taxes

Audit Procedures for Cigarette Tax

Chapter 4 – Audit Procedures for Texas Distributors

Internal Controls

As in any audit, test internal controls before proceeding with fieldwork. Randomly select six months to use as test months. Evaluate the taxpayer' process of recording purchases and reconcile the amounts to the summary records and to the reports. Analyze the effect of any discrepancies. If adjustments are necessary, decide whether to proceed in detail or to consider a sample and projection.

Reconciliation of Unstamped Cigarettes Inventory

The use of the correct beginning and ending inventories is important when determining total cigarettes to account for and total cigarettes stamped. In examining the history, verify whether the reported beginning inventory is equal to the preceding month' ending inventory. Reported inventory should only include inventory located in Texas. Furthermore, inventories should only include unstamped cigarettes since the report does not provide for stamped inventories. If a taxpayer is no longer stamping cigarettes during the audit period, it is important to verify that all ending inventory has been accounted for.

If the beginning audit period does not correspond with the prior audit' ending inventory, use the reported beginning inventory numbers. If there was no prior audit or ending inventory number and the reported beginning period inventory number does not match the reported prior months ending inventory, use auditor judgment to determine the most accurate beginning inventory available. Accurate inventories are essential to reliable audit results.

Verifying the Inventory

It is recommended that the audit fieldwork start date be set to correspond with a month end. This allows the ending audit period to correspond to the monthly reports and avoids scheduling of receipts and disbursements for a partial month.

The auditor should take or closely observe a physical inventory of unstamped cigarettes. The cigarettes are customarily received in cases of 12,000 (12M) or 6,000 (6M). Verify that the cases are packaged in the 12M or 6M quantities. Pay particular attention to counting cartons of partial cases. Retention of a work sheet of the inventory in the audit file is recommended. The auditor and taxpayer/representative must sign an Inventory Verification form at the conclusion of the physical inventory. This form will supply the governing inventory numbers for the audit. An example of an Inventory Verification form may be found in the Appendix of this manual.

Purchases

One of the most important elements of auditing distributors is verifying that all cigarettes acquired have been reported and can be accounted for. Distributor' and manufacturer' reports are used to facilitate a reconciliation of reported cigarettes and reported stamps.

Distributor' and Manufacturer' Reports

Each distributor submits a "Texas Distributor Monthly Report of Cigarettes and Stamps" (Form 69-100) which reflects all purchases and receipts of cigarettes and stamps. They also file a monthly supplemental report entitled "Texas Distributor Receiving Record of Cigarettes" (Form 69-108). This receiving report lists the manufacturer, received date, invoice number and number of cigarettes for each purchase. This report can be used as a starting point for verifying cigarette purchases.

Manufacturers report the number of cigarettes they ship to Texas distributors on a monthly basis. There is no set form for these reports. The reported numbers can be obtained using CICS and the inquiry XIRPTS. The report is listed by manufacturer and invoice number as well as the number of cigarettes shipped to a particular distributor. The reports available through XIRPTS only list the major manufacturers. Other manufacturer' reports may be viewed using the Mid-Client imaging system using the applicable DLN number. The DLN number can be obtained using CICS and the inquiry MTIGDI.

Reconciliation of Reported Cigarettes

As mentioned in Chapter 2, Pre-Audit Research, the auditor should prepare a Manufacturer' Comparative Reconciliation prior to starting fieldwork. By using the list of exceptions prepared during the pre-audit reconciliation, only a review of invoices of shipments with problems will be necessary during fieldwork.

Complete as much of the reconciliation of the reported amounts to the comparative statements as possible. Then trace the differences to purchase invoices and related bills of lading. Sometimes differences occur because an order is short due to damaged cases that were returned to the manufacturer. The distributor may maintain other internal receiving records that are beneficial in tracing the actual total received. If receiving reports appears to be incomplete, use purchase journals and general ledgers to supplement the available information. Samples may be difficult due to problems in obtaining representative sample and population bases.

Prepare a schedule of any discrepancies by invoice and bill of lading. Obtain copies of invoices and bills of lading to support shortages, damaged cigarettes, or clerical reporting errors, if possible.

Deductions

Another important element of auditing distributors is verifying reported cigarette deductions. Each distributor is required to keep records of all cigarette sales and exemption forms for a period of four years.

Allowed deductions for distributors include sales to Native American Reservations and Federal Organizations. Deductions are also allowed for interstate sales, cigarettes returned to manufacturers, and cigarettes lost in shipment.

Sales to Native American Reservations and Federal Organizations

Each sale of unstamped cigarettes by a distributor to a Native American Reservation or a Federal Organization must be supported by a separate sales invoice and a properly completed Texas Certificate of Tax Exempt Sale (Form 69-302) — prior to 09/01/09, or Texas Certificate of Tax Exempt Sale (Form 69-315) effective 09/01/09. Verify these documents during fieldwork.

Sales into Interstate Commerce

Each sale of cigarettes in interstate commerce by a distributor must be accompanied by a Texas Distributor Interstate Sales Report (Form 69-110). The number of cigarettes reported should include only those cigarettes sold or distributed in interstate commerce.

Cigarettes Returned to the Manufacturer

These cigarettes are unstamped cigarettes which were damaged in shipping from the manufacture to the distributor. To take the deduction, the distributor must first refuse the damaged product and send it back to the manufacturer. Then the distributor must report the number of cigarettes listed on the invoice on the return. After receiving a credit memo from the manufacturer, the distributor may take the deduction. In most cases, the distributor will refuse the product, send it back to the manufacturer, and report the number of cigarettes which they actually accepted (report the invoice short).

Cigarettes Lost in Shipment

This category includes cigarettes that are listed on shipping documents but were not with the shipment when received at the distributor' location. To take the deduction, the distributor must first report the cigarettes on their return. After receiving a credit memo from the manufacturer, they may take the deduction. In most cases, the distributor will make a note on the shipping document to file a claim with the manufacturer and report the number of cigarettes which they actually received (report the invoice short).

Reconciliation of Reported Stamps

As mentioned in Chapter 2, Pre-Audit Research, the auditor should prepare a "stamp reconciliation" prior to starting fieldwork. By using the list of exceptions prepared during the pre-audit reconciliation, the auditor can quickly reconcile any differences with the taxpayer records. Run a stamp credit report to see if any stamps were returned by the distributor because of damaged stamps or called backs.

Inventory of Stamps

Stamps are packaged in rolls of 30,000 and 7,200, as well as in sheets of 100 and 150. The rolls of 30,000 are affixed to packages of cigarettes containing 20 sticks. They contain 2000 rows of stamps with 15 stamps per row. The rolls are marked with numbers on every 300th stamp. The top number indicates the number of stamps used on that roll while the bottom number indicates the number of stamps remaining on the roll. The rolls of 7,200 stamps are affixed to packages of cigarettes containing 25 sticks. This series is segregated into groups of 240.

Complete an actual inventory of all unused stamps by state. The unused Texas stamps will be used as the ending inventory of stamps on hand. Pay attention to the most current stamps delivered by the Comptroller' office to verify the receipts by the distributor. The purpose of the inventory of all state stamps is to ensure that the distributor has enough stamps on hand to cover the unstamped packs of cigarettes. To facilitate the inventory process, a partial roll can be counted by determining the descending number on the edge of the roll that reflects the number of stamps remaining on the roll. Record the serial numbers of each partial roll in the audit plan. The distributor should remove partially used rolls from the stamping machine(s) for counting. Only full stamps are allowed for inventory. Stamps are considered full if two-thirds of the original stamp is intact and all the digits are fully legible.

If a taxpayer has an outlet that is closing or an entity change involving a closeout audit , the unused stamps should be returned to the Comptrollers Office, Account Maintenance (cigarette & tobacco section) via any means of traceable transportation.

Stamps Lost, Stolen, or Mutilated

Only stamps that have been lost or stolen are reported on the return. The comptroller does not authorize credit for stamps lost due to theft, negligence, or any unaccountable loss. No credit is allowed for stamps affixed over stamps already on the package of cigarettes (double stamping).

Obtaining Credit for Stamps

In order to receive credit for stamps, the distributor must provide the following information:

  • Stamps that have been destroyed by vandalism, fire, flood, or other natural disasters: The distributor must present evidence to the Comptroller that the stamps were purchase by the distributor and were subsequently destroyed by a natural disaster.
  • Stamps affixed to cigarette carton flaps rather than the cigarette packs: The distributor must submit the stamped carton flaps to the Comptroller in order to obtain credit.
  • Stamps that have been torn or damaged by stamping machines: The distributor must submit the damaged stamps to the Comptroller in order to obtain credit.
  • Stamps affixed to packages of cigarettes that become damaged or are unfit for sale and return to the manufacturer: The manufacture must send the distributor an affidavit which states the cigarettes and stamps have been destroyed. The distributor must file this affidavit with the Comptroller to receive credit on their stamp purchases.

Sampling Procedures

When possible, sampling should be considered in cigarette audits using the procedures covered in the Sampling Manual found on the Audit Division/Manuals website.

The following is a list of items or phases of a cigarette tax audit where projections might be used:

  • Cigarette purchases
  • Tax free sales to Native American Reservations
  • Tax free sales to federal organizations
  • Cigarettes stamped for interstate sales
  • Cigarettes returned to manufacturers
  • Cigarettes lost in shipment

The following is a list of items or phases of a cigarette tax audit where projections are not recommended:

  • Stamps purchased
  • Ending inventory of cigarettes
  • Stamps on hand

Note: The preceding lists are not all inclusive since circumstances may vary greatly.

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(Revised 09/2010)