oversight

Tax Administration: More Criteria Needed on IRS' Use of Financial Status Audit Techniques

Published by the Government Accountability Office on 1997-12-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to the Chairman, Committee on
                Ways and Means, House of
                Representatives


December 1997
                TAX
                ADMINISTRATION
                More Criteria Needed
                on IRS’ Use of
                Financial Status Audit
                Techniques




GAO/GGD-98-38
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division

      B-275099

      December 30, 1997

      The Honorable Bill Archer
      Chairman, Committee on Ways and Means

      The Honorable Nancy L. Johnson
      Chairman, Subcommittee on Oversight
      Committee on Ways and Means
      House of Representatives

      Each year, Internal Revenue Service (IRS) auditors identify billions of
      dollars in additional income taxes owed through audits of individual
      taxpayers. Such tax audits have been a fundamental part of IRS’
      enforcement strategy for many years, helping to ensure that taxpayers pay
      the amount of taxes they owe. Tax audits may occur in a variety of forms,
      ranging from a simple review of a return with little taxpayer contact to a
      detailed on-site examination and investigation of a taxpayer’s financial
      records. Increasingly, however, the way IRS conducts its audits has been
      criticized by taxpayers, tax professionals, and Congress as being overly
      intrusive and burdensome for taxpayers.

      Much of this criticism has stemmed from IRS’ reemphasis on detecting
      unreported income. In the early 1990s, IRS managers became concerned
      that auditors were not fully using audit techniques designed to identify
      unreported income. In a 1994 initiative, to address this concern, IRS
      implemented a training program to reemphasize the need to consider a
      taxpayer’s financial status by focusing on whether the taxpayer’s income
      and expenses were roughly proportional. The training program
      reemphasized certain audit techniques for identifying unreported income.
      These techniques are sometimes referred to as financial status audit
      techniques.

      You asked that we review IRS’ use of financial status audit techniques. In
      this report, we (1) estimate how frequently IRS used financial status audit
      techniques in audits closed in tax years prior to the 1994 initiative (1992
      and 1993) and in tax years following the initiative (1995 and 1996);
      (2) consider how IRS’ need to contact taxpayers for additional taxpayer
      information when using financial status techniques might intrude on
      taxpayers; (3) estimate the audit results from using financial status audit
      techniques in terms of the amount of adjustments to reported income; and
      (4) determine how IRS applied its audit standards, quality controls, and
      measurement of audit quality to the use of financial status techniques.




      Page 1                            GAO/GGD-98-38 Financial Status Audit Techniques
             B-275099




             As our primary method for addressing these objectives, we selected
             random samples of audits of individual returns completed before and after
             IRS implemented its financial status audit initiative in 1994 and examined
             the IRS audit workpapers for the sampled tax returns. We discussed our
             observations about the audits we reviewed with IRS officials. We did not
             contact individual taxpayers about the audits we reviewed. However, we
             discussed the issues of intrusiveness and burdens of IRS’ financial status
             audits with knowledgeable tax professionals.


             IRSdefines the tax gap as the amount of tax that taxpayers owed but have
Background   not paid. IRS estimates the individual income tax gap to be $95.3 billion for
             1992. Unreported income accounts for a major portion of this tax
             gap—$58.6 billion or over 60 percent. In the early 1990s, IRS became
             concerned that its auditors were not fully probing for income that should
             have been, but was not, reported on tax returns. This concern as well as
             others led IRS to reemphasize the need for its auditors to consider a
             taxpayer’s financial status and to probe for unreported income.1 This
             reemphasis came to be known as the financial status audit program.2

             IRS initiated the financial status audit program in late 1994 with a training
             course for auditors.3 In the training course, IRS stressed the importance of
             identifying unreported income by determining whether the taxpayer’s
             reported income roughly conforms to his or her spending. Such an
             evaluation requires consideration of the taxpayer’s spending patterns in
             addition to verifying items reported on tax returns. If reported income and
             spending patterns differ, the auditor is supposed to decide whether the
             difference is significant enough to warrant asking the taxpayer for an
             explanation.

             The training course stressed the importance of meeting with taxpayers,
             checking nontraditional data sources (such as state and local

             1
              IRS had also announced a plan in 1994 to conduct an expanded program of audits of a stratified
             random sample of returns to measure taxpayer compliance. IRS wanted to ensure that these
             compliance audits were accurate because the results would be used to update the estimates of the
             income tax gap and the formulas used to objectively select tax returns for future audits. Because of
             public and congressional concerns about the scope and intrusiveness of this proposed program and
             IRS’ budget constraints, it was ultimately cancelled.
             2
              When originally conceived, the financial status audit program was referred to as the Economic Reality
             Program.
             3
              The term auditor, as referred to in this report, includes revenue agents and tax auditors because both
             do face-to-face audits with taxpayers. For individuals, revenue agents usually audit taxpayers who
             report significant amounts of business income or file very complex returns while tax auditors usually
             audit those who do not report significant amounts of income or file simpler returns.



             Page 2                                         GAO/GGD-98-38 Financial Status Audit Techniques
    B-275099




    governments), and using four indirect audit techniques.4 These four
    techniques, the cornerstones of financial status audits, are

•   bank deposit analysis, in which the auditor uses the taxpayer’s bank
    statements to ensure that total deposits are accounted for on the tax
    return or as nontaxable receipts;
•   net worth method, in which the auditor analyzes changes in the taxpayer’s
    assets to determine any potential for unreported income;
•   normal markup/unit of sales method, in which the auditor uses the
    taxpayer’s cost of goods sold and average markups within the industry to
    estimate business gross receipts; and
•   cash transaction (Cash-T) method, in which the auditor compares the
    taxpayer’s expenditures to income sources. Under this method, if a
    taxpayer’s expenditures exceed reported income and the source for such
    expenditures cannot be explained, the excess represents potential
    unreported income.

    The Cash-T method also includes a preliminary Cash-T in which the
    auditors use only the information available on the tax return to determine
    whether the expenditures exceeded reported income. The preliminary
    Cash-T can be completed without contacting the taxpayer for information.

    The consideration of a taxpayer’s financial status and the use of these
    techniques to probe for unreported income are not new concepts.
    Historically, the techniques have been used in fraud and criminal
    investigation cases, but they have also been available for use by other IRS
    auditors. IRS officials noted that the use of financial status techniques has
    been mentioned in the Internal Revenue Manual at least as far back as
    1961. According to IRS officials, the 1994 financial status initiative was
    intended primarily to reemphasize instructions that auditors receive in
    other IRS training courses.

    By early 1995, IRS was receiving considerable criticism about audits using
    these financial status techniques. The American Institute of Certified
    Public Accountants (AICPA), Members of Congress, and various taxpayer
    groups were concerned that these audits were more time consuming and




    4
     In its letter commenting on a draft of this report, IRS said that it uses the term “financial status audit”
    to mean nothing more than an examination of a return where a potential unreported income issue was
    identified through the analysis of the taxpayer’s financial status. IRS auditors then use indirect
    techniques to check out this potential for unreported income. We refer to these indirect techniques as
    financial status techniques.



    Page 3                                           GAO/GGD-98-38 Financial Status Audit Techniques
                   B-275099




                   intrusive than other auditing techniques.5 AICPA officials had several
                   concerns about the taxpayer burden and intrusiveness that they associated
                   with IRS’ use of financial status techniques. Specifically, they were
                   concerned about IRS’ practice of asking financial status questions at the
                   initial interview before having any evidence of underreported income.
                   Similarly, AICPA officials were concerned about IRS sending a request for
                   personal living expense (PLE) information with the letter notifying the
                   taxpayer of the audit, before finding any evidence of unreported income.

                   In response to these criticisms, IRS provided additional instructions to its
                   auditors to clarify the intent of financial status audits. Between August
                   1995 and March 1996, three memoranda were issued from the Office of the
                   Assistant Commissioner (Examination) to Regional Chief Compliance
                   Officers to provide the clarifications. The August memorandum supported
                   the use of financial status techniques but urged auditors to use sound
                   judgment in asking financial status questions at the initial interview,
                   particularly when no indication of underreported income existed. The
                   December 1995 and March 1996 memoranda provided similar instructions,
                   including guidance indicating that PLE forms should not automatically
                   accompany notification letters. AICPA officials acknowledged to us that
                   these instructions helped to reduce some of their concerns, but they said
                   they were still concerned about the added time and intrusiveness
                   associated with IRS’ use of financial status audit techniques.


                   On the basis of our review of samples of IRS audits completed before and
Results in Brief   after IRS reemphasized the use of financial status techniques, we found no
                   statistically significant change in the frequency with which these
                   techniques were used or in the types of returns for which the techniques
                   were used.6 For audits completed in 1992 and 1993, before IRS’ reemphasis
                   on financial status techniques, we estimated that auditors used the
                   techniques on about 24 percent of the universe of 556,000 audits. Similarly,
                   for audits completed in 1995 and 1996, after the reemphasis, we estimated
                   that auditors used the techniques on about 22 percent of the universe of
                   421,000 audits. Because IRS lacks specific criteria on when to use the
                   techniques, we could not determine whether the frequency of use was
                   appropriate for either time period.

                   5
                    Auditors generally have three sources for verifying the taxpayers’ income: (1) taxpayers (e.g., records,
                   admissions); (2) third-parties (e.g., those filing information returns with IRS to report payments made
                   to taxpayers); and (3) one or more of the financial status audit techniques.
                   6
                    We selected two samples, totaling 838 audits. The before sample contained 484 completed audits, and
                   the after sample contained 354 audits. A more complete description of our sampling methodology can
                   be found in appendix I.



                   Page 4                                         GAO/GGD-98-38 Financial Status Audit Techniques
B-275099




We also estimated that, during both periods, over 75 percent of the audits
using financial status techniques involved individual returns with business
or farm income—the types of taxpayers that IRS has historically found to
be the most likely to underreport income. Virtually all of the audits from
both periods that used one or more of these techniques used Cash-Ts
(preliminary or comprehensive), bank deposit analyses, or both.

Financial status audit techniques vary in the need for taxpayer contact and
how much additional burden or intrusiveness may be perceived by the
taxpayer. For example, IRS auditors used only a preliminary Cash-T in
about 23 percent of the 1995 and 1996 audits we reviewed where a
financial status audit technique was used. This technique imposed no
additional burden on the taxpayer because it requires no contact with the
taxpayer. In the remaining 77 percent of the audits, some additional
contact with the taxpayer was necessary to obtain financial status
information. We did not attempt to measure the additional burden or
intrusiveness attributable to the use of financial status techniques in these
cases because first, IRS has no definitions of burden and intrusiveness and,
second, even if it had the definitions, the audit workpapers did not contain
sufficient quantitative data for such measurements.

We were able to examine at least two points where intrusiveness could
occur, however. Financial status audits have been criticized by tax
professionals and others for, among other things, seeking information
about financial status without having evidence of unreported income.
Such intrusions into taxpayers’ spending patterns could occur (1) before
the initial interview and (2) during the initial interview. Critics suggested
that such intrusions increased after the 1994 initiative. Our analysis of the
sampled audits for the two time periods indicates that the frequency of
occurrence of these two alleged types of intrusions have not changed
much.

First, IRS used the PLE form to inquire about expenses at the time of the
notification letter in fewer than 5 percent of the audits for both the 1992
and 1993 and 1995 and 1996 periods. Second, the case files showed that
auditors infrequently asked intrusive, financial status type questions at the
initial interview. Of the 16 questions identified by AICPA as questions it
considered intrusive, most were asked in the initial interview in fewer than
5 percent of the audits. The frequencies with which the questions were
asked were about the same for both periods.




Page 5                             GAO/GGD-98-38 Financial Status Audit Techniques
    B-275099




    Concerning the results, auditors made no adjustments to the individual’s
    reported income attributable to the use of financial status audit techniques
    in 83 percent of the audits in which these techniques were used.
    Notwithstanding this relatively high no-change rate, the use of financial
    status audit techniques helped to identify a significant amount of
    unreported income in some audits. On the basis of our sample for the 1995
    and 1996 period, we estimated that IRS was able to identify over
    $300 million in underreported income using the financial status
    techniques.

    IRS has three tools to oversee the use of financial status audit techniques:
    (1) audit standards to guide auditors, (2) supervisory review of auditors’
    adherence to the standards, and (3) a system to measure adherence to the
    standards. Our analyses focused on how IRS applied these tools to the use
    of financial status audit techniques. While these tools offered important
    controls over the use of the financial status techniques, they each have
    limitations. For example:

•   IRS’ nine audit standards did not have specific criteria to guide auditors on
    when to use financial status techniques and to what degree.
•   Our analysis of the IRS workpapers indicated that supervisory review of the
    audits appeared to be limited. IRS officials we met with acknowledged that
    managers cannot review all audits, and the managers told us they tried to
    at least maintain general oversight of auditors’ ongoing audit inventories.
•   Because the standards did not include specific criteria on when to use
    financial status audit techniques, IRS’ measurement did not address
    whether the auditors should have used the techniques.

    As the administrator of the nation’s tax system, IRS is responsible for
    identifying the correct amount of tax that is owed. Because our tax system
    is based on voluntary compliance, an appropriate balance must be
    maintained between collecting evidence and information to assist the
    auditor in identifying the correct tax and avoiding unnecessary burden and
    intrusiveness for the large majority of taxpayers. More specific criteria for
    IRS auditors to use in making case-by-case decisions about whether and to
    what extent to use financial status audit techniques would be helpful to
    auditors in achieving that balance. On the basis of our review of IRS audit
    workpapers, we believe that the lack of specific criteria may have
    contributed to the relatively large percentage of audits in which the use of
    financial status audit techniques resulted in no adjustments to income.
    During the course of our work, IRS agreed that it needs more specific




    Page 6                            GAO/GGD-98-38 Financial Status Audit Techniques
              B-275099




              criteria to guide its auditors in exercising their judgment to use the
              financial status techniques.


              To determine the extent to which IRS’ use of financial status techniques has
Scope and     changed, we selected random samples of audits of individual returns
Methodology   completed before and after IRS began reemphasizing the techniques in
              1994. We selected these samples from IRS’ Audit Information Management
              System (AIMS) database.7 For the “before” sample, we selected audits that
              were opened on individuals from October 1991 through October 1992 and
              closed during fiscal years 1992 and 1993. For the “after” sample, we
              selected audits that were opened from October 1994 through October 1995
              and closed during fiscal years 1995 and 1996.8 Each sample audit included
              one or more individual income tax returns. Our sample contained 838 valid
              audits selected from an estimated population of 977,000 audits. All the
              numbers used in this report are estimates developed on the basis of
              weights assigned to the sampled audits so that they represent the
              population from which we sampled. See appendix I for a more detailed
              description of our sampling methodology and the procedures used to
              develop our estimates.

              We used the IRS workpapers associated with each audit to determine
              whether and how auditors used the financial status techniques and which
              type of techniques were used. For each sample audit, using a data
              collection instrument that we developed, we gathered specific information
              from the case files about the types of techniques used, amounts of any
              adjustments to taxable income and tax liability, types of questions asked
              the taxpayers, and information about both the auditor and taxpayer. We
              also met with National Office officials responsible for implementing the
              financial status program to discuss our sampling methodology and results.
              We did not determine whether IRS’ auditors made appropriate choices in
              deciding when to use financial status techniques and what techniques to
              use because IRS had no specific criteria against which to make this
              judgment.

              To obtain information on how the use of financial status techniques
              increased the need for taxpayer contact and might have affected the

              7
               We did not validate the accuracy of information in the AIMS database.
              8
               Our sample excluded audits closed on AIMS that did not involve looking at taxpayers’ books and
              records and those that could not be expected to use the financial status techniques. These audits
              included correspondence audits at IRS Service Centers and limited scope audits to pass through
              adjustments from partnership audits to the partners, identify nonfilers, prepare substitute returns for
              nonfilers, and review taxpayers’ claims for refund.



              Page 7                                         GAO/GGD-98-38 Financial Status Audit Techniques
B-275099




taxpayer, we again used data from the audit workpapers. We collected
information from the case files on the types of techniques being used,
whether or not Cash-Ts were preliminary or comprehensive, the nature of
the taxpayer contacts, the types of questions asked at initial interviews,
and whether or not IRS requested PLE information when first notifying the
taxpayer of the audit. Additionally, we met with IRS’ National and Field
office officials to learn how each technique was used. As part of our work
on this issue, we discussed the financial status program with officials at
AICPA. These officials raised several concerns about IRS’ use of financial
status techniques and the whole approach to audits resulting from the
emphasis on the techniques. To the extent possible, we used our sample
data to evaluate these concerns.

To determine the results of audits using financial status techniques, we
used the samples and workpapers previously discussed. For each audit,
we recorded the adjustments to income and additional taxes found on all
returns. We also recorded the amount of the changes to income
attributable to the use of one or more of the financial status techniques.

To determine how IRS applied its audit standards, quality controls, and
quality measurement to the use of financial status techniques, we met with
officials in the Examination Division, including the Quality Measurement
staff, at the National Office and four district offices.9 We also discussed
quality review procedures with group managers at the district offices. We
obtained copies of the audit standards and reviewed their applicability to
the financial status program. Otherwise, we did not evaluate the adequacy
of the standards. We reviewed IRS’ Examination Quality Measurement
System (EQMS) to determine how IRS measures audit quality and what the
measures show. At three of the four district offices, we examined several
EQMS cases, selected by IRS personnel, to see how EQMS reviews were done.
We did not examine any cases at the Philadelphia district office because
all EQMS reviews in that region are done at another district office. We did
not try to assess the accuracy of EQMS reviews. (See appendix II for a
summary of IRS’ audit standards.)

We requested comments on a draft of this report from the Commissioner
of Internal Revenue. On November 20, 1997, we received written
comments from IRS, which are summarized at the end of this letter and are
reproduced in appendix IV. These comments have been incorporated into
the report where appropriate.

9
 These district offices, selected for their proximity to our staff locations, were Baltimore, Oakland,
Philadelphia, and Richmond.



Page 8                                          GAO/GGD-98-38 Financial Status Audit Techniques
                                     B-275099




                                     We performed our audit at IRS headquarters offices in Washington, D.C.,
                                     and at district offices and service centers in Fresno and Oakland, CA;
                                     Baltimore, MD; Philadelphia, PA; and Richmond, VA. Our work was done
                                     between October 1996 and August 1997 in accordance with generally
                                     accepted government auditing standards.


                                     IRS’ renewed emphasis on financial status audit techniques produced little,
Little Change Shown                  if any, change in how often these techniques were used. Comparing audits
in the Use of Financial              done before and after IRS’ emphasis on financial status, we estimated that
Status Techniques                    the use of one or more of the financial status techniques was 24 percent
                                     for the 1992 and 1993 period and 22 percent for the 1995 and 1996 period.
                                     The difference in these percentages is not statistically significant. During
                                     both periods, financial status techniques were used predominately on
                                     returns involving business or farm income. IRS research has found that
                                     taxpayers with these types of income are more likely to underreport
                                     income than taxpayers whose income is reported by third parties on
                                     information returns. Table 1 compares the two periods we reviewed.

Table 1: Number and Percentages of
Audits That Used Financial Status                                                                      Sampling period
Techniques, Before and After IRS’    Audits                                                          1992-1993                1995-1996
Reemphasis
                                     Estimated total auditsa                                            556,000                  421,000
                                     Percentages of audits that used one or more                              24%                        22%
                                     financial status technique
                                     Percentage of audits that used one or more                               75%                        84%
                                     financial status technique involving returns
                                     with business or farm income
                                     Percentage of audits with business or farm                               38%                        34%
                                     income where one or more of the financial
                                     status techniques were used
                                     Percentage of audits with no business or                                 12%                        7%
                                     farm income where one or more of the
                                     financial status techniques were used
                                     a
                                      This estimate was calculated on the basis of our sample of audits and is adjusted to account for
                                     audits that were excluded or missing. (See app. I for additional information on the sampling
                                     methodology.)

                                     Source: GAO analysis of IRS audit workpapers.



                                     IRS managers were concerned that auditors were not making use of
                                     techniques to identify unreported income. The financial status program
                                     and the associated training was designed to correct this problem. IRS
                                     officials could not tell us why the percent of financial status audits had not



                                     Page 9                                       GAO/GGD-98-38 Financial Status Audit Techniques
                                      B-275099




                                      changed after the reemphasis and training. However, they noted that one
                                      reason may have been because of the limited amount of follow-up training
                                      provided by the districts and the limited amount of National Office
                                      oversight due to IRS’ reorganization activities after the initial training. In
                                      commenting on our draft report, IRS officials indicated that the financial
                                      status training focused less on increasing the use of a specific technique
                                      and more on improving the auditors’ ability to identify unreported income.

                                      We also analyzed whether IRS changed the types of techniques being used.
                                      We found no significant change in usage by type of financial status
                                      technique since the reemphasis. Generally, only two techniques were used,
                                      often in combination, during our two sample periods. Table 2 describes
                                      the results of this analysis.

Table 2: Types and Percentages of
Financial Status Techniques Used in                                                                   Sampling period
Audits Before and After IRS’          Audits using techniques                                      1992-1993a           1995-1996a
Reemphasis
                                      Estimated number of audits                                       136,000               91,000
                                      Audits using Cash-T (preliminary and                                  50%                  47%
                                      comprehensive) only
                                      Audits using bank deposit analysis only                               29%                  21%
                                      Audits using both Cash-T and bank deposit                             20%                  32%
                                      analysis
                                                                                                              b
                                      All other combinations                                                                      1%
                                      Total                                                                100%                 100%
                                      a
                                      Percentages may not total to 100 due to rounding.
                                      b
                                          Percentage equals less than 1/10th of 1 percent.

                                      Source: GAO analysis of IRS audit workpapers.



                                      To put the data presented in tables 1 and 2 in perspective, in 1995, about
                                      116 million taxpayers filed their 1994 individual income tax returns. On the
                                      basis of historical data and information from our sample, we estimate that
                                      between 126,000 and 183,000 will receive an audit that uses at least one of
                                      the four financial status techniques during the 3 years before the statute of
                                      limitations expires.




                                      Page 10                                        GAO/GGD-98-38 Financial Status Audit Techniques
                     B-275099




                     Financial status audit techniques vary in the extent of additional taxpayer
Need for Taxpayer    contact needed and the amount of information being sought from
Contact When Using   taxpayers. IRS has no data showing how much additional taxpayer contact
Financial Status     is associated with each technique or how intrusive the additional
                     information needed might be. However, we were able to make some
Techniques Varies    general observations based on our review of the workpapers.

                     For example, the Cash-T method can be separated into two
                     types—preliminary and comprehensive. In the preliminary Cash-T, the
                     auditor uses only information available on the tax return to identify any
                     indications of unreported income. This technique, therefore, requires no
                     additional contact with the taxpayer. Of the estimated 126,000 to 183,000
                     audits of tax year 1994 individual returns in which IRS used a financial
                     status technique, we estimated that between 29,000 and 42,000 of these
                     audits (23 percent) only used a preliminary Cash-T, requiring no response
                     from the taxpayer.

                     The comprehensive Cash-T and each of the other techniques require some
                     additional taxpayer contact. The amount of contact required and
                     information sought can vary with each taxpayer and the type of financial
                     status technique used. In a comprehensive Cash-T, the auditor needs
                     information from the taxpayer on nonreturn items such as cash on hand,
                     savings, and PLE. For a bank deposit analysis, the auditor requires access
                     to the taxpayer’s bank account records and may require considerable
                     taxpayer contact to ask the taxpayer to explain significant discrepancies
                     between total deposits and the income shown on the tax return. The net
                     worth and normal markup methods require taxpayer contact primarily to
                     explain any identified discrepancies.

                     AICPA has been among the critics of IRS’ reemphasis on financial status
                     audits since the program began in late 1994, claiming that IRS auditors use
                     the techniques without having any evidence that taxpayers have
                     underreported income. Such intrusions into taxpayer’s spending patterns
                     could occur at two points—(1) before the initial interview and (2) during
                     the initial interview. Critics suggested that such intrusions increased after
                     the 1994 initiative. Using the data gathered from our reviews of IRS’ audit
                     workpapers, we looked at the frequency of the two concerns.

                     We gathered information on how often IRS used the initial notification
                     letter to request that the taxpayer provide PLE information. We found no
                     significant difference between the 1992 and 1993 period (before the
                     reemphasis on financial status) and the 1995 and 1996 period (after the



                     Page 11                            GAO/GGD-98-38 Financial Status Audit Techniques
B-275099




reemphasis). During both periods, less than 5 percent of the initial
notification letters to the taxpayers also requested that they provide
information on their PLE.

Recognizing the potential for intrusiveness, the Acting Assistant
Commissioner (Examination) in a March 1996 memo, clarified the PLE
instructions. The memo indicated that while auditors had the
responsibility to secure an overall financial picture of the taxpayer, they
were not expected to automatically request PLE information with the
notification letter. According to AICPA officials, sending PLE forms with the
notification letters has decreased since the distribution of this memo.

We also gathered information on the types of questions IRS auditors asked
taxpayers at opening interviews. Financial status critics believe that
questions designed to determine the taxpayer’s financial status were
inappropriate unless IRS had evidence that the taxpayer had underreported
income. AICPA officials provided a list of the questions, which focused on
personal spending habits such as how often a taxpayer eats at restaurants
and where a taxpayer vacations.

Based on our analysis of the documents in the case files, most of these
interview questions occurred in fewer than 5 percent of the audits. For the
1995 and 1996 sample period, only four of the questions were asked during
the initial interview in over 10 percent of the audits.10 In addition, the
frequency in which the questions were asked was about the same in our
samples of audits for 1992 and 1993 and for 1995 and 1996. Appendix III
provides information about the specific questions and how often they
were asked.




10
  The frequency for these four questions ranged from 11 percent to 24 percent of the audits.



Page 12                                        GAO/GGD-98-38 Financial Status Audit Techniques
                                      B-275099




                                      The results of using financial status techniques have been mixed. The use
Results From Audits                   of the techniques resulted in IRS auditors identifying large amounts of
Using Financial Status                unreported income in some cases.11 At the same time, a high percentage of
Techniques Have Been                  audits resulted in no adjustments to reported income attributable to the
                                      use of financial status techniques.12 Table 3 summarizes these results.
Mixed
Table 3: Estimated Results of Using
Financial Status Techniques,                                                                              Sampling period
1992-1993 and 1995-1996               Audits using techniques                                          1992-1993                 1995-1996
                                      Estimated number of audits                                           136,100                    91,400
                                      Use of financial status techniques resulted in                             81%                        83%
                                      no adjustment to reported income
                                      Use of financial status techniques resulted in                             12%                         8%a
                                      adjustments to reported income of less than
                                      $10,000
                                      Use of financial status techniques resulted in                              7%                         9%
                                      adjustments to reported income of $10,000
                                      or over
                                      Total                                                                     100%                        100%
                                      a
                                       This figure includes one case in which the use of financial status techniques actually resulted in
                                      reducing the taxpayer’s reported income.

                                      Source: GAO analysis of IRS audit workpapers.



                                      IRSreemphasized the use of financial status techniques to address its
                                      concerns with finding unreported income. In the audits we reviewed in our
                                      1995 and 1996 sample, we estimated that auditors used financial status
                                      techniques to identify unreported income totaling over $300 million.13 Our
                                      review of the IRS workpapers indicated that the auditors were unlikely to
                                      have identified unreported income without using the techniques. The
                                      workpapers did not show that this income was reported on an information
                                      return or identified by the taxpayer, the other two primary techniques
                                      used to verify the accuracy of reported income.



                                      11
                                       Adjustments to taxable income include changes to income, such as wages or business gross receipts,
                                      business expenses, personal deductions, and exemptions. Financial status techniques primarily detect
                                      unreported income.
                                      12
                                        On average, audits using financial status techniques made larger adjustments to reported income
                                      than those not using the techniques. However, the information available in IRS’ workpapers did not
                                      allow us to determine whether this difference was attributable to the use of the techniques or the type
                                      of returns on which they were used. Rather than compare the results of audits that used and did not
                                      use the techniques, we focused on the results produced by using the techniques.
                                      13
                                        Actual changes in income identified using the techniques for audits we reviewed ranged from a
                                      reduction of about $8,700 to an increase of about $162,600.



                                      Page 13                                       GAO/GGD-98-38 Financial Status Audit Techniques
B-275099




However, table 3 shows that the use of financial status techniques has
resulted in no adjustments to income in a significant number of cases. For
example, in our 1992 and 1993 sample, 81 percent of the audits using
financial status techniques resulted in no adjustments to reported income
attributable specifically to the techniques. Similarly, for the 1995 and 1996
sample, 83 percent resulted in no adjustment to reported income
attributable to the use of the techniques.14

Audits having no change attributable to the use of financial status audit
techniques may have had changes attributable to other audit techniques.
These no-change audits were closed with either (1) no changes to any tax
issue or (2) changes such as reducing claims for a tax deduction,
exemption, or credit after the auditor reviewed the taxpayer’s
documentation. For the 1992 and 1993 audits having an 81 percent
no-change rate, 23 percent had no change for any reason and 58 percent
had changes to taxable income that were not attributable to the use of
financial status techniques. For 1995 and 1996, the 83 percent no-change
rate breaks out as 28 percent with no change for any reason and
55 percent with changes to taxable income that were not attributable to
the use of financial status techniques.15

This high percentage of no change attributable to the use of financial
status techniques raises issues about whether IRS can further help auditors
in judging when and how to use these techniques. Given the complexity of
the tax code and the fact that tax return forms provide for limited, if any,
explanation of the numbers entered by the taxpayer, it is not reasonable to
expect an adjustment every time a financial status technique is used nor is
it desirable that all auditor judgment be removed from the decision about
when to use the techniques. It is important, however, that IRS make the
most effective and efficient use of its limited resources while striking an
appropriate balance between collecting information and evidence to assist
the auditor in identifying the correct tax, and avoiding unnecessary burden
and intrusiveness for the taxpayers. Thus, the best interest of both IRS and
the taxpayers is achieved when the no-change rate is at some acceptable
low point. To this end, we believe that more specific criteria on when to
use financial status techniques would provide auditors with additional


14
  In commenting on our draft report, IRS said that the no-change rate attributable to the use of the
techniques does not mean that the usage was inappropriate. We generally agree but also believe that
the rate we found seems high.
15
 In its letter commenting on a draft of this report, IRS said that although use of the techniques may not
have led to changes to reported income, usage could have helped identify other tax changes. We did
not find this outcome in any of the sampled audits we analyzed.



Page 14                                        GAO/GGD-98-38 Financial Status Audit Techniques
                              B-275099




                              context around which to exercise their professional judgment on a
                              case-by-case basis, and would likely result in a reduced no-change rate.


                              IRS has three primary tools to oversee use of financial status audit
IRS Tools to Oversee          techniques: (1) audit standards to guide auditors, (2) supervisory review of
Use of Financial              auditors’ adherence to the standards, and (3) a system to measure
Status Techniques             adherence to the standards. Our analyses focused on how IRS applied these
                              tools to the use of financial status audit techniques. While these tools
                              offered important controls over the use of the financial status techniques,
                              they each have limitations. For example, the audit standards do not guide
                              auditors on when and when not to use financial status techniques. IRS’
                              managers at the group level review a small portion of the audits because of
                              a lack of time caused by other duties. IRS’ measurement system, like the
                              standards, focused on whether financial status techniques, when used,
                              were used correctly from a technical perspective, not on when to use the
                              techniques and to what degree.


Audit Standards Lack          IRSuses its audit standards, which have evolved since the 1960s, to define
Specific Criteria for Using   audit quality. However, the standards do not offer specific criteria to guide
Financial Status              auditors on when and when not to use financial status techniques and to
                              what degree. Instead, the standards focus on whether actions were taken
Techniques                    and, if so, whether they were taken correctly from a technical perspective.

                              IRS uses nine audit standards to address the scope, audit techniques,
                              technical conclusions, workpaper preparation, reports, and time
                              management of an audit. Each standard is composed of key elements that
                              operationally define a quality examination. IRS guidance stipulates that for
                              a standard to be rated as being “met,” each of the key elements must be
                              rated as “met” or “not applicable.” The standards and the associated key
                              elements are summarized in appendix II.

                              Of the nine audit standards, Standard 2, Probes for Unreported Income,
                              has four key elements that address whether the auditor (1) considered the
                              adequacy of internal controls, (2) considered the types of books and
                              records maintained, (3) considered the taxpayer’s financial status, and
                              (4) appropriately used indirect audit techniques to probe for unreported
                              income. These last two elements directly address financial status analyses
                              and audit techniques. Under Standard 2, auditors are instructed to
                              consider financial status in all audits and only use a financial status audit
                              technique when they suspect unreported income.



                              Page 15                            GAO/GGD-98-38 Financial Status Audit Techniques
B-275099




However, IRS did not provide specific criteria in the standards to help
auditors decide when unreported income is likely. The key element for
evaluating appropriate use of these techniques addressed whether the
auditor considered using a technique, selected the appropriate technique,
and applied it correctly. Nothing in the standard provides the auditor with
specific criteria to determine when to use or not use a given technique or
to what degree to use it. For example, IRS has not instructed auditors on
how extensively to consider a taxpayer’s financial status and when that
consideration should prompt the use of a technique to probe for
unreported income. Nor has IRS instructed auditors on how large a
discrepancy between reported income and expenses should be to justify
more in-depth probing. On the basis of our review of the audit
workpapers, we believe that this lack of criteria has probably contributed
to the large percentage of audits in which the use of financial status
techniques resulted in no adjustments to income.

During the course of our work, IRS agreed with us that it needs specific
criteria to better guide its auditors on using the financial status techniques.
According to an IRS official, sections of the Internal Revenue Manual are
being revised to better instruct tax auditors and revenue agents about
when and when not to use financial status techniques and to what degree
to use them in probing for unreported income. In September 1997, we
received a draft of the revised manual sections. Our initial review of these
revised instructions indicated that they offered some guidance on when to
use financial status techniques but did not provide specific criteria. For
example, the revisions indicate that if a preliminary analysis yields a
Cash-T that is materially out of balance, the auditor should use subsequent
interviews and information gathering to resolve the imbalance.

The instructions define “material imbalance” as the significance of an item
in determining the correct tax liability. The instructions require auditors to
use their judgment on the return as a whole and the items that comprise
that return. In using their judgment on whether the imbalance is material,
the auditors must consider such factors as the comparative and absolute
size of the imbalance as well as the relationship between the size of the
imbalance and the tax liability. However, IRS has not provided instructions
to guide the auditor when analyzing the comparative or absolute size of
the imbalance or when comparing the relationship of the imbalance to the
tax liability. In commenting on a draft of this report, IRS officials said it
would be impractical to develop specific quantitative criteria to define
materiality.




Page 16                            GAO/GGD-98-38 Financial Status Audit Techniques
                     B-275099




                     We acknowledge that developing quantitative criteria to cover every
                     situation is difficult and that auditors’ judgment is still an important
                     element of any audit. However, we believe that the concept of “material
                     imbalance” could be made more specific by developing some quantitative
                     criteria that would use the preliminary Cash-T and establish thresholds for
                     the factors associated with an imbalance between reported income and
                     estimates of PLE, such as the comparative size of any imbalance. If the
                     preliminary Cash-T indicated that the income reported on the tax return
                     that was available for PLE was below the threshold—that is, apparently not
                     sufficient to support the living expenses indicated—the auditor would be
                     expected to conduct a more detailed probe for unreported income,
                     potentially using one or more of the other financial status techniques. If
                     the preliminary Cash-T showed the taxpayer’s reported income to be
                     above the threshold—that is, apparently sufficient to support the
                     estimated PLE—using the other financial status techniques would not be
                     expected.

                     In either case, the auditor could decide to go against the criteria but would
                     be expected to explain the reasons in the workpapers. Developing such
                     criteria would be an on-going task, as changes would likely occur as IRS
                     gained experience about how well the criteria were working.


Supervisors Cannot   The primary tool used by IRS to control quality is the review of audit files
Review All Audit     by managers of audit groups. The Internal Revenue Manual requires
Workpapers           supervisory review of cases but is vague on exactly when review is
                     necessary and how it should be documented.

                     According to IRS Examination officials, IRS managers cannot review all
                     audits.16 Rather, the managers must rely on the experience and judgment
                     of the auditors because the manager’s audit workload and other duties
                     limit the time available for review. Further, these officials said budget
                     constraints will likely cause the managers’ span of control to increase
                     rather than decrease in the future, resulting in more audits to oversee. The
                     analysis of our sample supports IRS’ assertions that not all audits are
                     reviewed by managers. We found evidence of supervisory review in about
                     9 percent and 6 percent of the audits for 1992 and 1993 and 1995 and 1996,
                     respectively.

                     16
                       However, IRS officials told us that managers should review all unagreed and trainee audits. Unagreed
                     audits are those that were closed without the taxpayer agreeing with the auditor’s recommended
                     adjustments to taxable income or tax liability. For fiscal year 1996, there were about 86,800 audits that
                     were closed as unagreed. Trainee audits are ones selected for purposes of training IRS auditors. For
                     fiscal year 1996, there were about 117,100 such audits selected.



                     Page 17                                        GAO/GGD-98-38 Financial Status Audit Techniques
                      B-275099




                      In the districts we visited, the managers acknowledged that they can only
                      review a small portion of all ongoing and closed audits for each auditor
                      annually because of the reasons cited. Managers told us they try to spend
                      more time reviewing the work of the least experienced auditors. At a
                      minimum, they said they try to maintain an ongoing discussion with all
                      auditors about their audit inventories.


EQMS Measurement Is   IRS conducts post-audit quality measurement through EQMS reviews. EQMS is
Limited by the Data   IRS’mechanism for collecting information about the audit process, changes
Collected             to that process, the level of audit quality, and the success of any efforts to
                      improve the process and quality. The Office of Compliance Specialization,
                      within IRS’ Examination Division, has responsibility for this program. This
                      office compiles and maintains a national database of the quality reviews
                      done at the district level. This database can be used to identify trends by
                      district and nationally. Of the 800,000 face-to-face audits done by IRS in
                      fiscal year 1996, EQMS staff reviewed a sample of 12,170 audits to measure
                      quality against the nine audit standards. According to IRS officials, this
                      sample provided a statistically valid basis for measuring audit quality. EQMS
                      staff reviewed the 12,170 audits to determine whether the auditors met the
                      criteria for each of the auditing standards. For fiscal year 1996, the
                      percentages of audits that were rated as having met the standards ranged
                      from 38 percent for Standard 9, Time Span/Time Charged, to 95 percent
                      for Standard 5, Findings Supported by Law. (App. II summarizes EQMS
                      results since fiscal year 1992.)

                      Before fiscal year 1997, IRS did not collect data on the reasons key
                      elements were not met. Starting in fiscal year 1997, however, IRS began
                      collecting these data. For the first 2 quarters of fiscal year 1997, reviewers
                      looked at 2,904 office audits and 2,859 field audits.17 Of these audits, IRS
                      rated 84 percent and 78 percent of the office and field audits, respectively,
                      as having met (i.e., passed) the key element under Standard 2 that involves
                      the consideration of financial status. Further, 74 percent and 82 percent of
                      these office and field audits, respectively, were rated as having met the key
                      element under Standard 2 that involves the appropriate use of financial
                      status audit techniques. Table 4 summarizes the EQMS-determined reasons
                      auditors did not meet these key elements of Standard 2. For example, the
                      most frequent reasons cited were that auditors did not (1) provide
                      evidence that they had evaluated financial status, (2) recognize the need to

                      17
                        Traditionally, IRS has conducted two types of face-to-face audits from its district offices: (1) field
                      audits, in which an IRS revenue agent visits an individual taxpayer who has business income or a very
                      complex return and (2) office audits, in which an individual taxpayer who has a less complex return
                      visits a tax auditor at an IRS office.



                      Page 18                                        GAO/GGD-98-38 Financial Status Audit Techniques
                                       B-275099




                                       use one of the financial status techniques, and (3) correctly compute the
                                       financial status technique.

Table 4: Reasons Two Key Elements of
Standard 2 Were Rated as Not Met                                                             Audits not meeting key element
(Oct. 1, 1996 Through Mar. 31, 1997)   Key element                                               Office audit          Field audit
                                       Consideration of financial statusa                                424                  584
                                       Reasons for being rated as “not met”
                                           No evidence of evaluation                                    61.2%                 48.7%
                                           Standard of living/PLE not considered                        25.5%                 19.7%
                                           Financial history not considered                              3.9%                 11.6%
                                           Potential source of funds not considered                      3.0%                  3.3%
                                           Accumulation of wealth/assets not                             2.8%                  4.6%
                                           considered
                                           Loans (receipts & payments) not                               1.6%                  4.8%
                                           considered
                                           Significant results considered insignificant                  1.1%                  2.0%
                                           Business environment not considered                           0.9%                  5.4%


                                       Appropriate use of financial status                               137                  265
                                       techniquesa
                                       Reasons for being rated as “not met”
                                           Did not recognize need for techniques                        65.1%                 32.5%
                                           Technique computed incorrectly                               14.7%                 42.7%
                                           Significant results considered insignificant                 12.8%                 10.2%
                                           Did not use appropriate method                                7.3%                 14.6%
                                       a
                                       Percentages may not total to 100 due to rounding.

                                       Source: IRS data.



                                       Knowing the reasons for not meeting the key element or the standard can
                                       provide insights on when the use of the financial status techniques would
                                       and would not be necessary to identify unreported income. However, the
                                       reasons identified by IRS, like the criteria in the audit standard on probing
                                       for unreported income, have not addressed the issue of when and when
                                       not to use financial status techniques and to what degree they should be
                                       used. Without this information, IRS cannot fully measure the quality of
                                       audits involving financial status techniques.




                                       Page 19                                     GAO/GGD-98-38 Financial Status Audit Techniques
              B-275099




              IRSauditors have used financial status audit techniques for years to help
Conclusions   identify unreported income. IRS’ renewed emphasis on the use of these
              techniques appears to have had little impact on how frequently auditors
              used them. Also, neither the type of technique nor the type of return on
              which they are used has changed to any statistically significant degree.

              IRS has not measured how the use of financial status techniques may add
              to the burden and intrusiveness of audits. Use of the preliminary Cash-T
              technique added no burden because this technique does not require
              additional taxpayer contact. Use of the other financial status techniques
              require some degree of taxpayer contact. The amount of contact and the
              amount of additional information sought from the taxpayer, however, can
              vary with each situation.

              The results of using financial status techniques were mixed. In a large
              majority of such audits, no adjustments to income could be attributed
              specifically to the techniques. While it is not reasonable to expect
              unreported income to be found every time these techniques are used, the
              current rate of no adjustments seems high. However, in the remaining
              audits, the use of the techniques helped auditors to find unreported
              income that probably would not otherwise have been detected.

              This detection capability and the high frequency of no adjustments to
              reported income raises the issues of how to decide when and when not to
              use financial status techniques and to what degree they should be used.
              Currently, auditors’ judgment primarily dictates these decisions because
              IRS does not provide the auditors with specific guidance for determining
              whether to use financial status audit techniques. While an auditor’s
              judgment is likely to continue to constitute a significant portion of the
              decisionmaking process, guidance, in the form of specific criteria, might
              help reduce the frequency in which these techniques are used but do not
              result in adjustment to income.

              Similarly, supervisory review of audits to guide the auditors’ performance,
              a key piece of IRS’ quality control system, was limited by workload
              constraints and when done, seldom addressed the use of financial status
              techniques. Finally, IRS staff reviewed some closed audits for quality
              through EQMS, but like the audit standards, these reviews did not focus on
              when and when not to use financial status techniques and to what degree
              to use them.




              Page 20                           GAO/GGD-98-38 Financial Status Audit Techniques
                         B-275099




                         Without establishing specific criteria to guide the usage of financial status
                         audit techniques, IRS does not have a good basis for evaluating the
                         auditors’ judgment in choosing to use or not use the techniques. We
                         believe that such criteria would help IRS auditors make their decisions.
                         Given that our tax system is based on voluntary compliance, an
                         appropriate balance must be maintained between collecting information to
                         assist the auditor in identifying the correct tax and avoiding unnecessary
                         burden and intrusiveness for the large majority of taxpayers. More specific
                         criteria to use in making case-by-case decisions about when and to what
                         extent to use financial status audit techniques would be helpful to auditors
                         in achieving that balance. Developing such criteria, however, would have
                         to be considered a work in progress, with changes and updates occurring
                         as needed when auditors and managers become more experienced with
                         their use. During the course of our work, IRS agreed that it needs more
                         specific criteria to guide its auditors in exercising their judgment to use
                         the financial status techniques and began developing instructions that
                         include such criteria to be included in the Internal Revenue Manual.


                         To provide better assurance that financial status techniques are not overly
Recommendations          burdensome and intrusive to taxpayers and that the most productive use is
                         made of limited audit resources, we recommend that the Commissioner of
                         IRS further pursue efforts to develop more specific criteria on when and to
                         what extent to use financial status techniques. To help develop and refine
                         these criteria, we recommend that the IRS Commissioner

                     •   ensure that these specific criteria on using the techniques are reflected in
                         the instructions for interpreting the audit standards and the evaluations
                         through EQMS and its reason codes of how well audits meet these
                         standards;
                     •   monitor the use of financial status techniques under the new criteria to
                         identify factors associated with successful and unsuccessful usage in
                         terms of when and to what extent to use the techniques as well as whether
                         the usage identified unreported income and if so, in what amounts; and
                     •   use these monitoring results to evaluate whether to make further revisions
                         to the criteria on using the techniques or in the system by which IRS
                         monitors their use.


                         We obtained comments on a draft of this report at a meeting on
Agency Comments          November 12, 1997, with officials who represented IRS. These officials
and Our Evaluation       included the Chief Compliance Officer, the Assistant Commissioner for



                         Page 21                           GAO/GGD-98-38 Financial Status Audit Techniques
B-275099




Examination and members of his staff, the National Director of
Compliance Specialization and members of his staff, and a representative
from IRS’ Office of Legislative Affairs. The Deputy Commissioner also
documented these comments in a letter dated November 20, 1997 (see app.
IV).

In general, IRS agreed with the substance of our report. It provided
technical comments to clarify specific sections of the report. These
comments dealt with issues such as the status and nature of the
instructions being developed on using financial status techniques and IRS’
position on intrusiveness of the techniques and on training. We have
incorporated these comments into the report where appropriate.

Concerning the recommendations in our report, IRS agreed with our overall
recommendation on developing more specific criteria to guide auditors in
using financial status techniques and generally agreed with the three
recommendations we made to help with this development. IRS officials
fully agreed to implement all of our recommendations by October 1998, as
reflected in IRS’ letter of November 20, 1997.


We are sending copies of this report to the Committee’s Ranking Minority
Member, the Chairman and Ranking Minority Member of the Senate
Committee on Finance, various other congressional committees, the
Director of the Office of Management and Budget, the Secretary of the
Treasury, and other interested parties. We will also make copies available
to others upon request.

Major contributors to this report are listed in appendix V. If you have any
questions concerning this report, please contact me at (202) 512-9110.




Lynda D. Willis
Director, Tax Policy
  and Administration Issues




Page 22                           GAO/GGD-98-38 Financial Status Audit Techniques
Page 23   GAO/GGD-98-38 Financial Status Audit Techniques
Contents



Letter                                                                                                1


Appendix I                                                                                           26
                        Study Population                                                             26
Statistical             Sample Selection and Weighting                                               26
Methodology for         Sampling Errors and Confidence Intervals of Estimates                        29
                        Controlling for Nonsampling Errors                                           30
Evaluating Financial
Status Audit
Techniques
Appendix II                                                                                          34

IRS’ Examination
Quality Measurement
System
Appendix III                                                                                         41

Analysis of AICPA
Concerns
Appendix IV                                                                                          44

Comments From the
Internal Revenue
Service
Appendix V                                                                                           48

Major Contributors to
This Report
Tables                  Table 1: Number and Percentages of Audits That Used Financial                 9
                          Status Techniques, Before and After IRS’ Reemphasis
                        Table 2: Types and Percentages of Financial Status Techniques                10
                          Used in Audits Before and After IRS’ Reemphasis
                        Table 3: Estimated Results of Using Financial Status Techniques,             13
                          1992-1993 and 1995-1996




                        Page 24                          GAO/GGD-98-38 Financial Status Audit Techniques
          Contents




          Table 4: Reasons Two Key Elements of Standard 2 Were Rated as                19
            Not Met (Oct. 1, 1996 through Mar. 31, 1997)
          Table I.1: Distribution of Tax Returns in the AIMS Database by               27
            Sample Strata
          Table I.2: Distribution of Audits by Year and Sample Disposition             28
          Table I.3: Confidence Intervals for Point Estimates Comparing                30
            1992-1993 and 1995-1996 Financial Status Audits
          Table I.4: Comparison of Adjustments to Income For 1995                      32
            Between Audits That Used Financial Status Techniques Versus
            Audits That Did Not
          Table I.5: Confidence Intervals for Estimates of Adjustments to              32
            Income Attributed to the Use of Financial Status Techniques
          Table I.6: Confidence Intervals for Estimate of Variables Without            33
            Comparisons—1992-1993 and 1995-1996 Audits
          Table II.1: Summary of IRS’ Examination Quality Measurement                  34
            System Auditing Standards (as of October 1996)
          Table III.1: Questions Asked by Auditors at Initial Interviews,              43
            Which Cause Concerns for AICPA Officials

Figures   Figure II.1: Standard Success Rates for Office Audits From Fiscal            37
            Years 1992-1996
          Figure II.2: Standard Success Rates for Field Audits From Fiscal             38
            Years 1992-1996
          Figure II.3: Key Element Pass Rates for Key Elements of Standard             39
            2 for Office Audits From Fiscal Years 1992-1996
          Figure II.4: Key Element Pass Rates for Key Elements of Standard             40
            2 for Field Audits From Fiscal Years 1992-1996




          Abbreviations

          AICPA      American Institute of Certified Public Accountants
          AIMS       Audit Information Management System
          DCI        Data Collection Instrument
          EQMS       Examination Quality Measurement System
          IRS        Internal Revenue Service
          PLE        Personal Living Expense


          Page 25                          GAO/GGD-98-38 Financial Status Audit Techniques
Appendix I

Statistical Methodology for Evaluating
Financial Status Audit Techniques

                       This appendix describes the methodology we used to sample Internal
                       Revenue Service (IRS) audits from 1992 and 1993 and from 1995 and 1996.
                       We used these samples to quantify the differences in audit practices before
                       and after IRS began its reemphasis on using the financial status techniques
                       and to estimate the results of these audits.


                       IRSreemphasized its financial status program late in fiscal year 1994. To
Study Population       determine whether financial audit practices and results had changed, we
                       compared audits within IRS’s Audit Information Management System (AIMS)
                       database that were completed before and after the reemphasis in 1994. We
                       restricted our study population to audits of books and records that IRS
                       conducted at district offices. This meant that we excluded limited-scope
                       audits initiated solely to assess an additional tax, resulting from an audit of
                       a partnership or corporation, audits opened as part of IRS’ nonfiler
                       compliance initiative, audits of taxpayer claims, and substitutes for returns
                       in which IRS prepares a return for a nonfiler. We expected that financial
                       status techniques would have the potential to be used on the audits we
                       included.

                       To identify audits that were completed before auditors were exposed to
                       the emphasis on financial status, we restricted the pre-1994 study
                       population to the estimated 566,268 audits that had begun in the period
                       from October 1, 1991, to October 31, 1992, and were completed by
                       September 30, 1993. To identify the most current audits subsequent to the
                       emphasis on financial status, we restricted the post-fiscal year 1994 study
                       population to the estimated 421,039 audits that had begun in the period
                       from October 1, 1994, to October 31, 1995, and were completed by
                       September 30, 1996. We selected a probability sample of audited tax
                       returns from each of the two time periods. We then obtained information
                       about the audits by reviewing IRS’s workpapers.


                       To obtain the sample of audits of books and records, we selected a
Sample Selection and   stratified, probability sample of 1,232 tax returns from among all returns
Weighting              audited in district offices by revenue agents and tax auditors within the
                       fiscal years 1992, 1993, 1995, and 1996 study periods. The samples were
                       drawn for 1992 and 1993 and for 1995 and 1996. The audit associated with
                       each selected tax return included all returns of a taxpayer that had been
                       completed during the study periods. As two of the sampled returns were
                       associated with the same audit, the initial sample of 1,232 returns resulted




                       Page 26                            GAO/GGD-98-38 Financial Status Audit Techniques
                                              Appendix I
                                              Statistical Methodology for Evaluating
                                              Financial Status Audit Techniques




                                              in a sample of 1,231 audits. These returns were stratified by year, income,
                                              and type of return as shown in table I.1.


Table I.1: Distribution of Tax Returns in the AIMS Database by Sample Strataa
                                                                                        Type of return
                                          b
                               FY opened              FY closed        Low income          High income             Business                  Total
In AIMS database                      1992                  1992             235,949              99,297               67,258              402,504
                                      1992                  1993             214,433              96,636               68,386              379,455
                                      1995            1995-1996              342,897             153,252             105,526               601,675
Total returns                                                                                                                          1,382,634
In our sample of AIMS                 1992                  1992                   75                  75                 125                    275
database
                                      1992                  1993                  140                 144                 148                    432
                                      1995            1995-1996                   150                 150                 225                    525
Total returns                                                                                                                                1,232
                                              a
                                               The low-income returns are nonbusiness returns on which the taxpayer reported less than
                                              $50,000 in income. The high-income returns are nonbusiness returns on which the taxpayer
                                              reported $50,000 or more in income. The business returns are those for which more than
                                              50 percent of the total income comes from the taxpayer’s farm or sole proprietor business.
                                              b
                                              The opening year includes the standard fiscal year that begins on October 1 as well as the first
                                              month of the next fiscal year, ending on October 31.

                                              Source: IRS’ AIMS database and GAO sampling data.



                                              The division of the population and sample of audits between different
                                              types of returns is shown in Table I.2. The low income, high income, and
                                              business columns contain audits associated with one or more returns from
                                              a single sample strata. The mixed category contains the audits that
                                              included returns from more than one of the tax-return strata. Table I.2 also
                                              indicates that IRS could not locate IRS audit workpapers for the 187 audits
                                              and that of the 1,044 audits for which workpapers were located, 838 were
                                              eligible for our study because they were books and records audits. The
                                              final sample for our analyses of these audits in this report are the 838
                                              audits identified in the next to last row of table I.2.




                                              Page 27                                      GAO/GGD-98-38 Financial Status Audit Techniques
                                       Appendix I
                                       Statistical Methodology for Evaluating
                                       Financial Status Audit Techniques




Table I.2: Distribution of Audits by
Year and Sample Disposition                                                           Type of return (opened 1992)
                                                                               Low         High
                                       Variable                             income      income Business       Mixed      Total
                                       Audits in AIMS database
                                         All audits                         364,820    154,443      95,946 14,225      629,434
                                         Audits in study populationa        342,916    124,053      81,711    6,996    555,676
                                       Audits in our sample
                                       Total                                    207         204        250       46        707
                                         Workpapers not found by IRS             25          27         31        6         89
                                            Workpapers available                182         177        219       40        618
                                            Excluded auditsb                     15          46         54       19        134
                                            Audits eligible for studyc          167         131        165       21        484
                                            Percent available                    88%         87%        88%    87%




                                       Page 28                                  GAO/GGD-98-38 Financial Status Audit Techniques
                                Appendix I
                                Statistical Methodology for Evaluating
                                Financial Status Audit Techniques




                         Type of return (opened 1995)
    Low income    High income                   Business                    Mixed                    Total              Grand Total


       265,426        120,403                      76,607                  11,780                 474,216                  1,103,650
       243,807        100,912                      69,573                    6,747                421,039                    976,715


           144           139                           213                      28                     524                      1,231
            26            25                            39                        8                     98                          187
           118           114                           174                      20                     426                      1,044
            13            24                            27                        8                     72                          206
           105            90                           147                      12                     354                          838
            82%           82%                           82%                     71%                                                 85%
                                a
                                    Estimated books and records audits.
                                b
                                 Excluded audits included correspondence audits at IRS Service Centers and limited scope
                                audits to pass through adjustments from partnership audits to the partners, identified nonfilers,
                                prepared substitute returns for nonfilers, and reviewed taxpayers’ claims for refund.
                                c
                                    Books and records audit.

                                Source: IRS’ AIMS database and GAO sampling data.



                                The items in the AIMS database that served as our sampling frame are
                                individual tax returns, not audits. Because an audit can include multiple
                                tax returns, the effect of multiple returns has been incorporated in the
                                weighting of the sampled audits in the analysis. The weights and sampling
                                errors have been calculated using a multiplicity estimator in which each
                                sampled audit is weighted to account for the total number of associated
                                returns in the AIMS sampling frame.1


                                The results shown in this report are estimates because they are based on
Sampling Errors and             the sample of audits drawn from the total population of all eligible audits.
Confidence Intervals            The accuracy of these estimates is quantified by their sampling errors,
of Estimates                    expressed as 95-percent confidence intervals. In table I.3, for example, the
                                estimate that 24 percent of the 1992 audits used a financial status audit
                                technique is surrounded by a confidence interval of + 5 percentage points,
                                indicating that we are 95 percent confident that the actual percentage in
                                the population of all audits lies between 19 and 29 percent. The


                                1
                                Sirken, Monroe G.S.: Stratified Sample Surveys with Multiplicity. Journal of the American Statistical
                                Association, March 1972, Vol. 67, pp. 224-227.



                                Page 29                                       GAO/GGD-98-38 Financial Status Audit Techniques
                                             Appendix I
                                             Statistical Methodology for Evaluating
                                             Financial Status Audit Techniques




                                             comparison column of the same table indicates that the difference of
                                             3 percent between the 1992 and 1995 samples is surrounded by a
                                             95-percent confidence interval of + 6 percentage points, indicating that we
                                             are 95 percent confident that the difference between the 1992 and 1995
                                             audits lies between –3 and +9 percent. Since, in this instance the
                                             95-percent confidence interval included the possibility that there is no
                                             difference, we conclude that the estimated difference of 3 percent is not
                                             statistically significant.


                                             In addition to the reported sampling errors, various obstacles can occur
Controlling for                              when conducting this type of review and may cause other types of errors,
Nonsampling Errors                           commonly referred to as nonsampling errors. For example, differences in
                                             how questions are interpreted and errors in entering data could affect the
                                             results. We included steps in both the data collection and data analysis
                                             stages for the purpose of minimizing such nonsampling errors. These steps
                                             involved the 100 percent review of completed data collection instruments
                                             (DCI) and data entry of those DCIs, and checking all computer analyses with
                                             a second analyst.

                                             Tables I.3 through I.5 describe our point estimates for the analysis of
                                             financial status audits and the related sampling errors.


Table I.3: Confidence Intervals for Point Estimates Comparing 1992-1993 and 1995-1996 Financial Status Audits
                                                1992-1993                 1995-1996                    Comparisona
                                                          Confidence                     Confidence                        Confidence
                                                       interval at the                interval at the                   interval at the
                                                           95-percent                     95-percent                        95-percent
                                                          confidence                     confidence      Percentage        confidence
Description                                Estimate              level   Estimate               level    Differencec              level
Audits where a financial status                 24%               + 5%        22%              + 4%                3%              + 6%
technique(s) was used (percentage of
all audits)
Audits using financial status techniques        75%              +10%         84%             +10%                 9%             +14%
that had business or farm income (as a
percentage of financial status audits)
Percent of returns with business or farm        38%                +7%        34%               +7%                4%             +10%
income where one or more of the
financial status techniques were used
Percent of returns with nonbusiness             12%                +6%          7%              +5%                4%               +8%
income where one or more of the
financial status techniques were used
Initial interview questions the AICPA considers inappropriate (as a percent of all audits with initial interviews documented)
Taxpayer’s education                             7%               + 3%        12%              + 5%                5%              + 6%
                                                                                                                           (continued)


                                             Page 30                                   GAO/GGD-98-38 Financial Status Audit Techniques
                                           Appendix I
                                           Statistical Methodology for Evaluating
                                           Financial Status Audit Techniques




                                                  1992-1993                        1995-1996                        Comparisona
                                                           Confidence                       Confidence                            Confidence
                                                        interval at the                  interval at the                       interval at the
                                                            95-percent                       95-percent                            95-percent
                                                           confidence                       confidence       Percentage           confidence
Description                              Estimate                 level     Estimate               level     Differencec                 level
Assets other than home or autos that               6%               + 3%            8%            + 4%                   2%                + 5%
cost over $10,000
Loans by and loan payments to the                  8%               + 3%            4%            + 2%                   3%                + 4%
taxpayer
Amount and monthly payments on                     9%               + 5%            6%            + 3%                   3%                + 6%
outstanding debt
Cash advances from credit cards                    3%               + 2%            1%            + 1%                   2%                + 2%
Amount of cash on hand                           27%                 +6%          24%             + 6%                   3%                +9%
                                                    b                   b                                                  b
Amounts transferred between accounts                                                1%            + 1%                                     + 1%
Safe deposit box                                 20%                + 6%          18%             + 6%                   2%                + 8%
Taxpayer involved in transactions of               4%               + 3%            3%            + 2%                   1%                + 3%
$10,000 or more
                                                    b                   b
Information about where the taxpayer                                                3%            + 2%                   3%                + 2%
vacations
                                                                                                                           b
Information about what college the                 1%               + 1%            1%            + 1%                                     + 2%
taxpayer’s children attend
Quality of the taxpayer’s clothing                 0%                  0%           0%              0%                   0%                 0%
                                                                                                                           b
Information about how often the                    1%               + 2%            1%            + 1%                                     + 2%
taxpayer eats out
                                                    b                   b
Information about how much the                                                      1%            + 1%                   1%                + 1%
taxpayer spends on entertainment
Information on taxpayer’s cash horde               7%               + 4%          11%             + 5%                   4%                + 6%
Information on the amount the taxpayer             3%               + 3%            1%            + 1%                   1%                + 3%
paid for utilities and personal living
expenses

                                           a
                                            For the comparisons between years, when the confidence interval of the difference is greater
                                           than the difference, the result is not statistically significant.
                                           b
                                               Percentages are less than 0.5 percent.
                                           c
                                            Percent of difference may not add to total due to rounding.

                                           Source: GAO analysis of sampled data.




                                           Page 31                                        GAO/GGD-98-38 Financial Status Audit Techniques
                                                Appendix I
                                                Statistical Methodology for Evaluating
                                                Financial Status Audit Techniques




Table I.4: Comparison of Adjustments to Income for 1995 Between Audits That Used Financial Status Techniques Versus
Audits That Did Not
                            Financial status                No financial status                    Comparisona
                                  Confidence interval at                  Confidence interval at                       Confidence interval at
                                     the 95-percent                          the 95-percent                               the 95-percent
                                    confidence level                        confidence level                             confidence level
                                       Low            High                      Low            High                          Low            High
Description            Estimate    estimate       estimate    Estimate      estimate       estimate      Difference      estimate       estimate
1995 sample results
Adjustments to          $14,732     $11,041        $19,622       $8,348        $6,998        $9,974           $6,384       $3,162        $12,882
income
                                              a
                                               For the comparison between audits that used financial status techniques and those that did not,
                                              when the confidence interval of the difference is greater than the difference, the result is not
                                              statistically significant.

                                              Source: GAO analysis of sampled data.




Table I.5: Confidence Intervals for Estimates of Adjustments to Income Attributed to the Use of Financial Status
Techniques
Dollars in millions
                                                 1992-1993 audits                                          1995-1996 audits
                                                    Confidence interval at the                                 Confidence interval at the
                                    Estimated      95-percent confidence level                Estimated       95-percent confidence level
Description of variable                dollars     Low estimate       High estimate              dollars      Low estimate       High estimate
Total adjustments to income            $1,154                $382             $3,483                $316                $188                $533
identified by financial status
techniques
                                                Source: GAO analysis of sampled data.




                                                Page 32                                    GAO/GGD-98-38 Financial Status Audit Techniques
                                                 Appendix I
                                                 Statistical Methodology for Evaluating
                                                 Financial Status Audit Techniques




Table I.6: Confidence Intervals for Estimate of Variables Without Comparisons—1992-1993 and 1995-1996 Audits
                                                          1992-1993 audits                     1995-1996 Audits
                                                                         Confidence interval at                      Confidence interval at
                                                        Percentage              the 95-percent       Percentage             the 95-percent
Description of Variables                                  Estimate            confidence level         Estimate           confidence level
Audits using financial status techniques that                      23%                       +9%              28%                    +10%
were closed with no change to tax or income
Audits using financial status techniques that                      81%                       + 8%             83%                    + 6%
were closed with no change identified by one
of the techniques
Adjustments of less than $10,000 identified by                     12%                       + 7%               8%                   + 5%
financial status techniques
Adjustments of $10,000 or more identified by                        7%                       + 4%               9%                   + 4%
financial status techniques
Audits where supervisory review was                                 9%                       + 3%               6%                   + 3%
documented in the workpapers
Audits with supervisory review where the                            0%                       + 0%               7%                   + 7%
supervisor mentioned financial status
Time examiners requested personal living                            2%                       + 3%               3%                   + 2%
expenses from taxpayers in a notification letter
Preliminary Cash-T was the only financial                         n/a                        n/a              23%                    +10%
status technique
Technique used was Cash-T only                                     50%                      +10%              47%                    +11%
Technique used was bank deposit only                               29%                       + 8%             21%                    + 9%
Technique used was combination of Cash T                           20%                       +8%              32%                    + 9%
and bank deposit
                                                                     a                          a
Other technique was used                                                                                        1%                   + 1%
                                                 a
                                                   Percentages are less than 0.5 percent.

                                                 Source: GAO analysis of sampled data.




                                                 Page 33                                    GAO/GGD-98-38 Financial Status Audit Techniques
Appendix II

IRS’ Examination Quality Measurement
System

                                            The Office of Compliance Specialization, within IRS’ Examination Division,
                                            has responsibility for Quality Measurement Staff operations and the
                                            Examination Quality Measurement System (EQMS). Among other uses, IRS
                                            uses EQMS to measure the quality of closed audits against nine IRS audit
                                            standards. The standards address the scope, audit techniques, technical
                                            conclusions, workpaper preparation, reports, and time management of an
                                            audit. Each standard includes additional key elements describing specific
                                            components of a quality audit. Table II.1 summarizes the standards and the
                                            associated key elements.


Table II.1: Summary of IRS’ Examination Quality Measurement System Auditing Standards (as of October 1996)
No.        Standard               Key Elements           Purpose                 Overview
1        Considered large,        A. Balance sheet and        Measures whether            This standard encompasses, but is not
         unusual, or questionable Schedule M considered       consideration was given     limited to, the following fundamental
         items                    B. Income, deduction,       to the large, unusual, or   considerations: absolute dollar value,
                                  and credit items            questionable items in       relative dollar value, multiyear comparisons,
                                  considered                  both the precontact         intent to mislead, industry/business
                                  C. Scope of examination     stage and during the        practices, compliance impact, and so forth.
                                  was appropriate             course of the
                                                              examination.
2        Probes for unreported    A. Consideration of         Measures whether the        Gross receipts were probed during the
         income                   internal controls for all   steps taken verified that   course of examination, regardless of
                                  business returns            the proper amount of        whether the taxpayer maintained a double
                                  B. Consideration of         income was reported.        entry set of books. Consideration was given
                                  books and records                                       to responses to interview questions, the
                                  C. Consideration of                                     financial status analysis, tax return
                                  financial status                                        information, and the books and records in
                                  D. Appropriate use of                                   probing for unreported income.
                                  indirect methods
3        Required filing checks   A. Consideration of prior   Measures whether            Required filing checks consist of the
                                  and subsequent year tax     consideration was given     analysis of return information and, when
                                  returns                     to filing and examination   warranted, the pick-up of related, prior and
                                  B. Consideration of         potential of all returns    subsequent year returns. In accordance
                                  related returns             required by the taxpayer    with Internal Revenue Manual 4034,
                                  C. Compliance items         including those entities    examinations should include checks for
                                  considered                  in taxpayer’s sphere of     filing information returns.
                                                              influence/responsibility.
                                                                                                                            (continued)




                                            Page 34                                  GAO/GGD-98-38 Financial Status Audit Techniques
                                        Appendix II
                                        IRS’ Examination Quality Measurement
                                        System




No.   Standard                 Key Elements                 Purpose                     Overview
4     Examination depth and    A. Adequate interviews       Measures whether the        The depth of the examination was
      records examined         conducted                    issues examined were        determined through inspection, inquiry,
                               B. Adequate exam             completed to the extent     interviews, observation, and analysis of
                               techniques used              necessary to provide        appropriate documents, ledgers, journals,
                               C. Fraud adequately          sufficient information to   oral testimony, third-party records, etc., to
                               considered and               determine substantially     ensure full development of relevant facts
                               developed                    correct tax.                concerning the issues of merit. Interviews
                               D. Issues sufficiently                                   provided information not available from
                               developed                                                documents to obtain an understanding of
                                                                                        the taxpayer’s financial history, business
                                                                                        operations, and accounting records in order
                                                                                        to evaluate the accuracy of books/records.
                                                                                        Specialists provided expertise to ensure
                                                                                        proper development of unique or complex
                                                                                        issues.
5     Findings supported by    A. Correct                   Measures whether the        This standard includes consideration of
      law                      technical/factual            conclusions reached         applicable law, regulations, court cases,
                               conclusions reached          were based on a correct     revenue rulings, etc. to support
                                                            application of tax law.     technical/factual conclusions.
6     Penalties properly       A. Recognized,               Measures whether            Consideration of the application of
      considered               considered, and applied      applicable penalties        appropriate penalties during all examination
                               correctly                    were considered and         is required.
                               B. Penalties computed        applied correctly.
                               correctly
7     Workpapers support       A. Fully disclose audit      Measures the                Workpapers provided the principal support
      conclusions              trail and techniques         documentation of the        for the examiner’s report and documented
                               B. Legible and organized     examination’s audit trail   the procedures applied, tests performed,
                               C. Adjustments in            and techniques used.        information obtained, and the conclusions
                               workpapers agree with                                    reached in the examination.
                               4318, 4700, and reports
                               D. Activity record
                               adequately documents
                               exam activities
                               E. Disclosure
8     Report writing           A. Applicable report         Measures the                Addresses the written presentation of audit
      procedures followed      writing procedures           presentation of the audit   findings in terms of content, format, and
                               followed                     findings in terms of        accuracy. All necessary information is
                               B. Correct tax               content, format, and        contained in the report, so that there is a
                               computation                  accuracy.                   clear understanding of the adjustments
                                                                                        made and the reasons for those adjustments.
9     Time span/time charged   A. Examination time          Measures the utilization Time is an essential element of the Auditing
                               commensurate                 of time as it relates to the Standards and is a proper consideration in
                               B. Exam initiation           complete audit process. analyses of the examination process. The
                               C. Examination activities                                 process is considered as a whole and at
                               D. Case closing                                           examination initiation, examination activities,
                                                                                         and case closing stages.

                                        Source: IRS data.




                                        Page 35                                     GAO/GGD-98-38 Financial Status Audit Techniques
                        Appendix II
                        IRS’ Examination Quality Measurement
                        System




Standard Success Rate   EQMS quality reviewers use the key element definitions to determine
                        whether an audit adhered to the standard. Thus, adherence to audit quality
                        is measured by the presence or absence of associated key elements. For a
                        standard to be rated as having been met, each of the associated key
                        elements must also be rated as met or not applicable. If the audit does not
                        demonstrate the characteristics described by one of the key elements,
                        then the standard is rated as not met.

                        One measure that IRS uses to evaluate the audit quality is the standard
                        success rate. It measures the percentage of cases for which all the
                        underlying key elements of each standard are rated as having been met.
                        According to IRS, this measure is useful for determining whether a case is
                        flawed and in what area. Figures II.1 and II.2 show the standard success
                        rates for each of the standards for fiscal years 1992 through 1996 for office
                        and field audits, respectively.




                        Page 36                                GAO/GGD-98-38 Financial Status Audit Techniques
                                                                                                                                               0%
                                                                                                                                                                            100%




                                                                                                                                                    20%
                                                                                                                                                          40%
                                                                                                                                                                60%
                                                                                                                                                                      80%
                                                                                                                         la Co
                                                                                                                           r
                                                                                                                        qu ge , nsi
                                                                                                                           es un de
                                                                                                                              tio us red
                                                                                                                                 na ua




                                                                                                         Standards




                                                                      1996
                                                                             1995
                                                                                    1994
                                                                                           1993
                                                                                                  1992
                                                                                                                                   bl l,
                                                                                                                                     e or
                                                                                                                                      ite
                                                                                                                                         m
                                                                                                                        un                 s
                                                                                                                          re P
                                                                                                                             po ro
                                                                                                                                rte be
                                                                                                                                   d sf
                                                                                                                                    in or
                                                                                                                                      co
                                                                                                                                         m
                                                                                                                                          e




                                                                                                                                                                                   Percentage of standard success rates
                                                                                                                                  R
                                                                                                                             fili eq
                                                                                                                                 ng uir
                                                                                                                                    ch ed
                                                                                                                                      ec
                                                                                                                                         ks
                                                                                                                     an Exa
                                                                                                                       d m
                                                                                                                        re in
                                                                                                                          co at
                                                                                                                            rd ion
                                                                                                                              s
                                                                                                                                                                                                                                                                                                              System




Page 37
                                                                                                                                ex dep
                                                                                                                                  am th
                                                                                                                                    in
                                                                                                                                                                                                                                                                                                              Appendix II




                                                                                                                                      ed




                                                  Source: IRS data.
                                                                                                                         su
                                                                                                                           pp F
                                                                                                                             o r in
                                                                                                                                te din
                                                                                                                                  d g
                                                                                                                                   by s
                                                                                                                                     la
                                                                                                                                       w
                                                                                                                      pr
                                                                                                                         op
                                                                                                                           er P
                                                                                                                             ly en
                                                                                                                               co a
                                                                                                                                 ns ltie
                                                                                                                                   id s
                                                                                                                                     er
                                                                                                                                                                                                                                                                                                              IRS’ Examination Quality Measurement




                                                                                                                                       ed
                                                                                                                                                                                                                          Figure II.1: Standard Success Rates for Office Audits From Fiscal Years 1992-1996




                                                                                                                       su
                                                                                                                         pp W
                                                                                                                            or or k
                                                                                                                              tc p
                                                                                                                                on ap
                                                                                                                                  clu ers
                                                                                                                                      sio
                                                                                                                                         ns
                                                                                                                       pr R
                                                                                                                         oc ep
                                                                                                                           ed or
                                                                                                                              ur t w
                                                                                                                                es ri
                                                                                                                                  fo ting
                                                                                                                                    llo
                                                                                                                                       w
                                                                                                                                         ed


                                                                                                                              Ti
                                                                                                                            tim me
                                                                                                                               e spa
                                                                                                                                 ch n
                                                                                                                                   ar /
                                                                                                                                     ge
                                                                                                                                       d




GAO/GGD-98-38 Financial Status Audit Techniques
                                                   Appendix II
                                                   IRS’ Examination Quality Measurement
                                                   System




Figure II.2: Standard Success Rates for Field Audits From Fiscal Years 1992-1996

 Percentage of standard success rates
100%




 80%




 60%




 40%




 20%




  0%
                 e or
                       s




                                                                            by s
                      e




                                                                                                id s




                                                                                                                           ed
                in or




                                                                                                                           ns
                                                                                                     ed
                                              ks




                                                                                w
                                         ch r ed




                                                                                                                    clu er s
                                                          am th
         tio us red




                                                              ed




                                                                                                                    fo ting
                     m




                                                                                              ns l tie
                                                                           d g
                     m




                                                                                                                                                 d
                                                                                                                                             ar /
                                                                              la
               d sf




                                                                                                                                           ch n
               bl l,




                                                        ex dep




                                                                         te din
                                           ec




                                                                                                                        sio




                                                                                                                         w
                  ite




                                                                                                  er




                                                                                                                                               ge
                                                            in
                  co
             na u a




                                                                                                                                         e spa
                                      ng ui
     es un de




                                                                                                                  on ap
                                                                                            co na




                                                                                                                      llo
                                                                                                                  es ri
            rte be




                                  fili eq




                                                                       or in




                                                                                                                ur t w
  qu ge, nsi




                                                                                                                tc p
                                                                                          ly e
                                                    rd ion
        po ro




                                                                     pp F




                                                                                                              or ork




                                                                                                                                      tim me
                                       R




                                                                                        er P




                                                                                                              ed or
   la Co




    re P




                                                  co at




                                                                                                            oc ep
                                                                                                            pp W




                                                                                                                                        Ti
                                                      s
                                                re in




                                                                                                          pr R
                                               d m
      r




                                                                   su
                                             an Exa




                                                                                      op
  un




                                                                                                          su
                                                                                    pr




   Standards



         1992
         1993
         1994
         1995
         1996



                                                   Source: IRS data.




Key Element Pass Rate                              IRSalso uses the key element pass rate as a measure of audit quality. This
                                                   measure computes the percentage of audits demonstrating the
                                                   characteristics defined by the key element. According to IRS, the key
                                                   element pass rate is the most sensitive measurement and is useful when
                                                   describing how an audit is flawed, establishing a baseline for
                                                   improvement, and identifying systemic changes. Figures II.3 and II.4 show




                                                   Page 38                                                GAO/GGD-98-38 Financial Status Audit Techniques
                                              Appendix II
                                              IRS’ Examination Quality Measurement
                                              System




                                              the pass rates for the key elements of Standard 2 for fiscal years 1992
                                              through 1996 for office and field audits, respectively.



Figure II.3: Key Element Pass Rates for Key Elements of Standard 2 for Office Audits From Fiscal Years 1992-1996


Percentages of key element pass rates

100%




80%




60%




40%




20%




 0%
                          s




                                                       s




                                                                                                                      ds
                   us or
               al trols of




                                                                                         s
                        es




                                                re f
                                                    rd




                                                                                  l s of




                                                                                                                 m of
                                               d no




                                                                                       tu
                 lb f




                                                                                                                    ho
                 n n

                      in




                                                  co




                                                                                     ta
                                                                               cia n




                                                                                                               ct se
               co tio




                                             an io




                                                                                                                  et
                                                                           an tio
                                            s rat




                                                                                                             re u
             al ra




                                                                        fin era




                                                                                                           di e
           rn e




                                          ok de




                                                                                                         in riat
         te id




                                                                            id
                                        bo nsi
       in ons




                                                                                                           op
                                                                         ns
                                         Co




                                                                                                        pr
                                                                      Co
          C




                                                                                                      Ap




        Key Elements of Standard 2, Probes for unreported income


              1992
              1993
              1994
              1995
              1996




                                              Source: IRS data.




                                              Page 39                                   GAO/GGD-98-38 Financial Status Audit Techniques
                                               Appendix II
                                               IRS’ Examination Quality Measurement
                                               System




Figure II.4: Key Element Pass Rates for Key Elements of Standard 2 for Field Audits From Fiscal Years 1992-1996


Percentages of key element pass rates

100%




 80%




 60%




 40%




 20%




  0%
                          s




                                                                                                                     ds
                                                         s
                   us or




                                                                                      us
               al trols of




                                                                                                                 et f
                                                                                  st f
                       es




                                                 re f




                                                                                                                m o
                                                                                al o
                                                      rd
                                                d no
                 lb f




                                                                                                                   ho
                                                                                    at
                  n n




                                                                              ci on
                     in




                                                                                                              ct se
                                                   co
               co tio




                                              an io




                                                                                                            re u
                                                                           an ati
             al ra




                                             s rat




                                                                                                         di te
                                                                        fin der
           rn e




                                                                                                       in pria
                                           ok de
         te id




                                                                            i
       in ons




                                         bo nsi




                                                                          ns




                                                                                                           o
                                                                       Co




                                                                                                        pr
                                          Co
          C




                                                                                                     Ap



         Key Elements of Standard 2, Probes for unreported income


              1992
              1993
              1994
              1995
              1996




                                               Source: IRS data.




                                               Page 40                                 GAO/GGD-98-38 Financial Status Audit Techniques
Appendix III

Analysis of AICPA Concerns


                   The American Institute of Certified Public Accountants (AICPA) has been
                   among the critics of IRS’ reemphasis on financial status audits since the
                   program began in late 1994. During 1995 and 1996, officials from IRS and
                   AICPA met several times to discuss these concerns and, to some extent, IRS
                   mitigated the problems with memos clarifying the use of financial status
                   techniques. AICPA has had a long list of concerns about actions taken by IRS
                   auditors, including

               •   sending a personal living expense (PLE) form with the letter notifying
                   taxpayers of the audit before finding any evidence of underreported
                   income;
               •   asking financial status questions at the initial interview, before having any
                   evidence of underreported income;
               •   arriving unannounced to inspect a personal residence;
               •   bypassing a valid power of attorney and requesting information or records
                   directly from taxpayers;
               •   interviewing taxpayers without the presence of their representative; and
               •   requiring taxpayers’ representative to submit a freedom of information
                   request to obtain third-party documents on their clients.

                   Neither AICPA or IRS had any objective data on these concerns. Using our
                   sample, however, we were able to collect data on the first two concerns
                   involving PLE forms and financial status questions.

                   As for the PLE forms, AICPA indicated that some audit notification letters
                   asked taxpayers to complete this form even though IRS had no evidence of
                   underreported income. AICPA officials believed this request was intrusive,
                   burdensome, and costly to taxpayers. The officials said PLE information
                   should be requested only after IRS had some objective evidence that
                   taxpayers had underreported income on tax returns.

                   In reviewing the workpapers for our two samples, we looked for copies of
                   notification letters. We found very few examples in which the letters asked
                   taxpayers to complete a PLE form. On the basis of our sample, we estimate
                   that IRS used the notification letter to request PLE forms in no more than
                   5 percent of the audits for both the 1992 and 1993 and the 1995 and 1996
                   samples.

                   In a March 1996 memorandum, the Acting Assistant Commissioner
                   (Examination) clarified the PLE instructions. The memorandum indicated
                   that while auditors had the responsibility to secure an overall financial
                   picture of the taxpayer, they were not expected to automatically request



                   Page 41                            GAO/GGD-98-38 Financial Status Audit Techniques
Appendix III
Analysis of AICPA Concerns




PLE information with the notification letter. According to AICPA officials,
sending PLE forms with the notification letters has decreased since the
distribution of this memorandum.

AICPA officials were also concerned that auditors were asking personal
questions about the taxpayer’s financial status at the initial interview
before having any evidence of underreported income. Auditors use the
initial interview to explain the audit process, the taxpayer’s rights, and
gain an understanding of the taxpayer’s situation. Generally, auditors
prepare workpapers to summarize these interviews. We reviewed these
interview write-ups and collected data on the types of questions asked by
auditors at this meeting.

AICPA officials identified questions that caused them concern. We collected
information on whether the auditors asked these questions both before
and after IRS began reemphasizing financial status. We compared these two
periods because AICPA had associated the questions with the renewed
emphasis by IRS on financial status audits, and the 1992 and 1993 period
was just prior to this renewed emphasis. Table III.1 shows how often
auditors asked these questions at initial interviews in 1992 and 1993 and in
1995 and 1996 audits.




Page 42                            GAO/GGD-98-38 Financial Status Audit Techniques
                                        Appendix III
                                        Analysis of AICPA Concerns




Table III.1: Questions Asked by
Auditors at Initial Interviews, Which                                                          Percent of time question asked
Cause Concerns for AICPA Officials      Initial interview questions                                 1992-1993               1995-1996
                                        Educational background of taxpayers                                    6                  12
                                        Assets other than home or autos, that cost                             6                   8
                                        over $10,000
                                        Loans by and loan payments to the taxpayer                             8                   4
                                        Amount and monthly payments on                                         9                   6
                                        outstanding debt
                                        Cash advances from credit cards                                        3                   1
                                        Amount of cash on hand                                               27                   24
                                        Amounts transferred between accounts                                 <1                    1
                                        Safe deposit box                                                     20                   18
                                        Taxpayer involved in transactions of $10,000                           4                   3
                                        or more
                                        Information about where the taxpayer                                 <1                    3
                                        vacations
                                        Information about what college the                                     1                   1
                                        taxpayer’s children attend
                                        Information about the quality of the                                   0                   0
                                        taxpayer’s clothing
                                        Information about how often the taxpayer                               1                   1
                                        eats out
                                        Information about how much the taxpayer                              <1                    1
                                        spends on entertainment
                                        Information on the taxpayer’s cash horde                               7                  11
                                        Information on the amount the taxpayer paid                            3                   1
                                        for utilities and personal living expenses
                                        Source: Analysis of GAO samples of IRS audits for 1992 and 1993 and for 1995 and 1996.



                                        As shown in table III.1, with few exceptions, little difference exists in how
                                        often these questions were asked at initial interviews in 1992 and 1993 and
                                        in 1995 and 1996 audits.

                                        In his March 1996 memorandum to Regional Chief Compliance Officers,
                                        the Acting Assistant Commissioner (Examination) provided general
                                        guidance on how far to probe for unreported income at the initial
                                        interview. He emphasized that auditors must evaluate the facts and use
                                        judgment. The memo further stated that performing in-depth income
                                        probes and asking questions about personal assets and expenditures were
                                        not effective uses of resources without a reasonable indication of
                                        unreported income.



                                        Page 43                                    GAO/GGD-98-38 Financial Status Audit Techniques
Appendix IV

Comments From the Internal Revenue
Service

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




                             Page 44   GAO/GGD-98-38 Financial Status Audit Techniques
Appendix IV
Comments From the Internal Revenue
Service




Page 45                              GAO/GGD-98-38 Financial Status Audit Techniques
Appendix IV
Comments From the Internal Revenue
Service




Page 46                              GAO/GGD-98-38 Financial Status Audit Techniques
               Appendix IV
               Comments From the Internal Revenue
               Service




               The following are GAO’s comments on the Internal Revenue Service’s letter
               dated November 20, 1997.


               1. IRS suggested that we change the title of the report to respond to the first
GAO Comments   objective of our work and suggested a title that would point out that IRS
               has not increased the use of financial status techniques. IRS believed that
               by focusing on the need for more criteria, readers of the report would infer
               that IRS was being unnecessarily intrusive. We considered changing the
               title but decided against it for various reasons. First, our report already
               discussed the issue of intrusiveness, pointing out that use of the
               techniques did not necessarily mean intrusions into taxpayers’ affairs,
               particularly when such usage identified changes to reported income.
               Second, such a title would ignore the other three objectives of our report.
               We concluded that the focus on the need for more criteria not only could
               be associated with all four objectives but also with the actions needed to
               prompt improvements.

               2. IRS said that the report cited no evidence of any increased intrusiveness
               and that the fact that use of the techniques led to no tax change does not
               diminish Examination’s responsibility to determine the correct tax
               liability. We believe that IRS misinterpreted our discussion of intrusiveness.
               In the draft report, we noted that the reason for no evidence of
               intrusiveness was that it was not available from IRS or others. We
               observed, however, that only the preliminary Cash-T results in no
               additional burden on the taxpayer, while the burden imposed through the
               use of other techniques varies depending on the amount of additional
               taxpayer contact. Also, our draft did not say that there is any relationship
               between the no change rate and IRS’ responsibility to determine the correct
               tax liability. Accordingly, we made no changes to the report to reflect
               these comments.




               Page 47                              GAO/GGD-98-38 Financial Status Audit Techniques
Appendix V

Major Contributors to This Report


                        Thomas D. Short, Assistant Director, Tax Policy and Administration Issues
General Government      Patricia H. McGuire, Assistant Director
Division, Washington,   Tim Outlaw, Senior Evaluator
D.C.                    James M. Fields, Technical Advisor
                        Susan F. Baker, Computer Specialist


                        Louis G. Roberts, Evaluator-in-Charge
San Francisco           Kathleen E. Seymour, Senior Evaluator
Regional Office         Samuel H. Scrutchins, Senior Data Analyst




(268762)                Page 48                          GAO/GGD-98-38 Financial Status Audit Techniques
Ordering Information

The first copy of each GAO report and testimony is free.
Additional copies are $2 each. Orders should be sent to the
following address, accompanied by a check or money order
made out to the Superintendent of Documents, when
necessary. VISA and MasterCard credit cards are accepted, also.
Orders for 100 or more copies to be mailed to a single address
are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office
P.O. Box 37050
Washington, DC 20013

or visit:

Room 1100
700 4th St. NW (corner of 4th and G Sts. NW)
U.S. General Accounting Office
Washington, DC

Orders may also be placed by calling (202) 512-6000
or by using fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and
testimony. To receive facsimile copies of the daily list or any
list from the past 30 days, please call (202) 512-6000 using a
touchtone phone. A recorded menu will provide information on
how to obtain these lists.

For information on how to access GAO reports on the INTERNET,
send an e-mail message with "info" in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web Home Page at:

http://www.gao.gov




PRINTED ON    RECYCLED PAPER
United States                       Bulk Rate
General Accounting Office      Postage & Fees Paid
Washington, D.C. 20548-0001           GAO
                                 Permit No. G100
Official Business
Penalty for Private Use $300

Address Correction Requested