REVENUE AUDIT MEMORANDUM ORDER NO.

1-00 - Part 1

March 17, 2000

REVENUE AUDIT MEMORANDUM ORDER NO. 1-00

SUBJECT : Updated Handbook on Audit Procedures and Techniques Volume I (Revision —Year 2000)

TO : All Internal Revenue Officers and Others Concerned

I. OBJECTIVE

This Order prescribes the use of the Updated Handbook on Audit Procedures and Techniques (Volume I) in the audit of tax
returns. The Handbook is intended to provide revenue officers with minimum standard procedures and a uniform guideline for
the proper examination and/or investigation of tax liabilities. This updated version was prepared in order to conform with the
provisions of the Tax Reform Act of 1997".

II. QUALITY AUDIT

The purpose of auditing a tax return is to determine the taxpayer's substantially correct tax liability. A quality audit is the
examination of the taxpayer's books and records in sufficient depth for the purpose of ascertaining the correctness and validity of
entries and the propriety of application of tax laws. To ensure quality audit of tax returns, revenue officers are enjoined to utilize
their technical skill, training and experience, and follow the minimum audit procedures prescribed in the Handbook under Annex
"A" hereof.

III. REPORTING REQUIREMENTS

Revenue Officers are required to make a report after the audit has been conducted. All reports should contain the minimum
documentary requirements specified under Chapter XVII of the Handbook.

IV. REPEALING CLAUSE

This Order supersedes Revenue Audit Memorandum Order No. 2-95, all revenue issuances and portions thereof inconsistent
herewith.

V. EFFECTIVITY

All revenue officers and other employees concerned are hereby directed to refer to the aforesaid Handbook in the audit/
investigation of tax returns immediately after the approval of this Order. CTSHDI

(SGD.) DAKILA B. FONACIER

Commissioner of Internal Revenue

HANDBOOK ON AUDIT PROCEDURES AND TECHNIQUES

VOLUME I

(Revision - Year 2000)

PREFACE

The enactment of the National Internal Revenue Code of 1997 and its implementation effective January 1, 1998 marked
significant changes in Philippine taxation and the BIR's tax administration policies. Hence, it is necessary to revise and update the
existing revenue issuances and assessment manuals in accordance with the new provisions of the Tax Code.

In order to utilize audit as an effective tool in the enhancement of voluntary compliance, the first volume of the Handbook on
Audit Procedures and Techniques has been revised and updated to conform with the new Tax Code. This volume discusses
general procedures and techniques designed to assist the Revenue Officer in the investigation of tax liabilities of taxpayers. The
audit procedures and techniques for the investigation of Value-Added Tax liabilities are prescribed in a separate manual.

ACKNOWLEDGMENT
The updating of this Handbook on Audit Procedures and Techniques — Volume I was completed under the leadership of
Commissioner Dakila B. Fonacier and Deputy Commissioners Romeo S. Panganiban, Estelita C. Aguirre, Sixto S. Esquivias IV
and Lilia C. Guillermo.

This Handbook is a project of the Assessment Service with the Assessment Programs Division as the lead division which
spearheaded the project. Acknowledgment is also extended to Atty. Arnulfo B. Romero, Mr. Rodolfo Mendoza and Mr. Manny B.
Jimenez for their comments and invaluable contribution to the project.

ASSESSMENT SERVICE

Nars P. Tamayo Acting Assistant Commissioner

Elvira R. Vera Acting Head Revenue Executive Assistant

ASSESSMENT PROGRAMS DIVISION

Leticia C. Batausa Officer-In-Charge

Ione S. Alejo Section Chief

Elenita V. Balonzo Section Chief

Cristina T. Billones Section Chief

Urania C. Salvacion Section Chief

Gladys M. Aquino Revenue Officer III

Dessie V. Garcia Revenue Officer II

Elmira C. Viray Revenue Officer I

Gean M. Dienzo Computer Operator I

Cristina V. Pangan Computer Operator I

Table of Contents

I. Introduction

Revenue Tax Administration

Purpose

Contents of the Handbook

II. Accounting Methods

Cash Basis

Accrual Basis

Completion of Contract Basis

Percentage of Completion Basis

Installment Basis

Crop Year Basis

III. Bookkeeping Systems

Single Entry System

Double Entry System

IV. Accounting Records

Journal

Ledger

Subsidiary Book

Computerized Accounting System

V. Accounting Period

Calendar Year

Fiscal Year

VI. Financial Statements

Income Statement

Balance Sheet

VII. Purpose and Standards of Audit

General Standards

Standards of Preliminary Planning

Standards of Field Work

Standards of Public Relations

VIII. Preliminary Approach to Examination

Pre-audit Analysis of Tax Returns

Work Planning

Contact with Taxpayer

Preliminary Evaluation of Miscellaneous Records

Initial Examination Techniques

Evaluation of Internal Control

Sampling Techniques

IX. Balance Sheet Approach to Examination

Cash on Hand and in Bank

Notes and Accounts Receivable

Allowance for Bad Debts

Inventories

Advances to Stockholders/Officers

Investments
Depreciable Assets

Allowances for Depreciation, Amortization and Other Valuations

Reserves

Intangible Assets

Prepaid Expenses and Deferred Charges

Other Assets

Exchange, Clearing or Suspense Accounts

Current and Accrued Liabilities including Notes Payable

Fixed Liabilities

Deferred Credits

Loans From Shareholders/Officers/Owners

Capital Accounts

Capital or Owner's Equity

Partners' Capital

Stockholders' Equity

Capital Stock

Retained Earnings

X. Audit of Income and Expenses

Audit of Income Accounts

Sales

Rent Income

Professional Fees

Income From Sale of Asset

Other Income

Audit of Expense Accounts

Purchases

Cost of Goods Sold

Salaries, Wages and Other Employees' Benefits

Fringe Benefits

Rents

Royalties

Interest
Taxes

Repairs

Bad Debts

Losses

Abandonment and Demolition

Casualty/Theft

Net Operating Loss Carry Over

Depreciation

Depletion

Contribution

Transportation and Travel, Representation and Entertainment

Stationery and Office Supplies

Professional Fees

Insurance Fees

Light and Power, Telephone and Telegraph

Miscellaneous Expenses

XI. Audit of Minimum Corporate Income Tax and Improper Accumulation of Earnings Tax

XII. Auditing Computer-Produced Records

Impact of Computer Records on Audit

Accounting Software Systems

Audit Techniques for Computer-Produced Records

XIII. Indirect Approach

Percentage Method

Net Worth Method

Bank Deposit Method

Cash Expenditure Method

Unit and Value Method

Third Party Information (Access to Records) Method

XIV. Audit Procedures on Other Kinds of Taxes

Withholding Taxes

Capital Gains Tax

Estate Tax
Donor's Tax

XV. General Policies in the Investigation of Tax Fraud Cases

Jurisdiction

Procedures

Civil Fraud

XVI. Closing Conference

XVII. Report Making

Document Locator Form

Table of Contents

Narrative Report

Duly Accomplished Revenue Officer's Audit Report

Working Papers

Attachments to the Docket of the Case

Appendix

Revenue Memorandum Order No. 15-95

General Policies in the Investigation of Tax Fraud Cases

Revenue Memorandum Order No. 53-98

Checklist of Documents to be Submitted by a Taxpayer upon Audit of his Tax Liabilities as well as of the Mandatory Reporting
Requirements to be Prepared by a Revenue Officer, all of which comprise a complete Tax Docket

I. INTRODUCTION

A Revenue Tax Administration

The function of the Bureau of Internal Revenue is to administer the provisions of the National Internal Revenue Code. It is the
duty of the Bureau to implement the Tax Code and related laws enacted by Congress in a fair and impartial manner.

The mission of the Bureau is to enforce internal revenue laws with impartiality, consistency, collect the correct amount of taxes at
the least cost to the government and least inconvenience to the taxpayer and serve the public honestly and efficiently in a manner
that will elicit the highest level of confidence in the Bureau of Internal Revenue.

Investigation supports the mission of the Bureau by enhancing a high degree of compliance and encouraging the correct reporting
of income, transfer, business and other taxes. This is accomplished by:

1. Measuring the degree of voluntary compliance as reflected on filed returns;

2. Reducing non-compliance by identifying returns and taxpayers that need to be investigated; and

3. Conducting quality audit of selected tax returns on a timely basis.

The purpose of auditing a tax return is to determine the taxpayer's correct tax liability. A quality audit is the examination of a
taxpayer's books and records in sufficient depth so as to ascertain the correctness and validity of entries thereon and- the propriety
of application of tax laws.

B. Purpose
The updated Handbook on Audit Procedures and Techniques has been prepared to equip all Revenue Officers who conduct field
examinations with-the necessary knowledge for the proper examination of tax returns and provide them with confidence in
carrying out the investigation. This Handbook is designed to ensure that the Revenue Officer acquires useful auditing skills,
progresses from simple audit techniques to more sophisticated procedures, and advances in examination procedures from a single
proprietorship to a large corporation and from a simple bookkeeping system to a highly computerized one.

The Revenue Officer's job is to familiarize himself with the business activity and/or undertaking of the taxpayers assigned to him
for audit, to evaluate the various methods and procedures the taxpayers apply, to be imaginative, observant and inquisitive in his
examination, and above all, to use common sense.

C. Contents of the Handbook

The handbook contains guides, instructions and suggestions in the conduct of audit for various taxpayers. The discussions begin
with the analysis of tax returns and financial statements, familiarization with accounting methods, bookkeeping systems, books of
accounts and other related records. The audit procedures for balance sheet and income statement accounts are laid out together
with investigation techniques for each type of tax. This does not preclude, however, the Revenue Officer from carrying out other
audit techniques which are deemed necessary in the circumstances surrounding a particular case.

The Handbook is neither intended to provide a source of tax law or procedural doctrine nor a substitute reference material of
revenue issuances. Each Revenue Officer is presumed to have a working knowledge of the Tax Code, the latest amendments
thereon, and an update of existing revenue regulations, revenue rulings, revenue memorandum orders and other issuances.

The other contents of the handbook include documentary requirements in the investigation process and proper report making.

II. Accounting Methods

The taxable income of a taxpayer shall be computed in accordance with the method of accounting he regularly employs in
keeping his books. However, if the taxpayer does not regularly employ a method of accounting which reasonably shows his
correct income, the computation of income shall be made in such manner as in the opinion of the Commissioner of Internal
Revenue or his -duly authorized representative that clearly reflects such income.

The methods of accounting recognized under the Tax Code are:

A. Cash Basis is a method of accounting whereby all items of gross income received during the year shall be accounted for
such taxable year and that only expenses actually paid for shall be claimed as deductions during the year. This method of
accounting is generally used by taxpayers who do not keep regular books of accounts. Under this method, income is realized
upon receipt of cash or its equivalent including those constructively received (such as deposits for the taxpayer's account by
customers) but not including gifts or donations. Users of cash basis accounting are mostly individuals engaged in business and
practice of profession, professional partnerships and professional service organizations.

B. Accrual Basis is a method of accounting for income in the period it is earned regardless of whether it has been received
or not. In the same manner, expenses are accounted for in the period they are incurred and not in the period they are paid. Under
this method, net income is being measured by the excess of income earned during the period over the expenses incurred.
Expenses not being claimed as deductions by taxpayers in the current year when they are incurred cannot be claimed as deduction
from income for the succeeding year. Thus, a taxpayer who is authorized to deduct certain expenses and other allowable
deductions for the current year but failed to do so cannot deduct the same for the next year. The accrual basis of accounting is
being used by taxpayers whose nature of business uses inventories since this method of accounting will correctly reflect income
by matching purchases and expenses against sales. This method is being applied by most medium and large corporations.

C. Completion of Contract Basis is an accounting method applicable to contractors in the construction of building,
installation of equipment and other fixed assets, or other construction work covering a period in excess of one year.

Under this method, gross income is to be reported in the taxable year in which the contract is fully completed and accepted by the
contractee if the taxpayer elected it as a consistent practice to treat such income, provided that such method clearly reflects the
net income. Under this method, all expenditures, are deducted from gross income during the life of the contract which are
properly allocated thereto, taking into consideration any materials and supplies charged to the work under the contract but
remaining on hand at the time of the completion.

However, pursuant to Republic Act No. 8424 which took effect on January 1, 1998, contractors are no longer allowed to adopt
this method of reporting their income derived in whole or in part from long-term contracts.

D. Percentage of Completion Basis is a method applicable in the case of a building, installation or construction contract
covering a period in excess of one year whereby gross income derived from such contract may be reported upon the basis of
percentage of completion. In determining the percentage of completion of a contract, generally one of the following methods is
used:

1. The costs incurred under the contract as of the end of the tax year are compared with the estimated total contract costs;
or

2. The work performed on the contract as of the end of the tax year is compared with the estimated work to be performed.

In such case, the return should be accompanied by a certificate of the architect or engineer showing the percentage of completion
during the taxable year of the entire work performed under contract. There should be deducted from such gross income all
expenditures made during the taxable year on account of the contract, account being taken of the materials and supplies on hand
at the beginning and end of the taxable period for use in connection with the work under the contract but not yet so applied.

Beginning January 1, 1998 income from log-term contracts are required to be reported using this method only.

E. Installment Basis is a method considered appropriate when collections extend over relatively long periods of time and
there is a strong possibility that full collection will not be made. As customers make installment payments, the seller recognizes
the gross profit on sale in proportion to the cash collected.

F. Crop Year Basis is a method applicable only to farmers engaged in the production of crops which take more than a year
from the time of planting to the process of gathering and disposal. Expenses paid or incurred are deductible in the year the gross
income from the sale of the crops are realized.

In relation to the foregoing accounting methods, the Tax Code provides for a tax credit system in computing the tax payable by
certain taxpayers. While the tax credit system is not an accounting system, it is discussed here for the proper understanding of the
computation of taxes due from taxpayers.

The tax credit system is a method used to account for the creditable taxes deducted by the withholding agents from the income
payments to certain payees (as in the case of withholding tax at source pursuant to Revenue Regulations (RR) No. 6-85, as
amended by RR 2-98, or the creditable tax added to the sales price (as in the case of value-added tax). The creditable taxes should
be clearly identified in the books of the taxpayer, such as:

1. Creditable income tax (asset)

2. VAT input tax (asset)

3. Withholding tax payable-Compensation (liability)

4. Withholding tax payable-Expanded Withholding Tax (EWT) (liability)

5. VAT output tax (liability)

III. Bookkeeping Systems

Bookkeeping may be classified into two systems, namely, (1) the single entry and (2) the double entry.

A. Single Entry System of bookkeeping is basically a type of "net worth" method of arriving at net income. It records only
the debit or credit of each transaction, or an account with the debtor or creditor and a simple record of cash receipts and
disbursements.

Whenever a system of record keeping does not include equal debit and credit to asset, liability, proprietorship, income and
expense accounts, it is referred to AA a "single entry system". The single entry is often used by comparatively simple ventures
such as small retail or commission merchants, professional firms, estates and trusts. In many cases, the only record of income and
deductions consists of entries on the stubs of their checkbooks. Some taxpayers maintain an income tax folder in which they
place documents to support their income tax deductions.

A single entry system may be merely a chronological record of transactions posted in a notebook or journal.

Sometimes, the records consist of a complete set of journals (cash, sales, purchases and general journal) and general ledger
providing important accounts.

The accounting cycle starts with source documents (invoices, bills, paid checks, loan documents, bank deposit slips, and bank
statements) proceeding to the cash receipts and cash disbursements journal, working paper summary and ending with the tax
return.
Reconciliation of the taxpayer's books, working paper summary and records to the return is a very important audit step. In this
way, the Revenue Officer will become familiar with the taxpayer's accounting system, policies and control procedures. If the
records available are organized, this will lend more credibility to the tax return, but if they are inadequate, then the Revenue
Officer should closely scrutinize the information on the income tax return. Therefore, when encountered with the lack of formal
books and records, the Revenue Officer must use source documents and other available documents to establish the taxpayer's
financial position which shall be compared with the taxpayer's standard of living and business activity for validation.

The following formulae for reconstruction of income and expenses may be found useful:

1. Computation of Sales

Cash Sales (cash book) xx

Add: Sales on account:

Collections from customers (cash book) xx

Less: Accounts receivable (beginning balance) xx

Collections from sales for the period xx

Add: Accounts receivable (ending balance) xx xx

— —

TOTAL SALES xx

==

2. Computation of Purchases

Cash purchases (cash book) xx

Add: Purchases on account:

Payments to creditors (cash book) xx

Less: Accounts payable (beginning balance) xx

Payments for purchases for the period xx

Add: Accounts payable (ending balance) xx xx

— —

TOTAL PURCHASES xx

==

3. Computation of Expenses

Cash payments for allowable expenses (cash book) xx

Add: Prepaid expenses (beginning balance) xx

Accrued expenses (ending balance) xx xx

— —

Total xx

Less: Prepaid expenses (ending balance) xx

Accrued expenses (beginning balance) xx xx

 — —

TOTAL EXPENSES xx

==

B. Double Entry System — Under this system of bookkeeping, accounting recognizes the two-fold effect of every
recorded event, the debit and the credit or the object of the event and the equitable interest in that object. Every recorded event
affecting one side must necessarily affect the other side. This can be presented in an equation:

Assets = Liabilities + Capital

This can be analyzed into its component elements which show that there are two distinct parties that have right in the assets of the
business, the creditors and the owners. The rights of the creditors are the claims of such creditors on the assets of the business
which are referred to as liabilities and the rights of the owners on the business are referred to as capital.

In the double entry method, any net increase and net decrease in asset has a corresponding increase and decrease in either
liabilities or capital.

Audit of accounting records under this system shall be detailed as presented in the discussions of audit of real and nominal
accounts.