Determination of Unreported Income

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

Assets 31/12/2009 31/12/2010
1 Chase bank 15,000 112500
2 TD Ameritrade 50,000 75,000
3 Rental property 400,000 405,000
4 Personal residence 800,000 800,000
5 Vehicles 33,000 55,000
6 Bank of Nova 240,000 230,000
Total 1,538,000 1,677,500

Total liabilities

Liabilities 31/12/2009 31/12/2010
1 Mortgage residence 200,000 188,000
2 Mortgage – Commercial property 300,000 176000
Total 500,000 364,000

Unreported income

Assets 1,677,500
Less Liabilities 364,000
Net worth of 2010 1,313,500
Less Prior year net worth (for 2009) 1,038,000
Add Living expenses 60,000
Net income (expenses) 335,500
Less Funds from known sources 307,000
Funds from unknown sources 28,500

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

Expenses
1 Estimated living expenditure 60000
2 Mortgage –residence 12,000
3 Mortgage – commercial 24,000
4 Stipend to mother 12,000
5 Suburban 40,000
6 Trip expenses 24000
Total 172000

Known sources of funds

1 Income 207,000
2 Investment income 21,000
3 Rental income 12,000
4 Tax refund 12,000
5 Loan 25,000
6 Sale of a vehicle 20,000
7 Inheritance 10,000
Total 307,000

Unreported income

Expenditure 172,000
Subtract Known sources of funds 307,000
Funds from unknown sources -135,000

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).

Chase bank Bank of Nova Scotia
Deposits Checks Deposits Checks Total deposits Total checks
Jan 18,250 10,000 5,000 0 23,250 10,000
Feb 18,250 10,250 5,000 70,000 23,250 80,250
March 18,250 10,500 5,000 0 23,250 10,500
April 18,250 11,000 5,000 12,000 23,250 23,000
May 28,250 10,250 5,000 0 33,250 10,250
June 18,250 10,000 5,000 0 23,250 10,000
July 18,250 10,000 5,000 0 23,250 10,000
Aug 43,250 10,250 5,000 0 48,250 10,250
Sept 18,250 10,000 5,000 0 23,250 10,000
Oct 38,250 11,000 5,000 12,000 43,250 23,000
Nov 18,250 10,000 5,000 0 23,250 10,000
Dec 18,250 45,000 5,000 0 23,250 45,000
Total 274,000 158,250 60,000 94,000 334000 252,250

Cash expenses

1 Estimated living expenditure 60000
2 Mortgage –residence 12,000
3 Mortgage – commercial 24,000
4 Stipend to mother 12,000
5 Suburban 40,000
6 Trip expenses 24000
172000

Funds from known sources

1 Income 207,000
2 Investment income 21,000
3 Rental income 12,000
4 Tax refund 12,000
5 Loan 25,000
6 Sale of a vehicle 20,000
7 Inheritance 10,000
Total 307,000
Total deposits to all accounts 334,000
Less Transfer and redeposits 12,000
Net deposits to all accounts 322,000
Add Cash expenditures 172,000
Total receipts from all sources 494,000
Less Funds from known sources 307,000
Funds from unknown sources 187,000

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.

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