IRS Audits: Workpapers Lack Documentation of Supervisory Review (Letter
Report, 04/15/98, GAO/GGD-98-98).

GAO reviewed the condition of the Internal Revenue Service's (IRS) audit
workpapers, including the documentation of supervisory review.

GAO noted that: (1) during its review of IRS' financial status audits,
the workpapers did not always meet the requirements under IRS' workpaper
standards; (2) standards not met in some audit workpapers included the
expectation that: (a) the amount of tax adjustments recorded in the
workpapers would be the same as the adjustment amounts shown in the
auditor's workpaper summary and on the report sent to the taxpayer; and
(b) the workpaper files would contain all required documents to support
conclusions about tax liability that an auditor reached and reported to
the taxpayer; (3) these shortcomings with the workpapers are not new;
(4) GAO found documentation on supervisory review of workpapers prepared
during the audits in an estimated 6 percent of the audits in GAO's
sample; (5) in the remaining audits, GAO found no documentation that the
group managers reviewed either the support for the tax adjustments or
the report communicating such adjustments to the taxpayer; (6) IRS
officials indicated that all audits in which the taxpayer does not agree
with the recommended adjustments are to be reviewed by the group
managers; (7) if done, this review would occur after the report on audit
results was sent to the taxpayer; (8) even when GAO counts all such
unagreed audits, those with documentation of supervisory review would be
an estimated 26 percent of the audits in GAO's sample population; (9)
GAO believes that supervisory reviews and documentation of such reviews
are important because they are IRS' primary quality control process;
(10) proper reviews done during the audit can help ensure that audits
minimize burden on taxpayers and that any adjustments to taxpayers'
liabilities are supported; (11) although Examination Division officials
recognized the need for proper reviews, they said IRS group managers
cannot review workpapers for all audits because of competing priorities;
(12) these officials also said that group managers get involved in the
audit process in ways that may not be documented in the workpapers; (13)
they stated that these group managers monitor auditors' activities
through other processes, such as by reviewing the time that auditors
spent on an audit, conducting on-the-job visits, and talking to auditors
about their cases and audit inventory; and (14) in these processes,
however, the officials said that group managers usually were not
reviewing workpapers or validating the calculations used to recommend
adjustments before sending the audit results to the taxpayer.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-98-98
     TITLE:  IRS Audits: Workpapers Lack Documentation of Supervisory 
             Review
      DATE:  04/15/98
   SUBJECT:  Tax return audits
             Reporting requirements
             Auditing procedures
             Auditing standards
             Tax administration systems
             Taxpayers
             Tax nonpayment
             Quality assurance
IDENTIFIER:  IRS Examination Quality Measurement System
             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


Cover
================================================================ COVER


Report to the Chairman, Subcommittee on Oversight, Committee on Ways
and Means, House of Representatives

April 1998

IRS AUDITS - WORKPAPERS LACK
DOCUMENTATION OF SUPERVISORY
REVIEW

GAO/GGD-98-98

Documentation of Supervisory Review

(268838)


Abbreviations
=============================================================== ABBREV

  EQMS - Examination Quality Measurement System
  IRM - Internal Revenue Manual
  IRS - Internal Revenue Service

Letter
=============================================================== LETTER


B-279085

April 15, 1998

The Honorable Nancy L.  Johnson
Chairman, Subcommittee on Oversight
Committee on Ways and Means
House of Representatives

Dear Chairman Johnson: 

Part of the mission of the Internal Revenue Service (IRS) is to
encourage the highest possible degree of voluntary compliance with
the tax laws.  To further this goal, IRS audits tax returns to
determine taxpayers' correct tax liability.  IRS' Examination
Division annually conducts about 750,000 face-to-face audits of
individual taxpayers' returns.\1

IRS' ability to fulfill this part of its mission is directly related
to the quality of the audits of these taxpayer returns.  IRS requires
its auditors to examine a taxpayer's books and records in sufficient
depth to fully develop the relevant facts and correctly apply the tax
laws to these facts.  IRS auditors are to document these activities
and their conclusions in audit workpapers. 

On December 30, 1997, we issued a report, at the request of the
Committee, on IRS' use of financial status audit techniques.\2 For
that report, we reviewed workpapers for a random sample of 354 IRS
audits to measure how often IRS auditors used the financial status
audit techniques and what these techniques produced in tax
adjustments.\3 We uncovered two procedural issues that extended
beyond the specific objectives of the financial status assignment. 
These issues involve the adequacy of audit workpapers and
documentation of supervisory review of those workpapers. 

In this report, our objective is to evaluate the condition of the
workpapers, including documentation of supervisory review, that we
found in doing the work for the December 1997 report. 


--------------------
\1 These face-to-face audits with individuals are conducted in the
IRS district offices and do not include other types of IRS audits,
such as service center and corporation audits. 

\2 See Tax Administration:  More Criteria Needed on IRS' Use of
Financial Status Audit Techniques (GAO/GGD-98-38, Dec.  30, 1997). 

\3 During our 1996 and 1997 review, we used a random sample of 354
audits from a population of about 421,000 that focused on individual
tax returns audited through district offices and closed during fiscal
years 1995 or 1996.  This sample excluded audits, such as those done
at service centers, that were unlikely to involve financial status
audit techniques. 


   BACKGROUND
------------------------------------------------------------ Letter :1

The Internal Revenue Manual (IRM) describes the desired outcome of an
income tax audit as the determination of the correct taxable income
and tax liability of the person or entity under audit.  In making
these determinations, the auditor has a responsibility to both the
audited taxpayer and all other taxpayers to conduct a quality audit. 

IRS uses nine audit standards, which have evolved since the 1960s, to
define audit quality.  These standards address several issues, such
as the scope, techniques, technical conclusions, reports, and time
management of an audit, as well as workpaper preparation.  Each
standard has one or more key elements.  (See table I.1 in app.  I for
a list of these standards and their associated key elements.)

Workpapers provide documentation on the scope of the audit and the
diligence with which it was completed.  According to the IRM, audit
workpapers (1) assist in planning the audit; (2) record the
procedures applied, tests performed, and evidence gathered; (3)
provide support for technical conclusions; and (4) provide the basis
for review by management.  Audit workpapers also provide the
principal support for the auditor's report, which is to be provided
to the audited taxpayer, on findings and conclusions about the
taxpayer's correct tax liability. 

The primary tool used by IRS to control quality under the nine
standards is the review of ongoing audit work.  This review is the
responsibility of IRS' first-line supervisors, called group managers,
who are responsible for the quality of audits done by the auditors
they manage.  By reviewing audit workpapers during the audit, group
managers attempt to identify problems with audit quality and ensure
that the problems are corrected. 

After an audit closes, IRS uses its Examination Quality Measurement
System (EQMS) to collect information about the audit process, changes
to the process, level of audit quality, and success of any efforts to
improve the process and quality.  EQMS staff are to review audit
workpapers and assess the degree to which the auditor complied with
the audit standards.  To pass a standard, the audit must pass all of
the key elements. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

During our review of IRS' financial status audits, we noticed that
workpapers did not always meet the requirements under IRS' workpaper
standards.  Standards not met in some audit workpapers included the
expectation that (1) the amount of tax adjustments recorded in the
workpapers would be the same as the adjustment amounts shown in the
auditor's workpaper summary and on the report sent to the taxpayer
and (2) the workpaper files would contain all required documents to
support conclusions about tax liability that an auditor reached and
reported to the taxpayer.  These shortcomings with the workpapers are
not new.  EQMS data for fiscal years 1992 through 1997 show similar
problems, with the percentage of workpapers that did not meet all
standards ranging from 28 percent to 51 percent during these years. 

We found documentation on supervisory review of workpapers prepared
during the audits in an estimated 6 percent of the audits in our
sample.  In the remaining audits (94 percent of our sample), we found
no documentation that the group managers reviewed either the support
for the tax adjustments or the report communicating such adjustments
to the taxpayer.  In response to our finding, IRS officials indicated
that all audits in which the taxpayer does not agree with the
recommended adjustments are to be reviewed by the group managers.  If
done, this review would occur after the report on audit results was
sent to the taxpayer.  Even when we count all such unagreed audits,
those with documentation of supervisory review would be an estimated
26 percent of the audits in our sample population. 

We believe that supervisory reviews and documentation of such reviews
are important because they are IRS' primary quality control process. 
Proper reviews done during the audit can help ensure that audits
minimize burden on taxpayers and that any adjustments to taxpayers'
tax liabilities are supported.  Although Examination Division
officials recognized the need for proper reviews, they said IRS group
managers cannot review workpapers for all audits because of competing
priorities.  These officials also said that group managers get
involved in the audit process in ways that may not be documented in
the workpapers.  They stated that these group managers monitor
auditors' activities through other processes, such as by reviewing
the time that auditors spent on an audit, conducting on-the-job
visits, and talking to auditors about their cases and audit
inventory.  In these processes, however, the officials said that
group managers usually were not reviewing workpapers or validating
the calculations used to recommend adjustments before sending the
audit results to the taxpayer. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

Our observations about the adequacy of the audit workpapers and
supervisory review during audits are based on our work during 1996
and 1997 on IRS' use of financial status audit techniques.  Among
other things, this work relied on a random sample of individual tax
returns that IRS had audited.  This sample excluded audits that were
unlikely to use financial status audit techniques because the audit
did not look at individual taxpayers' books and records.  Such
excluded audits involved those done at service centers and those that
only passed through various types of tax adjustments from other
activities (e.g., partnership audits and refund claims).  This random
sample included 354 audits from a population of about 421,000 audits
that were opened from October 1994 through October 1995 and closed in
fiscal years 1995 or 1996.  Each audit covered one or more individual
income tax returns.\4

The sample of audits from our previous work focused on the frequency
in which IRS auditors used financial status audit techniques, rather
than on the adequacy of audit workpapers.  Consequently, we did not
do the work necessary to estimate the extent to which workpapers met
IRS' workpaper standard for the general population of audits. 
However, our work did identify several cases in which audit
workpapers in our sample did not meet IRS' workpaper standard. 

We held follow-up discussions about the workpaper and supervisory
review requirements, as well as about our observations, with IRS
Examination Division officials.  On the basis of these discussions,
we agreed to check for documentation of group manager involvement by
examining employee performance files for nine of our sample audits
conducted out of IRS' Northern California District Office to get a
better idea of how the group managers handle their audit inventories
and ensure quality.  According to IRS officials, these files may
contain documentation on case reviews by group managers even though
such documentation may not be in the workpapers. 

We requested comments on a draft of this report from the Commissioner
of Internal Revenue.  On March 27, 1998, we received written comments
from IRS, which are summarized at the end of this letter and are
reproduced in appendix II.  These comments have been incorporated
into the report where appropriate. 

We did our work at IRS headquarters in Washington, D.C., and at
district offices and service centers in Fresno and Oakland, CA;
Baltimore, MD; Philadelphia, PA; and Richmond, VA.  Our work was done
between January and March, 1998, in accordance with generally
accepted government auditing standards. 


--------------------
\4 For a more detailed discussion of our sampling methodology and the
resulting sample, see appendix I of our previously mentioned report,
GAO/GGD-98-38. 


   IRS' AUDIT WORKPAPERS DID NOT
   ALWAYS MEET THE AUDIT WORKPAPER
   STANDARD
------------------------------------------------------------ Letter :4

One of IRS' audit standards covers audit workpapers.  In general, IRS
requires the audit workpapers to support the auditor's conclusions
that were reached during an audit.  On the basis of our review of
IRS' audit workpapers, we found that IRS auditors did not always meet
the requirements laid out under this workpaper standard. 

IRS' workpaper standard requires that workpapers provide the
principal support for the auditor's report and document the
procedures applied, tests performed, information obtained, and
conclusions reached.  The five key elements for this workpaper
standard involve (1) fully disclosing the audit trail and techniques
used; (2) being clear, concise, legible, and organized and ensuring
that workpaper documents have been initialed, labeled, dated, and
indexed; (3) ensuring that tax adjustments recorded in the workpapers
agree with IRS Forms 4318 or 4700\5 and the audit report; (4)
adequately documenting the audit activity records;\6 and (5)
appropriately protecting taxpayers' rights to privacy and
confidentiality. 

The following are examples of some of the problems we found during
our review of IRS audit workpapers: 

  -- Tax adjustments shown in the workpapers, summaries, and reports
     did not agree.  For example, in one audit, the report sent to
     the taxpayer showed adjustments for dependent exemptions and
     Schedule A deductions.  However, neither the workpaper summary
     nor the workpapers included these adjustments.  In another
     audit, the workpaper summary showed adjustments of about $25,000
     in unreported wages, but the report sent to the taxpayer showed
     adjustments of only about $9,000 to Schedule C expenses. 

  -- Required documents or summaries were not always in the workpaper
     bundle.  For example, we found instances of missing or
     incomplete activity records and missing workpaper summaries. 

  -- Workpapers that were in the bundle were not always legible or
     complete.  The required information that was missing included
     the workpaper number, tax year being audited, date of the
     workpaper, and auditor's name or initials. 

Although we are unable to develop estimates of the overall quality of
audit workpapers, IRS has historically found problems with the
quality of its workpapers.  This observation is supported by
evaluations conducted as part of IRS' EQMS, which during the past 6
years (1992-97) indicated that IRS auditors met all of the key
elements of the workpaper standard in no more than 72 percent of the
audits.  Table 1 shows the percentage of audits reviewed under EQMS
that met all the key elements of the workpaper standard.\7



                                Table 1
                
                Success Rate for EQMS Workpaper Standard
                 for District Audits From Fiscal Years
                                1992-97

                          (Numbers in percent)

                                      Success rate by fiscal year\b
                                    ----------------------------------
Type of face-to-face audit\a        1992  1993  1994  1995  1996  1997
----------------------------------  ----  ----  ----  ----  ----  ----
Office audit                          61    66    69    69    71    72
Field audit                           58    62    62    67    61    49
----------------------------------------------------------------------
\a IRS has two types of face-to-face audits through its district
offices:  (1) field audits, in which an IRS revenue agent visits a
taxpayer who has business income or a very complex return and (2)
office audits, in which a taxpayer who has a less complex return
visits a tax auditor at an IRS office. 

\b The standard success rate represents the percentage of audits that
met all of the key elements of the workpaper standard. 

Sources:  IRS EQMS reports--fiscal years 1992 through 1997. 

The success rate, as depicted in table 1, indicates whether all of
the key elements within the standard were met.  That is, if any one
element is not met, the standard is not met.  Another indicator of
the quality of the audit workpapers is how often each element within
a standard meets the criteria of that element.  Table I.2 in appendix
I shows this rate, which IRS calls the pass rate, for the key
elements of the workpaper standard. 

Workpapers are an important part of the audit effort.  They are a
tool to use in formulating and documenting the auditor's findings,
conclusions, and recommended adjustments, if any.  Workpapers are
also used by third-party reviewers as quality control and measurement
instruments.  Documentation of the auditor's methodology and support
for the recommended tax adjustments are especially important when the
taxpayer does not agree with the recommendations.  In these cases,
the workpapers are to be used to make decisions about how much
additional tax is owed by the taxpayer.  Inadequate workpapers may
result in having the auditor do more work or even in having the
recommended adjustment overturned. 


--------------------
\5 Summaries of audit work include IRS Form 4318, which is used by
revenue agents, and Form 4700, which is used by tax auditors.  These
summaries include information on the issues audited and the findings
of the audit and indicate the index mark where the workpapers
supporting these findings can be located. 

\6 The activity record is a summary of the auditor's contacts with
taxpayers and/or their representatives.  These records also document
what actions are occurring and the amount of time required to
complete these actions. 

\7 Similar to our random sample of audits, EQMS samples both office
audits and field audits done through the district offices. 


   DOCUMENTATION OF SUPERVISORY
   REVIEW OF AUDIT WORKPAPERS WAS
   LIMITED
------------------------------------------------------------ Letter :5

IRS' primary quality control mechanism is supervisory review of the
audit workpapers to ensure adherence to the audit standards. 
However, our review of the workpapers in the sampled audits uncovered
limited documentation of supervisory review.  As a result, the files
lacked documentation that IRS group managers reviewed workpapers
during the audits to help ensure that the recommended tax adjustments
were supported and verified, and that the audits did not
unnecessarily burden the audited taxpayers. 

The IRM requires that group managers review the audit work to assess
quality and ensure that audit standards are being met, but it does
not indicate how or when such reviews should be conducted.  However,
the IRM does not require that documentation of this review be
maintained in the audit files.\8

We found little documentation in the workpapers that group managers
reviewed workpapers before sharing the audit results with the
taxpayer.  In analyzing the sampled audits, we recorded whether the
workpapers contained documentation that a supervisor had reviewed the
workpapers during the audit.  We counted an audit as having
documentation of being reviewed if the group manager made notations
in the workpapers on the audit findings or results; we also counted
audits in which the workpapers made some reference to a discussion
with the group manager about the audit findings.  On the basis of our
analysis of the sampled audits closed during fiscal years 1995 and
1996, we estimated that about 6 percent of the workpapers in the
sample population contained documentation of group manager review
during the audits.\9

In discussions about our estimate with IRS Examination Division
officials, they noted that all unagreed audits (i.e., those audits in
which the taxpayers do not agree with the tax adjustments) are to be
reviewed by the group managers, and they pointed to the manager's
initials on the notice of deficiency\10 as documentation of this
review.  We did not count reviews of these notices in our analysis
because they occurred after IRS sent the original audit report to the
taxpayer.  If we assume that workpapers for all unagreed audits were
reviewed, our estimate on the percentage of workpapers with
documentation of being reviewed increases from 6 percent to about 26
percent.\11 Further, we analyzed all unagreed audits in our sample to
see how many had documentation of group manager review during the
audit, rather than after the audit results were sent to the taxpayer;
this would be the point at which the taxpayer either would agree or
disagree with the results.  We found documentation of such a review
in 12 percent of the unagreed audits.\12

The Examination Division officials also said that a group manager may
review the workpapers without documentation of that review being
recorded in the workpapers.  Further, they said that group managers
had limited time to review workpapers due to many other
responsibilities.  The officials also told us that group managers can
be involved with audits through means other than review of the
workpapers.  They explained that these managers monitor their
caseload through various processes, such as evaluations of auditors'
performance during or after an audit closes, monthly discussions with
auditors about their inventory of audits, reviews of auditors' time
charges, reviews of audits that have been open the longest, and
visits to auditors located outside of the district office.  The
Examination Division officials also noted that any time the audit is
expanded, such as by selecting another of the taxpayer's returns or
adding a related taxpayer or return, this action must be approved by
the group manager.  According to these officials, these other
processes may involve a review of audit workpapers, but not
necessarily during the audit. 

We agreed that we would check for documentation of these other
processes in our nine sample audits from IRS' District Office located
in Oakland.  We found documentation of workload reviews for one of
these nine sample audits.  In these monthly workload reviews,
supervisors are to monitor time charges to an audit.  In one other
audit, documentation showed that a special unit within the
Examination Division reviewed and made changes to the form used to
record data for input into IRS' closed audits database.  However,
none of this documentation showed supervisory review of the audit
workpapers.  If any other forms of supervisory involvement with these
audits had occurred, the documentation either had been removed from
the employee performance file as part of IRS' standard procedure or
was not maintained in a way that we could relate it back to a
specific taxpayer.  As a result, we do not know how frequently these
other processes for supervisory involvement occurred and whether
substantive reviews of the audits were part of these processes. 

IRS is currently drafting changes to the IRM relating to workpapers. 
In the draft instructions, managers are required to document
managerial involvement.  This documentation may include signatures,
notations in the activity record, or summaries of discussions in the
workpapers.  When completed, this section is to become part of the
IRM's section on examination of returns.  According to an IRS
official, comments from IRS' field offices on the draft changes are
not due into headquarters until May 1998. 


--------------------
\8 Supervisory review is a well-established standard in the audit
community.  Generally accepted government auditing standards require
that all audit workpapers be reviewed and that evidence of this
supervisory review be maintained in the workpapers.  Auditing
standards developed by the American Institute of Certified Public
Accountants have similar requirements. 

\9 The confidence interval for this estimate is ï¿½ 3 percent. 

\10 IRS sends a notice of deficiency to inform taxpayers of the
additional taxes that have been determined to be owed after taxpayers
have received an earlier notice about tax adjustments that had been
recommended by the auditor.  Generally, the statutory notice gives
the taxpayer 90 days to file a petition with the tax court for a
determination of the deficiency. 

\11 The confidence interval for this estimate is ï¿½ 6 percent. 

\12 The confidence interval for this estimate is ï¿½ 9 percent. 


   CONCLUSIONS
------------------------------------------------------------ Letter :6

IRS audits tax returns to ensure that taxpayers pay the correct
amount of tax.  If auditors do quality work, IRS is more likely to
meet this goal while minimizing the burden on taxpayers.  Quality
audits should also encourage taxpayers to comply voluntarily. 
Supervisory review during the audits is a primary tool in IRS'
efforts to control quality. 

IRS requires group managers to ensure the quality of the audits,
leaving much discretion on the frequency and nature of their reviews
during an audit.  IRS officials noted that group managers are to
review workpapers if taxpayers disagree with the auditor's report on
any recommended taxes.  The IRM does not specifically require that
all of these supervisory reviews be documented in the workpapers,
even though generally accepted government auditing standards do
require such documentation.  However, recent draft changes to the IRM
may address this issue by requiring such documentation. 

We found little documentation of such supervisory reviews, even
though these reviews can help to avoid various problems.  For
example, supervisory review could identify areas that contribute to
IRS' continuing problems in creating audit workpapers that meet its
standard for quality.  Since fiscal year 1992, the quality of
workpapers has been found wanting by IRS' EQMS.  Inadequately
documented workpapers raise questions about whether supervisory
review is controlling audit quality as intended.  These questions
cannot be answered conclusively, however, because the amount of
supervisory review cannot be determined. 

The lack of documentation on workpaper review raises questions about
the extent of supervisory involvement with the audits.  Proposed
changes to the IRM's sections on examination of returns require
documentation of management involvement in the audit process. 


   RECOMMENDATION
------------------------------------------------------------ Letter :7

We recommend that the IRS Commissioner require audit supervisors to
document their review of audit workpapers as a control over the
quality of audits and the associated workpapers. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

On March 25, 1998, we met with IRS officials to obtain comments on a
draft of this report.  These officials included the Acting Deputy
Chief Compliance Officer, the Assistant Commissioner for Examination
and members of his staff, and a representative from IRS' Office of
Legislative Affairs.  IRS documented its comments in a March 27,
1998, letter from the IRS Commissioner, which we have reprinted in
appendix II.  In this letter, IRS agreed to make revisions to the IRM
instructions for the purpose of implementing our recommendation by
October 1998.  The letter included an appendix outlining adoption
plans. 

The IRS letter also expressed two concerns with our draft report. 
First, IRS said our conclusion about the lack of evidence of
supervisory review of audit workpapers was somewhat misleading and
pointed to examples of other managerial practices, such as on-the-job
visitations, to provide oversight and involvement in cases.  We do
not believe our draft report was misleading.  As IRS acknowledges in
its letter, when discussing the lack of documentation of supervisory
review, we also described these other managerial practices.  Second,
IRS was concerned that our draft report appeared to consider these
other managerial practices insufficient.  Our draft report did not
discuss the sufficiency of these practices but focused on the lack of
documentation of supervisory review, including these other managerial
practices.  We continue to believe that documentation of supervisory
review of workpapers is needed to help ensure quality control over
the workpapers and audits. 

At the March 25, 1998, meeting, IRS provided technical comments to
clarify specific sections of the draft report that described IRS
processes.  IRS officials also discussed the distinction between
supervisory review and documentation of that review.  We have
incorporated these comments into this report where appropriate. 


---------------------------------------------------------- Letter :8.1

We are sending copies of this report to the Subcommittee's Ranking
Minority Member, the Chairmen and Ranking Minority Members of the
House Ways and Means Committee and the Senate Committee on Finance,
various other congressional committees, the Director of the Office of
Management and Budget, the Secretary of the Treasury, the IRS
Commissioner, and other interested parties.  We will also make copies
available to others upon request. 

Major contributors to this report are listed in appendix III.  If you
have any questions concerning this report, please contact me at (202)
512-9110. 

Sincerely yours,

Lynda D.  Willis
Director, Tax Policy
 and Administration Issues


IRS' EXAMINATION QUALITY
MEASUREMENT SYSTEM
=========================================================== Appendix I

The Office of Compliance Specialization, within the Internal Revenue
Service's (IRS) Examination Division, has responsibility for Quality
Measurement Staff operations and the Examination Quality Measurement
System (EQMS).  Among other uses, IRS uses EQMS to measure the
quality of closed audits against nine IRS audit standards.  The
standards address the scope, audit techniques, technical conclusions,
workpaper preparation, reports, and time management of an audit. 
Each standard includes additional key elements describing specific
components of a quality audit.  Table I.1 summarizes the standards
and the associated key elements. 



                                       Table I.1
                        
                          Summary of IRS' Examination Quality
                         Measurement System Auditing Standards
                                   (as of Oct. 1996)

No  Standar
.   d        Key elements    Purpose                       Overview
--  -------  --------------  ----------------------------  ----------------------------
1   Conside  A.Balance       Measures whether              This standard encompasses,
    red      sheet and       consideration was given to    but is not limited to, the
    large,   Schedule M      the large, unusual, or        following fundamental
    unusual  considered      questionable items in both    considerations: absolute
    , or     B.Income,       the precontact stage and      dollar value, relative
    questio  deduction, and  during the course of the      dollar value, multiyear
    nable    credit items    examination.                  comparisons, intent to
    items    considered                                    mislead, industry/business
             C.Scope of                                    practices, compliance
             examination                                   impact, and so forth.
             was
             appropriate

2   Probes   A.Consideratio  Measures whether the steps    Gross receipts were probed
    for      n of internal   taken verified that the       during the course of
    unrepor  controls for    proper amount of income was   examination, regardless of
    ted      all business    reported.                     whether the taxpayer
    income   returns                                       maintained a double entry
             B.Consideratio                                set of books. Consideration
             n of books and                                was given to responses to
             records                                       interview questions, the
             C.Consideratio                                financial status analysis,
             n of financial                                tax return information, and
             status                                        the books and records in
             D.Appropriate                                 probing for unreported
             use of                                        income.
             indirect
             methods

3   Require  A.Consideratio  Measures whether              Required filing checks
    d        n of prior and  consideration was given to    consist of the analysis of
    filing   subsequent      filing and examination        return information and, when
    checks   year tax        potential of all returns      warranted, the pick-up of
             returns         required by the taxpayer      related, prior and
             B.Consideratio  including those entities in   subsequent year returns. In
             n of related    taxpayer's sphere of          accordance with Internal
             returns         influence/responsibility.     Revenue Manual 4034,
             C.Compliance                                  examinations should include
             items                                         checks for filing
             considered                                    information returns.

4   Examina  A.Adequate      Measures whether the issues   The depth of the examination
    tion     interviews      examined were completed to    was determined through
    depth    conducted       the extent necessary to       inspection, inquiry,
    and      B.Adequate      provide sufficient            interviews, observation, and
    records  exam            information to determine      analysis of appropriate
    examine  techniques      substantially correct tax.    documents, ledgers,
    d        used                                          journals, oral testimony,
             C.Fraud                                       third-party records, etc.,
             adequately                                    to ensure full development
             considered and                                of relevant facts concerning
             developed                                     the issues of merit.
             D.Issues                                      Interviews provided
             sufficiently                                  information not available
             developed                                     from documents to obtain an
                                                           understanding of the
                                                           taxpayer's financial
                                                           history, business
                                                           operations, and accounting
                                                           records in order to evaluate
                                                           the accuracy of books/
                                                           records. Specialists
                                                           provided expertise to ensure
                                                           proper development of unique
                                                           or complex issues.

5   Finding  A.Correct       Measures whether the          This standard includes
    s        technical/      conclusions reached were      consideration of applicable
    support  factual         based on a correct            law, regulations, court
    ed by    conclusions     application of tax law.       cases, revenue rulings, etc.
    law      reached                                       to support technical/
                                                           factual conclusions.

6   Penalti  A.Recognized,   Measures whether applicable   Consideration of the
    es       considered,     penalties were considered     application of appropriate
    properl  and applied     and applied correctly.        penalties during all
    y        correctly                                     examination is required.
    conside  B.Penalties
    red      computed
             correctly

7   Workpap  A.Fully         Measures the documentation    Workpapers provided the
    ers      disclose audit  of the examination's audit    principal support for the
    support  trail and       trail and techniques used.    examiner's report and
    conclus  techniques                                    documented the procedures
    ions     B.Legible and                                 applied, tests performed,
             organized                                     information obtained, and
             C.Adjustments                                 the conclusions reached in
             in workpapers                                 the examination.
             agree with
             4318, 4700,
             and reports
             D.Activity
             record
             adequately
             documents exam
             activities
             E.Disclosure

8   Report   A.Applicable    Measures the presentation of  Addresses the written
    writing  report writing  the audit findings in terms   presentation of audit
    procedu  procedures      of content, format, and       findings in terms of
    res      followed        accuracy.                     content, format, and
    followe  B.Correct tax                                 accuracy. All necessary
    d        computation                                   information is contained in
                                                           the report, so that there is
                                                           a clear understanding of the
                                                           adjustments made and the
                                                           reasons for those
                                                           adjustments.

9   Time     A.Examination   Measures the utilization of   Time is an essential element
    span/    time            time as it relates to the     of the Auditing Standards
    time     commensurate    complete audit process.       and is a proper
    charged  B.Exam                                        consideration in analyses of
             initiation                                    the examination process. The
             C.Examination                                 process is considered as a
             activities                                    whole and at examination
             D.Case closing                                initiation, examination
                                                           activities, and case closing
                                                           stages.
---------------------------------------------------------------------------------------
Source:  IRS data. 

IRS uses the key element pass rate as one measure of audit quality. 
This measure computes the percentage of audits demonstrating the
characteristics defined by the key element.  According to IRS, the
key element pass rate is the most sensitive measurement and is useful
when describing how an audit is flawed, establishing a baseline for
improvement, and identifying systemic changes.  Table I.2 shows the
pass rates for the key elements of the workpaper standard for fiscal
years 1992 through 1997 for office and field audits. 



                                    Table I.2
                     
                     Key Element Pass Rate for EQMS Workpaper
                     Standard for District Audits From Fiscal
                                  Years 1992-97

                               (Numbers in percent)

                                  Key element pass rate by fiscal year\a
                          ------------------------------------------------------
                                                   1995         1995
Key elements for                              (10/94-3/     (4/95-9/
workpaper standard        1992  1993  1994          95)          95)  1996  1997
------------------------  ----  ----  ----  -----------  -----------  ----  ----
Office audits:
--------------------------------------------------------------------------------
Fully discloses audit       81    85    87           89           87    90    90
 trail and techniques
Legible and organized       86    88    88           88           89    93    93
Workpapers agree with       89    91    91           92           90    93    94
 Form 4318 or Form 4700
 and audit report
Activity record             90    90    92           91           88    88    87
 adequately documented
Disclosure\b               n/a   n/a   n/a          n/a           96    99    99

Field audits:
--------------------------------------------------------------------------------
Fully discloses audit       83    86    87           86           90    87    81
 trail and techniques
Legible and organized       88    89    91           90           91    90    84
Workpapers agree with       93    93    91           92           93    92    92
 Form 4318 or Form 4700
 and audit report
Activity record             80    81    81           83           80    80    72
 adequately documented
Disclosure\b               n/a   n/a   n/a          n/a           97    96    94
--------------------------------------------------------------------------------
Legend:  n/a = not applicable

\a The pass rate measurement computes the percentage of audits
demonstrating the characteristics defined by the key element. 

\b The key element "Disclosure" was added in the middle of fiscal
year 1995. 

Source:  IRS data. 




(See figure in printed edition.)Appendix II
COMMENTS FROM THE INTERNAL REVENUE
SERVICE
=========================================================== Appendix I



(See figure in printed edition.)



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix III

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Thomas D.  Short, Assistant Director, Tax Policy and Administration
Issues
Tim Outlaw, Senior Evaluator

SAN FRANCISCO FIELD OFFICE

Kathleen E.  Seymour, Evaluator-in-Charge
Louis G.  Roberts, Senior Evaluator
Samuel H.  Scrutchins, Senior Data Analyst


*** End of document. ***