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Identifying Unreported Income

Introduction

Individuals and businesses should give a full disclosure of income in the financial statements. 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 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. The paper identifies 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 weaknesses of the three methods used for estimation.

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Net worth method

The difference between assets and liabilities for a definite period gives the net worth for Mr. Jung. The value obtained is compared with the net worth for prior years. Unjustified rate of increase of net worth for different periods gives indications for unreported income. In this approach, the net worth of the client at the beginning and end of the period should be computed accurately. The increase in net worth that cannot be accounted for shows unreported income.

Calculation of unreported income

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 table, unreported income amounted to $28,500. It implies that the changes in net worth in the two years could not be justified. The results obtained are not reasonable. They may not be relied on due to a number of weaknesses such as failure to keep money in financial institutions and the inability to obtain records for expenses. These two depends on the customer’s willingness to disclose required information. In addition, it might not be possible to identify personal assets bought during the year.

Sources and application of funds method

The method compares expenses and income of the client. Undisclosed income is the excess of uses over sources.

Calculation of unreported income

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 table, revenues exceed expenses. It means that Mr. Jung does not have unreported income. However, the estimates are not reasonable. For instance, the net cash deposits in the bank ($322,000) exceed known sources of funds ($307,000). The difference shows the unreasonableness of the estimates. The approach has a number of weaknesses such as, unreported income may result from overstating expenses or understating revenue. 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 compares bank deposits and credit of the customer. Adjustments are made to eliminate transfers between banks and non income 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

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 amounts to $187,000. The result is reasonable since the method captures all the financial activities of the customer. 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.

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Conclusion

The paper identifies the presence of unreported income for Mr. Jung using three methods. The results of computations show that there is existence of unreported income. The three methods are not effective though they give an indication of the existence of unreported income. Besides, they provide information about the client such as frequency of income, sources of funds, and ways in which 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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