Forensic and Investigative Accounting

1. Forensic and Investigative Accounting Chapter 6 Indirect Methods of Reconstructing Income © 2011 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com

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. 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. Forensic and Investigative Accounting

4. 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. Forensic and Investigative Accounting

5. 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. Forensic and Investigative Accounting

6. 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 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. Forensic and Investigative Accounting

8. 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. 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. (continued on next slide) 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). Forensic and Investigative Accounting

11. 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). Forensic and Investigative Accounting

12. Preliminary Cash-T Forensic and Investigative Accounting

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. Forensic and Investigative Accounting

14. 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. Forensic and Investigative Accounting

15. 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. Forensic and Investigative Accounting

16. Gross Business Receipts Formula Forensic and Investigative Accounting

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. Forensic and Investigative Accounting

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

19. Procurement Fraud Techniques • Cost mischarging. • Contract specification failures. • Duplicate, false, or inflated invoices. • Split purchases. • Unnecessary purchases. • Defective delivery. Forensic and Investigative Accounting

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. 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. Forensic and Investigative Accounting

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. Forensic and Investigative Accounting

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. Forensic and Investigative Accounting

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. Forensic and Investigative Accounting

25. 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. Forensic and Investigative Accounting