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
Total liabilities
Unreported income
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
Known sources of funds
Unreported income
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
Unreported income
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.