Closely Held Businesses
In evaluating a dissolved marriage where one of the spouses owns a closely held business (sole proprietorship), Donegan would look at the level of suspicion and animosity in the relationship. The more distrust and hostility exist, the more likely that one spouse is or will be trying to hide assets. Often the easiest way for a controlling spouse to hide assets or income is in a closely held business, somewhere the other spouse has no knowledge of. Because one spouse had little or no involvement in the business, the task of hiding assets would be easy for the business owner where they exercise control over the business and its activities (money/assets).
The basic purpose of a forensic examination of a closely held business is to analyze four important items. The first item that needs to be analyzed is whether the business used funds to acquire personal assets. The second is to determine if business funds were used for personal expenses. The third is to uncover or identify unreported business income. The fourth and final item is the gathering of information necessary in order to determine the value of the ownership interest.
The first two items, use of business funds for personal assets and for personal expenses, go hand in hand. One of the tactics would be to focus on the business fixed-asset schedule to determine if "company" assets are actually personal assets. Such assets typically include cars, real estate, boats, and collectibles. As far as personal expenses, closely held businesses often pay common personal expenses such as utility bills, cellular phone bills, insurance, home taxes, recreational club dues, and vehicle expenses. These personal expenses reduce the amount of personal income and thus the "family" income. This can have a direct effect on the eventual divorce settlement and potential child support and alimony payments.
Another critical focal point in a divorce engagement that includes a closely held business is the third item: evaluating and searching for unreported income. This may be the most difficult job for a forensic accountant, considering that this income is often hidden from outside services, particularly the IRS. We must consider what type of business the client has, because certain businesses - such as those with high volumes of cash sales, like restaurants, gas stations, or convenience stores - lend themselves more easily to hiding and underreporting income.
Finding Hidden Income
Internal controls. The first step for a forensic accountant is to review a business's internal controls. The bigger the business, the more likely that internal controls will be present, especially if the business is a publicly traded company. However, many businesses are small businesses without the resources or personnel to fully implement good internal controls. As in most cases, the person who is receiving deposits or cash is the same person who is recording the deposit. Given that the business owner will have the ability to override any internal control functions, Donegan must carefully review the internal controls for weaknesses and evaluate whether it is possible that the owner could divert cash and underreport income.
Business markup and profitability. After analyzing internal controls, a forensic accountant will focus on two reviews. The first review is the typical markup and profitability of the business. By understanding the normal markup of a business, either through historical comparison or industry standards, one can infer the possibility that income has been unreported. For example, if the average markup on cost is 50% for a retail clothing store, and the cost of clothing sold for the year is $1 million, then sales should be around $1,500,000. If on review of the books, the related sales are only $1,100,000, then a review of the inventory records and turnover should indicate that sales are underreported.
The normal level of expenses. The second review involves analyzing the normal level of expenses. Many times certain businesses have expenses that have a direct relationship to income. If we can determine and understand the normal level of expenses associated with the business, then we should be able to estimate sales.
If either review gives the impression that sales are unreported and thus cash has been diverted, then we have several methods to confirm this. We would first look at the amount and frequency of bank deposits. Any inconsistencies in the deposits should be evaluated and reviewed. If possible, a comparison of deposits (or sales) from the same time period in prior years should help in this review.
Additional methods. Several other methods can be used to detect unreported income and cash. One method would be to compare the journal entries to the receivables accounts. Any journal entries showing significant write-offs should be reviewed for efforts to collect, such as letters or correspondence. If no documentation exists, it is possible that "someone" pocketed the cash and subsequently wrote off the account. Another method is to have spotters and surveillance, such as a restaurant. This would allow us the ability to see the business in action and determine if any "skimming" is occurring.
Determining the Value of the Business
A forensic accountant must determine if a spouse is purposely trying to minimize the value of a closely held business. This would impact the value of the marital assets and thus affect the ultimate settlement the other spouse is entitled to.
Example: Husband may try to transfer assets or income to other businesses, especially one the spouse is not aware of. I may be able to find out information on the concealed company through corporate filings. Correlating this information with data retrieved from personal checkbooks, other public records, and tax returns often can reveal where assets are being hidden. The husband may also purposely try to reduce the profitability of the company through discounted or inflated transactions with related parties. Related parties typically include other family members or personal friends. If I believe that husband is purposely reducing income, then I would investigate any unexplained changes in revenue and expenses, investigate customers and vendors for any related parties, evaluate any related-party transactions, and review accounts payable and receivables for unusual patterns. The two or three years prior to a divorce filing is the critical time period when a spouse may conspire with related parties.
Seek Assistance
The spouse was wise to hire Donegan as her CPA; they could never have done this type of forensic investigation on their own. While there's an old saying that "everyone loses in a divorce," sadly, this is not always the case. It can be a complicated matter of who gets the house versus the retirement assets, or both. Quite often, the spouse who is not the primary breadwinner will likely need to be particularly aggressive in a divorce proceeding, and this is where Donegan can help. Also note that CPAs can provide a valuable service that builds on their existing expertise in tax, audit, and accounting services.