How Financial Tracking Documents Can Help Find Hidden Perks

Personal Documents

Large or unusual checks can provide useful information to a forensic examiner. An examination of the back of a check negotiated by the suspect party or subject business may show unknown bank accounts being used by the party or business. Payroll checks, for instance, may show a spouse’s money being funneled through an employee.

In addition, hidden liabilities and assets may be found by obtaining a credit report. A credit report that contains joint information can be obtained by either spouse; however, bear in mind that it is illegal to obtain or use an unauthorized credit report.

Obtaining loan and leasing applications, prior divorce decrees, tax returns, and W-2s for the party often also provides useful information. With W-2s, specifically, examine each of the boxes, as these contain important information regarding pensions, deferred compensation, dependent care benefits, etc. From these documents, you should always attempt to determine whether the alleged income matches the lifestyle of the parties.

Business Documents

Several business documents can prove valuable in tracking assets or determining income. Comparative statements for as many years as possible can alert you to nonrecurring, unusual, or extraordinary financial occurrences. The general ledgers of the business should be reviewed by your client for entries that appear out of the ordinary. Particular attention should be paid to the cost of goods sold, repairs, outside services, and expenses of the business. In addition, be sure to obtain any buy/sell agreements adopted by the business. Finally, attempt to determine whether personal expenses of the party are being paid by the business.

Any business documents obtained should be reviewed to determine whether the business is utilizing an accrual or cash basis of accounting because that may significantly alter income. For example, a business using the accrual basis of accounting can manipulate both its income and assets by simply making a journal entry that adjusts its accounts receivable. Other adjustments to income or irregularities hidden in the journal entries may also be discoverable.

Financial Statements

When reviewing financial statements, always make sure the financial statements correlate with the underlying books and records of the business. There are certain general financial abuses you should be looking for, such as the duplicate processing of income or expenses; the recording and reporting of transactions before they occur; the shifting of current income or expenses to a later or earlier period; whether profits or losses are the results of nonrecurring transactions; whether income is being assigned to business partners, family members, and/or close, personal friends; and whether there are income timing differences due to accrual versus cash basis of accounting.

There are also some common financial abuses that will not be recorded in the financial statements or underlying books and/or records of the business. These include unrecorded promises and commitments; unrecorded or pending legal liabilities; unrecorded sales, receipts, and disbursements in separate, unrecorded accounts; inadequate or incomplete disclosures; use of funds for illegal payments and transfers; hidden interests in joint ventures; transfers at other than fair value; and insider trading.

In addition, the following specific areas should be examined to protect your client’s rights:

1. cash versus accrual accounting method,
2. compensation,
3. interest income,
4. dividend income,
5. tax-free exchanges,
6. rents,
7. pension income,
8. personal injury damages,
9. illegal or unreported income,
10. depreciating assets, and
11. other nonreported income.

Business owners can use one of two methods of accounting for their company’s books and records. A cash basis accounting method records revenue and expenses when cash is received or paid, while an accrual basis of accounting records revenues and expenses when they are incurred, regardless of when cash is exchanged. If a business utilizes an accrual method of accounting, then you will see “Accounts Receivable” and “Accounts Payable” on their income statements. Businesses have the ability to distort their revenue or expenses in a given time period depending on which method of accounting they use. Accounts receivables is the primary cash-accounting-versus-accrual-accounting method that can dramatically affect the amount of revenue reported. Watch for unreasonable write-offs of accounts receivable as uncollectible. View aged accounts receivable. Determine if orders are booked as accounts receivable when an order is placed or shipped. Depending on the jurisdiction, accounts receivable can create a double-dipping issue whether they are an asset or next month’s income.

In trying to calculate income, there are many ways a person can be compensated for services. The predominant method is salary or wages, which includes overtime, holiday pay, vacation pay, and sick days. Other forms of compensation include tips, bonuses, restricted stock units, stock options, incentive stock options, commissions, severance pay, golden parachutes, cash payments, side jobs, petty cash, travel and entertainment reimbursements, property payments, barter, and deferred compensation.

There are employee benefits that should be scrutinized, including the accident and health plan, medical reimbursement plan, meals and lodging, dependent care reimbursement, commuter passes, parking, tuition reimbursement, moving expense reimbursement, VITA (volunteer income tax advice) programs, professors’ family tuition waivers, employee achievement awards, employee discount, group term life insurance, cafeteria plans, health spending accounts, flexible spending accounts, group legal services, group life insurance, disability insurance, accident and health benefits, and dependent care benefits.

Pensions can be another overlooked form of compensation. Some employer plans include profit-sharing plans, money-purchase plans, defined-benefit state and federal plans, and union and private employer plans. Look closely at the W-2 to see if a box is checked identifying an employer plan. Also watch for employer matching in defined contribution plans such as 401(k)s and 403(b)s. Annuities are not reported on tax returns when purchased. Lump-sum distributions can be rolled over to an IRA or another qualified plan.

Some interest income does not immediately appear on tax returns. EE Savings Bonds are tax deferred until the bonds mature or are redeemed. They are often part of the contents of safe deposit boxes. Federal obligations are not subject to state tax. State and local bonds are not subject to federal tax.

A type of dividend income that can go undetected is constructive dividends. These types of dividends can arise from shareholders paying personal expenses through their business. Such expenses can include home or cellular phones, a company car used for personal use, personal meals and entertainment, reimbursement of commuting expenses, withdrawals or shareholder loans above salary without obligation of repayment, personal vacations tacked on to business trips, and household expenses. Completing a yearly comparative analysis of the business’s expenses to find irregularities disguised as constructive dividends is strongly recommended.

Rents can be manipulated to distort income. Examine leases for back-loaded rental leases that may, up front, give free rent for higher payments at the end of the lease. Alternatively, the free rent can be straddled around a divorce. A tenant’s improvements can be stipulated in a lease that then affects the rent paid. Determine if a tenant is bartering services for lower rent. Are relatives or friends not paying fair market value? Have you accounted for security deposits in escrow?

Personal injury damages are usually tax free, but the interest on the tax-free amount is still taxable and will be reported on a tax return. Look for a sudden increase in interest.

Other kinds of nonreported income include life insurance proceeds, withdrawals and loans, gifts and bequests, scholarships and fellowships, parsonage housing allowances, and, of course, illegal or unreported income. Ask a simple question: Does cash flow match lifestyle?

Tax Returns

Corporate Returns

On corporate returns, look closely at Schedules M-1 and M-2. Form 1120, page four, provides for book versus tax income (i.e., tax-exempt interest, key man life insurance, cash versus accrual adjustments, etc.). On the Schedule M-1, you need to add back book adjustments for federal income tax to net income per book to equal taxable income on Form 1120. Look to add back capital losses in excess of capital gains. Adjust for income subject to tax though not recorded on books. Adjust for expenses reported on books though not deductible, such as adjustments for meals and entertainment, key person life insurance premiums, excess depreciation, contributions carryover, and foreign tax credits. Conversely, on Schedule M-1, adjust for income recorded on books though not included on the tax return, such as tax-exempt interest and key person life insurance proceeds. Adjust for deductions not charged against book income, including depreciation (straight line versus accelerated), contribution carryover, and capital loss carryover.

On Schedule M-2, account for unappropriated retained earnings and review opening and end-of-year balance figured on Schedule M-2 and entered on Schedule l, note distributions, pending lawsuits, declines in inventory values, any sinking fund for capital expenses, purchase of treasury stock, appropriations with bond holders or creditors, and prior period adjustments for change in accounting principles.

Examine all partnership and S corporation K-1s for amounts distributed to a partner, which may not be the same amount as that reported as income.

Personal Returns

When reviewing a party’s tax returns, be aware of certain items that can help you identify undisclosed assets. For example, retirement, Keogh, and simplified employee pension (SEP) contributions, which can be found in the adjusted gross income section on IRS Form 1040 and on the face of business tax returns, may be used as a vehicle to divert compensation into retirement investment activities. This is particularly important if the compensation would have otherwise been included in calculations for child support and maintenance or if the retirement account in question is a nonmarital asset.

Pay close attention to IRS forms and schedules. Form 1040 Schedule A may have state tax deductions that may identify undisclosed income from another state, real estate tax deductions that identify undisclosed real assets, and investment and interest expenses that may identify undisclosed investment assets. The inventory reported on IRS Form 1040 Schedule C Part III, “Costs of Goods Sold,” is often approximated, which impacts the business income reported. General business credits reported on IRS Form 3800 may identify undisclosed assets, and foreign tax credits reported on IRS Form 1116 may identify undisclosed foreign assets.

Some specific kinds of income/expense distortions may include shipping goods before a sale is finalized, reporting revenue when important uncertainties exist, recording revenue when future services are still due, recording income on the exchange of similar assets, recording funds from suppliers as revenue, using bogus estimates on interim financial reports, boosting profits by selling undervalued assets, boosting profits by retiring debt, failing to segregate unusual and nonrecurring gains or losses, improperly capitalizing costs, depreciating or amortizing costs too slowly, failing to write off worthless assets, reporting revenue rather than a liability when cash is received, failing to accrue expected or contingent liabilities, failing to disclose commitment and contingencies, engaging in transactions to keep debt off the books, accelerating discretionary expenses into the current period, and writing off depreciation or amortization for future years. Ask yourself: does inventory or do supply purchases make sense in light of revenue reported?

E-Tracking

E-tracking has become an important device for financial tracking purposes to ascertain whether a party’s income and/or assets are being distorted or intentionally hidden. Unlike paper documentation, electronic documents are not easily deleted or destroyed, and they may contain valuable information such as a creation date and which computer or person created the document. They may be easier to navigate using search functions in large volumes of documents.

However, attorneys and clients should be careful when accessing electronic documents so that they do not run afoul of the Federal Wiretap Act and the Federal Stored Communications Act. Acquisition of a communication, such as an email on a computer, during its transmission is a violation of the Wiretap Act. A defense to Wiretap Act violations is that a person had prior consent to such interception. 18 U.S.C. § 2511(2)(d). Consent may be express or implied and, if a party consents to the interception of a portion of a communication, a court must inquire as to whether the interception exceeds the scope of the consent. Blumfoe v. Pharmatrak, Inc. (In re Pharmatrak, Inc. Privacy Litig.), 329 F.3d 9, 23 (1st Cir. 2003).

The circuits were previously split on whether there was a spousal exception to the Wiretap Act. Today no circuit recognizes a spousal exception to the Wiretap Act, and, therefore, one spouse may be liable to the other spouse for violating the Act. Glazner v. Glazner, 347 F.3d 1212, 1215–16 (11th Cir. 2003). The issue then becomes whether evidence obtained from a violation of the Wiretap Act is admissible in court. The answer is no. The Wiretap Act expressly prohibits the use of any wire or oral communication intercepted in violation of the Act from being admitted in any trial, hearing, or other court proceeding. 18 U.S.C. § 2515.

Just as consent is a defense to Wiretap Act violations, so too is consent a defense to Stored Communications Act violations. Pharmatrak, 329 F.3d at 16–17. Violations may result in fines, imprisonment, or both. 18 U.S.C. § 2701(b). An aggrieved party may also be entitled to civil relief under the statute, including equitable or declaratory relief, damages, and reasonable attorney fees and litigation costs. 18 U.S.C. § 2707(a)–(b). In contrast to the Wiretap Act, the contents of electronic communications obtained in violation of the Stored Communications Act may be disclosed or otherwise shared with others unless the disclosing party is the provider of an electronic communication service. Wesley College v. Pitts, 974 F. Supp. 375, 389 (D. Del. 1997) (citing 18 U.S.C. § 2702(a)). Furthermore, unlike the Wiretap Act, the Stored Communications Act does not contain an express prohibition of the use of electronic communications obtained in violation of the Act. Thus, while information obtained in violation of the Stored Communications Act may subject a party to criminal and civil sanctions, the information obtained may be admissible in court.

For discovery purposes, the parties are entitled to full disclosure regarding any matter relevant to the subject matter involved in a pending action. The term “documents” is usually broadly defined to include communications and electronically stored information such as writings, sound recordings, and any other data or data compilations in any media from which electronically stored information can be obtained. This means that even if one spouse takes a computer used by the other spouse and that computer was used for both personal and business purposes, there may not be a violation of any statute. Byrne v. Byrne, 650 N.Y.S.2d 499, 500 (Sup. Ct. 1996). In Byrne, the court analogized a computer’s memory to a filing cabinet containing financial documents located in the marital residence, which is “obviously subject to discovery.” Id. See also Etzion v. Etzion, 796 N.Y.S.2d 844 (Sup. Ct. 2005).

—J.W.B. & J.M.F.

Reasons for a Forensic Analysis

Businesses often manipulate revenues, expenses, assets, and liabilities on financial statements for a specific purpose. The reason or reasons a business may distort income may or may not be legitimate and legal.

Some of the common reasons a business owner might understate a company’s assets and revenues are that the owner is seeking to get divorced, pay less federal and state tax, pay less rent when rent is based on revenue earned, make future earnings look better when management is newly appointed, and/or negotiate legal settlements. Some of the reasons a business owner might overstate a company’s financial strength and performance are to obtain additional credit from lenders, make the company more attractive to investors, earn greater management bonuses and sales commissions, establish a stronger track record of earnings, lower costs of loans, avoid filing for bankruptcy, induce prospective buyers, and/or list the company on a stock exchange.

One way that attorneys can help parties resolve an impasse is by finding an impartial means of generating a solution. On important issues such as valuation, taxes, tracing questions, and characterization issues or related problems, an impartial solution may mean finding a professional or a method that both parties will trust or at least consider. In litigation, parties resolve (and sometimes create) such differences by using various kinds of experts. If the parties can agree on a single expert or a single method or approach to address the issue, they can lessen the controversy and also lessen the cost of finding the necessary information. When one party in a divorce believes that the other party is not providing full disclosure of information or is in some way distorting the information provided, it may be prudent for that party to retain a forensic accountant.

In the context of a financial investigation, the accountant can assist the parties in numerous ways. He or she can enable the parties to decide how to gather all the pertinent information, understand the scope of the property to be divided, and appreciate the available choices for dividing the assets and the consequences (e.g., tax consequences) of such choices. The accountant can ultimately help the parties draft an agreement to present to their attorneys for review, and he or she can provide a neutral, third-party point of view.

Ordinarily, business decisions relating to the operation of a business and reporting of income are decided long before a divorce is contemplated or without regard to a pending divorce. Judges can consider the reasons why a party’s income and assets as reported by a business should not be the same as the party’s income and assets within the context of the divorce proceeding. Often such reasons provide a strong argument for eventually persuading a court to equitably divide assets and set a spouse’s income level in a manner compatible with the accountant’s theory of the case, rather than as indicated by the records of the business.

In the event that financial issues are litigated, the courtroom presentation of evidence can be a deciding factor in a judge’s decision. As such, it is imperative to remember the Boy Scout motto: “Be prepared.” The attorney should spend adequate time preparing the forensic accountant for testimony. It is important to sequence the forensic accountant’s testimony so it is easy for the judge to follow. This approach will also help lay the proper foundation and paint a picture for the court. The expert should be encouraged to explain as much as possible in layman’s terms and use demonstrative evidence to highlight the facts relied on to develop his or her opinion.

—J. W. B. & J.M.F.