AP-11: Audit Program for Income

Taxes
Company Balance Sheet Date

The company has the following general ledger accounts related to income taxes.

General Ledger Number Description of the Account

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by
FINANCIAL STATEMENT ASSERTIONS

E/O Existence or occurrence. V/A Valuation or

allocation.
C Completeness. P/D Presentation
and disclosure.
R/O Rights and obligations.

AUDIT OBJECTIVES
A. Tax laws and regulations have been properly applied, and
no items are improperly excluded in the determination of taxes
estimated to be currently payable, and the related current tax
 liability is adequate but not excessive (assertions E/O, C, R/O, and
V/A).

B. The provision for income taxes and related balance sheet

amounts, if any, for deferred taxes are properly stated in accordance
with applicable accounting principles (assertions E/O, C, R/O, and
V/A).

C. The valuation account for deferred tax assets is adequate

but not excessive (assertions V/A and P/D).

D. Income taxes payable, deferred tax assets (and related

valuation allowances) and liabilities, income tax expense, and
related note disclosures are properly described and disclosed in the
financial statements (assertion P/D).

IDENTIFICATION CODES

The letters preceding each of the above audit objectives, i.e., A, B,

etc., serve as identification codes. These codes are presented in the
left column labeled “Audit Objectives” when a procedure
accomplishes an objective. If the alpha code appears in a bracket,
e.g., [A], [B], etc., the audit procedure only secondarily
accomplishes the objective. If an asterisk precedes a procedure, it is
a preliminary step or a follow-up step that does not accomplish an
objective.

BASIC AUDIT PROCEDURES

* 1. Obtain or prepare an analysis of income tax related

accounts and related tax return information. Perform the following
procedures:

a. Scan the accounts and compare opening balances to the

prior year’s workpapers.

b. Review the prior year’s tax return and the results of any
IRS examinations completed during the period.

c. Inspect supporting documents for significant transactions

during the period, i.e., estimated tax payments, refunds, etc.
Document the items tested.
Practical Considerations:
 ¯ SAS No. 96, Audit Documentation, requires documentation of
substantive tests of details involving inspection of documents to
include identification of the items tested. The authors believe items
tested can be identified by listing the items; by including a detail
schedule in the workpapers, such as an income tax account
analysis, on which the items are identified; or by documenting in
the workpapers the source and selection criteria. For example:

¯¯ For tests of significant items, documentation may describe the

auditor’s scope and the source of the items (for example, all
transactions greater than $5,000 from the 20X2 income tax payable
account detail).

SAS No. 96 is effective for audits of financial statements for

periods beginning on or after May 15, 2002, with early application
permitted.

¯ Some small businesses may operate in several states, and the

auditor should consider the taxing jurisdictions the client is subject
to. In some cases, state and local taxes on income may be
significant.

¯ In many small businesses, income taxes are recognized to the

extent of the amounts paid or received only. Liability, receivable, or
deferred accounts may not be used during the year. The auditor will
be expected to adjust the accounts during the course of the audit.
Under such circumstances, the analyses may be prepared as the
auditor determines the appropriate adjustments.

B 2. Calculate the current year provision for income taxes by

preparing a draft of the tax return or a tax calculation workpaper.

a. Reconcile income before taxes per the financial statements

to taxable income per the tax return.

b. Explain the nature of all permanent and temporary

differences.

c. Compute the current tax provision by considering taxes

computed under both the regular tax system and the alternative
minimum tax system.
 Practical Consideration:

¯ The auditor should obtain all information needed for the tax
return during the conduct of the audit for more efficient completion
of the tax return. Some of the more common types of information
needed are: (See also Chapter 12, EXHIBIT 12-2.)

¯¯ Reconciliation of financial statement captions to descriptions

required by the income tax return.

¯¯ Depreciation schedule in accordance with tax methods and

using tax bases for assets.

¯¯ Calculations of investment tax credit recapture arising from

dispositions of property, if applicable.

¯¯ Identification and computation of all applicable tax

preference items.

¯¯ List of dividends by source.

¯¯ Property acquisitions or dispositions identified as to specific

assets, dates acquired or sold, cost, depreciation method, life,
amount of accumulated depreciation, gain or loss involved.

¯¯ Details of officers’ compensation, including time devoted to

business, percent ownership, addresses, social security number, and
expense account allowances.

¯¯ Detail of noncash contributions, including a description of

property and method of determining fair market value.

¯¯ Listing of amounts and dates of income tax prepayments.

¯¯ Necessary pension or profit sharing plan information.

A 3. Evaluate the adequacy of the amount for income taxes

payable in the balance sheet. Perform the following procedures:

a. Discuss the status of any IRS examination in progress with

client personnel.
 b. Assess the adequacy of the balance of taxes payable in
light of possible assessments for disputable items in this year’s
return and any open prior years, including possible penalties and
interest.

c. Consider vouching current year tax payments to paid

checks. Document any items tested.
Practical Considerations:

¯ Some small businesses will have no, or insignificant,

disputable items, and this step will be little more than a routine
accrual calculation.

¯ If there is a tax cushion beyond a minor allowance for matters

that might arise between the audit date and the actual filing of the
return, the accrual should be evaluated in light of the requirements
of SFAS No. 5. (See paragraph 1202.8.)

B 4. Calculate the deferred tax asset or liability and the related

deferred tax provision.
Practical Considerations:

¯ The additional audit procedures section provides more detailed

procedures for calculating deferred taxes.

¯ The MACRS methods are acceptable GAAP methods unless

salvage value would be material. The recovery periods for real
estate and for 3-year and 5-year property closely approximate
GAAP. However, large acquisitions in the other classes should be
evaluated to determine whether different depreciable lives should
be used for financial reporting. Similarly, the allowance for
Section 179 property may cause material departures for which
deferred taxes should be provided.

C 5. Evaluate whether it is more likely than not that deferred tax

assets will be realized.
Practical Consideration:

¯ The additional audit procedures section provides more detailed

procedures for evaluating the realizability of deferred tax assets.

B 6. Evaluate items for which there has not been an accrual (or
 which have been partially accrued) under APB Opinion No. 23 to
determine if the items have been properly treated.

Practical Consideration:

¯ Under SFAS No. 109, deferred taxes must be provided for all
temporary differences unless they qualify under the exceptions
listed in APB Opinion No. 23. Most small businesses do not
qualify for those exceptions. However, undistributed earnings of a
domestic subsidiary or joint venture arising in fiscal years
beginning on or before December 15, 1992 that are essentially
permanent in duration qualify for the exception. Deferred taxes are
not provided on these items until it becomes apparent that the
temporary differences will reverse in the foreseeable future. See the
discussion in paragraph 1200.17.

D 7. Document in the workpapers the financial statement

presentation and disclosure information for income taxes.
Practical Consideration:

¯ The disclosure checklist at CX-13 presents the required

disclosures under SFAS No. 109.

* 8. Consider the need to apply one or more additional

procedures. The decision to apply additional procedures should be
based on a consideration of whether information obtained or
misstatements detected by performing substantive tests or from
other sources during the audit alter your judgment about the need to
obtain a further understanding of control activities, the assessed
level of risk of material misstatements (whether caused by error or
fraud), and on an evaluation of whether the basic procedures have
been sufficient to achieve the audit objectives. Attach audit
program sheets to document additional procedures.
Practical Considerations:

¯ Certain common additional procedures relating to the

following topics are illustrated following this program:

¯¯ Accounting for deferred taxes.

¯¯ Deferred tax assets.

 ¯ Practitioners may refer to PPC’s Guide to Fraud Investigations
for more extensive fraud detection procedures if it is suspected that
the financial statements are materially misstated due to fraud.

* 9. Consider whether procedures performed are adequate to

respond to identified fraud risk factors. If fraud risk factors or other
conditions are identified that require an additional audit response,
consider those risk factors or conditions and the auditor’s response
in connection with the performance of Step 11 in AP-1b.
Practical Consideration:

¯ Specific responses to identified fraud risk factors are addressed

in individual audit programs. In connection with evaluation and
other completion procedures in AP-1b, the auditor considers the
need to perform additional procedures based on the results of
procedures performed in the individual audit programs and the
cumulative knowledge gained from performing those procedures.

* 10. Consider whether the results of audit procedures indicate

reportable conditions in internal control and, if so, add to the memo
of points for the communication of reportable conditions. (See
section 1504 for examples of reportable conditions, and see CX-18
for a worksheet that can be used to document the points as they are
encountered during the audit.)
CONCLUSION

We have performed procedures sufficient to achieve the audit

objectives for income taxes, and the results of these procedures are
adequately documented in the workpapers. (If you are unable to
conclude on any objective, prepare a memo documenting your
reason.)

Additional Audit Procedures for Income Taxes

Instructions: Additional procedures will occasionally be necessary on some small
business engagements. The following listing, although not all-inclusive, represents
common additional procedures and their related objectives.

Accounting for Deferred Taxes

B Procedures related to deferred income tax accounting under SFAS

No. 109:

a. Reconcile accounting income to taxable income,

identifying exempt income and nondeductible expenses (for
example, interest on municipal bonds, officer’s life insurance, etc.),
and temporary differences (for example, direct charge-off vs. the
allowance method for bad debts, accelerated vs. straight-line
depreciation, installment sales, capitalization of certain inventory
costs, cash vs. accrual basis, etc.).

b. Determine the reasonableness of, or calculate, the deferred

tax provision as follows:

(1) Identify the taxable and deductible temporary differences

and loss carryforwards available for tax reporting at the end of the
year.

(2) Calculate the deferred tax liability by multiplying total

taxable differences by the applicable tax rate.

(3) Calculate the deferred tax asset by multiplying total

deductible differences and loss carryforwards by the applicable tax
rate.

(4) Identify the tax credit carryforwards available for tax

reporting at the end of the year and record a deferred tax asset for
the total of the carryforwards.

(5) Provide a valuation allowance for the portion of the

deferred tax asset for which there is more than a 50% chance that
the benefit of the deductible differences and carryforwards of losses
and tax credits will not be realized.

(6) Subtract the net deferred tax asset or liability at the end of
the year from the net amount at the beginning of the year to
 determine the deferred tax benefit or expense for the year. (The net
deferred tax asset or liability is the difference between the deferred
tax liability and the deferred tax asset net of the related valuation
allowance.)

(7) Add the deferred tax provision to the current tax provision
to determine the total tax provision for the year. The current tax
provision represents income taxes for the period as reported in the
company’s tax returns.

(8) If necessary, allocate the total tax expense or benefit

between continuing operations and other applicable items (for
example, extraordinary items).

c. Consider the classification of the deferred tax asset or

liability by current and noncurrent amounts.

Practical Considerations:

¯ The calculation of deferred taxes is discussed further in section

1202.

¯ For each tax paying component within a tax jurisdiction,

current assets and liabilities and deferred tax assets and liabilities
should be offset and presented as a single current amount and a
single deferred amount. Any valuation allowance should be
prorated and included in the net current and net deferred amount.

¯ The current/noncurrent classification is based upon the specific

asset or liability giving rise to the difference. If the deferred tax is
not related to a specific asset or liability (e.g., a net operating loss
carryforward), it should be classified based on its expected reversal
date.

¯ Guidance for applying SFAS No. 109 can be found in PPC’s

Guide to Accounting for Income Taxes.

Deferred Tax Assets

C Procedures related to deferred tax assets under SFAS No. 109. Test
the adequacy of the valuation allowance for deferred tax assets:
 a. Determine whether there is both negative and positive
evidence regarding whether the deferred tax asset will be realizable.

Practical Consideration:

¯ Section 1202 discusses examples of positive and negative

evidence.

b. If there is only positive evidence that the deferred asset will

be realizable, and the company historically has been profitable and
has paid taxes:

(1) Inquire of management and assess whether this trend is

likely to continue.

(2) If it is determined that the trend is likely to continue,

document in the workpapers the reason a valuation allowance is not
needed.

(3) If it is determined that the trend is not likely to continue,

negative evidence exists. Proceed to Step c.

c. If there is both negative and positive evidence that the

deferred asset will be realizable:

(1) Evaluate the client’s calculations and rationale regarding a

need for a valuation allowance or, if not available, prepare an
analysis of taxable income to determine if a valuation allowance is
needed.
Practical Considerations:

¯ The more negative evidence that exists about the realizability

of a deferred tax asset, the more positive evidence is required to
support a conclusion that a valuation allowance is not needed for all
or part of the deferred tax asset.

¯ A valuation allowance is needed if it is more likely than not

that all or a portion of the deferred tax asset will not be realized.
More likely than not is defined as greater than a 50% chance.

¯ When evaluating whether a valuation allowance is needed, the

sources of taxable income outlined in SFAS No. 109 and discussed
in section 1202 of this Guide should be used. If it is determined that
a source (or sources) of taxable income is adequate to realize the
deferred tax asset, it is not necessary to evaluate the remaining
sources.

¯ When evaluating whether prior or future taxable income will

be available to realize a deferred tax asset, the auditor must
consider the expiration date of the operating loss carryforwards and
carrybacks. Under current U.S. tax law, the carryback period is
limited to two years and the carryforward period is limited to 20
years.

¯ Separate evaluations may be needed for each taxing

jurisdiction depending on whether their tax laws conform to federal
tax laws.

¯ It may be necessary for the company to schedule reversals of

taxable temporary differences in order to ensure that the deferred
tax asset will be realized within the carryback, carryforward period.

¯ When estimating future taxable income, a forecast or budget

(as those terms are defined in professional standards) is not
required. However, if the client prepares prospective financial
information to support an estimate of future taxable income,
auditors should consider the adequacy of evidence relating to
significant assumptions underlying the information, particularly
assumptions that are material to the prospective information,
especially sensitive or susceptible to change, or inconsistent with
historical trends. This consideration should include reading the
prospective information and the underlying assumptions and
comparing prospective information for prior or current periods with
actual results or results to date.

(2) Conclude and document (a) the rationale for the valuation
allowance or (b) that a valuation allowance is not required.

Practical Consideration:

¯ As discussed in section 1202, auditors should consider

obtaining representations regarding management’s responsibility
for determining the amount of the valuation allowance, estimating
future taxable income, and determining the prudence and feasibility
of tax planning strategies.
Additional Audit Procedures for Income Taxes
Beginning Balance in Initial Audit
Company Balance Sheet Date

Audit N/A Workpaper

Objectives Performed Index
Audit Procedures for Consideration by

Instructions: Additional procedures will be necessary in an

initial audit. These procedures are applied to opening balances and
differ depending whether you are relying on your review of a
predecessor’s work or placing no reliance on a predecessor’s audit.
(Section 1803 discusses considerations when replacing a
predecessor auditor, including a discussion of what the term
reliance means when used in this program.) These procedures may
be applied in conjunction with the basic procedures applied to the
ending balance. The asterisks preceding the procedures indicate
that they are an intermediate step in achieving audit objectives for
the ending balance.

* 1. If a predecessor’s audit of the prior period’s financial

statements is to be relied on:

a. Review the predecessor’s workpaper analyses of income

tax related accounts and related tax return information and compare
amounts to opening balances; note the existence of any:

(1) Significant disputable items in open prior years.

(2) IRS examinations in progress during the predecessor’s

audit.

(3) IRS assessments as a result of past examinations.

(4) Carryforwards or other unused deductions or credits with

expiration dates.

(5) Significant temporary differences and related deferred tax

asset valuation allowances.
 b. Consider the information obtained from the predecessor
and evaluate the adequacy of the provision for income taxes and
balance of taxes payable for the prior period.

Practical Consideration:

¯ The basic procedures for the current period normally include

review of prior years’ tax returns and results of past IRS
examinations, vouching of tax payments of the prior period’s taxes
payable, and consideration of possible assessments for disputable
items in any open prior years. Thus, review of the predecessor’s
workpapers supplements these basic procedures.

* 2. If no reliance on a predecessor is planned or possible:

a. Obtain or prepare analyses of income tax related accounts,

test clerical accuracy, compare amounts to opening balances, and
consider reasonableness of amounts in relation to information
obtained in the current audit.

b. Inquire of the person responsible for tax matters

concerning:

(1) Significant disputable items in open prior years.

(2) IRS examinations in progress during the prior period and

the results if known.

(3) IRS assessments from past examinations.

(4) Carryforwards or other unused deductions or credits with

expiration dates.

(5) Significant temporary differences and related deferred tax

asset valuation allowances.

c. Consider the information obtained from the above

procedures and evaluate the adequacy of the provision for income
taxes and the balance of current and deferred assets and liabilities
for the prior period.
Practical Considerations:
¯ Even if the client has not had an audit in prior years, a CPA
may have prepared the client’s tax returns, and the CPA’s tax
workpapers may be available.

¯ The basic procedures for the current period normally include

review of prior years’ tax returns and results of past IRS
examinations, vouching of tax payments of the prior period’s taxes
payable, and consideration of possible assessments for disputable
items in any open prior years. Thus, the additional procedures
supplement these basic procedures.

¯ In an initial audit, five years is normally a reasonable period

for review of prior years’ tax returns and related matters.