How do I reconstruct the books and prepare financial statements when the underlying records are incomplete?

What must you map before rebuilding anything?

Reconstruction is expensive and directional, so its first product is a gap register, not a ledger. For each period and account area, record what exists, what is missing, how the absence arose, which surviving evidence can fill it and the approach you will take. Leave alone any area the register shows to be complete. If records exist but are disordered rather than missing, the job is a catch-up, which is a separate question. Work in the order the deliverable needs: a lender's balance sheet needs balances first, an insurance claim needs inventory and property, and a return needs income and deductible expenses. The deliverable decides which areas you rebuild first and how far; within those areas, keep the dependency order set out below.

This register is for a retailer whose laptop failed during Year 2, after the bookkeeper who kept Year 1 had left:

When records were lost to a device failure, fire, theft or a closed account, request third-party duplicates before rebuilding. The IRS's page on reconstructing records after a natural disaster or casualty loss points to bank statements for income, supplier invoice copies for lost inventory, and Form 4506 for copies of past returns. Some windows are short: the IRS page on transcript types for individuals says a tax return transcript is available for the current and three prior tax years, and a wage and income transcript, showing data from information returns such as Forms 1099, for the current and nine prior tax years. The same page says this transcript shows only information returns filed with the IRS, which may not be all those issued to you, and is limited to approximately 85 income documents. These windows are for individuals; a business that files its own return should use the IRS's separate business tax transcript route, linked from the same page, and ask what it can obtain. Ask each bank and supplier how far back it can reproduce records; recovering evidence after a bulk loss is a separate question. A supplier's copy invoice is evidence for the books, not an instruction to pay, and any copy showing new or different payment details needs verifying before anything is paid, as a separate question.

Which surviving evidence can rebuild what?

The PCAOB's audit-evidence standard for auditors, AS 1105, says that, in general, evidence from a knowledgeable source independent of the company is more reliable than evidence obtained only from internal company sources, so build from third-party records and use internal remnants to explain them. The same paragraph ranks original documents above copies and digitized versions, so the evidence index should record whether each item is an original or a copy.

The IRS's disaster-reconstruction page says bank deposits should closely reflect what sales were for a given period, and that last year's federal, state and local tax returns, including sales tax reports, payroll tax returns and business licenses, reflect gross sales. Neither makes the bank account a complete record of results.

Which reconstruction technique fits each gap?

The Internal Revenue Manual's chapter on examination of income (IRM 4.10.4) describes formal indirect methods as audit techniques for determining tax liability based on unreported income, relying on indirect evidence of income. It treats them as appropriate when a taxpayer's books and records are missing, incomplete or show irregularities, or when a financial status analysis shows a material imbalance of cash flows after other adjustments. The IRM notes they require in-depth analysis of actual costs and extensive detailed information, one reason to involve a professional when an indirect method carries a large share of the result. Three of the methods it lists suit a business rebuilding its own books, each under IRM conditions:

• Bank deposits and cash expenditures. Receipts are deposits, less nontaxable items such as loans and transfers, plus funds spent before deposit. The IRM recommends it where most expenses are paid by check or card, not for cash-intensive businesses leaving significant takings unbanked.
• Markup. Receipts are cost of sales at the business's actual markup where known, which the IRM requires. The IRM recommends it where inventories are a principal income-producing factor, or where purchases come from a limited number of identifiable sources and prices are reasonably consistent.
• Net worth. Income is the increase in net worth, adjusted for nondeductible spending and nontaxable funds such as the owner's money in and out. The IRM says it requires a complete reconstruction of financial history, accounting for all assets and liabilities.

Choose the method whose IRM conditions fit your business and whose every input your evidence supports; as your own check, run a second method with different inputs. What survives sets the starting point:

How do you set the opening position when the prior period is missing too?

The Internal Revenue Manual's methods-of-proof chapter (IRM 9.5.9) calls establishing a reliable beginning net worth, including all of the assets and liabilities on hand, the key to a successful net worth investigation. FASB's Concepts Statement No. 8, Chapter 4, defines equity as the residual interest in an entity's assets that remains after deducting its liabilities. So opening equity is never estimated directly; it is what remains once each asset and liability is supported. Set it in this order:

1. Pick a start date for which bank, card and lender statements show balances.
2. List every asset and liability at that date with its outside support, such as bank, card, lender and supplier statements, customers' records, counted cash, inventory from a count at that date or the closing inventory on the prior return, and purchase records or the prior return for equipment.
3. Mark any line without outside support as an estimate and enter it on the estimates schedule.
4. Take opening equity as the balancing figure and check the arithmetic.

Name the accounting basis on the schedule and use the one the business's books and returns already use. IRS Publication 538 says that under the cash method you include income you actually or constructively received during the tax year and generally deduct expenses in the tax year you actually pay them; under an accrual method, income is generally included in the tax year the all events test is met. Publication 538 also says that, generally, if you produce, purchase or sell merchandise, you must keep an inventory and use an accrual method for those sales and purchases, with exceptions set out separately. If yours sells merchandise on the cash basis, keep that basis for the reconstruction and have a qualified professional confirm it qualifies; the same publication says changing an accounting method generally needs IRS approval. On the accrual basis, unpaid customer invoices and unpaid bills at the start date are posted:

Collecting the 3,200.00, income of the earlier period, clears the receivable and is not income again; paying the 2,600.00 clears the payable and is not an expense again. On the cash basis, the same two items are listed on a memo schedule but not posted:

They become income and expense when collected and paid. Posting them into opening equity on the cash basis would mean that collection and payment never reach income or expenses. On either basis each item reaches the results once; the equity figures differ by 600.00, the receivable less the payable.

In what order should account areas be rebuilt?

Several figures can only be derived once others are settled, so work in this order:

1. Rebuild cash and bank from the statements.
2. Rebuild loans, cards, transfers and owner transactions from lenders', issuers' and the owner's own statements, to identify money that is neither income nor expense.
3. Rebuild purchases and expenses from supplier and card statements, marking any paid from takings before banking.
4. Derive sales from the deposits that remain, less any sales tax collected, plus takings spent before banking identified in the previous step; on the accrual basis, finish sales only after receivables at the closing cut-off are set.
5. Derive inventory and cost of goods sold, which need purchases and counts.
6. Set receivables, payables and accruals at each cut-off, on the accrual basis only.
7. Rebuild fixed assets and depreciation, then prepare the trial balance.

Deriving sales before step 2 overstates them by every loan, transfer and owner deposit still in the total.

What does deriving one account area look like?

A cash-basis retailer has lost its Year 2 till records, so sales are derived by the bank deposits method from the surviving evidence:

FASB's Chapter 4 says comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners, which is why the owner's 5,000.00 comes out; the loan is a liability and the transfer is the business's own money. Sales tax collected comes out too: the business owes it to the taxing authority, and FASB's Chapter 4 defines a liability as a present obligation of an entity to transfer an economic benefit; how it is treated on a return is for a qualified professional. Where a card processor deposits sales net of its fees, add the fees back from its statements.

The assumption recorded with the figure: all takings were banked except cash paid to suppliers against receipts, as the owner's signed and dated note states.

Corroboration uses the markup method, whose inputs are independent of the deposits. Opening inventory of 9,000.00 from the Year 1 return, plus purchases of 119,000.00 from supplier copies, less closing inventory of 11,500.00 from the count sheet, gives cost of goods sold of 116,500.00. At the owner's stated 60% markup on cost, checked against a sample of supplier invoices and shelf prices, expected sales are 186,400.00. The methods differ by 1,600.00, under 1%; the difference and its likely causes go on the workpaper, and any remainder they cannot explain is listed on the estimates schedule and disclosed. The 1% here is illustrative, not a pass mark: the test is whether the difference is explained, not how small it is. On the accrual basis, the derivation would also remove what customers owed at the start of the year and add what they owed at the end.

When is the reconstructed ledger reliable enough to derive statements from?

Run these tests before deriving any statement:

• Cash ties. Each account's reconstructed balance agrees with the bank statement at every month-end.
• Outside balances tie. Loan, card and supplier balances agree with the lender's, issuer's and suppliers' statements at each period end.
• Reported figures reconcile. Income agrees with, or is reconciled to, sales tax reports, payroll reports and information returns for the period.
• An independent method agrees. The difference between the two methods is explained by identified items, and any unexplained remainder is listed on the estimates schedule and disclosed.
• The books balance and roll forward. Debits equal credits, and closing equity equals opening equity plus the result plus owner contributions less owner withdrawals.
• Every untied figure is listed. Anything no test supports is on the estimates schedule.

The PCAOB's AS 1105 tells auditors that when evidence from one source is inconsistent with another, or its reliability is in doubt, they should perform the procedures necessary to resolve the matter and determine its effect on other aspects of the audit; treat a failed test the same way. The ledger is reliable enough when every test passes or each difference is explained and documented, and a knowledgeable person not involved could follow each figure from its evidence to the same result. FASB's Concepts Statement No. 8, Chapter 3, describes verifiability as different knowledgeable and independent observers reaching consensus, although not necessarily complete agreement, that a depiction is faithful; the same-result test above is stricter, a working rule for re-performing a figure from its recorded inputs.

Preparing the statements from the tested trial balance follows the ordinary preparation steps, which are a separate question; what changes for reconstructed books is the title and the note below.

What do you do with an amount no evidence supports?

Each unsupported amount takes one of three paths, and the choice is recorded:

FASB's Chapter 3 says an estimate can be faithfully represented if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing it. It adds, using an impairment estimate as its example, that an estimate whose uncertainty is sufficiently large will not be particularly useful but, if there is no more faithful alternative, may provide the best available information; so a highly uncertain amount can still be estimated, with its uncertainty explained, and omission is for items no estimate can be made for at all. It also says a complete depiction includes all information necessary for a user to understand it, including necessary descriptions and explanations, so no omission is silent.

What must you document and keep?

Keep a reconstruction file that lets someone else re-perform the work, with these contents:

• The gap register, with the cause of each gap
• An evidence index showing each document, whether it is an original or a copy, who supplied it and when, and every request still outstanding
• The opening position schedule and its support
• A derivation workpaper for each account area, like the one above
• An estimates schedule giving each estimate's account, period, amount, method, inputs, assumption, author and date, with the corroboration applied and its result
• The tie-outs from the reliability tests and the final trial balance

Do not discard the file once the statements exist; without it the figures are unsupportable the moment they are challenged. IRS Publication 583 says you must keep your records as long as they may be needed for the administration of any provision of the Internal Revenue Code, and this file is the record behind the reconstructed figures. It adds that this generally means keeping records that support an item of income or deduction on a return until the period of limitations for that return runs out. Confirm the periods for returns the reconstruction touches with a qualified professional.

What must the statements disclose, and how are they labelled?

Statements from reconstructed books must not pass as statements from a complete record base. The note below carries the descriptions and explanations that FASB's Chapter 3, as set out above, ties to a faithful estimate and a complete depiction. Title each statement as reconstructed from incomplete records; this title is a recommendation for statements you prepare yourself, and a recipient's own requirements, or an engaged accountant's no-assurance statement, apply in addition. Add a note covering these points:

• The periods and account areas reconstructed, and why records were incomplete
• The evidence and method used for each area
• The opening position and its support
• Each significant estimate, with its amount and basis
• Items omitted and items awaiting evidence
• The accounting basis

Under a lender's, insurer's or authority's deadline, state in the note which areas are complete, estimated or pending, and when further evidence is expected. What that recipient accepts is set by its own requirements or your agreement with it, so obtain them in writing before submitting.

If an accountant in public practice is engaged to prepare the statements, the AICPA's preparation standard, AR-C section 70, says the accountant should ensure each page carries a statement indicating, at a minimum, that no assurance is provided; if that cannot be done, the accountant should issue a disclaimer, perform a compilation engagement or withdraw. It does not require the accountant to verify the accuracy or completeness of the information management provides, so a prepared set does not validate the reconstruction; reviewing or auditing the statements is a separate question.

When must the work pass to a qualified professional?

Bring in a CPA or other qualified professional when any of these applies:

• The reconstructed figures differ from anything already filed or given to a lender, insurer or authority.
• The opening position cannot be supported from outside evidence.
• A reliability test fails and the difference cannot be explained.
• Estimates or omissions are large relative to what the user will rely on.
• The gap suggests records were withheld or removed.
• The result is for an authority, a lender's covenant test or an insurance claim.

An accountant engaged to prepare statements meets the same limit. AR-C section 70 says that if the records or other information used are incomplete, inaccurate, or otherwise unsatisfactory, the accountant should bring that to the attention of management and request additional or corrected information; if management fails to provide it, the accountant should disclose the material misstatement or withdraw from the engagement and inform management of the reasons.

What must you settle separately before relying on the result?

When the incomplete periods were already reported, finish the reconstruction but settle its consequences with a qualified professional before relying on it:

• Returns already filed. IRS Publication 538 says that if you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect income.
• How the IRS may test the figures. IRM 4.10.4 makes examiners' formal indirect methods, the same techniques used to rebuild, subject to IRC 7602(e), which bars using them to determine unreported income without a reasonable indication that such income is likely.
• Deductions resting on payment records. Under Publication 583, proof of payment alone does not establish a deduction, so some expenses the books carry may not be supportable on a return.
• Other reports. Sales tax and payroll reports already filed may disagree with the reconstruction.
• Statements already given out. What follows with a lender, insurer, franchisor or grantor depends on the agreement with each; correcting an error in a reported period is a separate question.

Settle these before you file, amend or send anything about the reconstructed periods.