Most forensic accountants begin their assignments by preparing a list of documents needed. Attorneys sometimes respond to these requests by calling them overburdensome and excessive. This article will explain some of the reasons why those documents are being requested.
Financial Statements
An analysis of financial statements, especially over a five year period, will present a good picture of the financial condition of the company. In addition, it can show new patterns that are developing, if sales are growing steadily, if profits are growing, if assets are increasing, that tells one kind of story. If sales are going up and then down every year or so, if the company does very well and then very poorly, that tells a different story. The different stories being told will then indicate the amount of further analysis that will be needed. In addition, sometimes a business is very steady until the year of divorce, at which point sales suddenly decrease, or legal expenses suddenly increase, or the gross profit percentage becomes inconsistent, or some other type of change occurs. This change is a flag to the accountant suggesting the need for greater attention to the changes in order to determine their legitimacy.
Tax Returns
Tax returns are filed under penalty of perjury with governmental agencies and as such are significant documents. It is also of value to compare what is reported on the tax returns with that which is reported on financial statements, to see if aggressive tax positions are taken. Aggressive tax positions indicate the probability of significant perquisites, personal expenses paid by the business, which affect the business valuation as well as spousal support calculations.
Accountants' Workpapers
The workpapers of the accountant who prepares the financial statements, the business tax returns and the personal tax returns are usually very informative. They help explain the basis for certain figures and the nature of certain transactions. Sometimes, the workpapers are so skimpy that that itself indicates that the accountant has no real knowledge of the business. If he has no real knowledge, then usually the only person who does is the owner and the forensic accountant has to deepen the analysis in such a situation. Occasionally, the owner is hiding something from his/her own accountant (such as paying significant personal expenses by the business) and one must try to find out what is really going on.
General Ledgers and Journals
These are the documents from which the financial statements and tax returns are prepared, and they are therefore of great importance. They provide the details behind the broad picture presented by the financial statements and tax returns. If the financial statements stated that a certain amount was paid for purchases or some other expense, the general ledger and the journals would provide the details regarding every disbursement, showing who and what was paid, when and the amount of each transaction.
Paid Bills
Paid bills provide the basis for determining if a certain disbursement was for a business or other purpose. A review, for example, of the paid bills for legal fees shows if the payments made were for business consulting or for divorce proceedings or for estate planning, etc. The paid bills may, therefore, be very useful in determining the amount of perquisites, if any.
Payroll Tax Returns
Some business owners reduce their taxable income by paying certain people who do not provide any business services. A girlfriend, minor children, or friend might be on the payroll. It is often quite productive to review the state payroll tax returns, which itemize the names of each person being paid, or the W-2 statements issued at the end of the year, with someone such as the out-spouse, who might recognize certain names.
Bank Statements and Canceled Checks
Bank statements sometimes reveal that which the general ledger and journals would not disclose. Bank statements may show that a deposit was a wire transfer from an account that was not known to exist, perhaps even from out of the country such as Switzerland or the Cayman Islands, and that may show that other funds exist that were not known of before. Similarly, the statements may show wire transfers going out or certain other unusual transactions which may war-rant further analysis.
Canceled checks of those paid to the business operator often explain where the business owner does his personal banking. How he endorses his checks, and where he deposits his checks, may be very informative. Quite often, unknown bank accounts are discovered by simply looking at the reverse of those checks.
Accounts Receivable Records
These records are necessary to determine what amount of collectible receivables should be included in a valuation. Old accounts receivable would be examined to determine if they are of value.
A second purpose for the review of receivable records is to verify that all income is being recorded. If a doctor's patient pays his bill and the doctor deposits the check into his personal or offshore bank account, then the deposits to his business bank account may not agree with the payments reflected on his accounts receivable records.
Sometimes, a business owner will arrange with his close business associates that he will write off their balance in the year of his divorce proceedings and they will pay him back "under the table". A review of the write-offs and adjustments for unusual activity may disclose this type of arrangement.
Corporate Minutes
The corporate minutes sometimes discuss company policy or company plans, such as new expansions or acquisitions. This information is often tailored to fit a certain need, which sometimes backfires. In a recent case in which the author was involved, the husband claimed that the large sums of profits and money left in his corporation were not available for spousal support because the funds were needed for a certain corporate expense. For years the company's corporate minutes were virtually the same, but in the year of the divorce proceedings, a new paragraph was added stating "that in order to enhance the profitability of the corporation, the corporation shall continue to retain its earnings". The case settled in every respect except for spousal support and apparently the husband assumed that that too would settle, because in the months following the property settlement, the corporation distributed all of the available funds that it had been hoarding. It became quite clear that the corporate minutes were modified in an attempt to mislead the other party.
Audits by Taxing Authorities
Audit reports issued by the IRS, Franchise Tax Board or the State Board of Equalization are important because those agencies may have discovered something of interest or relevant to the dissolution proceeding. They may disclose unreported income, deductions of personal expenses, unreported sales, business entities that were not previously known to exist, business locations that were not known to exist, etc.
Insurance Policies
Claims by a business owner that his/her business is doing poorly are often matched with business interruption insurance. If the business records reflect low income and yet high premiums are being paid for large amounts of business interruption insurance, then the business records should be reviewed much more closely. Severe insurance claims to the insurance company must be verified, so there should be records of some sort that would substantiate potential claims.
Insurance policies are also of value in determining perquisites paid by the business. They may show that personal assets are being insured and that payments for life and health insurance are for personal benefit.
Finally, the policies may disclose that assets are being insured that the spouse did not know were owned by the family.
Lease Agreements
A spouse may claim that his business is doing poorly and that he is no longer utilizing all of the business space that he is renting. If, for example, a business lease shows that the lease is ending soon, then one could try to determine, through deposition or other means, if there is any attempt to rent smaller quarters. If it is clear that there is no intention of moving, then that may be a clue that the business has expectations of significant increases in income.
Company Brochures and Advertisements
Brochures and advertisements may indicate places of business that were not known before, they may indicate the status of the company in the industry ("we are #1 in sales in Southern California") and they may disclose products being sold that were not known before. They also alert one to potential cross examination questions. A real estate developer may be having a poor year, but his ads in the paper for his homes may state that "only three homes are left". What may be happening is that the homes are selling, but at such reduced prices that there is very little profit being generated. Thus, there may be an attempt to unload the homes so that he could reduce the cost of carrying the inventory.
Personal Financial Statements
While financial statements often include values and incomes that are intended to impress a potential lender, they, nonetheless, may disclose assets and sources of income that were not known before. Cash surrender values of insurance policies and real estate investments are often discovered from the personal financial statements. They are also of value when compared to other documents. For example, in a recent case, the husband valued his medical institutions by a certain price per bed for a settlement proposal to his wife and for the bank, his value per bed was exactly twice that amount.
Consulting Agreements
Consulting agreements are often a mechanism to structure a sale so that the buyer can deduct the purchase payments. For example, Tom sells his business to Jerry and Jerry wants to deduct the purchase payments currently, rather than depreciating and amortizing the purchase costs over many years. Jerry, therefore, arranges that his business will "hire" Tom as a consultant (with the understanding that Tom does not have to do any work for the buyer) and the purchase payments are paid out as consulting fees and deducted currently as such. (This is often done, but it does not comply with tax regulations.)
One should, therefore, review consulting agreements and related documents and try to ascertain if an underlying sale is involved. The underlying sale indicates what the buyer and seller considered to be the fair market value of the business and if the business was fairly constant, that value would be important to consider in a present valuation. In addition, the payments made for consulting services should be added to reported income for valuation purposes because the payments that are being deducted as a current expense are really capital investments.
Personal and Business Calendars
Doctors and other professionals often claim that their income has dropped dramatically around the date of separation and from then forward. They may claim that they have fewer patients or expected future income looks much worse than it was during marriage. A close review of appointment calendars should be made for the period before and after separation as a means of validating that assertion. The personal calendar should be used to see if business appointments are being scheduled and to determine if efforts are being made to promote business. If the calendar shows extensive vacations instead of extensive efforts to build up the business, one could argue that there is a deliberate effort to deflate the income.
In addition, patient and business appointments could be compared to the accounts receivable records to see that all patient activity is being recorded in the internal accounting system. If a patient was treated, for example, and there is no record of that patient being billed and there is no record of any collection from that patient, that is an indication that further analysis may be warranted.
Caveat. Cost-Benefit
It is often very time-consuming to thoroughly analyze all available records, and so the cost should be considered with the potential benefit. Experience and judgment must be used to determine the intensity of a review of documents.
In conclusion, the records listed above are some of the documents frequently requested by accountants. There are, of course, many other documents that are requested and, of course, there may be valid reasons for those requests. This article should illustrate that while certain requests may appear not relevant to the dissolution action or to the attorney or client, they may serve as valuable sources of information to a forensic accountant.
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