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In search of unreported income

December 5, 2012

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A forensic expert can help find missing assets

Getting your client a fair divorce settlement is challenging enough. But when the other spouse siphons off a business’s income, there’s double trouble. That’s why it’s critical to employ a forensic expert at the first sign of malfeasance. He or she can use several accounting methods to uncover missing income in divorce cases.

Something’s missing

As you can imagine, there are many valuation approaches and methods to choose from. But regardless of the road that a valuator takes to arrive at a value, the destination is the same: a business’s value, based on its ability to generate income. But what if a company conceals its assets? Or, what if it fails to report all of its earnings on its financial statements and tax returns?

Fortunately, there are two basic approaches that forensic experts can use to uncover such missing income. One is to search for hidden cash. The other is to identify any and all concealed sources of income.

Finding cash in all the wrong places

Business owners with unreported income almost always receive it in the form of cash. To avoid detection, the business might not record the income in its books or deposit the cash in its bank account or might delay depositing cash. Fortunately, forensic experts typically rely on certain forensic accounting techniques to: 1) prove that cash is missing and 2) estimate how much the owner isn’t reporting. The IRS also routinely uses these methods to unearth fraud.

Valuators often choose to use the “bank deposits method” to help reconstruct income. He or she analyzes the spouse’s bank deposits, canceled checks and currency transactions, accounting for cash payments made from undeposited currency receipts as well as nonincome sources of cash — such as loans, gifts, inheritances or insurance proceeds.

Another way forensic experts can uncover hidden cash is by using the “source and funds application method.” Here, the valuator analyzes the business owner’s personal sources and uses of cash. This method is effective in ascertaining where the owner’s income and other funds came from, and how they eventually were used. If the owner is spending more money than he or she is taking in, the excess represents unreported income.

With the “net worth method,” the expert assumes that an unsubstantiated increase in a business owner’s net worth is attributable to unreported income. The valuator estimates the spouse’s net worth using telltale documents such as bank and brokerage statements, real estate records, and loan or credit card applications. The forensic expert starts with the amount of gain in net worth, and then subtracts any reported income. Then he or she adjusts this amount to reflect any nondeductible expenditures — such as capital asset acquisitions — and nonincome sources of funds.

Last, the valuator has the option to choose the “percentage markup method,” in which net income is estimated by applying a benchmark profit percentage to sales or some other base amount. In most cases, valuators use this method as a reasonableness check to corroborate the results of other methods.

Building a case

Even if missing cash is undetectable, the expert can employ forensic accounting techniques to reconstruct unreported income by examining potential sources of that income. For example, Harry and Bernice have decided to get a divorce. Unfortunately, Bernice suspects that Harry is underreporting income from his aircraft manufacturing business, Fly-By-Night. Bernice employs a valuation consultant who discovers that just two distributors supply all the parts Fly-By-Night uses in its operations.

Bernice’s lawyer subpoenas the distributors’ records, which show how many airplane parts the company purchased during the last three years. The valuator uses this information to reconstruct Fly-By-Night sales, which turn out to be 20% higher than the company reported.

Leaving no stone unturned

As you can imagine, unreported (or missing) business income in divorce cases can be difficult to prove. That’s why it’s critical that you hire qualified experts — who can research the business and dig into its financial records — for all divorce proceedings.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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