opinion No. 23 todetermine if the items have been properly treated.


UnderSFAS No. 109, deferred taxes must be provided for all

temporary differences unless they qualify under the exceptionslisted inAPB Opinion No. 23. Most small businesses do notqualify for those exceptions. However, undistributed earnings of adomestic subsidiary or joint venture arising in fiscal yearsbeginning on or before December 15, 1992 that are essentiallypermanent in duration qualify for the exception. Deferred taxes arenot provided on these items until it becomes apparent that thetemporary differences will reverse in the foreseeable future. See the

discussion inparagraph 1200.17.

D 7. Document in the workpapers the financial statementpresentation and disclosure information for income taxes.


The disclosure checklist at CX-13 presents the requireddisclosures underSFAS No. 109.

* 8. Consider the need to apply one or more additional

procedures. The decision to apply additional procedures should bebased on a consideration of whether information obtained ormisstatements detected by performing substantive tests or fromother sources during the audit alter your judgment about the need toobtain a further understanding of control activities, the assessedlevel of risk of material misstatements (whether caused by error orfraud), and on an evaluation of whether the basic procedures havebeen sufficient to achieve the audit objectives. Attach auditprogram sheets to document additional procedures.


Certain common additional procedures relating to thefollowing topics are illustrated following this program:

Accounting for deferred taxes.

Deferred tax assets.
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Instructions: Additional procedures will occasionally be necessary on some smallbusiness engagements. The following listing, although not all-inclusive, representscommon additional procedures and their related objectives.

Accounting for Deferred Taxes

B Procedures related to deferred income tax accounting underSFASNo. 109:

a. Reconcile accounting income to taxable income,identifying exempt income and nondeductible expenses (forexample, interest on municipal bonds, officers life insurance, etc.),and temporary differences (for example, direct charge-off vs. the

allowance method for bad debts, accelerated vs. straight-linedepreciation, installment sales, capitalization of certain inventorycosts, cash vs. accrual basis, etc.).

b. Determine the reasonableness of, or calculate, the deferredtax provision as follows:

(1) Identify the taxable and deductible temporary differencesand loss carryforwards available for tax reporting at the end of theyear.

(2) Calculate the deferred tax liability by multiplying totaltaxable differences by the applicable tax rate.

(3) Calculate the deferred tax asset by multiplying totaldeductible differences and loss carryforwards by the applicable taxrate.

(4) Identify the tax credit carryforwards available for taxreporting at the end of the year and record a deferred tax asset forthe total of the carryforwards.

(5) Provide a valuation allowance for the portion of thedeferred tax asset for which there is more than a 50% chance thatthe benefit of the deductible differences and carryforwards of lossesand tax credits will not be realized.

(6) Subtract the net deferred tax asset or liability at the end ofthe year from the net amount at the beginning of the year to
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determine the deferred tax benefit or expense for the year. (The netdeferred tax asset or liability is the difference between the deferredtax liability and the deferred tax asset net of the related valuationallowance.)

(7) Add the deferred tax provision to the current tax provision

to determine the total tax provision for the year. The current taxprovision represents income taxes for the period as reported in thecompanys tax returns.

(8) If necessary, allocate the total tax expense or benefitbetween continuing operations and other applicable items (forexample, extraordinary items).

c. Consider the classification of the deferred tax asset or

liability by current and noncurrent amounts.


The calculation of deferred taxes is discussed further in section1202.

For each tax paying component within a tax jurisdiction,

current assets and liabilities and deferred tax assets and liabilitiesshould be offset and presented as a single current amount and asingle deferred amount. Any valuation allowance should beprorated and included in the net current and net deferred amount.

The current/noncurrent classification is based upon the specificasset or liability giving rise to the difference. If the deferred tax isnot related to a specific asset or liability (e.g., a net operating losscarryforward), it should be classified based on its expected reversaldate.

Guidance for applying SFAS No. 109can be found in PPCs

Guide to Accounting for Income Taxes.

Deferred Tax Assets

C Procedures related to deferred tax assets underSFAS No. 109. Testthe adequacy of the valuation allowance for deferred tax assets:
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a. Determine whether there is both negative and positive

evidence regarding whether the deferred tax asset will be realizable.


Section 1202 discusses examples of positive and negativeevidence.

b. If there is only positive evidence that the deferred asset willbe realizable, and the company historically has been profitable andhas paid taxes:

(1) Inquire of management and assess whether this trend islikely to continue.

(2) If it is determined that the trend is likely to continue,document in the workpapers the reason a valuation allowance is notneeded.

(3) If it is determined that the trend is not likely to continue,negative evidence exists. Proceed to Step c.

c. If there is both negative and positive evidence that thedeferred asset will be realizable:

(1) Evaluate the clients calculations and rationale regarding aneed for a valuation allowance or, if not available, prepare ananalysis of taxable income to determine if a valuation allowance isneeded.


The more negative evidence that exists about the realizability

of a deferred tax asset, the more positive evidence is required tosupport a conclusion that a valuation allowance is not needed for allor part of the deferred tax asset.

A valuation allowance is needed if it is more likely than notthat all or a portion of the deferred tax asset will not be realized.More likely than not is defined as greater than a 50% chance.

When evaluating whether a valuation allowance is needed, the

sources of taxable income outlined inSFAS No. 109 and discussedin section 1202of this Guide should be used. If it is determined thata source (or sources) of taxable income is adequate to realize the
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deferred tax asset, it is not necessary to evaluate the remainingsources.

When evaluating whether prior or future taxable income will

be available to realize a deferred tax asset, the auditor mustconsider the expiration date of the operating loss carryforwards andcarrybacks. Under current U.S. tax law, the carryback period islimited to two years and the carryforward period is limited to 20years.

Separate evaluations may be needed for each taxing

jurisdiction depending on whether their tax laws conform to federaltax laws.

It may be necessary for the company to schedule reversals of

taxable temporary differences in order to ensure that the deferredtax asset will be realized within the carryback, carryforward period.

When estimating future taxable income, a forecast or budget

(as those terms are defined in professional standards) is notrequired. However, if the client prepares prospective financialinformation to support an estimate of future taxable income,auditors should consider the adequacy of evidence relating tosignificant assumptions underlying the information, particularlyassumptions that are material to the prospective information,especially sensitive or susceptible to change, or inconsistent with

historical trends. This consideration should include reading theprospective information and the underlying assumptions andcomparing prospective information for prior or current periods withactual results or results to date.

(2) Conclude and document (a) the rationale for the valuationallowance or (b) that a valuation allowance is not required.


As discussed insection 1202, auditors should consider

obtaining representations regarding managements responsibilityfor determining the amount of the valuation allowance, estimatingfuture taxable income, and determining the prudence and feasibilityof tax planning strategies.
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Additional Audit Procedures for Income TaxesBeginning Balance in Initial Audit

Company Balance Sheet Date

AuditObjectives

Audit Procedures for Consideration

N/APerformedby

WorkpapIndex

Instructions: Additional procedures will be necessary in aninitial audit. These procedures are applied to opening balances anddiffer depending whether you are relying on your review of apredecessors work or placing no reliance on a predecessors audit.(Section 1803discusses considerations when replacing apredecessor auditor, including a discussion of what the termreliance means when used in this program.) These procedures maybe applied in conjunction with the basic procedures applied to theending balance. The asterisks preceding the procedures indicatethat they are an intermediate step in achieving audit objectives forthe ending balance.

* 1. If a predecessors audit of the prior periods financialstatements is to be relied on:

a. Review the predecessors workpaper analyses of incometax related accounts and related tax return information and compareamounts to opening balances; note the existence of any:

(1) Significant disputable items in open prior years.

(2) IRS examinations in progress during the predecessorsaudit.

(3) IRS assessments as a result of past examinations.

(4) Carryforwards or other unused deductions or credits withexpiration dates.

(5) Significant temporary differences and related deferred taxasset valuation allowances.
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b. Consider the information obtained from the predecessor

and evaluate the adequacy of the provision for income taxes andbalance of taxes payable for the prior period.


The basic procedures for the current period normally include

review of prior years tax returns and results of past IRSexaminations, vouching of tax payments of the prior periods taxespayable, and consideration of possible assessments for disputableitems in any open prior years. Thus, review of the predecessorsworkpapers supplements these basic procedures.

* 2. If no reliance on a predecessor is planned or possible:

a. Obtain or prepare analyses of income tax related accounts,test clerical accuracy, compare amounts to opening balances, andconsider reasonableness of amounts in relation to informationobtained in the current audit.

b. Inquire of the person responsible for tax mattersconcerning:

(1) Significant disputable items in open prior years.

(2) IRS examinations in progress during the prior period andthe results if known.

(3) IRS assessments from past examinations.

(4) Carryforwards or other unused deductions or credits withexpiration dates.

(5) Significant temporary differences and related deferred taxasset valuation allowances.

c. Consider the information obtained from the aboveprocedures and evaluate the adequacy of the provision for incometaxes and the balance of current and deferred assets and liabilitiesfor the prior period.



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Even if the client has not had an audit in prior years, a CPA

may have prepared the clients tax returns, and the CPAs taxworkpapers may be available.

The basic procedures for the current period normally include

review of prior years tax returns and results of past IRSexaminations, vouching of tax payments of the prior periods taxespayable, and consideration of possible assessments for disputableitems in any open prior years. Thus, the additional proceduressupplement these basic procedures.

In an initial audit, five years is normally a reasonable period

for review of prior years tax returns and related matters.

income taxes program

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