1. Forensic and Investigative Accounting Chapter 6 Indirect Methods of Reconstructing Income © 2013 CCH Incorporated. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 CCHGroup.com

2. Chapter 6Forensic and Investigative Accounting2 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. 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.

3. Chapter 6Forensic and Investigative Accounting3 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. Indirect methods use economic reality and financial status techniques in which the taxpayer’s finances are reconstructed through circumstantial evidence.

4. Chapter 6Forensic and Investigative Accounting4 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. 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.

5. Chapter 6Forensic and Investigative Accounting5 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. 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.

6. Chapter 6Forensic and Investigative Accounting6 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

7. Chapter 6Forensic and Investigative Accounting7 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.

8. Chapter 6Forensic and Investigative Accounting8 Indirect Methods 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 omitted 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. There is a significant increase in year-to-year net worth. Gross profit percentages change significantly for that particular business. 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. The taxpayer’s expenses (both business and personal) exceed reported income, and there is no obvious cause for the difference.

9. Chapter 6Forensic and Investigative Accounting9 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. (continued on next slide)

10. Chapter 6Forensic and Investigative Accounting10 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).

11. Chapter 6Forensic and Investigative Accounting11 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).

12. Chapter 6Forensic and Investigative Accounting12 Preliminary Cash-T Gross Receipts: Business Expenses: Schedule C $120,000 $95,000 $95,000 Preliminary Understate-ment Personal Living Expenses $60,000 $155,000 $60,000 $155,000 $35,000 $35,000

13. Chapter 6Forensic and Investigative Accounting13 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.

14. Chapter 6Forensic and Investigative Accounting14 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: 1.Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of a period. 2.Add nondeductible living expenses to the increase in net worth. 3.Account for any difference between reported income and the increase in net worth during the year as (a) nontaxable income and (b) unidentified differences.

15. Chapter 6Forensic and Investigative Accounting15 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.

16. Chapter 6Forensic and Investigative Accounting16 Gross Business Receipts Formula 1. Total bank deposits $XXX Less: 2. Nontaxable and nonbusiness receipts deposited (XXX) 3. Net deposits resulting from business receipts $XXX Add: 4. Business expenses paid by cash $XXX 5. Capital items paid by cash XXX 6. Personal expenses paid by cash XXX 7. Cash accumulated during the year from receipts XXX 8. Subtotal $XXX 9. Less: Nontaxable and nonbusiness cash used for (4) through (7) (4) through (7)(XXX) 10. Gross business receipts as corrected $XXX 11. Adjustments for accrual basis taxpayers $XXX

17. Chapter 6Forensic and Investigative Accounting17 Six Requirements for a Valid Contract 1. 1. Offer and acceptance. 2. 2. Lawful objective. 3. 3. Capacity of parties to perform. 4. 4. Something of value exchanged. 5. 5. Appropriate form (e.g., in writing). 6. 6. Entered into freely.

18. Chapter 6Forensic and Investigative Accounting18 Procurement Fraud Techniques Bribes and kickbacks. Bid rigging. Defective pricing. Phantom vendors (www.picalo.org). Product substitution. Conflict of interests. False claims.

19. Chapter 6Forensic and Investigative Accounting19 E & Y’s 12 th Global Fraud Survey Actions CFO’s would take to help their business survive: Entertainment to win/retain business 34% Entertainment to win/retain business 34% Cash payments to win/retain business 15% Cash payments to win/retain business 15% Personal gift to win/retain business 20% Personal gift to win/retain business 20% Misstating company’s financial performance 4% Misstating company’s financial performance 4% As examples, in Indonesia 60 percent of respondents considered making cash payments to win new business acceptable. In Vietnam, 36 percent of the respondents considered it acceptable to misstate their company’s financial performance.

20. Chapter 6Forensic and Investigative Accounting20 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.

21. Chapter 6Forensic and Investigative Accounting21 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.

22. Chapter 6Forensic and Investigative Accounting22 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.

23. Chapter 6Forensic and Investigative Accounting23 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.

24. Chapter 6Forensic and Investigative Accounting24 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.

25. Chapter 6Forensic and Investigative Accounting25 Bid Rigging A Virginia businessman paid a $47,000 penalty for rigging bids during North Carolina’s forclosure auctions. Bruce McBarnette and his company Summit Connection would enter into agreements with other bidders to stop bidding on certain properties in exchange for payments from the other bidders. The auctions took place in Durham and Mecklenberg counties in North Carolina. McBurnette said he did not know the activity was illegal because he had seen the practice before. Source: Raleigh (AP), “Va Businessman Pays Fine for Bid-rigging in N.C.,” Independent Tribune, December 28, 2010, p. A-6.

26. Chapter 6Forensic and Investigative Accounting26 Piercing the Corporate Veil Also known as alter ego or single enterprise theory. Also known as alter ego or single enterprise theory. Forensic accountants may be called upon on either side of a legal dispute to treat the rights or duties of a corporate entity as the rights or liabilities of its shareholders. Forensic accountants may be called upon on either side of a legal dispute to treat the rights or duties of a corporate entity as the rights or liabilities of its shareholders. Plaintiffs often try to pierce, lift, or collapse the corporate veil and make the shareholders responsible for wrongful acts. Plaintiffs often try to pierce, lift, or collapse the corporate veil and make the shareholders responsible for wrongful acts. Or the technique can be used to make shareholders liable for debts where the business is unable to pay its creditors. Or the technique can be used to make shareholders liable for debts where the business is unable to pay its creditors. If the court pierces the corporate veil, then creditors can have a claim on the shareholders’ assets to satisfy any company debt. If the court pierces the corporate veil, then creditors can have a claim on the shareholders’ assets to satisfy any company debt.