Clarifying Revenue and Cash Inflows Discrepancy in Tax Audits
In a tax audit, discrepancies between cash inflows recorded in a company’s bank accounts and revenue reported in the Corporate Income Tax (CIT) Return often become the primary cause for a correction. Frequently, every cash receipt is immediately assumed to be unreported sales. In fact, cash inflows are not always identical to revenue, and such simplification may lead to incorrect conclusions.
One method commonly applied by tax auditors is accounts receivable flow testing. This method is aimed at determining accrued sales by analyzing movements in trade receivables, customer advances, deferred revenue, and receivables settlement received by a company, whether in cash or other non-cash mechanisms.
Conceptually, this approach is logical. Credit sales increase receivables, while the settlement of receivables generates cash inflows. Based on changes in receivables, tax auditors attempt to assess the fairness of the revenue reported by the taxpayer.
Issues arise when accounts receivable flow testing is conducted in a limited scope, for example by merely matching bank account movements against reported revenue, without a deeper examination of the transaction context and the underlying accounting treatment. In business practice, the relationship between sales, receivables, and cash flows is often far more complex than just a numerical comparison.
Sources of Discrepancy Between Revenue and Cash Inflows
In business activities, discrepancies between cash inflows recorded in bank accounts and revenue recognized are relatively common. The discrepancies may arise from various legitimate transaction mechanisms and accounting treatments, ranging from taxes, banking charges, settlement methods, to foreign exchange effects. Understanding the sources is crucial to ensure that cash inflows are not automatically treated as revenue, particularly in the context of tax audits. Common sources of the discrepancies in business practices include the following.
a. Value Added Tax (VAT)
For transactions subject to VAT, customers pay the selling price plus an 11% VAT. From a cash perspective, the company receives the gross amount. However, in the context of CIT, only the tax base is considered a revenue. VAT is not a revenue, as it is simply an amount held temporarily to be paid to the government. Without separating the VAT component, cash inflows will consistently appear higher than the revenue recorded in the financial statements and the CIT Return.
b. Bank Charges, Penalties, and Transaction Fees
Further discrepancies may also arise because the cash credited to the company’s bank account has been reduced by charges imposed by banks or third parties, such as administrative fees, clearing charges, late payment penalties, or transfer fees. From an accounting perspective, the charges are recorded as separate expenses and do not reduce the amount of trade receivables settled.
In other words, the customer has effectively settled the receivable at the gross amount, but the company only receives the net cash after deductions. If tax auditors rely solely on bank statements, cash receipts may appear lower than the actual sales value. However, substantively, the receivable has been fully settled.
c. Non-Cash Settlement of Receivables
Not all receivables are settled through cash or bank transfers. In business practice, settlement often occurs through offsetting receivables and payables with the same counterparty. In other cases, receivables may be reclassified to other accounts, for example, due to changes in transaction characteristics, dispute resolution, or bookkeeping adjustments.
Accordingly, trade receivables decrease without any corresponding cash inflow in the bank account. If the non-cash settlements are not identified from the beginning, comparisons between receivable movements and cash inflows will appear inconsistent. This may give rise to assumptions of unreported revenue, even though the discrepancy is caused by settlement methods rather than concealed sales.
d. Use of Bank Overdraft Facilities
Other than non-cash settlements, a similar condition may also arise from how a company manages its bank accounts. Certain companies maintain accounts linked to overdraft facilities or short-term loans, which can result in a negative balance.
In such circumstances, payments from customers do not increase cash balances but are instead applied directly to reduce bank liabilities. Economically, the company still receives settlement of receivables, but no additional balance is reflected in the bank account. If tax auditors focus only on debit movements or ending balances in bank statements, receivable settlements through overdraft facilities may appear as if no cash inflow occurs, despite the fact that the settlement has indeed taken place.
e. Foreign Exchange Discrepancy on Receivables Settlement in Foreign Currency
In transactions denominated in foreign currencies, an exchange rate discrepancy is also an important factor. For receivables in foreign exchange, the cash received during settlement is highly affected by changes in the exchange rate. Receivables are recorded using the exchange rate at the transaction date, while settlement follows the exchange rate prevailing when the payment is received.
The resulting exchange discrepancy is recorded separately as foreign exchange gains or losses. Consequently, the cash received may be higher or lower than the recorded receivables. As a result, numerical discrepancies arise in accounts receivable flow testing, even though the previously recognized sales remain unchanged.
f. Other Incomes Recorded Through Trade Receivables
Other than the exchange rate factor, in certain circumstances, a company may record trade receivables not only from core sales transactions but also from other income items, such as interest receivables, claim receivables, or compensation receivables.
When the receivables are settled, cash inflows in the bank account do not entirely reflect sales revenue but also include the settlement of other incomes. If the components are not separated, cash inflows may appear higher and be fully treated as revenue, even though part of the amount relates to other incomes account.
g. Recognition of Sales Through Other Receivables Accounts
Conversely, there are conditions where certain sales are not recorded as trade receivables but rather as other receivables. This may result from specific transaction characteristics, account misclassification, or internal corporate accounting policies.
As a result, when accounts receivable flow testing focuses only on trade receivable movements, certain settlements related to sales may not be identified within that account. This creates the impression of discrepancy between the revenue and the receivable settlements, even though the receivables have been substantially recorded and/or settled through other receivables accounts.
h. Tax Credit Reducing the Settlement Amount
The situation becomes even more complex when customers withhold tax prior to payment, such as withholding ITA 22, 23, or Final ITA 4(2). From the company’s perspective, sales amount remains the same as the gross amount before the tax withholding. However, the cash received is lower because a portion has been withheld and paid to the state by the customer. Accordingly, in an accounts receivable flow testing, tax credits must be added back so that the settlement value does not appear lower than the actual sales amount.
The conditions demonstrate that discrepancies identified through accounts receivable flow testing do not automatically indicate unreported revenue. Discrepancies may arise from timing differences, accounting treatments, or transaction characteristics that are legally and commercially valid.
Accounts Receivable Flow Testing: A Correction Tool or A Reconciliation Tool?
In the context of tax audits, an accounts receivable flow testing can be used to identify potential non-compliance. However, the method should not be positioned solely as a correction tool. Taxpayers have a legitimate evidentiary basis to demonstrate that not all cash inflows are revenue, and that not all receivable settlements relate to sales in the same fiscal year.
Therefore, well-maintained accounting documentation is critical. Subsidiary ledgers for receivables, details of bank receipt records, aging schedules, tax withholding slips, reclassification journals, and explanations of customer advances and deferred revenue are not mere formalities but essential tools for transaction verification and proof.
The accounts receivable flow testing should be viewed not only as a correction tool, but also as a reconciliation tool to ensure consistency between financial reporting and the economic reality of business activities. By understanding this mechanism, taxpayers can be better prepared to explain discrepancies between cash inflows and revenue, while avoiding misinterpretation during tax audits. When conducted objectively and based on data, accounts receivable flow testing can contribute to a fairer audit process and provide certainty for business actors. (KEN)
Disclaimer! This article is a personal opinion and does not reflect the policies of the institution where the author works.
