Auditing electronic data: a report of the Steering Committee Task Force on EDI Audit and Legal Issues for Tax Administration.

The following report on Auditing Electronic Data was released in February 1997 by the Steering Committee of the Federation of Tax Administrators, Task Force on EDI Audit and Legal Issues for Tax Administration. The paper provides taxpayers and state tax administrators with guidance on identifying approaches to audits of electronic records, including EDI. The paper is a companion piece to the Task Force's Model Recordkeeping and Retention Regulation, which was released in March 1996 and is reprinted in the May-June 1996 issue of The Tax Executive. (For a related story, see TEI's comments on the Multistate Tax Commission Hearing on the Model Recordkeeping Regulation at page 68 of the January-February 1997 issue.) TEI members who participated in the workgroup that developed the Auditing Electronic Data White Paper include Barbara Barton of EDS and the late Manny Davila of AT&T. The bibliography to the paper, which is contained in Appendix B, sets forth an extensive list of print and electronic sources of information related to Electronic Data Interchange. Appendix B is not reprinted here. TEI members may request a copy of Appendix B by calling DeAnn Mueller at TEI Headquarters at (202) 638-5601; a copy has been posted under The Tax Executive's March-April 1997 listing on TEI On-Line.

Introduction

On October 7, 1994, the Federation of Tax Administrators (FTA) hosted a meeting to begin the process of forming a task force of state and private sector tax administrators to address Electronic Data Interchange (EDI).(1) The meeting was attended by representatives of the Committee On State Taxation (COST), Institute of Property Taxation (IPT), Tax Executives Institute (TEI), Multistate Tax Commission (MTC), FTA and commissioners from several state revenue departments.

The meeting focused on understanding the concerns of the taxpayer community and tax administrators in five key areas.

1. How is EDI used today?

2. How does it affect a tax audit?

3. What issues need to be addressed by the task

   force?

4. How should the task force be organized?

5. How should the task force approach the issues

   and problems of EDI and electronic audits?

   Formally titled the Task Force on EDI Audit and Legal Issues for Tax Administration (Task Force),(2) it is comprised of members from each taxpayer organization and most state revenue departments. In addition, taxpayer and tax authority representatives were selected to serve as co-chairs for each work group. Early on, the Task Force was divided into two main work groups: EDI Audit Approaches and Legal Requirements and Recordkeeping. The Legal Requirements and Recordkeeping group was solely concerned with developing an electronic record retention regulation that could be used as a model by state and local government. The EDI Audit Approaches group was concerned with the EDI and electronic record issues as they affect the tax audit. The EDI Audit Approaches group was further divided into three subgroups: System Integrity Audits, Electronic Records Audits, and Educational Needs and Approaches. This white paper contains the work product of the EDI Audit Approaches work group.

   Basic Framework

   The change in business process that removes a traditional source of information demands the creation of new audit procedures to conduct the compliance audit. Although much has been published on electronic commerce as a whole, no source of prepared materials related to the conduct of a tax audit has been found.

   In developing the audit white paper, the participants focused on identifying the issues involved when auditing electronic records and assessing alternative approaches to the audit of such records. However, the reader should note that no attempt was made to address the nuances of each individual taxpayer or tax authority audit program.

   The audit white paper represents the considerable work product of a large number of tax administrators and taxpayer representatives. It attempts to achieve a realistic balance between the needs of tax administrators and the needs of taxpayers. Above all, it is aimed at facilitating an efficient and effective tax administration process.

   The Tax Audit

   In the simplest terms, the tax audit verifies that taxpayers have properly determined and paid their tax liability. Generally, the typical tax audit is made up of seven fundamental elements:

1. Scope - Determine the scope of the audit

2. Plan - Develop the audit plan

3. Audit - Perform the audit steps: Tests,

   procedures, correlation, etc.

4. Opinion - Formulate an opinion about the

   accuracy of reporting

5. Close - Present the findings to the taxpayer

6. Report - Report the findings to management

7. Review - Review the audit for error, omission or

   oversight

   The specific scope of taxpayer audits is dependent on several factors:

   * Tax involved: Type and number

   * Records: Complexity, quality, location, and

   availability

   * Taxpayer type: Individual, proprietorship,

   corporation, etc.

   A tax audit usually involves one-on-one contact with taxpayers. During the contact process, the auditor reviews the facts, circumstances, records, and other information that support the taxpayer's return. The audit work may take as little as a few days or as long as a few months, depending on the complexity of the situation, i.e., size of business, diversity of operations, etc. Ultimately, the auditor makes a determination that the taxpayer's return is: filed correctly (no change), overpaid (taxpayer is entitled to a refund), or underpaid (taxpayer owes additional tax).

   The Electronic Data Tax Audit

   The primary objective of the tax audit does not change because all or a part of the taxpayer's records are in electronic form. However, the mix of electronic data to physical data within a taxpayer's accounting system does determine whether the review of electronic records serves as a component of the overall tax audit program, or functions as the overall tax audit program.

   The tax auditor's scope of examination includes the tax accrual and reporting systems, procedures and methodologies. It is within the auditor's scope to review the internal controls in place for the tax accounting process. This is true whether the accounting system is paper-driven or electronic. The evaluation of internal controls helps the auditor formulate an opinion on the level of reliability that can be placed on the tax accounting/accrual system. Reliability of the internal controls is the foundation for determining the scope of the tax audit.

   What the Auditor Needs to Know

   * Are the electronic records available? What is the taxpayer's record retention policy? What controls are in place to safeguard records? Are detail and summary records available for the audit period?

   * Are the electronic records reliable? What internal controls are in place to support the tax accrual system? Do the internal controls produce an acceptable level of assurance that...