Income Tax Audit Manual

Compliance Programs Branch (CPB)

Information

This chapter was last updated in May 2024.

Chapter 13 - This chapter is under review and an updated version will be released at a later date

Disclaimer

To avoid renumbering cross-referenced material, when it has become necessary to delete or relocate information in the manual, the section or chapter has been marked as “for future use” or “section removed.”

Hyperlinks to external or unaffiliated websites are for information purposes only. The Canada Revenue Agency (CRA) is not responsible for the content or practices of such websites. While efforts are made to make sure that hyperlinks are current and up-to-date, it is not guaranteed.

Chapter 13.0 Audit techniques

13.1.0 Computer-assisted audit techniques
13.2.0 Audit of non-taxable sources of funds
13.3.0 Indirect verification of income
13.4.0 Assessing net worth technique
13.5.0 Assessing unidentified bank deposits technique
13.6.0 Assessing projections technique
13.7.0 Testing and sampling
13.8.0 Auditing the balance sheet
13.9.0 Auditing the income statement
13.10.0 Auditing bribes, kickbacks, and similar payments
- 13.10.1 Introduction
- 13.10.2 Income tax implications
Appendix 13.1.0 Letters – Under review
Appendix 13.2.0 Checklists – Under review
Appendix 13.3.0 Sample net worth working papers
Appendix 13.4.0 Sample Working Paper – Bank deposit analysis
Appendix 13.5.0 removed
Appendix 13.6.0 Sample Working Papers – Source and application of funds

13.1.0 Computer-assisted audit techniques

13.1.1 Introduction

The CRA auditor's responsibility is to examine a taxpayer's records to ensure compliance with related legislation. The majority of taxpayers maintain a computer-based accounting system and auditors need to be able to analyze the taxpayer’s electronic records. A variety of software packages and techniques are used to analyze taxpayer files maintained in electronic format.

Computer-assisted audit techniques (CAATs) are generally used if:

the volume of transactions is too large to enable effective and efficient testing; or
the audit trail is not visible.

If the audit trail is not visible from the hard copy of the taxpayer's books and records, the electronic information needs to give enough information or detail to confirm the accuracy and reliability of the tax liability.

Using CAATs does not replace the need for the auditor to use professional judgement to decide which audit procedures are appropriate or to develop conclusions based on the information found.

During the preliminary file review, decide if a computer-assisted audit (CAA) approach will be used and if help from the Computer Audit Specialist Division will be needed (also go to 10.2.9, Electronic transfer of accounting data). While a CAA generally increases the efficiency and effectiveness of an audit, a manual audit may be required if:

the taxpayer does not maintain books and records in electronic format;
there is no trained computer audit specialist (CAS) available and the auditor is not trained to complete a computerized audit without help;
costs of converting the files are excessive and outweigh the benefits; or
the electronic files kept by the taxpayer are not suitable for CRA audit purposes.

Integras software allows:

the auditor to complete the working papers in an electronic format;
electronic storage of the audit file; and
automated upload of the audit results to the CRA’s mainframe.

13.1.2 Advantages of computer-assisted audit techniques

Computer-assisted audit techniques (CAATs) are used to independently:

process the taxpayer electronic records;
perform inquiries on the records to decide if the information in the records accurately reflects the business operations; and
perform various audit tests and analysis.

The CRA standard file conversion software is Interactive Data Extraction and Analysis (IDEA) for Windows. The specific advantages of using IDEA include:

increase coverage by verifying a significantly greater number of transactions or items than manually possible;
give better information by using more analysis and data profiling;
balance a large number of detailed transactions to totals reported by the taxpayer;
extract selected customers, products, or specific items from the total population of items in the file quickly and efficiently;
extract selected transaction types, such as credit notes, consignment sales, and purchases, from specific vendors from the file;
review exception reports showing transactions with errors;
improve the reliability of the population sample selected for manual review by using various sampling tools available;
verify taxpayer calculations;
classify pertinent data into relevant categories;
print specific items selected for review;
combine fragmented files;
study the entire electronic file and apply a consistent level of review to each record in the file; and
receive or extract from the file, if errors are found within the selected sample, necessary statistics or listings of the transactions with errors.

13.1.3 Assistance from Digital Compliance and Audit Support Division specialists

Introduction

Computer audit specialists (CAS) are available to help conduct audits if:

the taxpayer's records are computerized;
a manual review of records would be time consuming and inefficient; or
the auditor needs help to use Interactive Data Extraction and Analysis (IDEA) software during an audit.

Computer audit specialist mandate

A CAS helps auditors to increase the efficiency and effectiveness of audits by using computer-assisted audit techniques (CAATs).

Asking for assistance from a computer audit specialist

During the planning stage of the audit, decide if you need assistance from a CAS. Contact the CAS well before the start of the audit with:

the auditor’s experience, or inexperience, in using IDEA software during an audit;
the scope of the audit;
the type of audit (income tax or employer compliance);
the audit period;
any information available about the taxpayer's hardware and software;
if the taxpayer has any subsidiaries or divisions that may impact the audit;
the taxpayer audit contact;
the scheduling of the audit or projected start date;
the time allocated for the audit;
when the reports are required; and
specifics of the auditor's hardware – if there is enough disk space for the taxpayer's records; software needs (MS Works, Excel, IDEA).

Procedures to request assistance from the Digital Compliance and Audit Support Division specialists

Create a CAS case using the Create ECAS case sub-action in Integras.
Attach the CAS Assistance Request Form. Ensure it is properly completed with all the details of the assistance required. Add the form through the Electronic Documents tab (browse to location of form on your shared drive) or the Template Library tab. The form is also available at CAS Service Standards.
If there are any other applicable data files that need to be attached to the ECAS case (that is, data already collected from the taxpayer for Lab processing), attach the additional data files under the Electronic Documents tab.
Promote the ECAS case in Integras. The ECAS case will be transferred to the CAS team leader to be assigned to a CAS officer.
Email your local CAS team leader to inform them that a new case has been created.
The CAS team leader will assign the request to a CAS, then will email the auditor and the CAS assigned to the case.

Once the CAS completes the assist, the converted data is stored in the Electronic Documents tab of the Integras ECAS case.

For more information, go to:

Integras Reference Guide
learning product HQ1165-000, Integras Fundamentals for Income Tax Audit

To learn more, login to the Computer Audit Specialist Division’s Wiki page, Guidelines for auditors to request CAS assistance in Integras.

For technical CAS support about an audit case, contact the CAS assigned to it.

The computer-assisted audit process

The computer-assisted audit (CAA) process is quite detailed and requires a good knowledge of systems, auditing experience, and knowledge of programs, such as IDEA, used to manipulate data from the taxpayer's electronic files.

If a CAS is available to help the auditor, a meeting will usually be set up with the auditor, the CAS, and the taxpayer. A test to verify data transfer may be conducted to make sure that the information meets the auditor's needs and that the taxpayer's computerized records are compatible with CRA technology.

The CAS usually completes planning of the specific CAATs after discussions have established the needs to complete the objective of the audit. The CAS is available for follow up and to coach the auditor as required. The auditor's skill, knowledge of and comfort level with computer audit software, such as IDEA, will determine if the auditor can complete portions of file conversion and manipulation.

The CAS will generally:

establish the CAA parameters;
plan specific techniques to be used;
decide which taxpayer records are required, in consultation with the auditor;
review the format of the taxpayer's records and decide if changes are required;
decide on the specific tools required (hardware and software);
transfer the taxpayer's records required for audit purposes;
verify the layout and integrity of the data;
perform the actual CAATs including:
file conversion;
file manipulation (merge, append, extract, modify, maintain a trail, reconcile manipulated files, generate reports, stratify and summarize data); and
transfer data from the CAS to the auditor;
coach the auditor as required;
be available for follow up on the file with the auditor;
back up the electronic data;
document the file; and
complete a business systems evaluation (BSE).

Processing data through the Lab

The CAS Processing Laboratory (the Lab)’s priority consists of processing files generated by the most common accounting software packages used by taxpayers, minimizing processing and turnaround times while providing comprehensive and extensive analytical output files.

When the auditor has determined that a taxpayer uses accounting software that generates files that can be processed by the Lab, the auditor asks the taxpayer to create a backup file from that software.

Go to Accounting system packages processed by the Lab for more information and other resources to help auditors to obtain data files.

CASD procedures to have data processed through the Lab

The auditor retrieves the data from the taxpayer and uploads to Integras into the ECAS audit case.
The CAS asks the Lab to process these taxpayer’s data files.
The Lab processes the data, then uploads the resulting files into the ECAS audit case.
The Lab emails the CAS and the auditor to inform them that the processed data from the Lab are available in the ECAS case.
The auditor downloads a copy of the Lab data to their audit case.

The auditor may use the CAS Feedback Form at CAS Service Standards to share their comments and suggestions with the CASD.

For more information, go to Computer Audit Specialist (CAS) Processing Lab - Auditors Guidelines.

Security and data transfer guidelines

As security is a high priority for the CRA, it is important for auditors to be aware of and to apply the guidelines to transfer data from outside the CRA (for example, from taxpayers and representatives) to the CRA’s network (RCNET). For more information, go to the May 26, 2017, memorandum, Updated data transfer guidelines for auditors.

My Business Account, My Account, and Represent a Client portals on the CRA website have two mechanisms, “Submit documents” and “Audit enquiries,” available to the taxpayer or their authorized representatives to submit data and answer queries from the CAS auditor or the auditor.

For more information, go to Information and Systems Protection Standards.

Coaching from CAS

If resources permit, CAS are available to provide auditors with coaching, as needed. Examples of coaching include showing the auditor how to:

organize the working folder in IDEA and explain why it is important to do so
navigate through the IDEA screens
click on the “Action" field in a trial balance to identify all transaction details for one account
calculate the control total for an "Amount" field
index a field in ascending or descending order
use criteria to search for or view specific items or information
use various functions, such as @isini

CAS may ask the auditor questions such as:

What accounts are you interested in reviewing?
What are the audit issues?
What type of analyses would you like to do in IDEA?
Would you like to know how to extract all the journal entries that affect one account in the general ledger?

The goal of this coaching is to assist auditors in using IDEA effectively and making optimal use of the data provided by CAS.

CAS service by program

The following CAS standards apply to a computer-assisted audit (CAA) not involving the CAS Processing Lab (Lab). The lead time for files processed by the Lab is less than seven days.

Workload prioritization

Resources permitting, CAS conducts CAAs requested by auditors, according to CAS workload priorities as stated in CASD's business plan. Files with revenues over one million dollars or involving Point of Sales (POS) data should get higher priority for CAS assistance. Also, AU‑02 files should get higher priority than AU‑01 files, and AU‑01 files should get higher priority than SP‑06 or lower files.

Timeliness

The CAS turnaround time for Program 17 - Small Business Audit Program - income tax - is four weeks.

The CAS turnaround time for Program 18 - Medium Business Program - income tax - is six weeks.

CAS require lead time for all CAA referrals. Lead time (turnaround time) is the time difference between the date the auditor submits the CAA request, and the date the CAS provides the auditor with the data. The standard lead time reflects CAAs under normal circumstances (that is, cooperative taxpayer, data is available, domestic file/not international). CAS recognize that turnaround time may not be appropriate for non-standard workload, such as non-resident files or electronic sales analysis files.

CAS advises the auditor of delays as CAS becomes aware of the event.

CAS describes the reason or reasons for the delays in the CAA report.

For more information, go to CAS Service Standards.

Feedback

At the completion of the CAS assistance, auditors may submit a feedback form indicating how the CAS program met their expectations with respect to the CAS service standards. The feedback is important to continue to improve the CAS program.

The CAS Feedback Form is in the Integras Template Library. Email the completed feedback form to Feedback-CPB GST/HST CAS / Rétroaction-DGPO TPS/TVH SVI, with a copy to the CAS team leader.

13.1.4 Preparing the taxpayer's information for computer-assisted audit techniques

After the information has been received from the taxpayer and converted to a useable format for audit purposes by a computer audit specialist (CAS), the files are further manipulated to prepare for specific audit procedures. File manipulation may include:

joining files;
merging files;
appending existing files;
extracting information from files that are too large, or extracting information required for the audit; and
modifying files to facilitate further procedures.

The CAS will normally keep a detailed trail of manipulations and reconcile the information to the taxpayer's records.

13.1.5 Procedures using computer-assisted audit techniques

Audit procedures often completed using computer-assisted audit techniques (CAATs) include:

analysis;
extraction;
summarization;
stratification;
sampling;
consolidation or joining;
matching;
duplicate detection; and
gap detection.

Analysis

Analysis compares the relationship of one thing to something else or the segregation of something into its component parts. Use computer audit programs to calculate ratios and profit margins, detect the frequency of occurrence, and print detailed reports of the exceptions.

Analyzing data may include comparing:

operating results from period to period;
divisions of the same taxpayer; or
results of the taxpayer being audited to industry standards.

Analyze over a period of time to detect specific periods that need more review because of variances or to determine limited audit testing.

One example of analysis is aging. IDEA includes an Aging function. To use this function, the file must contain a date field. Inventory, accounts receivable, and accounts payable are common accounts where aging might be used to determine areas that need more review. Outstanding longer than usual accounts receivable and accounts payable items may include non-arm's length transactions that need review. Inventory held longer than normal might be obsolete or may not have been invoiced, resulting in understated sales.

Extraction

Identify transactions that satisfy specific criteria selected and create a new file with these transactions to sample or analyze. Extracted transactions are often exceptions to the expected result (for example, GST that is less than 5% or HST less than that prescribed by the participating provinces (13-15%) of the sale amount).

For assurance that capital items have not been expensed, set a threshold amount based on risk and the type of business, and all transactions over the threshold amount are extracted for testing.

Summarization

Summarize transactions with a common element by accumulating or totalling the value of numeric fields for all records according to specific criteria.

Summaries can be prepared for:

general ledger accounts;
purchases from vendors;
sales to customers; and
projects.

The types of summaries depend on the format of the files available. Summary information includes:

account code;
account description;
number of debit items;
debit amount;
number of credit items;
credit amount;
total number of items;
net amount;
number of debit, credit, and total items in the file; and
net amount of the file.

Stratification

Stratify a population for sampling. In large audits, stratifying a file often gives an overview of the information and an understanding of the taxpayer's data. Profiles can be identified and trends or deviations from expected results become evident. Gain this understanding as part of the audit planning process to help decide where the largest risk of revenue loss is likely to be. It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning. Stratification involves summarizing the file into various blocks. IDEA allows four field types of stratification:

numeric – gives a single analysis for each numeric field across a series of values;
key – produces a numeric stratification analysis for each unique key in the data base;
character – produces a single profile based on a character or text field; and
date – produces a single profile based on a date range.

Sampling

Sample a population by using a small number of items to test various audit assertions and include audit evidence of compliance of the entire population. Four common sampling techniques are:

statistical;
random;
judgemental; and
block.

Consolidation or joining

Data in a computerized business system is often spread out over many files and possibly even different computer systems. Depending on the audit procedure, a single file is usually more manageable. Files can only be consolidated or joined if they contain a common link or key field. The key field must have the same parameters in each file.

Use IDEA’s Join Databases option to consolidate files and join:

the chart of accounts master file with the general ledger detail file;
the vendor master file to the accounts payable or general ledger detail file;
the customer master file to the accounts receivable, sales, or general ledger detail file; and
project or location detail files from the appropriate master file to a detail file.

Matching

Files can be consolidated or joined and specific references within the file matched to determine a common element. Match files to make sure that all sales are made to customers with a valid customer account. The sales invoice file can be sorted by customer and matched to the accounts receivable customer file. Extract exceptions to review further.

Duplicate detection

Use the Duplicate Key Detection function to create a file with duplicate invoice numbers, cheque numbers, account numbers, or any other type of information unique within the transaction. IDEA can detect both duplicate character and numeric fields.

Gap detection

Use this test to detect gaps in a numerical or chronological sequence of records; for example to:

make sure that there are sales invoices for all work orders by sorting the invoice file by work order number and then verifying any missing items;
detect missing sales invoices or cheque numbers; and
make sure that sales are reported for each business day by converting dates in the file to numerical format and then verifying any gaps in the sequence.

For more details on CAATs, go to 13.1.3, Assistance from Digital Compliance and Audit Support Division specialists.

Electronic records audit procedures

Although the format and type of information used to complete an audit will vary significantly from audit to audit, the essential audit procedures do not vary and are not based on the format of the information. When the information is acquired electronically, the procedures include:

Gather information – While most of the financial information is gathered electronically, certain non-financial information and information gained through discussion and observation is gathered manually and can be necessary to complete the audit.
Walk through the system – The computer audit specialist (CAS) usually verifies the system’s integrity. Business system evaluations (BSE) are usually completed at the same time with the computer audit assist.
Review system controls – The CAS generally evaluates the system controls.
Review internal controls – As the system controls and internal controls are closely related, the auditor and the CAS will usually work together to complete the review and risk-assess these areas. It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning.
Analysis – After detailed information is summarized, analysis may include comparing the taxpayer's operating results to industry averages or standards.
Testing – The extent of testing (sampling) and the specific sampling techniques depend on the reason for the audit. The findings of the various analyses completed, items noted based on an overview of the returns as filed (T1, T2, and T3), and the assessment of the system and internal controls affect the extent of testing required. Specific sampling techniques may depend on the format of the information received and the degree to which the information can be manipulated.

Gather information

The CAS usually completes retrieval of the electronic information. In some cases, the auditor may complete the retrieval process. Whether the auditor gets the information independently or with a CAS’ help, depends on the skills of the auditor, availability of a CAS, and the format of the taxpayer's records. For more information, go to 13.1.3, Assistance from Digital Compliance and Audit Support Division specialists.

Acquiring the electronic information necessary to complete the audit generally involves a download of the taxpayer's financial information. Depending on the design and features of the accounting system, individual accounting modules including the general ledger, accounts receivable, sales, accounts payable, and purchases may need to be downloaded to manipulate the information to complete the audit steps required.

As well as financial information, supporting information files may be required. These files may include a current detailed chart of accounts as well as an explanation of codes used in the accounting system. If information needs to be compared, the history of the chart of accounts is necessary if there have been changes during the audit period or since the prior audit. Details of the chart of accounts information is not likely available in the accounting modules.

It is important to note that not all numerical information on the financial results is gathered from the accounting records. Other sources of information, such as discussion with key personnel and observation while at the taxpayer's premises, give valuable information not in the accounting records.

Analysis

Analysis of the electronic records includes many possibilities and choices depending on the records available, the reason for the audit, the type of business being audited, and the time allowed for the audit.

Some common types of analysis include:

Ratios, such as the quick ratio or acid test - calculate and compare to previous results and industry averages to show that the business is financially viable. Compare working capital from period to period to show trends and the possibility that the taxpayer may be unable to meet current obligations without extending long-term debt. For examples of common ratio analysis and calculations based on financial operating results, go to 13.1.8, Examples of computer-assisted audit techniques, Example 1, Financial statement analysis. Most intermediate accounting texts discuss the different ratios and the formulas used to calculate the ratios and how to interpret the results.
If the taxpayer operates in several locations, the analysis would likely compare the profit margins of individual locations to determine if the results are similar and to determine areas for further audit work. Extract or summarize the sales and expenditures by location code. Results that vary significantly by location show that further analysis is required and may depend on factors that affect one location and not another that are outside the taxpayer’s control, such as local competition, general economic conditions of the area, and higher transportation costs.
Match work orders to sales invoices to make sure that all work orders are recorded in the sales ledger. A further procedure may include matching work orders to the accounts receivable file to make sure that all work orders are for valid customer accounts.
Extract work orders and sales invoices when the delivery address is different from the billing address and sample to determine possible risks of personal use or unrecorded benefits.
It is easy to verify total sales (quantity sold times price per unit). Use the electronic information to verify the accounting software calculations; use formulas inserted in the file with individual sales invoices and check for variances. Add the various individual products sold to make sure that all items are included in the reported sales subtotal and are invoiced.
Review of the vendor file may show that purchases have been made from suppliers that are inconsistent with the taxpayer's operations. Analyze further to determine the specific purchases and to decide if more action is required.
Analyze and compare individual line item expenditures from period to period for significant changes that need more testing to determine the reason for the variance. Compare individual expenditures to sales to determine if the fluctuation is due to an increase or decrease in sales or if the expenditure is not directly related to sales. Increased expenditures may include expensed items that should be capitalized.

Testing

Financial information analysis determines the extent of detailed testing and varies greatly depending on the results of the preliminary audit procedures, the evaluation of system and internal controls, the reason for the audit, and the audit scope.

Use of computer-assisted audit techniques

Although income tax is not a transaction-based tax, expenses are sampled and specific areas considered high risk often require detailed review. Extract the accounts included in these highrisk areas to review a large volume of information and to quickly identify items meeting the risk criteria. Common errors and areas of risk include:

items expensed that should be capitalized;
personal items or expenses charged to the business;
sales understated; and
assets incorrectly classified for capital cost allowance (CCA).

Extract and sample purchases or expenditures greater than a certain value to quickly decide if the taxpayer has expensed items that should be capitalized. Summarize these purchases and calculate the tax adjustment. For more information, go to 13.1.8, Examples of computer-assisted audit techniques, Example 2, Review expenses for possible capital acquisitions.

Review expenses for personal items, including travel, charged to the business. The results can be significant as the expense to the business is disallowed and the individual may be assessed a personal benefit. Extract delivery addresses from all job sheets that do not match any addresses in the customer account file to decide if work is being done for personal use or at private residences for others. For more information, go to 13.1.8, Examples of computer-assisted audit techniques, Example 3, Review expenses for possible benefits.

Sales may be understated in many ways. To detect gaps in the sequence, use the work order reference on sales invoices and sort the file by work order instead of invoice number. Note missing work orders and examine further to decide if they have been cancelled, replaced, or not invoiced. For more information, go to 13.1.8, Examples of computer-assisted audit techniques, Example 4, Review numerical sequence of work orders.

Sort the sales invoices and convert the date to numerical format to verify that sales are recorded for each business day. Verify the numerical sequence to detect any gaps.

To decide if the taxpayer has correctly classified assets acquired during the audit period, extract transactions in the capital asset accounts. Common errors include passenger vehicles with a cost over the prescribed limit or that have been incorrectly added to Class 10 instead of Class 10.1. Other common errors include buildings, structures, and their components incorrectly classified. This example shows that information can be used for many audit tests. For more information, go to 13.1.8, Examples of computer-assisted audit techniques, Example 5, Capital asset acquisitions.

13.1.6 Computer-assisted audit technique software

Auditors with adequate training can use Interactive Data Extraction and Analysis (IDEA) to conduct their own computer-assisted audit techniques (CAATs). For help, ask a computer audit specialist (CAS), who has received in-depth training in CAATs.

To decide on the software package to use, it is important to consider the volume of information and ease of download. Other factors to consider include available hardware and software required by the various software packages, the auditor's knowledge of the software, and time constraints. A CAS will usually decide which software package is most suited to the taxpayer's system and the specific audit needs.

IDEA

The CRA standard file conversion software is IDEA for Windows. It is generally used for substantive testing and to verify data generated by a taxpayer's accounting system, but is also a useful analytical tool.

While many software packages and techniques are used to analyze taxpayer files maintained in electronic format, most auditors have been trained to use IDEA.

CRA maintains a site licence for IDEA and this permits the use of the software on any CRA computer (laptop or desktop).

Use IDEA to assess transaction completeness, analyze accounts, detect gaps in numerical or chronological sequences, prove calculations quickly and efficiently, and extract individual transactions or items based on set criteria. Also use the program to verify computer controls, perform edit checks, and match transactions from one file to another.

IDEA does not verify internal control procedures. Verify internal controls manually.

The program has many uses and is a powerful audit tool. Use IDEA to:

identify exceptional items by extracting items based on selected criteria;
analyze what would not be otherwise feasible by using functions, such as stratification;
verify system controls and perform edit checks using functions, such as field statistics or virtual field options;
match information to other computer-based procedures, such as match the accounts payable file to the employee master file to check for payments to employees outside the payroll system or match sales of large ticket items, such as vehicles to purchases and inventory;
test for gaps and duplicates;
verify if information is complete; and
check if information is valid; based on a selected sample, apply the results of the sample to the entire population.

IDEA offers three types of sampling:

systematic (evenly covers a population range);
random (used if projections are required without bias); and
monetary unit (used if a financial assessment of error is required with items that can be partially incorrect).

For more information, go to learning product TD1130-000, Introduction to IDEA.

Audit Command Language

Audit Command Language (ACL) has functions similar to IDEA and can analyze, extract, summarize, and verify, as well as write reports. Most Audit and Criminal Investigations Divisions have a copy of this software for the CAS’ use in specific situations.

Monarch

Although each TSO has a copy of Monarch for the CAS to use, the CRA standard file conversion software is IDEA. Using Monarch may be required to access taxpayer information or Monarch may be more efficient than using IDEA.

Monarch is a data access and analysis tool used to read reports and print files. After the report is read and/or printed, perform these procedures:

query;
filter;
analyze;
visualize;
convert files to a fixed length; and
export files into other programs, such as Excel and Lotus.

Monarch input files must be in a fixed-length ASCII text format. Other types may be used if the PREP utility function is applied before input into Monarch. Use this function for delimited ASCII files, files with long lines or strings, files with no carriage return, DBF files, and files with disruptive headers.

SPF/SourceEdit

SPF/SourceEdit (SPF/SE) is a file manager and full-screen text editor similar to the mainframe version of ISPF used to run and edit COBOL and RPGII programs. A CAS uses SPF/SE to edit programs and text files that have unprintable characters or characters that don’t apply. This software is used:

if records are variable in length;
if a file is missing characters;
to expand the length of a record; and
to replace characters or strings of characters that result in problems.

Microsoft Office

Word and Excel software within the Microsoft Office package are often used to prepare various reports and working papers. Documents created with various Microsoft Office software are compatible with Integras.

In many cases, extracted files or other taxpayer information that has been received electronically may be directly transferred to a working paper and further manipulated for audit purposes. Excel contains many useful functions, such as an analysis toolpak and report writer, for audit purposes. An add-in is required to perform statistical functions.

Other software

A CAS will often use other software to perform functions, such as:

transfer files to an auditor;
edit other programs and text files;
develop flowcharts to describe a taxpayer's business system;
back up data, restore lost data, permanently delete information from a hard disk, or compress files for storage; and
convert data to make it compatible to CRA software or to translate data.

13.1.7 Business systems evaluation

Background

A computer audit specialist (CAS) usually completes the evaluation of the taxpayer's electronic books and records through analysis at the time of audit. This process is known as business systems evaluation (BSE).

Effective June 18, 1998, subsection 230(4.1) was added to the Income Tax Act (ITA) and requires that every person keeping records in an electronically readable format must keep these records as required by subsection 230(4) of the ITA. Before this subsection was added, hard-copy records were accepted as sufficient audit evidence.

The minister may grant an exemption to the requirements to keep electronic records under certain terms and conditions or by applying subsection 230(4.2).

Previous BSEs may be useful and reduce the time to evaluate the taxpayer's system if there have not been significant system changes.

Do not disclose systems information received during the BSE from the taxpayer's systems personnel to the financial personnel.

Objective

A BSE analyzes a taxpayer's computerized accounting system to decide what data files are needed to conduct the audit in an efficient and effective way.

Process

A review of the taxpayer's computerized record-keeping system is done at the same time as the audit. The review includes:

identify the taxpayer's machine-sensitive data required to complete the audit using computer-assisted audit techniques (CAATs);
get documents in enough detail to identify audit trails;
evaluate internal controls;
review the records produced by the system; and
review the policies to make sure that the taxpayer is in compliance with record retention requirements.

In some cases, the CAS may be asked to complete a review of a taxpayer’s system under development (SUD). If a review of the system is completed before the start of an audit, the information is available for future use to conduct a CAA and BSE.

Scope

The system review covers only an evaluation of the system for record retention. Systems design is not included as part of the overview of the taxpayer's computer system.

System document requirements

Require a complete description of the system documents from the taxpayer. This includes the operation of the accounting system and the files that feed into the accounting system. The description should be detailed enough to include the:

application being performed;
procedures employed in each application; and
controls used to make sure processing is accurate and reliable.

Documents about specific files include:

record formats (including the meaning of all codes used to represent information);
flowcharts for both the system and programs;
label descriptions;
source listing of programs that created the files; and
detailed charts of account.

Findings of the business systems evaluation

After the BSE, the CAS gives information about the taxpayer records that apply to complete an audit.

13.1.8 Examples of computer-assisted audit techniques

Example 1 – Financial statement analysis

Financial statement analysis
	Audited year ended July 31, 2013	Audited year ended July 31, 2012	Audited year ended July 31, 2011
Working capital (Deficiency)	2,270,616	2,490,814	976,585
Total assets	56,977,471	56,262,965	51,901,871
Long-term debt currently due	1,426,331	1,172,310	1,285,900
Total debt	44,471,999	42,969,542	36,042,056
Total equity	12,505,472	13,293,423	15,859,815
Sales/Revenue	33,537,868	32,239,698	21,640,521
Profit (Loss)	787,951	1,873,608	282,254
Non-cash expenses (such as depreciation)	2,444,042	2,326,601	2,235,769
Interest expense	3,282,871	2,885,804	2,948,757
Dividends paid	0	0	0

Financial analysis – Changes
	Change from previous year 2012 to 2013	Change from previous year 2011 to 2012	Current year as % of previous year 2013/2012	Current year as % of previous year 2012/2011
Working capital (Deficiency)	(220,198)	1,514,229	91.16%	255.05%
Total assets	714,506	4,361,094	101.27%	108.40%
Long-term debt currently due	254,021	(113,590)	121.67%	91.17%
Total debt	1,502,457	6,927,486	103.50%	119.22%
Total equity	(787,951)	(2,566,392)	94.07%	83.82%
Sales/Revenue	1,298,170	10,599,177	104.03%	148.98%
Profit (Loss)	(1,085,657)	1,591,354	42.06%	663.80%
Non-cash expenses (such as depreciation)	117,441	90,832	105.05%	104.06%
Interest expense	397,067	(62,953)	113.76%	97.87%
Dividends paid	0	0	0	0

Ratio analysis
	Year ended July 31, 2013	Year ended July 31, 2012	Year ended July 31, 2011	Change: 2012 to 2013	Change: 2011 to 2012
(A) Liquidity
Quick ratio (actual : 1)	0.59	0.51	0.68	0.083	(.170)
Current ratio (actual : 1)	1.27	1.29	1.15	(0.023)	.136
Inventory turnover (# times)	5.38	6.62	10.17	(1.239)	(3.553)
Average age of payables (# days)	25.39	31.22	46.55	(5.837)	(15.328)
Average collection period of receivables (# days)	45.82	39.72	48.86	6.101	(9.139)

(B) Debt
Debt to net worth (# times)	3.56	3.23	2.27	0.324	.960

(C) Coverage
Interest coverage (# times)	1.24	1.65	1.10	(0.409)	.554
Cash flow coverage (# times)	1.38	1.75	1.29	(0.363)	.455

(D) Profitability
Gross profit margin %	12.16	19.36	17.40	(7.199)	1.965
Net profit margin %	2.35	5.81	1.30	(3.462)	4.507
Return on assets %	1.38	3.33	0.54	(1.947)	2.786
Sales/Total assets (# times)	0.59	0.57	0.42	0.016	.156

Cost of goods sold (CGS)
CGS as % of total expenses	2013	2012	Change
	2013	2012	Change
Purchases	22,860,682	20,279,184	2,581,498
Manufacturing expenses	6,181,201	5,301,443	879,758
Amortization	416,654	416,654	0
TOTAL	29,458,537	25,997,281	3,461,256
Cost of goods sold	77.60%	78.01%	-0.40%
Manufacturing expenses	20.98%	20.39%	0.59%
Amortization	1.41%	1.60%	-0.19%
TOTAL	100%	100%
Administration expenses as a % of sales	2013	2012	2011
	4.42%	4.28%	4.84%

Example 2 – Review expenses for possible capital acquisitions

As a result of analysis of individual line item expenses and based on the taxpayer's operations, volume of transactions, and previous history, the maintenance and repairs expenses appear unusually high. Extract all transactions in the account over $600 (value selected based on an overview of the population, the number of transactions, and materiality) to review the purchase information and decide if any expensed amounts should be capitalized.

Example 3 – Review expenses for possible benefits

Analysis shows that travel expenses during the audit period are significantly greater in relation to sales than other businesses in the industry. A review of all travel expenses is considered warranted. Stratify the population of transactions in the travel account to remove small amounts paid to employees for mileage and review all large amounts. From the selected sample, note the individual travelling, the destination, and the transportation method. Examine further any unusual items.

While reviewing travel expenses often charged to the corporate credit card, other credit card purchases show significant office expenses. Of specific interest are several months that show an entry to office expense that are significantly greater than normal. Office expenses appear to have increased significantly from the prior year. Review of the individual credit card statements shows a number of purchases from a jewellery store in the neighbourhood. Further verification determines that these purchases are in fact personal.

Example 4 – Review numerical sequence of work orders

The sales invoice file is sorted by work order. Detect random gaps. Review of a sample of the missing work order numbers shows that all missing work orders have been cancelled and replaced with other work orders. However, review of the sequence also shows that work orders numbered from 28,001 through 28,300 are missing. Further verification shows that when work order forms were reordered, the printer used the wrong starting number. Based on the findings, no adjustment is required and no more testing of this issue.

Example 5 – Capital asset acquisitions

A brief overview shows that several vehicles were acquired during the audit period. Extract all purchases in excess of $20,000. Review each item to determine if the purchase is a vehicle. If the purchase is an automobile, determine if the acquisition was placed in the correct class of assets (Class 10 or 10.1). If purchases exceed the prescribed limit and are incorrectly classified, an adjustment may be required.

Review the use of each vehicle to make sure that personal use of the employer's automobiles is reported as a benefit to the employees.

13.1.9 Related topics

9.7.0, Audit tools;
10.2.0, Books and records; and
10.2.9, Electronic transfer of accounting data.

13.2.0 Audit of non-taxable sources of funds

13.2.1 Overview

If unexplained deposits or discrepancies in income are noted during an audit, the taxpayer may state that the reason for any discrepancy or unexplained funds is a non-taxable source of income or loan. Common examples of non-taxable sources of funds include:

cash-on-hand;
gifts, loans, and inheritances;
lottery and other winnings; and
funds from a non-taxable foreign source.

Non-taxable funds should be determined as early in the audit process as possible (often during the initial interview). Details given should include source, timing, and amount.

For example, the taxpayer states, during the initial interview, that they received an inheritance paid out in three lump sums: one in the summer of 2012, one just before Christmas, and another just after the new year and the amounts were “about” $60,000; $20,000; and $30,000. The auditor, then finding a deposit in July 2012 of $61,922; in late November 2012 of $19,831, and in early February 2013 of $30,600 may feel there is no risk for these deposits. If the auditor had assessed the credibility of the information as low, it may be worth doing a third-party check with the executor.

Funds such as cash-on-hand, and anything else that does not get deposited to a bank, need a detailed rationale as to how the amount was determined.

If funds are deposited to a business or personal bank account and the balance of probabilities does not show that the funds originate from a taxable source, they remain nontaxable and cannot be assessed. For more information, go to 13.5.0, Assessing unidentified bank deposits technique.

Only audit material amounts of non-taxable sources of funds. Ordinarily, it is reasonable to conclude that a taxpayer maintains a cash float or receives cash gifts from friends or family members. Exercise discretion and reasonableness and avoid extensive inquiries into minor and trivial items. For more information, go to 9.17.0, Assessment of materiality.

13.2.2 Interviewing the taxpayer

Auditors are not permitted to use audio or video recorders to record interviews, nor may they consent to being taped or recorded. If it becomes known that the taxpayer has turned on a recording device, the interview must be stopped immediately and the taxpayer informed that management will be in contact to discuss the issue and make other arrangements (from archived Communiqué AD-01-02, Conducting Enforcement Actions Under Unusual Circumstances).

Question the taxpayer about all sources of funds early in the audit, usually during the initial interview. For more information, go to 10.1.0, Interviewing the taxpayer.

Take every possible step to establish the reliability of the taxpayer's statements and to get the details of the information necessary to complete the audit. Throughout the audit, it is mandatory to update the taxpayer on the progress of the audit. Thoroughly interview and document all discussions on Form T2020, Memo for file, available in the Integras Template Library. Request a signed statement from the taxpayer detailing any funds received from friends and family members during the audit period.

Comments and statements made by a taxpayer at the beginning of the audit or during the initial interview often carry more weight than statements made at a later point in the audit. If there is any doubt about the source of funds, the benefit of that doubt should be decided in the taxpayer's favour. The Taxpayer Bill of Rights states that the taxpayer has the right to be treated professionally, courteously, and fairly. For more information, go to Taxpayer Bill of Rights.

13.2.3 Audit of cash-on-hand

Cash-on-hand is any cash currency held that is not included in a bank or investment account and is a common issue to determine a net worth assessment. Cash-on-hand may arise in a case if attempting to identify sources of funds to support the taxpayer's accumulation of assets, lifestyle, deposits to personal bank accounts, or contributions to the business.

Ask the taxpayer if cash-on-hand has ever been maintained at the business, home, or at any other location. If a material amount of cash-on-hand is shown, determine the source of the cash, denominations, where the cash was stored, and later disposition of the funds. Also review the purpose of the cash-on-hand and the reasons why the cash was kept outside of business or personal bank accounts.

13.2.4 Opening and closing cash-on-hand

It is important to determine both the opening and closing balances of cash-on-hand. If the taxpayer states that a residual balance of cash-on-hand exists at the time of audit, request a physical count of the cash-on-hand. This may involve a visit to the taxpayer's bank to inspect the contents of the safety deposit box.

Before asking to count the cash or inspect the contents of the safety deposit box, make sure that the exercise will be witnessed – preferably by another CRA employee. If this is not practical, the auditor or the taxpayer should arrange for a reliable third party to be present.

Record the amounts, denominations, and serial numbers of large bills. Serial numbers can be traced to date of issue and show the timing of the accumulation. Only financial institutions supply bills wrapped in official denomination bundles. Also note the general condition of the bills, if worn or mint condition, and if they are old or new currency formats.

Prepare an inventory list of all cash and valuables examined. Those present during the examination should sign the inventory list and the taxpayer should certify that all items were returned to the safety deposit box. A will included in the contents of the safety deposit box must not be examined or read under any circumstances.

Especially if cash-on-hand is an issue, auditors should get a copy of the signature access card from the bank's branch location. The taxpayer's pattern of access of the safety deposit box and unexplained deposits or cash acquisitions and expenditures may give valuable information. If a taxpayer refuses access to the safety deposit box, an auditor cannot compel access under the civil sections of the ITA.

13.2.5 Analysis of bank accounts

When reviewing material cash-on-hand issues, all business and personal bank accounts should be closely examined for at least a three-month period prior to the audit period to determine the flow of cash in and out of these accounts. As well, an analysis of bank accounts for a three-month period (or longer) following the audit period may reveal undisclosed cash-on-hand at the close of the audit period. If a taxpayer has a history of loaning money to business associates, relatives, or others, substantial deposits of cash in the post-audit period could disclose loans advanced during the audit period for which there is no disclosed source of funds.

There may be patterns in the taxpayer's finances that support or discredit statements made about the existence of opening cash-on-hand. Suggested items to review include:

If possible, review reported earnings for the preceding 5, 10, or 15 years and compare to the taxpayer's lifestyle; this may support or discredit a taxpayer's statement that cash-on-hand was accumulated from prior earnings.
Substantial cash withdrawals from business or personal bank accounts may be considered to not match a taxpayer's statement about there being cash-on-hand. However, substantial cash deposits that are not consistent with the taxpayer's business cycle may lend support to the existence of cash-on-hand.
A taxpayer's reliance on conventional banking, including savings accounts and investment certificates, can be argued as incompatible with a stated preference for cash over secure banking.
New loans or previously existing loans and the payment of interest may be considered contradictory to the notion of an existing balance of cash-on-hand.

Do not ignore the business records. A review of deposits may reveal that no cash or only minimal cash is deposited to the business bank accounts or that cash in denominations greater than $20.00, is excluded from deposits. These may show that the taxpayer suppresses income to maintain a lifestyle (include accumulation of assets) that is not supported by reported income.

13.2.6 Audit of gifts, loans, and inheritances

Gifts, loans, and inheritances from friends or family members may arise if attempting to identify sources of funds to support the taxpayer's accumulation of assets, lifestyle, deposits to personal bank accounts, or contributions to the business.

Inheritances generally carry legal obligations for the executor of an estate. As well, the will may be probated, as the trustee may be concerned with legal recourse available to parties and beneficiaries with an interest in the estate. As a result, inherited funds are often easier to verify. However, there is often no legal requirement to probate a will. As well, even if a will is probated, there are no reporting or record retention requirements for the trustee under the ITA beyond filing the deceased individual’s final T1 Income Tax and Benefit Return and keeping the related records. For more information, go to 17.2.0, Estates and Trusts Program.

There is no requirement for the trustee to request a clearance certificate and a testimonial trust. Filing of trust returns is only required if there are undistributed assets and taxable transactions, other than rights and things, after death. An audit of an inheritance is ordinarily limited to a review of the executed will and source documents supporting the transfer of funds or assets. However, in rare circumstances, there may be no audit trail to confirm an inheritance.

Ask the taxpayer if any substantial gifts, loans, or inheritances were received from friends or family members during the audit period. If there is a material amount, ask the taxpayer to identify the payer (including name, complete address, and relationship), the timing and the form of receipt (cheque or cash), and details of the disposition of the funds. Also request any documents that support the receipt. If significant amounts of cash are received, ask the taxpayer to state the denominations.

If there is doubt about the gift or loan, contact a third party to confirm the information. Interview the payer or review their books and records, including personal banking records. For an inheritance, interview the estate’s executor or review their books and records. For more information, go to 10.6.0, Obtaining information from third parties.

In some cases, the taxpayer may get the third-party confirmation or a copy of the relevant third‑party banking records on behalf of the auditor. This is often done for gifts, loans, or inheritances from family members. Information directly from the third party often is more reliable; the auditor must use professional judgement to decide whether it is valid audit evidence.

If a third-party confirmation cannot be obtained (for example, the payer is deceased or cannot be located), rely on the credibility of statements to determine with some degree of assurance the source of the funds. Examine contradictions between the taxpayer's statements and the audit evidence accumulated from a review of the taxpayer's business and personal records.

If there is audit evidence to support that based on the reported earnings and identifiable assets of the payer, that the payer neither had the funds, nor the income to support the gift, loan, or inheritance amount, the auditor will not consider the amount as part of the taxpayer’s resources. However, if the situation is not clear, the benefit of the doubt must be decided in the taxpayer's favour.

13.2.7 Audit of lottery and other winnings

Lottery and certain other winnings are non-taxable in Canada. However, if the taxpayer is in the business of gambling, consider the proceeds and losses for income tax purposes.

Non-taxable lottery and other winnings may arise if attempting to identify the source of funds to support the taxpayer's accumulation of assets, lifestyle, and deposits to personal bank accounts, or contributions to the business.

If the taxpayer states that the source of funds is lottery or other winnings, for all winnings and losses, request:

type and frequency of gaming or betting;
minimum, maximum, and average gaming loss or bet;
source of funds used to place wagers – cash, bank withdrawal;
frequency of wins versus losses; and
minimum, maximum, and average gaming win.

Request documents that support the winnings and losses for all significant amounts.

Test actual transactions to verify the taxpayer's statements. In some instances, use third-party confirmation at the gaming establishment to verify amounts. Suggested sources of information include:

Provincial lottery corporations regulate lotteries and each has specific rules on the payout to winners. Commonly, winnings over a set dollar amount must be mailed or picked up at the provincial lottery offices. The purchaser must be identified and the payout by the lottery corporation follows in the form of a cheque or money order. Only provincial lottery winnings less than an established dollar limit can be paid out over the counter in cash by a representative retail vendor.
Casino, bingo, and racetrack winnings are generally paid out in cash. There is no identification of the winner outside of the initial production of the winning chips or ticket. However, certain casinos, bingo halls, and racetracks keep records of winners or payouts over an established dollar amount.
E-commerce or online betting and gambling are an emerging growth economy. Online betting and gambling require the use of a credit card or e-commerce account where wagers are withdrawn and winnings are deposited. Payments to or payments from an ecommerce account are ordinarily by credit card, but may also be by money order.
Non-regulated betting and gambling is the most difficult to confirm. However, if the taxpayer bets or gambles with friends, seek third-party confirmation on the frequency, wager limits, and potential winnings and losses.

If audit evidence of the transaction cannot be obtained from the taxpayer's records or from a third party, rely on judgement and reasoning to determine the source of the funds. Decide if there are apparent contradictions between the taxpayer's statements and the audit evidence accumulated from a review of the taxpayer's business and personal records.

A taxpayer may often recall wins but have to be prompted to recall losses. If there is genuine doubt about the receipt of lottery and other winnings, the benefit of the doubt must be decided in the taxpayer's favour.

For an in-depth discussion on gambling as a source, read:

2007 DTC 307, Leblanc et al v The Queen;
Lottery and game of chance, paragraph 40(2)(f) of the ITA; and
Prizes included in income, paragraph 56(1)(n).

13.2.8 Audit of non-taxable funds from a foreign source – Under review

During an audit, it may be disclosed in statements made by the taxpayer or during a review of the taxpayer's bank deposits, that funds were received from a foreign source. The taxpayer may state that the foreign source is non-taxable, such as a gift, loan, or inheritance from friends or family members residing in the foreign jurisdiction, or the taxpayer's own funds kept in a foreign holding or a foreign bank.

The existence or absence of a tax treaty or reciprocal agreement between Canada and the foreign source country creates complications to confirm the validity of statements made by the taxpayer on whether the foreign funds are taxable sources of income in Canada. As well, many countries have foreign currency controls that may make the transfer of funds from a foreign source an illegal act in that jurisdiction. Such existing controls can cause a taxpayer to be reluctant to disclose information about the transfer of funds from a foreign source.

If the taxpayer states significant funds from foreign sources, request the details of the transactions, including:

nature of the receipts;
identification of the payer, including name, address, and relationship to the taxpayer;
timing of the receipts;
format of the receipts – if by wire transfer, cheque, or cash (if cash is received, request that the taxpayer state both the currency and the denominations of the funds received, plus details of any foreign exchange transactions);
taxpayer's disposition of the funds; and
any obligations for repayment.

Request a copy of documents to support the receipt of the funds and keep in the audit file.

If the source of funds is the taxpayer's own foreign asset holdings or bank account, the taxpayer must produce complete supporting documents and records. These documents may include the taxpayer's application for immigration to Canada, detailing declared foreign asset holdings. Requirements to the taxpayer for information in these situations are generally made at the same time under subsection 231.1(1) and subsection 231.6(2) of the ITA. Section 231.6 deals with foreign-based information and subsection 231.6(8) says that if the taxpayer has not complied with the requirement, that information cannot be introduced later as evidence. Subsections 231.6(3) to (7) have clarifications to this rule.

If the taxpayer fails to comply with a requirement under subsection 231.1(1) to provide supporting documents and information, consider assessing the amount received as taxable income received from a foreign source. In some cases, a compliance order to produce supporting documents may be requested. For more information, go to 10.8.0, Requirement guidelines, and Chapter 11 of the Criminal Investigations Manual. As a choice, the CRA may ask for the information from the foreign-based taxing agency that can result in foreign and domestic audits of the taxpayer's affairs at the same time.

If the funds are received from a foreign source and are non-taxable funds from a friend or family member, the taxpayer should identify the individual, including name, address, business and corporate affiliations, or employer. If practical, the taxpayer may get and produce a copy of the payer's banking documents supporting the transfer of funds.

Wire transfers may carry information to identify the foreign source bank and account number. The name attached to the foreign source bank account may be shown on the taxpayer's copy of the wire transfer. Whether or not to request confirmation of the transaction depends on the situation. In making this decision, consider the possibility that the taxpayer uses a nominee for foreign holdings.

If funds are received in cash and deposited to the taxpayer's Canadian bank account, the bank should have a record of both the deposit and the foreign exchange transaction. However, if the taxpayer uses an exchange broker or money mart to exchange small amounts over a period of time, there may no record of the transactions.

If supporting information is not available, use other indirect audit techniques to determine the source of funds. Some suggested techniques include:

Test the consistency of the taxpayer's statements to transactions entered in the records.
Use a bank authorization signed by the taxpayer to obtain information on transfers of funds or foreign exchange transactions through the taxpayer's domestic Canadian bank. A bank operating in a foreign jurisdiction may also honour a written request for documents and information concerning foreign-based accounts, if it is accompanied by an authorization signed by the taxpayer.
Request third-party confirmation by telephone or letter from the foreign jurisdiction. It is mandatory to include a copy of all correspondence in the audit file. The payer, unless a Canadian resident, has no obligation under the ITA to give any information or documents.
Request information from the local TSO's International Audit section – information may be available from the foreign-based taxing agency.
Consider a referral to the Criminal Investigations Program when evidence of tax evasion, fraud or other tax related offences have been discovered. It is mandatory to include a copy of all referrals and resulting reports in the audit file.

In each case, consider the materiality of the payment received to decide on the extent of follow‑up action to be pursued.

If audit evidence supports that the source of funds is taxable, consider an assessment. However, if there is doubt, the benefit of the doubt must be decided in the taxpayer's favour.

13.3.0 Indirect verification of income

13.3.1 General comments

The next sections discuss the CRA policy about using supporting indirect verification of income (IVI) tests and assessing IVI techniques if a taxpayer's books and records are non-existent or inadequate, inaccurate, or unreliable or if audit findings indicate that some taxable revenue has not been accurately recorded in the books and records.

A supporting IVI test is a risk assessment tool to help determine the focus of the audit. Three of the supporting IVI tests require complete banking information before risk analysis can take place. It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning. A supporting IVI test can be used to support an assessing IVI technique; however, it cannot be used as the basis of an income tax assessment or reassessment.

The supporting IVI tests discussed are:

bank deposit analysis (mandatory IVI step);
rough net worth;
source and application of funds; and
ratio analysis.

For audits in the Small Business Audit Program (program 17) and audits in the Medium Business Program (program 18) where IVI testing has been mandated by Business Intelligence, auditors must conduct the bank deposit analysis test and one of: rough net worth test, source and application of funds test, or ratio analysis.

Where IVI testing is not mandated by Business Intelligence, the audit approach taken depends on the reliance that can be placed on the internal controls and the quality of the books and records. Therefore, even in these audits, if the reliability of the accounting records is suspect or the apparent lifestyle of the taxpayer is inconsistent with reported income, auditors should use supporting IVI tests.

These tests are described in greater detail in 13.7.8, Supporting indirect verification of income testing.

IVI testing is required if either of these conditions is met:

When mandated by Business Intelligence;
Where the auditor has identified risks of unreported income by considering the reliance that can be placed on the internal controls and the quality of the books and records.

In cases where the shareholder or taxpayer has prepared the books and records, and neither condition 1 or 2 is met, the auditor will:

Exercise professional judgement and consult their team leader in developing an audit plan that addresses all material risks of non-compliance;
Complete a revenue reconciliation. The findings from the revenue reconciliation must be incorporated into the auditor's analysis on the extent of additional revenue testing as outlined in their audit plan; and
Document the steps they took to risk assess the file, as well as their findings as to the required areas of audit testing.

For more information, go to October 30, 2020, memorandum, Requirement to Perform Indirect Verification of Income Testing.

The Income Tax Assessing IVI Decision Tree is a mandatory working paper that must be completed early in the conducting stage of every audit where IVI has been mandated by Business Intelligence or where the auditor has identified risks of unreported income. The Income Tax Assessing IVI Decision Tree incorporates the technical and policy conditions that impact the choice of assessing IVI technique used in a given situation. The Income Tax Assessing IVI Decision Tree follows the hierarchy of the assessing IVI techniques as stated below.

IVI Decision Tree 2016 is available in the Integras Template Library. For more information, go to May 2, 2016, memorandum, Income Tax Assessing Indirect Verification of Income (IVI) Decision Tree – Revised.

Auditors must follow the Integras procedures to send the Income Tax Assessing IVI Decision Tree to the team leader for approval and keep this with the Integras case.

An Assessing IVI technique is restricted by technical or policy conditions and is therefore more formal and time consuming than a supporting IVI test. The data used in an assessing IVI technique is gathered from many sources, including banks, detailed testing of the books and records, and third-party sources. It can be used as a basis of income tax assessments and reassessments; case law supports this use.

The hierarchy of the assessing IVI techniques for audits is:

assessing net worth, go to 13.4.0;
assessing projections, go to 13.6.0; and
assessing unidentified bank deposits; go to 13.5.0.

The distinction between an assessing IVI technique and a supporting IVI test is therefore one of formality and detail. The assessing IVI technique must be based on sufficient additional audit evidence for the result to be credible in court. Demonstrate a preponderance of audit evidence to support, not just the assessing IVI technique, but also the details of the calculation. Multiple indicators of a revenue understatement increase the weight of the audit evidence.

The hierarchy is based on risk coverage. A net worth is conservative; determining net income as opposed to gross income, but it considers the largest base:

bank transactions (through a determination of personal expenditures);
change in assets not affecting bank accounts (purchase or disposition);
changes in liabilities not affecting bank accounts (receipt of funds, or payment of debt); and
household unit is considered, because of the consideration of personal expenditures and joint assets/liabilities.

A projection determines gross revenue, usually based on an expense input, such as cost of goods sold, but only for a revenue stream where a reasonable base can be determined. For example, pizza sales may be projected based on pizza boxes used, but that will not affect fountain pop sales, or other subsidiary revenue streams.

Assessing unidentified bank deposits captures only revenue that was deposited to a known bank account.

The team leader must be consulted and approve the appropriate assessing IVI technique. Update the Audit Plan, making reference to the Income Tax Assessing IVI Decision Tree as justification. Team leader approval is necessary at various stages of the audit; document the team leader’s involvement and/or approval on Form T2020, Memo for file.

13.3.2 Coding for indirect verification of income cases – Under review

The correct indirect verification of income (IVI) coding of all completed audit files is imperative, as the information is used to track the types of IVI files completed, as well as to identify the areas of non-compliance within the Small Business population. The mandatory IVI coding applies to all audits. IVI coding must be entered in Integras under Audit Analytics in the Finalize Audit Attributes tab.

The bank deposit analysis (BDA) is mandatory if supporting IVI tests are conducted, so only the second supporting IVI test must be coded. From the drop-down list for IVI Test Conducted, the viable choices for programs 17 and 18 are:

no supporting tests performed
source and application of funds
rough net worth
ratio analysis

Coding the assessing IVI technique is also mandatory and the choices are:

no assessing technique performed
net worth
projections
unidentified bank deposits
third party data

If an assessing IVI technique was completed and proposed, then the coding should state that a technique was performed, regardless of the final audit result. This will ensure that both the risk assessment and audit effort are captured.

Requirement coding

Near the bottom of the Finalize Audit Attributes tab in Integras, the Requirement Coding box is for the mandatory coding of any requirements issued.

For each distinct combination of Entity, Type of Enforcement, and Outcome, a separate coding should be entered.

For example, if during the audit case, the auditor issues twelve section 231.2 requirements to financial institutions and received information and one informal request to keep adequate books and records with no follow-up, this would result in two entries in the Requirement Coding box.

Entity: D – Financial Institution, Type of Enforcement: F – Requirement, Outcome: 1 – Action resulted in compliance, Number of Requirements: 12
Entity: A – Taxpayer/registrant (and related parties), Type of Enforcement: A – Informal request to keep adequate books and records, Outcome: 3 – Result of action is unknown, Number of Requirements - 1

Audit result codes

Enter audit result code 652 for all IVI files and any audit where unreported revenue is assessed. This information helps evaluate Audit's ability to identify unreported income, which is a key performance indicator.

Unreported sales for audit period reassessed is gross revenue from all normal income streams which has not been reported. For example, a convenience store that leases the upstairs space for residential purposes and commercial storage would include both retail sales and rental income as part of its normal income streams. This does not include any adjustments for technical issues, such as capital gains on the sale of commercial buildings.

13.3.3 Inadequate, inaccurate, or unreliable books and records

For information on what is considered as part of the books and records, go to 10.2.0, Books and records.

Inadequate is with reference to subsection 230(1) of the ITA; are the books and records adequate to determine taxes payable or amounts to be withheld or deducted.
Inaccurate refers to mathematical inaccuracy as well as incompleteness.
Unreliable is primarily a rating of the internal control. It may also indicate that although the books and records may appear fine, they do not support lifestyle or some other criterion.

13.3.4 Legislative authority

The legislative authority for proceeding with IVI techniques is found in subsection 152(7) of the ITA that says that the minister is not bound by a return or information supplied by the taxpayer.

13.3.5 Burden of proof

The burden of proof to refute an audit adjustment or assessment lies with taxpayer.

The burden of proof to establish facts for penalties applied under sections 163 or 163.2 of the ITA lies with the minister.

13.4.0 Assessing net worth technique

13.4.1 Introduction

This section gives information on when to consider the assessing net worth technique and establishes the policies and procedures to use to conduct and complete a net worth audit. Use this audit technique to verify reported income or determine unreported income.

The decision to use the assessing net worth technique should be made during the early stages of the audit work. Do not devote significant hours to a factual review of the taxpayer's business records if it is determined that the records are inadequate, inaccurate, or are considered unreliable.

Auditors are generally expected to use the assessing net worth technique whenever the books and records are inadequate, inaccurate, or unreliable and there are indications of unreported income. The Income Tax Assessing IVI Decision Tree incorporates the technical and policy conditions that impact the choice of assessing IVI technique used in a given situation.

13.4.2 Definitions

Definitions and terms used in this section include:

Base year – The base year of a net worth is the year prior to the audit period. The ending balances for assets/liabilities of the base year are the opening balances for the period under audit (opening January 1, 2013 = ending December 31, 2012).
Factual review – An audit of the contents of actual records, as opposed to relying on indirect tests or net worth to determine compliance.
Net worth – A taxpayer's net worth at any point in time is the cost of all assets, minus liabilities. Use all assets and liabilities, both business and personal, to calculate net worth.
Normal reassessment period has the meaning assigned by section 152 of the ITA.

13.4.3 Coding for assessing net worth technique

If a rough net worth test or an assessing net worth technique is used, refer to the instructions in 13.3.2, Coding for indirect verification of income cases.

13.4.4 Principles of the assessing net worth technique

A taxpayer must have sufficient income (taxable and non-taxable) for a tax year to equal any increase in net worth plus personal expenditures (PEs) incurred.

The assessing net worth technique will not measure income with absolute certainty, but will give a conservative estimate of income, as not all the taxpayer’s PEs will be documented during the net worth period.

The technique measures an individual’s total income based on changes of both business and personal assets and liabilities after taking into account PEs and other appropriate adjustments. In the audit of a partnership, the assessing net worth technique can be applied to individual partners to determine total income of the partners. In the audit of a corporation, the assessing net worth technique can be applied to the shareholders to determine total corporate income appropriated by the shareholders.

The assessing net worth technique is used if a taxpayer's assets have increased without a corresponding increase in sources of funds or income or if reported income does not support the apparent lifestyle of the taxpayer. Although the onus is on the taxpayer to substantiate that an adjustment is inaccurate if a net worth is required to support an assessment or reassessment, use the principle of conservatism to arrive at a credible and reasonable conclusion.

13.4.5 Section removed

The information from this section is now included in 13.3.4, Legislative authority.

13.4.6 Circumstances that warrant proceeding to an assessing net worth technique

The assessing net worth technique is an effective audit tool to identify and assess underreported income.

Typically, the first indication that a net worth should be used is that there appears to be a “source of funds” issue. This means that total reported income does not appear to be sufficient to support:

a lifestyle in a given postal code;
a normal lifestyle for a given family size;
the increase in business assets listed on the capital cost allowance (CCA) schedule; or
the increase in the due to shareholder account.

After the initial interview, tour of premises and the preliminary review (review of internal controls, books and records, and sales cycle, and bank deposit analysis), for audits where IVI has been mandated by Business Intelligence or where the auditor identified risks of unreported income, the auditor must always conduct the bank deposit analysis test and one other supporting IVI tests such as a rough net worth, a rough source and application of funds test (Medium) or a ratio analysis.

For the rough net worth, it is mandatory to calculate a minimum amount of PEs through a summary withdrawal analysis (SWA). Go to the October 14, 2015, memorandum, Summary withdrawal analysis to calculate personal spending, for detailed procedures.

In the same way that a SWA must be used to calculate the minimum amount of PEs in a rough net worth or a source and application of funds test, the detailed withdrawal analysis (DWA) must be used to determine a minimal level of PEs for the assessing net worth technique. The only difference is that as part of the assessing technique, the DWA will require more effort in tracking payments from accounts and determining payments not made from any known account. The DWA prepared by the auditor must provide a breakdown of the taxpayer's spending by category. The categories chosen must be relevant to the taxpayer's spending habits. Go to the October 5, 2017, memorandum, Detailed withdrawal analysis to calculate personal spending in assessing net worth, for more information.

Based on professional judgment, if the auditor believes that the PEs calculated through the SWA are not sufficient to support the lifestyle of the taxpayer, the auditor must document the reasons for this determination and choose:

The taxpayer’s estimates from the PE worksheet (go to 13.4.18, Personal expenditure interview). The auditor and team leader should evaluate whether the taxpayer’s estimates are representative of the apparent lifestyle. Document the team leader’s involvement on Form T2020, Memo for file, available in the Integras Template Library.

Statistics Canada estimates, which should also be evaluated as to whether the taxpayer’s PEs are likely to approximate these amounts.

For greater clarity, a transfer is only considered a transfer if the account receiving funds is also part of the accounts analyzed.

If the rough net worth indicates significant risk (as evaluated by the auditor and team leader), then the auditor proceeds with an assessing net worth technique. Document the team leader’s involvement on Form T2020, Memo for file.

It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning.

For more information, go to 9.16.0, Continued risk assessment while the audit is in process.

Considering the assessing net worth technique to verify income, implies that one or more of these factors are present:

Unidentified deposits to the taxpayer's personal or business accounts can only be explained as unreported income.
The only source of funds to account for amounts identified as contributions to the business or business expenses paid by the taxpayer is unreported income.
The taxpayer has used or appropriated unreported income to pay personal expenditures, acquire personal assets, or reduce liabilities.

The decision to adopt the assessing net worth technique during an audit is ordinarily based on:

issues identified during risk assessment/audit selection;
preliminary review of the audit file;
initial interview;
tour of premises;
analysis of internal controls and the accounting system;
bank deposit analysis;
withdrawal analysis (for PEs);
source and application of funds;
rough net worth; and
Income Tax Assessing IVI Decision Tree.

13.4.7 Understated or unreported income

Exercise judgement and consult with the team leader to determine if reported income has been materially understated. Document the team leader’s involvement on Form T2020, Memo for file.

13.4.8 Section removed

The information from this section is now included in 13.3.3.

13.4.9 Circumstances that do not warrant an assessing net worth technique

As an assessing net worth technique is performed on a household unit, if there are multiple sources of income within the unit, it may not be possible to build a rationale to assess the net worth amount to any individual. For example, two spouses with two adult children living in the household, all are self-employed consultants with poor books and records. If their finances are intertwined (such as PEs or undocumented loans between members of the unit), the assessing net worth technique may well indicate underreported amounts, but it may not be possible to assess any individual their reasonable proportion.

If, after proposing a net worth adjustment, enough factual audit evidence comes to light to mitigate the net worth (such as a signed and supported admission by the taxpayer), or reduce it to an immaterial amount, the net worth amount may be dropped as an adjustment, but will still stand as an assessing tool.

13.4.10 File selection and risk assessment indicates assessing net worth technique warranted

It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning. The computer-assisted audit selection (CAAS) system identifies source of funds issues, such as increases in investment income or compares average neighbourhood income.

The Business Intelligence team will identify cases where there is a high probability of:

an accumulation of business and personal assets;
a reduction in business or personal liabilities; or
PEs and a lifestyle that is not consistent with the taxpayer's reported income and identified sources of financing and non-taxable sources of funds.

A material net worth discrepancy may be based on identified PEs if there is no apparent increase in the taxpayer's net worth or asset holdings. This is common in a weak economic environment or within specific industry sectors, such as the hospitality and service sectors.

If a net worth comparison is suggested for a file selected for audit, it may be based on a number of factors, including:

family income versus average family income for the taxpayer's neighbourhood;
number of dependants;
level of drawings or contributions to the business;
increasing investment income;
real property transactions;
vehicle registry information; and
property taxes or rent paid (claimed as a provincial or territorial tax credit in some jurisdictions).

For corporations, the screener also considers any increase in the shareholder's loan payable from the corporation (that is, due to shareholder).

The assessing net worth technique is often used if there is a high frequency of cash transactions. Suppressed cash receipts may not be deposited to a bank account and may only be detected by analyzing the taxpayer's PEs, cash contributions to the business, or acquisitions of business and personal assets.

As well as identifying suppressed cash sales transactions, consider the rough net worth test if any of these transactions are evident or suspected:

unidentified deposits made to personal or business accounts;
unsubstantiated amounts recorded as contributions to the business (or shareholder's contributions for a corporation);
cheque substitution;
electronic commerce (e-commerce); or
barter, if personal assets or services are received in exchange for business sales or services.

During the initial interview, confirm with the taxpayer if a copy of correspondence is also to be sent to the representative. If a copy of correspondence is to be sent to a representative, make sure there is appropriate and current authorization on file. If the authorization is not on file or if it has expired, prior to communicating with the representative, request the taxpayer give consent by authorizing the representative. It is mandatory to include a copy of all correspondence in the audit file.

13.4.11 Overview of the net worth

The net worth identifies unreported income of an individual’s household unit by assuming:

A taxpayer's net worth at any point in time is the cost of assets minus liabilities (both business and personal).
A taxpayer's total income for a period is equal to the increase in net worth, plus personal expenditures (PEs) incurred, plus non-deductible losses incurred, less non-taxable sources of income received.

The expected total income from the net worth is then compared to the combined total incomes (Line 150 of the T1 Income Tax and Benefit Return) reported, for all contributing members of the household that were considered. Any positive variance is considered unreported income.

13.4.12 Net worth audit period

The audit period for the net worth will ordinarily include the most current tax year for which an income tax return has been filed, plus prior years for which the reassessment period has not expired. Usually this is three years plus the fiscal year-end balances for the base year. Go to 13.4.39, Assessing net worth technique fiscal year and assessment period for a corporation.

13.4.13 Exceptions to the normal assessment period

In some circumstances, the net worth audit period may be expanded to include returns for which the normal reassessment period has expired. This includes if carelessness, neglect, or possible fraudulent misrepresentation is clearly indicated. There must also be a reasonable assurance that records, including personal banking records, which are needed to complete the net worth, are available from the taxpayer or third parties for the additional periods. Extending the audit period for greater than three years is based on professional judgement and requires the team leader's approval. Document the team leader’s involvement and/or approval on Form T2020, Memo for file.

13.4.14 Basis of the net worth assessment

Use the assessing net worth technique to determine the net worth assessment. The Statement of changes in net worth details and summarizes transactions recorded from the rough net worth test through to the assessing net worth technique.

The Statement of changes in net worth includes six distinct schedules that cover the audit period and a PE worksheet for each period:

Schedule 1, Balance sheet – Assets
Schedule 1a, CCA schedule
Schedule 2, Balance sheet – Liabilities
Schedule 3, Calculation of the discrepancy in total income per net worth
Schedule 4, Summary of personal expenditures
Schedule 5, Analysis of income tax discrepancy per net worth
Personal expenditure worksheet

The Statement of changes in net worth is based on a determination of the taxpayer's business and personal assets and liabilities and personal expenditures. Personal assets, liabilities, and expenditures include assets, liabilities, and expenditures of a shared household unit. The household unit ordinarily includes the taxpayer, a spouse or common-law partner, and any minor dependent children residing with the taxpayer during the net worth period. If other adults live in the household unit and there are indications that assets, liabilities, or personal expenditures are comingled, the other adults may also be included in the Statement of changes in net worth.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth available in the Integras Template Library under Worksheets:

Net Worth – Individual – 5–year Assessing v2019
Net Worth – Shareholder – Calendar Year v2019
Net Worth – Shareholder – Off Calendar year v2019

The versions available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > Statement of changes in net worth > v2019 are for reference purposes only and should not be used to raise an assessment.

13.4.15 Section removed

The information from this section is now included in 13.4.25, Preparing the assessing Statement of changes in net worth.

13.4.16 Assessing net worth technique resulting from a Business Intelligence referral

An audit using the assessing net worth technique may be the result of a Business Intelligence referral from GST/HST. If this is determined to be a consequential adjustment (non-complex: no more audit work), then follow the policy listed in the memorandum issued April 15, 2013, Income Tax Consequential Adjustments and Income Tax Small and Medium Business Audits. Otherwise, the file will be screened as a normal full-scope file.

13.4.17 Assessing net worth technique – Application of penalties – Under review

In all instances where the assessing net worth technique results in an assessment for underreported income, consider applying penalties under subsection 163(2) of the ITA, as well as a referral to Criminal Investigations Program if warranted. It is mandatory to include a copy of all referrals and resulting reports in the audit file. For more information, go to:

10.11.8, Referrals to Criminal Investigations
28.0, Penalties

Determining if penalties must be applied depends on the facts of each case; however, penalties must be considered and addressed. If they were not proposed, it is not necessary to complete a Penalty Recommendation Report, but the consideration and rationale for not proposing penalties must be included in Form T20, Audit Report. Not applying penalties in these cases is the exception. For exceptions, go to 28.4.5, Situations where a gross negligence penalty is not imposed.

For a letter template, go to the Integras Template Library:

letter A-11.1.8, Assessing Net Worth Proposal with Gross Negligence Penalty
letter A-11.1.13, Change with Compliance Issues

The taxpayer has 30 days to respond to the audit proposal. It is mandatory to include a copy of all correspondence in the audit file.

13.4.18 Personal expenditure interview

The personal expenditure (PE) discussion is an important part of the initial interview in any file where IVI is an issue (go to 10.1.0, Interviewing the taxpayer). It is also an essential component of the assessing net worth technique. The Appeals Division and the Tax Court of Canada may place more weight on statements made by the taxpayer during the PE interview than on contradictory, self-serving, and unsupported statements made at a later date. Document the interview and include in the audit working papers. Auditors are not permitted to use audio or video recorders to record interviews nor should they allow themselves to be recorded. If an auditor becomes aware that they are being recorded, the interview should be stopped, the reasons explained, and alternate arrangements made.

The PE interview is important to identify the source and application of funds, including balances of cash-on-hand and non-taxable sources of funds, such as inheritances, gifts, gains and losses on disposition of personal assets, and gaming and lottery winnings.

Some auditors and team leaders prefer to send a copy of the PE worksheet with the initial contact letter and ask that the taxpayer have it completed for the initial interview (go to 9.18.0, Contacting the taxpayer). Others prefer to first discuss the PEs at the initial interview. Still others, especially when dealing with a shareholder of a corporation that is the principal file under audit, prefer to discuss the personal matters at a separate time from the business portion. Whichever method is chosen, it is normally best to do it as soon as possible, as it gives a basis of understanding for the auditor for the transactions they are about to review and may well reduce audit queries and issues as the audit progresses.

Who should attend the personal expenditure interview?

It is important that a record of statements made by the taxpayer during the PE interview be corroborated in the event that the statements made are contested in a later appeal. The taxpayer has the right to a formal review and a later appeal; for more information, go to the Taxpayer Bill of Rights.

The auditor and the team leader should attend a PE interview. If the team leader is unavailable, another auditor should attend. Document the team leader or other auditor’s involvement on Form T2020, Memo for file.

As the PE discussion is normally conducted with the initial interview, the taxpayer is generally present, but is not always the most knowledgeable person to ask about the household finances. If PEs and finances of the taxpayer's household unit are shared with the taxpayer's spouse or common-law partner, that person should also be asked to attend.

However, the attendance of the taxpayer's spouse, common-law partner, or any other individual should be approached with caution. There may be certain transactions or situations where the taxpayer may have dealings or transactions that they do not want to discuss in the presence of other persons. Make sure there is no breach of the confidentiality provisions of section 241 of the ITA.

If the third party is not an authorized representative, the auditor must receive the completed and signed Form AUT-01, Authorize a Representative for Offline Access, or written consent from the taxpayer. The information about a representative on Form AUT-01 is considered taxpayer information of the authorizing or consenting party.

A taxpayer can authorize a representative for online access using the “Authorize my representative” service in My Account or My Business Account. Online access is deemed to provide consent for offline activities as well.

Normally, the initial interview is about asking questions as opposed to divulging confidential details. In that instance, verbal assurance from the taxpayer that a third party is allowed to be present is acceptable. The auditor should have a CRA witness and ensure that all parties understand that the taxpayer’s assurance is for that point in time only: a blanket verbal assurance is not acceptable. For more information, go to 3.4.0, Privacy and confidentiality. It may be necessary to schedule a separate PE interview.

Conducting the personal expenditure interview

Any value to PE estimates, regardless of the source of the estimate, must be weighed against the taxpayer’s apparent lifestyle. If possible, request that the initial interview, or at least the PE portion, be conducted at the taxpayer's residence. This may help indicate the taxpayer's lifestyle. However, this is a sensitive area and the taxpayer is not legally obligated under subsection 231.1(2) to allow access to a residence without a warrant. The Taxpayer Bill of Rights, reaffirms the taxpayer’s right to privacy and confidentiality.

If access to the taxpayer's residence is not permitted, drive by the residence (if practical) and note the type of accommodation, the nature of the neighbourhood, and any assets, such as recreational vehicles or exterior upgrades to the property.

If an auditor has followed the structure of the Interview Questionnaire found in the Integras Template Library (also go to 10.1.0, Interviewing the taxpayer), questions about the business have been followed by questions dealing with personal assets, liabilities, taxable and non-taxable sources of funds. The discussion of PEs is a normal flow-through of this information.

At a minimum, before discussing PEs, the auditor should determine:

personal bank accounts, including account type, account number, branch location, purpose of the account and nature and source of deposits;
non-taxable sources of funds, including gifts, loans, and inheritances from friends or family members, lottery and other gambling winnings, and non-taxable funds from foreign sources;
cash-on-hand maintained before and during the net worth period, including location, amounts, denominations, and source of funds (also go to 13.2.4, Opening and closing cash-on-hand);
safety deposit boxes, including location, purpose, how often visited, and contents;
personal investments, including term deposits, treasury bills, stocks and bonds, mutual funds, and life insurance;
real property bought, sold, or owned;
vehicles, vessels, aircraft, motorbikes, recreational vehicles, and trailers bought, sold, or owned;
other personal asset acquisitions and dispositions, including furniture, appliances, antiques, coins, works of art, and collectibles;
any other investments, including foreign based holdings and accounts;
bank accounts for minor and dependent children that reside with the taxpayer;
personal loans, mortgages, and lines of credit;
non-institutional loans, including loans from friends or family members; and
monies held in trust for or by others.

As well as the amount of any given expenditure, when discussing PEs with the taxpayer (or knowledgeable person), it is necessary to determine:

the general nature of the taxpayer's PEs;
information about the number of people living with and/or being supported by the taxpayer;
how various expenses are paid: by cash, cheque, credit card, or debit card, or through the taxpayer's business;
rationale for how the amount was determined (per week, rough guess, from receipts); and
what each amount actually includes (food from stores may be interpreted as “groceries,” which may also include light bulbs, cat food, stamps, etc.).

If the taxpayer has not maintained a copy of all documents, ask the taxpayer to authorize access to those records in writing or to contact the representative to advise them that the auditor will need the information. While the taxpayer has the right to be represented by a person of their choice (go to the Taxpayer Bill of Rights), ask the taxpayer if they are opposed to contacting their representative for this request, as the taxpayer will usually be billed for the representative’s time.

Authorization to obtain banking information

During the initial interview:

For Small and Medium Business audits, where IVI has not been mandated by Business Intelligence and where the auditor has not identified any risk, the request for a bank authorization and a customer profile are not mandatory. As well, the supporting IVI tests (including the bank deposit analysis (BDA)) are not mandatory in this situation.
For all Small and Medium Business audits, where IVI has been mandated by Business Intelligence, the auditor may ask the taxpayer to sign a bank authorization allowing the auditor to obtain documents from the banks. If bank authorizations are used, each contributing member of the household must be asked as well. If the taxpayer or a contributing member of the household refuses to sign a bank authorization, document the reasons for the refusal.

If the taxpayer and the contributing members of the household have kept and provided all banking information, it is still mandatory to include a customer profile, for the taxpayer and every contributing member of the household, from each financial institution that holds any financial instrument of a taxpayer or contributing member of the household. At a minimum, this will provide negative confirmation.

Example: A corporation has two bank accounts with Bank A, the sole shareholder has accounts only at Bank B, and their spouse does their banking at Bank C. There are no other contributing members in the household. A customer profile from Bank A should be obtained for the corporation. Customer profiles for both spouses should be obtained from Bank B and for both spouses from Bank C.

“Customer profile” is a generic term that may have different meanings from one institution to another. The auditor should discuss what does and does not appear on the profile. Some examples of concern to the audit include:

accounts held in joint with either minors or other adults;
accounts recently closed, but open during the audit period;
ownership of safety deposit boxes; and
investments (registered or otherwise) purchased from the institution.

If the taxpayer refuses to sign a bank authorization, document the reasons for the refusal. The customer profile can also be obtained using a requirement served to the financial institution.

The majority of larger financial institutions now have designated locations called Third Party Demands Group (TPDG) where all requirements are served and processed. Consequently, these financial institutions may no longer give customer information (including the customer profile) at their local branches. In these situations, auditors should:

Serve the requirement to the designated branch (TPDG), as shown at Collections and Verification Branch’s RFI / RTP Financial Institution contacts.
If no branch is designated or if the auditor believes that not all information from a local branch was forthcoming in a previous requirement to a designated branch (TPDG), serve the requirement on the branch of account.

Some branches of larger financial institutions in smaller communities and local institutions, such as credit unions (for example, Caisse Desjardins), may still give, directly at their branch, information such as the customer profile and access to the branch manager’s file, and sometimes other account information. If the taxpayer’s branch of account agrees to give such information, the auditor can use the bank authorization form as a tool, to be presented directly at the branch. However, if the branch refuses to give the information and offers to transfer the bank authorization form to the designated branch (TPDG) for processing, the auditor should use a requirement served to the designated branch (TPDG), and not give the bank authorization to the branch of account.

If banking information is missing and an initial letter was sent requesting the information (go to 9.18.3, Communicating with the taxpayer by letter), consult your team leader. If the information has not been requested, ask the taxpayer to get the missing bank records from the financial institution for the auditor’s use. Confirm the request in writing and list the specific banking records requested, which also gives another opportunity to give the bank authorization. If neither the verbal or written request is complied with, consult the team leader to plan the next course of action. Document the team leader’s involvement on Form T2020, Memo for file.

For more information, go to:

10.6.6, Obtaining information from financial institutions, Bank authorizations; and
10.8.5, Preparing requirements, Serving a requirement to a third party, Serving a financial institution.

For a template of the bank authorization, go to letter A-10.1.27, Bank Authorization, available in the Integras Template Library. The letter template is also available at Letters (CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Letters > Chapter 10).

Documenting the interview

An accurate and complete record of what was said during the interview is essential. The auditor's hand-written notes or computer log prepared at the time of the interview should be signed, printed (in the case of a computer log), and dated by the auditor and any other CRA representative present.

Prepare a complete record of statements made at the time of the interview and avoid preparing the record of the interview from memory. If a summary of the interview is prepared after the interview on Form T2020, Memo for file, the notes used to prepare the summary must also be kept in the audit file for more support that the document truly represents the discussion that took place. This will be useful if the net worth assessment is appealed.

13.4.19 Tour of premises

Conduct a tour of the taxpayer’s place of business to become familiar with the business operations and to help relate the physical assets and operations to the books and records, unless the place of business is the taxpayer’s dwelling house and the taxpayer refuses entry. The taxpayer has the right to privacy and confidentiality.

For more information, go to the Taxpayer Bill of Rights.

13.4.20 Assessing net worth technique – Audit of business records

Do not devote significant hours to a factual review of the taxpayer's business records once it is determined that the records are not reliable. The audit of the business records may be limited to:

an overview of business records, including a review of internal controls and accounting practices and confirmation if the business records reconcile to the income tax returns;
a confirmation of all business assets and liabilities to include on the Statement of changes in net worth;
an overview of revenue to indicate the method of recording transactions and confirmation if revenue reported reconciles to the income tax returns;
a scan of expenses to identify personal expenditures (PEs) included in business records. It is not essential to determine if PEs were claimed by the taxpayer as business expenses. The state of the taxpayer's records may make it difficult to determine if PEs are included in the business records; or
a review of owner's or shareholder’s drawings and contributions detailing all transactions for the net worth period.

An audit based on an Assessing Net Worth Technique does not require the factual auditing of expense accounts. This means the auditor should limit their factual review of T1 or T2 expense accounts to those accounts that the auditor and audit team leader determine to be at risk for material misstatement.

13.4.21 Audit of the taxpayer's personal finances

Significant time will be devoted to the review of the taxpayer's personal financial records to determine personal assets and liabilities and personal expenditures to be included on the Statement of changes in net worth.

The taxpayer’s personal financial records may include, but are not limited to:

banking and investment account records;
credit card statements and vouchers;
mortgage and loan documents;
insurance policies, including vehicle, home, and life insurance;
asset acquisition records;
property tax statements and utility bills (including heat, electricity, and telecommunications); and
expense vouchers.

13.4.22 Lack of supporting information

There is no obligation under the ITA for the taxpayer to keep documents and information pertaining to acquisitions of personal-use property (PUP) or personal expenditures (PEs). Often these records may not have been kept by the taxpayer for the net worth period.

If the taxpayer has not kept documents to support acquisitions of personal property and other expenditures, records for the current period may be requested. These records may help to identify personal spending patterns and ascertain the reasonableness of PE estimates given by the taxpayer.

13.4.23 Third-party sources of information – Under review

If conducting a net worth, information may be available from these third parties:

banks and financial institutions;
credit card companies;
suppliers;
insurance brokers;
stock brokers and investment firms;
lawyer's and accountant's office;
provincial land registry offices;
municipalities – municipal taxes, building and other permits;
vehicle, vessel and aircraft registries; and
other individuals or organizations.

Each TSO may have available data banks of relevant information. Exercise caution in relying on such data banks to support assessments. A third-party confirmation may be required to confirm that the information contained in the data bank is accurate and current.

Suppliers may be relied upon to identify material business and personal asset acquisitions and personal expenditures that cannot be identified through the taxpayer's available source documents.

As well, if it is known that a taxpayer receives income from a relatively limited number of sources, it may be appropriate to verify the taxpayer's business clients to get pertinent information with or in lieu of conducting a net worth. Third-party information may support the assertion of business income as the probable source to account for a net worth discrepancy. This may also assist to apply a penalty or a referral to the Criminal Investigations Program. It is mandatory to include a copy of all referrals and resulting reports in the audit file.

13.4.24 Banking information

Banking information generally is information from financial institutions such as: banks, mortgage companies, credit card companies, and investment companies. It would include balances, transactions, and customer profiles. For the bank deposit analysis (for deposits), the rough net worth, and the source and application of funds (for PEs) IVI tests, the information reviewed includes bank accounts and near-bank accounts.

For greater clarity, bank accounts and near-bank accounts, in the context of IVI tests and the assessing net worth technique, include the balances and transaction listings of all accounts used to fund noncorporate business expenses and personal expenditures, on a regular basis (for the taxpayer and contributing members of the household). Refinancing a mortgage to pay off credit cards and take a family vacation typically only happens once in an audit period, so the mortgage account would normally be treated as a liability and not a bank account.

Assets and liabilities that would normally be considered a bank or near-bank account of contributing members of the household unit include:

individual’s business bank account;
partnership business bank account;
personal savings and/or chequing account;
savings or chequing account held jointly with anyone else, regardless of age or other person’s residence;
shareholder loan account;
PayPal account;
investment trading account;
other electronic money account (such as “bit coin”);
line of credit; and
credit card.

Assets and liabilities that would normally not have the frequency of transactions to be considered a near-bank account include:

registered retirement savings plan (RRSP);
registered education savings plan (RESP);
tax-free savings account (TFSA);
guaranteed investment certificate (GIC);
loan receivable;
institutional loan;
family loan (if receipt of the money happens infrequently – less than once a month); and
mortgage.

The assessing net worth technique requires an analysis of personal assets, liabilities, and expenditures. Review the taxpayer's personal banking, credit card, and cash transactions in detail. It is essential to get all the taxpayer’s bank and credit card statements for the net worth period. Year-end balances of the accounts do not give sufficient detail for purposes of the net worth.

The review of personal banking includes a review of all bank accounts identified during the preliminary review, personal expenditure interview, and review of business records. During the review, transactions that include more undisclosed accounts may become apparent.

If personal bank records for the net worth period have not been kept by the taxpayer, ask the taxpayer to sign a bank authorization so that the information can be received from the taxpayer's bank. For more information, go to 10.6.0, Obtaining information from third parties, and more specifically, 10.6.6, Obtaining information from financial institutions.

Request all information about loans, investments, and safety deposit boxes that the taxpayer did not give. However, when requesting information from a bank, recognize that it takes substantial time and cost to retrieve copies of all records. Initial requests for information may be limited to customer profiles to confirm accounts and bank statements and transaction reports. Based on later discussions with the taxpayer and a review of available records for current or past periods, the auditor may not need to request all withdrawals, cheques, and deposit information from the bank.

13.4.25 Preparing the assessing Statement of changes in net worth

The assessing net worth technique is performed on an individual and the individual’s household unit. It includes all contributing members of the household unit and concludes at Line 150 of the T1 Income Tax and Benefit Return. It therefore includes no assets, liabilities, or equity of a corporation unless they are also an asset of the individual (shareholder loan, cost of shares), or a liability of the individual (shareholder loan).

As the assessing net worth technique addresses individuals, use of the word “business” will have the same meaning as in paragraph 3(a) of the ITA, where the taxpayer is one of the individuals in the household unit.

If a partnership is the business and every partner is a contributing member of the household unit, the business assets and liabilities will appear on the Statement of changes in net worth. If there are members of the partnership who are not also contributing members of the household, the partnership is viewed as per paragraph 96(1)(a). This means that the assets and liabilities of the partnership would not be considered on the Statement of changes in net worth, but only the changes in the residual value / capital account / partner’s equity account, which would be similar to the treatment of a shareholder loan account.

The Statement of changes in net worth includes six distinct schedules that cover the audit period and a PE worksheet for each period:

Schedule 1, Balance sheet – Assets
Schedule 1a, CCA schedule
Schedule 2, Balance sheet – Liabilities
Schedule 3, Calculation of the discrepancy in total income per net worth
Schedule 4, Summary of personal expenditures
Schedule 5, Analysis of income tax discrepancy per net worth
Personal expenditure worksheet

It is important to remember that the Statement of changes in net worth is a template that has been developed to give structure and to allow clarity in presentation. It is not an exhaustive list and it may be necessary for an auditor to add rows or alter descriptions as needed.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth available in the Integras Template Library under Worksheets:

Net Worth – Individual – 5 – year Assessing v2019
Net Worth – Shareholder – Calendar Year v2019
Net Worth – Shareholder – Off Calendar Year v2019

Schedule 1

The increase or decrease in net worth for each year is based on the change in the taxpayer's balance of assets less liabilities for that year. Assets are typically presented at the cost value, with some exceptions:

Non-depreciable property will be listed at its adjusted cost base (ACB) or historical cost. If the cost of a non-depreciable asset is not known and the asset was acquired prior to the net worth period and remains at the end of the audit period, the asset may be listed at an estimated value or nominal value, usually $1.00. It is the actual additions and dispositions that are of consequence to a net worth discrepancy.
Depreciable property will be listed at the year-end balance of undepreciated capital cost (UCC), as accepted or adjusted by the auditor. For depreciable property that has been prorated (20% of the principal residence is depreciated as a business asset), or capped by regulation (class 10.1 may not exceed $30,000 plus taxes that apply), the non-depreciable portion will be reflected as a business or personal asset as appropriate.
Goodwill or eligible capital property will be listed at the year-end balance of the cumulative eligible capital. The 25% non-eligible portion will be reflected as a business asset at its historical cost.
Inventory will be listed at cost – usually lower of cost or fair market value, as recorded on the taxpayer's financial statements.

A general rule of thumb is that any asset purchased at a cost of less than $200 is to be treated as an expense or personal expenditure (PE). Any item purchased for more than $200 that has an enduring benefit will be listed as an asset, either business or personal.

The cash surrender value of a life insurance policy is not usually reflected as an asset, unless there has been a change during the audit period. Some policies allow for a borrowing or withdrawal for the cash value. Premiums paid on these polices are treated as PEs in the year paid.

Registered retirement savings plans (RRSP) and registered education savings plans (RESP) are usually reflected as a personal asset at the taxpayers' contributed amount with no increase in asset value for income earned in the plan. As a result, sheltered income earned in the plan does not result in an increase in the taxpayer's net worth and there is no need for any further adjustment. However, an adjustment to the net worth will be required for any income received, amount withdrawn, or contribution to an RRSP or RESP.

A tax-free savings account (TFSA) is another registered plan, but gains are non-taxable at any time, nor are losses tax-deductible. Currently, up to $5,500 per year can be used to purchase a TFSA and the account itself can be denominated in dollars, secured bonds or certificates, mutual funds, etc. The auditor should record and carry the value of the TFSA at cost on Schedule 1 and if there is a withdrawal that triggers an increase or decrease in the net worth, the auditor should make an adjustment on Schedule 3 to make the transaction tax neutral.

The shareholder loan account in a credit (from the perspective of the corporation) position is an asset for the individual. This amount is recorded and carried on Schedule 1 at its audited (or accepted) value. For example, if the corporation reports a shareholder loan payable in the amount of $200,000 in 2012 and $240,000 in 2013, the individual’s net worth will appear to have increased. If this amount was a genuine error that the auditor does not believe should be a subsection 15(1) benefit, then the amount should be carried on Schedule 1 as $200,000. In a situation like the example, the auditor will:

request the adjusting entries from the corporation;
audit the entries;
verify that the entries have been updated in the corporate books; and
adjust the corporate income tax return.

Schedule 1a

This should contain the audited / accepted amounts for depreciable assets. If using the Excel template from the Integras Template Library, the auditor must understand that certain transactions will not be recorded correctly without overriding existing formulae.

Examples:

Half-year rule on last year of use and “no terminal loss” rule for class 10.1.
If proceeds of disposition exceed class pool.
A class with multiple rates (class 1, see Regulations 1100(1)(a.1) and (a.2)).

The template is built to capture factual adjustments to CCA, forward them to Schedule 5 and UCC, and then forward them to Schedule 1.

Schedule 2

Liabilities will be reflected at the outstanding year-end balances and will include all business and personal commercial loans and mortgages, credits cards, and loans from friends or family members.

Personal income tax payable is not recorded as a liability on the net worth statements. Personal income taxes are recorded as an adjustment to the net worth when paid.

Record audited or accepted amounts owing as at year-end for normal business payables, such as:

trade accounts payable;
payroll deductions at source payable;
payroll / bonus payable; and
worker’s compensation payable.

GST/HST is recorded as per amounts filed with CRA and recorded in our system (go to 9.9.6, Other systems).

Other taxes that are self-computed (property taxes are charged by an invoice; most provincial sales taxes are ‘self-computed’ by the taxpayer), are credited when it is shown the amounts have been paid. The rationale is that auditors cannot assert that amounts accrued are calculated correctly.

At the bottom of Schedule 2, the household’s net worth is calculated (assets – liabilities). The net worth is then compared to the prior period’s net worth to determine the increase (decrease) in net worth for the period. This amount is then forwarded to Schedule 3.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth which includes schedules 1, 1a, and 2. The template is available in the Integras Template Library under Worksheets:

Net Worth - Individual - 5 - year Assessing v2019
Net Worth – Shareholder - Calendar Year v2019
Net Worth – Shareholder - Off Calendar Year v2019

For reference only, a sample Statement of changes in net worth is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > Statement of changes in net worth > v2019 > Net Worth - Individual – 5 – year Assessing v2019.

13.4.26 Summary of personal expenditures

Personal expenditures (PEs) include all private or individual spending (non-business spending) for which there are no increases to personal assets or decreases in liabilities included on Schedule 1 or Schedule 2. PEs recorded on Schedule 4 are included as an adjustment addition on Schedule 3. As a result, every dollar of identified PE increases the net worth discrepancy by the same amount and every dollar of PE missed results in an understatement of the discrepancy.

Review source documents for personal expenditures

The most informative records for determination of PEs are the banking and credit card statements. As these documents have to be reviewed to compile the mandatory bank deposit analysis (BDA), it is often more efficient to review the PEs based on actual withdrawals / purchases.

All withdrawals from the bank need to be considered. The value of the withdrawals, net of transfers, must either be captured on Schedule 1 (as an increase in assets), Schedule 2 (as a decrease in principal amount of liabilities), or on Schedule 3 (business expense inherent in taxpayer’s Line 150, added as a PE, or added as a non-deductible withdrawal). Any withdrawal uncaptured will result in an understatement in the net worth discrepancy by that same amount.

This is the main reason why the amount determined by a summary withdrawal analysis (SWA) has been mandated as the minimum amount to be used as PEs in the rough net worth or source and application of funds tests. Go to the October 14, 2015, memorandum, Summary withdrawal analysis to calculate personal spending, for more information.

In the same way that a SWA must be used to calculate the minimum amount of PEs in a rough net worth or a source and application of funds test, the detailed withdrawal analysis (DWA) must be used to determine a minimal level of PEs for the assessing net worth technique. The only difference is that as part of the assessing technique, the DWA will require more effort in tracking payments from accounts and determining payments not made from any known account. The DWA prepared by the auditor must provide a breakdown of the taxpayer's spending by category. The categories chosen must be relevant to the taxpayer's spending habits. Go to the October 5, 2017 memorandum, Detailed withdrawal analysis to calculate personal spending in assessing net worth, for more information.

The Personal expenditure worksheet in the Integras Template Library may be used to index and summarize information and the audit evidence received. While the auditor is not bound by the PE categories presented in the template, it is often a helpful tool to notice when a category has zero or too few dollars allocated to it. In certain cases, it may be more efficient to adopt other formats, for example:

PEs paid by:
- cheques or debits through personal bank accounts;
the taxpayer's business;
credit cards;
cash; or
PEs based on vendor:
- grocery store: 100% personal;
- clothing store: 100% personal;
- hardware store: 100% business; or
- department store: 20% business, 80% personal (as determined by review or query).

Based on an analysis of drawings / purchases from the actual account, estimates given by the taxpayer during the PE interview, average household expenditure estimates from Statistics Canada, and reasonableness testing of PE estimates, draw a conclusion on the PE amounts for the net worth analysis. The auditor must remember that the amount determined by the SWA / bank withdrawal method is the minimum amount to be considered as PEs. See 13.4.28, Determination of personal expenditure estimates.

13.4.27 Personal expenditure worksheet

The Personal expenditure worksheet in the Integras Template Library includes these columns:

“Description” details 16 expenditure categories: food, shelter, household operations, clothing, transportation, health care, personal care, recreation, reading material and other printed matter, education, tobacco and alcohol, security, gifts and contributions, miscellaneous, and other;
“Taxpayer’s Estimate” is to record the taxpayer’s estimate of personal expenditure (PE);
“+ or – Adjustment” and “Explanation of adjustment” are to reflect adjustments to the “Taxpayer’s Estimate” based on factual verification;
“Note 1 or 2” – Record Code 1 to use Statistics Canada estimates or record Code 2 to use the total of the “Taxpayer’s Estimate” and “+ or - Adjustment”; and
“Revised Amount” records the revised amount of the taxpayer’s PE.

13.4.28 Testing of personal expenditure estimates

Analyzing bank withdrawals is an efficient means of determining a minimum level of personal expenditures (PEs) and will help determine if the taxpayer’s estimates are credible. It also gives a factual base of numbers to help explain:

business processes;
level of lifestyle; and
potential missing sources of funds.

The withdrawal method (either summary or detailed withdrawal analysis) is based on an assumption that the majority of PEs is funded through purchases directly from the bank/credit card accounts, or from cash withdrawn from those accounts.

Determining personal expenditures – Detailed withdrawal analysis

In the same way that a summary withdrawal analysis (SWA) must be used to calculate the minimum amount of PEs in a rough net worth or a source and application of funds test, the detailed withdrawal analysis (DWA) must be used to determine a minimal level of PEs for the assessing net worth technique. The only difference is that as part of the assessing technique, the DWA will require more effort in tracking payments from accounts and determining payments not made from any known account. This method captures PEs that are paid from any of the known bank accounts, lines of credit, or credit cards, plus PEs paid from any non-deposited funds that are known.

As the business records of a T1 (sole proprietorship or partnership) include the personal records, all bank accounts, lines of credit, credit cards, and any other financial instrument that operates in a similar fashion should be summarized and then adjusted for known information. For a T2 principal file, the individual shareholder’s personal accounts, including the shareholder loan account, are summarized and adjusted by the amount of the PEs found factually being paid from the corporation’s bank account and not debited to the shareholder loan (go to 13.4.24, Banking information).

As well as known payments or purchases that have not gone through the bank, adjustments are made for all information already captured on Schedule 1 or Schedule 2. A partial list of adjustments that must be made to the total withdrawals includes:

Less:

transfers from one of the accounts in the BDA to another;
business expenses (less CCA);
purchases of assets (business and personal, from Schedule 1);
principal payments of liabilities (business and personal, from Schedule 2); and
Canada Pension Plan (CPP) / Quebec Pension Plan (QPP), Employment Insurance (EI), and income tax payments.

Plus:

cash not deposited (gifts, lottery, gambling);
decrease in cash-on-hand;
negative bank deposit analysis variance; and
PEs paid by corporate bank account and not debited to shareholder loan account.

The remainder should be a conservative estimate of PEs, as it does not capture any unknown amounts that were not processed through one of the bank accounts.

While determining the personal expenditures, the auditor should consider facts from Schedule 1, Schedule 2, and from the initial interview:

If there was a car loan, are the payments identified from one of the accounts?
If there was an asset purchase, is it identified in one of the accounts?
If the taxpayer took a vacation, is the cost of the plane tickets, hotels, etc. withdrawn from one of the accounts?
On large transactions (house sale, inheritance, mortgage refinance), were all funds deposited to the bank accounts?

If not, these are further adjustments to be added to the analysis.

The auditor must use professional judgement when analyzing whether the PEs determined are sufficient to support the taxpayer’s lifestyle. If not, there is the potential that all business expenses were not paid through the bank accounts or another unknown source still exists.

The DWA prepared by the auditor must provide a breakdown of the taxpayer's spending by category. The categories chosen must be relevant to the taxpayer's spending habits. Go to the October 5, 2017 memorandum, Detailed withdrawal analysis to calculate personal spending in assessing net worth, for more information.

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

Statistics Canada’s average household expenditures

The tables generated by Statistics Canada on average household expenditures include a broad range of categories: from the “basket of goods” that we typically identify as PEs, to payments of liabilities and purchases of financial assets (pensions, RRSPs) and non-financial assets. As a whole, the tables give a statistically valid average of how much each Canadian household spends.

The accuracy of the totals increase as you narrow the subject field (size of the household, province, some municipalities), but decrease as you narrow the expenditure field (group of categories or subgroup). This is because of the methodology used in collecting the information: the amount spent on food by four-person households was tracked separately from the amount spent on food by one-person households (subject field).

When looking at the values of any particular subgroup, the reader must understand that the amount is the total amount spent in this subgroup by all respondents, divided by the number of all respondents (regardless if many respondents spent $0 for that subgroup). To give a clear example, in 2014, the amount spent by One person households – all (subject field) for Rent is $4,686.30. Comparatively, the amount spent by Five or more person household – all during the same year and same subgroup is $2,447.96. This does not mean that it is less expensive for a five‑person household to rent living space than a one-person household. It means that the total amount spent on Rent by five-person households divided by the total number of five-person households is far less than the total amount spent on rent by one-person households divided by the number of one-person households.

Reviewing the Personal expenditure worksheet that is part of the net worth template, this last example shows that as the category narrows, the amounts lose accuracy: the value in Rent is less accurate than the value in Shelter, which is less accurate than the value in Grand Total. As Grand Total is still only a portion of the total household expenditures, it is likely that this is the only amount that is still statistically valid.

However, Statistics Canada’s average household expenditures can be used as a guide to determine the reasonableness of the taxpayer's PEs. These average amounts are a good comparison to start building professional judgement, and a “reasonable” amount when the SWA cannot give one. (For example, the withdrawal analysis is negative, or when zero dollars have been spent on food through the banks.)

Use PE estimates to establish net worth when there is no supporting information for the particular expenditure. Use the Statistics Canada amount if the taxpayer agrees with the amount or when one or both of these factors is present:

The taxpayer has not co-operated by providing adequate PE information and reasonable efforts to get the information have been unsuccessful and are documented.
PE amounts given by the taxpayer are materially lower than Statistics Canada average household expenditures and audit evidence supports the conclusion that the PE estimates given by the taxpayer are not credible. The conclusion may be based on documented observations of the taxpayer's lifestyle, banking activity, patterns of identified cash and cheque withdrawals, and factual expenditures. Testimony as to the taxpayer's credibility may also be drawn from any misleading or erroneous statements made by the taxpayer during the audit.

As well, if PEs are estimated, the benefit of the doubt must favour the taxpayer. It is preferable to reach an agreement with the taxpayer as to the amount to be used, even though the amount may be slightly less than the amount believed to be reasonable. If the taxpayer or their representative is not reasonable in their negotiations, use a reasonable but conservative estimate for PEs.

Accept, reject, or adjust the taxpayer's spending estimates based on knowledge of expenditures determined during the review of the business and personal records and information received from third parties. Document the rationale for adjustments on Form T20, Audit Report, and working papers and support by information received during the PE interview or other information received during the audit.

13.4.29 Assessing net worth technique – Calculation of the discrepancy in total income per net worth

This section explains Schedule 3, Calculation of the discrepancy in total income per net worth.

Schedule 3 begins with the increase (decrease) in net worth from Schedule 2, adds back all nondeductible depletions, subtracts all non-taxable sources, makes adjustments for specific issues, and compares the total to household Line 150.

Increase (decrease) in net worth

Taken from the bottom of Schedule 2, any increase in net worth is an indicator of how much income (taxable and non-taxable) is reflected in increasing assets and decreasing liabilities. A decrease in net worth is an indicator of how much a taxpayer needed to liquidate or borrow to fund personal and business expenditures.

Non-deductible depletions

Items that reduce the net worth, but are not deductible by the ITA, are added to make those transactions tax neutral. Examples:

PEs reduce the amounts that remain in the bank accounts (decreases the net worth), but are not deductible for tax purposes.
Losses on personal-use property (PUP) reduce the net worth, but are not deductible for income tax purposes (personal vehicle carried at a cost of $20,000 is sold for $8,000 – loss of $12,000).
Capital losses that must be carried forward (no gains to offset in current year).
Payments for income tax, CPP and/or QPP, EI, reduce the net worth, but are not deductible for tax purposes.
Non-deductible portion of meals and entertainment business expenses are not PEs, and are not deductible for tax purposes.
Other withdrawals from the near-bank accounts that do not appear to be PEs should be listed separately to allow for easy identification and explanation to the taxpayer and other readers. Auditors should title these entries in an appropriate way (for example, “Nondeductible withdrawals”).

Non-taxable sources

Non-taxable sources are normally identified during the initial interview and are funds received, thereby increasing the net worth, which should not be considered when comparing to Line 150. Examples:

Lottery and gambling winnings, gifts, inheritances, non-business insurance payouts (if the premiums were not deductible).
Income tax refunds, GST/HST credits, provincial credits, capital dividends.

Tax specific issues

Tax specific issues may have no off-set in the net worth, but need to be made to represent the proper tax treatment. Examples:

Union dues, universal child care or EI repayment, moving expenses, business investment loss, are all deductible, but after Line 150. As the Statement of changes in net worth stops at Line 150, these items should all be treated as non-deductible depletions, with appropriate explanations. If accepted, the items will be allowed in the calculation of taxable income.
RRSP withdrawals. An RRSP is carried on Schedule 1 at $1,000 and is withdrawn, the individual receives $900 (tax is withheld at source). The net worth is decreased by $100, meaning that if no change is made on Schedule 3, the individual experiences a reduction to taxable income for withdrawing an RRSP. The tax withheld ($100) is added on Schedule 3 to make the transaction tax neutral. The total amount of the withdrawal ($1,000) is then added to Schedule 3 to show that this is the amount to be taxed; to include in computing Line 150.
Gross up amounts for dividends. $100 in dividends is received into the bank (or asset portfolio, if it is a stock dividend) and increases the net worth for that amount. However, the amount to be included in computing Line 150 is the grossed up amount, which varies depending on whether it is an eligible or non-eligible dividend.
TFSA withdrawals. The amount is carried at cost of $5,000 on Schedule 1, but when it is withdrawn, the market value is $5,200. The increase is non-taxable and must be removed on Schedule 3. If the opposite is true and the market value had decreased, the loss would be added on Schedule 3. Withdrawals from a TFSA must be made tax neutral.
Election of principal residence is a non-taxable source, once the election and computations (if necessary) have been verified. The gain on the sale is removed from Schedule 3 as a non-taxable source. (Proceeds less expenses are $650,000, residence was carried at cost on Schedule 1 at $400,000, remaining mortgage of $100,000. Before the sale, the net worth stands at $300,000 (asset minus liability), after the sale, the proceeds have paid the mortgage, the house no longer exists as an asset and the bank has increased by $550,000. The increase in net worth from Schedule 2 is $250,000 ($550,000 - $300,000) which is the gain ($650,000 - $400,000)).
Losses from an investment in a limited partnership that exceed the “at-risk amount.” The “at-risk amount” is generally the amount invested and is the amount recorded on Schedule 1. Losses may flow through until the total amount of net losses equal the original at-risk amount. This may be tracked on Schedule 3 for each year, or it may be presented as a decrease to the original investment on Schedule 1.
Gains under subsection 40(3) of the ITA for negative adjusted cost base (ACB) on certain property.

Compare to household Line 150

Line 150 is the line for Total Income on the T1 Income Tax and Benefit Return.

Schedule 3 generates a total called “Income per adjusted net worth,” that is the expected combined Line 150 for each contributing member of the household. This total is then compared to the combination of each contributing member’s Line 150. Any positive variance appears as unreported income.

It is important to note, that if an individual’s Line 150 amount is included at the bottom of Schedule 3, then all of that person’s assets, liabilities, PEs, and adjustments must be included throughout the other schedules. If the individual’s Line 150 is not included, then none of that person’s assets, liabilities, PEs, and adjustments should be included. In many instances, this may not be possible.

For example: A couple suffers a breakdown in their relationship that causes a separation at the start of the most current year of the audit period. Until that point, the couple had shared household expenses at varying ratios. If the individual under audit has kept the house and the mortgage, each payment by the individual who left that was not captured through a bank withdrawal (assets not included), will appear as unreported income for the individual under audit.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth which includes Schedule 3, Calculation of the discrepancy in total income per net worth. The template is available in the Integras Template Library under Worksheets:

Net Worth – Individual – 5 – year Assessing v2019
Net Worth – Shareholder – Calendar Year v2019
Net Worth – Shareholder – Off Calendar Year v2019

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

13.4.30 Analysis of income tax discrepancy per net worth

Analyze the discrepancy in total income per net worth. Deduct from the discrepancy, all known or factually identified audit adjustments to total income, including personal portions of business expenses and adjustments to CCA. The remaining balance is the unreported business income per net worth.

Unless there is factual evidence to show otherwise, the unreported business income per net worth is exclusive of GST/HST. Some rare examples of when GST/HST might be considered included in the unreported business income per net worth:

The source shown is a taxi business, where all rates and receipts are considered GST/HST inclusive.
The taxpayer agrees with the gross amounts, but states (in writing and by filing amended GST/HST returns), that the amounts were inclusive.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth which includes Schedule 5, Analysis of income tax discrepancy per net worth. The template is available in the Integras Template Library under Worksheets:

Net Worth – Individual – 5 year Assessing v2019
Net Worth – Shareholder – Calendar Year v2019
Net Worth – Shareholder – Off Calendar Year v2019

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

13.4.31 Section removed

13.4.32 Section removed

13.4.33 Fiscal year other than December 31st

If an individual owns a business and has elected under subsection 249.1(4) of the ITA to keep a non-calendar fiscal period, then that taxpayer reports business income on the fiscal period with adjustments as described in section 34.1. This means the fiscal period of the business determines the net worth period.

All assets, liabilities, and personal expenditures are recorded on the Statement of changes in net worth on the basis of that year-end. All individual transactions that can be traced to a date (such as sale of residence, receipt of dividends, and payment of income tax) should be captured in the appropriate fiscal period. All income earned in general over the calendar year (interest income) should be prorated between the periods. Finally, the auditor must include the adjustment per section 34.1 or Form T1139, Reconciliation of 2019 Business Income for Tax Purposes.

13.4.34 Assessing net worth technique for multiple businesses and different year-ends

The fiscal year of the taxpayer's business will determine the net worth period. When the taxpayer has two or more businesses with different fiscal periods, choose which of the fiscal periods will be used for purposes of the net worth period. Base the decision of which fiscal year-end to use on a comparison for each business of the audit risk assessment, taxpayer's involvement, nature of internal controls, adequacy of books and records, type of activity, and opportunity to suppress income.

Regardless of which fiscal period is adopted, there will be at least one business with a fiscal period that does not correspond to the net worth period. If the fiscal period does not correspond to the net worth period, present the investment in the second business on Schedule 1, using the balances of assets and liabilities as determined at the fiscal year-end of the first business.

As a choice, present the investment using the equity approach if the taxpayer's year-end equity investment in the second business is adjusted for later drawings and contributions to calculate the adjusted equity balance. The net worth presentation will also include an adjustment in the Calculation of the discrepancy in total income per net worth to apportion income earned from the second business across the net worth periods.

13.4.35 Net worth of a partner in a partnership

The process of conducting an assessing net worth technique on an individual does not vary considerably just because that individual is a member of a partnership.

If the partnership consists entirely of members who are contributing members of the same household, then the net worth technique is identical to that described in 13.4.0 to 13.4.34.

If at least one member of the partnership is not a contributing member of the individual under audit’s household, then the assets and liabilities owned by the partnership will not appear on Schedule 1 or Schedule 2. Instead, the partnership will be treated similar to a separate entity as stated in paragraph 96(1)(a) of the ITA.

The individual’s capital account or investment account will be calculated and included on Schedule 1. Partnership assets not owned by the partnership, but by the members themselves, will be represented at the prorated (if not owned 100% by the individual) amount as a business asset on Schedule 1. Do not disclose information pertinent to the net worth of one partner to other partners.

If the assessing net worth technique results in a material positive amount and it is apparent that the partnership is the only source of income to which it can be attributed, consider sending a referral to Business Intelligence to see if other partners may indicate risk. It is mandatory to include a copy of all referrals and resulting reports in the audit file.

13.4.36 Partner's investment in partnership

A taxpayer's investment in a partnership will be listed as an asset on Schedule 1, Balance sheet – Assets, at the adjusted cost base (ACB) of the partnership interest. Any presentation based on the partner's percentage share of partnership assets and liabilities may distort the increase or decrease in net worth as actual drawings and contributions may vary from the partner's percentage of ownership.

If the ACB of the partnership interest is not known and the interest was acquired before the net worth period, the asset may be listed in the base year at an estimated or nominal value, usually $1.00. The ACB for later years will be calculated based on the ACB of the partnership interest for the base year, the partner's share of reported annual profits and losses, and the partner's actual drawings and contributions.

13.4.37 For future use

13.4.38 Assessing net worth technique for a shareholder of a corporation

An assessing net worth technique is performed on an individual’s household and not a corporation. The only information that is common to the books and records of the corporation and the individual’s net worth are loans or receivables between the two. Typically there is at least one shareholder loan or receivable.

The corporate audit is screened as the principal file. Secondary files may be screened based on the risk identified by Business Intelligence, or risk identified by the auditor and team leader - normally during the initial interview. Each secondary file screened will have a separate assessing net worth technique performed for each household unit. Do not disclose information pertinent to the net worth of one shareholder to other shareholders. It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning.

If the assessing net worth technique results in a positive variance, it is typical for the source to be unreported income from the corporation. Although typical, the auditor should still be able to support the decision to classify the income in the hands of the individual as an appropriation or benefit and the source to be the corporation, as opposed to a source external to the corporation.

As a separate entity, the corporation must be given enough information on how amounts assessed were derived; however, care must be taken not to give too much personal information of the shareholder.

13.4.39 Assessing net worth technique fiscal year and assessment period for a corporation

The net worth audit period will ordinarily include the most recent tax year of the corporation for which an income tax return has been filed and the two previous years. As the net worth is conducted on the shareholder, no assets, liabilities, sales, or expenses of the corporation are considered, save for the due to/from shareholder account. The shareholder account is still considered, based on its attribute of being an asset or liability of the shareholder (go to 13.4.24, Banking information).

13.4.40 Adjustments for fiscal year-ends other that December 31st

If the net worth period is based on a corporate fiscal year-end other than December 31st, an appropriation under subsection 15(1) of the ITA must be allocated to the correct calendar years for assessment purposes. Expand the Statement of changes in net worth based on a fiscal and calendar year presentation as follows:

Combined presentation (assuming March 31st fiscal year-end)
- December 31, 2010
- March 31, 2011
- December 31, 2011
- March 31, 2012
- December 31, 2012
- March 31, 2013
- December 31, 2013

If income (T4, interest) or personal expenditures flow evenly throughout the year, these amounts may be prorated to the relevant periods.

If the corporation is determined to be the only source of funds available for the net worth amounts, then the appropriation that occurred between December 31, 2010, and December 31, 2013, is assessed under subsection 15(1) to the shareholder but only the amounts apportioned to the periods March 31, 2011, to March 31, 2013, are assessed under subsection 9(1) to the corporation.

13.4.41 Base year

Although the net worth places a significant reliance on amounts recorded as due to or from the shareholder and the shareholder loan balances based on the financial statements filed by the taxpayer cannot be disputed, the emphasis is placed on a three-year review of the individual. This follows from the supporting IVI tests indicating that the risk was on the individual’s return. The base year, therefore should coincide with the individual’s taxation year-end (typically December 31).

It is a fact whether a transaction has occurred or not. If a transaction has occurred, it happened at a point in time. It is not unreasonable to expect the corporation to give a correct accounting of the shareholder loan account for December 31.

13.4.42 Section removed

13.4.43 Shareholder's investment

Record the shareholder's investments in the corporation, generally consisting of shares and a shareholder loan account, as personal assets on Schedule 1, Balance Sheet – Assets. Record a loan payable by the shareholder to the corporation as a personal liability on Schedule 2, Balance Sheet – Liabilities. List shares at their cost amount.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth which includes schedules 1 and 2. The template is available in the Integras Template Library under Worksheets:

Net Worth – Individual – 5 – year Assessing v2019
Net Worth – Shareholder – Calendar Year v2019
Net Worth – Shareholder – Off Calendar Year v2019

13.4.44 Reason for discrepancy in net worth

Completing a net worth for a shareholder may conclude the likely source of unreported total income as calculated is unreported sales of the corporation appropriated by the shareholder. However, it is important to establish this link before completing the net worth audit. Be attentive to other potential sources of undisclosed income outside of the corporation that may account for the net worth discrepancy.

If the likely source of the discrepancy is established to be unreported income of the corporation, assess the shareholder the unreported amount as an appropriation under subsection 15(1) of the ITA. Assess the corporation the unreported revenues under subsection 9(1).

13.4.45 Analysis of discrepancy in income

In the Analysis of income tax discrepancy per net worth, known adjustments to the shareholder's reported total income will be deducted to arrive at total income per net worth. Any adjustments to corporate income identified as a result of a factual review of the corporation's books and records have no bearing on the net worth presentation and are reported separately. It is possible that a factual adjustment for unreported sales of the corporation may mitigate the subsection 9(1) adjustment from the net worth.

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

For reference only, sample working paper A-13.3.14, Net worth of a shareholder – Calculation of the discrepancy in total income per net worth, is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A-13.3.14.

In cases involving multiple shareholders, when proposing the income tax net worth assessment to the corporation, explain that the corporation's audit assessments are based on a discrepancy of the shareholders’ income as calculated in the net worth. The auditor must be careful to give enough information on the calculated adjustment to the corporation, while preserving the confidentiality of the individual. Section 241 of the ITA covers issues of confidentiality and subsection 241(4) specifically states that the auditor may give taxpayer information “that can reasonably be regarded as necessary for the purposes of the administration or enforcement of this Act.” It is a question of fact whether information disclosed could be “reasonably regarded” as necessary.

13.4.46 Completing the assessing net worth technique

As the taxpayer has the right to complete, accurate, clear, and timely information (go to the Taxpayer Bill of Rights), it is important that the Statement of changes in net worth prepared be accurate and give full disclosure, if possible, to the taxpayer of how the amounts were determined. The auditor's team leader approves the Statement of changes in net worth before any proposal or assessment is issued. Team leader approval is necessary at various stages of the audit; document the team leader’s involvement and/or approval on Form T2020, Memo for file.

When proposing a net worth assessment, give the taxpayer a copy of the Statement of changes in net worth, including the Personal expenditure worksheets in the Integras Template Library, and any working papers relevant to the figures calculated in the net worth. The taxpayer has 30 days to respond to the audit proposal. It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

Carefully consider representations submitted by the taxpayer. If there is non-concurrence, set out the taxpayer's arguments impartially on Form T20, Audit Report, and prepare a rebuttal point by point.

If it is difficult to get an agreement, gather all the facts about the issues and discuss them with the team leader. Document the team leader’s involvement on Form T2020, Memo for file. If there is doubt concerning any point with no further audit evidence, the adjustment should be in the taxpayer's favour. The taxpayer has the right to be treated professionally, courteously, and fairly (go to the Taxpayer Bill of Rights).

When contemplating the issue of doubt, consider if all or any part of the discrepancy per net worth is supported directly or indirectly by alternate means, such as bank deposit analysis, ratio analysis, or third-party confirmations. As well, less weight may be attached to unsubstantiated statements made by the taxpayer at the end of the audit versus statements made by the taxpayer in the initial interview. Refer to 13.2.0, Audit of non-taxable sources of funds, including:

cash-on-hand;
gifts, loans, and inheritances from family members;
lottery and other winnings; and
non-taxable funds received from a foreign source.

Also refer to 13.4.26, Summary of personal expenditures.

Be aware that net worth assessments have been widely accepted by the courts for many years and are considered objective, so long as estimates are conservative and are not used extensively.

13.4.47 Assessing net worth technique working papers

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures. Properly index and sufficiently detail Form T20, Audit Report, and the working papers for the assessing net worth technique to show the:

documented Audit Plan – include review of internal control, review of accounting records, audit risk assessment and rationale to adopt the assessing net worth technique; it is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning;
adequacy of books and records and, if it applies, action taken to make sure that the taxpayer will keep proper records in the future;
extent of verification of:
- assets and liabilities;
- capital gains and losses;
- reported sales;
- any non-taxable income; and
- personal expenditures (specify the source of any estimated amounts and the supporting information);
extent of direct and indirect testing carried out to confirm income as the likely source to explain the discrepancy per net worth;
extent of direct testing and support for any identified factual adjustments;
record of taxpayer contact, including initial interview, Form T2020, Memo for file, representations, and rebuttal; and
final Statement of changes in net worth; team leader approval indicates the audit case meets established policy, as well as procedural and legislative standards in all material respects.

13.4.48 Assessing net worth technique and Form T20, Audit Report

Form T20, Audit Report, must refer to supporting audit evidence attributing the likely source to account for the discrepancy in net worth as unreported business income. Supporting audit evidence may include inadequacies or irregularities in the taxpayer's record keeping, unexplained sources to account for cash expenditures or contributions to the taxpayer's business, unidentified deposits to personal or business bank accounts, projections, or third-party information. In some cases, this information will not be readily apparent from the rough net worth and further audit tests may need to be conducted to confirm the likely source.

In rare circumstances, the assessing net worth technique will conclude that the likely source cannot be determined. There may be no known or suspected business activity or the discrepancy per net worth may be so significant that attributing any discrepancy to a known or suspected business activity would be unreasonable. In such cases, the discrepancy per net worth may be assessed as other income from non-commercial activities, if it is ascertained that the taxpayer has no reasonable explanation to attribute the income to non-taxable sources.

The onus for supporting the application of gross negligence penalty rests with the minister. If a penalty is considered or applied as a result of an assessment of unreported income, Form T20, Audit Report, must include enough detail to ensure that the penalty is justified. For more information, go to 28.0, Penalties.

13.5.0 Assessing unidentified bank deposits technique

Before proceeding with an audit based on the assessing unidentified bank deposits (AUBD) technique, the auditor must be familiar with 13.3.0, Indirect verification of income.

The AUBD is the most restricted of the three IVI techniques. It captures only monies that were deposited into known bank accounts and is limited to those specific amounts that the auditor is willing to assert are likely unreported sales.

When there is a variance in the bank deposit analysis (BDA) test, it is an indication of suppressed income. Generally, the assessing net worth or assessing projections techniques are stronger or more complete methods of arriving at the correct income amount.

If neither of the other two techniques is appropriate and the auditor and team leader have decided to proceed with an AUBD, the auditor must make every effort to establish if the deposits represent suppressed income. Consider:

A bank deposit may list payers of cheques deposited. Determine the nature of the bank deposit through a further review of the taxpayer's records and follow-up with the taxpayer or confirm with a third-party.
Request a bank authorization to receive a copy of the deposit slip from the bank if specific deposit slips are missing. In some cases, the bank may have a microfilm or electronic copy of the cheque deposited.
If practical, consider analyzing direct deposits or 100% matching of sales invoices to deposits to disclose any discrepancies in bank deposits versus sales reported and available sales records.
Remove other possible sources for the bank deposits, such as loans, transfers, income tax refunds, and proceeds from the disposition of personal assets.

If direct testing fails to identify the source of the bank deposits, the initial interview may. Possible non-taxable sources of funds include gifts, loans, or inheritances from friends or family members, lottery and other winnings, non-taxable funds from foreign sources, and dispositions of personal assets. A review of cash-on-hand could also give some information about the source of funds.

Ask the taxpayer to explain the source of all unidentified bank deposits. Often, the taxpayer will not be able to identify the specific deposits, but the process of reviewing the unidentified deposits may determine other sources of revenue. If the taxpayer either identifies the deposits specifically or agrees that the deposit is additional income, request written confirmation. If the taxpayer identifies deposits as income and gives written confirmation, an assessment may be based on the amounts so identified.

In certain cases, the taxpayer will not be able to explain the source of the unidentified bank deposits and will not agree that the amounts are income. In such cases, an assessment can be based on the bank deposits if there is a high degree of assurance that the source of those deposits is income. This implies that all other non-taxable sources have been removed, any taxpayer explanation as to another source has been proven unreasonable, and one or more of the following is true:

Verifying income through a review of sales records, including sales invoices, detailed tapes, and sales summaries, is not possible as records are inadequate or unreliable. As a result, bank deposits are the only reasonable means to verify income and assess.
The taxpayer's reported income is based on bank deposits and it is reasonable to conclude, based on a summary of the audit evidence that unidentified deposits are the result of an error in the original summary of income.
Direct audit testing or third-party confirmations establish that the taxpayer has unreported income that directly or indirectly account for a portion of the unidentified bank deposits. Based on a summary of the audit evidence, it is reasonable to conclude that the remaining unidentified deposits are also income.
The nature of the unidentified deposits is consistent with the taxpayer's revenue stream. The taxpayer has not been able to give a reasonable explanation for the deposits or confirm that the deposits are from a non-taxable source of funds. It is reasonable to conclude based on a summary of the audit evidence that the unidentified deposits should be included in business income.

As all deposits for the AUBD are listed specifically, it is a question of fact whether or not each one is GST/HST inclusive. Without reasonable assurance that the GST/HST has been collected and reported or remitted, the AUBD amounts are considered GST/HST exclusive.

13.5.1 Audit evidence

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures. Clearly document audit evidence supporting an assessment based on deposits on Form T20, Audit Report, and other working papers to include:

details of the specifically listed deposits that are included in the assessment;
all matters about other non-taxable sources;
a clear and concise summary of all conversations with the taxpayer; and
other IVI tests (for example, rough net worth) used to support the assessment.

If there is genuine doubt as to the source of the unidentified deposit, the benefit of the doubt should be decided in the taxpayer's favour.

13.5.2 Section removed

13.5.3 Penalties

If an assessment is based on the AUBD, consider applying a gross negligence penalty under subsection 163(2) of the ITA. Taxpayer written confirmation that the source of unidentified deposits is additional revenue may not be sufficient to support an assessment or a penalty, as taxpayers sometimes recant this confirmation when discussing the audit results.

Generally speaking, unidentified bank deposits are not sufficient in themselves to support a penalty. It is usually possible to identify the source of some of the funds beyond all reasonable doubt and in some cases, third-party checks can specifically identify the source of part of the funds. In these circumstances, a penalty should be levied, if the burden of proof test is met.

The burden of proof to establish the facts supporting a penalty rests with the minister and should only be applied if there is sufficient audit evidence to support the assessment without the taxpayer's submission. In all cases if the penalty is applied, there must also be sufficient audit evidence to support the contention that a false statement was made knowingly or under circumstances amounting to gross negligence.

For more information, go to 28.0, Penalties.

13.6.0 Assessing projections technique

13.6.1 Overview

Before proceeding with an audit based on the assessing projections technique, the auditor must be familiar with 13.3.0, Indirect verification of income.

A projection is a means to estimate an outcome based on an identifiable and reliable trend or set of variables. Apply projections to determine revenue and expenses.

A good knowledge of the taxpayer's business activity is needed to be able to isolate pertinent information.

13.6.2 Audit evidence

Clearly document audit evidence supporting the assessing projections technique on Form T20, Audit Report, and the supporting working papers. A rough net worth, bank deposit analysis, or ratio analysis tests can also be used to support the assessment. If there is genuine doubt as to the reliability of the assumptions and the projection analysis, the benefit of any decision should be decided in the taxpayer's favour.

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures. For more information, go to:

9.8.0, Working papers; and
10.5.0, Audit evidence.

13.6.3 Section removed

13.6.4 Indirect versus direct verification

The assessing projections technique is an indirect means of verifying income tax and is separate from direct audit techniques, such as specific or representative testing used if records are adequate and reliable. Separate the assessing projections technique from estimates used to determine areas of concern based on an analysis of reported amounts as compared to industry averages. For more information, go to 13.7.0, Testing and sampling.

13.6.5 Section removed

The information from this section is now included in 13.3.4.

13.6.6 Section removed

The information from this section is now included in 13.3.5.

13.6.7 Projections to determine income

Projections are ordinarily applied to determine income when there are indications that the amounts reported by the taxpayer may be understated or applied to determine the reasonableness of expenses claimed.

The auditor must be able to determine a base that is relevant to revenue; an expense or process that drives sales. Through queries and other analysis, the auditor determines the relationship and considers possible adjustments.

Example 1: Beer sales in a bar are in direct relation to beer purchases (markup percentage), and adjustments may be: spoilage, theft, personal consumption.

Example 2: Containers used in a chip truck (french fry vendor), may relate to sales more closely than purchases of potatoes. Adjustments may be: spoilage, discounts, shortage (no large containers, so give two small), variations (with gravy, poutine, etc.).

13.6.8 Circumstances that warrant proceeding to the assessing projections technique

Projections are an effective audit tool to identify and assess unreported income that would be undetected using direct testing audit techniques. Generally, if revenue was not deposited into any known bank account and there is no ability to quantify undeposited funds through a determination of personal expenditures (PEs) or increase in net assets, then bank deposit analysis, rough net worth, and source and application of funds tests will likely show no material variance. Often a ratio analysis of profitability and turnover ratios will show if the assessing projection technique may be appropriate.

The screener's comments or reason for the audit include areas of concern including understated income. Apply the assessing projections technique if the assessing net worth technique will not give a reliable basis for assessment.

13.6.9 Section removed

The information from this section is now included in 13.3.3.

13.6.10 Reasonable projections

Base projections on reasonable information and records that support the basis to determine the projected amount. For example, use cost of sales to project total sales revenue. However, if cost of sales have not been verified, the projected revenue is difficult to estimate with a reasonable degree of accuracy.

If the internal control is low or non-existent, the books and records will be deemed to be unreliable. Unreliable books and records require a large amount of substantive testing. In the event that an expense is chosen as a base, there is a multiplier used to calculate revenue. The auditor should give enough audit evidence to support the base level (amount), so that a statement that expenses were overclaimed does not negate the assessment.

A reasonable basis means that a reliable projection factor, such as mark-up based on cost of sales, can be determined. Determine a projection factor by calculating the mark-up on a sample of sales transactions during the audit period. Base the projection factor on an analysis of transactions specific to the taxpayer's business instead of using industry standards or consumer based data, such as the Consumer Price Index (CPI).

Make sure that a projection factor derived from the analysis of the sample is relevant for the entire audit period. For example, if sales are subject to seasonal fluctuations (products may vary depending on the time of year), or there has been a change in business operations, adjust the sample to account for the fluctuations or changes.

When selecting a base and determining a projection factor, remember that if your base or projection factor is GST/HST inclusive, your revenue projection likely will be as well. Examples are:

Taxi driver with mileage as a base and drop rate + meter rate (GST/HST inclusive) as a projection factor will yield a revenue amount that is inclusive.
Restaurant with food purchases (GST/HST exclusive) and a markup of 60% as a projection factor will yield a revenue amount that is GST/HST exclusive.

13.6.11 Assumptions

State and validate assumptions based on the facts and circumstances of each case. When using the assessing projections technique, consider these assumptions:

Inflation – if adjustments are made for inflation, working papers disclose the basis for the adjustments and the effect on the projection analysis.
Market price – if sales are projected based on a mark-up analysis of cost of sales, disclose identified fluctuations in selling price or purchase price that have been used in the projection analysis.
Seasonal demand – if the projection analysis is based on records for a period of less than one year, disclose seasonal based fluctuations in sales and purchases that have been used in the projection analysis. State the reason for the limited basis for the projection.
Annual demand – if there are significant changes in business operations during the audit period due to the economy or for other reasons, disclose what adjustments were made to the projection analysis to reflect these changes.

For each assumption, comment if the assumption is constant throughout the period of the projected amounts or if the figures are adjusted for variances in the sample period. Base the variances on actual audit evidence gathered by interviewing the taxpayer or from reviewing the taxpayer's records.

If taxpayer information is not reliable, use published industry guidelines or statistical reports to project revenue, if the purchases or expenses have been verified. If the information is published on a website (such as fuel economy for a given vehicle), keep both the URL of the site and a screen shot of the information in case the site changes or becomes defunct.

Discuss the projections with the team leader in terms of the taxpayer’s "market reality." Document the team leader’s involvement on Form T2020, Memo for file. The projections could be affected by the location of the business, the expertise of the business managers, and by many other similar aspects. Handle the file professionally and apply the concept of conservatism to support an assessment based on projections. It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

13.6.12 Assessing projections technique versus assessing net worth technique

Both assessing techniques are considered appropriate if the taxpayer's records are determined to be inadequate, inaccurate, or unreliable. For more information, go to 13.3.1, General comments.

A net worth relies heavily on banking information to determine personal expenditures and a combination of banking information and invoices / statements to determine asset and liability balances. Projections rely on a verifiable base (normally an expense) and a sound projection factor. Projections will only determine revenue for a given stream if a base is found, while a net worth accounts for all taxable sources. A net worth must also consider questionable nontaxable sources of funds before assessing based on a net worth discrepancy.

The technique used must be justified in the circumstances and must be supported in the case of appeal. Do not select the technique based on time required to complete the audit procedures. The Taxpayer Bill of Rights states that the taxpayer has the right to be treated professionally, courteously, and fairly; the taxpayer has the right to have the law applied consistently; and the taxpayer has the right to expect CRA to be accountable.

13.6.13 Circumstances that do not warrant proceeding to the assessing projections technique

If there is no reasonable base, relative to the taxpayer, that is reliable enough to project sales, the assessing projections technique should not be used. Industry standards are an indicator, but should not be used to assess. A consultant that bids per job as opposed to an hourly rate, may have no reliable base that ties directly to the revenue stream.

13.6.14 Sample selection

To determine a reasonable sample to use in a projection analysis, both a reasonable sample period and reasonable sample size are needed.

13.6.15 Types of projections

Proceed according to responsible minimum standards that result in a credible and defendable conclusion when using the assessing projections technique. This implies that the selected sample is thorough and the underlying assumptions for the projection are sound.

Some common bases of projecting income include:

gross profit ratio;
cost of goods sold; and
inventory turnover.

Key business ratios are often used when projecting sales revenue. Go to 13.6.16 and 13.6.17 for two examples that show how industry standards are used to indicate risk that may be captured by a projection analysis. These figures are available from Dun and Bradstreet or from Statistics Canada. For more information, go to 13.7.0, Testing and sampling.

13.6.16 Gross profit and cost of goods sold ratio

During the audit, information may show that the gross profit of one product line is materially understated. The gross profit is calculated as:

Example: Gross profit calculation
Sales	$3,200,000
Cost of goods sold	$2,180,000
Gross profit	$1,020,000
Gross profit percentage	31.875
Industry standard gross profit percentage	42.5

Therefore, the gross profit should be $1,360,000 ($3,200,000 x 42.5%).

The potential gross profit discrepancy is $340,000.

Or, if the cost of goods sold figure is used to estimate sales (the auditor strongly suspects understated sales due to unreported cash sales) at the industry standard gross profit rate, the sales are understated by approximately $591,000 ($2,180,000/57.5% - 3,200,000).

Information from the initial interview is very important to decide on the most effective and efficient way to determine taxpayer compliance.

13.6.17 Inventory turnover

Inventory turnover can be used to give assurance that the cost of goods sold as reported is free from material misstatement as follows:

Example: Potential discrepancy calculation
Reported ending inventory	$453,000
Industry average inventory turnover (# times / year)	4.2
Purchases in the last 87 days (365/4.2)	$752,000
Potential discrepancy	$299,000

Therefore, cost of goods sold may be overstated by $299,000.

As a choice, use the sales and gross profit percentage to estimate ending inventory as follows:

Example: Ending inventory estimation
Sales January 1 to March 31 (approximately 87 days)	$1,350,000
Gross profit (42.5%)	$573,750
Cost of goods sold January 1 to March 31	$776,250
Reported ending inventory	$453,000
Potential discrepancy	$323,250

Therefore, using the other method of estimating ending inventory, cost of goods sold may be overstated by $323,250.

13.6.18 Completing an audit where the assessing projections technique is used

The auditor must be able to establish that based on the balance of probabilities, the basis for the assessing projections technique is both accurate and reasonable. The balance of probabilities implies proceeding by reasonable minimum standards to arrive at a credible conclusion (from Khuu My Huyen v The Queen, 1997 ETC 2888).

13.6.19 Jurisprudence

Khuu My Huyen v The Queen, 1997 ETC 2888

At issue was whether the appellant, the owner of a convenience store, was liable for GST not collected, plus interest and penalty. The liability was based on a GST audit where the audit results of a three-month period were applied to the 39-month audit period.

The appeal was allowed in part. Although the audit method is legal, its reliability is questionable. Because of the many findings of inaccuracy, the respondent should have taken steps to make sure the audit was more complete and thorough. The appeal was allowed in part to the extent that the appellant was assessed only the GST for the three months that were audited.

Burden of proof should not exempt the minister from the duty of proceeding according to responsible minimum standards that allow for arriving at a credible conclusion. The CRA drew conclusions from a sample of three months' operations and applied the conclusions to the 39-month audit period. Although it was legal, the judge considered the method's reliability to be questionable, especially as the documents supplied by the appellant were correct as to the sales records, correct as to the amount of tax collected, and correct as to the ITC. The judge's opinion was that under the circumstances, the registrant kept very acceptable accounts.

Note: The conclusion to be drawn from this case is that projections from one period audited cannot be applied to other periods, without an audit of those periods.

FBF Limited v The Queen, (TCC 2000-07-19)

The taxpayer operated a smoke/convenience store and purchased cigarettes for resale, without paying GST, and did not record the sales or remit the GST payable on these sales. The taxpayer appealed and challenged the accuracy of the assessment, which was based on a mark-up on purchases method, and included video surveillance, which verified disputed deliveries of cigarettes to the taxpayer. The taxpayer could not refute the basis for the projection and the minister had clearly demonstrated the wilful misrepresentation on the part of the taxpayer. The appeal was dismissed.

In this case, the assessment, interest, and penalties as well as gross negligence penalties were upheld.

13.7.0 Testing and sampling

13.7.1 Overview

After planning, reviewing the taxpayer's books and records, and evaluating the accounting system, gather audit evidence. This procedure is also referred to as testing. The extent of testing and the specific tests depend on the findings of the audit procedures completed and include other factors, such as:

screener's comments;
reason for the audit;
audit history; and
degree of assurance required

Judgement and the interpretation of the preliminary findings also impact the types of tests and extent of testing required.

An attempt at revenue reconciliation is a mandatory step for Small Business Audits. Revenue reconciliation compares the amounts reported as revenues to amounts listed in the final books of account along with any adjusting journal entries and taxpayer explanations. The reconciliation will give the auditor information on: internal controls, quality of records and books of account, and verification of the reporting function of the sales cycle. If there is no efficient way to complete this step, a detailed comment must be included in the T20 Audit Report or T2020 Memo for file. [Reasons why it may be inefficient: books of account do not exist and records are too extensive – such as cash register tapes, with no summaries, OR books of account do not exist and there are no sales records. If the taxpayer has stated that sales are reported by deposits to the business bank account, then the bank statements should be considered the final books of account.]

Revenue reconciliation is a mandatory step for Medium Business Audits. Revenue reconciliation compares the amounts reported as revenues on the T2 returns to amounts listed in the final books of account along with any adjusting journal entries and taxpayer explanations. The reconciliation will give the auditor information on how sales are recorded, and may also give more information on the level of internal controls and the quality of records. If the revenue cannot be reconciled, the auditor must document this in a detailed working paper and, if adequate audit evidence is received, the difference may be part of the audit adjustment. It is also important to review the reconciliation of deferred revenue and Schedule 1 adjustments to see if there is an item included there that affects the sales reconciliation. Unreported revenues can also be directly charged to the shareholder account.

Audit tests involve gathering, analyzing, and interpreting information to support the audit results about the taxpayer's operations and the level of compliance with legislation that applies. Sufficiently document audit evidence to support the findings and conclusions.

Testing in any environment must be appropriate to be useful. The tests must be reliable and relevant to the situation. In the audit environment, relevance depends on the assertions to be tested and the audit objectives that relate to the assertions. Information must be sufficient and competent to give a basis for audit findings and the conclusions that are drawn from the respective tests.

The testing method used to verify the taxpayer's information depends on the situation. If the taxpayer's records are incomplete or unreliable, use indirect testing to determine compliance. Use direct testing when records are reliable and an audit trail is evident.

13.7.2 Direct testing

The two main types of direct testing are:

Specific testing – Individual items are examined due to their size, nature, or method of recording. Examples include purchases of major capital equipment and analytical tests of selected account balances.
Representative testing – A typical selection of items (sample) drawn from the population to reach a conclusion of how the taxpayer has dealt with all such items (the population).

Use sampling to test the information and transactions to increase the efficiency and effectiveness of the audit. Cost and time constraints do not usually permit 100% verification of the taxpayer's information nor does the relative risk warrant 100% verification. However, in rare situations, 100% verification may be required.

Use the sampling procedure to test for attributes or to determine variables within the population.

13.7.3 Statistical sampling

Although not used extensively, there may be situations that require statistical sampling techniques to be used. For example, if the results of the sample are applied to the entire population for an assessment, statistical sampling must be used.

Statistical sampling is permitted under generally accepted auditing standards of the accounting profession. Computer programs and applications simplify the required elements calculated, such as standard deviation, sample size, sampling error, etc.

If statistical sampling techniques are used, the results may be projected across the population for assessment or reassessment. CRA guidelines are:

Assessments raised by means of projecting the results of a statistical sample shall be based on a confidence level of 90% (two-sided test). To attain fairness and consistency, use the mean of the sample distribution to calculate the assessment or reassessment resulting in a 95% confidence level in a two-sided test instead of using the upper or lower bounds.
A two-sided test to give 95% assurance that the population meets the established criteria of the test requires that the sample tested be within 1.96 standard deviations of the mean.

13.7.4 Appropriateness of tests

Testing is useful only when appropriate under the circumstances. To make sure that the taxpayer has complied with legislative requirements, selected tests must be reliable and relevant to the assertions and the audit objectives.

To give a basis for audit findings and recommendations, testing must be:

sufficient to make sure that there is enough audit evidence gathered so that another person could reach the same conclusion;
competent to give reliable and representative information on the circumstances of the audit; and
relevant and consistent with the objectives of the audit procedure and support the audit findings.

13.7.5 Audit assertions

Financial statement information is based on assertions of:

existence;
occurrence;
completeness;
ownership;
valuation;
measurement;
statement preparation; and
compliance.

Existence

Verifying that an item exists and is actually available for use in the taxpayer’s business activity. For example, verify that a capital asset is available for use during the tour of the premises. Documents to support the cost of the asset reported for CCA purposes must be available to verify and satisfy the valuation assertion.

Occurrence

Occurrence is the assertion that a reported transaction for the audit period did in fact take place. The measurement assertion verifies that the transaction is reported at the proper amount and in the correct period. For example, verify that the acquisition of a capital asset did in fact occur and that the asset has not been disposed while continuing to claim CCA expense and failing to report the proceeds of disposition.

Completeness

Verify that all assets, liabilities, revenue, acquisitions, and dispositions of assets are recorded. For example, make sure that all items shipped have been recorded in the sales journal; review the numerical sequence of shipping documents matched to sales invoices to make sure that each shipment has been recorded.

Ownership

Ownership is the assertion that an asset is owned by the taxpayer at a given point in time.

Valuation

The valuation assertion makes sure that an asset, liability, revenue, or expense is recorded at the appropriate value.

Measurement

Verify revenue and expenses to make sure that transactions are recorded at the proper amount and in the correct period.

Statement presentation

Review the taxpayer’s general policies and procedures to determine if the disclosure of information is according to generally accepted accounting principles.

One of the most commonly followed practices is accrual accounting. The taxpayer reports all sales when the sale is made and not when the account receivable is collected. The offsetting principle is matching, whereby the taxpayer claims an expense when incurred. The expense is often recognized before disbursement of the cash for payment to the supplier. Another example is claiming depreciation over the life of an asset instead of expensing the asset at the time of acquisition.

An exception to accrual accounting is available for the farming and fishing industries. Farmers and fishers may use the cash method of reporting income and claiming expenses.

Compliance

A major concern of tax auditing is compliance with the legislation that applies. Examples of compliance include:

assets have been recorded in the correct class and CCA is claimed at the correct rate for that class of assets;
expenses are incurred for business purposes and recorded in the correct period; and
revenue is reported in the correct reporting period (that is, when receivable).

13.7.6 Designing and selecting relevant audit tests

The five steps to design or select an audit test are:

Identify the area to be examined.
Identify the assertion for that area.
State the objective for each assertion.
Design the test.
Document and evaluate the test results.

To document each test:

State the audit objective of the test conducted.
Describe the documents selected for examination.
Disclose the size of the population from which the sample will be selected.
Determine the number of items selected for detailed examination from the population.
Disclose the method of selecting the sample.
Disclose all exceptions to the expected results – all items tested are listed on the working paper and the test results of each item noted.

Evaluation of the test results includes stating the findings of the type and magnitude of errors discovered in enough detail and drawing a conclusion based on the findings. Significant errors that are consistent and recurring or systematic may show that a larger sample should be taken; expand the test to make sure that the preliminary sample results are confirmed by the second test. If errors are determined to be isolated and non-recurring, assess based on the effect of the errors detected. If the number of isolated errors in a sample is significant, discuss the need for a second sample with the team leader to limit the risk of under auditing and to make sure that the time required for more testing is warranted. Document the team leader’s involvement on Form T2020, Memo for file. It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

13.7.7 Compliance testing

Introduction

Compliance testing involves determining the number of occurrences in a population that a policy or procedure meets or does not meet the established guidelines. Usually a sample is tested from the population to determine if in fact the policies or procedures described are adhered to. Attribute sampling is a method of compliance testing. The nature of compliance testing differs from other types of audit testing. Compliance testing alone does not quantify an error for purposes of an assessment or adjustment to tax payable.

Judgement and experience are important to decide on an appropriate approach to complete the audit. The detailed analytical approach (that is, receive an overview of the taxpayer's business operations) is also important to determine the tests and procedures that apply. For more information, go to 13.9.0, Auditing the income statement.

Attribute or compliance sampling

Attribute sampling attempts to determine the frequency a certain characteristic occurs within a population. The characteristic could involve any or all of the following:

a critical internal control procedure that the auditor must rely on;
that the taxpayer postings are free from error;
that documents to support a policy are in place as described.

Conclusion

When attribute or compliance testing is completed, determine the degree of substantive testing. Use substantive testing to determine the effect of errors or omissions for an adjustment to net income.

13.7.8 Supporting indirect verification of income testing

Overview

It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning. Supporting indirect verification of income (IVI) tests are an effective audit tool used to quickly determine the risk of non-compliance. Use supporting IVI tests as a tool to assess risk to:

test the accuracy of a taxpayer's records;
test the accuracy of the audit findings;
examine the taxpayer's financial position from a different angle; and
reduce audit hours by helping to quickly determine the risk of non-compliance.

A supporting IVI test is a tool to determine areas of risk in the audit. An assessment cannot be made only on the basis of any supporting IVI tests, as the assessment or reassessment will not be upheld by the Court. Supporting IVI tests are merely methods to be used to determine areas for more audit action.

If a supporting IVI test reveals no discrepancies, it does not necessarily mean that there is no potential for assessment. It is possible that information received during the audit has a significant impact on the supporting IVI tests and these may need to be revised.

For all income tax audits where IVI has been mandated by Business Intelligence or where the auditor identified risks of unreported income, in addition to the mandatory bank deposit analysis (BDA), a second supporting IVI test must be completed.

Where IVI is not mandated by Business Intelligence, the audit approach taken depends on the reliance that can be placed on the internal controls and the quality of the books and records. Therefore, even in these audits, if the reliability of the accounting records is suspect or the apparent lifestyle of the taxpayer is inconsistent with reported income, auditors should use supporting IVI tests.

IVI testing is required if either of these conditions is met:

When mandated by Business Intelligence;
Where the auditor has identified risks of unreported income by considering the reliance that can be placed on the internal controls and the quality of the books and records.

In cases where the shareholder or taxpayer has prepared the books and records, and neither condition 1 or 2 is met, the auditor will:

Exercise professional judgement and consult their team leader in developing an audit plan that addresses all material risks of non-compliance;
Complete a revenue reconciliation. The findings from the revenue reconciliation must be incorporated into the auditor's analysis on the extent of additional revenue testing as outlined in their audit plan; and
Document the steps they took to risk assess the file, as well as their findings as to the required areas of audit testing.

For more information, go to October 30, 2020, memorandum, Requirement to Perform Indirect Verification of Income Testing.

Following the one-plus-one rule (or one-plus-two for IVI), the IVI tests are conducted on the most current year, or on the year where risk has been identified. It is not mandatory to continue testing other years. It is not mandatory to update the IVI tests, nor the Income Tax Assessing IVI Decision Tree, after a proposal has been made to the taxpayer.

If a supporting IVI indirect test indicates a discrepancy, prove the correct assessment, whether it has been determined to be by factual audit techniques or by using an assessing IVI technique. Before proceeding with an audit based on an assessing IVI technique, the auditor must be familiar with 13.3.0, Indirect verification of income.

The supporting IVI tests are:

bank deposit analysis (mandatory audit step);
rough net worth;
source and application of funds; and
ratio analysis.

Bank deposit analysis – Supporting IVI test

The bank deposit analysis (BDA) is a supporting IVI test used to calculate gross revenues and additional funds required to pay for expenses incurred. The purpose of the BDA is to test the risk of unreported streams of income. Do not use the BDA to analyze or determine the source of every deposit.

A BDA is a mandatory test for audits where IVI has been mandated by Business Intelligence or where the auditor identified risks of unreported income. The extent of the testing depends on what accounts the taxpayer has.

If it is an unincorporated business with a single entry accounting system and weak to non‑existent internal controls, the BDA will include an analysis of deposits to business and personal accounts plus a calculation of cash withheld from deposits for business and personal expenditures (PEs) paid by cash.

For an incorporated business, conduct the IVI BDA mandatory test on the shareholder’s personal accounts to identify any source of funds issues.

An analysis of the deposits to the corporate business bank accounts is direct audit testing of the reported sales and receipts. It will also give valuable information on how the corporation is organized. A separate variance analysis should be conducted that evaluates risk or audit concern when known sources of funds (for example, reported sales, collected taxes, decrease in accounts receivable) have been removed from total deposits net of transfers. A transfer is only considered a transfer if the account disbursing the funds is part of the analysis.

A specific review should be made of each transaction that is a source of funds from an individual shareholder, or from a related corporation, with a view to verifying the giver’s capacity to give those funds. Depending on the risk issues, a scan of withdrawals may also be conducted. Items of concern would be: unusual items, and shareholder benefits or appropriations made without a corresponding debit to the shareholder loan account.

For reference only, sample working paper A-13.4.1, Bank deposit analysis to calculate income variance, is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A‑13.4.1.

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

Bank deposit analysis – Corporate account

If a shareholder net worth assessing technique has been performed, it is important to understand the banking transactions of the corporation before determining the appropriate amount to assess to the corporation. For example: the corporation paid for the shareholder’s family vacation to Florida, but did not claim it as an expense on the T2 return. Because the review of the corporate bank account detected this transaction, the gross net worth assessment will be reduced by a factual subsection 15(1) adjustment. Go to 13.4.38, Assessing net worth technique for a shareholder of a corporation.

Calculation of expenditures paid by cash

Calculate PEs paid in cash not deposited to quantify the amount of funds that have been withheld from deposit. Through discussion of PEs during the initial interview, a later review of the bank accounts will show which expenditures may have never been processed through the bank. PEs paid by funds not deposited should be added to the BDA variance.

If the BDA reveals a discrepancy, it may be due to understated gross revenue or overstated cash expenses. The next audit step is to prove the correct amount to assess by factual audit techniques, including direct testing of deposits.

The BDA requires that assumptions be made for business and PEs paid by cash. It is presumed that business expenses paid by cash can be determined from a review of the business records.

Rough net worth – Supporting IVI test

A rough net worth is an indirect audit test to measure potential unreported income.

A rough net worth is appropriate:

if the reason for the audit or if audit evidence received during the audit shows that the taxpayer has an accumulation of business and personal assets and a lifestyle inconsistent with reported personal income and identified sources of financing and non‑taxable sources; and
to test the reasonableness of reported income amounts if the records are inadequate, internal control is weak, or if the accounting system lacks controls or established procedures.

Prepare the rough net worth from available information on business and personal assets, liabilities, and PEs. Certain items are known exactly, while others must be estimated. A rough net worth as a supporting IVI test includes the personal and non-corporate bank account records of the taxpayer.

The rough net worth test is distinguished from the assessing net worth technique by the certainty of the amounts calculated. A rough net worth may rely on estimated balances of accounts, investments, and liabilities. Minimum PEs are calculated through a summary withdrawal analysis (SWA), as opposed to the extra rigour of verifying amounts paid from the bank and amounts paid outside of the bank. The rough net worth test cannot be used as a basis for assessment, whereas the assessing net worth technique can.

If a rough net worth results in a discrepancy, consider completing an assessing net worth.

Personal expenditures and the rough net worth

For the rough net worth, it is mandatory to calculate a minimum amount of PEs through a SWA. Go to the October 14, 2015, memorandum, Summary withdrawal analysis to calculate personal spending, for detailed procedures. Essentially, the SWA is: opening balance of each account, plus deposits, less ending balance, less transfers (identified in the BDA), leaves net withdrawals. Subtract any known purchases (non-corporate business expenses paid from bank, personal or non-corporate business assets), principal payments to liabilities, remittances to governments (GST/HST, income tax payments, etc.). The result is a minimum estimate of PEs.

A rough net worth will always incorporate assets, liabilities, PEs, and adjustments for both the taxpayer and the taxpayer’s spouse or common-law partner, unless there is a clear and distinguishable segregation of their financial affairs.

Rough net worth year-end

The rough net worth fiscal year-end is the taxpayer’s fiscal year-end for income tax purposes.

Partnership and shareholder investments

Record a partner's investment in a partnership as an asset on Schedule 1, Balance sheet – Assets, based on the equity approach. Record a shareholder's investment in a corporation as an asset on Schedule 1, Balance sheet – Assets, based on the year‑end balance of the shareholder loan account and share capital.

For raising assessments using the assessing net worth technique, use the template Statement of changes in net worth, which includes Schedule 1. The template is available in the Integras Template Library under Worksheets:

Net Worth – Individual - 5-year Assessing v2019
Net Worth – Shareholder - Calendar Year v2019
Net Worth – Shareholder - Off Calendar Year v2019

Source and application of funds – Supporting IVI test

A source and application of funds test measures identified sources of funds, including reported income, against known applications of funds in a tax year to estimate the variance in total income reported.

The test applies to the audit of a self-employed taxpayer. It may be adapted for the audit of a partner in a partnership or a shareholder of a corporation. However, the rough net worth may be a better indirect test in the audit of partners and shareholders.

The source and application of funds test uses a taxpayer's reported total income and compares the amount to sources and applications of funds to determine any variance. Source is defined as taxable and non-taxable income. This model is appropriate for audits of self-employed individuals. Income and expenses calculated on the cash basis will differ from those calculated on the accrual basis.

Source and application of funds – Cash method

This method may be used only for audits of self-employed taxpayers, such as farmers or fishers that report income on the cash basis. Source is defined as taxable and non-taxable income.

Applications of funds include, but are not limited to:

PEs – a minimum amount calculated through SWA;
personal income tax payments and deductions at source;
increase in cash and bank accounts (including personal accounts);
decrease in bank loans and mortgages payable (including personal loans and mortgages);
decrease in personal accounts payable; and
increase in investments and fixed assets (business and personal).

Sources of funds include, but are not limited to:

net income from business plus CCA and cumulative eligible capital amounts;
personal income tax refunds, child tax benefits, and personal GST/HST credits;
decrease in cash and bank accounts (including personal accounts);
increase in bank loans and mortgages payable (business and personal);
proceeds of sales of investments and fixed assets (business and personal); and
non-taxable income.

Estimated unreported income is the application of funds total in excess of the source of funds total.

For reference only, sample working paper A-13.6.1, Source and application of funds – Cash method, is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A‑13.6.1.

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

Source and application of funds – Accrual method

This model is appropriate for audits of self-employed individuals that report income on the accrual basis. Source is defined as taxable and non-taxable income.

Applications of funds include, but are not limited to:

PEs – a minimum amount calculated through SWA;
personal income tax payments and deductions at source;
increase in cash and bank accounts (including personal accounts);
increase in accounts receivable and inventory;
decrease in bank loans and mortgages payable (including personal loans and mortgages);
decrease in trade accounts payable; and
investments and fixed assets purchased (business and personal).

Sources of funds include:

net income from business plus CCA and cumulative eligible capital amounts;
personal income tax refunds, child tax benefits, and personal GST/HST credits;
decrease in cash and bank accounts (including personal accounts);
decrease in accounts receivable and inventory;
increase in bank loans and mortgages payable (including personal loans and mortgages);
increase in trade accounts payable;
proceeds of sales of investments and fixed assets (business and personal); and
non-taxable income (business and personal).

Estimated unreported income is the application of funds total in excess of the source of funds total.

For reference only, sample working paper A-13.6.2, Source and application of funds – Accrual method, is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A‑13.6.2.

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

Ratio analysis – Supporting IVI test

Use ratios for important comparisons to determine if expected relationships exist between various financial statements and reported items. A ratio will reveal a normal or an unusual situation but will not reveal the cause. Get an explanation for any unusual items. Perform ratio analysis on company specific information or compare to industry averages. For the comparison to be valid, calculate the ratios on a consistent basis for all periods under audit and compare to industry averages, or between two different businesses, depending on the type of comparison.

As well as the ratios described below, ratio analysis may also include:

GST/HST versus reported revenues per T1 or T2 financial data;
GST/HST ITCs versus cost of sales and operating expenses per T1 or T2 financial data; and
GST/HST to ITCs or GST/HST to gross revenue.

Gross profit ratio

Compare the gross profit ratio percentage to prior year ratios of the same entity and ratios of similar entities outside the organization (that is, the standard ratio for this type of business). These ratios can give measures of average performance and can serve as a basis for identifying unusual financial relationships.

Formula Gross profit ratio

Gross profit/Sales = Gross profit ratio (%)

This ratio may be useful to estimate the reasonableness of purchases to sales (that is, compared to other periods for this business, or compared to the industry average). It could also show the reasonableness of inventory values or reported sales. Remember, this is only a guide and a variance can have many different explanations. If sales are unreported consistently across several periods, this type of test will not detect understated sales when the ratio is compared to prior periods.

Working capital ratio

The working capital ratio is represented by the formula:

Formula Working capital ratio

Current assets/Current liabilities = Working capital ratio

Generally, a ratio significantly less than 2 to 1 indicates financial difficulties. It is possible to suspect that the inherent risk of understated sales is high due to financial pressure.

Keep in mind that the 2:1 ratio is only a guideline and varies across industries. Industry publications help evaluate these results. For two great resources for industry research and a lot of information on business sectors by NAICS code, visit:

Statistics Canada, North American Industry Classification System (Canada) 2022 ; and
Industry Canada, Find your industry sector.

Use ratios, such as gross profit and inventory turnover, to test information in the taxpayer's financial statements and determine the reasonableness of the amounts stated.

Inventory turnover

The inventory turnover ratio is represented by the formula:

Formula Inventory turnover ratio

Cost of goods sold/((Beginning inventory + Ending inventory)/2) = Inventory turnover

Analyze inventory turnover to calculate revised estimates of sales and purchases based on figures for reported inventory. Or, if the taxpayer's reported purchases or sales are determined to be accurate, analyze inventory turnover to calculate revised estimates of ending inventory. If the ratio analysis determines a significant discrepancy, verify if an adjustment is warranted; in this case, demonstrate that income is understated. Complete a second supporting IVI test to support the discrepancy identified by the ratio analysis.

13.8.0 Auditing the balance sheet

13.8.1 Introduction

Audit the balance sheet to decide if the taxpayer has disclosed all assets and liabilities, regardless of the type of audit. Emphasize locating undisclosed assets and liabilities. Adjustments to reported assets or liabilities may lead to adjusted revenue and expenses and a change to net income or income tax and result in an assessment.

Account for any changes in the asset or liability accounts, as this may increase or change the scope of the audit. Evaluate the extra information to determine its impact on the audit scope and if warranted, the audit scope is amended. Any change to audit scope must be approved by the team leader. Team leader approval is necessary at various stages of the audit; document the team leader’s involvement and/or approval on Form T2020, Memo for file.

A lead or referral may be necessary if the tax not being audited is likely to be adjusted. A change in income tax may require a change in GST/HST and vice versa. Refer any related input tax credits (ITCs) on the workload referral template, Income Tax Workload Referral to GSTHST.xlsx, available in the Integras Template Library. The template is also available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A‑9_13_4.

It is mandatory to include a copy of all referrals and resulting reports in the audit file.

13.8.2 Auditing asset accounts

Verify assets used to calculate income, regardless if the taxpayer prepares a balance sheet. These assets include inventory and accounts receivable. Any change in these accounts results in a change to net income and income tax payable.

If capital assets can be physically inspected, verify that the asset described on the business premises matches the asset described on the purchase invoice. Equipment serial numbers are usually recorded on a purchase invoice; compare to the asset on hand during the audit. If land or buildings are reported on the balance sheet, verify the description using property tax bills or legal documents received when the property was acquired.

Cash-on-hand

The amount of cash-on-hand depends on the taxpayer's business activity. In some industries, cash-on-hand is in fact the float in the cash registers used to make change on cash sales and to refund returns. Usually, the amount of the float does not change.

Some businesses deal mainly in cash and the amount may vary significantly during the audit period. Test throughout the audit period to determine the accuracy of the cash tally.

Audit procedures include a review of all journal entries to the cash-on-hand account during the audit period and query unusual entries.

Tests for cash-on-hand

To determine the reasonableness of cash-on-hand, include these procedures in the audit steps:

Have the taxpayer count the cash-on-hand at the time of the audit. Avoid handling cash if possible.
Review cash sales as recorded on sales invoices from the last deposit before year-end to the end of the tax year. Deduct cash expenses from the cash sales. This amount should equal cash-on-hand at year-end.
If the taxpayer records accounts receivable, add the amounts collected to the cash sales noted on sales invoices, less cash expenses.
Include credit card sales in the total sales from the time of the last deposit.
The taxpayer may buy fixed assets using cash-on-hand. If so, add the amount used for asset purchases to the cash expenditures.
Adjust cash-on-hand for proceeds from dispositions of fixed assets.
If the balance sheet does not separate cash-on-hand from cash in the bank balance, review the bank reconciliation. Add the cash-on-hand to the balance in the bank accounts.

Discuss material variances in cash-on-hand with the appropriate personnel and conduct more audit steps if the explanation is unsatisfactory.

Example 1

The example works from the last deposit forward to the current cash-on hand-balance.

Example 1: Calculation cash-on-hand
Sales from last deposit to year-end	$5,700
Less: sales charged to accounts receivable	3,200
Add: float	400
Add: accounts receivable collected	4,500
Less: cash expenses	800
Calculated cash-on-hand	$6,600

Bank accounts

A review of the bank accounts is usually included in the Audit Plan. If revenue is adjusted because other bank accounts are located during the audit or expenses are adjusted because the taxpayer has issued cheques that have been outstanding for long periods of time, there may also be GST/HST consequences.

Outstanding cheques

Review cheques for material amounts that have been outstanding longer than usual. A third‑party check may be required to confirm that the expense was in fact incurred.

Undisclosed bank accounts

It is important to recognize clues that may show undisclosed bank accounts. The taxpayer may divert funds from the business to an unknown bank account for personal use. As a result, the taxpayer may understate revenue and proprietors’ or shareholders’ draw or income.

Indicators of more bank accounts include:

closure of a known bank account, if disposal of the funds cannot be traced;
sales that cannot be traced to bank deposits in known accounts;
taxpayer's lifestyle is not supported by the personal income reported on the income tax returns; or
expenditures that cannot be traced to debits in known bank accounts.

Useful techniques to determine if other bank accounts exist:

Examine the endorsement on cancelled cheques paid to the taxpayer.
Examine all bank debit and credit memos. An unusual number of errors corrected may show several bank accounts with similar or identical names that employees and bank employees are getting confused.
Reconcile bank interest reported to interest earned from known bank accounts.
Review any unusual notations on bank documents.
Trace the use of borrowed funds. It is possible that the taxpayer has deposited borrowed funds to another bank account. Make sure that loan payments to the business account are made from known sources.
Trace large or unusual sales to the deposit slips or known bank accounts. Consider a third-party check for deposits that cannot be traced.

Although the scope of the audit may not include verifying bank accounts, be aware of the indicators of more accounts.

Trade accounts receivable

Trade accounts receivable that remain fairly constant from year to year are not generally a cause for concern. However, if there has been a significant change in sales or the economy, there will often be a corresponding change in accounts receivable. Scan the account to decide if there are any unusual entries. Examine adjusting entries and unusual fluctuations without explanation may warrant further audit steps.

Verification of accounts receivable

Many methods can verify the accounts receivable control account, including:

The taxpayer may note on sales invoices the date they received customer payment. Review sales invoices that do not show receipt of payment and compare to the outstanding accounts receivable.
Duplicate deposit slips may contain enough detail to allow the review of deposits during the early part of the new fiscal year. Prepare a list and compare to the sales journal.
Review journal entries and other material adjusting entries. The taxpayer may have written off material amounts considered uncollectible. For more information, go to 13.9.22, Claiming expenses, Auditing of bad debt expenses.
Calculate the accounts receivable balance as a percentage of annual sales and compare to previous years. Unusual variances may include a change in credit policy.
Review the company credit policy. Calculate the average collection period of accounts receivable and compare to the credit policy and to periods in previous years. Review unusual changes or variances.
The taxpayer may give the bank a copy of the balance sheet and use accounts receivable as security for loans. Compare these documents to the information the taxpayer gives during the audit. However, the taxpayer may maximize the accounts receivable for presentation to the bank and the bank may not keep a detailed listing of the accounts receivable. Banks seldom verify stated accounts receivable.
If warranted, verify accounts receivable by a third-party check.

Inventory

The taxpayer does not always maintain detailed inventory records. The taxpayer may estimate inventory for year-end purposes or calculate ending inventory based on beginning inventory, sales, and purchases to arrive at an ending inventory value.

Limit the time spent auditing the reported inventory, unless a material discrepancy is apparent. If the inventory value reported is incorrect, make a single adjustment to correct the value.

In some cases, the taxpayer may adjust ending inventory to reduce reported income by increasing the cost of goods sold. This may become apparent if the calculated gross margin is lower than expected and there is no reasonable explanation.

Verification of inventory

If records are not available, helpful techniques to verify inventory include:

Review insurance coverage. If the insurance coverage is greater than reported inventory, verify the variance to decide if there are significant seasonal fluctuations. Review total insurance costs to make sure that the taxpayer has made all insurance policies available for review.
Consider the location of inventory on hand to decide if the reported inventory includes all locations.
Review the method used to value the inventory. If a change in the method is required, discuss with the team leader. Document the team leader’s involvement on Form T2020, Memo for file.
Review property tax and utility expenses. Address and service locations may include more storage facilities that the taxpayer did not disclose.
Review purchase orders and delivery slips attached to receipt of goods documents. Goods delivered to other addresses may include off-premise storage facilities or more business or storage locations.
Calculate the inventory turnover ratio. Compare the calculated ratio to that of other businesses in the industry. Unusually high turnover may include an understated inventory.
Estimate ending inventory by using the inventory turnover rate in days and review the purchases for the same period of time. Adjustments may be required for seasonal fluctuations.
The taxpayer may give a balance sheet to the bank. Compare the reported inventory to the amount reported to the bank.
If individual inventory items can be identified, verify the ending inventory by testing a sample of the reported items. Compare the sample of the physical inventory on hand to the reported inventory. The automotive industry is an example of a field where this might be helpful; separately identify each item by the vehicle identification number (VIN).
Determine if the taxpayer has inventory on consignment at other locations. Indicators of consignment inventory include:
receipts for product from taxpayers in similar businesses;
delivery slips indicating other locations;
purchase orders with different delivery addresses;
audit evidence that the taxpayer has inventory on hand that belongs to someone else; or
a volume or number of units purchased that seems unusual for the space available.

If any of the above techniques show that inventory may be understated, discuss the matter with the taxpayer. The taxpayer’s comments can be used to establish a reasonable inventory value. If an adjustment is required based on the best available information, the burden of proof of the value of the inventory reverts to the taxpayer.

The ITA does not recognize a standard write-down percentage for obsolete inventory. If the taxpayer adjusts for obsolete inventory, confirm the amounts during the audit.

If a taxpayer in the business of farming, is in a loss position, review inventory to make sure that the mandatory inventory adjustment is made.

Investments

Review cash disbursements and cash receipts for:

payments to brokerage or investment firms;
T5 slips issued by brokerage or investment firms if no income is reported;
unexplained deposits to bank accounts;
unexplained sources of capital;
dividends regularly received that cease;
statements and other correspondence from brokerage or investment firms; and
personal investments pledged as security for business loans.

Land and buildings

The valuation of land and buildings reported on the balance sheet may be of concern if the purchaser and the seller are not dealing at arm's-length. Consider the fair market value provisions of section 69 of the ITA where necessary. If the parties are dealing at arm's-length, the consideration is deemed reasonable.

Gains or losses on disposition of land or buildings may be treated as capital gains or losses or as business income. Audit procedures verify that dispositions have been allocated according to legislation.

The purchaser and the seller must allocate proceeds to buildings and land consistently. Refer discrepancies in the allocation of costs or proceeds to the Real Estate Appraisal Section for review. It is mandatory to include a copy of all referrals and resulting reports in the audit file. The taxpayer may allocate a higher value to the buildings to increase the maximum allowable CCA.

Audit procedures verify that all land and buildings are reported on the balance sheet. Use property tax bills and utility bills to make sure that the taxpayer has reported all assets.

Equipment

In most cases, the taxpayer reports all equipment on the balance sheet to maximize CCA and reduce taxable income. Include these procedures in the Audit Plan:

Physically inspect the asset, if possible. If not, trace the acquisition to disbursements (cancelled cheques) and to insurance policies. The balance sheet may include a loan payable for equipment and detail the equipment in the notes to the financial statements.
Verify the cost of the equipment. Make sure that the taxpayer includes legal fees and instalation costs in the capital cost and not as an expense.
Verify the date of acquisition. For more information, go to Income Tax Folio S3-F4-C1, General Discussion of Capital Cost Allowance.
Verify that the equipment is available for use.
Establish the use of the equipment to make sure that the equipment was acquired for business use.
Review records to make sure that the taxpayer records dispositions of equipment as required. Make sure that trade-ins are credited to the CCA schedule. Unexplained sources of funds or unidentified deposits may include proceeds from the sale of equipment. Proceeds from insurance for lost, stolen, or destroyed equipment must be credited to the CCA schedule.

Goodwill

Goodwill is eligible capital property. Instead of CCA, three-quarters of the eligible capital expenditure is added to the taxpayer’s cumulative eligible capital (CEC). The taxpayer may deduct up to 7% of the CEC from income at year-end. However, if deductions exceed the additions at the end of the fiscal year, the negative balance is included in income or deemed a taxable capital gain. Goodwill attributed to an investment in property that is not used for business does not qualify.

Audit procedures make sure that the allocation of cost to goodwill is reasonable and according to generally accepted accounting principles. For more information, go to Income Tax Interpretation Bulletins:

IT123R6, Transactions Involving Eligible Capital Property ;
IT143R3, Meaning of Eligible Capital Expenditure ; and
IT386R, Eligible capital amounts.

Other intangible assets

Quotas, permits, customer lists, and franchises are forms of intangible assets that are similar to goodwill for amortization of costs. Costs of acquisition are amortized and the taxpayer may deduct from income 7% of the CEC at year-end. However, if deductions exceed the additions at the end of the fiscal year, the negative balance is included in income or deemed a taxable capital gain.

Audit procedures make sure that the allocation of cost to quotas, permits, customer lists, and franchises is reasonable and according to generally accepted accounting principles.

13.8.3 Auditing liability accounts

During the audit, verify the liabilities reported on the balance sheet using procedures to make sure that all liabilities are reported in the financial statements.

Not all taxpayers prepare a balance sheet. If no balance sheet is available, review outstanding liabilities due to the relationship between liabilities, revenue, and expenses.

Bank overdrafts

If the bank account is overdrawn, the amount is recorded as a liability on the balance sheet. Review the bank reconciliation to determine if any cheques have been outstanding longer than normal. Bring to the taxpayer’s attention cheques that have been outstanding for more than six months. If cheques have been outstanding for unusually long periods, review to make sure that the cheque was in fact issued and that the expense was not fictitious.

Bank loans

The taxpayer will normally disclose all bank loans to deduct the interest expense. Verify the purpose of the loan to make sure that the taxpayer used the proceeds to purchase an income-producing asset.

The taxpayer may not disclose loan details if:

the loan is fictitious and is really unreported income;
interest expense is inflated; or
the proceeds of the loan were used to purchase an asset that was not revealed because:
- the asset is collateral for outstanding debts, so there is a risk of seizure;
- the asset is being used to earn unreported income; or
- an income-producing asset secured the loan – the taxpayer attempted to hide both the asset and the related income.

Indications of undisclosed bank loans

Some common indicators of undisclosed bank loans are:

interest expense cannot be reconciled to outstanding loans (that is, interest expense exceeds the interest at market rate on loans reported on the balance sheet);
the taxpayer has acquired assets without an apparent source of funds;
review of bank deposits includes unidentified amounts; or
frequent withdrawals cannot be identified.

Verification of bank loans

To make sure that the taxpayer has reported all bank loans on the balance sheet:

Review all documents, including the loan agreement, promissory note, or chattel mortgage that covers security and any other correspondence or financial information that the taxpayer may have submitted to secure the loan.
Review collateral pledged as security and check against reported assets.
Trace the proceeds of the loan through the bank account and look for loan payments in later months.
Reconcile interest expense to loans outstanding to make sure that the expense is reasonable based on the reported loans outstanding.
Review insurance policies if loans are advanced at low interest rates.

Notes and mortgages payable

Procedures to verify bank loans also apply to notes and mortgages payable.

If the taxpayer receives a loan or mortgage from a source that is not in the business of lending money, make sure that the lender reports sufficient income to give a source for the funds to make the loan. If doubt exists, generate a lead.

Accounts payable

Ask for a list of current and prior year accounts payable. Amounts that have been outstanding for long periods may show fictitious liabilities and overstated expenses. Overstated liabilities could also be unreported revenue.

Verification of accounts payable

Procedures to verify outstanding accounts payable include:

Trace large amounts to the original purchase invoice and delivery receipt.
Trace purchase invoices through the cash disbursement journal. If a cheque is outstanding for an unusual period, the liability may be fictitious.
Reconcile any significant shipments of product or supplies received before year-end to inventory and sales invoices.
Review amounts outstanding for extended periods, as they may show fictitious liabilities, overstated expenses, or unreported revenue.
Consider section 78 of the ITA, if outstanding amounts payable are not at arm's-length. For more information, go to Income Tax Interpretation Bulletin IT109R2, Unpaid Amounts.

Accrued liabilities

Procedures to verify accounts payable also apply to accrued liabilities.

An accrued liability is an obligation incurred in an accounting period but chargeable or payable in another. Audit procedures include a review of accrued liabilities to make sure transactions are allowable expenses. Obligations paid in the year incurred and possible accrued liabilities include:

convention expenses (subsection 20(10) of the ITA);
landscaping of grounds (paragraph 20(1)(aa));
investment counsel fees (paragraph 20(1)(bb));
representation expenses (paragraph 20(1)(cc));
investigation of site (paragraph 20(1)(dd)); and
utilities service connection (paragraph 20(1)(ee)).

Deferred revenue and reserves

Audit procedures include a review of the working papers the taxpayer used to calculate deferred revenue and reserves. Make sure that the reserve or deferral is allowed under the ITA.

Revenue may be deferred if:

goods are not to be delivered to the customer until after year-end;
services are not rendered until after year-end;
proceeds from the sales of property are made on a deferred payment basis; or
the amount deferred has been included in income.

For detailed information on reserves, go to Income Tax Interpretation Bulletins:

13.8.4 Auditing equity accounts

Audit procedures include a review of the equity accounts. The taxpayer may make adjusting entries directly to the equity account. Query any unusual entries (journal entries or entries from unusual source journals).

13.9.0 Auditing the income statement

13.9.1 Introduction

To audit income, auditors use various techniques depending on the specific circumstances. This often means going beyond the documented records to determine the reasonableness of reported sales. Analyze and observe to make sure that income from all sources is reported.

During the preliminary stage of the audit, determine the types of sales and the method of reporting these sales. As part of the audit working papers, describe the sales system, including an example of a sales transaction documents from start to finish. It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

13.9.2 Auditing using the detailed analytical approach

To use the detailed analytical approach, get a general understanding of the taxpayer’s business operations. The initial interview and observing day-to-day functions are useful tools to help determine areas where errors are most likely to occur.

Observe, discuss, and get documents and records from the taxpayer or from other sources for information. Techniques to complete audits include using:

judgement;
an imaginative approach and adapting the Audit Plan to meet the objectives and identified risks of the audit in progress; and
information outside the accounting records.

The audit approach and the selection of tests depend on the nature of the business and the type and detail of the records available. Some tests may not be conclusive but may give the information necessary to verify other procedures. Knowledge and understanding of the accounting records and business functions are essential to effectively use the detailed analytical approach.

Use these detailed analytical audit techniques to verify the completeness of reported revenue if books and records have sufficient detail and are available for audit:

Select a sample of purchases and trace through to the sale to make sure that each unit is recorded as a sale or remains in inventory (for example, vehicle sales traced by serial number or vehicle identification number (VIN) or electronic equipment traced by serial number).
If purchases include material for resale measured in units such as tons, cords, or cubic metres, compare the quantity purchased to the quantity sold. Examine material variances.
Compare job site addresses, delivery addresses, and special shipping instructions on work orders to addresses on sales invoices. Closely examine addresses that cannot be matched. This is especially important if goods can be diverted for personal use.

In the manufacturing industry, use standard costs to calculate estimated sales and compare to reported sales. Examine material variances. Review other items, including:

collection records or reports to verify reported sales;
warranty records that may include more sales;
appointment books for information to support revenue – use a sample period to make sure that all sales are reported;
client deposits or retainers in a trust account to detail sources of income;
bank deposits reconciled to sales and collections – follow up material variances; and
journal entries may show an unusual number of corrections or adjustments – query unusual entries as they may adjust suppressed sales or show that controls are not effective.

13.9.3 Analysis and observation

It is very important to analyze and observe for audit evidence of potential problems with reported income and expenses. Analyze the financial statements and the income tax returns for information to include areas that need more audit action, including:

analyze gross and net profit margins;
analyze the taxpayer’s drawings;
analyze assets (an increase in assets without a corresponding source of funds may include suppressed revenue);
review the supplier list and the timing of purchases for assurance that the purchases relate to the reported income; and
analyze for audit evidence that the taxpayer's residence and lifestyle are not compatible with reported income.

13.9.4 Testing and sample selection

It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning. The auditor's assessment of risk based on the internal control system, a review of the accounting system, analysis of the returns and financial statements, previous experience with the taxpayer, the type of business, and the scope of the audit determine the degree of testing required.

Many methods may be used to select a sample of items for testing. Common criteria to select a sample include:

amounts over a certain limit;
all large items;
by supplier or customer;
by month; and
a certain percentage of transactions (based on the dollar value or the number of entries).

For more information, go to 13.7.0, Testing and sampling.

13.9.5 Third-party information

Valuable information can be received from third parties during the audit, but there needs to be sufficient audit evidence to warrant third-party verification.

Third-party information may be useful:

if the audit was initiated as the result of a lead, to narrow the scope of the audit and reduce the time required to complete the audit;
to verify income by contacting customers; because of the possible ramifications, use this only when no other method to verify sales is available; and
to identify income sources, such as lists of permits issued for work sites or a listing of revenue from vehicle insurance claims from local authorities such as registry offices.

For more information, go to 10.6.0, Obtaining information from third parties.

13.9.6 Auditing cash vs accrual method of reporting income

Confirm the method of reporting sales during the initial interview with the taxpayer. Since 1972, virtually all taxpayers are required to use the accrual method to report sales. Farmers and fishers may continue to use to the cash method under subsection 28(1) of the ITA and professionals may use a modified accrual method to report income under subsection 34(1). For more information, go to Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

If the taxpayer does not record revenue on the accrual basis, income reporting may not be according to legislative requirements.

13.9.7 Adjusting from the cash method to the accrual method

The taxpayer's method of reporting income during the year may require year-end adjustments for income tax purposes. Adjust accounts receivable and accounts payable to convert the taxpayer's records from the cash method to the accrual method.

Subtract opening receivables and payables from the reported revenue and expenses. Add ending receivables and payables to the reported revenue and expenses. Add opening inventory and subtract closing inventory from cost of goods sold.

13.9.8 Internal controls

It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning.

Internal controls help determine the level of risk and the degree of testing required. If internal controls are effective and reliable, the amount of testing required can often be reduced. However, if controls are poor, ineffective, or non-existent, substantial testing is usually required.

Examine cash transactions in detail during the audit, as they are considered particularly high risk due to the lack of an audit trail. Assessments based on the assessing net worth technique are often used when auditing businesses that lack internal controls and if there is a risk of unreported income. For more information, go to 13.3.1, General comments.

If there is an Underground Economy group of auditors in the TSO, it can be worthwhile to discuss the situation with them. The Underground Economy group is experienced in auditing where controls are weak and risk of unreported revenue is high.

If there is no segregation of duties, or no effective segregation, then internal control is weak to non-existent. For example, the bookkeeper that records all of the sales invoices, cheques, and expense vouchers that are put in the in-box, is not an effective control to stop the taxpayer from overclaiming expenses or underreporting sales.

13.9.9 Auditing the various types of sales

The nature of the taxpayer's business often determines the primary types of sales. In the retail industry, most sales are cash sales (payment made by credit and debit card is included in cash sales), while in manufacturing or wholesaling, most sales will be on credit.

Electronic commerce is a common method to conduct business. Transactions are handled entirely online through many Internet sites and there may be limited documents to verify the accounts. Consider the adequacy of books and records. For more information, go to 13.9.12, Auditing electronic commerce records.

Other types of sales include instalment, lay-away, conditional, and consignment.

13.9.10 Sales on account

Sales made on account can be recorded in many ways. The sale may be entered on a cash register or a sales invoice may be prepared and entered in a sales journal. The taxpayer usually has some form of credit policy and limits credit based on past experience with the customer.

Suppression of sales made on account

A common method to suppress sales made on account is to record the income in an account other than the sales account. Often an asset account is credited with the amount of the sale. When the customer remits payment, the same account is debited which results in no net change to the asset account but effectively understates income.

Accounting controls

Depending on the taxpayer's accounting system, there may be system-based controls to make sure that sales on account and receivables collected are recorded properly.

Many integrated computerized systems automatically post sales to the account specified based on the information entered in a customer profile.

Suggested audit procedures

If reviewing sales made on account:

review the taxpayer's credit policy;
review the sales recording system;
determine if there are reliable system-based controls;
verify that controls are functioning as described;
test a sample of customer accounts to make sure that the sales are posted to an income account;
test a sample of posting entries, if the taxpayer uses a double entry journal system;
review the sales summaries – test a sample of monthly summaries to make sure that sales are posted to income accounts; and
in many journal systems a column is used to post amounts to infrequently used accounts – review these amounts to make sure that sales are not recorded to balance sheet accounts.

Complications of suppressing credit sales

Attempting to suppress sales made on credit is complicated for reasons including:

the customer must be invoiced to collect payment;
the invoice must be omitted from the sales journal or suppressed by some other means;
the receivable amount must be monitored until payment is received; and
the payment received from the customer must be appropriated by the taxpayer without any record or notation in the cash receipts ledger.

13.9.11 Cash sales

If a significant portion of the taxpayer's sales are cash sales, the method to record sales is very important. A cash register, counter sales book, cash box, or cash drawer may be used to record sales.

If a cash box or cash drawer is used, the receipts may be pocketed without issuing an invoice or providing any record of the sale. Bank deposits are often used to record cash sales.

Control of cash is important to make sure that the reported sales are free from material understatement. Determine the method of reporting cash sales along with an overview of the controls in place to prevent loss. There is often limited segregation of duties in smaller organizations if the majority of sales are cash sales and, therefore, the risk that sales are understated is high. Other methods are often necessary to determine the reasonableness of reported income. For more information, go to 13.7.0, Testing and sampling.

Suppression of cash sales

Cash sales are easy to suppress if deposits are used to record sales. If cash registers are used to record sales, nil sales (most cash registers have a no sale key) may be entered to open the till to make change or the sale may not be entered if the customer has the correct change. Be alert to change outside the cash register used to make change, as this may show that some portion of sales are not being recorded.

Suppressing sales paid by cheque is somewhat more difficult, but possible methods include:

substitute the cheque for cash from unreported sales;
endorse the cheque to pay for cash business purchases; and
use the cheque to pay for personal expenditures.

Suggested audit procedures

During the review of cash sales:

determine how cash is controlled;
determine how cash sales are summarized and recorded;
determine if cash is withdrawn before deposit to pay for expenses or as drawings;
review input tax credits (ITCs) claimed - may show if expenses were paid by cash;
test a sample of the postings to the sales summary if counter sales invoices are prepared;
observe the handling of cash, operation of the cash register, and preparation of the bank deposit during the audit;
test a sample of the calculations on manually prepared sale invoices;
verify the numerical sequence of the counter sales books;
verify the continuity of the sales books; and
review a sample of cancelled or void transactions – query any unusual amounts or questionable items.

If the frequency of no sale entries on the cash register tape appears unusually high, determine if there is a pattern. If possible, check the frequency of no sale entries by employee and determine if the frequency of no sale entries is higher at a certain time of day. Check the tapes to determine if the tape is shorter than for the time the business is open. For example, does the tape start with early morning sales, or is the tape cut off before closing time?

13.9.12 Auditing electronic commerce records

Electronic commerce (e-commerce) is a significant way to conduct business in Canada's economy. The administration of the tax system has to be continually modernized to keep up-to-date with technological advances. Tax laws have to be modified and the CRA’s compliance policies and programs have to respond to the ways to conduct business to maintain the integrity of Canada's tax base in an e-commerce environment.

E-commerce can be broadly defined as the delivery of information, products, services, or payments by computer, telephone, or other automated media. This encompasses much more than purchasing goods and services electronically.

E-commerce transactions include:

banking;
purchasing and restocking;
paying bills; and
trading in digitized goods and services.

Typically the customer places an order for a product or conducts transactions such as telephone banking and bill payment using the electronic online system. If the transaction is for a product that cannot be delivered electronically, the mail system or a courier is often used for delivery to the customer. Many products or services such as banking services, computer software, music, videos, technical services, blueprints, books, documents, and forms can be delivered electronically. The transaction is complete when the customer disconnects. Products and services are usually paid by credit card or an online payment system linked to a credit card or bank account.

Issues surrounding electronic commerce

Some evident issues for e-commerce transactions include:

determining if an activity took place;
verifying the reported revenue;
identifying the jurisdiction that has the authority to levy taxes; and
ensuring the same tax treatment as for non-electronic transactions.

Non-reporting

If sales are made using online systems, an audit using computer-assisted audit techniques (CAATs) is likely required. For more information, go to:

13.1.3, Assistance from Digital Compliance and Audit Support Division specialists; and
13.1.0, Computer-assisted audit techniques.

Suggested audit procedures

When planning the audit, review all types of sales transactions; the taxpayer may have income from sales made by electronic means.

Other methods to show e-commerce sales and income include:

a review of advertising expenses - may show that the taxpayer uses the Internet to solicit new customers; and
an Internet search – may show the taxpayer has a website to market products and/or services.

Reconcile credit card cash receipts to the reported sales to verify that all sales are reported; if a significant discrepancy is apparent, unreported electronic transactions might be the cause.

13.9.13 Auditing conditional, instalment, and lay-away sales

Conditional sales are sales of tangible personal property if possession of the property is transferred, but ownership passes only after certain conditions are fulfilled. Instalment sales are sales of tangible personal property if ownership of the property transfers immediately, but the property is paid for in instalments. For lay-away sales, possession and ownership transfer only after the recipient makes full payment to the supplier. The impact of these types of sales can be significant.

Conditional and instalment sales generally meet the criteria to be recognized as revenue, while layaway sales do not. Conditional and instalment sales are normally recognized in the accounts receivable and layaway sales are held in a deposit type of account.

Auditing construction contracts, progress payments, and holdbacks

Revenue reporting on long-term contracts is determined by the service contract between the supplier and the recipient, provincial laws that govern the contracts and the timing of payments made to the supplier. Progress payments are generally made based on a percentage of completion of the contract less any prescribed holdback.

Reporting revenue for tax purposes is only an issue when the contract straddles the supplier's year-end. Large contracts may straddle more than one year-end. For more information, go to Income Tax Interpretation Bulletin IT92R2, Income of contractors.

13.9.14 Auditing the sales recording system

Taxpayers use many methods to record sales. The sophistication of the system depends to a certain extent on the size and type of business. During the preliminary stage of the audit, gather information on all methods of recording income. Common methods to record sales include:

cash registers;
sales invoices prepared manually or by a computerized system; and
bank deposits.

If the taxpayer suppresses sales, there will often be a second sales recording system such as a separate sales invoice sequence or certain forms of payment diverted to a separate bank account.

Sales invoices

Sales invoices may be prepared manually or by a computerized sales system. A word processing system may be used to prepare invoices that appear to be computer generated but are effectively manually prepared based on operator input. A fully integrated computerized sales system from purchases and inventory through to the financial statements usually gives the most effective system-based controls. If the system is not integrated, methods may be used to summarize sales.

Manually prepared sales invoices

Sales invoices that are prepared manually should be on pre-numbered forms. If the invoices are not pre-numbered, there is no control over the invoices issued and verifying the numerical sequence does not give assurance of the completeness of sales, making it necessary to use other methods to verify if the sales are complete.

Audit procedures include:

Verify the sequence of the recorded sales invoices. If the review shows gaps in the numerical sequence, determine the reason for the missing invoices; they may be marked as cancelled.
Test a sample of cancelled invoices to make sure that the invoice was in fact cancelled. If there is audit evidence that goods were shipped, the cancelled invoice should include notation of the replacement invoice.
Verify the numerical continuity of invoice books.
Make sure that sales are recorded for each business day.

Internal controls

If sales invoices are prepared manually, audit procedures include:

Verify the sales invoice calculations.
Test a sample of daily sales to make sure that the daily summaries agree to the total sales invoices issued.
Reconcile deposits to sales and accounts receivable.
Review the procedures for issuing and recording refunds and credit notes.
Query the controls over returned goods.

13.9.15 Sales summary

There are two methods used to prepare a sales summary of manually prepared sales invoices:

cash register; and
journal system.

Regardless of the method to summarize sales, audit procedures include testing a sample of posting entries to make sure that they are free from material error.

Cash register sales summary

Sales invoices are entered using a cash register that summarizes daily sales. The till tapes are used to prepare a sales summary, usually in the form of a journal.

Sales journal

The sales invoices are entered to a journal that can be in the form of a simple ledger (manual or electronic spreadsheet) or a one-write system. A one-write system also permits the recording of credit sales by using individual customer ledger cards. The journals are usually totalled at the end of each month.

Sales invoices prepared by a computer system

If a computer system is used to generate sales invoices, the system review determines if the invoice number is system generated or based on operator input. If based on operator input, verifying the numerical sequence will not give assurance that sales are complete.

Other procedures are required to make sure that all sales are invoiced and recorded.

Bank deposits

In many small business operations, the bank deposits are used to record sales. Receipts are deposited to the bank account daily, weekly, or as considered prudent by the owner or manager. In many cases, the deposits are not summarized in a ledger and the deposit records are the only record of sales.

For income tax purposes, the GST/HST remitted is deducted from the deposited amounts to determine income.

A weakness of using bank deposits to record sales includes possible understated income if:

invoices are not issued for customer purchases;
cash received is used to pay for purchases or expenses; or
cash withdrawn is used for personal expenditures (PEs).

Suppressed sales

If cash payments are often received from customers, the potential to suppress sales is significant and very difficult to detect using standard audit techniques. If bank deposits are used to record income, sales may be suppressed by withholding or diverting all or a portion of the cash receipts. If the suppressed sales are material, indirect audit procedures may be needed to estimate the value of understated sales. For more information, go to 13.7.0, Testing and sampling.

Internal controls

In such cases, there are usually no controls to rely on and due to the limited records available, indirect testing procedures will likely be necessary to determine the reasonableness of reported income.

13.9.16 Audit of cash registers

The information in this section is a general guideline for auditing a taxpayer who uses a cash register to record sales. For information specific to particular industries, review the sector profiles at CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax Sector Profiles. Suggested procedures for auditing cash registers are available in the Integras Template Library, Audit Techniques for Cash Register Systems and Questionnaires for Cash Registers and Other Systems.

Introduction

Retail business operations, including restaurants, grocery stores, convenience stores, hardware and department stores, use point of sale (POS) equipment such as cash registers, to record sales.

Cash registers consist of a mechanical or electronic calculating device connected to a drawer where the money is kept. Cash registers may also include bar code scanners, credit card and debit card terminals, scales, and check-stands. Many cash registers are actually computers equipped with POS software.

Cash registers are used to record sales and transactions. First invented to prevent employee theft and embezzlement, they still serve that purpose. Cash registers have many functions, such as monitor inventory, comprise detailed sales reports based on user-defined data, and print detailed customer receipts.

Types of cash registers

There are three main types of cash registers:

standard;
PC-based POS systems; and
self-check-out counters.

Common in retail stores and restaurants, standard cash registers have minimal functions, such as tracking sales of various departments and printing receipts. PC-based POS cash registers allow the cashier to scan an item's bar code, which retrieves pricing and other sales information. The customer can also pay for the goods with a credit card, debit card, or cheque. Self-check-out counters allow customers to scan the bar code of items without a cashier. The customer then pays for the items with a credit card, debit card, or cash directly through the terminal.

Cash register features

A standard cash register can be programmed with:

price look ups (PLUs) - sales and inventory of specific products are tracked by assigning prices to product codes – the product is described on the customer's receipt with its price; as well, cashiers directly enter the price for miscellaneous items;
department-group products to track the sales and tax status of a particular product;
clerk’s name; and
cash register ID, if more than one cash register is used.

Print a confirmation report listing the above items programmed on the cash register.

The cash register may be able to be connected to a PC through a serial port or USB interface. This allows the cash register to be integrated with accounting software or to export information to a spreadsheet program, such as Microsoft Excel. This is usually done by generating standard X and Z reports at the PC. By being connected to a PC, the cash register can be integrated with inventory control software, be programmed for example, to add new PLUs or back up data.

Other features that may be available include:

optional information printed on the customer receipt such as the clerk name, machine number, transaction number, date, time, and tax;
happy hour setting, for both restaurants and retail stores, permitting different prices for a PLU, depending on the time;
settable high digit lockout - a maximum value for certain entries, such as coupon discounts;
gallonage mode for departments - for PLUs with quantity measures such as volume, weight, length;
training mode for practicing register operations - values entered in training mode do not affect the register totals;
inventory tracking of remaining stock for each PLU;
support for discount coupons, refunds, returns;
support for tips; and
support for voiding an item, without canceling the whole sale.

A switchable restaurant/retail mode is useful for restaurants. Restaurant mode can include these features:

“Tables,” “Open a table” - add orders without ending the sale, until the table is closed;
“Floating guests” - track customers if they move to another table or to the bar; and
“Cooking messages” - instructions for kitchen staff (steak: raw) - needs a second printer.

Tax calculation features are important, especially if the tax is complicated, for example:

exempt tax on an item or an entire sale;
set tax by PLU department code; and
calculate tax after discount, not before.

Cash register reports

Reports may be produced at the cash register and printed out through the receipt printer or generated at a connected PC and exported to accounting software.

While different makes and models generate different types of reports and give them different names, common reports are:

X report - gives a running total and can be generated at any time of the day. Generating an X report does not clear the totals.
Z report - produced at the end of the day, week, or month. Producing a Z report clears the totals.

X and Z reports give many totals, including:

total sales by:
department;
type of transaction;
payment method;
cashier/server ID number;
cash register number;
date;
cut-off (closing register) time; and
total number of customers by payment method.

Cash registers number Z reports with a distinctive sequence number, which gives the owner assurance that the employee who has the authority to generate Z reports has not generated a report earlier in the day and concealed some sales. X reports have no distinctive sequence number, but have a consecutive transaction number issued by the cash register.

Most models of cash registers print Z report cumulative totals from when the cash register was instaled (for example, total sales, total plus registrations, and total minus registrations). These totals cannot be reset and are commonly called GT (grand total).

Other types of reports that may be available include:

method of payment;
sales by department;
sales PLU;
gross profit by department;
hourly sales;
cashier or cash drawer readout;
withdrawals;
deposits to safe;
cash balance or discrepancy;
card payment; and
tips.

Payment methods

Cash registers are designed to accept many methods of payment; most commonly:

cash;
credit cards and debit cards;
cheques;
coupons;
gift certificates; and
bottle and container returns.

Pay close attention to cash transactions, as they do not leave an audit trail and, therefore, are a greater risk to suppress sales.

For credit card or debit card transactions, examine the documents the taxpayer usually keeps, such as transaction records, point-of-sale (POS) terminal batch closures, and POS bank reports. The POS terminal batch closure contains all card transactions by terminal and the POS bank report contains all card transactions for all of the POS terminals. The information in the POS terminal batch closures and the POS bank reports reflects the actual figures and cannot be modified by the taxpayer.

Understand how a cash register works

To effectively complete an audit if a cash register is used to record sales, it is essential to understand how the cash register works.

To gather useful information, observe the cash register while it is in operation, interview the appropriate personnel, and get and review the operating manual.

Under section 231.1 of the ITA, the auditor has the authority to:

require the taxpayer to explain how the cash register or cash register system and the accounting system work;
get a reading of an X report or of the sales summary (without a zero reset); then ask the taxpayer to explain the information in the report;
require the taxpayer to explain how cash is balanced;
require the taxpayer to give the user manual for the cash register or cash register software, for consultation; if the taxpayer does not have the user manual, contact the cash register supplier or software designer to get it; and
require the taxpayer or any other person present, to answer all relevant questions, including completing the relevant questionnaires from the Integras Template Library.

Balance the cash register

Most businesses use the information generated from the cash register to report the sales for accounting purposes. Therefore, it is essential to understand how the cash registers are balanced and to get the documents used in the balancing process.

Cash registers may be balanced for each cash register or each cashier. In some businesses, each cashier balances their cash register or cash drawer and the head cashier, manager, or owner intervenes only if there is a problem. In other businesses, the head cashier, manager, or owner conducts the balancing, and not the cashier.

Suppression methods

Sales are suppressed to not only reduce revenues for tax purposes, but also to divert funds for other purposes, including:

Personal use.
Cash purchases – this usually means that no invoices are issued by the suppliers. Without an invoice, the expense cannot be recorded in the books. The cash for these purchases often comes from unrecorded cash sales; therefore, an analysis of purchases would reflect some inconsistencies.
Some employees may be paid cash under-the-table to avoid paying benefits. Most often this cash is from unrecorded cash sales. Analyze the payroll journal, collective bargaining agreement, and other documents to identify inconsistencies.

Methods to suppress sales (revenues) using a cash register include:

a) "No sales" key (POS or no sale) and the open-drawer method

The sale is not recorded at the time of the transaction, particularly when the customer pays cash.

In some cases, the cash drawer is left open. The cashier does not enter the transaction, places the money in the drawer, and gives the customer change, if required.

If the cash drawer is closed, the cashier presses the "No sales" key (POS or no sale), opens the cash drawer, places the money in the drawer, and gives change. As the sale is not recorded in either situation, the transaction is not included in the Z sales report totals or the sales summary.

b) Not printing on the control tape roll

The cash register is programmed to not print certain transactions on the control tape roll even though the transaction is recorded on the cash register as the Z report totals reflect all transactions.

For example, an electronic cash register is programmed so that negative-mode transactions, which allow the user to set the price to a negative number, are not printed on the control tape roll. At the end of the day, a negative-mode transaction is recorded to reduce the total sales; the transaction does not appear on the control tape roll, but reduces the total sales on the Z report.

The Z report sales amount is reported, which is less than the actual total sales on the control tape roll.

c) Exclude departments

A cash register is programmed so that certain transactions are not added to the totals on the Z report, even if a transaction slip is issued to the customer and the transaction appears on the control tape roll.

For example, the cash register is programmed so that transactions for a particular department are not added to the sales total, meaning they are not included on the Z report. The Z report sales amount is reported, which is less than the actual sales figure.

d) Add key to record sales

A cash register is programmed so that sales are recorded using two different keys, one of which does not record data in the cash register's memory. Transactions recorded using this key are not included in the sales total.

The Z report sales amount is reported, which is less than the actual sales figure, as the sales figure in the Z report only includes sales made using the normal key for recording sales.

e) Add a second memory

Usually all transactions entered on a cash register are recorded in its memory and the sales figure in the Z report is derived from the totals by category or department stored in its memory.

A second memory is added to the cash register and using a switch on the cash register, the memory where transactions are recorded is changed. For example, all sales between 4:00 p.m. and 8:00 p.m. may be saved on the second memory. At the end of the day, a Z report is printed from the first memory and only the sales recorded on that memory are reported.

f) Use training mode

Most electronic cash registers and computerized cash register systems use a training mode to train new employees. Transactions entered in training mode are not included in the actual sales total and do not appear on the control tape roll. Training mode is meant to be used for simulations, not for actual transactions.

Receipts produced in this mode will be marked "Training". A skilled programmer modifies the cash register's program so that "Training" does not appear on the receipts.

Knowing that transactions in training mode are not recorded in the actual sales total, a particular cash register or cashier is registered in training mode to hide sales.

g) Point-of-sale terminal registered under another business name

There are several cash registers to process transactions paid by credit card or debit card, each connected to a separate point-of-sale (POS) terminal. At the end of the day or shift, the terminals are closed; the bank, managing the POS terminals, deposits the total amount (batch totals per terminal) into the bank account and forwards a transaction report for each terminal.

It is more difficult to suppress transactions paid by credit card or debit card, as they appear on the POS terminal bank report. To suppress one cash register’s sales and not leave a trace of the transactions paid by card on that cash register, the bank is instructed to deposit the amounts into a separate bank account under another business name, as though it were a concession. These sales transactions are not reported and all trace is removed.

h) Partially record a sale for transactions with deposits

A deposit is required for a layaway or to order an item for a customer.

The customer is given a manually prepared receipt for the deposit. The deposit is not recorded as an instalment payment or as a sale on the cash register and the deposit is pocketed.

A cash deposit is easier to suppress, since credit card or debit card deposits appear on the POS report from the financial institution.

When the balance is paid, it is recorded in the cash register as a sale, with only part of the sale reported.

i) Manipulate sales taxes

Most cash registers have a feature to customize taxes. It is very quick and easy to make changes to calculate taxes at any time; examples include:

use a slightly higher tax rate than is in effect;
add an extra tax; and
charge a tax on non-taxable items.

At the end of the period, the books are adjusted to bring the amount of taxes collected to the correct amount and the extra amount collected is pocketed.

An adjusting journal entry at the end of the period can also be made to transfer a certain amount of taxable sales to non-taxable sales to affect the amount of taxes collected. Because the sales are taxable, an amount of collected taxes to be remitted to the government is pocketed.

j) Record fictitious transactions

Generally, net sales represent sales after subtracting:

discounts;
merchandise returns;
cancellations;
corrections;
negative-mode transactions; and
non-refundable store coupons.

Sales are decreased by fictitious transactions and/or cash register recordings, such as merchandise returns, and an amount equal to the fictitious merchandise return is pocketed.

k) Periodically omit deposits

Some sales are recorded based on bank deposits. Any sales not deposited are not reported in the sales journal and are pocketed.

l) Omit a cash register

There are several cash registers and not all sales are reported from one or more of them.

A particular cash register is used to ring in only cash sales, the register is hidden when not in use, and the sales recorded on it are not reported.

Or, only sales from some cash registers are reported, with claims that the others were never used.

m) Early or multiple closures

Cash registers are usually closed at the end of the day and the day's sales are posted from the financial report. The electronic cash register’s Z report is generated and the cash register is reset.

More than one Z report can be generated in a day and only the sales from one of the reports is posted, resulting in underreported sales.

n) Unreported day

Sales are not reported for one day. For example, with multiple cash registers, reporting the sales from one of them is skipped one day a week. The records show sales recorded every day, but some sales are not reported.

o) Record invoices by batch

Not all sales are recorded directly on the cash register. For example, a restaurant does not record sales on the cash register during rush periods, such as lunchtime. The cash drawer remains open and when a customer pays cash, the cashier takes the invoice and payment from the customer and makes change without recording the payment. All the invoices are recorded later at once on the cash register.

Each invoice is recorded at a lower amount, or only some of the invoices are recorded, and the unrecorded amount is pocketed.

At the end of the day, a financial report is generated to determine the total sales recorded and the cash is balanced using this total and the surplus is pocketed.

p) Re-ring method

Transactions already recorded are re-recorded to create a lower sales total. At the end of the day, the cash register is closed and the financial report is printed. The amount of sales to suppress is selected and the day's transactions are entered a second time on the same cash register or on another cash register kept in the office or elsewhere.

Suppressed sales are deleted by entering:

only a portion of the transactions;
all the transactions with a lower sales amount; or
a combination of the two.

To not leave any trace, the original financial report and the original data (control tape roll or computer file) are destroyed and the new financial report and new data (new control tape roll or new electronic file) are kept.

q) Erroneous entries in the sales journal

Usually the cash register sales amount is manually posted from the financial report to the sales journal.

Sales lower than the financial report amount, or no sales, are reported.

r) Change a method of payment

The method of payment for a sale is changed to hide cash taken from the cash register.

For example, a sales transaction to be paid by cheque at a later date is not reported. At the time of the transaction, the sale is not recorded on the cash register. When the cheque is received later, the cheque payment is replaced for a cash payment on the cash register for the day. The total amount of cash is reduced by the amount of the cheque and the amount paid by cheque is increased by the same amount. To balance the cash register, the cheque is placed in the cash register and an equivalent amount of cash is removed.

s) Correct (alter) and cancel invoices in computerized cash register systems

These suppression methods, often used in the restaurant sector, alter invoices or cancel them all together, using functions included in the cash register software to correct invoice errors.

To reduce sales figures after receiving payment, invoices are:

altered to reduce the number or types of items sold;
altered to give a discount;
altered to show a tip;
cancelled randomly; and
cancelled by batch.

t) Zapper programs

Using a computerized cash register system, sales are decreased by zapping. The computer program alters sales and renumbers invoices to maintain the integrity of the numbering system.

The cash register software manufacturer adds this feature or an independent program is acquired to be used for zapping.

The program writes new data to the original file. With different cash register reports, the changes are reflected and altered sales figures are posted to the sales journal.

To decrease sales, the program is launched using a secret code and the program makes one of these modifications:

decreases each invoice by a certain percentage;
suppresses certain invoices to achieve an approximate percentage of total sales and renumbers invoices;
suppresses certain invoices according to a set order, for example, every seventh invoice, and renumbers invoices; or
suppresses certain items from invoices, such as coffee or dessert.

The changes are applied to cash transactions or to any sales transaction, regardless of the payment method.

u) Cash register disconnected from the network

Usually several cash registers are connected to a network and transaction data from each cash register is transmitted directly to a central system, which produces cash register reports.

However, some computer systems enable cash registers to be operated in stand-alone mode or off-line. One or several cash registers is operated without being connected to the network to suppress sales.

Using a simple computer command, a cash register is disconnected from the network for a set period of time. Transactions continue to be entered on this cash register, but because the register is disconnected the transaction data is not transmitted to the central system and is stored on its hard drive.

A stand-alone cash register report is automatically generated by the cash register, indicating the total sales and the payment methods for transactions entered on the cash register during the disconnection period.

All data saved to the cash register's hard drive is deleted using special codes before reconnecting to the network to prevent the central system recovering the data from the cash register when it is reconnected to the network.

Since transactions paid by a credit card or debit card leave a trail, the transactions paid by card from the disconnected cash register are transferred to another cash register operating during the disconnection period, an equivalent amount from the cash sales on that register is deducted, and the cash is pocketed.

v) Other methods of suppression

Given the rapid evolution of the computer sector and the creativity of software designers, other increasingly sophisticated programs will be created to allow concealing income.

Using suppression methods creates many inconsistencies that demonstrate that not all income is reported, such as:

owner's lifestyle is higher than reasonable, given the reported income;
business' operations differ significantly from the norms for the sector;
obvious lapses of internal controls; and
unusual records in electronic files.

When the books and records are deemed to be adequate, accurate, and reliable, base the assessment on factual audit evidence contained in the taxpayer's books and records.

When the books and records are inadequate, inaccurate, or unreliable, regardless if they are verifiable, the auditor should consider an assessing IVI technique.

Before proceeding with an audit based on an assessing IVI technique, the auditor must be familiar with:

13.3.0, Indirect verification of income;
10.2.0, Books and records; and
10.2.3, Requirement to keep adequate books and records.

Suggested audit techniques

The world of electronic cash registers has evolved significantly. Most of these registers, intended for use by small business operators, can be purchased for less than $400. They offer many advantages over their predecessors: they are compact and lightweight, portable, have larger memory capacities, and need only one paper tape roll.

Although these are definite advantages to the business owner, these attributes pose more hurdles to overcome. Since the registers are easily portable and relatively inexpensive, more than one register can be operated, which could result in the opportunity to use one or more of the sales suppression methods discussed earlier. Hiding a second cash register out of sight when it is not in use may make it undetectable during on-site observations. As well, since the register only has one tape roll, used to print all customer receipts and some reports, printing a journal tape would be necessary instead of waiting for the roll to expire (as with the old-style electronic cash registers) and is at the discretion of the owner. The memory capacity in these cash registers can store transaction information for much longer periods of time; however, the information is lost (truncated) eventually (dependent on memory capacity), if the information is not printed.

Rely on IVI techniques whenever the cash register information cannot support the revenues recorded in the taxpayer's accounting system. At a minimum, the owner should still be printing Z reports to support sales and the auditor must understand the information on these reports. To verify the accuracy of revenues reported, it is important to examine control numbers, grand totals (GT), customer counts, cheque counts, cash receipt totals, etc. Consider reviewing current available memory data printouts for comparative analysis using similar periods of the taxation years under audit.

For computerized cash register systems or electronic cash registers connected to a computer, work in close co-operation with the computer audit specialist (CAS).

Suggested audit procedures to audit cash registers are available in the Integras Template Library, Audit Techniques for Cash Register Systems and Questionnaires for Cash Registers and Other Systems.

The audit techniques depend on the type of records the taxpayer keeps:

Z reports and control tape rolls;
Z reports but not the control tape rolls;
does not keep the Z reports or the control tape rolls;
electronic data; or
does not keep the electronic data, but the traditional records are available.

Use the audit techniques available in the Integras Template Library, Audit Techniques for Cash Register Systems/Auditing Computerized Cash Register and Stand Alone Systems, A-13.2.4, when a cash register is disconnected from the network. The audit techniques depend on the taxpayer's specific situation:

keeps the electronic data and the system for recording transactions paid by credit card or debit card is integrated;
keeps the electronic data, the system for recording transactions paid by credit card or debit card is not integrated, and each cash register is connected to separate point-of-sale (POS) terminal;
keeps the electronic data, the system for recording transactions paid by credit card or debit card is not integrated, and cash registers are not connected to separate POS terminals;
does not keep the electronic data, traditional records are available, the system for recording transactions paid by credit card or debit card is or is not integrated, and each cash register is connected to a separate POS terminal; or
does not keep the electronic data, traditional records are available, the system for recording transactions paid by credit card or debit card is or is not integrated, and cash registers are not connected to separate POS terminals.
Some basic bookkeeping principles that apply when using cash registers include:
The electronic cash register’s control tape rolls (copy of cash register receipts) constitute the business's sales invoices and are part of the records to be given to conduct the audit. For more information, see paragraph 7 of Income Tax Information Circular IC78‑10R5, Books and Records Retention/Destruction.
When a computerized cash register system is used to generate records or books of account, the electronic media must be kept, even if a paper copy is kept. A backup copy of electronic records must also be kept at all times in accordance with subsection 230(4.1) of the ITA. For more information, see paragraph 8 of Income Tax Information Circular IC05‑1R1, Electronic Record Keeping.
Paper and electronic books and records, as well as accounts and supporting vouchers necessary for their validation, must be kept for a period of six years from the last taxation year to which they relate pursuant to subsection 230(4) (go to subsection 230(5) for extension period for non-filers).
When a turnkey or packaged software is used to keep electronic books and records (computerized cash register system), the taxpayer is responsible to keep adequate records notwithstanding the deficiencies in the software. A taxpayer cannot disclaim responsibility for defects in the software used. For more information, see paragraph 23 of Income Tax Information Circular IC78-10R5, Books and Records Retention/Destruction.

Observation of the business operations

Observe the business operations to assess the credibility of the books and records kept by the taxpayer.

For example, if the auditor observes that the cashier does not enter all sales on the cash register, despite the fact that the taxpayer gives all documents generated by the cash register and the reports produced balance with the financial statements, the books and records are inadequate because a portion of the sales are not recorded.

To assess the credibility of the books and records, use the questionnaire, General Questions for Cash Registers, in the Integras Template Library, Questionnaires for Cash Registers and Other Systems.

Observing the owner or shareholder's lifestyle may suggest a discrepancy to indicate amounts are used from undeclared sales for personal purposes.

Observation of the equipment

Examine each cash register to gain a better understanding of its operating capabilities and the various reports and information produced. Use the questionnaires in the Integras Template Library, Questionnaires for Cash Registers and Other Systems.

Determine the number of cash registers used and their locations, the number of POS terminals attached and the various functions, and how various transactions are processed.

Observation of the documents

Examine the cash register reports generated by the cash register system. If documents for the period prescribed by the ITA have not been kept, the books and records are deemed to be inadequate. Prepare a written request to the taxpayer to list the inadequacies, and confirm the request made for corrective action. For more information, go to 10.2.3, Requirement to keep adequate books and records.

When analyzing the Z reports:

determine how often a Z report is printed (for example, daily, weekly);
check if there are Z reports for each cash register;
check the date and numerical sequence of the Z reports for each cash register to determine if all Z reports are available for audit;
compare the print of the reports including style, size, font, etc., to make sure they are the same;
determine the total used for posting sales to the sales journal; the amount should be the net sales before GST/HST or PST;
reconcile the sales amount reported in the sales journal to the totals from the Z reports for each cash register;
conduct some comparative analyses of sales from one day to another, for example, compare gross sales, net sales, sales by department;
make sure controls are in place to apply the proper percentage of tax and to make sure the calculation complies with the legislation on rounding of amounts;
reconcile deposits by method of payment (for example, cash, cheque, credit card, debit card, vendor coupons) to the Z reports;
analyze the various types of transactions, such as vendor coupons, store discount coupons, withdrawals, merchandise returns, cancellations, corrections, negative-mode transactions, rebates and discounts, POS transactions;
analyze the training mode to determine if the employees who used this mode are new employees; if not, determine why this mode was used; and
compare the sales data per employee to the hours worked if the taxpayer requests an addition to the Z report by cashier.

Also analyze the control tape rolls; spot check to:

verify if control tape rolls are available for each cash register;
compare the style, size, font, etc. of the print on the control tape rolls and reports;
analyze the chronological order of the transactions on the control tape roll to determine if there are missing periods;
examine the numerical sequence of the transactions to make sure there is no break in the numbering; ask for an explanation of breaks;
analyze the transactions on the control tape rolls to identify any questionable transactions, such as a high number of POS transactions, cancellations at the end of a day, high sales amounts;
add the transactions on the control tape roll to identify the use of a suppression method, such as a non-add department, second memory, or two sales keys;
verify for manual entries on the control tape roll; a portion of the control tape roll with the totals for the day may be torn off and a lower sales figure manually entered;
check if any transactions were paid by a credit card or debit card using the POS terminal bank report; if so, identify the transactions on the control tape roll and determine if the amounts are entered and if the information, such as date, time of the transaction, and amount, is the same;
compare manually prepared invoices, if used, to the control tape roll to make sure that all transactions are recorded on the cash register and that the amounts match; if not, a new cash register may have been acquired or Z reports may be printed on a hidden cash register; and
determine the elements that make up the various totals on the Z reports. These amounts represent cumulative totals from the later of the last time the cash register was reset or the time it was instaled. The names of these totals may differ depending on the model of the cash register. Also refer to the user's manual for the cash register for information about the various totals.

If a POS terminal is used for card transactions, many documents can be analyzed, for example:

reconcile the amount of deposits by card shown on the Z report to the closure of POS terminal batches;
reconcile the batch closures to the POS terminal bank reports;
reconcile the batch closures to the payment by card reports;
use a sample to reconcile the report of payment by card to the transaction records;
examine batch closure documents from the POS terminals to determine which terminals were in operation; and
use a sample from the control tape rolls to check if the cash registers connected to the inoperative POS terminals were actually inoperative.

Many reports can be generated when a computerized cash register system is used. Even though the names of the reports are different from those produced by electronic cash registers, they serve the same purpose. As the information is in electronic format, a CAS should help the auditor.

Manipulating electronic sales data to suppress sales can result in errors or inconsistencies. The auditor and CAS:

Analyze the names of the sales files. Some cash register software creates sales files with different names when the original data is modified.
Check if there is more than one sales file for a single day. If there are two closures in one day (which is unusual), some cash register software creates two files with different names.
Analyze the date the sales files are created. For example, at closing every day, a different sales file is created for each day. A missing file for one day raises questions.
Analyze the time the sales files were created. For example, night processing could mean that cash registers are closed automatically after business hours. A cash register being closed early raises questions.
Check if there are modification dates for the files. For example, if the sales file for a specific day is modified, at a later date, the file properties will have a date the original file was created and a modification date. Analyze modifications.
Compare the size of sales files. Question if two sales files for comparable days are not roughly the same size.
Check for inconsistencies in files other than sales files. The information entered on the cash registers is saved in various files, for example: sales files, inventory files. Even if a sales file is modified to suppress sales, other files may not have been modified, resulting in inconsistencies between the files.

Review documents to identify certain inconsistencies, such as:

some bank deposits do not correspond to the sales reported;
significant discrepancies between the hours worked and the times recorded on sales invoices;
analysis of documents generated by the cash register shows that one cashier worked on two cash registers at the same time;
some invoicing is conducted outside business hours; and
analysis of purchases of a certain product reveals a discrepancy with the sales reported.

Private automatic teller machines

A private automatic teller machine (ATM) may be made available to clients even though the taxpayer accepts credit card or debit card payments. This type of banking machine operates in the same way as an automated banking machine owned by a financial institution, except that the client can only make withdrawals and the taxpayer receives a percentage of the fees charged to the client for the transaction (convenience fees). Ask for a copy of the reports it generates to properly understand how a private ATM works. The auditor can also contact the ATM provider for the user manual. Ask the electronic banking transaction service provider for a copy of the service contract and reports of convenience fees earned by the taxpayer to make sure they are reported. For more information, go to 10.6.0, Obtaining information from third parties.

Vending machines

Vending machines are in many businesses, such as supermarkets, pharmacies, business cafeterias. The machines often sell soft drinks, bottled water, candies, or coffee.

To easily manage the sales, vending machines are equipped with a display to read the counters, but the vending machines do not print statements. Generally, the counters offer:

cumulative grand total (GT);
amount of sales (total and/or by product) since the last reset (Z counter); and
number of products sold (total and/or by product) since the last reset (Z counter).

Ask how the vending machine works and learn what controls exist over it, how receipts are balanced, and the method used to record its income. Also ask the taxpayer to demonstrate reading the counters, contact the vending machine supplier for the user manual, or ask how the machine works. Make sure that all income from the vending machine is reported. For a detailed list of questions, see the Integras Template Library, Questionnaires for Cash Registers and Other Systems/A‑13_8_7 Appendix G - Vending Machines.

13.9.17 Forms of payment

Reconcile all forms of payment to the total sales as an audit procedure. The more common forms of payment are cash, cheque or money order, credit card and debit card. Specific procedures by method of payment follow.

Cash, cheques, and money orders

Cash, cheques, and money orders are generally recorded in the same way. However, cheques may be returned to the taxpayer as non-negotiable for insufficient funds, closed bank accounts, stop payments, etc. As a result, the taxpayer may incur bad debts related to accepting cheques. Money orders are most common in the mail order business or if payments are made in a foreign currency.

Suggested audit procedures

Include these audit procedures:

Determine who handles the cash and if it is kept before deposit.
Determine how the proprietor verifies that all cash is deposited if employees handle cash.
Determine how the total daily receipts are determined.
Reconcile a sample of the deposits to the till tapes, if a cash register is used.
Determine if the daily receipts are balanced to the bank deposits.
If sales are recorded net of expenses, determine if there is potential for duplicate recording of the expense.
If cash or money orders in a currency other than Canadian funds is accepted, determine how the difference in exchange rates is handled. A currency exchange gain/loss account may be used and the difference included as other income (or expense) at year-end.

Example:

The taxpayer accepts American currency at an exchange rate of 1.40.

The customer's purchase totals $54.96 (Canadian).

The customer gives the clerk $50 US.

The bank exchange rate is $1.455.

Amount of sale $54.96

Cash received ($50 x 1.40) 70.00

Change to customer (Canadian) $15.04

Effective bank deposit ($50 x 1.455) $72.75

Difference in exchange $ 2.75

Auditing debit cards

Unlike cheques, there is limited risk to the taxpayer once the transaction is completed and approved at the time of sale.

The sale is difficult to suppress if payment is made by debit card. There is no deposit prepared for debit card transactions, as the funds are automatically transferred and appear on the taxpayer's bank statement. However, the taxpayer may substitute debit card transactions for cash in the same way that cheques may be substituted for cash; a debit card sale for $20 is remembered and a cash sale of similar amount is not rung through, the money is pocketed.

The taxpayer is charged a fee for debit card transactions similar to the fees paid for credit card transactions. The same equipment is used for credit cards and debit cards. A cash register is not needed to process debit card payment.

Suggested audit procedures

Include these audit procedures in the Audit Plan:

Make sure that deposits from debit card receipts are made to a known bank account.
Reconcile the total debit card receipts to the bank deposits.
Make sure that the taxpayer is not substituting debit card receipts for cash.
Reconcile the fees charged by the bank and compare to the agreement with the banks to determine the reasonableness of debit card receipts.

Auditing credit card payments

Although credit card sales are more difficult to suppress than cash sales, be aware of the cards accepted by the taxpayer and the bank accounts related to the various credit cards. A fee is charged for credit card transactions similar to the fees paid on debit card transactions. The same equipment is used for both credit card and debit card transactions. A cash register is not needed to process credit card payment.

Suggested audit procedures

Audit procedures should include:

Make sure that deposits from credit card receipts are made to a known bank account.
Reconcile the total credit card receipts to the bank deposits.
Make sure credit card receipts are not substituted for cash.
Reconcile the fees charged by the bank and compare to the agreement with the banks to determine the reasonableness of credit card receipts.

13.9.18 Methods of suppressing income

Sales debited or credited directly to accounts receivable

Sales may be suppressed by debiting or crediting a portion of sales to accounts receivable. The result of a credit entry is a credit recorded on the customer's receivable account and a general understatement of the receivables. To clear the credit on the customer's account the taxpayer may:

write a cheque to cash when the amount is appropriated;
leave the credit indefinitely; or
adjust the receivables by preparing an adjusting journal entry to credit another asset account.

A debit to accounts receivable will usually result in recording a payment received without a corresponding sale and a credit to an asset or liability account. This results in an understatement of assets or an overstatement of liabilities. The debit to the accounts receivable entry will be cleared when the customer remits payment. The taxpayer will likely clear the credit in the asset or liability account by:

writing a cheque to cash;
using an offsetting suspense or miscellaneous account as a clearing account that is brought to zero at year-end.

Suggested audit procedures

Audit procedures should include:

Review credit balances in the accounts receivable sub-ledger to determine their cause and verify their authenticity.
Review journal entries that debit accounts receivable.
Verify that the accounts receivable sub-ledger balances to the control account.
Review accounts receivable to determine if there are any false accounts that may be used as a clearing account for misappropriated funds.

Suppressed collections

Verifying that cash receipts are recorded for all accounts receivable outstanding as at year-end gives assurance that the receivable reported was in fact accurate. If there is no audit evidence of collection of an outstanding amount and the receivable is not reported as outstanding in the following year, the amount may have been written off as a bad debt, the customer may have returned the goods or the money collected may have been suppressed.

Hiding suppressed cash

Possible methods of hiding suppressed cash include:

undisclosed bank accounts;
using cash received for personal living expenses;
expensing personal and business capital improvements;
safety deposit boxes; and
loans to others.

Internal controls

One method to control the cash account is to use a cash clearing account. The account is debited when cash is received and credited when cash is deposited. The balance equals outstanding deposits. Review any journal entries to the cash clearing account.

Unreported income

Indicators of unreported income include:

an unusual number of "no sale" entries on cash register tapes;
missing or hand written totals on cash tapes;
sales not reported for each day of business;
no deposits for payments made by credit card or debit card, but it is apparent that the taxpayer accepts these forms of payment;
many adjusting journal entries to reconcile accounts receivable or to other balance sheet accounts; and
inventory or purchases cannot be reconciled to sales (the units purchased exceed the units sold).

Verifying unreported income

Other records and methods can be used to identify unreported revenue. These include:

Verify with third party.
Determine if purchases and expenses are excessive when compared to reported sales.
Calculate the gross margin and compare to similar businesses.
Trace a sample of goods through to sales to verify that sales are reported for them or they are still in inventory.
Review appointment books and diaries and compare to sales.
Review delivery addresses of supplies to make sure that sales are reported for work at the addresses shown on the delivery slips.
Review licenses and permits issued by local authorities to determine that sales are reported for all locations for which a permit or license was issued.

Internal control considerations

Review the internal control system to determine if:

goods could be shipped without billing;
duties are segregated; and
shipments are made directly to the customer from the supplier.

Review the order and sales system by tracing a transaction from receipt of the order to receipt of payment. Audit procedures concentrate on areas where controls are weak.

Cancelled sales invoices

Ask for a copy of cancelled invoices. Determine how cancelled invoices are authorized and what controls, if any. Make sure that the transaction was, in fact, cancelled and not simply marked void to suppress the sale. An unusual number of cancelled invoices may show that sales are being suppressed using this method.

Missing sales invoices

If the audit procedures show missing invoices, more procedures are required to confirm the completeness of sales. Shipping records, delivery slips, order books, and freight bills can give the information necessary to confirm if goods were or shipped or may show a replacement invoice for a cancelled invoice.

If a significant number of missing invoices is noted, look for a pattern. It is possible that sales on certain days of the week or certain times of the day are suppressed by some means.

Journal entries

Review journal entries that make material adjustments to sales to make sure that information is available to support the adjustment and that the adjustment is logical based on the explanation given. A significant number of adjustments that result from credit notes issued may show a weakness in controls.

Unidentified deposits may show that a sale was in fact made and that the transaction was reversed by journal entry.

Returned sales

Review a sample of sales returns. Unidentified deposits may show that a sale was in fact made, but that a credit note was issued to cancel the transaction.

Inadequate records

If records are inadequate, indirect tests may be required to determine the reasonableness of reported sales. The risk of revenue loss due to inadequate records increases when the business is owner operated due to the absence of effective internal controls. Take appropriate action to make sure that adequate records are maintained in the future.

For more information, go to:

13.3.3, Inadequate, inaccurate, or unreliable books and records;
13.7.0, Testing and sampling; and
10.2.3, Requirement to keep adequate books and records.

13.9.19 Unidentified deposits

If bank deposits cannot be traced to reported income, determine the source of the funds. Possible sources of funds include:

bank loans;
loans from family members;
supplier rebates;
bank transfers;
disposition of assets; and
GST/HST or income tax refunds.

Discuss unidentified deposits with the taxpayer. If the taxpayer agrees that the unidentified deposits are income, request written confirmation. If the taxpayer confirms in writing that the unidentified deposits are income, assess income tax based on the unidentified amounts.

For more information, go to 13.5.0, Assessing unidentified bank deposits technique.

Non-arm's length sales at less or more than fair market value

Review non-arm's length transactions to determine if sales and dispositions are at fair market value. Verify only transactions with material tax consequences. These transactions are generally most often for sales of products that are general household items or dispositions of fixed assets. Review the dispositions of fixed assets, such as vehicles, to make sure that consideration is adequate.

Recovery of bad debts

Review the process and policy for the recovery of amounts previously written off to make sure that a recovered amount is included in income.

Sale of repossessed merchandise

The business may include the repossession of merchandise. If repossessed merchandise is sold, the sale must be added to income. Repossessions are often handled by a bailiff or collection agency and the fees paid for the service by the taxpayer may show the extent of repossessions.

Audit procedures include:

Determine how the cost and sales of repossessed merchandise are recorded.
Determine how the taxpayer disposes of the outstanding account receivable.
Determine if the receivable has been claimed as a bad debt expense.
Make sure that the repossessed merchandise is in inventory or that a sale is recorded.

Consignment sales

Generally speaking, goods on consignment are not treated as a sale until the consignee reports the merchandise sold. Audit procedures include:

Review the documents used to record sales of goods on consignment.
Make sure that goods held on consignment are not included in inventory; until the goods on consignment are sold, include in the consignee’s inventory.
Review commissions paid to the consignor to determine the extent of sales made on consignment.

Barter transactions

Barter transactions are the exchange of goods or services between two parties. If the income and expense are for business use, both income and expenses are understated. If the expense incurred is of a personal nature, the income of the supplier is understated.

Personal consumption of goods and personal use of assets

Include the value of goods consumed or taken from stock by the taxpayer and their family in income on the T1 Income Tax and Benefit Return. If the taxpayer resides in a building used for business purposes, only the portion of operating costs and CCA for business use is claimed as an expense. Prorate the expenses attributed to personal use and adjust based on the actual expenses incurred.

Miscellaneous income

Common sources of miscellaneous income include:

service or instalation fees at the time of sale;
fees for clothing alterations;
repairs and alterations to furniture and fixtures;
additions or extras in the construction industry;
deposits or down-payments on sales (these may be deposited to an undisclosed bank account);
sales of scrap or by-products;
sales of salvaged items (prevalent in the automobile repair industry);
commissions on vending machine sales (juke boxes, pinball, pay telephones, soft drinks, and snacks);
cash discounts or volume rebates;
royalty or commission income;
freight rebates or damage claims;
insurance proceeds;
provincial gasoline tax refunds or federal excise tax refunds;
refunds of deposits on containers or tenders on contracts;
investment income (dividends, bonds, bank interest, mortgage interest);
rental revenue (equipment and real estate);
parking revenue; and
administrative or management fees.

Be aware of potential sources of miscellaneous income, since the income may not be reported.

13.9.20 Auditing purchases and expenses

Introduction

The taxpayer is likely to keep as much audit evidence as possible to support expenses unless the expenditure is related to suppressed income. Audit procedures not only verify the expenses claimed, but also give assurance that the expenses were incurred to earn income. Audit procedures may determine that expenses claimed include amounts incurred to earn income that is not reported.

Audit procedures are adequate and appropriate to make sure that the expenses claimed were incurred to earn income; make sure that documents to support the expense are available. The time spent auditing expenses is related to the assessment of risk made in the planning stages of the audit in process. It is mandatory to include in the audit file, documentation of adequate risk assessment and audit planning.

13.9.21 Auditing the recording of expenses

There are many ways to record expenses and the auditor must understand the accounting system used to record the transactions. It may be a sophisticated computerized system that is fully integrated with the various accounting modules (purchases, inventory, sales, accounts receivable, accounts payable, and financial statements) or a manual system that consists only of purchase invoices, cancelled cheques and bank statements.

In the preliminary stage of the audit, trace a purchase from initiation of the purchase order through to the cancelled cheque. Weaknesses in the system may become evident at this early stage and help determine the audit procedures and the amount of detailed testing required. Existing internal controls may become clear to start to design tests that verify the effectiveness of the internal controls.

13.9.22 Claiming expenses

Virtually all taxpayers, except farmers and fishers, must use the accrual method of accounting to claim expenses. In some cases, expenses are recorded on a cash basis throughout the year with an adjustment at year-end for outstanding accounts payable. Make sure that documents meet requirements.

Internal control

Taxpayers who have an established routine that is consistently used to record expenses are more likely to have internal controls in place, limiting the potential for material error. Expenses recorded promptly are more likely to be recorded accurately than expenses recorded sporadically.

During the preliminary stage of the audit, determine if internal controls are in place and if they are functioning effectively and as described.

Cut-off techniques

Verify the cut-off procedures at year-end and at the end of reporting periods as a standard audit procedure. If an adjustment has been made at year-end to determine net income for income tax purposes to accrue expenses, the audit procedures ensure that there are sufficient documents to support the expense claimed and that the accrual is not based on estimates. Review the next year to make sure that the expense is not duplicated.

Cut-off errors are timing adjustments and may be isolated or recurring. Advise the taxpayer of the errors and the requirements of the relevant legislation. Expenses disallowed in one period as a result of a cut-off error will be allowed in a next reporting or fiscal period. Adjust material errors.

Adjustments to purchases

The effect of any adjustments to purchases for discounts, volume rebates, or returns is to reduce the cost of goods sold or the expense incurred for income tax purposes. Audit procedures verify that such adjustments have been properly recorded, including:

Determine the procedures to record shortages in shipments received or damaged goods.
Determine how cash refunds from suppliers are recorded by the taxpayer.
Determine, if possible, the supplier's policy to issue refunds and make sure that the taxpayer's description is according to the supplier's policy.

Purchase discounts

Purchase discounts may be in the form of a price adjustment or a prompt payment discount. The recorded expense is the net amount of the purchase after the discount. Review supplier statements for adjustments to verify that the taxpayer has recorded discounts received.

Volume rebates

Suppliers often issue volume rebates based on annual purchases with a refund cheque or a credit issued on the account to be applied against future purchases.

Purchase returns

Suppliers may issue a credit for returns with a:

cash refund;
credit note that is later redeemed for cash; or
credit to be applied against future purchases.

Auditing expenses claimed without supporting vouchers

If expenditures are not supported with the appropriate documents, disallow the expense unless there is other satisfactory audit evidence to support the amount claimed. Indirect audit techniques may be used to determine the reasonableness of expenses without supporting documents.

Any missing voucher may be significant regardless of the fact that most other vouchers are available for verification. Consider the nature of the transaction, the amount involved, and the taxpayer’s explanation to decide whether to ask for the supporting documents or information from a third party.

Use judgement if minor items are concerned. If there are many small items that are not supported by voucher or if the taxpayer has been advised in the past to keep supporting information, an adjustment may be warranted.

If the taxpayer does not have a formalized system of filing purchase invoices, give a list of invoices to the taxpayer and time allowed to locate them for review.

A cancelled cheque is not sufficient audit evidence to support a claimed expense. A statement of account or credit card statement is also not sufficient audit evidence. Examine the source document to verify significant expenditures.

The form of payment may indicate concern. If expenses are normally paid by cheque, include cash payments for significant expenses in the sample selected for testing.

Auditing prorated expenses

If the taxpayer purchases supplies or uses capital property for both business and personal use, only the portion of the expense or capital cost used for business purposes is deductible for income tax purposes. The allocation must be reasonable under the circumstances. If the expense claimed is for the business use of a vehicle, a mileage log is strongly suggested, but other methods to determine use have been accepted by the courts. For more information, go to Motor vehicle records.

Examination of vouchers

Examine the sample of vouchers selected for testing to make sure they are valid and give the required support for the expense claimed.

Review the selected vouchers to make sure that the event or transaction occurred. Verify that:

receipts for hotel and transportation costs are supported by travel expense claims or business reasons for being at that locale;
a creditor's invoice or some other appropriate document supports a liability to a creditor; monthly statements may be useful to make sure that the liability is valid, but are not in and of themselves valid documents for supporting expenses claimed;
if a voucher refers to another document, such as a contract or agreement, examine that document;
journal entries are supported by the appropriate documents;
purchases made are congruent with the taxpayer's business;
if there is an established procedure for the receipt of goods or supplies, any changes or anomalies are closely examined;
if delivery slips are attached to purchase invoices, any invoice with a missing delivery slip is queried;
freight or delivery slips that are not pre-printed with the company name and address are valid; examine the disbursement records to make sure that the amount was actually paid;
deviations from normal payment procedures are valid (that is, if suppliers are generally paid in 30 days by invoice, payments on account to one supplier may show that the purchaser and the supplier have a mutually accommodating arrangement); and
significant purchases from unknown suppliers are valid including examining the cancelled cheque issued for payment.

More analysis may be needed if:

pricing is noted on packing slips;
handwritten freight or purchase invoices, if usually they are typed (or typed, if they are normally hand-written);
multiple copies of purchase invoices are received by the taxpayer;
the colour of invoice paper is not consistent;
the taxpayer normally uses purchase orders and no reference to a purchase order is made on the purchase invoice;
quantities purchased are unusual or the quantity does not match the delivery information; and
verification of receipt of the goods is by someone who does not normally work in the shipping area.

Fictitious vouchers

Scan the purchase journal for large or unusual purchase amounts. Query transactions that do not agree with the normal business activities. Specific items to watch for include:

changes or additions on vouchers (including changes made using corrector or any other method of adjusting quantities or amounts);
any form used by a supplier that is different from the supplier's normal form;
vouchers issued that do not match the transactions shown on the statement; and
unusual entries at year-end may include fictitious entries that the taxpayer is claiming to reduce taxable income.

Auditing of cheques payable to cash

If cheques are made payable to cash, make sure that supporting documents are available. If possible, determine the reason for making the cheque payable to cash instead of the supplier or individual. Review the banking information, such as:

where was the cheque cashed;
which bank cleared the cheque; and
does the taxpayer have an account at the bank that cleared the cheque.

Journal entries

Analyze debits to purchases or expenses if the credit is to drawings or a personal account for expenses paid using personal funds. Allow only if proper vouchers support the amount claimed.

Personal expenses

When scanning the purchase journal, watch for:

purchases from suppliers that do not carry goods that would be used in the normal business activity;
purchase invoices made out to the taxpayer personally or to a family member; and
invoices where the delivery address is the taxpayer's residence.

Personal purchases may be paid by credit card. Scan the credit card statements to determine if the purchases include personal items. Make sure that the taxpayer has not claimed personal travel as a business expense.

If the business activity includes selling or purchasing products that are general household items, the risk of personal use of products increases and it may be necessary to conduct supporting indirect verification of income (IVI) tests to determine if unreported income is indicated. For example, the taxpayer's residence may be in an area that would not normally be affordable given the reported earnings. A source and application of funds test can be prepared. An assessing net worth technique may be required if material amounts are involved.

Travel and entertainment expenses

During the review of travel and entertainment expenses, consider:

Were the travel expenses incurred for business or personal purposes?
Was the purpose of the travel mainly about the acquisition of capital assets, disposition or reorganization of a business? If so, the expense must be added to the cost base and claimed as CCA.
If another person accompanied the taxpayer, is that person an officer or employee of the company?
To account for meals and other incidental expenses without vouchers, request the diary or itinerary of the traveler.
Are vouchers for gasoline signed by family members who are not employees? These may be used to help establish the personal use of an automobile.
Were expenses claimed for substantial gifts to clients or prospective clients? If so, make sure that the gifts are a legitimate business or advertising expense and not a personal gift from the taxpayer.

Food, beverage, and entertainment expenses are allowable, subject to the 50% limitation,

if the expense was incurred for business purposes, the amount is reasonable, the expense

is supported by vouchers and the expense is not otherwise restricted (club dues or memberships).

Auditing of expenditures that should be capitalized

Review expenditures to make sure that expenditures to be capitalized have not been expensed. Audit procedures include:

Make sure that mortgage payments are properly allocated to interest expense and principal.
Query legal bills; decide if the expense is allowed or if it is to be capitalized. For more information, go to Income Tax Interpretation Bulletin IT99R5‑CONSOLID, Legal and Accounting Fees.
Make sure that property taxes paid in the period before acquisition and in the period after disposition are capital expenses.
Make sure that installation costs, freight, customs duties, and foreign exchange are added to the acquisition cost of the capital asset.
Make sure that major repairs or alterations and improvements are capitalized. Examine the repair expense account to decide if any amounts are to be capitalized. In some cases, the voucher may not be enough to decide if an amount is a capital or current expense. Other correspondence may be available to establish the nature of the costs incurred. For more information, go to Income Tax Folio S3‑F4‑C1, General Discussion of Capital Cost Allowance.
Verify if repairs done as part of a general reconditioning or improvement project need to be capitalized.
Verify if the purpose of repairs is to put the property in a saleable condition, if so, the costs are capitalized.
Make sure that the costs of repair or alteration are capitalized if buildings or equipment are acquired that are in need of major repairs or alterations.
Verify if equipment purchased in components is incorrectly expensed instead of capitalized.
Verify if expenses incurred as the result of the disposition of an asset (commissions, legal expenses, transportation costs, etc.) are deducted from the proceeds of the disposition and not claimed as a current expense.

Classification of assets

Review how assets are classified to make sure that the asset is in the correct class. Incorrect classification may result in overclaimed CCA.

Auditing the allocation of real estate costs

When reviewing the classification of assets, make sure that a reasonable allocation of the cost of real estate is for land. If the land is undervalued, the taxpayer may be overclaiming CCA on the buildings and other structures located on the land. For more information, go to Income Tax Interpretation Bulletin IT79R3, Capital Cost Allowance – Buildings or Other Structures.

If the allocation is questionable, the case may be referred to the Real Estate Appraisal section. It is mandatory to include a copy of all referrals and resulting reports in the audit file.

This may be useful to determine if the allocation of the cost is reasonable:

Use land registry office information and compare the price to similar land in the vicinity.
Review the most recent city or municipal property tax assessment. The assessment may include a division between land and buildings. The actual value may not be realistic, but the relationship of the land to total value for assessment purposes can be used to determine the reasonableness of the allocation on acquisition.
The statement of adjustments prepared by a lawyer or a notary may include an allocation to the separate values of land and buildings.
If the primary purpose of the acquisition was to acquire the land, allocate the entire cost to the land.

Non-arm's length acquisitions

If the taxpayer acquires property from a person that is not at arm's length, make sure the transaction is recorded according to subsection 69(1) of the ITA.

Dispositions

Follow these procedures to review dispositions of fixed assets:

The asset account is credited with the lesser of the proceeds of disposition or the capital cost of the asset sold. If the individual cost of the asset is not known, the proceeds of disposition are credited.
Make sure that CCA is not being claimed on assets that have been disposed of. Review of insurance policies may be useful to show existence of assets on the capital asset schedule.
Proceeds of disposition are recorded net of any related costs (for example, commission and freight).

Auditing of capital cost allowance

Review the CCA calculated to make sure the expense claimed is free from material error.

These areas of risk may result in overclaimed CCA:

If the assets are acquired during the latter part of the fiscal year, make sure that the property is available for use.
If real property is acquired during the latter part of the fiscal year, make sure that title has passed and that the asset is eligible for the taxpayer to claim CCA.
If the taxpayer does not use a double entry bookkeeping system, make sure that an item is not written off to a profit and loss account and set up as a depreciable asset.

Auditing of bad debt expenses

To review bad debt expenses, consider:

Does the bad debt expense include any amount receivable from the proprietor, a partner, a shareholder, or a family member? This relief is not normally available on bad debts arising in respect of supplies made between parties not dealing at arm's length.
If amounts are written off, were they included in income when the sale originally took place? If income is reported on a cash basis, there is no bad debt expense.
Are there any bad debt recoveries? Make sure that such recoveries are included in income.
Did the taxpayer use the services of a collection agency? Review available correspondence.
Are any bad debts written off prematurely?
If merchandise is repossessed, how does the taxpayer return the goods to inventory? Are the repossessed goods sold at reduced prices? Be certain that such transactions are properly reported.
If the amount written off is a large amount, is there audit evidence that every means of collection was attempted?
Is the taxpayer still carrying on business with the debtor? Is the debtor still in business? Is the debtor still solvent? Review the debtor’s T1/T2 and GST/HST accounts. Would a reserve for doubtful accounts be more appropriate than a bad debt write‑off?

Audit procedures include:

Review the current year write-offs.
Compare the current year's bad debt expense to that for prior years.
Determine if collection action was taken before write-off.

Reserve for doubtful accounts

Review the basis to calculate the reserve for doubtful accounts. Apply these rules:

There must be a debt.
Unless the debt is the result of a loan and the taxpayer's business includes the lending of money, the amount must have resulted from a transaction that was included in income in the previous year.
Collection of the outstanding amount must be questionable.
The amount of the reserve must be reasonable.

Paragraph 18(1)(e) of the ITA prohibits the deduction of reserves for contingent liabilities. This paragraph applies to all taxpayers whose business requires that loans and advances be made in the ordinary course of business. The paragraph prohibits a reserve against advances to suppliers, loans to employees, or other amounts that were not included to compute income in a previous fiscal period.

Whether a debt is doubtful is a question of fact. Collection after write-off does not show that a debt was not doubtful at the time. Normally an analysis of the accounts receivable is completed to determine if the collection of any individual amount is doubtful. An aging analysis, together with past experience and present business conditions, is used to determine the amount in doubt. The reserve is not merely calculated as a percentage of total receivables.

The amount claimed as a reserve in one year is included in income in the following year. The requirements must be met each year.

To review the reserve for doubtful accounts, consider:

How is the reserve determined?
Review the company's bad debt write-off policy. If debts are written off quickly, the reserve is lower than otherwise expected.
Compare current write-offs to prior years.
Are there significant recoveries of amounts previously written off?
Do the current economic conditions dictate a change in the reserve calculated?

Reserves are not allowed for:

purchased accounts receivable;
loans to employees, unless the employer's business includes the lending of money;
advances to suppliers or others unless it is customary under the circumstances to make such advances;
discounted notes or bills receivable;
bottle deposits;
guarantees, indemnities, or warranties;
anticipated refunds or price adjustments on products sold;
cash or volume discounts to customers;
contingent liabilities, such as claims that are being contested (deductible only when determined);
inventory reserves; and
declines in the market value of investments.

For more information, go to Income Tax Interpretation Bulletin IT154R, Special reserves.

Audit of the payroll expense to detect errors

To review payroll expense, consider:

Review cheques payable to cash to make sure that the funds were paid out.
Review endorsements on cheques.
Query payments to employees if no deductions are withheld.
Determine if salaries or wages are paid to a proprietor's spouse or common-law partner, and if they are reasonable.
Are wages paid to any relatives that do not appear to perform any services for the business?

Auditing of advertising and sales expenses

The advertising or sales expense accounts are often used as a catch all expense account. Review material items charged to these accounts to make sure that the expenses are deductible. Entertainment expenses, donations, commissions, gratuities, and non-accountable allowances may be included in advertising expenses.

Limitation of advertising expenses

Sections 19 and 19.1 of the ITA limit the deductibility for income tax purposes of fees paid to non-Canadian newspapers and periodicals or for commercials broadcast by a foreign broadcasting undertaking.

In many situations, the U.S. parent corporation handles all sales originating in the U.S. market while a Canadian subsidiary handles sales originating in the Canadian market. The products sold are essentially identical. Advertising costs are incurred by the U.S. corporation from advertisements placed in the U.S. publications that are sold in both Canada and the U.S. The Canadian subsidiary reimburses the parent corporation for costs on the publications sold in Canada. These charges are generally disallowed under section 19. The same principle applies to advertising on U.S. television networks and radio stations by virtue of section 19.1. These provisions do not apply if the subsidiary's primary market is in the U.S., as the advertising is then directed at the U.S. market.

Advertising is directed at the Canadian market if it is designed to encourage Canadian readers, viewers and listeners to patronize a specific source of product or service available in Canada.

The advertising costs are deductible if a Canadian taxpayer advertises for an export market in a foreign publication with no circulation in Canada and the advertising is directed mainly to markets outside Canada if the costs were incurred to gain or produce income and are reasonable in the circumstances. Examples of costs considered deductible are:

Advertisements in a travel magazine directed at American readers with circulation in both Canada and the U.S. by a Canadian company operating a hotel chain in Canada.
Advertising costs by a Canadian company operating a fly-in fishing or hunting lodge in Canada in U.S. sporting magazines with some circulation in Canada. Over 80% of the customers of the lodge are U.S. residents and advertisements are directed mainly to a market outside Canada.
Advertisements on U.S. television stations with viewing audiences in Canada by a Canadian company operating a major tourist attraction in Canada. Where the main purpose of the advertisements is directed at encouraging American tourists to patronize the Canadian establishment while visiting the geographic area, the advertisements are considered directed at the U.S. market. A significant number of the visitors to the attraction should be from the U.S. Canadian advertising media is used to reach potential Canadian customers. The advertising aimed at the American public is to include material indicating that the advertising is aimed mainly at the American tourist visiting Canada.

Compliance tests carried out for sections 19 and 19.1 have shown that:

non-allowable costs are often added back on Form T2SCH1, Net Income (Loss) for Income Tax Purposes, of the subsidiary or affiliated Canadian corporation; and
Canadian companies are usually responsible for their own advertising in Canada; if advertisements are placed by parent companies in U.S. periodicals with a Canadian circulation, there is often no charge to the Canadian subsidiary as an advertising expense or management fee. In some cases, if Canadian companies placed advertising in U.S. or other foreign periodicals, they were reimbursed for the costs by the parent company whose product they were marketing.

When verifying the possibility of non-compliance for advertising costs, look beyond the taxpayer's advertising agency billings or invoices to determine the nature of the services. It may not be obvious that U.S. advertising is involved; determine exactly what advertising was placed by the agency on behalf of the Canadian client. A copy of the advertisement placed is often attached to the purchase invoice. If the advertising is for radio or television, a copy of the script is usually included. When reviewing the advertising expenses of larger companies, it may be useful to get pertinent information from the taxpayer’s advertising department.

Collection expenses

Determine if the taxpayer uses a collection agency to collect accounts receivable. Review correspondence to make sure that recoveries are recorded in the books of account.

Damage claims

Damage claims may be made for infringement of patent rights or copyrights and public liability suits. Review expenses claimed to make sure that the expense is allowable. Include procedures in the review of the records to determine if insurance proceeds for the damage claim were received by the taxpayer.

Claims for personal liabilities are not allowed as a business expense.

Commissions and other sales expenses

T4 or T4A slips can be used to reconcile the commission expense reported on the income tax return. If commissions have not been included in earnings, a lead should be prepared.

Automobile and truck expenses

Points to consider when reviewing automobile and truck expenses include:

Make sure that only authorized personnel sign credit card slips and vouchers.
Review periods if the expense appears unusually high, as this may include vacation travel, large repair bills, personal or capital expenditures.
If large repair bills are noted, determine if the repair is the result of an accident claim and if the taxpayer has received insurance proceeds.

Freight and delivery expenses

Freight and delivery vouchers may be used to verify the reasonableness of the reported sales. If the taxpayer charges customers for delivery, verify that the amount is included in income or offset to delivery expense.

Taxes, licenses, and permits

Taxes, licenses, and permits may detail unreported or secondary business activities. Verifying the address on property tax bills may show unproductive assets or expenses for non-business assets. Franchise fees that must be capitalized may be included in the license expense account.

Rent and royalties

If rent and royalty expenses are claimed, consider:

If the parties are not dealing at arm's length, examine the contract or agreement.
Review amounts paid or credited to non-residents to make sure that taxes have been withheld as required.
Leads may be prepared for substantial payments to verify that the income has been reported by the other party.
If a tenant has made payments for substantial alterations to a building, make sure that the taxpayer is not claiming CCA or an expense for such alterations.
If the rental agreement states that payments are based on production or use, review the records to make sure that the calculations are as stipulated in the agreement or contract.

Interest expenses

If reviewing interest expense, ask:

Is there a legal obligation to pay interest?
Is the rate of interest reasonable?
Is the interest expense incurred for the purpose of earning income?
Is the interest paid related to property where the income is tax exempt?
Should the interest expense be capitalized (for example, vacant land)?
Is the interest paid reported for information purposes as required?
Should a lead be prepared for interest paid and not reported on the information return?
Is there audit evidence of bonus payments made in connection with borrowed funds? Is the taxpayer repaying more than the borrowed amount?

Insurance expenses

Review of insurance expense includes:

Examine insurance policies if expenses have been claimed for premiums paid.
Make sure that the expenses claimed do not include premiums on personal assets or property.
Determine if life insurance premiums are claimed as an expense.
If the taxpayer is a proprietorship, make sure that the proprietor's portion of a group policy is charged to drawings.
Prepare a schedule indicating the assets, the location of the assets, and the coverage given by the policies.
If the taxpayer has prepared a schedule of insurance coverage, make sure that no personal assets are included in the coverage.
The taxpayer may be a subsidiary of a non-resident company and is charged for insurance through management or administrative fees as part of a blanket policy. Examine the charges and possibly refer for Excise Tax on Part I – Insurance Premiums other than Marine. It is mandatory to include a copy of all referrals and resulting reports in the audit file.

Advertising signs and score clocks

Treat sports score clocks and electrically illuminated signs as class 8 assets and not as an expense at the time of acquisition. If the item was expensed, determine if the taxpayer has title to the property. The taxpayer may be leasing the property from a supplier.

Expenses that relate to direct sales marketing

When verifying the expenses of taxpayers involved in direct sales marketing, disallowing personal and living expenses must be based only on the facts of the case. Ensure the activity is undertaken for the pursuit of profit.

New business ventures

Expenses claimed when a new business is started are deductible. For more information about incorporation, go to Income Tax Interpretation Bulletin IT454, Business transactions prior to incorporation.

To make sure that business operations are feasible, ask:

Has the taxpayer prepared sales forecasts, production plans, or marketing studies?
Is enough working capital available?
Has the taxpayer made solid and feasible financial arrangements and invested capital?
Have the required licenses (business and provincial sales tax, if they apply) and permits been acquired?
Is there an established system for bookkeeping and a separate bank account?
Is the business a personal endeavour or hobby?
Is the activity undertaken in the pursuit of profit?

Amounts incurred for the purpose of gaining or producing income from a business are deductible. The amount is deductible if the taxpayer was carrying on business in the period in which the expense was incurred. To determine if the taxpayer was carrying on a business:

Consider the number of units sold, the average dollar value of individual sales, and the frequency of individual sales.
Are sales made to the general public or exclusively to friends and relatives at a discount?
Does the taxpayer carry enough inventory on hand to meet customer demand?
Is there audit evidence of a warehouse or office with administrative services (telephone, answering machine, and clerical support)?
Are advertising and promotional activities reasonable under the circumstances?
Does the taxpayer have the necessary time to devote to the business?

Reasonable expectation of profit

On May 23, 2002, the Supreme Court of Canada (SCC) rendered its decisions in B. Stewart v The Queen and The Queen v Walls et al., that will affect Audit's approach to determine if an activity constitutes a commercial activity therefore giving rise to a source of income.

Personal and living expenses

Expenses for properties maintained for personal use and not connected with a business in pursuit of profit are not deductible. If expenses are incurred for both business and personal use, costs must be apportioned. The allocation method must be substantiated and be reasonable in the circumstances. Examples of expenses that are often incurred for both business and personal purposes include:

maintaining an office in the home;
travel expenses;
expenses claimed for food, beverages, entertainment, and hotels;
automobile expenses including CCA; and
casual labour expenses.

Miscellaneous fees and expenses

Get an analysis of any miscellaneous account from the taxpayer. If the taxpayer has not prepared such an analysis, scan the account and query unusual items. These fees are not deductible as business expenses:

entrance or initiation fees of professional organizations;
tuition fees of a proprietor, shareholder, or any family member; and
appraisal fees related to reorganization or anticipated sale.

Review legal and accounting fees to make sure that they are deductible. Determine if fees paid relate to non-allowable capital expenditures, such as patents. Include the sale of capital property legal fees, accounting fees, or commissions in the capital gain or loss calculated. For more information, go to Income Tax Interpretation Bulletin IT99R5-CONSOLID, Legal and Accounting Fees.

Auditing payments to foreign agents

If payments are made to foreign agents, suggested audit procedures include:

Determine, if possible, the disposition of the payment with cancelled cheques, correspondence, email, faxes, and telexes. Note any potential signs of diverted funds.
Trace payments through the bank, if significant amounts are involved, and use treaty provisions for information exchanges.
Query the appropriate personnel about the services performed by the agent to earn the fee.
Review foreign travel charges to determine the number and nature of trips and to determine if there were any stops enroute in tax havens or other countries with protective banking and secrecy laws.
Examine, if warranted, personal income tax returns, bank accounts, and net worth of corporate officers.
Review related correspondence, records, and minutes and examine financial statements of the subsidiaries to determine how funds are transferred to the parent or other affiliates if the taxpayer has controlled subsidiaries in tax havens or other countries with protective banking and secrecy laws.
Check unusually high mark-ups on items, such as spare parts - may show that commissions to foreign agents are funded by the high price.
Determine if there are indicators that a foreign agent or official received the payments; the commission expense is an allowable deduction from income.
Check for payments made by the taxpayer to foreign third parties and recorded as, or instead of, administrative or management fees payable to the foreign parent company.
Determine if there are payments for commissions on future business resulting from introducing new business to the country. Commissions may be paid on the same contract to the agent that handled the introduction and to the agent handling the current contract.

Note: Consider the implications for Part XIII Withholding Tax. A referral to International Tax may be warranted. It is mandatory to include a copy of all referrals and resulting reports in the audit file.

13.10.0 Auditing bribes, kickbacks, and similar payments

13.10.1 Introduction

Bribes, kickbacks, and other similar payments are generally under-the-table payments, over and above the documented price paid to receive a favour or any kind of bonus.

These payments are generally not included in income or are disguised in the accounting records. The sources of the funds are often cash sales that were not included in income by the payer. Use indirect methods of verification to audit.

Whether a transaction is paid under-the-table, disguised, or clearly identified, does not change the treatment for tax purposes.

13.10.2 Income tax implications

Kickbacks, bribes, and other similar payments are generally taxable in the hands of the recipient and in some circumstances may constitute deductible expenditures for the payer for income tax purposes.

Taxation in the hands of the recipient

Unless the recipient is explicitly exempt from income tax by a provision of the ITA, the amount received is ordinarily taxed in the same way as other revenue, other than capital, whether the revenue is from a source listed in section 3 of the ITA or not. It is the same for dispositions of capital property for which the capital gains stipulations apply.

Mclean v M.R.C., 62 DTC 1320 deals with income tax on disguised kickbacks.

Deductible expense for the payer

Expenditures are deductible if they have been incurred to produce income and if the amount claimed is reasonable in the circumstances, unless claiming the expenses as a deduction is specifically denied by the ITA. However, it is conceivable that some expenses cannot be justified as being incurred to produce income.

An expenditure that may be described as an under-the-table payment, such as a bribe, kickback, or similar payment, is not deductible unless:

the recipient of the payment is identified;
the expenditure was made or incurred to earn income; and
the amount is reasonable in the circumstances.

While disallowing the payment may offset the fact that the unidentified recipient did not, in all probability, pay tax on that amount, it is preferable that:

the recipient include that amount in income and be taxed thereon; and
the payer deducts the payment in computing income, if it is established the amount was paid to earn income and is reasonable in the circumstances.

United Colour and Chemicals Ltd., 92 DTC 1259 deals with deductible bribes, 65302 British Columbia Ltd., 98 DTC 6002 and 65302 British Columbia Ltd. v The Queen, (SCC) 99 DTC 5799 deal with expenditures for earning income.

Identifying the recipient

Make a concerted effort to get all relevant information and any document that may help to identify the recipient. Of particular concern is that an alleged bribe or kickback or any payment, if the recipient is not identified, does not, in fact, constitute an appropriation by a shareholder or an employee of a corporation or a benefit conferred upon that person.

Unidentified recipient

If the recipient of an alleged bribe or kickback is not identified, disallowing this expenditure and the possibility of including the disallowed expense in the income of a shareholder or employee will depend on the facts and the circumstances in each particular case.

If it is not possible to ascertain any link between the payments in question and a particular shareholder or shareholders, consider including the alleged bribe or kickback in the hands of the person who authorized its payment or, alternatively, the person who had control of the funds in question. The reassessment will be issued depending on whether that person is an employee or officer of the corporation or a shareholder or family member of a shareholder.

Recipient is an employee or officer of a corporation

When an employee or an officer of a corporation receives a bribe or similar payment while carrying out the duties from a client of the employer, it must be determined if that person received the payment by virtue of the office of employment or if it is the corporation’s income (that is, the payment is related to the business carried on by the corporation).

The amount of the payment will be taxed in the recipient's hands as remuneration under subsection 5(1), or as a benefit under paragraph 6(1)(a), if it was received by virtue of an office or employment. If the recipient is a shareholder and the amount is income of the corporation, the payment may also be taxed in the shareholder's hands under subsection 15(1).

Recipient is a shareholder or family member

If such payments are made by a closely held private corporation to an unidentified recipient and it is reasonable to conclude that the payment was received by, or for the benefit of a shareholder or a family member, the payment will be taxed in the shareholder's hands under subsection 15(1) or subsection 56(2) and the amount disallowed as an expense to the corporation.

Recipient is a member of a partnership

If an amount is determined to have been received by a member of a partnership, it must be determined whether the amount is the income of that partner or of the partnership.

Deducting illegal payments

Section 67.5 of the ITA prohibits the deduction of illegal payments made to foreign public officials, government officials of Canada, officials responsible for administering justice in Canada, persons fulfilling the duties of agents, or employees and persons responsible for collecting transportation or admission fees. These payments represent offences under the Criminal Code.

It is prohibited to deduct illegal payments if the payment is made for the purpose of doing anything that is an offence under section 3 of the Corruption of Foreign Public Officials Act or under any of sections 119 to 121, 123 to 125, 393 and 426 of the Criminal Code.

It is also prohibited to deduct payments made in connection with a conspiracy to commit one of the offences listed above or a similar offence under foreign legislation when the conspiracy took place in Canada.

An assessment can be made in these cases even when the assessment period is statute-barred.

Provisions of the Criminal Code that apply

Section 119 - bribery of judicial officers, etc.;
Section 120 - bribery of officers;
Section 121 - frauds on the government;
Section 123 - municipal corruption;
Section 124 - selling or purchasing office;
Section 125 - influencing or negotiating appointments or dealing in offices;
Section 393 - fraud in relation to fares, etc.;
Section 426 - secret commissions; and
Section 465 – conspiracy.

Go to Criminal Code.

Go to Corruption of Foreign Public Officials Act.

Deduction of payments to foreign agents

In other countries where the laws, businesses, and social customs and practices are different, it is common for Canadian businesses to have local contacts or agents to enable them to carry on a business (for example, to secure a contract or sell certain products). Incentive payments may be made to receive such business or to gain entry to the particular foreign market.

The payments made to agents may be recorded as commissions, instalation fees, freight, or administrative expenses. They may be clearly described as foreign commissions and supporting contracts or agreements are readily produced.

In other cases, the document is either difficult to get or is not available. Neither the agent nor principal gives an invoice or receipt for payment to the Canadian taxpayer. In most cases, incentive payments are included in the negotiated price and consequently do not affect the payer's profit. They may be sent to numbered bank accounts in a tax haven or other countries with secrecy laws and protective banking.

At times, these incentive payments may be made on behalf of a foreign parent (since such payments are strictly illegal under U.S. law) whose domestic laws forbid such payments.

Canadian government agencies that promote the export of Canadian goods and services may help Canadian businesses by naming suitable agents.

It is not the CRA's policy to disallow all incentive payments. Payments will be allowed as a deduction in computing income if all of the following conditions are met:

The amount is paid out to earn income, directly related to or associated with a specific contract or sale, and is reasonable (normally, the payment is not in excess of 10% of the gross amount of the contract).
The beneficiary is, or the beneficiaries are, reasonably identified by corroborating audit evidence and can be associated with the foreign country (that is, a recipient who would not usually be taxable in Canada).
The taxpayer furnishes all the documents available concerning the obligation to pay and the payment details.

If written agreements or other documents are not available or do not satisfactorily support the payments, more verification will be necessary. A referral to the Criminal Investigations Program should be made when evidence of tax evasion, fraud or other tax related offences have been discovered. It is mandatory to include a copy of all referrals and resulting reports in the audit file. For more information, go to 10.11.8, Referrals to Criminal Investigations.

Audit techniques

If possible, determine the ultimate disposition of the payment:

Examine correspondence, paid cheques, and foreign communications to verify transactions or to detect potential diversions of the funds.
Trace payments through a bank's international division.
Use tax treaty provisions for information exchanges or other tax provisions that apply when significant amounts are involved or other circumstances warrant such action.

Senior executives and decision making

In most cases, senior executives are involved in the decision to make these payments.

Interview and question the senior executives on the services performed by the agent for the fee.
Review senior executive foreign travel charges to identify the number and nature of the trips.
Give particular attention to trips with enroute stops in tax havens or other countries with protective banking and secrecy laws. There is always the possibility of payments that may go to foreign agents, which in fact are for the benefit of officials of the Canadian corporation.
Examine, when required, the personal income tax returns and bank accounts of the Canadian officers involved in the decision to make these payments.

Controlled subsidiaries

Question executives about the operations and activities of controlled subsidiaries in tax havens or other countries with secrecy laws and protective banking.
Review executive correspondence, records, minutes, etc., and examine the financial statements of the subsidiaries to determine how funds are transferred to parent or affiliated firms.
In some situations, if a major construction contract is being carried out in a foreign country, the government of that country will require that a subsidiary corporation be incorporated there, generally 50% owned by the foreign government. Payments to agents may be directed through such a company.

Commissions included in the price

Review the mark-ups in the Canadian taxpayer's records on items for the foreign contract, such as spare parts extras. Unusually high mark-ups could include commissions paid to foreign agents and funded by the excessive price. If there are indicators that the payments were received by a foreign agent, the commission most likely is acceptable as a deduction from income for income tax purposes.

Payments to third parties

In the case of Canadian subsidiaries of foreign parents, particularly U.S. corporations, be alert for payments made by the Canadian taxpayer to foreign third parties and recorded as or in lieu of administrative or management fees payable to the parent.

Royalty or licence fee vs commission

Watch for payments that might be described as continuing commissions on future business resulting from introducing new business to the country, similar to a royalty or licence fee, as opposed to a one-time commission for each contract. There could be situations where two commissions are paid on the same contract. For example, a commission could be paid to the agent who handled the introduction and to the agent dealing with the current contract.

Usually, the override commission paid to the agent that introduced the contract is lower. In either situation, attempt to determine that none of these commissions benefited the payers or other Canadian taxpayers in a way other than, for example, to receive the contract.

Appendix 13.1.0 Letters – Under review

No letters available

Appendix 13.2.0 Checklists – Under review

Appendix 13.3.0 Sample net worth working papers

It is mandatory to include in the audit file, complete working papers for all audit issues and procedures.

The Statement of changes in net worth (appendices A-13.3.1 to A-13.3.7, inclusive) is moved from the Income Tax Audit Manual (ITAM). For raising assessments using the assessing net worth technique, use the Statement of changes in net worth available in the Integras Template Library under Worksheets:

Net Worth – Individual – 5 – year Assessing v2019
Net Worth – Shareholder – Calendar Year v2019
Net Worth – Shareholder – Off Calendar Year v2019

Appendices A-13.3.8, A-13.3.9, A-13.3.11, and A-13.3.12 are removed from the ITAM since November 2014.

Appendix A-13.3.10 is moved from the ITAM. For reference only, sample working paper A-13.3.10 is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A-13.3.10.

Appendices A-13.3.13 and A-13.3.14 are combined as A-13.3.14. Appendix A-13.3.13 is deleted.

Appendix A-13.3.14 is moved from the ITAM. For reference only, sample working paper A-13.3.14 is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A-13.3.14.

Appendix 13.4.0 Sample Working Paper – Bank deposit analysis

Appendix A-13.4.1 is moved from the ITAM. For reference only, A-13.4.1 is available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A-13.4.1.

Appendix 13.5.0 removed

Appendix 13.6.0 Sample Working Papers – Source and application of funds

Appendices A-13.6.1 and A-13.6.2 are moved from the ITAM. For reference only, A-13.6.1 and A-13.6.2 are available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms.

Page details

Date modified:: 2024-07-10

Income Tax Audit Manual

Compliance Programs Branch (CPB)

Information

Chapter 13 - This chapter is under review and an updated version will be released at a later date

Disclaimer

Chapter 13.0 Audit techniques

Table of Contents

13.1.0 Computer-assisted audit techniques

13.1.1 Introduction

13.1.2 Advantages of computer-assisted audit techniques

13.1.3 Assistance from Digital Compliance and Audit Support Division specialists

13.1.4 Preparing the taxpayer's information for computer-assisted audit techniques

13.1.5 Procedures using computer-assisted audit techniques

13.1.6 Computer-assisted audit technique software

13.1.7 Business systems evaluation

13.1.8 Examples of computer-assisted audit techniques

13.1.9 Related topics

13.2.0 Audit of non-taxable sources of funds

13.2.1 Overview

13.2.2 Interviewing the taxpayer

13.2.3 Audit of cash-on-hand

13.2.4 Opening and closing cash-on-hand

13.2.5 Analysis of bank accounts

13.2.6 Audit of gifts, loans, and inheritances

13.2.7 Audit of lottery and other winnings

13.2.8 Audit of non-taxable funds from a foreign source – Under review

13.3.0 Indirect verification of income

13.3.1 General comments

13.3.2 Coding for indirect verification of income cases – Under review

13.3.3 Inadequate, inaccurate, or unreliable books and records

13.3.4 Legislative authority

13.3.5 Burden of proof

13.4.0 Assessing net worth technique

13.4.1 Introduction

13.4.2 Definitions

13.4.3 Coding for assessing net worth technique

13.4.4 Principles of the assessing net worth technique

13.4.5 Section removed

13.4.6 Circumstances that warrant proceeding to an assessing net worth technique

13.4.7 Understated or unreported income

13.4.8 Section removed

13.4.9 Circumstances that do not warrant an assessing net worth technique

13.4.10 File selection and risk assessment indicates assessing net worth technique warranted

13.4.11 Overview of the net worth

13.4.12 Net worth audit period

13.4.13 Exceptions to the normal assessment period

13.4.14 Basis of the net worth assessment

13.4.15 Section removed

13.4.16 Assessing net worth technique resulting from a Business Intelligence referral

13.4.17 Assessing net worth technique – Application of penalties – Under review

13.4.18 Personal expenditure interview

13.4.19 Tour of premises

13.4.20 Assessing net worth technique – Audit of business records

13.4.21 Audit of the taxpayer's personal finances

13.4.22 Lack of supporting information

13.4.23 Third-party sources of information – Under review

13.4.24 Banking information

13.4.25 Preparing the assessing Statement of changes in net worth

13.4.26 Summary of personal expenditures

13.4.27 Personal expenditure worksheet

13.4.28 Testing of personal expenditure estimates

13.4.29 Assessing net worth technique – Calculation of the discrepancy in total income per net worth

13.4.30 Analysis of income tax discrepancy per net worth

13.4.31 Section removed

13.4.32 Section removed

13.4.33 Fiscal year other than December 31st

13.4.34 Assessing net worth technique for multiple businesses and different year-ends

13.4.35 Net worth of a partner in a partnership

13.4.36 Partner's investment in partnership

13.4.37 For future use

13.4.38 Assessing net worth technique for a shareholder of a corporation

13.4.39 Assessing net worth technique fiscal year and assessment period for a corporation

13.4.40 Adjustments for fiscal year-ends other that December 31st

13.4.41 Base year

13.4.42 Section removed

13.4.43 Shareholder's investment

13.4.44 Reason for discrepancy in net worth

13.4.45 Analysis of discrepancy in income

13.4.46 Completing the assessing net worth technique

13.4.47 Assessing net worth technique working papers