Michael Goldman & Associates, L.L.C. - Consulting & CPA Services

Goldman's Critical Support - Winter  2001

Sniffing Out Unrecorded Income 

Both divorce and bankruptcy situations often lead to charges of misappropriated income. The methods used to hide income include not recording cash receipts (getting paid under the table), bartering, diverting income to another entity, overstating costs and expenses, paying expenses of another entity, and deferring income to a later time period. Detecting these tricks requires applying both experience and knowledge in a creative fashion, and being alert to transactions and happenings (or the lack thereof) in the context of their expected setting. Suspicion, inquisitiveness, and a willingness to dig beyond what is presented to you are critical in finding unreported income. 

The first step in an unrecorded income investigation is gathering the facts. If the target is an individual, these facts would include:

• Personal financial statements and tax returns
• Schedules of investments, receivables, credit cards, bank accounts, insurance policies, assets (such as real estate, vehicles, jewelry, collectables), safe deposit boxes, etc.
• Bank statements with cancelled checks, brokerage statements, loan statements, credit card statements, etc.
• Copies of contracts, employment agreements, leases, etc.
• Copies of all credit applications made in the past three years

For businesses, the list of facts to gather would be similar to those listed above, and would include additional items such as budgets and forecasts, business plans, accounting detail (general and subsidiary ledgers), inventory worksheets, promotional materials, price lists, material lists, list of significant customers and vendors, etc.  It is also useful to gather information such as trade associations the company belongs to, industry statistics, standards and key ratios, etc., to be able to form expectations of what should and shouldn’t be found in the company’s accounts. 

A thorough understanding of the target company’s business, system of accounting, and internal controls will help you evaluate the information you obtained. You should be able to answer the following questions:

·        Are cash or barter transactions typical in this kind of business?

·        Are there controls in place to ensure that all transactions are recorded?

·        What types of activities are most likely to be unrecorded?

·        Where are erroneous items most likely to be recorded (for example, cost overstatements or personal expenses run through the business)?

 One method used to determine net income is the net-worth method, which was first successfully used in the tax fraud case of Al Capone. The investigator adds up all assets and subtracts all liabilities of the subject to calculate net worth. Changes in net worth from one period to another must equal the subject’s net income. A danger in using this method is that (a) the initial or base net worth figure may be understated due to hidden assets, or (b) subsequently obtained assets may not be visible to the investigator.  

A variation of the net worth method is showing that the subject being investigated spent more money than can be accounted for by his available assets and income. Review the subject’s standard of living – expenditures for mortgage and car payments, education, grocery, entertainment, travel, clothing, domestic help, etc. Even in today’s society where most consumers are overextended in debt, the money had to come from somewhere, and if that somewhere is not identifiable, then there must be unrecorded income. 

Another common investigative practice for a business is to compare operating statistics to (a) industry averages and (b) trends over time. For example, a company paying an average of 30% of its revenues out as commissions, when the industry average is 10% and the variance from the average tends to be minimal, may be either overstating its commission expense or understating its revenue. When a business that has consistently made a 40% gross margin for years all of a sudden slides to a 20% margin, it may be experiencing operating problems, or somebody may be skimming income out of the company. 

After reviewing the big picture, the investigator will often find indicators of hidden income, and tips on where to look for it, buried in the accounting detail. Some common sources of leads include:

• Phone records with consistent calls to a specific number could lead an investigator to customers, vendors, or banks for whom transactions are not being recorded.
• Frequent flyer statements and passports can give indications of both expenditures and destinations.
• Utility bills can often be used to measure activity. The IRS has nabbed many a Laundromat owner by comparing his water usage statistics to his reported revenue from coin-operated machines.
• Cancelled checks contain a wealth of information, including who actually cashed the check (as opposed to who was recorded in the accounting records) and into what bank and account it was cashed.
• Laundry bills or detergent purchases will give a good indication of actual room usage in a hotel; or table turnover in a restaurant using cloth table cloths and napkins.
• Excessive inter-company transactions between related entities are usually an indication of a trail being intentionally obscured.
• An absence of expected payments in a subject’s personal accounts, such as for utilities, auto expenses, insurance, travel and entertainment, legal bills, etc. could indicate that they were being run through the business.
• Direct observation – electrical contractors, HVAC repairmen, plumbers, installers, etc. sometimes have vans and storage rooms full of tools and supplies that are not reflected as assets in their accounting records. Their time sheets, purchase orders, union reports, and Rolodexes could be clues leading to unreported income.

To determine the value of a business or the factors behind a bankruptcy, or to propose a divorce settlement, you have to know all of the economic income involved. Money almost always leaves some kind of trail, and cases where it doesn’t are so rare that the absence of a trial becomes a primary clue. Curiosity, experience, and an understanding of the subjects involved often lead to those trails and the rewards that lie at their ends.

© Michael Goldman 2001

For more information, please go to www.michaelgoldman.com 

Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.

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Last modified: March 31, 2007