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1 Presenting a live 110 minute teleconference with interactive Q&A Sampling Strategies in Sales Tax Audits Selecting a Sampling Methodology and Negotiating With Auditors THURSDAY, NOVEMBER 17, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Roger Pfaffenberger, Director of Audit Sampling Practice, Ryan, Dallas David Leifer, Director of Sales and Property Taxes, InterContinental Hotels Group, Atlanta Kenneth Helms, Tax Consultant, Atlanta For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 Sampling Strategies t in Sales Tax Audits Seminar Nov. 17, 2011 Kenneth Helms, Tax Consultant ueliparent@comcast.net Roger Pfaffenberger, Ryan roger.pfaffenberger@ryanco.com David Leifer, InterContinental Hotels Group dave.leifer@ihg.com

6 Today s Program Sampling Fundamentals [Kenneth Helms] Slide 7 Slide 11 Example Of Audit Gone Bad Over Sampling [Roger Pfaffenberger and David Leifer] Slide 12 Slide 24 Do's And Don'ts Of Sampling [Roger Pfaffenberger and Kenneth Helms] Slide 25 Slide 34 Assessing Various Sampling Methodologies Slide 35 Slide 57 [Roger Pfaffenberger] Planning And Negotiating A Sample [David Leifer] Slide 58 Slide 65

7 Kenneth Helms, Tax Consultant SAMPLING FUNDAMENTALS

8 Introduction I. Audit sampling Webinar objectives A. Provide information to assist you with sample audits B. Answer questions you may have about audit sampling II. Challenge of confronting sample audits in light of: A. Limited resources B. Juggling multiple audits C. Systems changes during audit period D. Aggressive auditors who know where you may be vulnerable E. Auditors with limited knowledge about audit sampling 8

9 Why Bother? The good Improved systems Improved processes The bad Lack of bandwidth Speed for speed s sake The ugly I did pretty well in my Stats class. How hard can this be? Forced from above 9

10 Ten Commandments Of Audit Sampling 1. Thou shall know thy data. 2. Thou shall know the rules, regulations, laws and court rulings concerning sampling for the tax jurisdiction. 3. Thou shall only include G/L codes that have indirect tax attributes in the audit population. 4. Thou shall never provide invoice data at kick-off meeting. 5. Thou shall always discuss procedures concerning currently unavailable for review invoices before beginning the audit. 10

11 Ten Commandments Of Audit Sampling 6. Thou shall always discuss how overpayments are calculated. 7. Thou shall never immediately sign a jurisdiction s sampling agreement (even for Ohio). 8. Thou shall not give the auditor data without first reviewing. 9. Thou shall always review the auditor s calculations. 10. Thou shall establish an audit schedule with defined milestones and work review (keep the wheels on ). 11

12 Roger Pfaffenberger, ff Ryan David Leifer, InterContinental Hotels Group EXAMPLE OF AUDIT GONE BAD OVER SAMPLING

13 Introduction I. Does the phase, wheels off sample audit mean anything to you? A. How did the wheels come off? B. Why did the wheels come off? C. What can be done now to salvage the audit? D. What can be done to prevent this from happening in the future? II. A case involving a sample audit gone badly is used to address these questions. 13

14 Case Study I. Case description A. Texas audit of sales and purchases B. Three-year audit period C. Firm operated several outlets during audit period. D. Several outlets were sold during audit period E. Most outlets were responsible for maintaining their accounting records (invoices, exemption certificates, resale certificates) Do we see where this is going? One or two wheels off, and counting! 14

15 Case Study (Cont.) II. Case chronology A. May 2005: Firm receives audit notification (audit period Jan. 1, 2002 through Dec. 31, 2004) B. June 2005 August 2005: Initial discussions with auditor focusing on use of block sampling for audits of purchases and sales C. August 2005 January 2007: Little or no communication with auditor during this period D. February 2007: New auditor assigned to audit Another wheel off? Why? 15

16 II. Case chronology (Cont.) Case Study (Cont.) A. March 2007: Auditor asks for and receives data files required for audit B. April 2007: Tax director receives report from auditor ( Here is what I have so far ) indicating seven exams were used in the audit (three for sales and four for purchases) and adding the following tidbits of information: i. Five exams have been completed. ii. Surprise #1: A stratified tifi random sample, not a block sample, was used for the purchases audit. iii. Surprise #2: Initial assessment for the purchases audit is $2 million-plus, due primarily to missing records. 16

17 Case Study (Cont.) II. Case chronology (Cont.) A. May 2007: Auditor sends results for remaining exams to tax director. Essential tidbits from the auditor s second missive: i. Sales audit is based on a block sample of 12 outlet/months, placed in two groups of six outlet/ months each. ii. Auditor declares sales audit will be estimated, since a minimum of 30 outlet/months are needed. iii. Auditor declares the purchases audit completed. Is something missing at this point in time? 17

18 Case Study (Cont.) II. Case chronology (Cont.) A. May 3, 2007: Auditor issues Texas notification of sampling procedures for the audit of purchases. B. Important Texas Statute (c): Before using a sampling technique to establish a tax liability, the comptroller or his designee must notify the taxpayer in writing of the sampling procedure to be used. C. The notification of sampling procedures was sent to tax director after the projected assessment was determined. Do we see an opportunity for challenging the audit results? 18

19 Case Study (Cont.) II. Case chronology (Cont.) A. May 2007 August 2007: Tax director works diligently to find missing invoices, to reduce purchase audit assessment. B. Texas Sampling Manual: Missing Invoices - Missing invoices are taxed at 100%. Taxpayers are required to maintain books and records for the periods in statute. Many states treat transactions with missing documentation as 100% taxable. What are ways to address this policy in order to reduce the assessment on missing items? 19

20 Case Study (Cont.) II. Case chronology (Cont.) A. August 2007: Auditor issues updated schedules for audit of exempt sales. B. September 2007: Auditor issues Texas notification of estimation procedures for state tax audit for the sales audit, implying that the sales audit does not meet Texas requirements. C. September 2007: Tax director is given a 60-day notice to produce missing exemption certificates and resale certificates for the sales audit. D. December 2007: Off to redetermination hearings we go! 20

21 Case Study Debriefing I. Issue: Decentralization ti of records A. Message: Maintain records or copies of records in a central location II. Issue: Reactive response to audit A. Messages i. Take a proactive role in managing audit ii. Stay on top of the audit from the beginning to the end iii. Don t hope the audit will go away; it won t. iv. Be engaged in every stage of the audit; don t take anything for granted. 21

22 Case Study Debriefing (Cont.) III. Issue: Level of knowledge of Texas audit sampling policies and procedures A. Message: Know your opponent well! Study the state s s sampling policies and procedures, and ask questions about things you do not understand. IV. Issue: Notification of sampling timing A. Message: Demand to be informed in a timely manner about how the audit will be conducted and what sampling procedures will be used. Demand clear and understandable explanations of the audit sampling methods by the auditor or by a state sampling specialist. 22

23 Case Study Debriefing (Cont.) V. Issue: Surprises in the audit missing documentation problem and size of assessed amount A. Messages i. Surprises in audits are generally not good! ii. Investigate potential problems (e.g., missing records, procurement card exposure) early in the audit, and discuss how the problems can be approached in the audit with the auditor. 23

24 Case Study Debriefing (Cont.) VI. Issue: Surprises in the audit missing documentation problem and size of assessed amount A. Messages i. Don t ignore problems and hope they will go away. ii. Do not attempt to hide problems from the auditor. iii. Take an active role when the company is buying/selling businesses, in order to ensure all parties know the tax issues. 24

25 Roger Pfaffenberger, Ryan Kenneth Helms, Tax Consultant DO S AND DON TS OF SAMPLING

26 The Do s Of Audit Sampling I. Treat the auditor with professional respect A. Develop rapport with auditor, in order to engender mutual respect and trust B. Provide quiet workspace for auditor C. Respond to reasonable requests from auditor D. Assign one contact person to meet with auditor E. Never let discourse with auditor become personal 26

27 The Do s Of Audit Sampling (Cont.) II. Take a proactive role in managing the audit A. Be prepared for initial meeting with auditor B. Stay on top of audit throughout its lifetime C. Close out the audit with notes for preparing for next audit 27

28 The Do s Of Audit Sampling (Cont.) III. Know your data well prior to the audit A. Understand the population data file, its attributes and systems that produce it B. Check for data download errors (duplicate records, missing transactions) C. Check for transactions outside audit period D. Reconcile population data file to ensure it is complete and appropriate for audit E. Test data for missing documents, exemption certificates, etc. 28

29 The Do s Of Audit Sampling (Cont.) IV. Know the jurisdiction s audit sampling guidelines, statutes and regulations A. Research sampling guidelines and audit sampling cases in jurisdiction B. Asked for explanations from auditor or computer audit specialist if you do not understand guidelines completely 29

30 The Do s Of Audit Sampling (Cont.) V. Be prepared to discuss data and sampling issues with the auditor A. Candidly and openly discuss any data deficiencies with the auditor B. Propose isolation of transactions with expected problems into separate group for sampling (e.g., procurement cards missing documentation) C. Understand the life cycle of audit data Get Data Reconcile Data Define Population Sample Design Results 30

31 The Do s Of Audit Sampling (Cont.) VI. Negotiate key issues with the auditor prior to starting the audit A. Develop an agreement that sets out road map for audit B. Decide on audit period C. Select accounts of interest D. Discuss groups for sample audit (e.g., assets, expenses, utilities) E. Mutually agree on sampling methods F. Mutually agree on procedure for deriving target (i.e., audit) population for sample audit 31

32 The Do s Of Audit Sampling (Cont.) VII. Review auditor s proposed sampling plan and sample procedures A. Confirm sampling plan is the agreed-upon plan B. Confirm agreements on treating missing documentation, etc. 32

33 The Do s Of Audit Sampling (Cont.) VIII. During the course of the audit: A. Keep all discussions, deliberations and negotiations at a professional level B. Mea culpa: Accept responsibility for problems or issues that you created or for which you share responsibility with the auditor C. Promptly respond to auditor requests, and demand the same from the auditor 33

34 The Don ts Of Audit Sampling I. Do not do the following during interactions with the auditor: A. Allow the auditor to have unrestricted access to your facility B. Allow the auditor access to any individual other than the designated contact person C. Allow the auditor access to your accounting systems D. Provide the auditor with a complete national download of your data files II. Do not take a reactive position with the management of the audit III. Do not offer any accounting/finance information i not pertinent to the audit 34

35 Roger Pfaffenberger, Ryan ASSESSING VARIOUS SAMPLING METHODOLOGIES

36 Topics For This Section I. Block sampling vs. statistical sampling II. Stratified random sampling III. Statistical sampling terminology IV. Sample size determination V. Sampling population definition iti VI. Refund claims based on samples 36

37 Block Sampling Methods I. Block sampling applications A. Typical blocks are time periods such as months within an audit period (e.g. six months are selected in a 36-month audit period, and all transactions are detailed for these months). B. Store-days in sales audits (or, store-day-hours for largest retailers) C. Vendors (e.g., from list of all vendors; choose subset to detail) 37

38 Block Sampling Methods (Cont.) II. Randomization in block sampling A. Texas: Randomly select at least two months for each year in audit period B. Randomly select store-days in retail sales audits C. Randomization is an insurance policy against bias in sampling. 38

39 Block Sampling Methods (Cont.) III. Block sampling advantages A. Selection of records all records in given month or all sales receipts at a particular store for the day; easy to pull sampled items B. Does not require understanding of statistical sampling procedures C. Recent months can be selected, if missing documentation is an issue for older months in audit period IV. Block sampling disadvantages 39 A. No mathematical basis for measuring sampling risk B. No information on periods or store-days not sampled

40 Statistical i Methods I. Statistical sampling methods 40 A. Simple random sampling i. Random sample taken from audit population B. Stratified random sampling i. Population is subdivided into groups called strata. ii. Transactions have similar properties within each group, but properties vary across groups. iii. A simple random sample is taken from each stratum. iv. Most frequently used statistical method in audits C. Sequential sampling i. Select every k th item (k > 1) in a list of items

41 Statistical i Methods (Cont.) I. Statistical sampling advantages A. Efficient: Typically, a smaller sample size is required when compared with block sampling. B. Produces measures of sampling risk i. Achieved relative precision ii. Confidence interval iii. Confidence bound 41

42 Statistical i Methods (Cont.) II. Statistical sampling disadvantages A. Requires knowledge of introductory statistics and sampling methods B. Can be complicated, particularly if advanced estimation methods are used (e.g., regression estimators) 42

43 Stratified Random Sample Example Stratum Label Lower Bound (absolute value greater than) Upper Bound (absolute value less than or equal to) Population Base Dollars Population Base Items Sample Base Dollars Sample Base Items Projection Factor ($ population per $ sample) Tax Projection on Average Variance between Sample and Item Population Means Group 1 - Expenses 1A $0 $ B $0 $1,000 $5,000, ,000 $65, $1, % 1C $1,000 $25,000 $15,000, ,000 $1,850, $4, % 1D $25,000 $75,000 $25,000, $10,375, $8, % 1E Detail $75,000 max $15,000, $15,000, Group 1 - Total $60,000, ,800 $27,290,

44 Stratified Random Sample Example (Cont.) I. Detail threshold set at $75,000 A. Try to set such that detail stratum contains at least 20% of population base dollars II. Number of sample strata three used in this plan A. Use between two and seven sample strata 44

45 Stratified Random Sample Example (Cont.) III. Lower exclusion threshold not used in this plan A. Example: Do not sample or audit items with absolute values less than some dollar amount (e.g., $10, $50, $100) IV. Projection factor (separate ratio estimation method) A. Population base dollars/sample base dollars B. Example: Stratum 1B $5,000,000/$65,000 = $76.92 C. Each $1 in tax error in sample projects to $76.92 in Stratum 1B population 45

46 Stratified Random Sample Example (Cont.) V. Tax projection on average item A. Sample average x projection factor x tax rate B. Example: Stratum 1B [$65,000/250] x x 8.25% = $1,650 C. Expected tax error amount for each sampled item is $1,650 46

47 Stratified Random Sample Example (Cont.) VI. Variance between sample and population means A. [Sample mean population mean]/[population mean] x 100% B. Example: Stratum 1B i. Sample mean = $65,000/250 = $260 ii. Population mean = $5,000,000/20,000 = $250 iii. Variance = [$260 - $250]/$250 $ x 100% = 4.00% 47

48 Statistical i Sampling Terminology I. Relative precision A. Percentage difference between estimate of tax error and actual population tax error B. Common values in audit sampling: 10%, 25% II. Confidence level A. Confidence for which we want estimate to achieve stated relative precision B. Common values in audit sampling: 75%, 80%, 90% 48

49 Statistical Sampling Terminology (Cont.) III. Typical statement: We want estimate to be within 10% of the actual value in population with 90% confidence. A. Interpretation: If the sample is repeatedly drawn many times, 90% of the samples will produce an estimate within plus or minus 10% of the actual population value. 49

50 Sample Size Determination i I. Rational and reasonable cost/benefit analysis A. Benefit: The larger the sample, the better the estimation precision. B. Cost: The larger the sample, the greater the auditing cost. C. Must achieve balance between cost and benefit 50

51 Sample Size Determination i (Cont.) II. Fixed sample size A. Texas: At least 100 per stratum for stratified sampling; at least 250 for simple random sampling B. Stratified random sampling i. Multistate Tax Commission: At least 200 per stratum, absolute minimum of 100 ii. California: At least 300 per stratum with invoice as sampling unit iii. Many states use minimum of 200 or 250 per stratum. 51

52 Sample Size Determination (Cont.) III. Sample size determination formulae A. Three inputs to formulae i. Relative precision i ii. Confidence level iii. Standard deviation of tax error (tax error = correct tax actual tax paid) 52

53 Sample Size Determination (Cont.) III. Sample size determination formulae B. Formula frequently misused i. Standard deviation of tax errors unknown no estimate until sample is audited ii. Mistake often made: Standard deviation of invoice or line item amount used in place of standard deviation of tax errors iii. Statistical formulae available to approximate standard deviation of tax errors C. Preference: Fixed sample size, not sample size determined by formula D. Expand sample if necessary, if audit work suggests sample not representative ti 53

54 Sampling Population Definition i i I. Accounts of interest A. Mutually select accounts of interest with auditor i. Educate auditor on accounts that do not need to be audited ii. Include accounts that may be in your favor (e.g., accounts containing potential overpayments of tax) 54

55 Sampling Population Definition (Cont.) II. Taxed vs. non-taxed purchase transactions A. Inclusion of tax paid and/or tax accrued transactions in population i. Include these in managed audits or in audits for states that permit projection of overpayments ii. Georgia: In sample strata, projected overpayment cannot exceed projected underpayment. iii. California: Ask auditor/computer audit specialist to develop sampling plan for accruals. 55

56 Refund Claims Based On Samples I. States permitting refund claims based on samples A. Texas: Statue B. Several states permit refund claims based on samples provided, there is state t involvement in developing the sampling plan and/or generating the sample (e.g., Alabama, California, Florida, Iowa, Kansas, Maryland, New York, Washington). C. States not permitting refund claims based on samples i. Pursue the issue with the auditor to permit refund based on sample ii. Ryan initiative: Working with these states in developing statutes and/or modifying sampling guidelines to permit refund based on sample iii. Matter of equity and taxpayer fairness 56

57 Refund Claims Based On Samples (Cont.) II. Crafting a proposal for using a sample as a basis for a refund claim 57 A. Texas: Follow guidelines in Texas Sampling Manual, which is available on the Comptroller s Office Web site. B. Other states i. Notify state of intention to file claim based on sample ii. Seek advice on process for submitting claim iii. Follow state s sampling guidelines in developing a block sample or a stratified sample C. Except for Texas, states will want to approve sampling plan and generate the samples according to the plan.

58 David Leifer, InterContinental Hotels Group PLANNING AND NEGOTIATING A SAMPLE

59 Planning And Negotiating A Sample Audit I. Know your data well prior to the audit A. Research changes in accounting system or in chart of accounts during the audit period B. Determine frequency and nature of transactions in holding or suspense accounts C. Determine the extent of electronic transactions such as procurement cards or evaluated receipts settlements 59

60 Planning And Negotiating A Sample Audit (Cont.) II. Know your data well prior to the audit (Cont.) A. Examine prior audits and refund claims i. What problems arose? ii. Is there potential for overlap? B. Research direct pay permits and resale exemption certificates C. Ascertain extent of purchases from out-of-state vendors 60

61 Planning And Negotiating A Sample Audit (Cont.) III. Know your data well prior to the audit (Cont.) A. Consider the extent to which use tax accruals can be tied to tax returns B. Determine what is necessary to get from a record in the data file to a physical invoice C. Describe any patterns of high or low error rates among types of transactions 61

62 Planning And Negotiating A Sample Audit (Cont.) I. Discuss data and sampling issues with the auditor A. Process of downloading data for the audit B. Reconciliation of download to GL/tax returns C. Sampling unit (line item, invoice, other) D. Removal of irrelevant entries from taxpayer file E. Explanation of negatively valued items and $0 amount items 62

63 Planning And Negotiating A Sample Audit (Cont.) I. Issues to negotiate prior to the audit A. Division of population into sub-populations i. Required by law e.g., by legal entity ii. To manage risk e.g., group for items likely to have missing documentation iii. To partition error rates e.g., assets and expenses B. Controlling date field i. Which date? Invoice date? ii. Is it user-entered? 63

64 Planning And Negotiating A Sample Audit (Cont.) II. Issues to negotiate prior to the audit (Cont.) A. Treatment of negatively valued transactions B. Treatment of missing records in the audit C. Sampling method selected for the audit D. Tentative ti timetable t for audit 64

65 Planning And Negotiating A Sample Audit (Cont.) I. Review proposed sampling plan and sampling procedures A. Ensure that the sampling plan used to draw the sample is the plan that was originally agreed to B. Confirm agreements on the treatment of negatively valued transactions and transactions with missing documentation C. Confirm the definitions, descriptions and specifications of the population and the sample 65