Restaurant Audit Assumptions

When the auditor arrives to audit your bar or restaurant, he or she will review your internal controls to ensure the accuracy and completeness of your recorded sales and the taxes thereon.  If the documentation is not available to determine that appropriate controls were effective throughout the audit period, the auditor will conclude that the controls were lacking and that the books and records may not be relied upon to support the sales taxes collected by the restaurant.  Most independent restaurants will fall into this category.  As a result, the auditor will proceed to apply an indirect audit approach to estimating the amount of sales that were likely to have been generated, based on your purchases of alcoholic beverages.  Several key assumptions are used in this method, which I will describe in the remainder of this post.

Keep in mind that the auditor is attempting to estimate your “true” sales based on certain facts, such as the amount and volume of alcohol purchased, and a variety of average assumptions, such as portion sizes, drink prices, sales mix, spoilage, theft, personal use, complimentary drinks, etc…  Every time one of these average assumptions differs from your restaurant’s actual situation, there is a potential for the auditor finding “unreported sales”.  Consequently, it is extremely important that the auditor’s assumption conform as closely as possible to the true state of affairs that took place during the period under audit.  Please note that I will examine these assumptions in much greater detail in future posts.

Sales Mix

During the initial interview, the auditor will ask you for a breakdown of your alcoholic beverage sales by category.  Typical categories might be:  bar shots, cocktails, martinis, draft beer, domestic bottled beer, imported beer, domestic wine and imported wine.  Few restaurateurs are able to provide detailed, accurate breakdowns of sales by category over a four year period.  Furthermore, the sales mix will likely have changed over the course of the audit period.

Most POS systems will provide reports to show the sales mix for a particular period of time, but the report will only be accurate if each menu item is set up properly in the appropriate category.  The restaurateur should review all POS menu items (and any new ones) to ensure that they are summarized in the proper category.  Detailed sales mix reports should be prepared for every fiscal year of the restaurant’s operation.  Without this information, the auditor may be forced to conclude that the sales mix matches the volume of alcohol purchased for each category.  This may lead to an inaccurate sales mix determination.

Average Sales Prices

In order to calculate an average sales markup for each category, the auditor must have an average sales price for the category for each year.  If the restaurateur is able to provide very accurate average prices for each category, the auditor will be forced to use these figures.  Otherwise, the auditor will attempt to estimate the average price, based on menus that were in effect during the year.  In the absence of more detailed, supportable, information from the restaurateur, the auditor may have to take an average of menu prices during the year.  Depending on when price changes came into effect, the average prices may not be accurate, leading to a distortion in the average markups that will be used by the auditor.

As a result, each restaurant and bar should maintain a detailed record of every price change for all alcoholic beverages, including the price change dates.  Combined with the sales mix information, this price data can be used to calculate a weighted average category price for each category, which will be substantially more accurate than the auditor’s simple average.

Portion Size

The auditor will ask you for the portion size of all alcoholic beverages and this information will be matched to drink sizes noted on menus.  The auditor will also enquire as to the existence of any alcohol dispensing systems that may have been used to help ensure proper control over the standard drink size.  The agreed upon portion size will be used to determine the cost of a serving for an average drink in each category.  Most categories will have a large number of drinks sold during a typical year.  Consequently, a small change in the average portion size will have a large impact on the total estimated sales for that category.

Each category of drink has a variety of factors that affect the portion size.  Draft beer with too little head will result in a substantial over-pour.  Multiplied by a large number of draft orders, it will appear to the auditor that there is a substantial amount of unreported sales of draft beer, when this happens.  Similarly, free-pouring of alcohol for shots and martinis can result in substantial overpouring of liquor.  Keep in mind that a 1/2 ounce overpour on a 1 oz drink represents a 50% overpour.  On a 1-1/2 ounce shot, the overpour is 33%.  Most auditors will attempt to use a much smaller overpouring percentage, often as low as 10%.  This will result in the finding of a significant amount of unreported sales of liquor.  Portion sizes for bottles of wine are obvious, but serious overpouring of wines sold by-the-glass can occur.  Average portion sizes must be determined and monitored by the restaurateur on an ongoing basis.  Documentation of this monitoring can be provided to the auditor, if necessary, to document known portion control issues.

Shrinkage

All auditors know that restaurants and bars experience some theft of their inventory, especially alcohol.  Where restaurateurs and the auditors differ, however, is in the amount of theft.  The auditor will attempt to provide a minimum allowance for theft, “based on average theft levels for similar establishments”.  Any attempt by the restaurateur to increase this  allowance will be challenged.  You will be asked for police reports to show that you reported the theft to the police.  In my experience, unless an employee was caught “red handed” in the act of stealing (and even rarely then), the police are never called in.  Most restaurants don’t want the negative image of a police cruiser in front of their establishment, so they will not report the theft.  The auditor, however, takes this to mean that it didn’t happen in the first place.  Most restaurants simply experience a loss of inventory without actually finding the thief.

As a result, it is extremely important that the restaurant document it’s findings of theft, based on regular inventory counts and POS usage reports.  Most POS systems allow you to create recipes for menu items, which will provide usage reports of all ingredients.  While this can be a significant amount of work setting it up, it will allow you to determine the loss of stock over a period of time.  In the case of wines sold by the bottle, you will be able to get a better estimate of the actual theft losses than by any other means.

Shrinkage also includes spoiled product.  For example, beer in the draft lines that is discarded rather than sold.  Wine bottles that are opened to be sold by-the-glass will become tainted, if it isn’t sold in a reasonable time.  Some wines are corked or otherwise tainted by the time they are opened.  Some wine sites on the internet provide documentation that as many as 1 in every 18 bottles of wine are tainted and unsuitable for sale.  This, alone, represents almost 6% spoilage, if the tainted bottles are not returned to the suppliers for credit.  Ideally, you need to have a process in place to document and prove the amount of tainted wine your establishment incurs.

Cooking Use

Some establishments use a considerable amount of alcohol in their food menu recipes.  Unless the auditor deducts the alcohol used in cooking from the purchased alcohol, projected sales will be substantially inflated, based on the markup method.  Therefore, it is important to document the amount and type of all alcohol (wine, liquor and beer) that is used in preparing and flavouring sauces that accompany food plates.

In particular, a proper demi glace, used as a base for many sauces uses a substantial amount of wine in making the sauce.  In my restaurant the demi glace was reduced at least four times from the original ingredients.  The auditor had an extremely hard time understanding this and kept picturing a main course swimming in wine, based on the wine used in cooking divided by the meals served.  Eventually, we were able to prove the amount of wine used, by documenting the number of batches of demi glace prepared during the year.  It was a lot of work to document after the fact.  After that, we documented all recipes that used wine and the batches prepared in a log.  This will provide strong evidence to support the amount of alcohol used in cooking recipes.  Ideally, the manager and the chef should initial each transfer of alcohol to the kitchen.

Customer Comps

In the absence of documented proof of complimentary drinks provided to customers, the auditor will consider this part of the shrinkage allowance.  Consequently, it is important to maintain details of all complimentary drinks.  Most POS systems will allow you to do this, most often by voiding the amount for the complimentary item.  While this may be accepted by the auditor, more credible evidence can be obtained by maintaining an ongoing ledger of all customer comps, supported by sales chits describing the reason for the comp, customer name, description of comped item and amount.  When documented on a daily basis, this isn’t too much trouble.  If you had to go back over four years to try and document your customer comps, it would be a monumental task.  Therefore, try to keep track of complimentary drinks every day.  As a minimum, make sure that all drinks are rung in and comped on the POS system.

Similarly, when drink orders are made but the customer sends them back (wrong order, changed mind, etc…), we usually void the order on the POS.  Care should be taken to distinguish between voids that were made (representing a loss) and those that were not made (keying mistake that was caught).  Alcoholic beverage voids that were made but not served should be documented to prove the amount to the auditor.

Summary

In this post, I have tried to describe the key assumptions that are made by sales (and income) tax auditors when auditing restaurants and bars.  Each establishment has its own unique aspects, which may involve other assumptions in addition to those detailed above.  It is important to understand the assumptions that are made and the documentary evidence that may be used to ensure more accurate, truthful assumptions are used by the auditor.  Not only will this save you a considerable amount of money, it may save your business.

5 Replies to “Restaurant Audit Assumptions”

  1. Great article, now…here is my dilemma…
    I am a seasoned F & B person, hailing from the CP Hotels, Banff Springs in the 80’s, owned my own English Pub…darn Irish Rovers got it at a great price!!!
    CP used to have “F & B” Auditors…they would sit at the bar, or in the dining room, over a persiod of time and WATCH…
    My dilemma is I have an X-Wife who is claiming to make $17K a year, she is a seasoned Bartender, ownes a $350K home, has vacations, car, kids, etc.
    My support paytment is pretty high because I have not YET proven she makes around $55K
    CRA doesn’t care, I called their 1-800-screw you-line…
    My Lawyer says it’ll cost me a fortune to prove.
    But I awoke at 4am today and decided I was going to persue this.
    Does anyone do this kind of work?, other than questionable PI’s with no real F & B background
    Any help would be great, thanks, Bob

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