When a California business is selected for a sales tax audit by the California Department of Tax and Fee Administration (CDTFA), the method of testing used by the auditor will determine whether the audit stays confined to verifiable records—or balloons into speculative assessments with often devastating financial consequences. The CDTFA prefers to use the direct method of testing—which compares actual source documentation across reporting systems—but will quickly pivot to the indirect method of testing if it finds your records incomplete, inconsistent, or unreliable. That pivot is often the tipping point—turning manageable audit risk into a full-blown audit crisis.
What Are Indirect Testing Methods?
Indirect methods are not objective analyses based on reality—they are extrapolations, often based on flawed statistics and guesswork. When auditors lack the documentation needed to reconcile sales tax returns to actual gross receipts, they construct entire assessments around sampling and statistical projections. These tools include observation tests, ratio analysis, bank deposit analysis, cash-to-credit card ratios, and markup methods. At their core, indirect methods reflect the CDTFA’s attempt to project a taxpayer’s actual sales tax liability when it claims that the taxpayer’s records do not tell the whole story.
For instance, in one of the most commonly used indirect methods—the cash-to-credit card ratio test—the auditor uses 1099-Ks and credit card sales reports to calculate a ratio, then projects that ratio across total deposits to estimate total taxable sales. In cash-heavy industries, this ratio can grossly exaggerate taxable income.
Another favorite is the observation test. Here, the auditor shows up—unannounced or otherwise—and records every transaction in your business for one or two days. They compare what was manually observed with what your POS system reports. If discrepancies exist, even on a single item, the CDTFA will often extrapolate those issues across years of sales data. A test of Tuesday lunch and Sunday dinner, for example, might be used to estimate a restaurant’s sales across a 1,000-day audit period. This is the audit equivalent of using a teaspoon to measure the Pacific Ocean—and treating the result as gospel.
Indirect methods rely on the assumption that small samples represent the whole business. But that assumption is rarely valid. Weekend credit card usage may differ drastically from weekday patterns. Holiday sales don’t match slow-season foot traffic. A single day of missing invoices or off-POS transactions doesn’t indicate fraud—it means a real business with moving parts and human error. Even worse, these indirect methods don’t exist in a vacuum. CDTFA often uses them when your records are otherwise capable of supporting direct testing.
Types of Indirect Methods Used by the CDTFA
The CDTFA employs several indirect testing methods, each with unique dangers:
- Observation Tests: Auditors record all transactions during one or two site visits and compare those with POS or sales records.
- Cash-to-Credit Card Ratios: Based on your 1099-K and POS reports, auditors estimate total sales by assuming a fixed ratio of cash-to-card usage.
- Bank Deposit Analyses: Used to estimate gross receipts by examining total deposits and comparing them with reported sales.
- Markup Tests: Common in restaurants and retail, auditors estimate the cost of goods sold and apply a markup to infer gross sales.
- Statistical Sampling: A random sample of invoices or days is used to extrapolate findings across months or years.
- Prior Audit Percentages of Error (PAPE): Averages from prior audits are carried forward and used to calculate current liabilities.
These methods are often deployed when businesses don’t have clean, reconciled documentation—or when an auditor is fishing for higher liability without sufficient supporting evidence.
CDTFA auditors are not statisticians. It is not uncommon to uncover sampling methods that ignore seasonality, fail to randomize sample periods, or include irregular or high-volume events in “representative” test periods. A few percentage points of error in a two-day test can result in six- or seven-figure liabilities over a three-year audit period.
These mistakes are not just academic—they have real-world, high-stakes consequences. Incorrect statistical sampling assumptions often mean the difference between a $50,000 assessment and a $500,000 disaster. Once the CDTFA finalizes its audit findings, reversing those assumptions becomes significantly more difficult, even through administrative appeals.
Contact the Tax Law Offices of David W. Klasing to Fight Back
A CDTFA sales tax audit that relies on indirect testing methods is not a neutral process—it’s a high-stakes numbers game tilted in the government’s favor. But that doesn’t mean you’re powerless. With the right legal and accounting team in your corner, you can reverse or contain the damage, protect your license, and keep your business intact.
At the Tax Law Offices of David W. Klasing, our dual-licensed California Sales Tax Attorneys and CPAs combine legal advocacy with deep accounting acumen to challenge CDTFA methodology at every step. We begin by conducting a thorough review of your records to determine whether the auditor has any legitimate basis for resorting to indirect testing. If the direct method is available but ignored, we push back hard.
When indirect testing is unavoidable, we vet the auditor’s sample selection, verify statistical validity, and demand that seasonal trends, industry-specific practices, and pricing patterns be considered. We cross-examine how the CDTFA defines the “population” and whether the test data was drawn correctly. We advocate for exclusion of nonrecurring, exceptional, or anomalous transactions from the sample set. And we challenge any uncorroborated inferences that don’t match the business’s real-world operations.
Our dual-licensed California Sales Tax Attorneys and CPAs deliver more than legal advice—we bring strategic defense grounded in accounting reality. If your business is under audit—or if you’ve received a Notice of Determination based on indirect methods—call us before the damage becomes irreversible. Contact the Tax Law Offices of David W. Klasing at (888) 564-1409 or reach out online for a reduced-rate initial consultation. Our mission is simple: Protect your financial future, challenge unjust audit findings, and restore order to the chaos CDTFA has brought to your door.
