Forensic and Investigative Accounting

Chapter 6
Indirect Methods of
Reconstructing Income

Forensic Accounting:Acct-527
 Forensic Audit Approaches Used
by the IRS
 Direct methods involve probing missing
income by pointing to specific items of
income that do not appear on the tax return. In
direct methods, the agents use conventional
auditing techniques such as looking for
canceled checks of customers, deed records of
real estate transactions, public records and
other direct evidence of unreported income.
Chapter 6 Forensic and Investigative Accounting 2
 Forensic Audit Approaches Used
by the IRS

 Indirect methods use economic reality and

financial status techniques in which the
taxpayer’s finances are reconstructed
through circumstantial evidence.

Chapter 6 Forensic and Investigative Accounting 3

 Minimum Income Probes
 For nonbusiness returns, an agent is to
question the taxpayer or the representative
about possible sources of income other than
reported on the return. If there is no other
information in the file indicating potential
unreported income, the minimum income
probe is met.

Chapter 6 Forensic and Investigative Accounting 4

 Minimum Income Probes

 For taxpayers who are self-employed and

file a Schedule C or F, an analysis is made
of tax return information to determine if
reported income is sufficient to support the
taxpayer’s financial activities.

Chapter 6 Forensic and Investigative Accounting 5

 Lifestyle Probes
The lifestyle of a taxpayer or employee may
give clues as to the possibilities of unreported
income. Obvious lifestyle changes may indicate
fraud and unreported income:
– Lavish residence
– Expensive cars and boats
– Vacation home
– Private schools for children
– Exotic vacations

Chapter 6 Forensic and Investigative Accounting 6

 IRS Financial Status Audits

If someone is spending beyond his or her

apparent means, there should be concern. If a
forensic accountant suspects fraud or
unreported income, a form of financial audit
may be appropriate that will enable the
investigator to check the lifestyles of the
possible perpetrators.

Chapter 6 Forensic and Investigative Accounting 7

 Indirect Methods
An indirect method should be used when:
 The taxpayer has inadequate books and records.
 The books do not clearly reflect taxable income.
 There is a reason to believe that the taxpayer has
omitted taxable income.
 There is a significant increase in year-to-year net worth.
 Gross profit percentages change significantly for that
particular business.
 The taxpayer’s expenses (both business and personal)
exceed reported income and there is no obvious cause
for the difference.
Chapter 6 Forensic and Investigative Accounting 8
Market Segment Specialization Program

The Market Segment Specialization Program

focuses on developing highly trained examiners
for a particular market segment. An integral part
of the approach used is the development and
publication of Audit Technique Guides.
(continued on next slide)

Chapter 6 Forensic and Investigative Accounting 9

Market Segment Specialization Program

These Guides contain examination techniques,

common and unique industry issues, business
practices, industry terminology, and other
information to assist examiners in performing
examinations. A forensic accountant can use
this resource to learn about a particular
industry.

Chapter 6 Forensic and Investigative Accounting 10

 Cash T
A cash T is an analysis of all of the cash
received by the taxpayer and all of the cash
spent by the taxpayer over a period of time.
The theory of the cash T is that if a taxpayer’s
expenditures during a given year exceed
reported income, and the source of the funds
for such expenditures is unexplained, such
excess amount represent unreported income.

Chapter 6 Forensic and Investigative Accounting 11

 Cash T

 Income $100,000
 Expenses 120,000

 Unreported
 Unexplained $20,000

Chapter 6 Forensic and Investigative Accounting 12

 Source and Application of Funds
Method (Expenditure Approach)
This technique is a variation of the net worth
method that shows increases and decreases in a
taxpayer’s accounts at the end of the year. The
format of this method is to list the applications
of funds first and then subtract the sources. If
the taxpayer’s applications exceed his or her
known cash receipts (including cash on hand at
the beginning of the year), any difference may
be unreported income.

Chapter 6 Forensic and Investigative Accounting 13

 Simple Source & Application of
Funds
 Tot. Application of Funds $120,000
 Tot. Source of Funds 75,000
 Adj. Gross Income 45,000
 Less Pers.Ex. & Item. Ded. 23,400
 Taxable Income 21,600
 Taxable Income Per Return 15,000
 Potential Understatement 6,600

Chapter 6 Forensic and Investigative Accounting 14

 Net Worth Method
The net worth method is a common indirect balance sheet
approach to estimating income. To use the net worth
method, an IRS agent or forensic accountant must:
1. Calculate the person’s net worth (the known assets
less known liabilities) at the beginning and ending of
a period.
2. Add nondeductible living expenses to the increase in
net worth.
3. Account for any difference between reported income
and the increase in net worth during the year as (a)
nontaxable income and (b) unidentified differences.

Chapter 6 Forensic and Investigative Accounting 15

 Simple Net Worth Method
Calculation
 Net Worth 12/31/06 $500,000
 Net Worth 12/31/07 600,000
 Increase 100,000
 Personal Living Expenses 50,000
 Reconstructed AGI 150,000
 Report AGI 100,000
 Potential Understatement 50,000

Chapter 6 Forensic and Investigative Accounting 16

 Bank Deposit Method

The bank deposit method looks at the funds

deposited during the year. This method
attempts to reconstruct gross taxable receipts
rather than adjusted.

Chapter 6 Forensic and Investigative Accounting 17

 Gross Business Receipts Formula
1. Total bank deposits $XXX
Less:
2. Nontaxable and nonbusiness receipts deposited (XXX)
3. Net deposits resulting from business receipts $XXX
Add:
4. Business expenses paid by cash $XXX
5. Capital items paid by cash XXX

6. Personal expenses paid by cash XXX

7. Cash accumulated during the year from receipts XXX

8. Subtotal $XXX

9. Less: Nontaxable and nonbusiness cash used for (XXX)

(4) through (7)
10. Gross business receipts as corrected $XXX
11. Adjustments for accrual basis taxpayers $XXX
Chapter 6 Forensic and Investigative Accounting 18