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AP-11: Audit Program for Income Taxes

Company Balance Sheet Date

The company has the following general ledger accounts related to income taxes. General Ledger Number Description of the Account

Audit Objectives Audit Procedures for Consideration FINANCIAL STATEMENT ASSERTIONS E/O Existence or occurrence. allocation. C Completeness. and disclosure. R/O Rights and obligations. AUDIT OBJECTIVES A. Tax laws and regulations have been properly applied, and no items are improperly excluded in the determination of taxes V/A P/D Valuation or Presentation

N/A Workpaper Performed Index by

estimated to be currently payable, and the related current tax liability is adequate but not excessive (assertions E/O, C, R/O, and V/A). B. The provision for income taxes and related balance sheet amounts, if any, for deferred taxes are properly stated in accordance 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 related valuation allowances) and liabilities, income tax expense, and related 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 the left column labeled Audit Objectives when a procedure accomplishes an objective. If the alpha code appears in a bracket, e.g., [A], [B], etc., the audit procedure only secondarily accomplishes the objective. If an asterisk precedes a procedure, it is a 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 related accounts and related tax return information. Perform the following procedures: a. Scan the accounts and compare opening balances to the prior years workpapers. b. Review the prior years tax return and the results of any IRS examinations completed during the period. c. Inspect supporting documents for significant transactions during the period, i.e., estimated tax payments, refunds, etc. Document the items tested.

Practical Considerations: SAS No. 96, Audit Documentation, requires documentation of substantive tests of details involving inspection of documents to include identification of the items tested. The authors believe items tested can be identified by listing the items; by including a detail schedule in the workpapers, such as an income tax account analysis, on which the items are identified; or by documenting in the 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, all transactions greater than $5,000 from the 20X2 income tax payable account detail). SAS No. 96 is effective for audits of financial statements for periods beginning on or after May 15, 2002, with early application permitted. Some small businesses may operate in several states, and the auditor should consider the taxing jurisdictions the client is subject to. In some cases, state and local taxes on income may be significant. In many small businesses, income taxes are recognized to the extent of the amounts paid or received only. Liability, receivable, or deferred accounts may not be used during the year. The auditor will be expected to adjust the accounts during the course of the audit. Under such circumstances, the analyses may be prepared as the auditor determines the appropriate adjustments. B 2. Calculate the current year provision for income taxes by preparing a draft of the tax return or a tax calculation workpaper. a. Reconcile income before taxes per the financial statements to taxable income per the tax return. b. Explain the nature of all permanent and temporary differences. c. Compute the current tax provision by considering taxes computed under both the regular tax system and the alternative minimum tax system.

Practical Consideration: The auditor should obtain all information needed for the tax return during the conduct of the audit for more efficient completion of 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 tax preference 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, and expense account allowances. Detail of noncash contributions, including a description of property and method of determining fair market value. A Listing of amounts and dates of income tax prepayments. Necessary pension or profit sharing plan information.

3. Evaluate the adequacy of the amount for income taxes payable in the balance sheet. Perform the following procedures: a. Discuss the status of any IRS examination in progress with client personnel.

b. Assess the adequacy of the balance of taxes payable in light of possible assessments for disputable items in this years return and any open prior years, including possible penalties and interest. c. Consider vouching current year tax payments to paid checks. Document any items tested. Practical Considerations: Some small businesses will have no, or insignificant, disputable items, and this step will be little more than a routine accrual 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 the return, the accrual should be evaluated in light of the requirements of SFAS No. 5. (See paragraph 1202.8.) B 4. Calculate the deferred tax asset or liability and the related deferred tax provision. Practical Considerations: The additional audit procedures section provides more detailed procedures for calculating deferred taxes. The MACRS methods are acceptable GAAP methods unless salvage value would be material. The recovery periods for real estate and for 3-year and 5-year property closely approximate GAAP. However, large acquisitions in the other classes should be evaluated to determine whether different depreciable lives should be used for financial reporting. Similarly, the allowance for Section 179 property may cause material departures for which deferred taxes should be provided. C 5. Evaluate whether it is more likely than not that deferred tax assets will be realized. Practical Consideration: 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

which have been partially accrued) under APB Opinion No. 23 to determine if the items have been properly treated. Practical Consideration: Under SFAS No. 109, deferred taxes must be provided for all temporary differences unless they qualify under the exceptions listed in APB Opinion No. 23. Most small businesses do not qualify for those exceptions. However, undistributed earnings of a domestic subsidiary or joint venture arising in fiscal years beginning on or before December 15, 1992 that are essentially permanent in duration qualify for the exception. Deferred taxes are not provided on these items until it becomes apparent that the temporary differences will reverse in the foreseeable future. See the discussion in paragraph 1200.17. D 7. Document in the workpapers the financial statement presentation and disclosure information for income taxes. Practical Consideration: The disclosure checklist at CX-13 presents the required disclosures under SFAS No. 109. * 8. Consider the need to apply one or more additional procedures. The decision to apply additional procedures should be based on a consideration of whether information obtained or misstatements detected by performing substantive tests or from other sources during the audit alter your judgment about the need to obtain a further understanding of control activities, the assessed level of risk of material misstatements (whether caused by error or fraud), and on an evaluation of whether the basic procedures have been sufficient to achieve the audit objectives. Attach audit program sheets to document additional procedures. Practical Considerations: Certain common additional procedures relating to the following topics are illustrated following this program: Accounting for deferred taxes. Deferred tax assets.

Practitioners may refer to PPCs Guide to Fraud Investigations for more extensive fraud detection procedures if it is suspected that the financial statements are materially misstated due to fraud. * 9. Consider whether procedures performed are adequate to respond to identified fraud risk factors. If fraud risk factors or other conditions are identified that require an additional audit response, consider those risk factors or conditions and the auditors response in connection with the performance of Step 11 in AP-1b. Practical Consideration: Specific responses to identified fraud risk factors are addressed in individual audit programs. In connection with evaluation and other completion procedures in AP-1b, the auditor considers the need to perform additional procedures based on the results of procedures performed in the individual audit programs and the cumulative knowledge gained from performing those procedures. * 10. Consider whether the results of audit procedures indicate reportable conditions in internal control and, if so, add to the memo of points for the communication of reportable conditions. (See section 1504 for examples of reportable conditions, and see CX-18 for a worksheet that can be used to document the points as they are encountered during the audit.) CONCLUSION We have performed procedures sufficient to achieve the audit objectives for income taxes, and the results of these procedures are adequately documented in the workpapers. (If you are unable to conclude on any objective, prepare a memo documenting your reason.)

Additional Audit Procedures for Income Taxes

Instructions: Additional procedures will occasionally be necessary on some small business engagements. The following listing, although not all-inclusive, represents common additional procedures and their related objectives.

Accounting for Deferred Taxes B Procedures related to deferred income tax accounting under SFAS No. 109: a. Reconcile accounting income to taxable income, identifying exempt income and nondeductible expenses (for example, 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-line depreciation, installment sales, capitalization of certain inventory costs, cash vs. accrual basis, etc.). b. Determine the reasonableness of, or calculate, the deferred tax provision as follows: (1) Identify the taxable and deductible temporary differences and loss carryforwards available for tax reporting at the end of the year. (2) Calculate the deferred tax liability by multiplying total taxable differences by the applicable tax rate. (3) Calculate the deferred tax asset by multiplying total deductible differences and loss carryforwards by the applicable tax rate. (4) Identify the tax credit carryforwards available for tax reporting at the end of the year and record a deferred tax asset for the total of the carryforwards. (5) Provide a valuation allowance for the portion of the deferred tax asset for which there is more than a 50% chance that the benefit of the deductible differences and carryforwards of losses and tax credits will not be realized. (6) Subtract the net deferred tax asset or liability at the end of the year from the net amount at the beginning of the year to

determine the deferred tax benefit or expense for the year. (The net deferred tax asset or liability is the difference between the deferred tax liability and the deferred tax asset net of the related valuation allowance.) (7) Add the deferred tax provision to the current tax provision to determine the total tax provision for the year. The current tax provision represents income taxes for the period as reported in the companys tax returns. (8) If necessary, allocate the total tax expense or benefit between continuing operations and other applicable items (for example, extraordinary items). c. Consider the classification of the deferred tax asset or liability by current and noncurrent amounts. Practical Considerations: The calculation of deferred taxes is discussed further in section 1202. For each tax paying component within a tax jurisdiction, current assets and liabilities and deferred tax assets and liabilities should be offset and presented as a single current amount and a single deferred amount. Any valuation allowance should be prorated and included in the net current and net deferred amount. The current/noncurrent classification is based upon the specific asset or liability giving rise to the difference. If the deferred tax is not related to a specific asset or liability (e.g., a net operating loss carryforward), it should be classified based on its expected reversal date. Guidance for applying SFAS No. 109 can be found in PPCs Guide to Accounting for Income Taxes.

Deferred Tax Assets C Procedures related to deferred tax assets under SFAS No. 109. Test the adequacy of the valuation allowance for deferred tax assets:

a. Determine whether there is both negative and positive evidence regarding whether the deferred tax asset will be realizable. Practical Consideration: Section 1202 discusses examples of positive and negative evidence. b. If there is only positive evidence that the deferred asset will be realizable, and the company historically has been profitable and has paid taxes: (1) Inquire of management and assess whether this trend is likely to continue. (2) If it is determined that the trend is likely to continue, document in the workpapers the reason a valuation allowance is not needed. (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 the deferred asset will be realizable: (1) Evaluate the clients calculations and rationale regarding a need for a valuation allowance or, if not available, prepare an analysis of taxable income to determine if a valuation allowance is needed. Practical Considerations: The more negative evidence that exists about the realizability of a deferred tax asset, the more positive evidence is required to support a conclusion that a valuation allowance is not needed for all or part of the deferred tax asset. A valuation allowance is needed if it is more likely than not that 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 in SFAS No. 109 and discussed in section 1202 of this Guide should be used. If it is determined that a source (or sources) of taxable income is adequate to realize the

deferred tax asset, it is not necessary to evaluate the remaining sources. When evaluating whether prior or future taxable income will be available to realize a deferred tax asset, the auditor must consider the expiration date of the operating loss carryforwards and carrybacks. Under current U.S. tax law, the carryback period is limited to two years and the carryforward period is limited to 20 years. Separate evaluations may be needed for each taxing jurisdiction depending on whether their tax laws conform to federal tax laws. It may be necessary for the company to schedule reversals of taxable temporary differences in order to ensure that the deferred tax 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 not required. However, if the client prepares prospective financial information to support an estimate of future taxable income, auditors should consider the adequacy of evidence relating to significant assumptions underlying the information, particularly assumptions that are material to the prospective information, especially sensitive or susceptible to change, or inconsistent with historical trends. This consideration should include reading the prospective information and the underlying assumptions and comparing prospective information for prior or current periods with actual results or results to date. (2) Conclude and document (a) the rationale for the valuation allowance or (b) that a valuation allowance is not required. Practical Consideration: As discussed in section 1202, auditors should consider obtaining representations regarding managements responsibility for determining the amount of the valuation allowance, estimating future taxable income, and determining the prudence and feasibility of tax planning strategies.

Additional Audit Procedures for Income Taxes Beginning Balance in Initial Audit
Company Balance Sheet Date

Audit Objectives Audit Procedures for Consideration Instructions: Additional procedures will be necessary in an initial audit. These procedures are applied to opening balances and differ depending whether you are relying on your review of a predecessors work or placing no reliance on a predecessors audit. (Section 1803 discusses considerations when replacing a predecessor auditor, including a discussion of what the term reliance means when used in this program.) These procedures may be applied in conjunction with the basic procedures applied to the ending balance. The asterisks preceding the procedures indicate that they are an intermediate step in achieving audit objectives for the ending balance. * 1. If a predecessors audit of the prior periods financial statements is to be relied on: a. Review the predecessors workpaper analyses of income tax related accounts and related tax return information and compare amounts to opening balances; note the existence of any: (1) (2) audit. (3) Significant disputable items in open prior years. IRS examinations in progress during the predecessors

N/A Workpaper Performed Index by

IRS assessments as a result of past examinations.

(4) Carryforwards or other unused deductions or credits with expiration dates. (5) Significant temporary differences and related deferred tax asset valuation allowances.

b. Consider the information obtained from the predecessor and evaluate the adequacy of the provision for income taxes and balance of taxes payable for the prior period. Practical Consideration: The basic procedures for the current period normally include review of prior years tax returns and results of past IRS examinations, vouching of tax payments of the prior periods taxes payable, and consideration of possible assessments for disputable items in any open prior years. Thus, review of the predecessors workpapers 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, and consider reasonableness of amounts in relation to information obtained in the current audit. b. Inquire of the person responsible for tax matters concerning: (1) Significant disputable items in open prior years.

(2) IRS examinations in progress during the prior period and the results if known. (3) IRS assessments from past examinations.

(4) Carryforwards or other unused deductions or credits with expiration dates. (5) Significant temporary differences and related deferred tax asset valuation allowances. c. Consider the information obtained from the above procedures and evaluate the adequacy of the provision for income taxes and the balance of current and deferred assets and liabilities for the prior period. Practical Considerations:

Even if the client has not had an audit in prior years, a CPA may have prepared the clients tax returns, and the CPAs tax workpapers may be available. The basic procedures for the current period normally include review of prior years tax returns and results of past IRS examinations, vouching of tax payments of the prior periods taxes payable, and consideration of possible assessments for disputable items in any open prior years. Thus, the additional procedures supplement these basic procedures. In an initial audit, five years is normally a reasonable period for review of prior years tax returns and related matters.