Forensic Accounting in the United States

Forensic Accounting for Attorneys

by Bruce A. Hughes: He is a partner at Hughes & Hughes in Tustin (California), and he practices family law. He also is a certified public accountant.

Attorneys who review accounting records may assume they have the key source documents that tell all about a given enterprise, but they should know that often the records they hold in their hands barely scratch the surface. Frequently, it’s what’s not shown on a balance sheet or income statement that matters most.

First, let’s review just what a balance sheet and an income statement are designed to show. They are interrelated, evolving documents that change from time to time; in a nutshell, they are adjusted to depict the current, working reality of a given business. The balance sheet is a snapshot of the business at any moment in time. The income statement is the result of business operations covering a specified time period, such as a year. If a number on the balance sheet increases, it typically reflects an increase in income; if it decreases, the opposite may be true. But that only pertains to the numbers that are presented. In many instances, what is not shown explains what’s really going on.

For example, consider insurance expenses – particularly those related to life insurance purchased with respect to a key employee. It’s not at all unusual for a small business to deduct the premiums as an expense without recording the policy’s cash surrender value as an asset. But that value is real, especially if the company decides to liquidate or borrow against the policy.

Equipment leases can be equally problematic. Whenever these expenses appear, be sure to examine the lease in question, for it may provide that at some point ownership of the equipment will transfer to the lessee for a nominal sum. If that is the case, the lease payment is actually a liability and not an expense – it’s really the purchase price of the equipment, and the present value of the lease should be disclosed as a liability of the business. At the same time, in order to accurately reflect the financial status of the item under lease, its value should be shown somewhere on the balance sheet.

What about bills paid near the end of the year? Often this practice reflects expenses paid in advance, such as for liability insurance, workers compensation insurance, interest on various obligations, and rent. In reality, these costs relate to refundable assets and are properly included as assets, not expenses.

On the opposite end of the spectrum are collections. A review of bank deposits in the first two weeks of a year generally shows unusual deposit activity for many businesses. For a cash-basis entity, this probably means that the payments were received before year’s end, but not deposited until after January 1. But such income should be counted when it is received, not when it is deposited. Dates of issue on deposited checks can be key to unraveling this issue – which may lead to revised accounting to reflect the real picture of year-end transactions.

In many small businesses, intangibles – things such as goodwill, patents, deferred tax assets, copyrights, and the like – are not usually reflected on the balance sheet. Someone should review business operations to see if these assets exist, and then determine whether they should be disclosed and at what value.

Fixed assets raise questions too. They are seldom stated at market value, which means the value of a company may be severely misstated. First, analyze what the firm’s assets are, and then assess their actual worth in the commercial world. When this is done through expert appraisal and testimony, a vastly different picture may begin to emerge.
Similar problems may pertain to leasehold improvements. If the premises where a company operates are owned by a third party, any leasehold improvements belong to the building owner, not the tenant. But if the building is owner-occupied, then the improvements frequently are written off to an expense account; this means that the true increased value of the asset is not properly reflected on the balance sheet.

To be sure, many of these line-item entries are tax driven. That is, the businesses are not trying to mislead creditors, spouses, potential lenders, or potential investors; they are simply trying to survive in a tax-heavy environment.

But if the true value of a business is in dispute, a line-by-line examination of the foregoing items – and every other entry on the pertinent balance sheet and income statement – is crucial to an intelligent assessment of the situation. Experienced counsel, not to mention a savvy forensic accounting expert, will be invaluable in such work.