Forensic and Investigative Accounting Chapter 6 Indirect Methods of Reconstructing Income © 2011...

Forensic and Investigative AccountingForensic and Investigative Accounting

Chapter 6

Indirect Methods of Reconstructing Income

© 2011 CCH. All Rights © 2011 CCH. All Rights Reserved.Reserved.

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Chapter 6 Forensic and Investigative Accounting 2

Forensic Audit Approaches Used Forensic Audit Approaches Used by the IRSby the IRS

Direct methodsDirect methods involve probing missing involve probing missing income by pointing to specific items of income by pointing to specific items of income that do not appear on the tax return. In income that do not appear on the tax return. In direct methods, the agents use conventional direct methods, the agents use conventional auditing techniques such as looking for auditing techniques such as looking for canceled checks of customers, deed records of canceled checks of customers, deed records of real estate transactions, public records and real estate transactions, public records and other direct evidence of unreported income.other direct evidence of unreported income.


Forensic Audit Approaches Used Forensic Audit Approaches Used by the IRSby the IRS

Indirect methodsIndirect methods use economic reality and use economic reality and financial status techniques in which the financial status techniques in which the taxpayer’s finances are reconstructed taxpayer’s finances are reconstructed through circumstantial evidence.through circumstantial evidence.


Minimum Income ProbesMinimum Income Probes

For nonbusiness returns, an agent questions For nonbusiness returns, an agent questions the taxpayer or the representative about the taxpayer or the representative about possible sources of income other than possible sources of income other than reported on the return. If there is no other reported on the return. If there is no other information in the file indicating potential information in the file indicating potential unreported income, the minimum income unreported income, the minimum income probe is met.probe is met.


Minimum Income ProbesMinimum Income Probes

For taxpayers who are self-employed and For taxpayers who are self-employed and file a Schedule C or F, an analysis is made file a Schedule C or F, an analysis is made of tax return information to determine if of tax return information to determine if reported income is sufficient to support the reported income is sufficient to support the taxpayer’s financial activities.taxpayer’s financial activities.


Lifestyle ProbesLifestyle Probes

The lifestyle of a taxpayer or employee may The lifestyle of a taxpayer or employee may give clues as to the possibilities of unreported give clues as to the possibilities of unreported income. Obvious lifestyle changes may indicate income. Obvious lifestyle changes may indicate fraud and unreported income:fraud and unreported income:

– Lavish residenceLavish residence– Expensive cars and boatsExpensive cars and boats– Vacation homeVacation home– Private schools for childrenPrivate schools for children– Exotic vacationsExotic vacations


IRS Financial Status AuditsIRS Financial Status Audits

If someone is spending beyond his or her If someone is spending beyond his or her apparent means, there should be concern. If a apparent means, there should be concern. If a forensic accountant suspects fraud or forensic accountant suspects fraud or unreported income, a form of financial audit unreported income, a form of financial audit may be appropriate that will enable the may be appropriate that will enable the investigator to check the lifestyles of the investigator to check the lifestyles of the possible perpetrators.possible perpetrators.


Indirect MethodsIndirect MethodsAn indirect method should be used when:An indirect method should be used when:The taxpayer has inadequate books and records.The taxpayer has inadequate books and records.The books do not clearly reflect taxable income.The books do not clearly reflect taxable income.There is a reason to believe that the taxpayer has There is a reason to believe that the taxpayer has

omitted taxable income.omitted taxable income.There is a significant increase in year-to-year net worth.There is a significant increase in year-to-year net worth.Gross profit percentages change significantly for that Gross profit percentages change significantly for that

particular business.particular business.The taxpayer’s expenses (both business and personal) The taxpayer’s expenses (both business and personal)

exceed reported income, and there is no obvious cause exceed reported income, and there is no obvious cause for the difference.for the difference.


Market Segment Specialization ProgramMarket Segment Specialization Program

The Market Segment Specialization Program The Market Segment Specialization Program focuses on developing highly trained examiners focuses on developing highly trained examiners for a particular market segment. An integral part for a particular market segment. An integral part of the approach used is the development and of the approach used is the development and publication of Audit Technique Guides. publication of Audit Technique Guides.

(continued on next slide)(continued on next slide)


Market Segment Specialization ProgramMarket Segment Specialization Program

These Guides contain examination These Guides contain examination techniques, common and unique industry techniques, common and unique industry issues, business practices, industry issues, business practices, industry terminology, and other information to assist terminology, and other information to assist examiners in performing examinations. A examiners in performing examinations. A forensic accountant can use this resource to forensic accountant can use this resource to learn about a particular industry (many are learn about a particular industry (many are free).free).


Cash TCash T

A cash T is an analysis of all of the cash A cash T is an analysis of all of the cash received by the taxpayer and all of the cash received by the taxpayer and all of the cash spent by the taxpayer over a period of time. spent by the taxpayer over a period of time. The theory of the cash T is that if a taxpayer’s The theory of the cash T is that if a taxpayer’s expenditures during a given year exceed expenditures during a given year exceed reported income, and the source of the funds reported income, and the source of the funds for such expenditures is unexplained, such for such expenditures is unexplained, such excess amount represent unreported income excess amount represent unreported income (e.g. embezzled income).(e.g. embezzled income).


Preliminary Cash-TPreliminary Cash-T

Gross Receipts:Gross Receipts: Business Expenses:Business Expenses:

Schedule CSchedule C $120,000$120,000 Schedule CSchedule C $95,000$95,000

Preliminary Preliminary Understate-mentUnderstate-ment

Personal Living Personal Living Expenses Expenses

$60,000$60,000 $155,000$155,000

$35,000$35,000


Source and Application of Funds Source and Application of Funds Method (Expenditure Approach)Method (Expenditure Approach)

This technique is a variation of the net worth This technique is a variation of the net worth method that shows increases and decreases in a method that shows increases and decreases in a taxpayer’s accounts at the end of the year. The taxpayer’s accounts at the end of the year. The format of this method is to list the applications format of this method is to list the applications of funds first and then subtract the sources. If of funds first and then subtract the sources. If the taxpayer’s applications exceed his or her the taxpayer’s applications exceed his or her known cash receipts (including cash on hand at known cash receipts (including cash on hand at the beginning of the year), any difference may the beginning of the year), any difference may be unreported income.be unreported income.


Net Worth MethodNet Worth MethodThe net worth method is a common indirect balance sheet The net worth method is a common indirect balance sheet approach to estimating income. To use the net worth approach to estimating income. To use the net worth method, an IRS agent or forensic accountant must:method, an IRS agent or forensic accountant must:

1.1. Calculate the person’s net worth (the known assets Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of less known liabilities) at the beginning and ending of a period.a period.

2.2. Add nondeductible living expenses to the increase in Add nondeductible living expenses to the increase in net worth.net worth.

3.3. Account for any difference between reported income Account for any difference between reported income and the increase in net worth during the year as (a) and the increase in net worth during the year as (a) nontaxable income and (b) unidentified differences.nontaxable income and (b) unidentified differences.


Bank Deposit MethodBank Deposit Method

The bank deposit method looks at the funds The bank deposit method looks at the funds deposited during the year. This method deposited during the year. This method attempts to reconstruct gross taxable receipts attempts to reconstruct gross taxable receipts rather than adjusted.rather than adjusted.


Gross Business Receipts FormulaGross Business Receipts Formula1. Total bank deposits1. Total bank deposits $XXX$XXX

Less:Less:2. Nontaxable and nonbusiness receipts deposited2. Nontaxable and nonbusiness receipts deposited (XXX)(XXX)

3. Net deposits resulting from business receipts3. Net deposits resulting from business receipts $XXX$XXX

Add:Add:

4. Business expenses paid by cash4. Business expenses paid by cash $XXX$XXX

5. Capital items paid by cash5. Capital items paid by cash XXXXXX

6. Personal expenses paid by cash6. Personal expenses paid by cash XXXXXX

7. Cash accumulated during the year from receipts7. Cash accumulated during the year from receipts XXXXXX

8. Subtotal8. Subtotal $XXX$XXX

9. Less: Nontaxable and nonbusiness cash used for 9. Less: Nontaxable and nonbusiness cash used for (4) through (7)(4) through (7)

(XXX)(XXX)

10. Gross business receipts as corrected10. Gross business receipts as corrected $XXX$XXX

11. Adjustments for accrual basis taxpayers11. Adjustments for accrual basis taxpayers $XXX$XXX


Six Requirements for a Valid ContractSix Requirements for a Valid Contract

1. Offer and acceptance.

2. Lawful objective.

3. Capacity of parties to perform.

4. Something of value exchanged.

5. Appropriate form (e.g., in writing).

6. Entered into freely.


Procurement Fraud TechniquesProcurement Fraud Techniques

Bribes and kickbacks. Bid rigging. Defective pricing. Phantom vendors (www.picalo.org). Product substitution. Conflict of interests. False claims.


Procurement Fraud TechniquesProcurement Fraud Techniques

Cost mischarging. Contract specification failures. Duplicate, false, or inflated invoices. Split purchases. Unnecessary purchases. Defective delivery.


Foreign Corrupt Practices Act (FCPA)Foreign Corrupt Practices Act (FCPA)

The purpose of the Foreign Corrupt Practices Act (FCPA) of 1977 is to combat corrupt business practices such as bribes and kickbacks. Thus, for more than 30 years these foreign bribery laws in the United States have restricted all U.S. employees, regardless of where the business is conducted.


Red Flags of Bribery and KickbacksRed Flags of Bribery and Kickbacks

Lack of standard invoices. Requests for funds to be routed to a foreign

bank. Requests for checks made payable to “cash”

or to “the bearer.” Commission substantially higher than going

rate. Requests for a large line of credit from a

customer.


Red Flags of Bribery and KickbacksRed Flags of Bribery and Kickbacks

Insistence by a government official that a certain third-party agent or supplier be used.

Lack of staff or facilities to actually perform the service.

Request by a local agent for a rate increase in the middle of negotiations.

Suggest need to utilize more than one local agent.


Red Flags of Phantom VendorsRed Flags of Phantom Vendors

Invoices for unspecified consulting or other poorly defined services.

Unfamiliar vendors. Vendors that have only a post-office-box

address. Vendors with company names consisting

only of initials. Many such companies are legitimate, but crooks commonly use initials when naming companies.


Red Flags of Phantom VendorsRed Flags of Phantom Vendors

Rapidly increasing purchases from one vendor.

Vendor billings more than once a month. Vendor addresses that match employee

addresses. Large billings broken into multiple smaller

invoices, each of which is for an amount that will not attract attention.


Bid RiggingBid Rigging

A Virginia businessman paid a $47,000 penalty for A Virginia businessman paid a $47,000 penalty for rigging bids during North Carolina’s forclosure rigging bids during North Carolina’s forclosure auctions. Bruce McBarnette and his company auctions. Bruce McBarnette and his company Summit Connection would enter into agreements Summit Connection would enter into agreements with other bidders to stop bidding on certain with other bidders to stop bidding on certain properties in exchange for payments from the other properties in exchange for payments from the other bidders. The auctions took place in Durham and bidders. The auctions took place in Durham and Mecklenberg counties in North Carolina. Mecklenberg counties in North Carolina. McBurnette said he did not know the activity was McBurnette said he did not know the activity was illegal because he had seen the practice before. illegal because he had seen the practice before.

Source: Raleigh (AP), “Va Businessman Pays Fine for Bid-rigging in N.C.,” Source: Raleigh (AP), “Va Businessman Pays Fine for Bid-rigging in N.C.,” Independent Tribune, December 28, 2010, p. A-6.Independent Tribune, December 28, 2010, p. A-6.

Forensic and Investigative Accounting Chapter 6 Indirect Methods of Reconstructing Income © 2011...

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