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As you will see, there is more to an audit of your Canada Revenue Agency (CRA) account than simply answering their inquiries. Audits present risks to your business. A CRA audit may arrive in the middle of the best quarter in a company’s history. This is when the revenue is high, all hiring plans have been approved and the entire leadership team is planning for future product development. At that point, a letter arrives with a request for an audit of a CRA account over three taxation years. In addition to determining if the company can respond to these requests, it also determines who keeps the necessary documents so that the company can respond.
In short, that is the moment when audit preparedness changes from being an accounting issue to a corporate governance one. As per CRA regulations, businesses must retain evidence for support of returns submitted over at least six years after the end of the taxation year to which they pertain. Therefore, even though the return may have been submitted several years ago; the supporting documentation must still be accessible.
When documentation and accountability are spread out amongst different employees including a bookkeeper, controller, external accountant, and file cabinets that no longer get opened since the last office relocation; the lost productivity due to distractions falls directly onto operating departments.
Audit Preparedness Must Be Considered Part of Corporate Governance
Most organizations consider tax compliance as an accounting function and therefore do not hold it to the same standards of corporate governance. However, once the need arises for corporate attention, the distinction ceases to exist.
The transition in the thought process is simple. An audit by the Canada Revenue Agency is primarily an operational challenge, and not solely a financial challenge. Although auditors provide some of the administrative oversight; ultimately the time of management is consumed while they gather information and prepare responses. Invoices are pulled, accounts are reconciled and explanations are provided for business decisions made years prior. Regardless of how much time is devoted towards this effort; that is less time spent on the operation of the business.
Therefore, it is essential that executive management oversee this area and ensure that someone at the leadership level is responsible for ensuring that documentation (e.g., invoices, receipts etc.) are maintained at a reasonable standard. While it would be unrealistic to expect a CEO to be knowledgeable about every aspect of the Income Tax Act; it is reasonable to expect that they could identify whether reconciliations are up-to-date; whether there is documentation available regarding expenses incurred; and whether anyone is accountable for maintaining those standards. Therefore, unless a senior management team reviews this documentation and asks themselves these questions, then they are essentially relying upon assumptions and not controls.
Accountability should be clearly defined. Financial personnel are responsible for maintaining documentation. External advisors are responsible for interpreting the tax treatment associated with that documentation. Senior management is responsible for making decisions related to business that are reflected in that documentation. When there is ambiguity within any of these areas, then there are likely going to be inconsistencies. An example of this type of ambiguity occurs when a company hires an external accountant to prepare its income tax return, and the internal bookkeeper maintains the company’s general ledger. Neither party has ever taken the time to reconcile the entries contained in both systems relative to bank statements.
Communication among stakeholders is critical to each group understanding what role they play. The reason why an item was incurred (i.e., business rationale), and why certain relationships existed between parties (i.e., intercompany transactions), typically only resides in the mind of a founder/owner. If documentation were created during preparation of those financial entries documenting the reason(s) why items were recorded; then that documentation could be accessed without significant burden or cost. However, if this documentation cannot be located because it was not documented initially, then reconstructing that information weeks/months later while under duress can become very costly.
Know Whether Your Records Support Your Tax Positions
Once a new management team begins to ask if your company’s records will stand up to scrutiny, perspective will begin to shift fast.
The first is how well you reconcile your ledgers and bank statements with your filed returns; these should match (or at least be able to be explained when they don’t). Common issues often arise from differences between what was deposited into the company bank account versus what was recognized in terms of revenue — as well as accounts that haven’t been reconciled since some form of system migration took place and/or prior year balances that were simply “carried over” without being scrutinized.
Secondly, you should examine the supporting documentation for all recorded expenses. Only as good as the receipt(s) attached to the recorded expense entry, documented expense entries are a weak link in many growing companies. Particularly when documenting large or repetitive expense entries, identifying and addressing weaknesses such as lack of documentation early on can help avoid unnecessary scrutiny from auditors regarding these areas. In fact, the CRA states in their guidelines that financial records should contain original source documents and that if there is any uncertainty surrounding an individual expense entry, documentation should be retained.
Thirdly, owner-managed businesses should pay close attention to shareholder-related transactions. While advances made to shareholders, repayment of such advances, benefits conferred upon shareholders and loans outstanding to/from shareholders can provide insight into a company’s financial performance — the underlying documentation for such activities is typically lacking. Thus, while most business owners do not consider it relevant to retain documentation of shareholder-related activity — doing so may be beneficial in order to demonstrate compliance with CRA requirements.
Lastly, consistency across all filing submissions is another important consideration. For example, amounts reported in the corporate return, the HST return, payroll remittance and any personal returns of the company’s owners should present a cohesive picture. If an identical transaction is characterized differently in two filing submissions, regardless of which characterization is defensible independently, that disparity will likely prompt inquiries from the auditor.
Develop an audit response plan
If a company does not develop an audit response plan prior to receiving notice of an audit request, the company will tend to respond reactively — which results in slower and more costly responses. Therefore, proactively developing a plan is the practical alternative.
It is helpful to designate a response coordinator. Although this person may not be required to answer all of the auditor’s questions individually, he/she/they should be designated as the primary point-of-contact for both the auditor and internal teams. Designating a single coordinator helps prevent duplication of effort among team members responding to the auditor, conflicting information and different answers to similar questions submitted by multiple individuals.
Additionally, it is also recommended that document owners be identified for each area being reviewed. Document owners for payroll records exist (e.g., hr), sales/receivable records exist (e.g., accounting personnel), etc. Identifying these owners in advance will significantly reduce the amount of time spent searching for and gathering requested documents.
Finally, an internal tracking mechanism for deadlines should be maintained. While the CRA’s deadline establishes the outside limit for submitting requested documentation, the internal deadline should be established far enough in advance to permit sufficient time for reviewing requested documents (and discovering that certain items cannot be located). Conversely, establishing a realistic internal timeline that allows for contingencies rather than trying to meet an unrealistic deadline is preferable.
As equally important as gathering data/documents is verifying that the data/document provided supports the related tax position(s). Therefore, it is essential to establish a review process prior to submitting any information/data/documents to CRA personnel. Someone familiar with both the requested documents and the corresponding tax positions should review the submitted data/documents to ensure that they accurately represent the taxpayer’s position(s) and that no additional inquiry will be generated due to inclusion of irrelevant information/data.
A CRA audit can create operational, financial and governance risks when records, responsibilities and response plans are not prepared in advance.
Manage the Operational and Financial Impact
It is honest to say that regardless of whether adjustments are made as a result of an audit, there will always be resource costs associated with an audit. It is one component of the process to budget for this expense when making an effort to manage it.
Immediate resource cost – staff workload
The staff responsible for keeping the records are typically the same individuals performing operational functions. This creates operational challenges if they are removed from operational duties to gather records. If you determine in advance which employees will cover these duties (and/or) what non-essential project(s) can be placed “on hold” during the time spent gathering records, then you can avoid having a record-gathering exercise turn into an operational crisis.
Financial impact – amount payable (where applicable)
A reassessment resulting in a financial liability could require an amount due. The canada revenue agency (CRA) posts guidelines for service levels regarding processing times for certain types of tax returns and objections; however, these provide no assurances regarding the timing of a particular assessment file. Establishing a worst-case scenario that includes the potential for a payment being required is more beneficial than establishing a worst-case scenario based on no payments being required.
Impact on cash flow – planning for a payment requirement
Companies experiencing fluctuating revenues (e.g., seasonal), companies currently involved in large-scale capital projects and/or companies experiencing limited working capital have a greater risk of requiring cash flow prior to the end of the year to address any liabilities that may arise as a result of a mid-year payment. Using the worst-case scenario when creating your cash flow model will allow you to plan accordingly and make decisions that do not negatively affect ongoing operating activities.
There are two cautions. The collection terms and timing of payment vary widely depending on the specifics of each individual assessment file; therefore, any generalizations concerning collections/deferments are unreliable. In addition, interest is applied to amounts owed while in dispute; thus, a company’s obligations regarding payment should be understood, even though the company is objecting to the assessment.
Support your objection with relevant documentation
Quality of response determines how long an assessment file remains open. Provide relevant documentation related to each question posed by the auditor, instead of providing whatever documentation is easiest to locate. Provide a sequential numbering system with corresponding documentation for every piece of requested data. This format will enable the auditor to follow your logic without having to search through the provided documentation.
If a question relates to multiple accounts/entities, your response should clearly connect all the components rather than expecting the auditor to infer connections.
Document business reasons clearly
In many cases, the best way to explain why you accounted for transactions in a manner that differs from expected norms is to provide context as to why. By doing so, you provide an answer to the underlying questions. Providing clear explanations for your actions and noting a legitimate business reason for accounting procedures supports your defense far better than listing documents.
Do not argue to correct misinformation
When correcting misinformation, use factual documentation as opposed to arguing against the misinformation. Since auditors review documents presented before them, discrepancies may occur merely as a function of timing, exchange rate, or unrecorded intra-company transfers. Documenting and presenting the necessary information and documentation to clarify and support correct information resolves issues immediately.
Know When Specialist Support Is Needed
Knowing when you need an expert can save money and give you control over your finances. Here are three main indicators that you may need professional assistance with accounting (and tax) services:
- A) The first is if you have a proposed accounting adjustment that will change the company’s overall financial condition; or,
- B) If there is limited documentation in support of certain entries — such as no supporting records of transactions and/or other items;
- C) And lastly, if there is a dispute as to how to classify certain expenditures, e.g., capital versus expense — which is a matter of “how” vs. “what”.
Where those circumstances apply, professional representation is a reasonable option. CRA audit representation is one example of how that support is structured, and the same questions apply to any adviser being considered: what the engagement covers, what records they need, who remains accountable for accuracy, and how fees are structured. A specialist can assist with organising records, preparing submissions and managing correspondence, but responsibility for the accuracy of what is filed remains with the company.
Turn Audit Findings Into Better Controls
The best way to improve record keeping is by making changes based directly upon the problems identified with your financial records.
If you have been having trouble documenting a certain type of expense, then require receipts as a part of the expense claim process.
If your reconciliations have fallen behind schedule, then create a monthly close date so that they can stay current.
If you have poor documentation about shareholder transactions (the reason for moving money), then create a routine to document the reason for every transaction.
It would be better to review reconciliation practices on a scheduled basis versus only when there are problems. Reviewing ledgers, bank accounts and filings on a quarterly basis will cost very little but prevent small discrepancies from adding up over the years until they become an unknown balance.
Management oversight is what ties all of these things together. Someone at the leadership level should periodically receive a brief update on whether or not records are current; whether or not reconciliations are complete; and if any outstanding issues exist. That one review will help keep the company from discovering their own records only after someone else requests them.
Frequently Asked Questions
1) Who should manage a company’s response to a CRA audit?
The company should name a single person to act as the primary point of contact for the CRA auditor and the internal team. The purpose is to eliminate the possibility of duplicate or conflicting information being provided. It does not matter how large the organization may be. The important factor is to identify this person and assign responsibility for coordinating the company’s response.
2) What records should I organize prior to my audit?
This includes all ledgers, bank statements, documentation related to sales and expenses, payroll records, HST filings, corporate tax returns, contracts, and documents detailing shareholder or intercompany transactions. Additionally, you should be prepared to provide the business justification for significant transactions, which is often difficult to recreate once completed.
3) Will I still be able to operate my business while I am going through an audit?
An audit is simply a review of your financial records. Therefore, you can continue to do business as usual. However, it will place additional pressure on those employees responsible for maintaining the financial records and providing access to them. To minimize disruption to your operation, plan ahead of time for adequate support for the employees involved in responding to the audit.