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Basic Financial Investigations

By Craig L. Greene, CPA/CFF, CFE, MCJ

Introduction

Forensic accounting can be defined as the application of accounting procedures to a matter that may or is to be litigated. In this session, I will share with you some of the basic procedures employed in financial investigations of litigation matters. These procedures can be used in both investigations of the financial affairs of entities and individuals.

Basic Approach to the Financial Investigation

The Association of Certified Fraud Examiners ("ACFE") has developed an approach to performing financial investigations. This approach is very useful when the forensic accountant has been retained to perform a financial investigation in a matrimonial matter. Using the ACFE's model, I have found the following steps to be useful in performing a basic financial investigation in a litigation matter:

  1. Planning of the assignment
  2. Performing the background investigations
  3. Examining the relevant documents
  4. Interviewing witnesses, information sources, and the subject.
  5. Analyzing the facts
  6. Preparing the report of findings

These steps are not always followed in the order shown. For example, while examining the documents you may also begin your analysis of them. Other interviews may be developed from analyzing the facts of the case. The background investigation may change how you plan the assignment. In this session due to time constraints, I would like to concentrate on the first three steps in the methodology. As to the remaining steps I offer the following comments. Often accountants do not feel comfortable in interviewing individuals and quite frankly it is an art. I would recommend that you attend a course in interviewing skills. As to analyzing the facts, each case is different and therefore it is difficult to give specific guidance in a general session. Finally, report writing is an art as well.

 

Planning of the Assignment

Initial Meeting with the Attorney

In the initial meeting with legal counsel, the forensic accountant begins to define the assignment. In defining the assignment the accountant must determine the elements of the case to be proved. Further, the forensic accountant needs to focus specifically on the elements to be proved as part of the financial investigation.

I believe that each case has a theme. In developing the case theory that theme should be kept simple and straightforward. I can not overemphasize the importance of listening to what is being said. At the initial meeting it is also important to determine the attorney's expectations from the financial investigation. On more than one occasion the expectations of the attorney can not or are not achieved by the financial investigation.

Important dates need to be obtained from the lawyer, such as discovery cutoff, the date that any expert reports must be completed by, and of course, deposition and trial dates. A time line for the investigation and an action plan can be developed from these dates.

Document Inventory and Requests

Since, the forensic accountant is generally engaged sometime during the discovery process, the attorney will have received a number of documents from the opposing party. A thorough inventory of these records should be done using either a data base or at a minimum a spreadsheet program. Storing the documents in this manner allows for ease in sorting the documents. Documents needed by the forensic accountant should be marked for photocopying and indicated as such in the database. In performing the examination the accountant should not mark on any of the original documents, only the copies.

More often than not, the documents gathered by counsel are not sufficient to complete the examination. The forensic accountant should prepare subsequent document requests. Sample subpoena information that is attached as an exhibit to this article should be used in developing an extensive discovery request. It is not unusual for the forensic accountant to prepare the subpoena language for the attorney.

Finally, I cannot emphasize enough a tracking system of the case's progress, including a follow-up system for open document requests and items. Ideally, a case log or diary should be maintained to document conversations, meetings and other procedures performed during the examination.

Storage of the Documents

Copies of the documents should be numbered or filed systematically for easy retrieval. Original documents should be placed in plastic envelopes and filed in three ring binders. In obtaining original documents, the forensic accountant should mark on the envelope: where the document was obtained from; the date is was received and the initials of the recipient. Needless to say, the documents should be stored in a safe and secure area.

Developing the Examination Plan

Brainstorming and creative thinking go a long way in making for a successful examination. Often, the accountant is faced with a large number of documents and what may appear to be an overwhelming task. The accountant should look for ways to break down the examination into smaller parts. As part of the thought process, the accountant should look for creative ways to bring the case to closure.

 

Performing the Background Investigation

Basic Identifying Information

The investigation of a subject should start with obtaining basic identifying information such as the following:

  • Full name correctly spelled.
  • Any nicknames or aliases the subject has been known to use (for example, Robert George Ryan might go by Bob Ryan or R.G. Ryan.
  • Address and phone number (primary, if available, secondary)
  • Date and place of birth
  • Social Security number
  • Driver's license number
  • Names of former spouse(s), all children, and parents.
  • Date and place of marriages and divorces
  • Income levels, wages, salaries, draws, etc.

 

Common Asset Hiding Techniques

In searching for hidden assets of the subject, the forensic accountant should be aware of the following ways by which assets can be hidden:

Hoarding or Conversion into Resalable Assets

Currency or cash can be hoarded or converted into assets that can be resold, such as jewelry, real estate, or investment securities.

Conversion into Other Liquid Instruments

Funds may be converted into other liquid instruments, such as savings bonds, traveler's checks, or cashier's checks. Through the purchase of cashier's checks or traveler's checks in denominations of less than $10,000, the subject can carry negotiable instruments that can be exchanged almost any place in the world.

Transfer to Other Persons

The most common means of hiding assets, particularly real estate and business interests, is to transfer the asset into the hands of another party that will allow the subject to maintain control. In many cases, the subject will transfer the assets into his or her brothers, sisters, business partner or close friend's name.

Transfers to other persons can be detected by comparing the oldest financial statement with the newest financial statement of the subject. Those assets that appear on the oldest statement, but do not appear on the most recent statement, should be examined closely to determine the nature of the transaction, the identity of the purchaser and the consideration for the sale.

Transfer of Assets to a Trust

Assets may be transferred to a children's or family trust. These assets would then be protected from judgement or bankruptcy proceedings in a court of law.

Transfer of Assets to a Fictitious Business or Bank Account

Assets may be hidden in fictitious businesses or in bank accounts established under a fictitious name. Identifying documents such as tax identification number or Social Security number may even be obtained in the fictitious name.

Transfer of Assets to Insurance Policies

Under the terms of a whole life or universal life insurance policy the borrower may make additional payments that accrue at a high rate of interest and enhance the overall value of the insurance policy. This income is often tax free and is not reported on CTR Reports or other financial documents reported to government regulators.

A sophisticated subject may deposit substantial moneys into an existing insurance policy thinking that the forensic accountant will not look beyond the face value of the policy into the equity built up by prepayments.

The forensic accountant should therefore always examine the financial statement of a defendant to locate insurance policies and examine the equity in these policies as a potential asset.

Conversion of Funds by Loan Repayment

In many cases, subjects seek to hide their assets from seizure by prepaying a significant portion of a real estate mortgage. This may allow the subject to shelter his assets in a homestead exemption (as allowed in Texas, Florida and other states) which will survive bankruptcy or other claim's against them.

By documenting the prepayment of the mortgage, the accountant can often show undisclosed or hidden income from outside sources.

Conversion of Funds by Prepayment of Credit Card Balances

Assets may be converted or hoarded by using them to create a credit balance in a credit card account. Payments are made in excess of the account balance. The resulting credit balance is applied against subsequent charges to the account for purchases. This is, in effect, a way to hoard cash.

Prepayment of credit card accounts may also be found in Cash Management Accounts (CMA's) offered by stock brokerage firms.

Sources of Information Public Records

Public records have a wealth of information available for locating a subject's assets. The forensic accountant should perform a thorough review of the records. The following local governmental offices can provide records of assets and liabilities:

County and Local Level
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Recorder of Deeds - maintains documents pertaining to real estate transactions, including deeds, grants, transfers and mortgages of real estate, releases of mortgages and powers of attorney. The office may also have documents such as:

  • Leases that have been acknowledged or approved
  • Mortgages on personal property
  • Wills admitted to probate
  • Official Bonds'
  • Notices of mechanics' liens
  • Transcripts of judgments that are made liens on real estate
  • Notices of attachments on real estate
  • Papers in connection with bankruptcy
  • Certified copies of decrees and judgments of courts of records.

 

Tax Assessor/Collector - maintains maps of real property in the city, including a property's dimensions, address, owner, taxable value, and improvements. A city/county tax collector's office maintains the following information:

  • Names and addresses of payers of property taxes, even if the taxes
    were paid by individuals other than the apparent owner
  • Legal descriptions of property
  • Amounts of taxes paid on real and personal property
  • Delinquency status of taxes
  • Names of former property owners

 

County Clerk / Clerk of the Court - maintains records that contain papers in such civil actions as liens, name changes and divorces. These papers generally include the complaint (identifying the plaintiffs, the defendants and the cause of action), the answer to the complaint, and the judgment rendered. In some instances, depositions are introduced as exhibits and become part of the court records. Whether a transcript of the proceedings was made may be indicated in the clerk's minutes or in the file jacket.

In divorce case files, the complaint should identify the plaintiff and defendant; place and date of marriage (which indicates the appropriate county's records); date of separation, if applicable; children's names, ages, and birth dates; marital (community) property; and grounds or charges, if any. The complaint also identifies the attorneys in the action and contains the plaintiff's signature. A cross complaint should also contain the defendant's signature.

A probate index will list actions alphabetically by the name of the estate or petitioner, and will give the date of filing and the docket number. The case file often lists causes of action and rulings regarding the estate, status of potential beneficiaries, status as a minor, adoption, incompetence or insanity.

State Level
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Secretary of State - maintains most of the public records that you would search. The following is a listing of the records typically maintained by the secretary of state office:

Corporation records for companies incorporated in that state. Many times you can use a "status check" to determine date of incorporation, status, type, registered agent and, sometimes officers or directors. This is a good way to find the start of a paper trail and/or to find affiliates of subject of your search. Many states will allow you to phone in status checks. Articles of incorporation or amendments and copies of annual reports, when available, may also provide useful information about a business or business owner.

Partnership records Limited partnerships are generally recorded at the state level. Partner names and addresses may be available. Some states have a department created specifically to administer limited partnerships and their records. These filings can provide a wealth of information about other partners, which in turn can lead to other businesses that may be registered.

Limited Liability Companies A new form of business entity that looks like a corporation but has favorable tax characteristics of a partnership is known as the Limited Liability Corporation. (LLC). More and more states are now permitting this type of entity.

Trademark Trade Name States will not let two entities use with the same, or close to the same, name or trademark. A trademark may be also known as a "service mark" Trade names may be referred to as "fictitious names," assumed names, or "DBAs." Most states will allow verbal status checks of names or worded marks. Some states will administer "fictitious names" while their respective counties administer "trade names," or vice versa.

Uniform Commercial Code All 50 states and the District of Columbia have passed a version of the model Uniform Commercial Code (UCC). Article 9 of the Code covers security interests in personal property. UCC filings are used in financing transactions such as equipment loans, leases, inventory, loans, and accounts receivable financing. Thus, other possible lenders are notified that certain assets of the debtor are being used to secure a loan or lease. UCC filings are a way to find bank accounts, security interests, financiers, and assets.

Vehicle Records: Ownership Registration Title History Plates State repositories of vehicle registration and ownership records encompass a wide range of public accessible data. Generally, you submit a name to find vehicle(s) owned, or you submit vehicle information to find a name and address. The records may not be held by the same state agency that oversee driver records.

Probably even more so than with MVR's, statutes vary widely from state to state regarding the release of these records for investigative purposes. State vehicle and owner databases can be excellent source for asset and lien data., among others.

Other Nonpublic Records
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  • Records from accountants and tax preparers
  • Mortgage company records
  • Telephone toll records
  • Credit card statements
  • Hotel and Travel Records
  • Telex Records
  • Overnight packages
  • Passports
  • Dun & Bradstreet Reports

Online Public Records Providers
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Many public records are now becoming available online and through CD ROM media. The two largest providers of public record information include:

CDB Infotek

6 Hutton Centre Drive
Santa Ana, CA 92707

(800) 427-3747
(714) 708-2000
(714) 708-1000 (fax)

Information America

600 Peachtree St. N.W.
Atlanta, GA 30308

(800) 235-4008
(404) 892-1800
(800) 845-6319 (fax)
(404) 881-0278 (fax)

 

Examining relevant documents

Financial Statements

The forensic accountant should perform a detailed analysis of the entity's financial statements and related schedules. This analysis should help identify accounts requiring further examination, provide comparisons with industry information and give good insight to the accountant as to the purported financial condition of the entity. There are traditionally two methods of percentage analysis of financial statements.

Vertical analysis is a technique for analyzing the relationships between the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages. This method is often referred to as "common sizing" financial statements. In the vertical analysis of an income statement net sales is assigned 100%; for a balance sheet, total assets is assigned 100% on the asset side; and total liabilities and equity is expressed as 100%. All other items in each of the sections are expressed as a percentage of these numbers. Vertical analysis emphasizes the relationship of statement items within each accounting period. These relationships can be used with historical or industry averages to determine statement anomalies.

Horizontal analysis is a technique for analyzing the percentage change in individual financial statement items from one year to the next. The first period in the analysis is considered the base, and the changes to subsequent periods are computed as a percentage of the base period. Like vertical analysis, this technique will not work for small, immaterial frauds.

 

Bank Records

Canceled Checks - enables the accountant to trace to the ultimate disposition of the payment. Examining the endorsement is crucial, often the endorsements tell you what the check was really used for. Also I have seen cases where employees have falsely Checks may lead to previously undisclosed assets purchased with checks.

Deposit Tickets - allows the accountant to trace the deposits to the initial source. Deposit tickets may lead to previously undisclosed assets sold or used to fund deposits.

Credit and Debit Memo - Leads to unusual transactions and previously undisclosed assets used to fund credit memos or purchased with funds reflected in debit memos.

Customer Correspondence Files - Leads to other assets and/or previously undisclosed relationships with other persons or entities.

Credit Reports - may reveal previously undisclosed assets and credit cards.

Financial Statements - Leads to previously undisclosed assets and liabilities. May provide starting point for net worth and expenditures method.

 

Income Tax Returns

Federal income tax returns can reveal both hidden assets and provide the accountant with significant information for the investigation. A thorough analysis should be performed on the current and previous years' filings. In examining personal income tax returns the Accountant should pay particular attention to:

Form 1040 - Schedule A - Itemized Deductions - the accountant should review in detail:

Real Estate Taxes - A comparison of the claimed taxes to the current home real estate taxes should be made. Any additional taxes may be attributable to hidden real estate interests. 

Home Mortgage Interest -Interest paid on contract purchases of real estate may be identified in this section. Further an analysis of the interest paid may lead to the disclosure of additional property interests.

 

Form 1040 - Schedule B - Interest and Dividend Income - This form lists names of payers of interest and dividends, if the amount exceeds $400.00. In addition to names of banks, brokers and company investments, the accountant will find names of contract purchasers of real estate.

The Form provides for a declaration as to investments in foreign accounts and trusts. If the taxpayer is holding investments as a nominee for the owner, this information should be disclosed as well.

 

Form 1040 - Schedule C - Profit or Loss From Business - Business interests operating as a sole proprietorship are reported on this form. Other items on the form to pay particular attention to, include:

Depreciation Expense - many times detailed schedules of property and equipment owned by the individual operating the business are attached as support for the entry.

Insurance Expense - a determination of the type of insurance being purchased should be made. As previously discussed, whole life policies may be used to hide assets.

Interest Mortgage - an analysis of the interest paid may again lead to the disclosure of additional property interests.

Pension and Profit Sharing Plans - contributions to these types of plans alerts the accountant to the existence of such plans.

Rent or Lease - an examination of this expense may lead to identifying valuable leasehold interests.

 

Form 1040 - Schedule D - Capital Gains and Losses - Sales of capital assets are reported on this schedule. The Accountant should review the schedule to determine if proceeds from sales of these assets have been accounted for or hidden.

Form 1040 - Schedule E - Supplemental Income and Loss - This schedule is a potpourri of other sources of income. As such it identifies many assets of the individual including:

  • Real Estate Rental Properties
  • Royalty Interests
  • Partnership Interests
  • S Corporation Interests, and
  • Estate and Trust Interests

 

Other Tips in Examining Documents

General ledgers and journals - Look for unusual items such as debits in liabilities accounts, credits in expense accounts, debits in revenue accounts, etc. Also look for large round amounts posted to the accounts and repetitive amounts such as checks or invoices shown in the journals.

Invoices - Examine invoices carefully looking for P.O. Boxes, sequential numbering, missing telephone numbers, vague descriptions and photocopies in lieu of original documents. Check existence of companies by finding phone book listings and calling the companies can determine the products and services they sell. A Freedom of Information request to the postmaster will show the "True Owners" of those boxes when they are used for business purposes.

 

Conclusion

Financial investigations can be challenging, but with a little creativity and auditing outside the books, the investigation can lead to a successful conclusion. Dogged determination of the accountant often leads to such a successful conclusion.

 

For additional information see: Sample Subpoena Language

 

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