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Chapter 13: forensic accounting.

OVERVIEW

The accounting scandals involving Enron, WorldCom, and other companies put accountants in the public spotlight as never before. For several months in early 2002, the media treated Americans to accountants giving Congressional testimony or making court appearances. However, so-called "forensic accountants" have been conducting these activities for quite some time in a quiet professional manner. New laws and regulations resulting from the "dot com" scandals have made the role of the forensic accountant more important than ever before in today's business world.

Simply put, forensic accounting includes any accounting engagement in support of a legal case. The word "forensic" has an exotic connotation but is really a very basic concept. For instance, forensic medicine is medicine that supports court cases. Although forensic accountants don't examine anything as exciting as dead bodies, like the medical examiner in a Patricia Cornwell novel, they do arrive to find the charred remains of companies that have been totally looted of their assets (e.g., the Adelphia Communications Company). Still forensic accountants may testify on the worth of a company in a heated court case dealing with a bitter divorce or a contested will. In other words, forensic accountants do get their fair share of excitement and thrills--and more importantly--play a significant and often key role in the divorce process.

WHAT IS FORENSIC ACCOUNTING?

Forensic (and investigative) accounting is the application of financial skills and an investigative mentality to unresolved issues conducted within the context of the rules of evidence. As a discipline, it encompasses financial expertise, the uncovering of fraud and concealment, as well as strong knowledge and understanding of business realities and the workings of the legal system. Its development has been achieved primarily by on-the-job training, as well as experience with investigating officers and legal counsel.

Forensic accounting involves those persons who have become experts (e.g., auditors, accountants, or even investigators) regarding certain aspects of legal and financial documents. But it is very important to understand that a financial divorce practitioner can also be involved with this process. After all, you will be reviewing tax returns, financial statements, correspondence, and much more. This process will lead you to ask many more questions that will ultimately lead you in many directions with the goal of helping your client discover and possibly locate "missing" or even "hidden" marital assets. As a financial divorce practitioner you must know when to get additional qualified help in this specialized field of financial discovery.

HOW ARE FORENSIC ACCOUNTANTS USED?

A forensic investigation can be used to unravel hidden information that might ultimately provide the financial support desired by a litigant. A forensic accountant is constantly thinking in terms of how and why assets might be missed or why or how a fraud might have been perpetrated and audit accordingly.

The skills of forensic accountants and their expert testimony can be called upon in a variety of assignments. Providing litigation support is an accurate, but extremely broad, description of the possible services that forensic accountants provide. Expert witness testimony, discovery assistance, validation of business facts, computation of damages, and determination of compliance are some of the more specific services that are performed by the forensic accountant.

TYPES OF FORENSIC SEARCHES

Forensic accounting engagements usually involve business valuations or fraud examination. Both types of forensic accounting have been around for a long time. Divorces, particularly messy ones, require the use of business valuation experts, as well as individuals who know where to look to uncover assets that one party in the divorce has unintentionally omitted mentioning or deliberately concealed because he/she does not want the other party to discover. In addition, business valuation experts are usually involved whenever the ownership of an organization changes or a business disruption occurs.

Fraud examination was given a strong boost with the adoption of the federal income tax in the early part of the 20th century. Forensic accountants sent the gangster Al Capone to jail for income tax evasion. Organizations usually employ fraud examiners directly or hire independent experts. In addition, many traditional auditors have adopted forensic accounting techniques during the review of their clients' accounting records.

WHEN TO USE A FORENSIC ACCOUNTANT

Uncover Hidden Assets

It has become increasingly necessary in divorce cases for a husband's assets (as an example) to be valued by a forensic accountant, who aims to discover any action that a husband might have taken to depress the value of those assets and decide if the past year's company accounts reveal the true profit or business value.

There are often suspicions that some accounts understate the true profit of a company and, therefore, constitute misleading information regarding the capital value which the other spouse should share or benefit from. This is particularly true in the case of cash businesses, but could arise in any business in any sector.

Preemptive "Strike"

In many cases, the best evidence of a husband understating his true business profits is an inconsistency between the declared income and the lifestyle of the couple during marriage.

It is suggested that persons anticipating divorce should build a protective financial dossier (e.g., keeping a record of his/her lifestyle; retaining hard evidence such as credit card bills, restaurant bills, holiday invoices, club memberships, store card account details, and anything else that affirms marital expenditure levels).

In essence, your client must also become a "detective." If one spouse thinks the other spouse is winding his or her business down to reduce a settlement, it is imperative that evidence be gathered that the spouse has deliberately depressed profits, overstated overheads, fudged capital expenditures, and the like.

Regarding employees, the practitioner should get the names of everyone who might be colluding with the other spouse, such as the finance director or someone in the accounting department.

USING THE TAX RETURN

One can sometimes work "magic" on figures in a divorce or other lawsuit using information found on a tax return. For example, the divorce financial practitioner can:

verify the existence of hidden, deferred, * ed, or transferred income;

* validate claims of separate property;

* determine disposable income and the standard of living; and

* identify "changed" property.

The practitioner can also identify personal assets acquired by a small business and ascertain its unreported income.

However, Form 1040 is not always a completely accurate reflection of a spouse's true income. The individual may: own tax-free investments; underreport income; exploit fringe benefits; report losses or low income (legitimately) and still draw considerable cash from that business; and even sell-off assets owned by a small business.

In preparation for litigation where the amount of income is in question, always obtain several (preferably at least three to five) years of Forms 1040 and W-2, state tax returns, and any related small business returns such as Forms 1065, 1120, 1120S, and Schedule K-1. If you suspect these returns to be forgeries or you cannot obtain them, have your client file IRS Form 4506 for Form 1040 and W-2s. If the client is a company or officer, he or she can also obtain the business returns.

Basics of Form 1040

Review several years of returns to gauge the level of income and deductions. Examine and plot trends and look for inconsistencies. Income tends to fall and expenses rise in anticipation of a divorce or lawsuit. Be alert for the following issues and items:

Schedule A (Itemized Deductions): Prepayments for future benefits may be detected on Schedule A. Analyze the property taxes that should be due annually to see if substantially more is deducted. Prepayment of a year or two of taxes can add up. Perform the same check on mortgage interest. An increase in the interest deduction from one year to the next could indicate prepayment of a few mortgage payments; conversely, a large decrease in deductions could indicate a refinancing or large principal pay-down.

Form W-2: Inspect the line 1 wages and lines Medicare wages boxes. Are these amounts different? Observe the line 15 check box. Is "Pension or Deferred Compensation" checked? If yes is the answer to either question, the employee has a retirement or 401(k) plan or other salary reduction benefit.

It might be concluded that a party may be planning to file for a large refund after the lawsuit if: (1) state income tax withheld is more than 6-8% by a person who does not live or work in the withholding state; or (2) federal tax withholding is a larger percentage than the tax bracket the person would likely fall within. In addition, do not assume that the W-2 is necessarily prepared correctly since many errors or omissions occur on these forms.

Schedule B (Interest and Dividends): If interest and dividends are reported, then some asset is obviously generating the income. If the other party owns growth stocks or other non-dividend producing assets, then little or no income will be reported.

Although tax-exempt municipal interest is supposed to be reported on line 8b of Form 1040, many filers omit this since such income is generally tax-exempt. Be aware that assets may be transferred to a child through a Uniform Gift to Minors Account (UGMA), to another person by gift, to a trust, or to a corporation, but the Service's reporting is on the other entity's Social Security number or employer identification number (EIN).

Schedule C (Sole Proprietorship): A sole proprietor does not have to keep a balanced, double-entry accounting system (in fact, some sole owners keep their records in a plain old spiral notebook).

Since the income statement and balance sheet are not required to be reported and reconciled together on the return, as is the case with a corporation, partnership/ LLC income manipulation can occur.

Consider whether the company is the type that would sell inventory and/or carry receivables on account. Most Schedule C forms are reported on the cash basis; thus receivables and inventory may exist, but may not be recorded anywhere.

If possible, inspect the other party's sales tax returns, customer invoices, or cash register tapes to ensure that all income is reported and not simply pocketed. Watch for excessive vehicle, travel, meal and miscellaneous expenses. Depreciation can be manipulated legitimately for tax reporting by writing off the full value of assets under IRC Section 179. Also note that assets that might appear to be leased may in fact be a disguised purchase.

Schedule E (Rental, Partnership/LLC and S Corporation): A common legitimate tax dodge allows individuals to pay rent to themselves for buildings they own and their small business uses in place of a larger salary or draw. The rent expense is deducted on the business return, but the reportable income is sometimes mysteriously absent on the individual's 1040 rental income Schedule E.

Schedule K-1. Profit or loss from a small business, after all expenses, for a partner/LLC member, or S corporation owner is reported to them in the form of a Schedule K-1, which is an attachment to a business tax return. A partner or LLC member should not receive a W-2 to report his/ her income since he/she is not a legal employee, but an S corporation owner should receive a W-2.

When inspecting the partnership/LLC and S corporation income section on page 2 of Schedule E of the 1040, scrutinize the income/losses figure and Section 179 expense taken. This may not necessarily reflect the actual income received by this owner.

An S corporation owner will commonly take compensation in the form of S corporation "draws", which are essentially unreported returns of capital likened to a dividend, in place of or in addition to his/her or W-2. If the K-1 is correct, the draw figure will appear on the second page. If not reported there, check the corporate tax return balance sheet on page 4 for the distributions.

A partner/LLC member receives most of his or her compensation by taking "return of capital" draws. The draws should be reported on the K-1 and on page 4 of Form 1065. Be aware that both LLCs and partnerships file on Form 1065, the partnership tax return. Another form of compensation, likened to a salary, is called a "guaranteed payment" and should be reported on that partner's/member's K-1. A common error (or deceptive practice) is to not report the guaranteed payment (salary) on the K-1 and bypass paying tax on it. Once again, income reported on the K-1 does not necessarily reflect the owner's actual income received.

Another aspect to consider is the amount of capital contributions or loans a small business owner may invest in or loan to his company. Owners can easily bury capital contributions on a tax return. To uncover such items, track the retained earnings or partners' equity from year to year. The basic formula is beginning (prior year's) balance plus net income earned minus draws equals ending balance. Analyze the total capital and owner-related loans. If these balances seem high for the type of business, ask yourself if this business needs a large amount of accumulated capital to operate.

Forensic Techniques after the Tax Returns Are "Dead"

Dead men don't talk, and sometimes tax returns don't either. Certified public accountants are often called upon to conduct an "autopsy" on the tax return to determine the cause of discrepancy in income claimed versus reality. The exercise of finding unreported income is very useful for alimony and child support issues, but also allows for some good negotiating room.

Assuming no personal or business financial statements are available and the tax returns are silent, where do you look? Five basic methods are available to prove unreported income:

1. Transaction Method.

2. Net Worth Method.

3. Expenditures Method.

4. Bank Deposit Method.

5. Percentage Method.

Transaction Method: This is the easiest method to employ since it involves identifying a specific item or transaction that was not reported on a tax return (e.g., a real estate or securities sale). Most financial transactions and earnings are reported to the IRS on some type of form, such as a Form 1099. An individual may fail to identify to the court or report on his or her tax return items that are recorded on a Form 1099-S (from a real estate sale), or a Form 1099-B (from a broker sale of securities). A business might also inflate inventory values or create fictitious payables in order to depress reportable income. In this case, a thorough fraud audit may need to be conducted on the business' books.

Net Worth Method: Many civil and criminal tax cases use this method to determine unreported income and to support findings from other methods employed. The concept is simple: if an individual's net worth from one year to the next increases beyond the reported income, then unreported income probably exists. Outside of a 1040, records of assets can be obtained from county assessors, bank and brokerage accounts, federal estate and gift tax returns, and loan/credit card applications.

After an unsubstantiated increase in net worth is established, a likely source for this income must be determined other than from accumulated cash, loans, inheritances, gifts, insurance proceeds, etc. If the individual claims the likely source was from accumulated cash, you need to establish the unreasonableness of this by searching for: checks returned for insufficient funds; bankruptcy filings; offers in compromise or installment agreements with the IRS; Social Security and employer records showing low income; and deposition answers about cash on hand.

Expenditures Method: This method is very simple to understand and apply and is useful when the individual spends most of his income and does not save much. Establish annual expenses through affidavits, checkbooks, bank statements, and canceled checks. If the expenses exceed the reported income, and it can be established that the gap was not bridged with accumulated cash, loans, inheritances, gifts or insurance proceeds, you probably have found unreported income.

Bank Deposits Method: The IRS commonly uses this method to catch tax cheats. All deposits recorded in all banks and other institutions are totaled, cash received by the individual that was not deposited and used to pay expenses is added, deposits that do not represent already reported and known taxable income are subtracted, and business expenses paid by check or cash are also subtracted. Finally, the standard deduction, or itemized deductions, and exemptions (as reported in the 1040) are deducted to arrive at taxable income. If more taxable income is found with this formula than was reported on the 1040, the individual probably has unreported income.

Percentage Method: Although not used as often, this is a good method for supporting findings from other methods when investigating a business. An established and reliable profit percentage typical of that business is multiplied by a reported income base, such as sales or gross profit, to determine net income. The formula net income is compared to that reported on tax returns or financial statements to establish an underreporting of income.

The transfer of income between an individual's 1040 and his business return, and visa versa, can be easily manipulated, and go undetected--but it is not necessarily illegal. Tax returns are often the first, best shot at establishing income and discovering assets. So read between the lines and keep your eye on the cash flow. And if that still is still not finding the income and assets that seems to exist, employ a forensic accountant to perform an autopsy on the paper.

WHERE CAN I FIND OUT MORE ABOUT IT?

The Association of Certified Fraud Examiners (ACFE) is the professional organization for fraud examiners. Located in Austin, Texas, the ACFE was founded by an ex-FBI agent, John Wells, in the mid-1980's. The ACFE has developed extensive training materials, a code of ethics and professional standards, and the Certified Fraud Examiner designation. It has consistently lobbied accounting standard-setting bodies for more rigorous anti-fraud measures. Information about the ACFE can be found on its Web site: www.cfenet.com.

LOOKING FOR A FORENSIC ACCOUNTANT

When looking for a forensic accountant, search for someone who:

* has specific knowledge of family law;

* is sensitive to your client's needs, listens to your client's financial concerns, and responds to clients in a sympathetic, compassionate manner;

* communicates well;

* is curious, intuitive, and creative and is willing to dig deep to uncover financial information and piece together the facts of your client's case; and

* has a solid knowledge of taxation.
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Title Annotation:Part 5: TAX AND FINANCIAL ISSUES
Publication:Tools & Techniques of Divorce Planning
Date:Jan 1, 2008
Words:3051
Previous Article:Chapter 12: filing status and tax issues.
Next Article:Chapter 14: acting as an expert witness.
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