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Follow the Money: How Forensic Accountants Use Lifestyle Analysis to Reveal the Truth

Magnifying glass, calculator and financial statementsOne of the most effective weapons in a forensic accountant’s arsenal is lifestyle analysis. This article talks about how experts seeking hidden assets and income sources conduct such analysis. It discusses several techniques, including the bank deposits, expenditures and asset methods. 

Forensic accounting methodology can reveal hidden assets and sources of income. They can be invaluable in a variety of litigation contexts. For example, forensic accountants can help support a fair division of property in divorce cases, trace and recover funds in fraud cases, gather data relevant to business valuations, and facilitate damages award collection. One of the most effective weapons in an expert’s arsenal is lifestyle analysis.

What Is Lifestyle Analysis?

Simply put, lifestyle analysis involves determining and analyzing a person’s income, expenses, assets and liabilities. By scrutinizing gaps or mismatches, a forensic accountant can uncover evidence that a party’s income or net worth isn’t what it appears to be. For example, if a party’s known income sources and liquid assets are insufficient to support his or her standard of living, it’s likely that he or she is hiding something.

The first step is to develop a comprehensive financial profile of the person in question. The accountant scrutinizes banking transactions, known income sources and expenditures, and changes in net worth for signs of unreported income or hidden assets.

What Techniques Do Forensic Accountants Use?

To avoid detection, many individuals with unreported income typically receive it in cash. Forensic accountants use a number of forensic accounting methodology techniques to show that cash is missing and to estimate the amount, including:

Bank Deposits Method

This technique is based on the assumption that all funds are either deposited or spent. To reconstruct a party’s income, the financial expert 1) analyzes bank deposits, canceled checks and currency transactions, and 2) accounts for cash payments from undeposited currency receipts and nonincome cash sources (such as gifts, loans, insurance proceeds and inheritances). Next, the expert deducts funds from known sources from total receipts to arrive at the total funds from unknown sources. 

Expenditures Method

Also known as the “source and application of funds method,” this technique involves analyzing a person’s personal sources and uses of cash during a given time period. Sources of funds may include salaries, inheritances, loans, gifts and cash on hand at the beginning of the period. If the person is spending more than he or she is taking in, the excess likely represents unreported income.

Asset method

Also known as the “net worth analysis method,” this technique operates under the assumption that any unsubstantiated increase in a party’s net worth reflects unreported income. The financial expert begins by estimating the party’s net worth using bank and brokerage statements, real estate records, loan and credit card applications, and other documents. Next, he or she determines the increase in the person’s net worth during the relevant time period and deducts reported income and known expenditures. The excess represents income from unknown sources.

How Do Experts Trace Hidden Assets and Funds?

Proving that a person has unreported income is one thing. Tracing that income to assets or accounts that can be used to support a claim or enforce a judgment is another story, particularly when the person is actively concealing those assets. 

To uncover hidden assets, forensic accountants examine a variety of documents, including tax returns, bank records, real estate records, insurance policies and court filings. Loan applications, employment applications and credit reports also may yield valuable clues about the value and location of a person’s wealth. Another potential strategy is to interview people with knowledge about that person’s finances, such as accountants, real estate agents or business partners. 

Tax returns are particularly useful. Why? Because people have strong incentives to prepare accurate returns, including the availability of deductions for certain expenditures and the fear of being charged with tax evasion. As a result, tax return entries may reveal clues about assets or income that someone is otherwise attempting to conceal. (See “Use tax returns as an investigative tool.”)

How Do You Read the Signs?

Proving, quantifying, and tracing unreported income and assets can be a challenge, especially when someone is actively attempting to conceal them. Forensic accountants have the skills and experience to read the signs that lead to hidden wealth, improving the odds of a satisfactory litigation result.  

Use Tax Returns as an Investigative Tool

Tax returns can be a rich source of information about a taxpayer’s financial condition and income sources. Typically, financial experts examine returns from several years to identify significant trends. For instance, an expert may note a large increase in interest or dividend income from one year to the next, which may indicate that the taxpayer sold stocks or other investments. What happened to the proceeds? Here are a few examples of tax return entries that can lead an expert to hidden income or assets: 

  • Income from wages may lead to undisclosed business interests.
  • W-2 entries may reveal unknown retirement plans.
  • An examination of real or personal property taxes may reveal undisclosed assets.
  • Entries for state and local income taxes may indicate income or assets in other states.

In addition, Schedule E  “Supplemental Income and Loss”  reports income from partnerships, S corporations, rental properties and trusts. An expert can examine income and expenses for signs that these entities are being used to hide assets. This schedule also reports royalty income, which can reveal undisclosed, income-producing assets.

Speak with a Meaden & Moore expert today to learn more.

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