## Box 1. Formula for using bank deposits and cash expenditure method; Box 5. Example: Unit and Volume Method

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---

### Box 1 — Formula (stepwise)
- Total deposits (including business and personal accounts)
- Add  Cash expenditure (cash payments for business, capital, and private expenses)
- Add Increase in cash on hand
- Less  Nontaxable receipts (e.g. VAT or sales tax, transfers between accounts, loans)
- Equals Gross receipts as corrected
- Less Gross receipts as per declaration
- Equals Understated income

### Box 1 — Methodological context and application
- If income has been correctly declared and the auditor has accurately reconstructed the taxpayer’s financial affairs using the source and application of funds method, the T-account will balance: the source of funds will equal the application of funds.
- If the application of funds figure is greater than the source of funds, the excess expenditure is concluded to represent an understatement of income, or overstatement of deductible expenditure, and unless the taxpayer can prove that income was derived from a non-taxable source, the taxpayer’s declaration of income is adjusted accordingly.
- Net worth method (asset betterment or asset accretion method):
  - Assumes increases in net assets, after adjustments for non-deductible expenditure and non-taxable income, represent taxable income.
  - Extends the source-and-application analysis over a number of years or tax periods to ascertain changes to net worth from one year to the next.
  - Relies on thorough analysis of all assets, liabilities, expenditure (business and private), and non-taxable sources of funds to reconstruct a taxpayer’s financial affairs over a number of years.
  - More commonly used where the taxpayer is suspected to have avoided tax and accumulated considerable assets or had substantial changes in net worth over some period of time.
- Net worth method formula (as presented in the source):
  - (a)  Assets less liabilities = net worth
  - (b)  Net worth at end of year
  - Less: Net worth at beginning of year
  - Equals  Increase or decrease in net worth
  - Add: Nondeductible expenditure
  - Less: Nontaxable income
  - Equals Aggregate annual income as corrected.

### Box 1 — Practical implication for auditors
- The bank deposits and cash expenditure formula provides a corrective computation of gross receipts where declared figures are incomplete or understated.
- Where application of funds exceeds sources, auditors may adjust declared income unless non-taxable sources can be proven by the taxpayer.
- The net worth extension permits reconstruction of taxable income across multiple periods to capture asset accumulation and long-term underreporting.

### Box 5 — Example calculation (Unit and Volume Method)
- Average sales price per item: 1,000
- Number of items manufactured: 920
- Equals: Total sales per unit & volume method: 920,000
- Less: Sales reported by manufacturer: 800,000
- Equals: Omitted sales: 120,000

### Box 5 — Use of industry benchmarks and third-party data
- The Australian Taxation Office (ATO) has developed and published industry performance benchmarks providing a range of ratios for:
  - (1) cost of goods sold to turnover;
  - (2) labor to turnover;
  - (3) rent to turnover;
  - (4) GST-free sales to turnover; and
  - (5) motor vehicle expenses to turnover.
- Input benchmarks developed showing an expected range of income for trades’ people working with domestic customers based on labor and materials they use.
- Other tax administrations (Germany, New Zealand, United States, United Kingdom) have developed industry standards and business profiles to aid audit staff.
- Third-party sources that can provide leads and data include financial institutions, government agencies, stock exchanges and brokers, trade suppliers, real estate agents, and sales agents.
- Increasing automation enables administrations to automatically capture and match such third-party information with taxpayer declarations.

### Box 5 — Legislative requirements for using indirect methods (Section III)
- The right to use indirect methods generally derives from powers to administer tax laws, including estimated assessments; legislation often remains silent on specific methods, implying administrations may choose appropriate methods.
- Courts have shaped acceptable use by ruling that administrations:
  - (1) may use any method to reconstruct income that is reasonable under the circumstances;
  - (2) may not be arbitrary in the use of this authority;
  - (3) may use an indirect method to test the accuracy of the taxpayer’s books and records;
  - (4) must investigate all reasonable evidence presented by the taxpayer refuting the computation of income;
  - (5) determinations are presumed to be correct and the taxpayer bears the burden of proving that it is incorrect;
  - (6) are not required to negate every possible non-taxable source for the unreported income in order to sustain a deficiency based on a reconstruction of income; and
  - (7) may use third party records (customers, suppliers, etc.) in the reconstruction.
- Examples noted:
  - Act on Assessment Procedure sections 27 and 30 (Finland) provides for estimates based on comparisons with similar taxpayers.
  - U.S. revenue code places burden of proof on the administration with respect to income reconstructed solely through statistical information on unrelated parties; auditors must provide other supporting evidence.
- Courts accept indirect methods that are reasonable and grounded in facts; estimations may “go close to guesswork” and yet be lawful, but figures cannot be “plucked out of the air.”

### Box 5 — Appropriate circumstances to use indirect methods (Section IV)
- Indirect methods are appropriate when:
  - Failure to file declarations and failure to maintain records.
  - Unexplained wealth, or declared income does not reflect the taxpayer’s standard of living.
  - Declared income does not correspond to the business activity of the enterprise.
  - Taxpayer consistently declares losses or insubstantial income for an extended period.
  - Most business operations are in cash.
  - Documents are incomplete, recordkeeping is poor, and internal controls are weak.
- Choice of method depends on nature of enterprise, facts and circumstances, and availability of relevant data.
- Methods relying on banking analysis (net worth, bank deposits, source and application of funds) are unsuitable if banking records are inaccessible; mark-up or unit and volume methods may be more appropriate if reliable extrapolation of inputs or outputs is possible.
- Industry benchmarks are useful for signaling high-risk cases and persuading taxpayers to review and amend declarations.

### Box 5 — Withstanding challenges to indirect method assessments (Section V)
- Indirect method assessments must be supported by recognized and accepted techniques; cannot be based on pure speculation.
- Auditor documentation must:
  - Clearly demonstrate the rationale for the assessment.
  - Fully describe all information used.
  - Detail all computations.
- Audit planning should include:
  - (1) accessing and analyzing available internal and external information (tax returns, customs data, licensing information, records held by other government agencies, authorities and third parties);
  - (2) studying taxpayer and industry information and computing comparative ratios;
  - (3) listing high risk or suspect areas or issues;
  - (4) planning audit approach, including questionnaires, checklists, and lead sheets.
- Initial interview and observations of business operations are critical; auditors should establish and verify income from non-taxable sources early.
- Contemporaneous working papers documenting taxpayer answers, third-party information, subsidiary records, and observations become instrumental to uphold an assessment.
- Administrations should provide policy and procedures in manuals and practice statements to guide staff; maintain up to date profiles of high risk industries and provide specific audit guidance notes.
- Position papers should explain proposed adjustments and allow the taxpayer to review and respond before assessments are issued.
- Common taxpayer contentions in bank deposits, net worth, and source and application of funds methods:
  - (1) non-taxable sources of income;
  - (2) cash on hand at the beginning of audit period;
  - (3) overestimation of personal expenses;
  - (4) incorrect computation in adjustments (accruals, non-cash deductions).
- Sanctions should be imposed for failure to file, failure to maintain adequate books and records, and underpayment of tax; a robust and consistent penalty regime deters noncompliance.

### Box 5 — Key points for tax administration design (Section VI)
- Encourage taxpayers, through education and enforcement, to maintain accurate books and records enabling accurate tax liability determination and adequate audit trails.
- Indirect methods:
  - Are not totally accurate.
  - Are costly to execute.
  - Should only be used when it is highly likely the taxpayer has significantly understated tax obligations.
- To ensure effective use, administrations must provide auditors with:
  - Necessary legislative framework.
  - Data and intelligence on business operations.
  - Policy and procedural guidance.
  - Training to enable competent application of indirect methods.

*Technical Notes and Manuals 10/05  |  2010*

### Box 1. Formula for using bank deposits

### Box 1. Formula for using bank deposits and cash expenditure method

### Formula (stepwise)
- Total deposits (including business and personal accounts)
- Add  Cash expenditure (cash payments for business, capital, and private expenses)
- Add Increase in cash on hand
- Less  Nontaxable receipts (e.g. VAT or sales tax, transfers between accounts, loans)
- Equals Gross receipts as corrected
- Less Gross receipts as per declaration
- Equals Understated income

### Methodological context and application
- If income has been correctly declared and the auditor has accurately reconstructed the taxpayer’s financial affairs using the source and application of funds method, the T-account will balance: the source of funds will equal the application of funds.
- If the application of funds figure is greater than the source of funds, the excess expenditure is concluded to represent an understatement of income, or overstatement of deductible expenditure, and unless the taxpayer can prove that income was derived from a non-taxable source, the taxpayer’s declaration of income is adjusted accordingly.
- Net worth method (asset betterment or asset accretion method):
  - Assumes increases in net assets, after adjustments for non-deductible expenditure and non-taxable income, represent taxable income.
  - Extends the source-and-application analysis over a number of years or tax periods to ascertain changes to net worth from one year to the next.
  - Relies on thorough analysis of all assets, liabilities, expenditure (business and private), and non-taxable sources of funds to reconstruct a taxpayer’s financial affairs over a number of years.
  - More commonly used where the taxpayer is suspected to have avoided tax and accumulated considerable assets or had substantial changes in net worth over some period of time.
- Net worth method formula (as presented in the source):
  - (a)  Assets less liabilities = net worth
  - (b)  Net worth at end of year
  - Less: Net worth at beginning of year
  - Equals  Increase or decrease in net worth
  - Add: Nondeductible expenditure
  - Less: Nontaxable income
  - Equals Aggregate annual income as corrected.

### Practical implication for auditors
- The bank deposits and cash expenditure formula provides a corrective computation of gross receipts where declared figures are incomplete or understated.
- Where application of funds exceeds sources, auditors may adjust declared income unless non-taxable sources can be proven by the taxpayer.
- The net worth extension permits reconstruction of taxable income across multiple periods to capture asset accumulation and long-term underreporting.

*Technical Notes and Manuals 10/05  |  2010*

### Box 5.  Example: Unit and Volume Method

### Box 5.  Example: Unit and Volume Method

### Example calculation (Unit and Volume Method)
- Average sales price per item: 1,000
- Number of items manufactured: 920
- Equals: Total sales per unit & volume method: 920,000
- Less: Sales reported by manufacturer: 800,000
- Equals: Omitted sales: 120,000

### Use of industry benchmarks and third-party data
- The Australian Taxation Office (ATO) has developed and published industry performance benchmarks providing a range of ratios for:
  - (1) cost of goods sold to turnover;
  - (2) labor to turnover;
  - (3) rent to turnover;
  - (4) GST-free sales to turnover; and
  - (5) motor vehicle expenses to turnover.
- Input benchmarks developed showing an expected range of income for trades’ people working with domestic customers based on labor and materials they use.
- Other tax administrations (Germany, New Zealand, United States, United Kingdom) have developed industry standards and business profiles to aid audit staff.
- Third-party sources that can provide leads and data include financial institutions, government agencies, stock exchanges and brokers, trade suppliers, real estate agents, and sales agents.
- Increasing automation enables administrations to automatically capture and match such third-party information with taxpayer declarations.

### Legislative requirements for using indirect methods (Section III)
- The right to use indirect methods generally derives from powers to administer tax laws, including estimated assessments; legislation often remains silent on specific methods, implying administrations may choose appropriate methods.
- Courts have shaped acceptable use by ruling that administrations:
  - (1) may use any method to reconstruct income that is reasonable under the circumstances;
  - (2) may not be arbitrary in the use of this authority;
  - (3) may use an indirect method to test the accuracy of the taxpayer’s books and records;
  - (4) must investigate all reasonable evidence presented by the taxpayer refuting the computation of income;
  - (5) determinations are presumed to be correct and the taxpayer bears the burden of proving that it is incorrect;
  - (6) are not required to negate every possible non-taxable source for the unreported income in order to sustain a deficiency based on a reconstruction of income; and
  - (7) may use third party records (customers, suppliers, etc.) in the reconstruction.
- Examples noted:
  - Act on Assessment Procedure sections 27 and 30 (Finland) provides for estimates based on comparisons with similar taxpayers.
  - U.S. revenue code places burden of proof on the administration with respect to income reconstructed solely through statistical information on unrelated parties; auditors must provide other supporting evidence.
- Courts accept indirect methods that are reasonable and grounded in facts; estimations may “go close to guesswork” and yet be lawful, but figures cannot be “plucked out of the air.”

### Appropriate circumstances to use indirect methods (Section IV)
- Indirect methods are appropriate when:
  - Failure to file declarations and failure to maintain records.
  - Unexplained wealth, or declared income does not reflect the taxpayer’s standard of living.
  - Declared income does not correspond to the business activity of the enterprise.
  - Taxpayer consistently declares losses or insubstantial income for an extended period.
  - Most business operations are in cash.
  - Documents are incomplete, recordkeeping is poor, and internal controls are weak.
- Choice of method depends on nature of enterprise, facts and circumstances, and availability of relevant data.
- Methods relying on banking analysis (net worth, bank deposits, source and application of funds) are unsuitable if banking records are inaccessible; mark-up or unit and volume methods may be more appropriate if reliable extrapolation of inputs or outputs is possible.
- Industry benchmarks are useful for signaling high-risk cases and persuading taxpayers to review and amend declarations.

### Withstanding challenges to indirect method assessments (Section V)
- Indirect method assessments must be supported by recognized and accepted techniques; cannot be based on pure speculation.
- Auditor documentation must:
  - Clearly demonstrate the rationale for the assessment.
  - Fully describe all information used.
  - Detail all computations.
- Audit planning should include:
  - (1) accessing and analyzing available internal and external information (tax returns, customs data, licensing information, records held by other government agencies, authorities and third parties);
  - (2) studying taxpayer and industry information and computing comparative ratios;
  - (3) listing high risk or suspect areas or issues;
  - (4) planning audit approach, including questionnaires, checklists, and lead sheets.
- Initial interview and observations of business operations are critical; auditors should establish and verify income from non-taxable sources early.
- Contemporaneous working papers documenting taxpayer answers, third-party information, subsidiary records, and observations become instrumental to uphold an assessment.
- Administrations should provide policy and procedures in manuals and practice statements to guide staff; maintain up to date profiles of high risk industries and provide specific audit guidance notes.
- Position papers should explain proposed adjustments and allow the taxpayer to review and respond before assessments are issued.
- Common taxpayer contentions in bank deposits, net worth, and source and application of funds methods:
  - (1) non-taxable sources of income;
  - (2) cash on hand at the beginning of audit period;
  - (3) overestimation of personal expenses;
  - (4) incorrect computation in adjustments (accruals, non-cash deductions).
- Sanctions should be imposed for failure to file, failure to maintain adequate books and records, and underpayment of tax; a robust and consistent penalty regime deters noncompliance.

### Key points for tax administration design (Section VI)
- Encourage taxpayers, through education and enforcement, to maintain accurate books and records enabling accurate tax liability determination and adequate audit trails.
- Indirect methods:
  - Are not totally accurate.
  - Are costly to execute.
  - Should only be used when it is highly likely the taxpayer has significantly understated tax obligations.
- To ensure effective use, administrations must provide auditors with:
  - Necessary legislative framework.
  - Data and intelligence on business operations.
  - Policy and procedural guidance.
  - Training to enable competent application of indirect methods.

*Technical Notes and Manuals 10/05 | 2010 — Box 5. Example: Unit and Volume Method*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/tnm/2010/_tnm1005.pdf_