Methods of searching for unreported income

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Editor’s Note: Last week, Tracy Coenen identified some of the challenges of searching for unreported income. This week, she takes a look at some of the methods of tracking down that information.

Lifestyle Analysis

For the employee who is receiving cash in lieu of a real paycheck or who is otherwise concealing wages and earnings, it can be very difficult to prove the case. Cash doesn’t leave much of a trail, and a company that is willingly participating in a fraud like this isn’t likely to offer up proof of the fraud either.

Probably the most common way to prove unreported income is through a lifestyle analysis. In a lifestyle analysis, we aim to prove that the lifestyle lived by the party exceeds the reported earnings.

The lifestyle analysis involves adding known expenses such as rent, mortgage, auto loan, credit card payments, and other items that are well-documented and easy to pinpoint a dollar figure. To this we add other estimated expenses like groceries, fuel, dining out, vacations, and other items that we know the party bought or paid for.

When the total is compared to reported or known sources of income, there may be a big gap, which can indicate unreported income. Of course, other possible sources of cash to fund the lifestyle must be ruled out, including loans, inheritances, tax refunds, and gifts. But in the absence of reasonable explanations, we’re likely left to conclude that all income has not been reported.

Expense Analysis

When a company attempts to conceal revenue, there are often clues left behind. If access to the accounting system is granted, it may be easy to see adjustments to the books and records that prove the manipulation of numbers. It’s usually not so easy, though.

Most times, we’re left looking at the financial statements with little or no detail about the numbers. Yet the financial statements can still provide interesting information. Even though a company may fail to report all revenues, they are usually still diligent about reporting all expenses. Most times a fraudster doesn’t even consider the idea of hiding some expense at the same time revenue is being hidden.

Why is this important? There are almost always expense line-items that have a predictable relationship to revenue. That is, we can see from historical financial statements that as revenue increased, costs increased in a predictable fashion, maybe as a percentage of the revenue.

A typical example of this is seen in a manufacturing company. Oftentimes, the cost of materials falls within a narrow range. Let’s make up a company, and say that the materials are 30 percent to 35 percent of revenue. If we see that during the time period in question, the cost of materials is now 55 percent of revenue, there is cause for concern. This might indicate underreporting of revenue.

Payroll is another account that often has a predictable relationship to revenue, especially if there are a large number of hourly employees. It stands to reason that those employees are only working if there is work to do, which means there is revenue coming in the door. If the payroll suddenly seems high compared to revenue, this again may signal unreported income.

Other line items that might have a close relationship to revenue include supplies, credit card fees (for a retail business that accepts credit cards), or cost of goods sold. For a service-based business such as an insurance agency or a law firm, items such as travel expenses, automobile expenses, meals and entertainment, or telephone might be indicators of the level of activity by the professionals.

Proof?

The examination of expenses and cash spending can provide valuable information about a person’s or company’s earnings. Does examining any of these items give definitive proof of hidden income? No. But they are definitely a good starting point, and the more suspicious items that are identified, the more likely you are to be onto something.

Hopefully the discovery of items that point to unreported income will help give leverage against the other party in order to help resolve the claims. Sometimes when this type of evidence is brought forth in a case, and then considered in light of other unusual or unfavorable information in the case, it can help bring a positive resolution for the client.

Tracy L. Coenen CPA, MBA, CFE is president of Sequence Inc, a forensic accounting firm with offices in Milwaukee and Chicago. She is also the author of Essentials of Corporate Fraud, and can be reached at 414.727.2361 or [email protected].