Hidden Income And Assets: A Forensic Accountant’s Process

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I’ve conducted hundreds of investigations involving allegations of fraud and abuse. I have personally seen the number of hours it can take to investigate broad or imprecise allegations, all to come up with nothing. What I have learned is that concerns that come in the form of “I know he/she moved money here,” or “how else would he/she pay for this” are no different from allegations I received regarding corporate fraud from employees who said, “I know something bad is going on.”

Both parties are scared and uninformed. They have a real belief something is wrong, but the fact is, it usually stems from their lack of understanding or possibly other feelings. This is not to say we dismiss these concerns. However, we shouldn’t begin an investigation into fraud or possible asset dissipation without understanding the big picture.

Duval Motor Company

The purpose of this article is to explain how forensic accountants look at the big picture, both financially and by understanding past behaviors, to uncover items that may help you or your client. Some of my biggest “wins” in fraud investigations started with broad allegations; however, the techniques used to identify and quantify these allegations were what really led me to success.

First, we need to understand what red flags or “fraud indicators” are there. This helps us narrow the scope of the analysis and understand what the issues are needing attention.

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Accountants know the basic accounting equation: Assets – Liabilities = Net Worth (Equity)

What needs to be further explained and understood is how income and expenses interact with the equation above. It is really quite simple: Income – Expenses = Excess Asset or Increased Liability

What forensic accountants do during is understand how income & expenses interact with and affect assets & liabilities. Where many practitioners get caught is in defining “income”. Taking income from a tax return will not provide a complete and accurate picture of what is called free cash flow. Too many times the indecision of accounting practitioners and the lack of understanding by attorneys and the courts have led to inaccurate communication of income. The good news is that a method is available that can accomplish a reconciliation between the assets, liabilities, income and expenses.

The Net Worth Method looks at the difference between a person or businesses net worth (total assets less total liabilities) on any two given dates. If the evidence collected can establish that net worth increased more than the receipts (i.e., income) received by a person/business in the form of money or property, less expenses, then this excess would be additional taxable income to that person or business. Also considered is discretionary spending, capital improvements, taxes, etc.

In “The Net Worth Method,” Andrew Ross states:

“The Net Worth Method has been endorsed by the U.S. Supreme Court and every circuit court. Its use is not limited to matters of tax fraud. Forensic accountants can also apply this technique to a wide array of cases, such as divorce litigations, shareholder/partnership disputes and fraud investigations. The Net Worth Method is considered an indirect method of proof that, if applied properly, presents compelling circumstantial evidence of a target’s hiding of unreported income.”

How do we determine income? If the 401K account and savings account balances have increased by more than the disposable income identified on a financial affidavit we know income hasn’t been completely and accurately accounted for by the other side. Consequently, if the argument is that income has been accounted for, then there exists a possibility than another asset has not been disclosed. The point and purpose of the Net Worth Method is to “root out” any inconsistencies and place them up for discussion. As the saying goes “lay all the cards on the table.”

I don’t think you will find an attorney who wouldn’t be happy to work collaboratively with the other side to ensure assets and income are fully understood and accurately reported. The Net Worth Method allows for such transparency in cases deserving of it. In cases where the other side is not open to collaboration, it will allow the forensic accountant to scientifically explain how one side must meet the other. More importantly, it takes a broad allegation and can then narrow the scope of areas where a forensic accountant should be working. For example, tracing bank accounts to uncover further hidden accounts or reviewing corporate tax returns in depth to understand cash flow available for support that has been used to secure other assets or reduce liabilities.

I like this method because first and foremost it is accounting at its best. No grey area, just black numbers on white paper telling us what is and isn’t. Second, it employs a transparent approach for both sides to become aware of assets, liabilities, income, and expenses that will arm them with the information they need. Josh Shilts 

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