Kimbereley Washer is a QuickBooks expert, who has been helping businesses in the Stockton area for years. She writes articles for a number of online sources and also speaks at accounting and QuickBooks seminars. Learn more about Kim by visiting Ascend Financial Management.
We’ve learned that the Internal Revenue Service has acquired licensed copies of the QuickBooks software. What will the IRS be doing with the software, and how will that impact the small business owner who is being audited?
With 89% of the market share, QuickBooks is, by far, the most widely used software for all small business industries. With so many businesses using the software, the IRS has gained interest in learning how to use information in the QuickBooks data file during their audits. The Internal Revenue Service has purchased 1500-2000 licensed copies of the QuickBooks software and is now training their revenue agents and examiners on how to generate information that will assist them during audits.
Beginning in 2010, the IRS examiners began requesting QuickBooks backup files (also referred to as .QBB) as part of its protocol for auditing small businesses and self-employed taxpayers. Many taxpayers were unknowingly providing the IRS with access to information they, themselves did not know resided within the data file as well as providing the examiner with financial activity outside of the period being audited.
What information is the IRS looking for in QuickBooks and how is that information used during the audit process?
Although we cannot identify everything that the IRS seeks for during an audit, we can tell you a few things that the software can provide them. The first are missing entries such as missing checks and missing invoices. These can be found by running standard reports and sorting them by the number field. Any time the IRS can query your data file, a list of questions can arise.
The bigger and more valuable tool being used by examiners and for which they are being trained is a tool called the Audit Trail. In QuickBooks versions 2005 and earlier, this tool was an option that the taxpayer could turn on or off in Preferences. In latter versions, Intuit (the maker of QuickBooks) set the Audit Trail as automatically and permanently turned on.
The Audit Trail is a listing of every entry that is put into the software. It includes the date, time, and user login and the details of the transaction in a journal entry format. For example, when you enter a vendor bill, the system will show the bill in the audit trail with a debit to the expense account(s) and a credit to the accounts payable account. If you go into the entry and change it – say, to add a note into the memo field – the audit trail will show the date, time, and user login and the change to the memo field that you made. If you go into that same entry later and delete the entry, the audit trail will show the date, time, and user login and the fact that the entry was deleted. The changes are shown in bold; the prior version of the entry is noted just below it. Every transaction and alteration to transactions is shown in the audit trail which makes it a very handy tool during an audit.
So, for example, let’s say you entered a cash receipt from a client for $10,000 on December 14th. Then, let’s say you changed the date from December 14th to January 1st so that the income could be recorded in the next tax year because that is when you actually took the check to the bank. The audit trail will show your original entry and your changed entry which suggests constructive receipt in the December 14th tax year.
Another example may be that you purchased $800 from an office supply store. The original entry shows that the $800 was charged to Owner’s Draw (or respective entity equivalent) and entered with a memo that says “son’s college computer.” Later, you deleted the memo and reclassified the expenses to office supplies. This will certainly draw the attention of the auditor.
Is there a way to limit the periods contained in a .QBB so that the IRS is provided with only the financial activity relative to the audit period?
Unfortunately, there is not. A QuickBooks backup file (.QBB) is a full backup of the activity AS OF the date it is created including all transactions processed for dates beyond the date of backup. Intuit has not designated a backup process to capture data for only a specified period of time. There are general ledger reports that can be generated for specific periods of time, but once the IRS knows you are using QuickBooks (or any computerized accounting software), they are almost always going to request a copy.
Are taxpayers required to give the examiner a full copy of the QuickBooks data file (or whatever computerized accounting software being used)?
Revenue Procedure 98-25 addresses IRS authority to request all financial and related records that may exist. So unfortunately, yes they do have authority to request a copy of your backup.
• What options are available for a taxpayer using QuickBooks when faced with an examiner’s request for a copy of their QuickBooks data file?
There is a utility built into QuickBooks which may be a good solution for the time being. It is a utility called Clean Up Company. This function takes all of the transactions within a selected period and compresses the data into a summary journal entry. Your year of activity ends up looking like your year-end trial balance. All of the detail is removed and the audit trail is emptied. The utility was initially designed for two purposes;
• To reduce data file size for company files that have a large volume of transactions or for clients migrating from the desktop version to the online version (file sizes are limited when migrating to the online version)
• To alleviate manipulation of closed books by users with administrative override access. Many clients aware of this Clean Up option are running the utility and providing the examiner with the “cleaned up” version. Although this may work for now, the future seems to be leaning toward a directive for an unaltered version. In response to the AICPA’s March letter, the IRS sent a letter on April 20, 2011 to the AICPA stating that “it is important an exact copy of the original electronic data file be provided to the examiner and not an altered version.”
• Assuming that in the future examiners will have full access to our QuickBooks data files, what steps can a user take to make sure his data file will HELP and not HURT him during an audit?
Transparency goes a long way during an audit. Here are a few recommendations we provide to our clients to maintain transparency without inhibiting the ability to use the software to their greatest benefit:
• Use caution with each entry, and consider the entries permanent. Assume the IRS will see every entry you make. If you are unsure how to record an entry, use the ASK MY ACCOUNTANT general ledger account. Moving from this account to a more accurate account lends transparency to the auditor that when you are unsure of how to record a transaction, you don’t just drop it into an account but rather seek immediate remedy to code it right.
• Do not let your ASK MY ACCOUNTANT general ledger account to go unresolved. Include this account as part of your month-end closing procedures.
• Keep up with your books. Doing entries far in advance or for closed periods lends to a concern of manipulation for your own benefit. Do your entries on a scheduled basis and be consistent.
• Accountants and accounting managers often make closing period adjustments after the normal entry for the period has been completed. This is normal. However, these adjustments should be minimal and should all be done in a relatively reasonable time period.
• Assign separate logins for each user, and do not allow sharing of access. Logins are used for tracking each entry or alteration; you want to make sure you know exactly who is doing what. If your accountant is doing entries in your data file, make sure they have their own login. If your accountant is providing you with year-end entries, annotate your entries as coming from your accountant. We recommend using AJE before any designation number or to put AJE in the memo fields.
• Never delete a transaction. Instead, void it and put in a description on the memo field to explain the entry. If you delete a customer invoice, the auditor may wonder why there is a missing invoice number….for example. It is better to show a voided entry with a void memo that says “duplicate entry” than have the auditor question why you are voiding transactions.
• Other than your accountant, do not make adjustments to closed periods. There is a Preference that allows you to deny entries attempting to make changes to a closed period. We highly recommend that you use this Preference at least upon completion of your year end, but perhaps even more frequently to discourage tardy entries or manipulations to books once closed.
While the IRS and Intuit continue to work together toward improved audit trails within the QuickBooks software, we are sure to hear more on this matter in the upcoming years. In fact, electronic files such as QuickBooks could become part of the standard protocol for IRS audit procedures.