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Using Information from Income Tax Returns as an Investigative Tool in Forensic Accounting

By Brian Harris

By Terry Silver

The term "forensic" means "suitable for use in a court of law."  By extension, the field of forensic accounting involves the utilization of accounting, auditing and investigative skills to assist in the resolution of a legal dispute.

As forensic accountants and business valuation analysts, we are most often called upon to either: (1) value the stock of a closely held business; (2) compute the economic damages suffered by an injured party; or (3) to perform a financial investigation (often to determine the true economic income of a business or to locate and quantify misappropriated assets).  Regardless of the type of engagement we are asked to perform, our forensic accounting skills are always utilized. 

When undertaking one of the above assignments, we often find that the financial data made available for review is scant. In some cases, the company is small and does not maintain sophisticated financial data. In other cases, the data may have been destroyed to conceal a fraud. One thing that most companies have in their possession (or can be obtained from the taxing authorities) is the income tax returns. These tax returns are an important source of data for the forensic accountant. Most business income tax returns contain financial information that is similar to the information found in financial statements. Absent other authoritative financial  documents (such as financial statements prepared in accordance with Generally Accepted Accounting Principles), the income tax returns are often the next best source of financial data. 

The forensic analysis of a company?s tax returns can range from the rudimentary to the sophisticated.  At the basic level, forensic accounting procedures will often involve a comparative analysis of revenues and expenses from year-to-year.  Significant changes in the level of revenue or expense may indicate the existence of issues that will affect the future operations of the business.  For example, an increase in professional fees may indicate the existence of contract litigation, tax compliance issues, shareholder disputes or regulatory inquiries. Likewise, a significant increase or decrease in insurance expense (property and casualty insurance, liability insurance, and disability insurance) may indicate serious legal or operational issues.

A significant change in the level of expenses may also indicate the presence of either fraudulent acts by management or criminal acts by employees.  For example, a year over increase in compensation or consulting expense may indicate the presence of fictitious employees or excessive owner / executive compensation.  Similarly, a year over year increase in travel, meals and entertainment expense may indicate the existence of unauthorized personal expenses.  Likewise, a variance in inventory purchases or gross profit margins may indicate the theft of inventory by employees.

Financial ratios tend to be consistent from year to year.  However, a simple variance in revenue or expense from year to year usually does not tell the entire story. When significant variances are identified, the forensic accountant must fully understand the possible causes and ramifications; only then will he or she know the right questions to ask.   

By way of a real world example, we were recently engaged to value the stock of a closely held construction business in the context of a matrimonial action.  Although detailed financial statements were not available, we were able to obtain the company?s income tax returns for several years leading up to the commencement of the action and the years following the commencement of the action. The company?s tax returns contained sufficient data to allow us to compare the company?s gross profit margins each year. Using a year over year variance analysis, we determined that the gross profit realized on the company?s construction contracts fell into a relatively tight range in the years leading up to the commencement of the divorce action. Once the divorce action was filed, however, the company began to report significantly lower gross profit margins. 

To determine the cause for the sudden change, we analyzed the company?s contract costs. Through our analysis we discovered that the company had changed its accounting policies regarding the recognition of contract expenditures. Based on our experience in the construction industry, we knew that construction contractors are often paid according to a fee schedule in which the completion of specific tasks results in contract progress payments. In order to accelerate these payments, it is not uncommon for construction contractors to employ a technique known as ?front-loading,? whereby construction costs are recorded in advance of their actual realization. Through our analysis of gross profit margins and the contact costs, we were able to adjust the company?s financial data to reflect accurate  gross profit margins and thereby arrive at a more accurate and reliable value. 

Even when detailed financial statements and supporting data are not made available to the forensic accountant, much can still be learned from the company?s tax returns. A simple comparison of the revenue and expenses reported on the tax returns may ultimately lead to valuable information about the operation of the company. However, the numbers alone do not tell the whole story. The forensic accountant must have the technical skills and experience to process the data and determine the right questions to ask ? only then will the story behind the numbers come to light.

Terry Silver is a certified public accountant and certified valuation analyst, for Citrin Cooperman & Co., an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at tsilver@citrincooperman.com or (215) 545-4800

Full post as published by The Legal Intelligencer Blog on July 23, 2010 (boomark / email).