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Chapter 6 - Accounting Records

Accounting Records in General

Reforestation contractors' accounting records can come in any number of forms (that is, boxes with no audit trail to double-entry systems). Therefore, the examiner should be prepared to deal with a variety of different accounting systems. It is not uncommon to find poor bookkeeping and recordkeeping practices among prime contractors as well as subcontractors. You can expect to find situations where ledgers don't balance, journal columns don't foot, invoices can't be found, and personal amounts are deducted as business expenses.

The majority of reforestation contractors operate as sole proprietors and keep their books and records on a calendar year basis. Lack of internal control seems to be a common element among the reforestation contractors. The contractors frequently are family- controlled businesses with one family member performing the duties of keeping the books and records as well as recording income. The lack of internal controls and adjustments (such as unreported income and unsubstantiated expenses) are discussed in more detail Chapters 7 and 8 of this Guide.

We have found that reforestation contractors use either the cash or accrual method of accounting. This guide is not meant to explain the various methods of accounting used in the reforestation industry, but rather to assist the examiner in determining what to look for under the various methods described.

Cash Method of Accounting

The cash method of accounting is used by most reforestation contractors. When examining a contractor on the cash basis, secure a listing of the contracts worked during the year. The list should include the contract number, the locations where the work was done, and the amounts and dates of the payments received during the year. In addition, request a list of contracts in process at the end of the year. Compare this list to the bank deposits to determine if all money received was deposited upon receipt -- this step will disclose if the contractor has postponed depositing receipts until after the end of the year or if the contractor's deposit reflects that he or she has taken cash and deposited the remainder.

Generally, cash-basis contractors use their bank deposits to determine total income. However, examination results revealed that it is common for contractors to cash income checks without depositing the income. In other instances, we found that the contractors deposited large amounts of cash for which they had no records. The high potential for large amounts of unreported income allows the examiner an opportunity to develop quality fraud referrals.
Question the contractor at the initial interview and determine which method was used to determine gross receipts reported on the tax return. It is important to secure as much information as possible early in the examination since the contractor may not be willing to supply information as the audit progresses. The methods used to determine unreported income appear in Chapter 7 of this Guide.

Also be aware that reforestation contractors, as a normal practice, are able to assign income to their bank. The bank will advance funds (usually 80 percent of the contract award letter) to the contractor. The bank then becomes the consignee and the Forest Service or BLM makes the checks payable to the bank. The bank normally receives the checks, pays off the outstanding loans, and deposits the remainder to the contractor's business account.
Examinations of cash-basis contractors also reflected frequent adjustments for their deducting items on their returns for which they have no documentation. Within the reforestation industry it is common practice for the contractors to use cash to pay business expenses. The contractors are often unable to supply proper documentation for the cash payments. According to the Bureau of Labor and Industries, the contractors use cash to pay their workers. We have found at least two reasons to explain why the contractors use cash to pay wages:

1. Illegal aliens perform much of the labor in this industry and they want to be paid with cash since they do not have Social Security Numbers to obtain bank accounts, and

2. Contractors want to avoid paying worker's compensation premiums and employment taxes on wages paid.

Accrual Method of Accounting

Occasionally you will encounter contractors who are using the accrual method of accounting. If you find contractors who are using the accrual method of accounting, you will need to find out why they are using this method and when they adopted this method. You will want to know if they were required to apply to the Commissioner of the Internal Revenue to change to this method of accounting. Cash- basis contractors are not allowed to switch to the accrual method without applying for a change of accounting method.

There appear to be few tax advantages or other reasons for reforestation contractors to use the accrual method of accounting, with the exception of a corporation who has a valid business reason for a yearend other than December 31. The reforestation industry is seasonal, which means that the contractors do not have employees working during every month of the year. There are some months of the year when weather conditions do not allow the contractors to have crews in the woods. The weather conditions during the month of December usually prevent contractors from working. Therefore, the contractor's accrued expenses should be minimal in December since wage expenses and the related employment taxes are the contractor's single largest expense (that is, between 50 and 60 percent of gross income). Exhibit 6-1 contains a newspaper article that can be used as a standard for wage expense in the reforestation industry. We have also found that the Small Business Administration requires their contractors to file quarterly financial statements; these financial statements are to be prepared using the accrual method of accounting. Therefore, you may find these Section 8A contractors using the accrual method of accounting for tax purposes. Make sure the contractors have a valid election since it is likely that the election was not made.
Inspect accounts payable at the end of the year to determine if the taxpayer has properly accrued expenses and that the expenses are deductible per IRC section 162.

Exhibit 6-1 Newspaper Article Used for Standard and Wage Expense [Exhibit omitted]