Why should a business owner be concerned about their account’s receivable balance during a tax audit? The answer to this question has to do with how the Canada Revenue Agency (‘CRA’) normally calculates unreported income while performing a factual audit.
CRA ‘Unreported Income’ Formula
In most scenarios, the CRA auditor starts collecting data for the unreported income formula by summing all deposits into the business’s bank account. With the deposit listing complete, the auditor then removes deposits that are definitively proven to be from non-income sources. Deposits that cannot be definitively ruled-out are consequently classified as business income earned during the period.
This first step is formulated as follows:
Total bank deposits – Deposits verified as non-income = Income per auditor
In the next step of the unreported income formula, the auditor deducts ‘Income as reported’ from ‘Income per auditor’, as generated in the formula above. The (positive) difference, if any, is classified as unreported income by the auditor. By definition, unreported income is revenue that the business has failed to report to the CRA.
The auditor’s unreported income formula, in its most basic form, is written as follows:
Income per auditor – Income as reported = Unreported income
For example, if the auditor identifies $100,000 in bank deposits (which cannot be verified as ‘not income’) and the business reports income of $90,000 on their tax return, then unreported income is calculated as ($100,000 – $90,000) = $10,000.
Realistically, if the business is a GST/HST registrant, bank deposits must be reduced by GST/HST collected to ensure income is correctly reported net of excise taxes. That is, bank deposits would naturally include GST/HST collected whereas income as reported would be net of GST/HST. Therefore, for GST/HST registrants, income per auditor must always have GST/HST backed-out to properly compare it against income as reported.
Using the scenario data presented above, for a GST registrant, the $100,000 of ‘Income per auditor’ requires 5% of GST removed before it may be properly compared to ‘Income as reported’. The $100,000 amount net of 5% GST is equal to (100,000 / 1.05) $95,238. Therefore, unreported income for the GST registrant is more accurately calculated as ($95,238 – $90,000) = $5,238.
Interestingly enough, if the same scenario data is used in the case of a 13% HST registrant, unreported income is a negative amount. This may indicate that the registrant over-reported income, or that a small percentage of income was not deposited into the business’s bank account.
What About Accounts Receivable?
For businesses with accounts receivable (‘A/R’), however, the auditor’s unreported income formula as presented above falls short.
Continuing the audit scenario above, consider that $100,000 in bank deposits are found, income of $90,000 reported, and A/R decreases by $10,000 during the audit period. How might we identify whether the extra $10,000 in deposits is explained by the change, or decrease, in A/R?
To simplify this problem, let’s momentarily ignore the impact of GST/HST. As we see below, the potential periodic change in A/R is best visualized by flipping the main components of the auditor’s unreported income formula:
Income as reported – Income per auditor = Potential change in A/R
Using our scenario data with this flipped formula we get:
$90,000 – $100,000 = – $10,000
With the unreported income formula in this new format, we generate positive or negative numbers that better represent a potential directional (+/-) change in the A/R balance. In our example scenario, the change in A/R over the audit period may now be verified as a decrease of $10,000.
The actual change in A/R per the beginning and ending A/R account balances is formulated as follows:
A/R ending – A/R beginning = Actual change in A/R
Assuming that the A/R ending balance is $0 and the beginning balance is $10,000 – and all other scenario data is the same – we may verify the actual change in A/R as follows:
$0 – $10,000 = – $10,000
Therefore, it is confirmed that the difference between ‘Income as reported’ and ‘Income per auditor’ may be explained by the difference in ‘A/R ending’ and ‘A/R beginning’ balances – the reporting period’s actual change in A/R.
The Revised Unreported Income Formula
Now that we have confirmed the inadequacy of the original unreported income formula, how may we fix it to ensure that it properly takes into account periodic changes in A/R?
Since we have shown that (Income as reported – Income per auditor) and (A/R ending – A/R beginning), when equal, may explain periodic ‘Change in A/R’ – if the two formulas are not equal – then we know that the business may have unreported income.
As such, the revised unreported income formula is applied as follows:
(A/R ending – A/R beginning) – (Income as reported – Income per auditor) = Unreported income
Note that a positive difference is unreported income while a negative difference is over-reported income. Important as well is that this revision does not take into account GST/HST. The impact of GST/HST on the formula is considered in more detail below.
Using the scenario data provided above, the formula may be applied to verify our prior conclusions:
($0 – $10,000) – ($90,000 – $100,000) = $0
Therefore, the $10,000 difference between income as reported and income per auditor may be explained as being due to the collection of $10,000 in prior-period accounts receivable. In other words, the difference between income as reported and income per auditor is not verified as unreported income.
However, before we get too excited with solving this problem. If the business is a GST/HST registrant, we still have an issue: three of the four components of the revised equation include GST/HST, but one does not.
To explain, both A/R beginning and A/R ending balances include GST/HST, and so does ‘Income per auditor’. However, ‘Income as reported’ does not include excise tax. Therefore, the easiest way to correct the revised unreported income formula is to gross-up the income as reported amount so that it includes the business’s appropriate GST/HST per cent.
For GST/HST registrants, the revised unreported income formula should be modified as follows:
(A/R ending – A/R beginning) – (Income as reported including GST/HST – Income per auditor) = Unreported income
To continue with our scenario data, we know that A/R beginning is $10,000 and A/R ending is $0. We also know that the business reported $90,000 of income net of excise taxes (let’s assume that the business is a 5% GST registrant), and that the auditor identified $100,000 of bank deposits classified as income.
Using the scenario data, the formula and result is generated as follows:
($0 – $10,000) – (($90,000 x 1.05) – $100,000) = …
(- $10,000) – ($94,500 – $100,000) = …
(- $10,000) – (- $5,500) = – $4,500
The negative result indicates that the business has potentially over-reported its income by $4,500 including 5% GST.
Let’s imagine a new scenario. This time the business is a 13% HST registrant whose A/R beginning is $10,000 and A/R ending is $0 with income reported of $100,000 (net HST) and income per auditor of $130,000. The result is as follows:
($0 – $10,000) – (($100,000 x 1.13) – $130,000) = …
(- $10,000) – ($113,000 – $130,000) = …
(- $10,000) – (- $17,000) = $7,000
The positive result indicates that the business has potentially under-reported its income by $7,000 including 13% HST. Using this data, the auditor may assess the business (7,000 / 1.13) $6,194.69 of unreported income with a consequential HST assessment of $805.31.
It is easy to imagine the confusion caused by applying the basic unreported income formula without considering periodic changes in A/R balances, and/or the impact GST/HST collected for registrants. With our initial conclusion of $10,000 in unreported income as first calculated above, the taxpayer would have been left scratching their head trying to figure out how they – or their accountant – managed to under-report their income by $10,000.
However, believe it or not, even the revised unreported income formula is an oversimplification of the accounting mechanics involved in determining unreported income. That being said, the following points should be fully considered when applying the revised formula to any particular scenario:
(1) What is the impact of GST/HST collected included in the sum of bank deposits in relation to GST/HST excluded from income as reported?
Realize that some components of the revised unreported income formula require adjustment for GST/HST registrants. Income as reported must be grossed-up to accurately compare it to deposits. Conversely, deposits must have GST/HST backed-out to compare it to income as reported. Accounts receivable balances also include GST/HST collectible on credit sales.
(2) What is the impact of GST/HST collected included in the sum of bank deposits in relation to GST/HST included in A/R balances?
Realize that a comparison of these amounts is a comparison of GST/HST grossed-up amounts.
(3) What is the impact of GST/HST collected included in the sum of bank deposits in relation to unreported income?
Realize that for GST/HST registrant’s, excise tax included in bank deposits should be backed-out to determine the correct unreported income amount (net of GST/HST). Be mindful of any adjustments or errors the auditor may have made when accounting for GST/HST included in bank deposits.
(4) What is the impact of A/R account write-offs and/or allowances in relation to the periodic change in A/R?
Realize that A/R account write-offs and allowances for doubtful accounts may also provide explanation for periodic changes in A/R, and may also impact the accuracy of the revised unreported income formula.
(5) What is the impact of other items that may explain change in A/R including sales returns, NFS cheques received, A/R factoring, conversion of A/R to notes receivable?
Realize that other irregular items may provide explanation for periodic changes in A/R, and may also impact the accuracy of the revised unreported income formula.
(6) What is the impact of inaccurate A/R record keeping?
Realize that inaccuracies in A/R record keeping may provide explanation for periodic changes in A/R, and may also impact the accuracy of the revised unreported income formula.
 For example, income as reported on a business’s Form T2125, T2 / S125 Income Statement, or GST/HST Return.
 If income reported, bank deposits, and beginning and ending accounts receivable balances are all correctly accounted for, then the following equation must be true: Revenue reported – Bank deposits = A/R ending – A/R beginning
 Unless, of course, the auditor has taken the time to back it out.
 Assuming the return has been properly filed. And, if the reported amount is taken from a GST/HST return, assuming that the business does not use the Quick Method.