Performance audit, Department of Revenue, Audit Division

              Performance Audit
Department of
Revenue–
Audit Division
Performance Audit Division
Debra K. Davenport
Auditor General
AUGUST • 2005
REPORT NO. 05 – 06
A REPORT
TO THE
ARIZONA LEGISLATURE
The Auditor General is appointed by the Joint Legislative Audit Committee, a bipartisan committee composed of five senators
and five representatives. Her mission is to provide independent and impartial information and specific recommendations to
improve the operations of state and local government entities. To this end, she provides financial audits and accounting services
to the State and political subdivisions, investigates possible misuse of public monies, and conducts performance audits of
school districts, state agencies, and the programs they administer.
The Joint Legislative Audit Committee
Senator Robert Blendu, Chair Representative Laura Knaperek, Vice Chair
Senator Carolyn Allen Representative Tom Boone
Senator Gabrielle Giffords Representative Ted Downing
Senator John Huppenthal Representative Pete Rios
Senator Harry Mitchell Representative Steve Yarbrough
Senator Ken Bennett (ex-officio) Representative Jim Weiers (ex-officio)
Audit Staff
Melanie Chesney, Director
Dot Reinhard, Manager and Contact Person
Anne Hunter, Team Leader
Copies of the Auditor General’s reports are free.
You may request them by contacting us at:
Office of the Auditor General
2910 N. 44th Street, Suite 410 • Phoenix, AZ 85018 • (602) 553-0333
Additionally, many of our reports can be found in electronic format at:
www.auditorgen.state.az.us
2910 NORTH 44th STREET • SUITE 410 • PHOENIX, ARIZONA 85018 • (602) 553-0333 • FAX (602) 553-0051
DEBRA K. DAVENPORT, CPA
AUDITOR GENERAL
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
WILLIAM THOMSON
DEPUTY AUDITOR GENERAL
August 24, 2005
Members of the Arizona Legislature
The Honorable Janet Napolitano, Governor
Mr. Gale Garriott, Director
Department of Revenue
Transmitted herewith is a report of the Auditor General, a Performance Audit of the Department of
Revenue, Audit Division. This report is in response to a November 20, 2002, resolution of the Joint
Legislative Audit Committee. The performance audit was conducted as part of the sunset review
process prescribed in Arizona Revised Statutes §41-2951 et seq. I am also transmitting with this report a
copy of the Report Highlights for this audit to provide a quick summary for your convenience.
As outlined in its response, the Department of Revenue agrees with all of the findings and plans to
implement all of the recommendations.
My staff and I will be pleased to discuss or clarify items in the report.
This report will be released to the public on August 25, 2005.
Sincerely,
Debbie Davenport
Auditor General
Enclosure
DD:Acm
Services:
The Audit Division helps ensure that the State receives tax
monies owed to it. Auditing is a critical function because the
State depends on taxpayers to voluntarily report and remit
taxes in a timely manner. Therefore, auditing educates tax-payers,
corrects differences between taxpayers’ obligations
and what they report and pay, and encourages compliance
with tax laws. The Audit Division is organized into sections by
tax type:
􀁺􇩃 Corporate Income Tax—Performs audits of corporate
income tax returns to ensure compliance with
Arizona’s corporate income tax laws, regulations, and
policies. This includes audits of national and multina-tional
corporations, and limited audits such as
reviews of the accuracy of corporate taxpayers’ spe-cific
tax credits.
􀁺􇩉 Individual Income Tax—Performs audits of individual
income tax returns and identifies individuals who
should have filed returns. Also performs audits of
partnerships and sub-S corporations, which are
organizations structured like a corporation but whose
taxes are paid by individuals.
􀁺􇩔 Transaction Privilege and Use Tax—Ensures that
businesses have a transaction privilege tax license
and promotes education in the area of use tax, which
is a tax on personal property for which a transaction
privilege tax was not paid, as well as performs trans-action
privilege (i.e., sales) tax audits. Also adminis-ters
the Cities Program, which coordinates the admin-istration,
collection, and auditing of sales tax for those
cities, towns, and counties that have entered into an
agreement with the Department to provide these serv-ices.
􀁺􇩓 Special Taxes—Processes licenses for and/or audits
several different smaller tax revenue sources. For
example, the section administers liquor and tobacco
taxes, and issues licenses for tobacco wholesalers.
Also investigates complaints and violations of bingo
laws and conducts workshops and consultations with
bingo licensees.
PROGRAM FACT SHEET
Arizona Department of Revenue
Audit Division
Discovery (4)
Administration (3)
Information
Technology (13)
Special
Taxes (20)
Corporate Income
Tax (63)
Transaction
Privilege Tax (137)
Individual
Income Tax (86)
Program revenue:
$15 million (fiscal year 2005 estimate)
Program staffing:
326 FTE as of February 2005, which included 30 vacancies
Office of the Auditor General
Tobacco Tax and
Health Care Fund ($256,000)
State General Fund ($14,755,000)
Facilities:
The Division’s staff are located in three offices state-wide. Specifically, division staff are located in
the agency headquarters, which is a state-owned building at 1600 West Monroe in Phoenix, and
in a state-owned building complex at 400 West Congress in Tucson. Finally, division staff are also
located in a privately owned facility at 3191 N. Washington Street in Chandler, Arizona. The
Division occupies 11,450 square feet of this 20,783-sq. ft. facility that the Department leases for
$283,426 annually, plus operating costs.
Equipment:
The Division has typical office equipment, such as office furniture, computers, and printers.
Mission:
To promote voluntary compliance by auditing, identifying common areas of noncompliance, and
educating taxpayers.
Program goals:
The Audit Division has adopted the Department’s three goals and associated objectives. The
goals are:
1. To maximize the return on investment.
2. To maximize customer and stakeholder satisfaction.
3. To maximize employee satisfaction.
Adequacy of performance measures:
The Division’s 38 performance measures appear to be generally appropriate and well-aligned
with the 3 department goals. Although the Division developed 4 overall performance measures,
the remaining 34 performance measures are specific to division sections. The Division and each
section have a variety of performance measures, including output, outcome, quality, and effi-ciency
measures.
Source: Auditor General staff analysis of unaudited financial schedules prepared by the Department of Revenue for the years ended or ending June
30, 2003 through 2005; the Department’s 2004 annual report and strategic plan; the Department’s organizational chart for the Audit
Division; and other information provided by the Department.
State of Arizona
The Office of the Auditor General has conducted a performance audit of the
Department of Revenue (Department), Audit Division (Division) pursuant to a
November 20, 2002, resolution of the Joint Legislative Audit Committee. This audit
was conducted as part of the sunset review process prescribed in A.R.S. §41-2951
et seq and is the first in a series of four reports on the Department of Revenue. The
subsequent reports will focus on the Department’s new integrated tax system, BRITS,
the Collections Division, and an analysis of the 12 statutory sunset factors.
The Audit Division helps ensure that the State receives tax monies through its
auditing function. The Department reports that during fiscal year 2004, the Division
conducted more than 37,000 audits, which identified more than $139 million in
additional taxes owed to the State (see Table 1, page 4). In fiscal year 2003, the
Department was appropriated additional full-time equivalent (FTE) positions which
were assigned to the Audit and Collections Divisions with the Audit Division
receiveing 81 of these positions. The Department expects that the new positions
assigned to both divisions will generate an additional $53.2 million each year.1
Division needs to take additional steps to better manage
limited resources (see pages 9 through 11)
The Division needs additional information to help it make effective resource allocation
decisions. A 1995 Auditor General performance audit found that the Division needed
to develop annual audit plans to proactively manage its resources. In 2004, each of
the Division’s sections developed an initial audit plan, which the Division refers to as
business plans. However, the plans lack basic data needed to analyze how the
Division uses its resources and the return on investment from its audits. For example,
the plans do not indicate the number of staff hours available for auditing, the number
of audits the Division plans to complete, how many dollars those audits are expected
to cost, and how many additional tax revenues can be expected to be assessed.
Capturing and analyzing such information can aid the Division in meeting its
objectives of maximizing revenues, audit coverage, and compliance rates.
1 Laws 2003, 1st S.S., Ch. 1.
Office of the Auditor General
SUMMARY
page i
The Division is implementing a new automated audit system known as ESKORT that
is targeted to be completed by August 2006. ESKORT should help gather the data
necessary to conduct the analyses of available resources as well as meaningful
return on investment analyses. Using ESKORT, the Division should be able to capture
data that is not currently being captured. Some additional steps will also need to be
taken. The Corporate Income Tax Section does not have accurate information about
the numbers of audits completed or the amount of tax revenues assessed, and other
sections do not capture complete information about audit costs. To use ESKORT to
capture and report data that will help it better manage its resources, the Division will
need to ensure that staff is trained on what data to enter, how to enter it, and why
correct data is so important.
Division should further improve its audit selection
processes (see pages 13 through 16)
The Division has improved some of its processes for deciding which taxpayers and
businesses to audit, but should take steps to ensure continued improvements. The
1995 Auditor General performance audit found that the Division needed to develop
systematic selection processes, focusing on high-liability taxpayers and
noncompliant segments of the tax base. Since the 1995 audit, written processes
have been developed for some types of audits, and in March 2005, the Division
drafted policies for all the sections that ensure that taxpayers cannot be unfairly
selected by auditors or selected for personal reasons. The Division has also taken
steps to ensure that it focuses its audit selection techniques on high-liability and
noncompliant taxpayers. For example, the Corporate Income Tax Audit Section has
established written procedures for selecting field audits that factor in a corporation’s
amount of tax liability.
The Division’s new automated audit system, ESKORT, should provide the Division
with the opportunity to further improve its audit selection processes. ESKORT
contains an audit selection component that evaluates taxpayers’ tax returns on the
basis of specific observations the Division defines. For example, many taxpayers who
take a certain deduction on their tax return may have a tendency to make an error on
their return. These patterns are entered into the system as logical “if, then” rules that
ESKORT applies. The Transaction Privilege Tax Audit Section and the field audit unit
of the Corporate Income Tax Audit Section have written ESKORT rules; however, the
Division needs to ensure that the units in each of its sections draft rules
encompassing key methods for selecting audits through ESKORT. In addition, the
Division should ensure that the ESKORT audit selection rules are regularly and
appropriately evaluated.
State of Arizona
page ii
Office of the Auditor General
TABLE OF CONTENTS
page iii
concluded
1
9
9
10
11
13
13
15
16
4
6
Introduction & Background
Finding 1: Division needs to take additional steps to
better manage limited resources
Division has developed audit plans
Division can improve its business plans through better use of data
Recommendations
Finding 2: Division should further improve its audit
selection processes
Division has taken some steps to address audit selection
concerns
Division should continue to improve audit selection processes
Recommendations
Agency Response
Tables:
1 Number of Audits Conducted, Net Assessments
Resulting from Audits
Number of Taxpayers and Number of Auditors by Tax Type
Fiscal Years 2000 through 2004
2 Audit Division
Schedule of Revenues and Expenditures, in Thousands
Years Ended or Ending June 30, 2003, 2004, and 2005
(Unaudited)
State of Arizona
page iv
The Office of the Auditor General has conducted a performance audit of the
Department of Revenue (Department), Audit Division (Division) pursuant to a
November 20, 2002, resolution of the Joint Legislative Audit Committee. This audit
was conducted as part of the sunset review process prescribed in A.R.S. §41-2951
et seq and is the first in a series of four reports on the Department of Revenue. The
subsequent reports will focus on the Department’s new integrated tax system, BRITS,
the Collections Division, and an analysis of the 12 statutory sunset factors.
Audit division helps ensure State
receives tax monies owed
The Audit Division is one of nine divisions within the
Department.1 The Department is responsible for
licensing, processing, collecting, and enforcing
most taxes for the State of Arizona (see text box). In
fiscal year 2004, the Department reports that it
collected more than $9.8 billion in state and local
revenues to pay for many public services, including
education, health, and welfare.
The Audit Division helps ensure that the State
receives tax monies owed to it. Auditing is a critical
function because the State depends on taxpayers
to voluntarily report and remit taxes in a timely
manner. Therefore, auditing is used to educate
taxpayers and to discover and correct differences
between taxpayers’ obligations and what they
report and pay. Auditing also serves to encourage
compliance with tax laws and helps instill
confidence in the fairness of state government by
reassuring taxpayers who comply that those who do
1 The other divisions are Administrative Services, Collections, External Services and Special Projects, Information
Technology, Processing Administration, Property Tax, Taxpayer Services, and Tax Policy and Research.
Office of the Auditor General
INTRODUCTION
& BACKGROUND
page 1
Arizona’s Primary Tax Revenue Sources
􀁺􇩔 Transaction privilege, use, and severance taxes—A
transaction privilege tax is imposed on a seller for
doing business in the State. Because it is usually
passed on to the customer, this tax is commonly
referred to as a sales tax. Use tax is imposed on the
purchase of personal property for which a transaction
privilege tax was not paid, and severance tax is
imposed on the business of mining metalliferous
minerals and severing timber. Some of these taxes are
collected for and distributed to Arizona’s cities and
counties.
􀁺􇨠 Individual income taxes—These are taxes imposed on
individuals earning income in Arizona. Additionally,
businesses or individuals who hire employees must
withhold income tax from their employees’
compensation and remit it to the Department. Income
tax revenues are shared with Arizona cities and towns.
􀁺􇩃 Corporate income taxes—These are taxes imposed on
corporations earning income in Arizona and are shared
with Arizona cities and towns.
not comply are at risk. The Audit Division’s mission is “to promote voluntary
compliance by auditing, identifying common areas of non-compliance and educating
taxpayers.”
The process of conducting an audit involves several steps. First, an
individual, corporate, or business taxpayer is selected for an audit
through one of several audit selection processes such as reviewing
federal tax return information and taxpayers’ reporting histories (see
Finding 2, pages 13 through 16). Then an auditor conducts either a
field or office audit (see text box).
Both types of audits include doing such things as reviewing expense
and sales records, and verifying computations and other information,
including income amounts. Finally, the auditor documents the work,
including one of the following three results: (1) additional tax is owed
by the taxpayer, referred to as a tax assessment; (2) a refund is owed
to the taxpayer; or (3) no assessment or refund is owed. The Division
has up to 4 years after a tax return is filed (or required to be filed) to
select and complete a taxpayer audit. A taxpayer also has the right to
protest an audit assessment, which is then reviewed by division
protest staff.
Section organization and responsibilities
The Division’s auditing functions are divided among four major sections, as listed
below. The Department reports that during fiscal year 2004, the Division conducted
more than 37,000 audits resulting in a total of $139 million assessed (see Table 1,
page 4).1 As of February 1, 2005, the Division had 326 FTE positions, of which 30
were vacant.
􀁺􇩔 Transaction Privilege Tax Audit Section (137 FTEs, 11 vacancies)—This section
is responsible for ensuring that businesses have a transaction privilege tax
license and performing transaction privilege (i.e., sales) tax audits. This section
also administers the Cities Program, which involves coordinating the
administration, collection, and auditing of transaction privilege tax for those
cities, towns, and counties that have entered into an agreement with the
Department to provide these services. As of May 1, 2005, 77 cities and towns,
as well as all 15 counties, were participating in the Cities Program.2 The majority
of the staff, 87 FTEs, work in the field audit units and conduct standard
1 These totals do not include the number of audits and amount of assessments for corporate office audits, or the dollars
collected for transaction privilege tax licenses, or transaction privilege tax collected as a result of the licenses issued. See
Table 1, page 4.
2 These services are provided to the cities, towns, and counties for free. A 1995 Auditor General Report (see Auditor
General Report No. 95-16) recommended that the Legislature consider amending A.R.S. §42-1451 to allow the
Department to charge an administrative fee for these services, but this recommendation has not been implemented.
State of Arizona
page 2
Types of Audits
Field audit—An audit conducted on larger
corporations, which may take more than a
year to complete and involves traveling to a
corporation’s or business’ headquarters, for
example, to review financial and tax records.
Office (or desk) audit—Office auditors do not
travel, and their work involves less-extensive
audit work, such as reviewing specific items
on a tax return for accuracy, such as a
specific tax credit.
Auditing encourages
compliance with tax
laws and helps instill
confidence in the
fairness of state
government.
compliance reviews at the business taxpayer’s location to ensure they are
submitting the appropriate amount of transaction privilege tax monies. The field
auditors also conduct multi-jurisdictional audits for the 12 cities that do not
participate in the Cities Program.1 A multi-jurisdictional audit allows a taxpayer
to be audited for state and city taxes at the same time. The remaining 50 FTEs
are assigned to a licensing compliance unit, an office audit unit, a refund unit,
and an administrative support unit. The licensing compliance unit consists of
staff who go out into the field and find businesses that are unlicensed. For
example, this unit went to the Arizona State Fair, located businesses that did not
have a transaction privilege tax license, and required them to become licensed.
The office audit (or desk audit) unit conducts audits by regularly sending out
informational letters to different categories of businesses about specific tax
requirements, reviewing information submitted by taxpayers in response to the
letters, and assisting taxpayers in determining the amount of tax due. The refund
unit is responsible for analyzing and processing taxpayer refund requests, and
the administrative support unit provides support by performing clerical tasks
such as maintaining audit files.
􀁺􇩉 Individual Income Tax Audit Section (86 FTEs, 8 vacancies)—This section is
responsible for performing audits of individual income tax returns and identifying
individuals who should have filed returns. The majority of this section’s staff, 47
FTEs, work in its office audit units. These office or desk auditors perform audits
of individual income tax returns and review amended returns. These audits
involve reviewing information in the office and primarily contacting the taxpayer
through the mail. For example, a letter sent by this unit may request clarification
or documentation for expenses a taxpayer claimed as a deduction. In contrast,
the eight field auditors perform audits of partnerships and sub-S corporations,
which are organizations structured like a corporation, but whose taxes are paid
by individuals. The remaining staff, approximately 31 FTEs, perform
administrative support duties such as analyzing and researching
correspondence, inputting data, and preparing audit files.
􀁺􇨠 Corporate Income Tax Audit Section (63 FTEs, 7 vacancies)—This section is
responsible for performing audits of corporate income tax returns to ensure
compliance with Arizona’s corporate income tax laws, regulations, and policies.
The majority of the staff, 43 FTEs, work in the section’s four field units. The field
units are responsible for performing field audits of large national and multi-national
corporations, which are conducted at the corporation’s headquarters.
According to the Division, the majority of its field audits are conducted on
businesses whose headquarters are outside of Arizona, and these audits can
sometimes take more than a year to complete. The section also has an office
audit unit composed of 9 FTEs that conducts audits that are generally limited in
scope and do not involve traveling to a corporation’s headquarters. For
example, this unit may review the accuracy of a specific tax credit taken by
corporate taxpayers. The office audit unit sends information to and collects
1 The nonprogram cities are Avondale, Chandler, Flagstaff, Glendale, Mesa, Nogales, Peoria, Phoenix, Prescott,
Scottsdale, Tempe, and Tucson.
Office of the Auditor General
page 3
information from taxpayers through the mail. The section also has a nexus unit
with 5 FTEs. Nexus is a tax term used to demonstrate a minimal tax connection
with a state. A multi-state corporation having nexus with Arizona must file an
Arizona corporate income tax return. For example, if a corporation has property
or a business location in Arizona, then the corporation is considered to have
nexus. However, if a corporation only solicits sales in Arizona, but does not own
property or have a place of business in the State, then there is no nexus, and the
corporation does not owe taxes to Arizona. The remaining 6 FTEs work in
administrative or support positions.
􀁺􇩓 Special Taxes Section (20 FTEs, 4 vacancies)—This section is responsible for
the processing of licenses for and/or auditing several different smaller tax
revenue sources. For example, the section administers liquor and tobacco taxes
and issues licenses for tobacco wholesalers. This section also issues licenses
State of Arizona
page 4
Table 1: Number of Audits Conducted, Net Assessments Resulting from Audits
Number of Taxpayers and Number of Auditors by Tax Type
Fiscal Years 2000 through 2004
Fiscal Years
2000 2001 2002 2003 2004
Transaction Privilege and Use Taxa
Number of taxpayers 167,921 175,239 168,209 172,186 171,924
Number of audits conductedb 1,279 1,049 870 899 1,109
Dollars assessed $38,515,229 $26,008,472 $26,453,914 $38,309,507 $44,116,256
Number of auditors 77 65 47 75 75
Number of licenses issued 1,511 944 1,888 3,143 3,347
License dollars collectedc $15,868,753 $16,029,630 $14,030,610 $18,521,861 $25,996,805
Individual Income Tax
Number of taxpayers 2,971,871 2,995,191 3,076,061 3,159,115 3,244,411
Number of audits conducted 38,553 39,681 38,341 32,376 36,729
Dollars assessed $17,829,887 $16,771,641 $16,541,486 $20,607,390 $29,141,673
Number of auditors 33 39 40 39 49
Corporate Income Taxd
Number of taxpayers 53,958 42,815 51,919 48,317 51,740
Number of audits conducted 82 62 64 66 73
Dollars assessed $79,079,443 $21,798,200 $57,107,193 $66,711,377 $65,771,746
Number of auditors 22 21 19 22 35
a The number of audits, dollars assessed, taxpayers, and auditors pertain to field audit staff only. The number of licenses issued and
dollars collected pertain to the office audit unit. The office audit unit also works to educate taxpayers about transaction privilege and
use tax laws and requirements (see page 3).
b This number does not include the audits that the Division conducts for nonprogram cities (see page 3).
c This number includes the dollars collected for the licenses issued as well as any transaction privilege and use tax collected for an
additional 12 months after the license is issued.
d The number of corporate office audits conducted and the amount of additional tax assessed during these fiscal years cannot be
reported because the Corporate Income Tax Section’s office audit unit does not have adequate controls in place to ensure that
auditors are correctly recording the number of audits conducted and the amount of tax assessed.
Source: Table prepared by Auditor General staff using figures for fiscal years 2000 through 2004 obtained from the Department of
Revenue Audit Division Legislative Report.
and conducts audits of bingo operators, investigates complaints and violations
of bingo laws, and conducts workshops and consultations with bingo licensees.
The Division also has the following management and administrative staff: an
Administrative section with 3 FTEs, an Information Technology section with 13 FTEs,
and a Discovery section with 4 FTEs. The Discovery section matches taxpayer data
from different sources in order to discover taxpayers who should have filed tax
returns, but did not.
Audit division undergoing changes
Several changes have taken place or are in the process of taking place within the
Department’s auditing function. In February 2003, the auditing function, which was
previously dispersed among several different divisions, became its own division. In
addition, during fiscal year 2003, the Department was appropriated additional FTEs
as part of a revenue-generating program.1 The revenue-generating program
expanded the Department’s enforcement function by assigning additional FTEs to
the Audit and Collections Divisions, with the Audit Division receiving 81 FTEs. The
Department anticipates that the new positions assigned to both divisions will
generate an additional $53.2 million for the State’s General Fund each year.
In addition, in February 2005, the Division began implementing a comprehensive
automated audit system, known as ESKORT. The ESKORT system is being
implemented as part of the Department’s new integrated tax system—BRITS.
According to the Department, ESKORT is targeted to be completely implemented by
August 2006 and will include the following components:
􀁺􇩁 Audit Selection—This component helps the Division select audits by analyzing
taxpayer information to help identify and prioritize the best candidates for audit.
􀁺􇩄 Data Warehouse—This component increases the amount of data that the
Division can store and use to help identify noncompliant taxpayers or identify
nonfilers, such as databases from other state agencies that can be used for
comparison to department data.
􀁺􇨠 Case Management and Tracking—This component captures data on each
audit selected, such as time and expense data, and allows the Division to track
and monitor the progress of audit activities. It will also allow the Division to
produce management and statistical reports.
􀁺􇨠 Audit Support—This component supports the day-to-day tasks associated with
planning, conducting, and documenting an audit. It contains such things as
templates for standardized letters; coaching tools, including a help menu for
1 Laws 2003, 1st S.S., Ch. 1.
Office of the Auditor General
page 5
new or inexperienced auditors; and support materials, such as checklists and
tax law and policy information.
Division budget
As detailed in Table 2, during fiscal year 2004, the Department allocated to the
Division approximately $14 million (or 22 percent) of its $63 million in appropriated
revenues. The majority of the Division’s expenditures were for personnel services and
employee-related expenditures. The Division’s next largest expenditure category is
travel, which amounted to approximately $500,000 in fiscal year 2004. According to
the Division, travel expenditures increased in fiscal year 2004 over the previous 2
fiscal years as travel budget reductions were lifted and staffing levels were increased.
State of Arizona
page 6
Table 2: Audit Division
Schedule of Revenues and Expenditures, in Thousands
Years Ended or Ending June 30, 2003, 2004, and 2005
(Unaudited)
2003 2004 2005
(Actual) (Actual) (Estimated)
Revenues:
State General Fund $10,832 $13,786 $14,755
Tobacco Tax and Health Care Fund 1 200 242 256
Total revenue $11,032 $14,028 $15,011
Expenditures:
Personal services and employee related $10,556 $13,275 $14,117
Professional and outside services 22 26 31
Travel 281 499 624
Other operating 149 188 221
Equipment 24 40 18
Total expenditures $11,032 $14,028 $15,011
1 Amount is the Division’s portion of Tobacco Tax Health Care Fund monies used to enforce tobacco tax
collections.
Source: Auditor General staff analysis of unaudited financial schedules prepared by the Department of
Revenue for the years ended or ending June 30, 2003, 2004, and 2005.
Scope and methodology
This audit followed up on the recommendations made in the 1995 performance audit
of the Department’s audit functions (see Auditor General Report No. 95-18). Further,
auditors focused their work on the Division’s audit functions related to the three
primary sources of tax revenue the Department collects: corporate income, individual
income, and transaction privilege tax. The audit report presents two findings and
associated recommendations:
􀁺􇩔 The Division needs additional information to help it make effective resource-allocation
decisions. In 2004, each of the Division’s sections created audit plans
to formulate and communicate ways to accomplish goals and objectives for the
upcoming year. While these plans are a step in the right direction, to help ensure
resource-allocation decisions are effective, the Division should include
additional information in these plans, such as the number of staff hours available
for audits and the costs of audits compared to the amount of additional tax
revenue received.
􀁺􇨠 The Division has improved some of its audit selection processes, but more work
is needed. The Division has developed systematic, written audit selection
processes for two areas that focus on selecting audits of high-liability and
noncompliant taxpayers. However, the Division has the opportunity to further
improve its audit selection processes by developing additional audit selection
rules and using its new automated audit system, known as ESKORT, to evaluate
whether its audit selection criteria are effective.
During the audit work, significant limitations in one division area were identified.
Because of the nature of the information collected and the need for confidentiality,
these concerns will be communicated in a separate letter report to the department
director.
Various methods were used to study the issues addressed in this audit. General
methods included interviews with department management and staff, as well as
interviews with professional organizations such the National Association of State
Auditors, Comptrollers, and Treasurers, and the Federation of Tax Administrators.
Auditors also reviewed Arizona Revised Statutes, the Arizona Administrative Code,
the Code of Federal Regulations, and department and division policies and
procedures, goals, objectives, and performance measures.
In addition, the following specific methods were used:
􀁺􇩔 To develop the report findings, auditors reviewed a previous performance audit
of the Division (see Auditor General Report No. 95-18) to determine whether
recommendations had been implemented. In addition, auditors reviewed
Office of the Auditor General
page 7
performance audits of other states’ tax enforcement agencies.1 Auditors also
reviewed and analyzed various internal documents, such as the Division’s audit,
or business plans, and observed an internal division audit selection committee
meeting and supervisors’ meeting. Auditors also reviewed technical literature
about the Division’s new automated audit system that is currently being
implemented, interviewed the project manager for this system, and attended a
training session on this system. In order to make general comparisons to
Arizona, auditors e-mailed a questionnaire to ten states that had similar tax types
as Arizona or were identified by the Federation of Tax Administrators as being
best-practice states.2 Finally, auditors reviewed academic literature on audit
selection methods and best practices in tax auditing.
􀁺􇨠 To develop the Introduction and Background section, auditors conducted
interviews with department management and staff, and compiled information
from state laws and regulations, and unaudited information from the
Department’s 2004 annual report, the Department’s organizational chart for the
Audit Division, the Department’s Web site and financial schedules, and other
information provided by the Department, as well as technical literature and
information from the State of Arizona Annual Financial Report.
The audit was conducted in accordance with government auditing standards.
The Auditor General and staff express appreciation to the director, division director,
and staff of the Department of Revenue for their cooperation and assistance
throughout the audit.
1 The state audit reports reviewed were the Utah Tax Commission; the Kansas Department of Revenue; the California State
Board of Equalization; the California Franchise Tax Board; the Idaho State Tax Commission; the Wyoming Departments
of Revenue; Audit and Transportation; the Florida Department of Revenue; the West Virginia Department of Tax and
Revenue; the North Carolina Department of Revenue; the Colorado Department of Revenue; the Nevada Department of
Taxation; the Michigan Tax Compliance Bureau; and the New Mexico Taxation and Revenue Department.
2 The states that were contacted provided information on such things as audit selection methods, number of audits
conducted, and the type of information used to evaluate audit outcomes and audit selection methods. Because the
information provided is of a sensitive nature, the states requested that they not be identified in this report.
State of Arizona
page 8
Division needs to take additional steps to better
manage limited resources
The Division needs additional information to help it make effective resource-allocation
decisions. The Division recently created audit plans to help address
concerns identified in a previous performance audit about whether it was proactively
managing its resources. While these plans are a step in the right direction, to help
ensure resource-allocation decisions are effective, the Division should use its new
automated audit system to include additional information, such as the number of
staff hours available for audits and the costs of audits compared to the amount of
additional tax revenue received.
Division has developed audit plans
The Division has developed audit plans, which it refers to as business plans, to
address concerns identified in a prior performance audit. A 1995 performance audit
(see Auditor General Report No. 95-18) found that the Division needed to develop
annual audit plans to proactively manage its resources. The report noted that the
audit sections did not have annual plans that specified such things as the number of
staff hours available for audits and the number of audits to be performed. The report
recommended that audit plans be developed that detailed goals, objectives, and
resource-allocation decisions. The report also noted that careful management of
auditing resources was particularly important since workload and productivity could
be impacted by a number of factors including changes in tax laws, the economy, and
automation.
The Division has only recently developed business plans that include some of the
recommended information. In 2004, each of the Division’s sections (i.e., Corporate,
Individual, etc.) developed an initial business plan. Each section’s plan includes a
data analysis section that presents information from previous years, such as the
number of audits conducted by type and the tax assessment amount, and a section
The Division has written
business plans to
comply with past
performance audit
recommendations.
Office of the Auditor General
page 9
FINDING 1
on ideas for accomplishing goals. According to the Division, the plans are used to
formulate and communicate ways in which the sections can accomplish goals and
objectives for the upcoming year.
Division can improve its business plans through better
use of data
While the Division’s business plans are a step in the right direction, they are missing
basic information needed to analyze how audit resources are used and a cost-benefit
analysis for its different types of audits. The Division should use its new
automated audit system, ESKORT, to help it gather the data necessary to conduct
these analyses and improve its business plans.
Business plans can be improved—The Division’s business plans can be
improved by including more information in the data analysis section. Specifically,
adding the number of staff audit hours available and completing a return on
investment (ROI) analysis, or a cost-benefit analysis, that compares the cost of audits
to the amount of additional tax revenues assessed will allow the Division to determine
and document its decisions on how best to allocate resources to meet its objectives
of maximizing revenue, audit coverage, and compliance rates. Several of the states
that auditors contacted regularly analyze the costs and profitability of audits.
A meaningful cost-benefit or ROI analysis should be conducted for each type of
audit. Currently, the Individual Income Tax Audit Section and the Corporate Income
Tax Audit Section conduct a limited ROI analysis by comparing the benefits, or total
assessments and collections, to the costs, or total expenditures for the sections as a
whole. The Individual Income Tax Section analysis indicates that it is collecting
approximately $5 for every $1 spent, and the Corporate Income Tax Audit section
analysis indicates that it is collecting approximately $15 for every $1 spent. However,
since it is done for the section as a whole, these analyses do not allow the sections
to determine the ROI for the different types of audits that they conduct.
Improving the business plans by including the number of audit hours available and
a return on investment analysis, or cost-benefit analysis for each type of audit, will
allow each of the Division’s sections to more clearly determine how best to use its
auditing resources. In addition, taken together, the Division could use the plans to
determine and document its decisions about whether resources should be moved
between the sections. Further, historical return-on-investment information could help
the Division determine whether it would be in the State’s interest to add additional
auditing resources.
The Division should
conduct a cost-benefit
analysis for each type of
audit.
State of Arizona
page 10
New audit system will help Division improve business plans—ESKORT,
the Division’s new automated audit system, is designed to capture additional data
that can be used to improve its business plans and enable the Division to more
effectively manage its resources. According to the Division, its resource allocation
decisions have been hindered by a lack of data and inaccurate data. However, using
ESKORT, the Division will be able to capture data that is not currently being captured,
such as the amount of hours spent on each audit. This information, coupled with the
amount of additional tax owed, could then be used to determine the return on
investment by categories of audits.
However, the Division will need to take steps to ensure that accurate data is captured.
Currently, the Corporate Income Tax Section’s office audit unit does not have
adequate controls in place to ensure that auditors are correctly recording the number
of audits conducted and the amount of tax assessed. The Division indicated that
these problems stemmed in part from a lack of training. In addition, not all of the
sections are capturing information on audit costs. Therefore, the Division should take
steps to ensure that staff is trained on which data must be entered into ESKORT, how
to enter the data, and the importance of complete and accurate data for ensuring
resources are effectively managed.
Recommendations:
1. To ensure its resource-allocation decisions are based on complete and accurate
information, the Division should ensure staff are trained on:
a. what data must be entered into ESKORT,
b. how to enter the data, and
c. the importance of ensuring the data is complete.
2. When the Division has complete and accurate data on ESKORT, it should use
the data to improve the business plans. Specifically, business plans should
include:
a. the number of staff hours available for audits,
b. the number of audits to be performed,
c. the analysis of audit costs compared to the additional revenue
received, and
d. the Division’s resource-allocation decisions.
ESKORT will capture
additional data that will
enable the Division to
more effectively manage
its resources.
Office of the Auditor General
page 11
State of Arizona
page 12
Division should further improve its audit selection
processes
The Division has improved some of its processes for deciding which taxpayers and
businesses to audit, but more work is needed. The Division has developed
systematic written audit selection processes for two areas, which include focusing on
selecting audits of high-liability taxpayers and noncompliant taxpayers. However, the
Division has the opportunity to further improve its audit selection processes by
developing additional audit selection rules and using its new automated audit
system, ESKORT, to evaluate whether its audit selection criteria is effective.
Division has taken some steps to address audit selection
concerns
The Division has taken some steps to address audit selection concerns identified in
the most recent performance audit.1 A 1995 Auditor General performance audit
(Auditor General Report No. 95-18) found that the Division needed to develop and
implement systematic processes for selecting audits, increase audits of high-liability
taxpayers, and focus some audit resources on noncompliant segments of the tax
base. The 1995 performance audit also noted that because audit resources are
limited, it is important that the Division have effective audit selection processes.
Documented selection processes—Since the 1995 audit, the most significant
steps the Division has taken are developing and implementing systematic written
processes for selecting audits in two areas: the Individual Income Tax Audit Section
and the Corporate Income Tax Audit Section’s field audit unit. Specifically, in 1999,
the Corporate Income Tax Audit Section established a committee that developed and
documented selection criteria for its field audit units. The criteria includes items such
as a corporation’s amount of tax liability and whether a corporate taxpayer has been
audited before. In 2001, the Individual Income Tax Audit Section documented its
1 Similar concerns were also identified in three previous audit reports. See Auditor General Performance Audit Report Nos.
81-2, 85-5, and 87-6.
Office of the Auditor General
page 13
FINDING 2
procedures for selecting audits, including criteria such as the estimated amount of
additional tax owed and prior audit results. In addition, when auditors discovered
during this audit that the Division did not have a policy that addressed selecting
audits through auditor leads, each of the sections drafted a policy in March 2005 to
ensure that taxpayers cannot be unfairly targeted by auditors or selected for personal
reasons.The policies require supervisory approval of audits selected through auditor
leads. Auditor leads generally refer to audits selected based on an auditor’s
judgment, such as information obtained during the course of an audit that results in
identifying the need for additional audits. The Division has not, however, developed
written processes for how it decides which taxpayers and businesses to audit for the
Transaction Privilege Tax Audit Section or the Corporate Income Tax Audit Section’s
office audit unit.
Identifying noncompliant taxpayers—The Division has taken steps to develop
audit selection techniques that focus on noncompliant segments of the tax base. For
example, the Individual Income Tax Audit Section’s written processes focus primarily
on identifying noncompliant taxpayers, such as taxpayers who have an error on their
federal tax return, and are therefore also likely to have an error on their Arizona tax
return. The Division also identifies noncompliant taxpayer groups by participating in
work groups with other states’ taxing authorities, and all of the sections use auditor
experience to pinpoint particular industries or groups that have tax compliance
problems. For example, although the Corporate Income Tax Audit Section’s office
audit unit does not have current systematic, written audit selection processes,
managers in this unit indicate that they have learned through experience that
corporations taking certain types of tax credits are more likely to have errors on their
tax returns. Therefore, the managers indicated that the office audit unit would focus
some of its auditing efforts on those corporations that claim the specific tax credits
because they are likely to be out of compliance.
Focusing on high tax liabilities—The Division has taken some steps to focus its
audit selection on high-liability taxpayers. Although it does not appear that the
Division has increased the proportion of audits of high-liability corporate taxpayers, it
has taken steps to ensure that it focuses on high liability taxpayers when selecting
corporate field audits. Specifically, the Corporate Income Tax Audit Section has
established written selection procedures which factor in a corporation’s tax liabilities.
The Transaction Privilege Tax Audit Section, on the other hand, does not have
documented audit selection criteria and therefore it cannot demonstrate that it is
focusing on high-liability taxpayers for audit.
Auditors focus their
efforts on taxpayers who
are likely to be out of
compliance with tax
laws.
State of Arizona
page 14
Division should continue to improve audit selection
processes
The Division’s new automated audit system, ESKORT, should provide it with the
opportunity to further improve its audit selection processes. However, the Division
needs to ensure that all of its audit units develop audit selection rules, and that the
rules are regularly and appropriately evaluated to determine if they result in selecting
the most effective audits.
Division writing rules that will help it select audits—ESKORT contains an
audit selection component that evaluates taxpayers’ tax returns by
using division-established rules that provide a score indicating the
likelihood for noncompliance (high, medium, low) and the potential
amount of additional tax owed to the State. Rules are basically
observations of taxpayer data. Specifically, the observations are
entered into the system as logical “if, then” rules. For example, a rule
may tell the system that taxpayers who take a certain deduction on
their tax return may likely have an error on their return. ESKORT
should also streamline the Division’s audit selection processes
because the system will examine and select taxpayers based on the
rules, whereas currently, auditors or administrative staff have to manually review
taxpayer records and search databases for specific information.
Some sections will need to develop rules for ESKORT. The Transaction Privilege Tax
Section has written audit selection rules for ESKORT that appear to encompass its
key methods for selecting audits. The Corporate Income Tax Audit Section’s field
audit unit has also written ESKORT rules; however, the office audit unit in this section
still needs to write rules. In addition, the Division is currently working with the
contractor to determine how to best use ESKORT’s office audit function in the
Individual Income Tax Section, and if the section decides to use the audit selection
component of ESKORT, it will need to write rules that encompass current audit
selection methods.
Division needs to ensure that rules are evaluated—Appropriate and
regular evaluation will ensure that the rules are written to select the type of audits that
will help the Division achieve its objectives of increasing tax revenues, compliance
rates, and cost-effectiveness. According to division officials, the audit selection rules
will be evaluated primarily through auditor feedback. However, the Division still needs
to determine how and when this feedback will be obtained. For example, ESKORT
comes equipped with a built-in evaluation mechanism whereby auditors can assign
a score to the rules that were used to select an audit when they have completed the
audit. The system is set up to score the rules on a scale from 1 to 10; however, the
Division must establish the criteria for the scoring. The Division can also change the
scale by using categories, such as fair, excellent, or poor. The score is intended to
assist the Division in evaluating whether the audit selection rules are appropriate and
Office of the Auditor General
page 15
ESKORT rules—Observations of
taxpayer data that ESKORT uses to
select which taxpayers to audit. Rules
are written in “if, then” format. For
example, “if a taxpayer has taken X
deduction, then there is a likelihood of
error.”
effective. However, to ensure that it captures auditor feedback through this
mechanism, the Division may need to require that its auditors fill in this field in order
to close out their audits. Auditors spoke to one state that is using ESKORT in its audit
division, and found that the division made the built-in feedback mechanism
mandatory for all audits to ensure that it could gather data with which to evaluate the
rules.
Regardless of how the Division decides to gather feedback, it should assess whether
the rules are selecting audits that will help meet division objectives. For example, the
Division should ensure that the rules are selecting some corporations for field audit
that do business only in Arizona because field audits are more thorough. Doing so
would create an audit presence among Arizona corporations and could result in
increased compliance, which is a division objective.
Recommendations:
1. The Division should ensure that all audit units draft rules encompassing key
methods for selecting audits through ESKORT.
2. The Division should ensure that the ESKORT audit selection rules are regularly
and appropriately evaluated. This evaluation should ensure that the audit
selection rules are selecting audits that help meet the Division’s objectives of
increasing revenues, compliance rates, and cost-effectiveness.
Division management
needs to ensure that the
new automated audit
system is selecting
audits that help meet its
objectives.
State of Arizona
page 16
Office of the Auditor General
AGENCY RESPONSE
State of Arizona
STATE OF ARIZONA
Department of Revenue
Office of the Director
(602) 716-6090
Janet Napolitano
Governor
Gale Garriott
Director
1600 West Monroe Street, Phoenix AZ 85007-2650 www.azdor.gov
August 19, 2005
Debbie Davenport, Auditor General
Office of the Auditor General
2910 North 44th St. Suite 410
Phoenix, Arizona 85018
Dear Mrs. Davenport:
The Department of Revenue (Department) has reviewed the August 10, 2005 Audit
Division’s report of the performance audit and sunset review. The Department commends
and thanks your staff for their understanding and professionalism throughout this
performance audit process.
The following comments are provided as the Department’s response to the findings and
recommendations.
Finding 1 – Division needs to take additional steps to better manage its limited
resources
Recommendation 1 – To ensure its resource allocation decisions are based on complete
and accurate information, the Division should ensure staff is trained on:
a) what data must be entered into ESKORT
b) how to enter the data, and
c) the importance of ensuring the data is complete.
The finding of the Auditor General is agreed to and the audit recommendation will be
implemented.
As the ESKORT system is implemented, extensive training is being designed to ensure
that all users of the system will be properly trained in a timely manner regarding the various
systems. The ESKORT procedure manuals and class handouts are being designed to be
very user-friendly to meet all levels of expertise regarding computer input. We are working
closely with members of the ESKORT system design teams to develop in-house trainers
that will be “resident experts” so the training of affected personnel and the transition to the
Debbie Davenport
August 19, 2005
Page 2
new systems will be easy, efficient, and effective. Additional emphasis will be placed on the
importance of accurate and complete data input by the ESKORT system users so
meaningful management reports can be produced for analytical purposes.
Currently, the Corporate Income Tax Audit and Transaction Privilege Tax Audit field audit
units have developed training plans and schedules and are awaiting final configuration of
the release in order to update the plans and schedules as needed to provide accurate and
timely training. The remaining training for the Audit Division will follow along with the
remaining ESKORT implementation.
The Audit Division, in conjunction with the vendor, completed an ESKORT Readiness Plan
in May 2005. This plan outlines the high-level timeline for the various awareness and
training events that need to occur and is supplemented by a detailed report on the
expected hours, broken down by employee and tax type that are expected to be needed. If
requested, these documents will be provided.
Recommendation 2 – When the Division has complete and accurate data on ESKORT, it
should use the data to improve the business plans. Specifically, business plans should
include:
a) the number of staff hours available for audits
b) the number of audits to be performed
c) the analysis of audit costs compared to the additional revenue received, and
d) the Division’s resource allocation decisions.
The finding of the Auditor General is agreed to and the audit recommendation will be
implemented.
The ESKORT system is only one part of the BRITS project, which is not due to be
completed until August 2006. This will delay the Audit Division’s complete use of the
ESKORT case management and tracking capabilities. The Corporate Income Tax Audit
and Transaction Privilege Tax Audit field audit units are scheduled to begin using
ESKORT’s case management and tracking in mid to late November 2005. The desk audit
units in these sections, as well as Individual Income Tax Audit are not scheduled to begin
using this ESKORT functionality until full BRITS implementation in August 2006. The
ESKORT system will provide all the remaining data elements necessary to facilitate the
business plan improvements.
Finding 2 – Division should further improve its audit selection processes
Recommendation 1 – The Division should ensure that all audit units draft rules
encompassing key methods for selecting audits through ESKORT.
Debbie Davenport
August 19, 2005
Page 3
The finding of the Auditor General is agreed to and the audit recommendation will be
implemented.
The ESKORT audit selection system requires that rules be drafted. These rules are written
and programmed into the system to electronically identify potential audit leads. These
rules will select audit leads based upon their specific criteria. Value points will then be
assigned to each lead and the lead will be designated as high, medium, or low for audit
potential. Since the February 2005 implementation, the Transaction Privilege Tax Audit
section has created 57 new rules that have been programmed into the system. Individual
Income Tax Audit and the desk audit units in Corporate Income Tax and Transaction
Privilege Tax Audit sections will be required to implement similar rules. However, the desk
audit units will also be able to use the field audit rules for their respective audit type.
Recommendation 2 – The Division should ensure that the ESKORT audit selection rules
are regularly and appropriately evaluated. This evaluation should ensure that the audit
selection rules are selecting audits that help meet the Division’s objectives of increasing
revenues, compliance rates, and cost-effectiveness.
The finding of the Auditor General is agreed to and the audit recommendation will be
implemented.
Since the implementation of the ESKORT audit selection system in February 2005,
Corporate Income Tax Audit has modified 4 of its rules and Transaction Privilege Tax Audit
section has modified 12. Combining this result with the additional 57 Transaction Privilege
Tax Audit Section rules that have been implemented demonstrates the ongoing evaluation
that is already taking place.
Additionally, within the ESKORT audit selection system, there is a “rules feedback”
mechanism wherein auditors are required to provide feedback regarding the effectiveness
of the rule(s) used in identifying taxpayers selected for audit (an audit can’t be completed
without having the auditor feedback). Training is being designed to ensure that all users of
the system will be properly trained in a timely manner regarding the various systems,
including the “rules feedback” mechanism. The ESKORT procedure manuals and class
handouts are being designed to be very user-friendly to meet all levels of expertise
regarding computer input. We are working closely with members of the ESKORT system
design teams to develop in-house trainers that are “resident experts” so the training of
effected personnel and the transition to the new systems will be easy, efficient, and
effective. Emphasis will be placed on the importance of accurate and complete data input
by the ESKORT system users, including “rules feedback” so meaningful analysis of the
effectiveness of the rules can take place. This will help ensure that the rules are properly
designed and functioning to identify the best possible audit leads with the greatest potential
for non-compliance. This, in turn, will assist the section with meeting the division’s
objectives of increasing revenues, improving compliance rates, and functioning cost-effectively.
Debbie Davenport
August 19, 2005
Page 4
Thank you for the opportunity to respond to the report.
Sincerely,
Gale Gariott
Director
GG:VP:dbl
cc: Vince Perez
File
03-08 Arizona Department of
Commerce
03-09 Department of Economic
Security—Division of Children,
Youth and Families,
Child Protective Services—
Caseloads and Training
04-L1 Letter Report—Arizona Medical
Board
04-L2 Letter Report—Gila County
Transportation Excise Tax
04-L3 Letter Report—Department of
Economic Security—Population
Estimates
04-01 Arizona Tourism and
Sports Authority
04-02 Department of Economic
Security—Welfare Programs
04-03 Behavioral Health Services’
HB2003 Funding for Adults
with Serious Mental Illness
04-04 Department of Emergency and
Military Affairs and
State Emergency Council
04-05 Department of Environmental
Quality—Water Quality Division
04-06 Department of Environmental
Quality—Waste Programs
Division
04-07 Department of Environmental
Quality—Air Quality Division
04-08 Department of Environmental
Quality—Sunset Factors
04-09 Arizona Department of
Transportation, Motor Vehicle
Division— State Revenue
Collection Functions
04-10 Arizona Department of
Transportation, Motor Vehicle
Division—Information Security
and E-government Services
04-11 Arizona Department of
Transportation, Motor Vehicle
Division—Sunset Factors
04-12 Board of Examiners of Nursing
Care Institution Administrators
and Assisted Living Facility
Managers
05-L1 Letter Report—Department
of Health Services—
Ultrasound Reviews
05-01 Department of Economic
Security—Division of
Employment and
Rehabilitation Services—
Unemployment Insurance
Program
05-02 Department of Administration—
Financial Services Division
05-03 Government Information
Technology Agency (GITA) &
Information Technology
Authorization Committee (ITAC)
05-04 Department of Economic
Security—Information Security
05-05 Department of Economic
Security—Service Integration
Initiative
Performance Audit Division reports issued within the last 24 months
Future Performance Audit Division reports
Department of Economic Security—Division of Developmental Disabilities
Arizona State Retirement System