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

By Brian Harris

By Terry Silver

In my July 23 blog, I discussed the benefits of utilizing information from income tax returns as an investigative tool in forensic accounting.

The subject of this blog is to discuss some of the pitfalls in extracting data from income tax returns when valuing stock in a privately held company, computing economic damages suffered by an injured party, or to perform a financial investigation. As I indicated previously, financial information available to conduct forensic examinations is often scant. For this reason, income tax returns ? which all companies prepare ? are used when more definitive documents, such as financial statements prepared in accordance with Generally Accepted Accounting Principles, or GAAP, are unavailable to the forensic accountant.

One significant difference between a financial statement prepared in accordance with GAAP and an income tax return may be the use of the cash basis of accounting versus the accrual basis of accounting. The Internal Revenue Service prescribes a sales level threshold, whereby companies with revenues below the threshold are permitted to file their income tax returns using the cash basis of accounting. For those companies, the use of the income tax returns will provide the forensic accountant with a cash basis of accounting. This includes collected revenues rather than billed revenues, and paid expenses rather than incurred expenses. The accrual basis of accounting will always yield financial results which are more accurate than the cash basis of accounting. For this reason, the use of income tax returns prepared on the cash basis of accounting provides the forensic accountant with the challenge of converting the cash basis to the accrual basis or to utilize the cash basis of accounting when the accrual basis conversion is impossible or impractical.

When the forensic accountant utilizes income tax returns, it is necessary to recognize the existence of significant differences between GAAP treatment of certain concepts and income tax treatment. For example, GAAP prescribes the use of an allowance for doubtful accounts. This allowance results in an accounting reserve to recognize that some portion of a company?s accounts receivable may be uncollectable. Conversely, the IRS specifically disallows the use of an allowance for doubtful accounts in the preparation of income tax returns.

Another common difference between what is referred to as ?book accounting? and ?income tax accounting? is the depreciation methods and depreciable lives for property, plant and equipment. The Internal Revenue Code allows the use of bonus or quick write-off depreciation whereas GAAP prescribes property, plant and equipment be depreciated over their estimated useful lives. This difference results in tax depreciation expenses in amounts which are in excess of book depreciation in the early years of an asset?s life and the reverse in the latter years of an assets life. The forensic accountant must recognize these book-to-tax differences in depreciation when determining the true economic cost to the company.

Certain intangible assets have book and tax amortization that differ markedly from each other. For example, a covenant-not-to-compete, for book purposes, is deducted over the life of the covenant, while the IRS prescribes a fixed 15-year amortization period for such an intangible asset. Similarly, other intangibles, such as copyrights and trademarks, often have amortizable lives, which differ significantly between GAAP methods of accounting and those used for income tax purposes.

There is significant value that income tax returns provide to the forensic accountant. Despite the advantages derived from the use of income tax returns, the forensic accountant must be aware of how GAAP impacts financial reporting in the case of financial statements and how the Internal Revenue Code and Regulations impact the income tax basis of accounting. This specific knowledge of both GAAP and income tax rules and regulations allows the forensic accountant to understand the subject company?s financial condition and results of operations in a manner that reflects its true economic circumstances. This illustrates the broad base of knowledge needed by the forensic accountant. The knowledge of forensic techniques is often only one of many skills the forensic accountant brings to an engagement and is often supplemented by their extensive knowledge of accounting rules and regulations (GAAP) as well as the IRS income tax code and regulations.

Terry Silver is a Certified Public Accountant, Certified Valuation Analyst and Certified in Financial Forensics, 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 August 26, 2010 (boomark / email).