GAO report on IRS's use of financial status audit techniques.

• Author: Raymon, Jeffrey L.
• Position: General Accounting Office

On Dec. 30, 1997 the General Accounting Office (GAO) released its report on the use of financial status audit techniques by the Service. Such "indirect" audit procedures, specifically designed to identify unreported income, have received widespread criticism as being unreasonably intrusive and burdensome to taxpayers. This study was performed at the request of the House Ways and Means Committee and focused on frequency of use, taxpayer burden, effectiveness and quality control.

The report cited four specific techniques that make up the arsenal of financial status auditing: bank deposit analysis (the reconciliation of total bank deposits to reported income), net worth method (reconciliation of change in net worth to reported income), normal markup/unit of sales method (reconciliation of cost of sales and expected markup to gross receipts) and Cash-T (reconciliation of uses of cash to sources of cash in order to determine unreported income). The study did not generally separate these procedures so that conclusions could be drawn on any single audit technique. Rather, it draws conclusions (e.g., as to effectiveness and quality control) based on a sampling of audits in which any one or more of the procedures might have been utilized. This is a significant weakness in the study. Bank deposit analysis, for example, is not truly an indirect, financial status procedure. It has, in fact, long been a standard component of a routine Schedule C audit. It was not a key focus of the IRS Financial Status training program, nor has it been the focus of criticism. The use of Cash-Ts and the related "lifestyle" questions and questioning techniques, on the other hand, were a key focus of the training program and of widespread criticism. The study does little to isolate and analyze the more objectionable aspects of financial status auditing procedures.

The AICPA has actively monitored and commented on this area of the Service's activity since 1994 when the search for unreported income during routine examinations was "reemphasized" through a special initiative and training program. The key concerns raised by the Institute have focused on (1) the overly aggressive use of these techniques by examiners and field agents who have no reasonable indication that unreported income exists; (2) the loss of the traditional "bright line" between a routine audit and an investigation for tax fraud that would typicalIy incorporate these indirect audit procedures; and (3) the...