1. Forensic and Investigative Accounting
Chapter 6
Indirect Methods of Reconstructing Income
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2. Forensic Audit Approaches Used by the IRS
Direct methods involve probing missing income by pointing to specific items of income that do not appear on the tax return. In direct methods, the agents use conventional auditing techniques such as looking for canceled checks of customers, deed records of real estate transactions, public records and other direct evidence of unreported income.
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Forensic and Investigative Accounting

3. Forensic Audit Approaches Used by the IRS
Indirect methods use economic reality and financial status techniques in which the taxpayer’s finances are reconstructed through circumstantial evidence.
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Forensic and Investigative Accounting

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

5. Forensic and Investigative Accounting
Minimum Income Probes
For taxpayers who are self-employed and file a Schedule C or F, an analysis is made of tax return information to determine if reported income is sufficient to support the taxpayer’s financial activities.
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6. Forensic and Investigative Accounting
Lifestyle Probes
The lifestyle of a taxpayer or employee may give clues as to the possibilities of unreported income. Obvious lifestyle changes may indicate fraud and unreported income:
Lavish residence
Expensive cars and boats
Vacation home
Private schools for children
Exotic vacations
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Forensic and Investigative Accounting

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

8. Forensic and Investigative Accounting
Indirect Methods
An indirect method should be used when:
The taxpayer has inadequate books and records.
The books do not clearly reflect taxable income.
There is a reason to believe that the taxpayer has omitted taxable income.
There is a significant increase in year-to-year net worth.
Gross profit percentages change significantly for that particular business.
The taxpayer’s expenses (both business and personal) exceed reported income, and there is no obvious cause for the difference.
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Forensic and Investigative Accounting

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

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

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

12. Forensic and Investigative Accounting
Preliminary Cash-T
Gross Receipts:
Business Expenses:
Schedule C
$120,000
$95,000
Preliminary Understate-ment
Personal Living Expenses
$60,000 $155,000
$35,000
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Forensic and Investigative Accounting 12

13. Source and Application of Funds Method (Expenditure Approach)
This technique is a variation of the net worth method that shows increases and decreases in a taxpayer’s accounts at the end of the year. The format of this method is to list the applications of funds first and then subtract the sources. If the taxpayer’s applications exceed his or her known cash receipts (including cash on hand at the beginning of the year), any difference may be unreported income.
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14. Forensic and Investigative Accounting
Net Worth Method
The net worth method is a common indirect balance sheet approach to estimating income. To use the net worth method, an IRS agent or forensic accountant must:
Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of a period.
Add nondeductible living expenses to the increase in net worth.
Account for any difference between reported income and the increase in net worth during the year as (a) nontaxable income and (b) unidentified differences.
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Forensic and Investigative Accounting

15. Forensic and Investigative Accounting
Bank Deposit Method
The bank deposit method looks at the funds deposited during the year. This method attempts to reconstruct gross taxable receipts rather than adjusted.
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Forensic and Investigative Accounting

16. Gross Business Receipts Formula
1. Total bank deposits
$XXX
Less:
2. Nontaxable and nonbusiness receipts deposited
(XXX)
3. Net deposits resulting from business receipts
Add:
4. Business expenses paid by cash
5. Capital items paid by cash
XXX
6. Personal expenses paid by cash
7. Cash accumulated during the year from receipts
8. Subtotal
9. Less: Nontaxable and nonbusiness cash used for
(4) through (7)
10. Gross business receipts as corrected
11. Adjustments for accrual basis taxpayers
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17. Six Requirements for a Valid Contract
Offer and acceptance.
Lawful objective.
Capacity of parties to perform.
Something of value exchanged.
Appropriate form (e.g., in writing).
Entered into freely.
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18. Procurement Fraud Techniques
Bribes and kickbacks.
Bid rigging.
Defective pricing.
Phantom vendors (
Product substitution.
Conflict of interests.
False claims.
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19. Procurement Fraud Techniques
Cost mischarging.
Contract specification failures.
Duplicate, false, or inflated invoices.
Split purchases.
Unnecessary purchases.
Defective delivery.
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20. 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.
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Forensic and Investigative Accounting

21. Red 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.
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22. Red 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.
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23. Red 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.
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24. Red 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.
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Forensic and Investigative Accounting