The net worth method in forensic accounting estimates a person's income indirectly. Measure what they owned and owed at the start and end of a period, add what they spent on living, subtract money from nontaxable sources such as gifts or inheritances, and compare the result with the income they reported. A large unexplained gap points to hidden income.
The net worth method formula, step by step
The net worth method formula starts from a simple idea: wealth cannot grow, and bills cannot be paid, without money coming from somewhere. If a person's net worth rose and they also paid for a household, the total must have come from income or from an identifiable nontaxable source. Whatever is left over is unexplained.
Net worth is assets minus liabilities. The IRS Internal Revenue Manual section on methods of proof, in its part on the net worth method (9.5.9.5), sets the computation out in this order:
- Compute net worth at the end of the period.
- Subtract net worth at the start of the period. The result is the increase in net worth.
- Add personal expenditures and nondeductible losses.
- Subtract nontaxable receipts, such as gifts, inheritances and federal tax refunds.
- The result is corrected adjusted gross income.
- For a tax case, subtract deductions to reach corrected taxable income, then subtract the taxable income actually reported. The difference is the understatement.
Outside tax work, forensic accountants often stop at step 5 and compare it with the income the person admits to: the salary on a financial affidavit, the draws from a business, or the income a lender was told about. The logic is the same; only the comparison figure changes.
The manual also says assets are generally entered at cost or other tax basis, not at market value. A house bought for 310,000 stays at 310,000 even if it would now sell for more, because the method measures money spent, not wealth gained from price changes.
Building the opening net worth statement
The opening net worth statement is the most important schedule in the analysis, because every later figure is measured against it. Understate the person's starting assets and the method will treat those assets as income earned during the period. The IRS manual lists establishing opening net worth with reasonable certainty as the first of the requirements a court looks for.
The manual says mathematical certainty is not required, but the investigation has to be thorough. In practice that means looking for every asset and debt that existed on the start date, not only the ones the person mentions.
Records that establish the starting balances
- Bank and brokerage statements for every account at the start date. The statement closing balances give cash and securities. When those balances come from statements the subject supplied, test them first: how to detect fake bank statements covers the checks.
- Property records and closing statements for real estate, showing cost.
- Vehicle titles and loan documents.
- Loan statements, mortgage statements and credit card statements for liabilities.
- Prior tax returns, loan applications and financial statements given to lenders. A loan application signed two years earlier that lists assets is strong evidence of what the person owned then.
- Business books. If the person owns a business, its reconciled bank balances and owner's equity become part of the picture. A company that reconciles its accounts in its accounting system, as described in NetSuite bank reconciliation, gives you year-end cash figures you can rely on far more than the owner's estimate.
Cash on hand at the start
Cash kept outside any bank is the hardest asset to fix. The manual calls the establishment of cash on hand critical and notes that uncertainty about it is a common defense. Evidence of low cash at the start helps: bounced checks, overdraft fees, small loans from family, or statements made to lenders that the person had no savings.
A worked net worth computation for one year
A worked net worth computation lays the two balance sheets side by side, then adds spending and removes known nontaxable money. The example below follows one person for one year. All names and figures are invented for illustration.
The person reports wages of 62,000 for 2025. During the year they received an inheritance of 10,000, documented by the estate. Living expenses traced through bank and card statements total 48,000.
Assets and liabilities, at cost
| Item | Dec 31, 2024 | Dec 31, 2025 |
|---|---|---|
| Checking and savings | 18,400 | 41,900 |
| Cash on hand (stated) | 2,000 | 2,000 |
| Brokerage account, at cost | 25,000 | 60,000 |
| Residence, at cost | 310,000 | 310,000 |
| Vehicles, at cost | 22,000 | 58,000 |
| Total assets | 377,400 | 471,900 |
| Mortgage | 240,000 | 232,500 |
| Vehicle loan | 0 | 20,000 |
| Credit cards | 4,100 | 2,600 |
| Total liabilities | 244,100 | 255,100 |
| Net worth | 133,300 | 216,800 |
From net worth to unexplained income
| Step | Amount |
|---|---|
| Net worth, end of 2025 | 216,800 |
| Less net worth, end of 2024 | (133,300) |
| Increase in net worth | 83,500 |
| Add living expenses | 48,000 |
| Less inheritance (nontaxable) | (10,000) |
| Income needed to explain the year | 121,500 |
| Less income reported | (62,000) |
| Unexplained | 59,500 |
The person needed about 121,500 to fund the year and admits to 62,000. The 59,500 gap is the finding. Note what drove it: the brokerage account grew by 35,000 at cost and a second vehicle was bought for 36,000, partly with a 20,000 loan. Each of those is a question to put to the person, and each has a document trail to follow.
When the bank statements behind the cash line show many deposits just under reporting thresholds, or a run of even-dollar amounts, the gap starts to have a shape. Those patterns are covered in structured cash deposits and round dollar transactions.
Which personal expenditures belong in a net worth analysis?
Personal expenditures in a net worth analysis are the living costs that consumed money without leaving an asset behind: food, utilities, insurance, travel, school fees, mortgage interest and property tax. They are added because money spent on them had to come from somewhere, yet it no longer shows on the balance sheet at year end.
The common error is counting something twice. A mortgage payment has two parts. The principal reduces the mortgage liability, which already raises net worth on the schedule, so only the interest and escrowed taxes belong in living expenses. The same applies to car loan payments and to any purchase that appears as an asset, such as the vehicle in the example.
Ways to measure living expenses, from strongest to weakest:
- Traced payments. Add up the actual bank and card payments, category by category, from statements.
- Third-party records. Utility, school and insurance records that state the amount paid.
- Cash withdrawals. ATM and counter withdrawals that were not redeposited are usually spending, though they can also be the cash hoard the person later claims.
- Published cost-of-living figures. A weak fallback when records are missing, and one an opposing expert will attack.
Spending paid in cash with no bank trail is the hardest to prove and also the most likely to hide unreported income. Lifestyle evidence, such as a vacation paid in cash, can fill part of that gap.
Cash hoards, gifts and loans: weak points of the net worth method
The net worth method's weak points are the explanations a person can offer for money that appears without income: a cash hoard saved over years, gifts from relatives, loans from friends, inheritances and asset sales. Each is plausible, and the method fails if one is true and ignored. The investigator's job is to test every explanation the person gives.
The IRS manual calls these leads and says those offered must be pursued when they are reasonably verifiable. It notes most concern cash hoards, gifts, inheritances and loans. It also says that if the government does not show it checked the leads, the court may treat the subject's explanation as true.
How each explanation is usually tested:
| Explanation | Test |
|---|---|
| Cash hoard from earlier years | Prior returns, prior loan applications, overdrafts or borrowing at the start date that a saver would not need |
| Gift from a relative | The giver's bank records, a gift tax filing, the giver's ability to pay |
| Personal loan | A written note, repayments on the statements, the lender's bank records |
| Inheritance | Estate records and the distribution check |
| Sale of an asset | The sale document, the buyer, and whether the asset was on the opening schedule |
The method has other weak points:
- Missing assets at the start. An account you did not find at the opening date will look like new income when it appears later.
- Market values instead of cost. Using appraised values instead of cost puts market gains into "income."
- Joint ownership. Assets held with a spouse or a business partner need a clear rule for how much belongs to the person.
- Short periods. One year is fragile. Several years, each computed the same way, show a pattern that is harder to explain away.
When should the net worth method replace a bank deposits analysis?
The net worth method should replace a bank deposits analysis when the person's money does not pass through the bank, or when the books and records are missing or unreliable. Cash that goes straight into assets or spending never shows as a deposit, so a deposits analysis understates it.
Situations that favor it:
- Cash businesses, where receipts are spent or hoarded before reaching an account.
- Visible assets bought with no visible income, such as property, vehicles or investments.
- Missing or destroyed books.
- A divorce or support case where one spouse's stated income does not fit the household's spending.
Situations where it is the wrong tool:
- Complete bank records with deposits that carry the income. A bank deposits analysis or a direct trace is more precise and easier to explain.
- A very short period. The opening and closing estimates can swamp the change you are trying to measure.
- A subject with large, hard-to-value assets, such as a closely held company, where cost basis is unclear.
- A known specific theft. If you already know which payments were taken, add them up. An indirect method adds nothing.
The bank statements are the backbone either way, because they fix the cash lines and prove much of the spending. PreciseBankFlow reads each statement, checks that it foots from opening to closing balance and flags duplicates and gaps, so the balances you carry into the schedule are ones you have tested. To try it on a case file, request early access.