Introduction
Individuals and businesses are expected to give a full disclosure in the financial statements of total income earned during a financial period. However, this happens not to be the case. Most individuals and businesses fail to report total income so as avoid tax. Unreported revenue comprises of certain income on the tax return of taxpayers that they fail to report with an aim of avoiding tax. There are a number of ways that the Internal revenue service may use to uncover unreported revenue. Some of these ways include bank deposit method, net worth method, source and application of funds method, lifestyle audit, third party contacts, market segment specialization program, percentage mark up analysis, and informants among others (Lundgren, 2012).
Selection of an appropriate method to use often depends on a number of factors such as industry in which the customer operates, the permanence of assets and liabilities, stability of net worth over a number of years, availability of clients financial information, and banking practices of the customer among others. Determination of unreported income is commonly carried out by auditors and tax authorities.
Aim of the paper
The paper determines unreported income for Mr. George Jung using three methods. These are net worth method, sources and application of funds method, and bank deposit method. Further, it discusses the reasonableness of the estimates and the shortcomings of the three methods used for estimation.
Net worth method
The net worth of client is the difference between assets and liabilities for a fixed period of time. The net worth of Mr. George Jung can be obtained by comparing his assets and liabilities for a given period. The value obtained is then compared with the net worth for prior years. Unreported income is shown by the unexplainable rate of increase of net worth for different periods (Roth, Witte, & Scholz, 2005). In using this approach, it is important to compute with certainty the net worth of the client at the beginning of the period and at the end of the period. Thereafter, a reasonable justification of source of change in net worth needs to be established. The portion of the increase in net worth that cannot be accounted for is considered as unreported income (Stein & Fleck, 2002).
Determination of unreported income using net worth approach
Total assets
Total liabilities
Unreported income
Explanation
From the calculations in the table above, it is evident that Mr. George Jung had unreported income amounting to $28,500. It implies that the changes in net worth from year 2009 to 2010 could not be adequately accounted for. The result of this method are not reasonable and may not be relied on with certainty due to a number of weaknesses such as when cash is not deposited in a financial institution or the expenditures cannot be obtained unless the customer discloses willingly. In addition, it might not be possible to identify main personal assets bought during the year or expenses the client has hidden away (Internal Revenue Services, 2012).
Sources and application of funds method
Source and application of fund method is the commonly used approach in verifying the rationality of the reported revenue. It is the most basic approach. Using this method, undisclosed income is identified when the known uses of the funds exceeds the recognized sources. The known sources of funds excludes loans, advances, gifts, taxable income and transfers between accounts among others (Stein & Fleck, 2002).
Determination of unreported income using the source and application of funds method
Known sources of funds
Unreported income
Explanation
From the computations above, revenues exceed expenses. This shows that Mr. George Jung does not have unreported income. The estimates above are not reasonable. For instance, the net cash deposits in the bank ($322,000) did not match with known sources of funds ($307,000). The difference casts doubt on the reasonableness of the estimates. The approach has a number of weaknesses such as, unreported income may result from overstated expenditure or understated income. Secondly, the method relies on an unreasonable assumption that the customer discloses all his spending. This might not always be the case. These assumptions make the method not an effective way of estimating unreported income though it might give an indication of the existence of unreported income (Internal Revenue Services, 2012).
Bank deposit method
Examination of bank statements during an audit help in revealing any unreported income. The method entails “adding up together all deposits and credits to all known bank accounts of the subject” (Stein & Fleck, 2002). When using this method, changes are made to show transfers between accounts and non income deposits. The net deposit obtained from the computations gives the total revenue for Mr. Jung. The method gives some trends that are essential in giving an indication of the possibility of unreported income. For instance, it shows the frequency of making deposits into the accounts, transfers made by the customer, period within the subject was involved in income generating activities, and the source of the deposits (Carter, 2006).
Cash expenses
Funds from known sources
Explanation
The calculations above shows that the client had unreported income amounting to $187,000. The results are reasonable since the method takes into account all the economic activities of the customer. However, it is based on the assumption that the customer banks all its revenue. The assumption is not practical especially when the customer decides to not to bank his revenue. In this case, it cannot uncover unreported revenue. In addition, the method is not reliable in the event that the client records are inadequate, nonexistent or they show possibility of being falsified (Internal Revenue Services, 2012).
Conclusion
The paper determines the presence of unreported income for Mr. George Jung using three approaches these are, net worth method, sources and applications of funds method and bank deposits approach. The results of computations using the three approaches are inconsistent though they show that there is existence of unreported income. The three methods are basic and may not be effective.
They help in giving a clue on the possible existence of unreported income. In addition, they provide necessary information about the client such as frequency of income, sources of funds, and ways in which the customer spend his earnings. An investigator should consider using other effective approaches such as unit and volume method, unreported income discriminant index, and mark up method (Internal Revenue Services, 2012).
References
Carter, C. (2006). Tax Breaks They Don’t Want You To Know About: What You Don’t Know Will Hurt You. United States of America: Lulu Press.
Internal Revenue Services. (2012). Examination of returns. Web.
Lundgren, G. (2012). Unreported income. Web.
Roth, J., Witte, A., & Scholz, J. (2005). Taxpayer Compliance. United States of America: University of Pennsylvania Press.
Stein, A., & Fleck, S. (2002). Issues relating to Hidden/Unreported income and tax fraud. Web.