Audited Financial Statements Don't Match the Income Tax Return and the BIR Has Sent a Letter: What to Do

Identify the letter: an inquiry, a discrepancy notice or an audit authority carry very different weight

A BIR letter asking you to "explain a discrepancy" can be one of at least three different things, and the way you respond and what is at stake differ sharply. Classify it on the day it arrives.

The first type is a general inquiry or discrepancy notice. The BIR's systems cross-match your filed AFS against your income tax, VAT and withholding returns, and when the numbers do not agree, a letter asks you to explain. These letters typically carry no Letter of Authority and are not a formal audit; the purpose is to obtain an explanation or a correction. A clear reply often ends the matter; silence or a vague answer invites escalation.

The second type is a formal audit under a Letter of Authority (LOA). The letter names the taxable year and tax types under audit and assigns revenue officers. Here the discrepancy explanation is one part of a larger process. How to verify the LOA, how the audit proceeds and how to respond to later assessment notices are covered in the BIR tax audit process explained. The reconciliation method in this article still applies, but you should proceed under the audit procedure with a lawyer or CPA alongside.

The third type is a notice about a specific activity, such as a sales discrepancy letter following surveillance. It sits between the first two, and the response is covered in replying to a BIR notice after surveillance.

To classify, look at the letterhead and signatory, whether an LOA number is cited, whether officers are assigned, what you are asked to do (explain, submit documents, appear, or pay) and the reply deadline. The deadline is whatever date the letter states; this article gives no number of days. If anything is unclear, verify directly with the issuing office through the contact details on the letter, and at the same time verify that the letter is genuine: letters purporting to come from the tax authority and demanding money do exist. Anything that asks you to pay into a personal account or to meet privately to "settle" should stop you until you have verified it, see someone claiming to be a tax or city inspector wants money.

One last thing: record the date of receipt, who received it and how it was delivered, and keep the envelope or the electronic message. When the clock started can become contentious later.

Building the reconciliation: from each line of the AFS to each box of the return

The reconciliation schedule is the heart of the reply. It must start from each relevant figure in the audited statements, pass through a series of supported adjustments, and arrive at the figure on the return, with a document behind every step. Without this schedule, no explanatory letter will hold.

Work in sequence. Step one, fix the basis of comparison. Find the figures the BIR letter cites and determine what is being compared with what: AFS revenue against gross income on the ITR, AFS revenue against the sum of four quarters of VAT sales, or AFS expenses against total payments on the withholding returns. Each comparison has its own set of legitimate differences and they must not be mixed.

Step two, state the AFS starting figure, citing the page and line of the audited report and attaching the relevant note where needed.

Step three, list the reconciling items one by one. Each item needs four things: what it is, its direction (add or deduct), why it arises, and the supporting document. Typical items include revenue recognised for accounting purposes but excluded or deferred for tax; items included for tax but not recognised in the accounts; timing differences where VAT returns follow collection or invoicing while the accounts follow accrual; the classification of zero-rated or exempt sales on the VAT returns; other income such as foreign exchange gains or interest sitting in a different place on the return; and expenses classified by nature in the accounts but by tax category on the return.

Step four, tie the adjusted figure to the return. Whatever remains is the "unexplained difference". List it separately and label it honestly; never force it to zero.

Step five, have a CPA review the schedule, ideally the auditor who signed the report or your tax accountant, because they hold the working papers.

Format the schedule so that a revenue officer can follow it: one summary page plus a detail page for each reconciling item, with every document numbered to the item it supports. This tie-out should have been done during the annual close, but many companies do it for the first time only when the BIR writes. If your audited report itself carries a problematic opinion, see also what to do after a disclaimer or adverse audit opinion.

Sort the differences into three classes: legitimate, presentational and filing errors, each with its own path

Once the schedule exists, every difference must be placed in one of three classes: a legitimate difference that arises because accounting and tax rules genuinely diverge, a presentational difference where the same fact is classified differently in the two documents, or a genuine filing error. The three are handled differently, and mixing them turns a simple matter into a complicated one.

Class one: legitimate differences. Accounting standards recognise income and expenses on an accrual basis, while tax rules have their own recognition timing and their own limits on deductibility. Typical examples: provisions accrued in the accounts that are not deductible for tax; income recognised in the accounts but taxed at a different point; depreciation methods and useful lives that differ between the two frameworks; income already subjected to final withholding tax that is excluded from taxable income on the return. These are normal, and a tax-to-book reconciliation should exist between the AFS and the return in any case; many income tax returns already carry a schedule for it. Treatment: list them in the reply with the CPA's reconciliation note. No amended return is needed.

Class two: presentational differences. The transaction appears in both documents but in a different place or at a different level of aggregation. The accounts show an item as other income while the return includes it in gross revenue; the accounts are annual while VAT is quarterly and a period straddles the year end; branches are consolidated in the accounts but reported separately. These need only a clear explanation, unless the review reveals that the return's classification was actually wrong under tax rules, for example taxable sales classified as exempt, in which case the item moves to class three.

Class three: filing errors. The difference exists because the return omitted, misstated or under-reported something, or because an item in the accounts was never reported at all. This class cannot be explained away; it requires an amended return under the proper procedure and an assessment of the resulting tax and surcharges, under the BIR's current rules. When an amended return is possible and when it is not is covered in filing an amended return with the BIR. Be aware that once a formal audit has started, the room to amend narrows, so have a CPA confirm your position as soon as the letter arrives.

There is also a common but awkward situation: the difference originates in the accounts, not the return. For example, the AFS carries a shareholder advance or a related-party transaction whose tax treatment was never addressed, and the BIR's matching has surfaced it. The issue then is the tax character of the transaction itself rather than the return, see owner took company money booked as shareholder advances and the auditor or BIR flagged it.

With the classification done you hold a clear list: items that only need explaining, items that need amending, items that need payment. That list is the basis for your discussion with the CPA and the lawyer, and the skeleton of the reply letter.

Writing the reply: structure, attachments, who signs and how to deliver it

The reply to the BIR has one purpose: to let the reader confirm in the shortest possible time that every difference has an explanation and that whatever needed correcting is being corrected. The tone is restrained, the structure clear, with no argument and no blame, and every conclusion points to an attachment.

A workable structure. Opening: cite the letter's reference, date and issuing office and state that this is the reply. Part one, overview: the figures the BIR cited, the company's conclusion that the difference consists of the following classes, and the totals per class. Part two, item-by-item explanation: following the numbering of the reconciliation schedule, one paragraph per item stating what it is, why it arises, which class it falls into and the supporting document reference. For legitimate and presentational differences, state that no tax was under-reported; for filing errors, state that an amended return was filed on a given date or is being prepared. Part three, unexplained balance (if any): state the magnitude honestly and the direction of ongoing verification, and commit to a supplementary explanation within a reasonable time. Do not invent explanations to appear complete. Part four, list of attachments: the reconciliation schedule, the supporting documents, acknowledgements of any amended returns, and the CPA's note. Closing: a company contact and an expression of willingness to cooperate with further verification.

The signatory should be an authorised representative, normally the president or an authorised finance officer; if a CPA or lawyer replies on the company's behalf, attach the authorisation. Delivery follows the letter's instructions, usually filing with the issuing office against a receiving copy, or keeping the system acknowledgement for electronic submission. Either way, keep a complete copy with all attachments on file; it is the record for any later dispute.

A few details. First, do not write that the auditor or a former accountant "got it wrong"; responsibility is an internal matter, irrelevant to the tax authority, and it reads as deflection. Second, do not volunteer material the letter did not ask for and that is unrelated to the differences; more is not safer. Third, every figure in the letter must match the attachments; a single inconsistency undermines the whole. Fourth, if the deadline genuinely cannot be met, apply in writing for an extension before it expires, with reasons; whether to grant it is the BIR's decision, but asking is far better than lapsing.

If the letter was issued within a formal audit, the reply must be consistent with the other documents in that process and should be reviewed by the accompanying CPA or lawyer.

What not to do: ignore it, let it lapse, alter the AFS to fit the return, or settle privately

What turns a matter that one reconciliation schedule could close into a formal audit or an assessment is usually not the difference itself but one of the following moves.

First, ignoring the letter or letting the deadline pass. Many owners read "please explain" and set it aside. Once the deadline passes, the authority's next step is often a formal procedure, and the chance to resolve the matter with an explanation shrinks considerably. The deadline is whatever the letter says; put it in the calendar on the day it arrives.

Second, altering the AFS to match the return. The audited statements were signed by a CPA under the standards and filed with the SEC. Changing them to fit a tax figure would require the auditor to stand behind an untrue report, which the auditor will not do and the company cannot do unilaterally. The direction is always the same: the AFS is the audited fact; if the return is wrong, amend the return; if the AFS is wrong, the auditor deals with it under the standards.

Third, dismissing every difference as "different bases". Book-tax differences are real, but the BIR wants them itemised and documented. A reply that says only "the differences arise from accounting versus tax treatment" with no schedule is close to no reply at all.

Fourth, paying first to make it go away. Some companies treat the entire difference as unreported income and pay tax on it to buy peace. That may mean paying tax that was never due, it amounts to a written admission of a misstatement that did not exist, and it colours later years. Whether and how much to pay must follow the classified schedule and the CPA's advice.

Fifth, settling privately. Anyone, whatever their claimed position, who asks you to pay an individual, bypass the formal reply, or offers to "have the letter withdrawn" should not be trusted. The lawful route is a written reply with a receiving copy, nothing else. The consequence of a private arrangement is not a penalty but a different category of legal exposure.

Sixth, letting someone without the working papers reply. Explaining the differences requires the audit and tax working papers. A new accountant or an agent drafting a letter without them will readily produce explanations that do not match the facts and are harder to correct later.

Finally: if the company also has missing returns or a stop-filer history, the discrepancy letter may be only the beginning. Check the open cases first, see clearing BIR open cases and stop-filer records.

Making the AFS and the returns agree by design, and how Yixing can help

The lasting fix is to make the book-tax reconciliation a standard output of the annual close, prepared before the AFS is finalised and the ITR filed, rather than after the BIR runs its matching. Companies that do this answer a discrepancy letter by attaching a schedule that already exists.

Four concrete arrangements. First, prepare the reconciliation during the close. The auditor who finalises the statements and the tax accountant who files the ITR should sit together before filing and tie the two out; the schedule is kept as a working paper to the return. Second, reconcile VAT returns to book revenue every quarter. After each quarterly return, compare cumulative VAT sales with book revenue and record the reasons for timing differences in the same quarter; by year end there is no large unexplained gap. Third, reconcile withholding returns to the expense ledger monthly. Payment-type expenses in the accounts and total payments on the withholding returns are a pair the BIR routinely matches. Fourth, characterise unusual transactions in the period they occur. Related-party dealings, shareholder advances, asset disposals and foreign exchange results should have their accounting and tax treatment settled, with contracts and vouchers filed, when they happen, not at year end. How these checks fit the filing calendar is covered in the Philippine corporate tax filing calendar.

Yixing (SEC registration CS202009551, Bureau of Immigration accredited agent CA-202624381-1, with DOLE and PRA accreditation) provides compliance retainer services to Chinese-owned companies in the Philippines: identifying the nature and deadline of a BIR letter, assembling the AFS-to-return reconciliation and document index, coordinating licensed CPAs and lawyers to draft the reply and decide whether an amended return is needed, and building the annual book-tax reconciliation into the retainer routine. We are a private consultancy with no affiliation to the BIR; we promise no particular outcome and do not replace professional accounting or legal advice. The rules on deficiency tax, surcharges and amended returns are those currently in force at the BIR. For your specific case consult a licensed lawyer or CPA; this article is not legal or tax advice.