During a tax audit, tax auditors may trace a company’s accounting records to verify the consistency of its reported transactions, from the general ledger (GL) and trial balance (TB) to tax invoices, cash movements, and accounts receivable. Companies should therefore perform flow testing and reconciliation before a tax audit begins.
Flow testing and reconciliation help companies identify discrepancies in their accounting records, trace their underlying causes, gather supporting documents, and prepare explanations for the transactions identified.
If auditors identify discrepancies first, the company must reconcile the records while also responding to the findings. The more discrepancies not mapped out in advance, the more transactions will need to be traced during the audit.
From GL to Sales Reconciliation
Before conducting flow testing, companies should first ensure that the underlying data is accurate. The first step is to screen the accounts recorded in the GL. Companies can then trace entries for each account, sample supporting documents to verify that journal entries were recorded properly, and compare the GL with the TB.
The GL balances should reconcile with the TB. Errors at the initial recording stage can affect the subsequent reconciliation process.
To make tracing easier, group transactions by date and account number. Spreadsheet functions such as SUBTOTAL or SUMIF can also process large volumes of transactions.
Once companies establish consistency between the GL and TB, they can reconcile sales transactions against output tax invoices. This step ensures that transactions recorded as revenue can be traced to the relevant tax documents.
The accounts subject to reconciliation are not necessarily limited to the main sales account. Depending on the company’s accounting structure, the reconciliation may cover sales of goods, sales of services, sales discounts, and other income related to business activities.
Reconciliation is not merely about arriving at the same figures. It should also explain each discrepancy based on the transaction’s nature and supporting documents. Companies need to identify the source of each difference and ensure that a defensible basis supports every adjustment.
For instance, a service sales account may contain transactions supported by documentation that follows a different pattern from other sales transactions. Identify and explain such differences to prevent them from being mistakenly treated as unreported transactions.
Accounts Receivable Flow Testing
In addition to sales, accounts receivable is an important account to examine through flow testing. Reconcile opening and closing accounts receivable balances to the TB, and trace customer payments through bank accounts associated with sales transactions.
Companies should also separate transactions that do not represent settlement of accounts receivable so they can reconstruct account movements accurately.
Accounts receivable flow testing helps ensure the closing balance can be explained by the opening balance, sales, customer payments, and other period adjustments. Once all components are identified, the reconciliation should leave no unexplained differences.
However, flow testing should be tailored to the business’s characteristics. In a retail business, for example, the high volume of transactions means that companies need to understand the GL, accounts receivable records, and the relationship between sales transactions and output tax invoices.
Companies need to understand the entire transaction flow, from the sales process through recording and reporting the related tax obligations.
For companies preparing for a tax audit or tax refund claim, Ideatax can assist with tax reviews and tax refund support to ensure tax data and accounting records can be substantiated.
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