April 1997

ELECTRONIC RECORDKEEPING, ACCOUNTANTS AND THE INTERNAL REVENUE SERVICE:  ACCOUNTABILITY WITH TEETH IN THE ELECTRONIC AGE  [WORKING DRAFT]

by Harold Thiele

	The ever expanding use of computers and other forms of information technology along with the push to introduce and convert financial instruments into electronic formats is causing concern within the accounting profession.  Accountants and auditors are being forced to come face-to-face with certain harsh realities of the electronic age.  From the mid 1980s a growing number of articles have appeared in the accounting literature that address some of the issues being raised by this movement into electronic accounting systems.  Examples of this literature include Alberto, Goletz & Byrne’s (1987) article on bank records and Skupsky’s (1988) article on IRS requirements.
	This unease within the accounting profession about electronic records, on the surface, appears to be correlated with the widespread introduction of desktop computers and networked systems into general business routines and the growing acceptance and use of Electronic Data Interchange (EDI) technology as part of the normal business activity.  This is also the time period when emphasis was placed on decentralizing and/or eliminating many of the traditional recordkeeping responsibilities.  Part of the response of the accountants to these changes is the recognition of the importance of electronic evidence, especially the validity, completeness and integrity issues.  (Williamson, 1997)
	Prior to this time period, the electronically based accounting functions resided on mainframe computers that operated under well established procedures and were in the care of Automated Data Processing (ADP) professionals.  Working with the mainframe shop, accountants could depend on well established procedures and characteristics to assist them in their activities.  The mainframe based computer operation maintained close security and control in a centralized location, resulting in a continuous chain of custody of the equipment, software, and datatapes that the accountants could rely on to demonstrate the reliability and trustworthiness of the system.  Another characteristic of the mainframe environment that accountants came to rely on was the stability of both the hardware and the software.  Because of the expense of developing and maintaining new versions of the hardware and software in the mainframe environment change occurred in a slow and incremental fashion that the accountants could monitor very easily.  The mainframes were expected to last five to eight years or longer, as was the software.  The operating systems were very stable and there were very few data migration problems.
	The advent of the desktop computer and networking environments have turned this comfortable world upside down.  In the new environment, the accountants are faced with a world in constant flux.  The hardware has an expected lifetime measured in two to three years, and software is about the same.  The operating systems are in constant revision.  The manufacturers and suppliers don’t provide long term support.  With the decentralization of the computer operations each individual is expected to assume responsibility for their own computer based operations.  Accountants are no longer sure of the chain of custody, and this calls into question the trustworthiness and reliability of the systems upon which they must depend in handling the business’s financial accounts.
	One of the unnoticed players in the development of electronic recordkeeping systems is the Internal Revenue Service (IRS).  In recent years the IRS has issued a series of regulations and procedures governing the handling of electronic records used for Federal tax purposes.  These IRS issued directives, regulations and notices directly impact all electronic records that might have any bearing on a Federal tax related issue.  Among the directives that are causing concerns among tax accountants are:
1.	Internal Revenue Code I.R.C. 6001 which governs recordkeeping responsibilities in the administration of the tax law.  (Crangle, 1997)
2.	Internal Revenue Regulations Regs. Sec. 1.6001-1(a) and (e) which deal with retention requirements.  (Berman, Stein & Gotliboski, 1996)
3.	Internal Revenue Procedure 86-19 which specifies the basic requirements for non-paper based systems (microfilm).  (Nelson, 1966)
4.	Internal Revenue Procedure 91-59 specifies the basic requirements within an automatic data processing (ADP) system, including microcomputers, data base management systems, EDI technology and the use of service bureaus, time-sharing services or value-added networks.  (Crangle, 1997)
5.	Internal Revenue Rules 76-447  that holds parent companies responsible for the records of their subsidiaries, both domestic and foreign.  (Crangle, 1997)
6.	Internal Revenue Notice 96-10 which identifies the requirements for electronic imaging and storage of tax records.  (Berman, Stein & Gotliboski, 1996)
	It is this group of IRS rules and procedures that is creating real worries for accountants and at the same time creating an opportunity for electronic records managers.  In the ongoing internecine warfare between the Information Systems/Information Technologists (IS/IT) and the Archivists and Records Managers (ARM) over the most appropriate approach to managing electronic records, the ARM staff have generally been ignored.  Their recommendations for recordkeeping systems as opposed to information systems usually run counter to the recommendations of the IS/IT staff who are constantly seeking to provide data that is timely, manipulable and non-redundant.  (Bearman, 1994b)  These IRS rules and procedures can provide the ARM staff with arguments that support their efforts to implement recordkeeping systems.  It is often helpful to have Godzilla in your corner when you enter into technical discussions with the IS/IT staff.
	Comparison between the IRS electronic records requirements being discussed and the Functional Requirements for Evidence in Recordkeeping (Bearman, 1994a;  School of Information Sciences, 1996) provides a benchmark of the areas of conformance between the ARM community and the accountants.  Wright (1996) points out that the EDI technologies include not only computer interchange, but also facsimile, electronic mail (E-Mail), telex, and computer conferencing systems or bulletin boards.  (About the only thing he missed was the voice mail system.)  He also makes the point that everyday it is becoming easier to transform an EDI transaction from one system to another, and/or generate mixed system or media EDI interactions.
	There are twenty Functional Requirements for Evidence in Recordkeeping identified by the University of Pittsburgh NHPRC Project.  Because of the obvious space limitations, I shall briefly examine only two of the functional requirements, compliant  and responsible - documented, and compare them to similar issues being raised in this series of articles.  I shall use Bearman’s latest version of the functional requirements.
	The first functional requirement is that the organization be compliant.  “Organization must comply with the legal and administrative requirements for recordkeeping within the jurisdictions in which they operate, and they must demonstrate awareness of best practices for the industry or business sector to which they belong and the business functions in which they are engaged.” (School of Information Sciences, 1996)
	The foremost legal requirement that all taxpayers subject to the United States Tax Code must comply with is Internal Revenue Code Section 6001.  This section states that “every person liable for any tax ... shall keep such records ... and comply with such rules and regulations as the [Treasury] Secretary may from time to time prescribe. ... [Secretary] may require ...[to] keep such records, ... to show whether or not such person is liable for tax under this title.”  (CCH, 1996: ¦ 36,401)  Two subsections expand on this section to require the maintenance of appropriate records to satisfy compliance with tax laws.
Internal Revenue Regulation ¤ 1.6001-1.  Records - (a) requires that “any person required to file a return of information with respect to income, shall keep such permanent books of accounts or records, including inventories, as are sufficient to establish the amount ...”  (CCH, 1996: ¦ 36,402)
Internal Revenue Regulation ¤ 1.6001-1. Records - (e) requires that “books or records required by this section shall be kept at all times available for inspection ... and shall be retained so long as the contents thereof may become materials in the administration of any internal revenue law.”  (CCH, 1996: ¦ 36,402)
	Accountants and ARM staff have little difficulty complying with these requirements in the paper based world.  There are standard accounting instruments and recordkeeping systems that meet these requirements.  The advent of microforms as a technological solution to the storage problems associated with the increasing amount of paper records caused the IRS to issued an Internal Revenue Procedure to deal with this new technology.  The Internal Revenue Procedure 81-46 set out procedures and requirements “under which mircofilm reproduction ... will be considered books and records within the meaning of Code Sec. 6001.” (CCH, 1996: ¦ 36,411.49)  Ten years later, in 1991, the IRS updated this procedure to “keep up with the ever-evolving technological changes in ADP” (Nelson, 1996) so that it would apply to electronic records.
	Internal Revenue Procedure 91-59 (CCH, 1996: ¦ 36,411.59) states that “Rev. Proc. 86-19 provides guidelines for record requirements to be followed in all cases where all or part of the accounting records are maintained within an ADP system.”  It further states that “the requirements set forth in ... this revenue procedure are intended to ensure that all machine-sensible records generated by a taxpayer’s ADP system are retained so long as they may be or may become material in the administration of any internal revenue law.”  Section 3.01 states that all types of data processing systems are included, including EDI technology, microcomputer, and networks.  Section 3.02 includes service bureaus (second and third party service providers) as part of a taxpayer’s ADP environment if they are used to process any tax related material.  Section 3.03 through Section 3.08 identify which groups of taxpayers are covered by this procedure.  Section 5 provides detailed requirements for recordkeeping systems that address retrievable, access, documentation, retention, verification, and the rest of the Functional Requirements for Evidence in Recordkeeping identified by the University of Pittsburgh NHPRC project.
	The first issue the accountants are faced with is who must comply with Revenue Procedure 91-59.  The initial reaction was that Revenue Procedure 91-59 only applied to taxpayers with assets in excess of $10 million or to taxpayers with assets less than $10 million if (1) their books and records were only available in machine-sensible formats, or (2) machine-sensible records were used for complex tax related computations, or (3) the IRS had notified the taxpayers that their machine-sensible records must be retained.  (Tallyen, 1992).  This viewpoint has undergone continuous evolution as the use of the computer and EDI have spread.  Today the general viewpoint is that Revenue Procedure 91-59 applies to everyone who uses a computer in business.  If you are using a computer to store and/or manipulate any tax related records, then this regulation applies to you.  (Nelson, 1996; Crangle, 1997)
	In short, the current position of the accounting profession is that everyone who uses a computer or related EDI equipment must comply with Revenue Procedure 91-59.  No longer can the accountants rely on the mainframe staff to provide them with 91-59 compliant electronic records.  Everyone within a business enterprise who deals with tax related records or information, no matter how marginal, must bring their recordkeeping systems into compliance with the appropriate Internal Revenue Regulations and Procedures.  Besides the traditional areas like the Finance or Bookkeeping Departments which handle accounts payable, accounts receivable, and payroll, related areas like the Warehouse Department which handles inventory will now have to upgrade their systems to comply.  This means that larger numbers of people in the business organization are going to be responsible for tax related records, and the accountants are going to be responsible for ensuring their compliance with the IRS mandates.
	What this means for organizations during this period of decentralizing business functions and moving away from mainframe based computing operations towards networked desktop client server environments is that the responsibility for complying with the IRS Code is going to be scattered throughout the organization, from the penthouse suite to the shop floor.  Management, accountants, ARM and IS/IT will have to provide close supervision and training to ensure that the tax laws are complied with or else face increasing amounts of risk and legal exposure.
	There third functional requirement of the twenty Functional Requirements for Evidence in Recordkeeping identified is that the organization be responsible: documented.  “Recordkeeping systems must have accurately documented policies, assigned responsibilities, and formal methodologies for their management.” (School of Information Sciences, 1996)
	Internal Revenue Procedure 91-59 mandates that you provide documentation about your ADP recordkeeping system and the records themselves. (Nelson, 1996)  Section 5.02 requires “documentation that provides a complete description of the ADP portion of the accounting system, including all subsystems and files that feed into the accounting system ... sufficiently detailed to indicate:  (1) the application being performed; (2) the procedures employed ...; (3) the controls used to ensure accurate and reliable processing; and (4) the controls used to prevent the unauthorized addition, alteration, or deletion of retained records.”  (CCH, 1996:  ¦ 36,411.52)
	Section 5.03 requires “the following specific documentation for all retained files ...:  (1) record formats ...; (2) flowcharts ...; (3) label descriptions; (4) source program listings ...; (5) detailed charts of accounts ... (6) evidence that periodic checks ... performed; and (7) evidence that the retained records reconcile to the books and the tax return.” (CCH, 1996:  ¦ 36,411.52)
	Tallyen (1992) interprets these sections to include “all subsystems and files that feed into the system ... punched cards, magnetic tapes, disks and other machine-sensible data used for recording , consolidating and summarizing accounting transactions and records within a taxpayer’s ADP system.”  What the IRS is requiring is nothing less than complete documentation of how the ADP portion of your accounting system is designed and what applications, procedures, and controls are in place.  (Nelson, 1996; Crangle, 1997)  Sellner (1993) produced a checklist that accountants could used as an aid in their audit of ADP systems to insure their compliance with Revenue Procedure 91-59.  This checklist does not provide any real guidance to what types of metadata should be collected to satisfy the requirements. This aside, it does provide a good entry for ARM staff to begin discussing the types of metadata that need to be captured to meet these IRS requirements.
	Section 5.04 is the section that is putting most business at risk in this new environment of decentralized business activities.  It states “any change to the ADP system which affects the accounting system and/or subsystems, together with their effective dates, shall be documented in order to preserve an accurate chronological records.  This documentation shall include any changes to software or systems and any changes to the formats of files.”
	Crangle (1997) mentions the problems associated with conversion from one operating system to another (specifically DOS to Windows).  Not only must the taxpayer provide complete documentation of both systems, but also he/she must also document how the conversion was made.  He goes on to state that “businesses replacing a system with a new one that is incompatible are required to convert preexisting records to a format compatible with the new system.”  Nelson (1996) is not sure that  you must convert all your old records to the new format or just document the system changes.  Section 5.11 states “... system that created the records is being replaced by a system with which the records would be incompatible, the taxpayer shall convert pre-existing records to a format that is compatible with the new system.”  (CCH, 1996: 36,411.52)  Despite this difference in their interpretation of Internal Revenue Procedure 91-59 Section 5.11, both are in agreement that resurrecting old systems is very difficult if not impossible.
	Also what is not in question is the taxpayer’s responsibility to be able to produce and process tax related records upon request.  In reference to Section 5.12, Crangle (1997) states “if at the time of an examination, a taxpayer fails to provide the Service [IRS] with the computer resources ... necessary for processing the records, this may be viewed as a failure to maintain books and records under Sec. 6001.”  Nelson (1996), in almost identical words, emphasizes this same point.
	What is not in doubt is the penalties that can be levied by the IRS for failure to produce adequate records.  At the minimum, under Internal Revenue Code Section 6662, you will be assessed an ‘accuracy penalty’ of 20 percent of the tax due.  (Nelson, 1996)  From a risk management approach to business decisions, and especially recordkeeping decisions, the risks associated with failure to meet the IRS requirements can be very costly.  If you are unable to produce the requested records, because of incompatible format and/or failure to maintain the electronic records, the IRS can deny your tax claims and charge you with additional taxes plus penalties in addition to the 20% accuracy penalty.
	The accounting profession is waking up to the nightmare of attempting to cross the yawning abyss of IRS requirements on a bridge of records constructed independent of a functionally compliant recordkeeping system.  The tenor of the examined articles from the accounting literature indicates that this profession is worried about electronic recordkeeping and the associated risks of not having compliant systems.  They are also upset about the relaxing of centralized control of the computer functions, because it makes their jobs more difficult.
	The theoretical framework supporting the Functional Requirements for Evidence in Recordkeeping should provide a strong framework that will enable the ARM community to join forces with the accounting profession in seeking robust and compliant recordkeeping systems.  If these two groups can find agreement with and use the functional requirements in conjunction with the IRS mandates to buttress their case with the IS/IT staff, they can develop a working recordkeeping system that supports the tax reporting requirements.  This effort should provide an exemplar system that can then be extended to cover other recordkeeping areas.

BIBLIOGRAPHY

Alberto, Patricia L., Goletz, Joyce A., & Byrne, John J.  (1987)  “Bank Records:  A management and legal primer (Part 1) / Records retention: Legal considerations (Part 2).”  ABA Bank Compliance.  8(7).  p 16-23.  Oct 1987.  ISSN 0276-4253.

Bearman, David (1994a)  “Appendix:  Functional requirements for recordkeeping systems.”  Electronic Evidence:  Strategies for Managing Records in Contemporary Organizations.  Pittsburgh:  Archives & Museum Informatics.  1994.  ISBN: 1-885626-08-8.

Bearman, David  (1994b).  Electronic Recordkeeping Issues November 17-18, 1994.  Archives & Museum Informatics Professional Seminars.  Sheraton Century Center Hotel.  Atlanta, GA.  November 17-18, 1994.

Berman, Howard J.; Stein, Ronald A.; & Gotliboski, Thomas J. (1996)  “Use of imaging systems for retention of books and records”.  The Tax Adviser.  27(11) Nov 1996.  p 672(1).  ISSN:  0039-9957.

CCH, Incorporate  (1996).  Standard Federal Tax Reports in Twenty-Two Volumes.  84th Edition.  ‘97 Volume 12 -- Code ¤ 1501-6030.  Chicago, IL:  CCH Incorporated.  1996.

Crangle, Jan Steensen. (1997).  “Record retention rules of the electronic highway”.  The Tax Adviser.  Jan 1997.  28 (1). p 43(2).  ISSN:  0039-9957.

Nelson, Bruce  (1996).  “Set in stone?”  Controller Magazine.  Premiere Issue.  URL:  http://www.duke.com/controller/issues/premiere/SetInStone.htm.

School of Information Sciences, University of Pittsburgh (1996).  “Functional Requirements for Evidence in Recordkeeping”  URL:  http://www.lis.pitt.edu/~nhprc/prog1.html.  Last modified 9/18/96.

Sellner, Mark A.  (1993).  “Record retention under rev. proc. 91-59: a checklist approach.  Tax Executive.   45(3).  May-June 1993.  p. 217-221.  ISSN:  0040-0025.

Skupsky, Donald S. (1988).  “Legal requirements for computer records containing Federal tax information;  An update.”  ARMA Records Management Quarterly.  22(3). Jul 1988. p. 32-35.  ISSN: 0034-172X.

Tallyen, Jeffrey J.  (1992).  “IRS record retention rules and the computer age.”  The Tax Adviser.  23(7).  July 1992. p. 441(2).  ISSN:  0039-9957.

Tax Executives Institute  (1993)  “Revision of IRS record retention procedures”.  Tax Executive.  45(4). July-August 1993.  p. 325-334.  ISSN:  0040-0025.

Williamson, A. Louise (1997).  “The implications of electronic evidence.”  Journal of Accountancy.  183(2).  February 1997.  p. 69-71.  ISSN:  0021-8448.

Wright, Benjamin (1996).  “EDI Implementation”.  In Ruh, Joseph F., Jr. (Editor).  The Internet and Business:  A Lawyer’s Guide to the Emerging Legal Issues.  The Computer Law Association, Inc.  1966.  ISBN:  1-885169-05-1.  URL:  http://cla.org/RuhBook/chp7.htm