College of Finance, Management and Development

Department Of Tax Administration (Master’s Program)

Auditing and Risk Management in Taxation (TXCA 5101)

Prepared and Submitted By Group-1:

1. Maria Ziad ------------------------ID NO: ECSU 1800758

2. Askale Ayfokeru------------------ID NO: ECSU 1800657
3. Zebib Belayneh-------------------ID NO: ECSU 1800726
4. Etaferahu Eshetu-----------------ID NO: ECSU 1800705
5. Demelash Desta-------------------ID NO: ECSU 1800694
6. Behar Mensur ---------------------ID NO: ECSU 1800673

Submitted to: Teklu Kasu (Phd)

ECSU
August, 2019
Addis Ababa, Ethiopia
 CONTENTS

CONTENT --------------------------------------------------------------------------PAGE
INTRODUCTION
1. EVOLUTION OF AUDIT IN ETHIOPIA--------------------------------------1
1.1. EVOLUTION OF TAX AUDIT-------------------------------------------------3

2. FREQUENT TAX EVASION SYSTEMS

2.1 Tax Evasion under Income Tax Law---------------------------------------7
2.1.1 Evasion of Declaration---------------------------------------------------------7
2.1.2 Evasion of Payment in Income Tax-----------------------------------------8
2.2 Tax Evasion under Tax administration proclamation no- 983/2008---9
2.3 Tax Evasion under Ethiopian Value Added Tax Laws-------------------11
2.4 Common Tax Evasion Methods-----------------------------------------------12

3. TAX AUDIT TECHNIQUES--------------------------------------------------15

3.1 Auditing Using the Detailed Analytical Approach ----------------------15
3.2 Auditing Cash vs. Accrual Method of Reporting Income--------------16
3.3 Auditing the Various Types of Sales---------------------------------------- 17
3.4 Auditing Construction Contracts, Progress Payments and Holdbacks 18
3.5 Auditing the Sales Recording System -------------------------------------18
3.5.1 Sales Invoices ----------------------------------------------------19

3.5.2 Bank Deposits------------------------------------------------------------------19

3.5.3 Audit of cash registers------------------------------------------------------ 20
3.5.4 Cost of goods sold -----------------------------------------------------------20
3.5.5 Purchase ------------------------------------------------------------------------21
3.6 Production or manufacturing expenses-------------------------------------22
3.7 Administration and distribution expenses --------------------------------23
INTRODUCTION
To the tax administration, tax audit refers to the examination of tax returns by concerned tax
officials primarily with respect to checking as to timely arrival, inclusion of all required forms
and attachments, and arithmetical accuracy. This may be called internal tax audit. A tax audit is
one of the most sensitive contacts between the taxpayer and a revenue body.
An audit will examine the issues seen as most significant to achieving an accurate assessment of
a taxpayer’s tax liability. Typically, these issues will include any indications of significant
unreported income or potentially over-claimed deduction items that may be apparent from an
examination of a taxpayer’s tax return and other information.
As well as income tax returns and other reporting, this includes supporting documents, which the
taxpayer should normally have. In the case of business audits, national law often requires a
business to obey certain bookkeeping and accounting standards. The audit may also involve
physical enquiries, such as the inspection and examination of goods in stock, premises etc. In this
paper chapter one looks about Evolution of General Audit and Tax Audit in Ethiopia, Chapter
two discusses the frequent Tax Evasion methods and the last chapter is focuses on Techniques of
Tax audit applied by Ministry of Revenue. The methods used to prepare the paper is secondary
data and primary data I ,e. by going to the ministry of Revenues and taking an interview or we
get a briefing on the issues by Tax audit departments.

1. EVOLUTION OF AUDIT IN ETHIOPIA

The history of Ethiopia’s supreme audit institution (SAI) is related to the 1931 constitution,
which stated the importance of the proper collection of the government revenue and the necessity
of setting procedures to control expenditures. However, the constitution failed to stipulate the
need for government auditing and establishing a SAI. But latter, proclamation No. 69 of 1944
established the first legal audit institution called Audit Commission.

The Establishment of Audit and Control Office in 1946, proclamation No. 79/1946 was provided
to centralize the audit control of all government accounts in one department by establishing the
Audit and Control office under the direction of the controller and Auditor General who reported
and was directly responsible to the prime Minister. As a result of this proclamation, the power
sand duties of the new office were clearly defined and the scope of its activities expanded.
According to the Revised Constitution of 1955 (1948 E.C.) provided even wider duties and a
large measure of independence. Accordingly, the Auditor General reported to the Emperor and
the Parliament on the financial operations of the government and was given access to all books
and records of government accounts. Functions of Auditors General Subsequently, the functions
of the auditor general were amended by decree No.32 of 1958 which was later renumbered as
proclamation No.179/1961(1958E.c).

The major power and Functions of Auditor General were as follows: Auditing the accounts of all
autonomous bodies existing by virtue of Imperial charters conducting the audit of the chartered
organizations. Which were established to provide essential services to the public, through its
charted organizations Audit Department1974 – 1991. Following a revolution in Ethiopia, a
military government came into power in Ethiopia in1974 and declared a communist ideology. As
a result, private companies under went nationalization and the number of state-owned companies
in the country increased. Following this, international public accounting firms that have been
operating in Ethiopia, were closed. However, beside the nationalization event an important
landmark in the history of accounting and auditing in this period was the formation of the Audit
Service Corporation (ASC) by Proclamation 126/1977 (Government of Ethiopia,
1977).Functions of Audit Service Corporations (ASC) The ASC mainly had performed external
audit of public enterprises. ASC had render audit services to production, distribution and service
giving organizations of which the Government is the owner or majority shareholder.

Financial reporting and external audit requirements of both private companies and State-owned
enterprises are mainly guided by the Commercial Code of Ethiopia. Legal documents and
regulations specifically concerning internal audit include the Federal Auditor General
Proclamation (Government of Ethiopia 1997), the Federal Government of Ethiopia Financial
Administration Regulation (Federal Government of Ethiopia 1996), the Ministry of Finance and
Economic Development‘s (MoFED) IA manual (MoFED 2004), and Privatization and Public
Enterprises Supervisory Agency5 (PPESA) Regulations (Privatization and Public Enterprises
Supervisory Agency 2004, 2005). The Auditor General Proclamation monitored internal audit in
both SOEs and ministry organizations from 1987 to 1996. Since 1996 (Federal Government of
Ethiopia 1996), MoFED monitors Internal Audit in Government ministries and PPESA monitors
internal audit in SOEs.
The Office of the Federal Auditor General (OFAG) of Ethiopia is responsible for external audit
of Federal ministries (Ejige 2003; Government of Ethiopia 1997). The regional states also
maintain auditor general offices. Furthermore, OFAG monitors the professional practice of
accounting and auditing in the Country. In the business sector, the Audit Service Corporation
conducts external audit of State-owned enterpr
During the post-1991 period, Ethiopia has been receiving World Bank (WB) and International
Monetary Fund (IMF) loans, grants, and economic policy reform advice in managing its
development. Largely with the assistance of these international financial institutions and Western
consultants, the Ethiopian Government embarked on reforms of public sector financial reporting
and internal auditing in the early 1990s (Peterson 2001). As part of economic policy reforms, the
Ethiopian Government has been working to modernize the financial infrastructure of the Country
and to encourage private investment via an improved platform for risk assessment and a climate
of mitigated corporate failure. Under this framework, a World Bank and IMF joint initiative
study, i.e., Reports on Observance of Standards and Codes (ROSC), was conducted on Ethiopia
in 2007. This report focuses on financial reporting and external audit in Ethiopia (World Bank
2007).
Ethiopian government has been providing increasing support to the development of internal audit
since 1994. It has provided this support not only by strengthening internal audit in ministry
offices and SOEs (Mihret, James & Mula 2009; Teklegiorgis 2000) but also by supporting IIA-
Ethiopia since its establishment as a chapter in 1996 (Argaw 2000b; IIA-Ethiopia 2009; Mihret,
James & Mula 2009).

1.1. EVOLUTION OF TAX AUDIT

Tax audit is an examination of whether a taxpayer has correctly assessed and reported their tax
liability and fulfilled other obligations. Tax audits are often more detailed and extensive than
other types of examination, such as general desk checks, compliance visits/ reviews or document
attaching programs (OECD 2006a).
A tax audit is a systematic examination of business`s relevant commercial system to determine
whether a taxpayer’s declaration states the tax liability correctly and complying with the
provisions of the tax laws and related subsidiary legislations. It involves examination of financial
statements, books of accounts and vouchers of a taxpayer by tax auditors to ascertain whether the
taxpayer has accurately considered revenues and expenses when determining the taxes shown in
the declarations as per the requirements of the tax laws. It also involves other approaches such as
observation of premises, direct monitoring of receipts in cash businesses, use of mark-up
techniques and analysis of key ratios (ERCA, 2014).

In Ethiopia, the modern tax system is a product of more than half a century of experimentation in
legislation and tax reform. Since its humble beginnings in the 1940s, the modern Ethiopian tax
system has developed and evolved by fits and starts as the needs for revenue arise, as
governments change and as the economy and international situations shift (Tadesse 2012, cited
in Worku 2016). In Ethiopian context, auditing is relatively new phenomenon in earlier periods,
the responsibility to administer and control the country’s revenue and expenditure was
exclusively performed by ministry of finance .Government auditing dates back to the
establishment of an Audit Commission by proclamation No. 69/1944 during Emperor Regime.
The government of Ethiopia has several options to finance its public expenditures and pursue its
fiscal policy. These options include imposing of taxes on businesses and persons, and non-tax
revenues such as service fees, money prints, loans (both domestic and foreign institutions),
property and investment income, privatization of public enterprises, and domestic and foreign
grants.

The scope of audit activities varies across countries, in part as a result of the system of
assessment in place. There are two generally accepted systems of tax assessment applied
worldwide (administrative assessment and self-assessment) In around half of OECD countries,
administrative assessment is employed to varying degrees in the administration of personal
income tax and corporate profits/income tax. All countries administer VAT under self-
assessment principles. (mesfine, 2008)
Since virtually all tax returns are accepted as filed without technical scrutiny when applying self-
assessment principles, it is essential for the system to be supported by a reliable automated audit
case selection system using risk-based screening techniques. Typically, such systems are
developed using risk-based criteria derived from analyses of completed audit cases and are
regularly updated to take account of the results of audit activities and to reflect important
changes in the behavioral patterns of taxpayers. Examples of risk identification models and
approaches are described in the companion note ‘Audit Case Selection. As systems of
administrative assessment and self-assessment have evolved over time in many countries there is
something of a fine-line in practice between their features and relative efficacy. (Eugene, 2011)

Tax audit is the independent examination of the returns submitted by taxpayers to the relevant
tax authorities to ascertain the level of tax compliance by taxpayers (EBIMOBOWEI, 2013).
Tax audit is the examination of an individual or organization’s tax report by the relevant tax
authorities in order to ascertain compliance with applicable tax laws and regulations of state. An
audit will examine the issues seen as most substantial to achieving an accurate assessment of a
taxpayer’s tax liability. Generally, these issues will include any signs of significant unreported
income (for example, as may be suggested by a very low ratio of net/gross business income ratio
computed from a taxpayer’s return) or potentially over-claimed deduction items that may be
apparent from an examination of a taxpayer’s tax return and other information (Kircher, 2008).

According to the Ethiopian Federal Inland Revenue Authority’s tax assessment and audit manual
(2006), an assessment is basically an initial review by tax official of the tax declarations and
information provided by tax payer and a verification of the mathematical
and technical accuracy of the declared tax liability shortly after the submission of the declaration.
The initial review also includes the application of various risk criteria to determine possible tax
underpayments and the subsequent selection for tax audit.
An audit on the other hand, is the conduct by audit staff for appropriate verification of selected
tax payers declared tax liabilities. This can include a review of tax payer’s systems, books of
account and other related information. It may also include cross checks of tax payer’s records
with those of tax payer’s suppliers or with other source of information such as the custom
authorities or other government departments and agencies.
Tax audit is needed to increase tax revenue and taxpayer compliance. Tax audit is a detailed
exploration into the activities of a taxpayer to determine whether he/she has been correctly
declaring the tax liabilities (OECD 2006a). Tax audit play a critical role in the administration of
tax laws through their detection of non-compliance and by serving as a deterrent to the wider
population of taxpayers who might otherwise engage in noncompliant behavior (Keen and Smith
2007). A Tax Audit would serve to ensure that the books of accounts and other records are
properly maintained; faithfully reflect the income of the tax payer and claims for deduction
correctly made by him/her; help in checking fraudulent practices; and facilitate the
administration of tax by a proper presentation of accounts before the tax authorities and
considerably saving the time of assessing officers in carrying out routine verifications like
checking correctness of totals and verifying whether purchases and sales are properly vouched or
not, thereby their time could be utilized for attending to more important investigational aspects
of the case (Reagan 2015). Since tax audit is an investigation into the background of tax returns
submitted by an individual or business to a tax agency, the idea of a tax audit normally conjures
up feelings of anxiety even in persons who believe their tax documents are perfectly in order.
While it is true that a tax audit may be called due to some perceived irregularity in one or more
returns, it is also true that an audit may be done simply as part of a random sampling (Alemu and
Deressa 2009).
The merger of the former Ministry of Revenue, Federal Inland Revenue and Ethiopian

Customs Authority, which took place on the 14 th day of July 2008, established the
Ethiopian revenue and customs authority /ERCA/ by proclamation no 587/2008 G.C
has helped to build a modern organization that is committed to leadership and client
service. ERCA is responsible for the administration of tax programs, as well as the
delivery of economic and social benefits. Lastly restructured as Ministry of revenues in
2018.
 2. FREQUENT TAX EVASION SYSTEMS
2.1 TAX EVASION UNDER ETHIOPIAN INCOME TAX LAWS
Ethiopian Income tax proc. no.286/94 was among the first laws that introduce the concept of tax
evasions with its contemporary development. Section 9, art 96 of the proclamation comes with
definition of the term.
Accordingly, “A taxpayer who evades the declaration or payment of tax commits an offense and,
in addition to the penalty for the understatement of income referred to in Article 86, may be
prosecuted and, on conviction, be subject to imprisonment for a term of not less than five (5)
years”
Pursuant to the above article tax evasion is regulated having two (2) aspects. Those include:
• Evasion of declaration
• Evasion of payment
2.1.1 Evasion of Declaration
Unlike the case of value added and turn over tax where the epicenter of tax evasion discourse
bases itself on whether we declare or pay the tax we collect on behalf of the government, under
income tax law regime what can be evaded in the sense of evasion of declaration is tax payers
income.
As majority of tax evasion cases fall under this category of evasion, we do believe tax
professionals should be well versed with it. Other than the above phrase, the proclamation does
not clearly define what evasion of declaration mean. Hence, we have no option than being
persuaded to discuss what evasion of declaration meant under developed tax jurisprudence.
The most common attempt to evade or defeat a tax is the affirmative act of filing a false return
that omits income and/or claims deductions to which the taxpayer is not entitled. Consequently,
such willful under reporting or overstating of costs constitutes an attempt to evade or defeat tax
by evading the correct assessment of the tax.
To establish evasion of declaration the government (prosecutor) must prove that:
The defendant committed an affirmative act to defeat or evade tax.
There must be a material amount of tax due and owing.
The defendant must act willfully.
The defendant committed an affirmative act to defeat or evade tax
Affirmative action is an action taken by the tax payers for the purpose of tax evasion. Taxpayer
must undertake some action, that is, engage in an affirmative act for the purpose of attempting to
evade or defeat the assessment of a tax
This might be in the form of:-
 Filing false tax return that omits income, or
 Claiming deductions to which the tax payer doesn’t have entitlement etc.
Apart from the above discussion, the new tax administration proclamation no 983/2008
clearly regulate failure to file a tax declaration/return as tax evasion. The proclamation
peculiarly comes with the phrase “with intent to evade tax” which clearly depicts the duty of
the government to unequivocally show the fraudulent intent of tax payer to evade tax with
the shadow of failure to file tax return.
In nutshell, the existence of affirmative act remains an essential element of Evasion of
declaration under income tax law regime. There must be a material amount of tax due and
owing.
2.1.2 Evasion of Payment in Income Tax
Unlike evasion of declaration, evasion of payment can’t deal with income. It is all about evasion
of income tax due and owing by the tax authority. Under income tax law evasion of payment
entails an action by the tax payers to evade payment of tax due and owed by the revenue
authority. In this kind of evasion the government must demonstrate the existence of a tax due and
owing, i.e. existence of tax deficiency, to prove tax evasion.
Unlike the differences in tax regime, the legal philosophy underlying tax evasion coincides in
evasion of payment. Under income tax law 286/94, value added tax proc 285/94, turn over tax
proc 308/95 and the new tax administration proc 983/2008 evasion of payment appear fashioned
the same.To sue the tax payer for crime of evasion of payment the prosecutor is expected to
show the following three essential elements of evasion of payment to the court of law:
 The existence of a tax due and owing, e., a tax deficiency, to prove tax evasion.
 There should be an affirmative acts to evade or defeat payment of tax.
This Affirmative acts of evasion of payment almost always involve some form of concealment of
money or assets with which the tax could be paid or the removal of assets from the reach of the
authority. Affirmative acts of evasion of payment generally involve schemes to deal in currency,
place assets in the names of others, transfer assets abroad or omit assets on a form to be filled by
the authority. Those includes concealment of money or assets with which the tax could be paid
or the removal of assets with which the tax could be paid from the reach of the authority.
Those includes
 Concealment of money or assets with which the tax could be paid or
 The removal of assets with which the tax could be paid from the reach of the
authority.
 Tax deficiency must be with intent to evade (with intent to not to pay due and
owing tax evade and conceal assets/property to be discussed by the authority.
Roughly interpreted by the writer from Federal Supreme Court cassation
decision volume 15 file no-84623 and Art 125 of TAP/.
2.2 Tax Evasion as introduced under Ethiopian Tax administration proclamation no-
983/2008
Unlike the former Ethiopian tax laws such as income, VAT, TOT &others which regulates tax
evasion distinctly, the new tax administration proclamation no-983/2008 introduced the concept
comprehensively with a single legislative provision under chapter three of the proclamation. As
tax administration proclamation aims to govern all domestic taxes with a single tax
administration system under single codified body of law, tax Evasion as a criminal offence and
immoral act defeating tax administration system was introduced under art 125 of the
proclamation with a single statutory language. As depicted under art.125 (1) of TAP, Who so
ever, with intention to evade tax, conceals his income or fails to file a tax declaration or pay tax
by the due date shall be punishable with a fine of birr 100,000(one hundred thousand birr) to
200,000(two hundred thousand birr) and rigorous imprisonment for a term of three to five years.
As the statutory language of this article matters a lot to grasp what tax evasion mean.
In Ethiopia, Income can be evaded through different techniques. Amongst:-
 Underreporting of income
 Overstating of costs/deduction of claims for false expenses
 Income shifting by multinational firms &Transfer pricing
 Failure to report sources of taxable income
 Artificial bank loans .etc.
 A. FAILURE TO FILE TAX DECLARATION WITH INTENT TO EVADE TAX:-
Failure to file a tax declaration is among the new notions that got legislative recognition under
the Ethiopian tax administration proclamation 983/2008 as criminal offence. To discuss the
detail of the concept it is needed to define what tax declaration is meant under TAP.

Under art 2/35 of TAP tax declaration is defined as ….a tax declaration required to be filed under
Federal income tax, Value added tax return, Turn over tax return and tax declarations required by
pursuant tax laws.
Under the above article to bring a criminal charge the prosecutors should proof the existence of
the elements of the offence. As can be inferred from the statutory language of the law failure to
file tax declaration ripe to criminal charge if and only if:
The tax payer fails to file his tax declaration pursuant to the substantive tax law that require him
to file on certain clear due date.
Tax payers fail to file his tax declaration on this due date.
The act is done willfully with intent to evade tax.
B. WITHHOLDING TAX EVASION UNDER TAP NO-983/2008
Unlike the former tax law regimes which don’t clearly criminalize withholding tax evasion the
new Ethiopian tax administration proc-983/2008 criminalize withholding tax evasion under art-
125/2 of TAP.
Accordingly “ A withholding agent who withholds tax from a payment but fails to pay the
withheld tax to the Authority by the due date with the intention to evade tax shall be punishable
by rigorous imprisonment for a term of three to five years.’’
Regarding withholding tax different jurisdictions criminalize both a willful failure to withheld
tax and a willful failure to truthfully account for and pay over tax withheld. U.S remains typical
of such legal system. Unlike that of U.S the new Ethiopian federal tax administration
proc.983/2008 article 125/2 can’t criminalize willful failure to withheld tax. However, any
willful failure to account already withheld tax to the tax authority with intent to evade tax is
plainly criminalized.
2.3 Tax Evasion under Ethiopian Value Added Tax Laws
Like all taxes VAT is also subject to evasion. Unlike the case of income tax ,where the bottom
line of evasion commence from concealing income, in case of VAT, Evasion is all about
fraudulent act done by the legal tax payer on tax collected from the ultimate tax payer.
VAT fraud takes different forms. Among the most common one includes:-
 Failure to register for VAT being qualifying for it
 Failure to file VAT return
 Under reporting of sales
Where different goods are taxed for VAT at different rates reducing tax payments by
misclassifying sales in to the category subject to a lower rates(or zero rate) of tax.
Even though in some respects, VAT offers distinctive opportunities for tax evasion through VAT
credit and refund mechanisms, the particular structure of VAT may reduce its exposure to
evasion. Under Ethiopian legal system, proc. no 285/94 is the pioneer law that regulates VAT
and proscribe VAT evasion.
A. EVASION OF DECLARATION IN CASE OF VAT
The first line of art 49 deals with evasion of declaration. It proscribes evasion of declaration of
tax. The provision entails that in case of VAT what is evaded is collected tax.
As expounded elsewhere in the same article, VAT Evasion have nothing to do with income of
the tax payer rather it goes with a legal duty imposed by law. The epicenter of VAT evasion is
tax. The law imposed the duty on tax payer to collect VAT and file a return of it. It is a rejection
of this duty to declare tax collected which ripe for evasion of declaration in case of VAT. In
VAT we evade declarations mainly through under reporting of sales of taxable transactions.In
such cases we evade taxes that we have collected from the ultimate tax payers on behalf of the
government. It also occurs through preparing fake invoices. This happens in situations where
buyers conspire with their seller customer to inflate their input VAT (happen in Custom where
importers over invoice their goods value). In internal revenues this happens through cutting the
values of goods less than the market values so as to cut off the would be VAT paid.
Likewise, Evasion of declaration in case of VAT also occurs in cases of failure to file Vat return,
and failure to register. Being qualified to be registered for VAT some tax payer fail to do it and
fail to collect a lot of VAT to be collected on behalf of the government.
2.4 COMMON TAX EVASION METHODS
Tax evasion methods are affirmative acts which tax payers use to evade taxes. Different tax
payers use different methods of evasion. Amongst the well-known affirmative acts of evasion
includes-
A. Filing of a false return and a false amended return
Failure to file return coupled with an affirmative act of evasion is commonly referred to as a
"Spies evasion." Passive failure to file tax returns is not tax evasion. If the taxpayer failed to file
a return, an evasion case can be maintained only if the taxpayer engaged in an affirmative act to
conceal or mislead. By way of illustration, and not by way of limitation, examples of conduct
which can constitute affirmative acts of evasion:
•Keeping a double set of books.
•Making false or altered entries.
•Making false invoices.
•Destruction of records.
•Concealing sources of income.
•Handling transactions to avoid usual records.
•Any other conduct likely to conceal or mislead.

B. Filing False tax exemption plus Failure to file a Return Equals Evasion
Filing false and fraudulent Forms W-4 claiming to be exempt from federal taxation in
combination with failure to file tax returns for each year can constitute an affirmative act of
evasion.
Beside the above methods, tax can be evaded by:-
•Making false statements to tax authority officer which relates to fraud.
•Corporate officer's diversion of corporate funds to pay personal expenses.
•Sluicing (washing) off corporate income to principal shareholders in the guise of commissions
or salaries out of proportion to the value of service rendered to the corporate taxpayer.
•Consistent pattern of overstating deductions.
•Concealment of bank accounts.
•Holding property in nominee names.
•Representing political gratuities as gifts.
•Doing business in diverse names and keeping large sums of cash in safe-deposit boxes in
numerous banks.
•Failure to file declaration of estimated tax, concealing or attempting to conceal true income,
failure to pay income tax due, and filing frivolous returns.
•Structuring cash transactions etc.

3. TAX AUDIT TECHNIQUES

According to Ethiopian‘ Domestic Audit Manual ,may 2014, There is no clearly identified and
stated techniques of auditing separately for manufacturing, merchandise and service companies.
But there is generally stated common approaches to be followed to conduct the audit and the
procedures to be followed separately to undertake actions in auditing the companies are clearly
provided in the manual.

Auditing income requires that auditors use various techniques depending on the specific
circumstances of the case. This often means going beyond the documented records to determine
the reasonableness of reported sales information. Analysis and observation are useful to ensure
that income from all sources has been reported. During the preliminary phase of the audit
determine the types of sales and the method of reporting these sales.

3.1 Auditing Using the Detailed Analytical Approach

The detailed analytical approach involves obtaining a general understanding of the business
operations of the taxpayers. The preliminary interview and observation of day-to-day functions
are useful tools that help determine areas where errors are most likely to occur.
The detailed analytical approach uses information obtained through observation, discussion,
documents or records obtained from either the taxpayers or from other sources.

Techniques used by auditors to complete audits include the following:

 using judgment
 using an imaginative approach and adapting the audit plan to meet the objectives and
identified risks of the audit in progress
 using information outside the accounting records to perform the audit
 Analysis and Observation
Analysis and observation are of primary importance to provide evidence of potential problems
with income and expenses as reported. Analysis of financial statements or the income tax return
may provide information that determines areas that require further audit action. Some typical
areas of analysis and observation include:
 analysis of gross and net profit margins
 analysis of the taxpayer's drawings
 analysis of assets (an increase in assets without corresponding source of funds may
indicate suppressed revenue)
 review of the list of suppliers and the timing of purchases can provide assurance that
the purchases relate to the reported income
 evidence that the taxpayer's residence and standard of living is not compatible with
reported income

Testing and Sample Selection

The degree of testing required is determined by the auditor's assessment of risk based on internal
controls, review of the accounting system, analysis of the returns and financial statements,
previous experience with the taxpayers, the type of business and the scope of the audit. Various
methods may be used to select a sample of items for testing. Some common criteria of selecting a
sample are as follows:
 a selection of amounts over a certain limit
 all large items
 by supplier or customer
 by month
 to select a certain percentage of transactions (either percentage of Birr value or
percentage of the number of entries)
Third Party Information

Valuable information can be obtained during the course of an audit from third parties but there
should be sufficient evidence that indicates that third party verification is warranted. Some
examples where third party information is useful include:-

Where the audit was initiated as the result of a lead, there may be enough information to narrow
the scope of the audit thereby reducing the time required to complete the audit.
Information may be gathered during the course of the audit that warrants verification of income
from customers. This method should only be used when no other method is available to verify
sales due to the ramifications that may result.
Local authorities such as registry offices and government agencies can be used to obtain
information such as lists of permits obtained for work sites or a listing of revenue from auto
insurance claims.
3.2 Auditing Cash vs. Accrual Method of Reporting Income

The preliminary interview with the taxpayers should confirm the method of reporting sales.
Virtually all company taxpayers are required to use the accrual method of reporting sales. Where
the taxpayer does not record revenue on the accrual basis, the remittance of VAT/TOT on sales
and the reporting of income may not be in accordance with legislative requirements. Audit
procedures should verify that VAT/TOT is remitted at the time of sale. Cut-off procedures
should be reviewed for purposes of remittance of VAT/TOT, claiming input tax credits,
reporting income and expenses.

Adjusting from the Cash Method to the Accrual Method

The taxpayer's method of reporting income during the year may require adjusting at year-end for
income tax purposes. Accounts receivable and accounts payable must be adjusted to convert the
taxpayer's records from the cash method to the accrual method. Opening receivables and
payables are subtracted from the reported amounts while ending receivables and payables are
added to the reported revenue and expenses. Inventory on hand at the beginning of the year is
added to cost of goods sold while inventory on hand at year-end is subtracted from cost of goods
sold.
3.3 Auditing the Various Types of Sales

The nature of the taxpayer's business often determines the primary types of sales. In the retail
industry, most sales are considered cash sales (payment made by credit card is included in cash
sales) while in manufacturing or wholesaling most suppliers have a credit policy and customers
have an established credit limit. Electronic commerce is now a common method of conducting
business. The transactions are handled entirely on-line through various Internet sites and there
may be limited documentation for use in verifying the accounts. The adequacy of books and
records must be considered.

Sales on Account
Sales made on account can be recorded in many ways. The sale may be entered in a cash register
or a sales invoice may be prepared and entered in a sales journal. Usually the taxpayers will have
some form of credit policy and credit limits based on past experience with the customer.
Suggested Audit Procedures
The following should be considered when reviewing sales made on account:-
 review the sales recording system
 determine whether there are reliable system based controls
 verify that controls are functioning as described
 test a sample of customer accounts to ensure that the sales are posted to an
income account
 if the taxpayers uses a double entry journal system, test a sample of posting
entries
 review the sales summaries – test a sample of monthly summaries to ensure
that sales are posted to income accounts
 in many journal systems a column is used to post amounts to infrequently
used accounts – review these amounts to ensure that sales are not recorded in
balance sheet accounts
3.4 Auditing Construction Contracts, Progress Payments and Holdbacks

The reporting of revenue and VAT/TOT on long-term contracts is determined by the contract for
service between the supplier and the recipient, provincial laws that govern the contracts and the
timing of payments made to the supplier. Progress payments are generally made based on a
percentage of completion of the contract less any prescribed holdback. Reporting revenue for
income tax purposes is only an issue when the contract straddles the supplier's year-end. Large
contracts may straddle more than one year-end. In this case, reporting of revenue is based on the
percentage of completion, as provided in the income tax proclamation 286/2002 Article (63).
VAT/TOT must be remitted on each progress payment in the reporting period that the payment is
due. Many contractors are required to file returns monthly. As a result the impact of this type of
contract is greater for VAT/TOT purposes than for income tax due to the more frequent filing of
returns. When progress payments are made net off retention /hold back/ VAT/TOT should be
paid on the gross amounts payable to the contractor.

3.5 Auditing the Sales Recording System

Various methods are used by taxpayers to record sales. The sophistication of the system depends
to a certain extent on the size and type of business. During the preliminary phase of the audit, all
methods of recording income must be obtained. Some common methods of recording sales
include:-cash registers

 sales invoices prepared either manually or by a computerized system

 bank deposits

Where the taxpayer is suppressing sales there will often be a secondary sales recording system
such as a separate sales invoice sequence or a diversion of certain forms of payment to a separate
bank account.

3.5.1 Sales Invoices

Audit procedures should include the following:-
 Where sales invoices are pre-numbered or system generated the sequence of the recorded
sales invoices should be verified. If the review indicates that there are gaps in the
 numerical sequence, procedures are required to determine the reason for the missing
invoices
 The numerical continuity of invoice books should be verified.
 Where missing invoices are noted they may be marked as cancelled. A sample of
cancelled invoices should be tested to ensure that the invoice was in fact cancelled.
Where there is evidence that goods were shipped the cancelled invoice should include a
notation of the replacement invoice.
 Ensure that sales are recorded for each business day.

Where sales invoices are prepared manually the audit procedures should include verification
of the following:-

 the calculations on the sales invoices should be verified

 a sample of daily sales should be tested to ensure that the daily summaries agree to the
total sales invoices issued
 deposits should be reconciled to sales and accounts receivable
 the procedure of refunds and credit notes should be reviewed
 the controls of returned goods should be queried
 the method of issuing refunds to the customer should be reviewed

Sales Summary Where the sales invoices are prepared manually, there are essentially two
methods of preparing sales summary. One method includes the use of a cash register the second
method uses a journal system. Regardless of the method used to summarize sales, the audit
procedures should include testing a sample of posting entries to ensure that the entries are free
from material error.

Cash Register Sales Summary Sales invoices are entered to a cash register that summarizes
daily sales. The till tapes are used to prepare sales summary that are usually in the form of
journals.

Sales Journal The sales invoices are entered to a journal that can be in the form of a simple
ledger (manual or electronic spreadsheet) or a one-write system. A one-write system also
permits recording of sales made on account by using individual customer ledger cards. The
journals are usually totaled at the end of each month.
Sales Invoices prepared by a Computer System

Where a computer system is used to generate sales invoices, the system review should determine
whether the invoice number is system generated or based on operator input. Where the invoice
number is based on operator input, verifying the numerical sequence will not provide assurance
of completeness of sales. Other procedures will be required to ensure that all sales are invoiced
and recorded.

3.5.2 Bank Deposits

In many small business operations the bank deposits are used to record sales. The receipts are
deposited to the bank account daily, weekly or as considered prudent by the owner, manager. In
many cases the deposit books are not summarized in a ledger and are the only record of sales.
Where bank deposits are used to record sales, there may not be sufficient evidence to support the
VAT collected/remitted. Unless supporting information is available, VAT should be remitted on
the tax-included amounts of 15%. For income tax purposes the VAT remitted is deducted from
the deposited amounts to determine income. Weaknesses of this method of recording sales
include:-

The taxpayers may not provide the customer with a voucher to support the expense incurred or
the amount of VAT paid
Income may be understated as a result of using cash received to pay for purchases or expenses

Income may be understated as a result of cash withdrawn for personal expenses

3.5.3 Audit of cash registers

The information in this section serves as a general guideline for an auditor who is auditing a
taxpayer using a cash register to record sales. Retail business operations including restaurants,
grocery stores, convenience stores, hardware, and department stores generally use some type of
point of sale equipment such as cash registers to record sales. Cash registers are used to record
and compile data, and to produce reports for business management. Where the taxpayer uses a
cash register to record sales, there are numerous areas of concern including the possibility of
suppressed revenues, manipulating or altering information, and internal control considerations.
Many industries have systems that produce numerous accounting reports and have system
controls in place to prevent the manipulation of information. In a small business the lack of
internal controls and the lack of segregation of duties increase the risk of sales being altered.
Cash transactions pose an even higher risk because usually there is no audit trail for cash
transactions. The auditor must determine the recording method for sales and calculation of
VAT/TOT. When a cash register calculates the applicable VAT/TOT, ensure that there are
controls in place to apply the proper percentage of tax and that the calculation complies with
legislative provisions regarding the rounding. The income reported for income tax purposes must
not include VAT/TOT.

3.5.4 Cost of goods sold

The composition of cost of sales which is, known as “cost of goods sold” in the case of
manufacturing companies will depend up on the nature of the company. In a trading company it
will be the opening stock of goods for resale, plus the purchase during the year and less the
ending stock. In a manufacturing company, it will comprise the total cost of goods produced, i.e
raw materials consumed and production expenses plus opening work in process and less ending
work in process, as adjusted for the difference between opening and ending stock of finished
products.

3.5.5 Purchase

The auditor will verify the amount of opening stock and work in process with the year’s working
papers and agree the closing/ending stock with the stock schedules. Purchase accounts should be
carefully scrutinized and material adjustments or other unusual entries vouched and the total of
the purchases accounts agreed with the nominal ledger control account balance. Cut-off
procedures should be examined to ensure that purchases include the cost of all goods received
and taken in to stock. This will involve an examination of the goods receiving note (GRN) of
both before and after the year end to ensure the integrity of the numerical sequences and that all
have been matched with a suppliers invoice or transfer from goods in transit, recorded in the
correct financial period. Attention must be paid to import purchases to verify that cost build up is
as per VAT proclamation No. 285/2002 article 15. The overall correctness of purchases and
materials consumed may be substantiated by applying performance indicators and overall
reconciliations.
 Review the taxpayers system of internal controls and internal checks that exist with respect to
the ordering, receipt, storage, payment, withdrawal from stores, to the eventual
sale/disposition and the recording in the books of account, subsidiary ledgers and general
ledger.

 Obtain a summary of the taxpayer’s importation for the period from ASYCUDA ++.
The information is also required to verify the taxpayer’s claim for the payment of
business income tax on imports and to ascertain if the taxpayer may be marketing
contraband goods;
 Confirm that the taxpayer is accruing expenses in, the correct taxation year with
respect to the purchases of services that apply to more than one taxation year;
 Confirm that the taxpayer is correctly accounting for VAT input tax credits and is not
duplicating deductions through the Customs Duty Drawback Scheme;
 Review the taxpayer’s accounting treatment for expenditures for repairs, renovations
or restoration with respect to capitalizing or expensing the outlays- proclamation
608/2008 Article11;
 Review the diversion of products for sale to personal use or consumption of the
owner/shareholders that may have income tax and VAT/TOT implications;
 Test the delivery slips to confirm the locations to which goods for resale were shipped
by suppliers (also for vehicle and building repairs for personal purposes rather than
business);
Confirm the validity and reasonableness of year-end accruals, by way of general journal entry,
such as additional wage bonuses, management fees or services rendered but not invoiced. Wages
should be taxed at the personal level to be allowable. Services must have been rendered equal to
the value accrued and be justified. Accruals to the related party are subject to withholding.
Test the taxpayers arrangements for the payment of commissions on sales to employees and
agents, including year-end accruals, in relation to the sales revenue reported;
Test credit notes given by major suppliers for annual volume discounts. The discount should
reduce the value of purchases reported by the taxpayer;
Review the taxpayer’s claims for commissions paid, often in cash, to secure contracts. These
claims should be disallowed unless the recipient is identified. The revenue authority should
follow up on the recipient’s subsequent declaration for personal income tax purposes.
Test the timing and recording of purchases for the periods immediately preceding and following
the year-end date to confirm the accurate accounting and tax treatment for the correct taxation
years
3.6 Production or manufacturing expenses
The detailed ledger accounts should be scrutinized for apparent correctness and any large or
unusual entries specifically validated as necessary. The reconciliation, if any, of the total charge
for direct wages with the monthly payroll totals, should be reviewed and attention paid to
expenses such as repairs & maintenance to ensure that capital expenditure has not been wrongly
charged to annual expenses as per Income tax proclamation number 608/2002 article11. The
following are examples of the types of tests that the auditor could conduct that are expanded
upon in the Audit Checklist:
Review the taxpayer’s costing methods, policies and procedures with respect to the
determination of the manufacturing cost and inventory valuations;
Review the taxpayer’s adjustments made during the year and/or at year-end to standard costs for
price adjustments, revised labor rates, charges for custom work and overhead rates;
Reconcile the costs of goods manufactured and the related inventories for the year to the
production records, general ledger, financial statements and the Business Income Tax
Declaration;
Confirm that the taxpayer has valued inventories in accordance with Article 22 of the Income
Tax Proclamation Trading Stock;
Confirm that the taxpayer has not established reserves to reduce the value of finished goods, for
such matters as obsolescence or unsubstantiated losses that are not deductible for the purpose of
calculating the business income tax liability;
Test the taxpayer’s system of internal control and internal check with respect to the
movement of the product through the manufacturing process to finished goods inventories and
the eventual sale or other disposition.

3.7 Administration and distribution expenses

Expenses are those incurred and contributed for the generation of income for the year under
audit. Those expenses incurred but will contribute generating income in the future years shall be
capitalized as deferred expenditures and amortized then after such expenses start generating
income. The auditor should check the schedules of expenses with the subsidiary ledger accounts,
carefully scrutinizing such accounts for apparent correctness and for large and unusual entries
which should be vouched /checked as necessary. When reviewing expense accounts, the auditor
should determine that a charge only for the year (twelve months) has been included for those
expenses which accrue on a time basis such as salaries, rent, interest, telephone and utilities. The
totals of the subsidiary ledger should be agreed with the control ledger account balances and
there to the financial statement amounts. Comparisons with budget and comparative figures can
show for the reasonableness of such expenses and any major variations shall be justified. Audit
tests on expenses can be referred under purchases tests above.

“THANK YOU”

REFERENCES
ERCA Tax Audit Manual, (2014).