Potential Unreported Income Case Study

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Table of Contents

Introduction
Aim of the paper
Net worth method
Computation of unreported income using net worth approach
Explanation
Sources and application of funds method
Bank deposit method
Conclusion

Introduction

Individuals and businesses should present a complete disclosure of income in the financial reports. Unreported revenue comprises of certain income that a taxpayers fail to report in their tax returns. The tax payers aim is to avoid paying tax or reduce tax obligation. There are a number of ways that can be used to discover unreported revenue.

They include bank deposit method, net worth method, source and application of funds method, lifestyle audit, third party contacts, and mark up analysis among others.

Selection of a suitable approach to use 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. Indentifying unreported income is commonly carried out by auditors and tax authorities.

Aim of the paper

The paper determines availability of unreported income for Mr. Jung. It uses the net worth method, sources and application of funds method, and bank deposit method. It also talks about the reasonableness of the estimates and the drawbacks of the three methods used for estimation.

Net worth method

The difference between assets and liabilities for a definite period gives the net worth for the client. The value obtained is compared with the net worth for prior years. unfounded rate of increase of net worth for different periods gives indications for unreported income.

In this approach, it is necessary to compute accuratelty the net worth of the client at the beginning and end of the period. The increase in net worth that cannot be accounted for gives an idea about unreported income.

Computation of unreported income using net worth approach

Total assets

	Assets	31/12/2009	31/12/2010
1	Chase bank	15,000	112,500
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	176,000
	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 calculation above, unreported income totaled to $28,500. It means that the changes in net worth in the two years could not be supported. The results obtained from the calculations are not reasonable. The method relies on a number of assumptions that are not realistic.

For instance, it assumes that the client keeps money in financial institutions. It also assumes that the records of income and expenses are accurate. These two weaknesses depend on the customer’s readiness to reveal required information. Besides, the investigator may not be able to identify private assets acquired during the year.

Sources and application of funds method

The approach evaluates expenses and income of the client. All known sources of funds should be used in this calculation. Undisclosed income is the excess of uses over sources.

Calculation of unreported income using sources and application of funds method

	Expenses
1	Estimated living expenditure	60,000
2	Mortgage –residence	12,000
3	Mortgage – commercial	24,000
4	Stipend to mother	12,000
5	Suburban	40,000
6	Trip expenses	24,000
	Total	172,000

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 calculations, revenues exceed expenses. It means that client did not unreported income. However, the estimates are not reasonable. For instance, the known funds used in the calculations are less than the totoal net chas deposit in the bank.

The difference shows the inaccuracy of the estimates. The approach has several weaknesses for instance, the customer may understate revenue or overstate expenses. Also, the method assumes that the customer will disclose all his spending. These assumptions reduce the effectiveness of the method.

Bank deposit method

Bank deposit method bank transactions of the customer these are, debits and credit. Changes are made to remove transfers between banks and non income deposits. The method is is beneficial since shows trends that are essential in giving an indication of the possibility of unreported income.

For instance, it shows the regularity 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.

Calculation of unreported income

	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	334,000	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

Unreported income

	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

From the calculations, unreported income totaled to $187,000. The result is reasonable because it takes care of all the financial activities of the client. The method assumes that the customer banks all revenues. Also, the method cannot be relied on when the client records are inadequate, do not exist or show possibility of manipulation.

Conclusion

The paper identifies the availability of unreported income for the client using three approaches. The results of the calculations show that the clien didi not disclose some income. The three methods used cannot be relied on with certainity since they are not effective. However, they give a hint of the availability of unreported income.

In addition, they give information about the client such as regularity of income, sources of income, and how the customer spend his earnings. An investigator should use effective approaches such as unit and volume method and mark up method to determine unreported income.

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