03 Jun Restaurants and Bars: IRS Audit Technique Guide an Introduction
Regardless of the type of restaurant one fact that is consistent when it comes to IRS audits is that all restaurants have numerous sales transactions with small(er) dollar amounts, taking place in a short time frame, such as during lunch or dinner. Many restaurants, especially smaller or closely held ones, are cash intensive and employees and/or owners handle large volumes of cash transactions every day.
For this reason, it is important to evaluate internal controls. When a sole proprietor counts cash at the end of the day, records all entries in the sales journal and makes the bank deposits, there is a possibility not all cash is reported and deposited. This can also be true when the same person takes the order, fills the order, receives the payment, records the payment and may even balance the cash register at the end of the day.
Restaurants have a high rate of turnover of employees who often have access to the inventories as well as the cash. As such, there is a potential risk of employee theft and embezzlement unless the restaurant implements and maintains a set of good internal controls.
Conversely, there are restaurants that have proper accounting systems, a good system of internal controls, and owners who report all transactions. These tend to be successful and profitable businesses, partly because once a system is designed that truthfully accounts for every transaction, owners have the information supplied to them from the accounting system and make accurate and wise management decisions.
The challenge for the IRS is to separate restaurant owners who are in compliance with the tax laws from restaurant owners who have failed to satisfy their tax obligations. To do this, the examiner focuses on:
- internal controls
- unreported income by the restaurant,
- cost of sales, and
- Unreported tip income by the employees.
The IRS examiner will have the taxpayer explain how the entire customer process, from the food order to paying the check, gets recorded in the books, by whom and where. Since there will be a large volume of anonymous transactions it will be difficult to trace specific items to receipts. Instead the examiner traces the process and test amounts by doing the following:
- Examine the customer checks for a sample shift, for example the 6:00 a.m. to 2:00 p.m. shift for a breakfast diner. Total the customer checks and determine where the income is initially recorded. It may be entered into a cash register and recorded on the tape, or it may be stored in a cash drawer and counted at the end of the shift. Expect the IRS Examiner to do the following:
- Count the number of checks the servers turned in for the shift. This is the number of customers that each server waited on during their shift. Is the amount consistent with the taxpayer’s initial interview statements?
- Make a note of the items sold. When the examiner reviews COGS, he/she will look to see if those items are replenished within a day or two. This could lead to the discovery that items not reported as sold, are continually being replenished. This may be a source of underreported income or overstated COGS.)
- Total the checks turned in by each server and match their entry to accounting records, such as daily sheets. Trace this amount to the monthly records and verify with the amount reported in the Statement of Profits and Losses.
- Note the ratio of cash, check, debit card and credit card payments by customers. And address the question of whether this this consistent with initial interview statements and observations as well as appropriate for the business.
- Determine how cash is stored, used and/or deposited. Many times the full amount of cash is not deposited. A set amount of cash may be retained to be used as change or to pay vendors. For your sample day, if the cash received is not the amount deposited you need to explain how the cash was used. Even though the gross receipts should be determined from sales, not the bank deposits, it is helpful to account for all of the cash for a sample period.
- Apply the taxpayer’s stated mark-up to purchases reported in the books to determine if it is consistent with reported gross receipts?
Cash management practices are a good indicator of the reliability of internal controls. If the restaurant or bar has no point-of-sales system that requires all transactions to be recorded, the IRS examiner will ask how proper reporting is insured and what measures are in place to discourage theft.
Internal controls can also be lacking in a system in which the controls designed for the point-of-sales system are not implemented, such as the recording of cash tips. This means that all of the cash received from customers is not accounted for and correct income is not reported. Usually in a bar, one person (for example, the bartender) may be handling all of the cash transactions including balancing out the cash drawers each day. This lack of separation of duties essential to a system of controls necessitates extending the income probe beyond the minimum required by the Internal Revenue Manual guidelines. AND YOU CERTAINLY WOULD PREFER THAT THEY NOT DO THAT. TRUST ME!