Investigative Accounting in Divorce

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Barson **FM (i-xxxviii)

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INVESTIGATIVE ACCOUNTING IN DIVORCE Second Edition


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KALMAN A. BARSON, CPA/ABV, CFE, CVA Rosenberg Rich Baker Berman & Company Bridgewater, New Jersey

JOHN WILEY & SONS, INC.

Copyright © 2002 by John Wiley & Sons, Inc., New York. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-41832-3. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com


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The pleasures in life are derived from the people closest and most important to us: Harry and Naomi Barson, my parents, to whom I am forever grateful; Janet Barson, my wife, who has always been totally supportive; Rebecca and Emily Barson, my daughters, a never-ending source of laughter and joy.


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ACKNOWLEDGMENTS First, to all those divorce clients, female and male, who have given me the opportunity to use my accounting experience and knowledge so as to learn this field and, in some small measure, bring my version of a sense of equity to this nearly insane system. It is, of course, the clients who pay our way and allow us to learn what we are then in a position to continue to sell to others. It is also these clients who, all too often, suffer under a system that just doesn’t care anymore and that tends to blindly, under the mantle of law and order, abuse the women and children (and, yet, even occasionally the men) going through the divorce process. To the family law practitioners, that body of attorneys without whom this work would be far less interesting. The conscientious family law practitioners bring a certain dignity and caring into an arena where there is unfortunately too little of that. They also provide an opportunity for the accountant practitioner to learn and to teach. To the support staff in my office, without whose help, patience, and diligence this book would consist of numerous untranscribed tapes. To my parents, Harry and Naomi Barson, who just before the publication of this book celebrated their 58th anniversary and who hopefully will always be an example to me of why, though I make my living doing this type of work, I would have to find a different specialty in a more perfect world. To my wife, who has long been truly a partner, a sounding board, and a support, and who spent a considerable amount of time helping to proofread the drafts of this book. Just before the publication of this book, we celebrated our 33rd anniversary. I have come home from many a divorce battle thankful that, for whatever differences two people have (and there are always differences), with a mutual respect and love we have been able to avoid the insanity of warfare all too often displayed in all too many cases. Finally, to the absolute joys of my life, my two daughters, Rebecca and Emily, who never cease to delight and amaze me, and who serve as a constant reminder of why we would all be better off if the need for this particular professional niche did not exist. In their relatively few years, they have truly earned my respect. K.A.B.

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ABOUT THE AUTHOR Kalman A. Barson is a partner in Rosenberg Rich Baker Berman & Company, a CPA firm with offices in Bridgewater and Maplewood, New Jersey. He is also past president of the National Associated CPA Firms — having served that organization as president for an unprecedented eight years. He has specialized in tax and financial planning, particularly for those in divorce actions, for nearly 30 years and is a recognized expert in investigative accounting, business valuations, and divorce taxation. Mr. Barson is a frequent lecturer on these matters, having spoken on behalf of the American Institute of CPAs, the New Jersey Society of CPAs, the Institute for Continuing Legal Education, the New Jersey Judicial College, and various other professional and business organizations. He is the author of four books on investigative accounting, and has authored many articles for professional publications.

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ABOUT THE CONTRIBUTORS Leonard M. Friedman, CPA, ABV, CBA, CVA is a partner with Kal in the firm of Rosenberg Rich Baker Berman and Company, a CPA firm with offices in Bridgewater and Maplewood, New Jersey. He deals with individual and corporate taxation, hedge fund auditing, as well as business valuation and divorce investigations. Mr. Friedman has written articles in several legal publications and has lectured on a variety of tax and valuation topics, and has co-authored chapters on divorce taxation and the use of computers in investigative accounting. He is a member of the American Institute of Certified Public Accountants and the New Jersey Society of CPAs’ Litigation Services Committee. Theodore S. Spritzer, CPA is a manager in the Tax Department of Rosenberg Rich Baker Berman and Company. Ted has specialized in all aspects of business and individual income tax planning including matrimonial tax issues for 15 years. He has written articles on a variety of tax issues and provided technical assistance for chapters and books authored by certain of the firm’s partners. Ted is a member of the American Institute of Certified Public Accountants and New Jersey Society of CPAs.

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SUMMARY CONTENTS Preface

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Introduction by Alan M. Grosman PART I

PRELIMINARY MATTERS

Chapter 1 Chapter 2 Chapter 3 Chapter 4

Getting Started Dealing with the Client Documents Parameters of the Inquiry

PART II

THE TARGET COMPANY

Chapter 5 Chapter 6 Chapter 7 Chapter 8

Dealing with the Target Company The Balance Sheet Sales and Income Operating Expenses

PART III

THE PARTIES

Chapter 9

Personal Financial Investigation

PART IV

VALUATION

Chapter 10 Valuing a Closely Held Business PART V

TAXES

Chapter 11

Taxes and Divorce

PART VI

REPORT AND TRIAL

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3 22 31 38

49 62 95 117

153

173

241

Chapter 12 The Final Stages Chapter 13 Postdivorce Services

281 298

Appendixes

307

Index

513

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DETAILED CONTENTS

PART I

PRELIMINARY MATTERS

1

Chapter 1

Getting Started

3

1.11 1.21 1.31 1.41 1.51 1.61 1.71 1.81 Chapter 2 2.11 2.21 2.31 2.41 2.51 2.61 2.71 2.81 Chapter 3 3.11 3.21 3.31 Chapter 4 4.11 4.21 4.31 4.41 4.51 4.61

Who Has Engaged You? Initial Discussions with the Attorney Interaction with Business Appraisers Disclosure and Information Statements Requesting Documentation Work Programs Stipulation versus Court Appointment Recognizing Financial Suicide

3 4 5 5 6 6 15 18

Dealing with the Client

22

Interview Your Client Conducting the Interview of the Nonbusiness Spouse Conducting the Interview of the Business Spouse Interviewing the Nonclient Business Owner Review of Initial Disclosure Statements Tax Neophyte Client Nonbusiness Spouse Interview Checklist Business Owner/Spouse Interview Checklist

22 23 24 25 25 25 26 28

Documents

31

Preliminary Disclosure Comparing Records Overview of the Books and Journals

31 33 35

Parameters of the Inquiry

38

Economic versus Tax Issues Business Form Valuation Date Nonmarital Assets Tax Fraud When a Business Is Not Involved

38 39 40 41 42 44 xv


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CONTENTS

PART II

THE TARGET COMPANY

47

Chapter 5

Dealing with the Target Company

49

Access to the Opposition Company’s Regular Accountant We’re Clean; There’s No Need to Investigate Working On-Site Working Conditions Walk Through the Business Understanding Internal Work Flow Multiple Companies Multiple Departments, Locations, or Products Divorce Planning Business Walk-Through Checklist

49 50 51 52 54 55 56 57 58 58 60

The Balance Sheet

62

Overview Cash Petty Cash Accounts Receivable Inventory Work in Progress Prepaid Expenses Fixed Assets: Property, Plant, and Equipment Notes Receivable Intangibles Accounts Payable Accrued Expenses Loans and Exchanges Loans to Officers, Owners, and Shareholders Loans and Notes Payable Payroll Taxes Withheld Sales Taxes Payable Equity

62 63 68 68 72 77 78 79 81 82 84 85 86 86 90 91 91 92

Sales and Income

95

5.11 5.21 5.31 5.41 5.51 5.61 5.71 5.81 5.91 5.10 5.11 Chapter 6 6.11 6.21 6.31 6.41 6.51 6.61 6.71 6.81 6.91 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18 Chapter 7 7.11 7.21 7.31 7.41

Becoming Well Grounded Seasonality Professional Practices Safe Deposit Box

95 98 99 101


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CONTENTS

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Gross Profit and Costs of Goods Sold Challenging Allegations of Unreported Income

102 113

Operating Expenses

117

Introduction Owner and Officer Payroll Other Payroll Rent Depreciation Retirement Plans Repairs and Maintenance Insurance Travel, Entertainment, and Promotion Automobile Expenses Telephone Professional Fees Payroll and Other Taxes Officer’s Life Insurance Employee Benefits Interest Expense Fines and Penalties Bad Debts Office Expenses and Supplies Memberships and Dues Subscriptions Utilities Miscellaneous Social Security Numbers

117 117 120 122 125 127 130 132 134 136 138 139 140 141 141 143 144 144 146 146 147 147 147 147

PART III

THE PARTIES

151

Chapter 9

Personal Financial Investigation

153

Overview Standard of Living Changes in Net Worth Personal Financial Statements Tax Shelter Issues Corporation as a Liability Hobbies and Collections Tax Return Analysis State Tax Returns Children’s Tax Returns

153 155 157 159 162 163 164 164 169 169

7.51 7.61 Chapter 8 8.11 8.21 8.31 8.41 8.51 8.61 8.71 8.81 8.91 8.10 8.11 8.12 8.13 8.14 8.15 8.16 8.17 8.18 8.19 8.20 8.21 8.22 8.23 8.24

9.11 9.21 9.31 9.41 9.51 9.61 9.71 9.81 9.91 9.10


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CONTENTS

PART IV

VALUATION

171

Chapter 10

Valuing a Closely Held Business

173

Overview There Is Value, and Then There Is Value Business Structure Understand the Business and the Industry

173 175 178 178

10.1 10.2 10.3 10.4

METHODS OF VALUATION 10.5 Revenue Ruling 59-60 10.6 Revenue Ruling 68-609 10.7 Industry Comparison: Price-to-Earnings Ratio 10.8 Industry Comparison: Rules of Thumb 10.9 Recent Sales 10.10 Capitalization of Income 10.11 Discounted Future Earnings (or Cash Flow) 10.12 Buy-Sell Agreement 10.13 In-Place Value 10.14 Liquidation Value 10.15 Discounts 10.16 Premiums 10.17 Enhanced Earnings Power 10.18 The Old Double Dip 10.19 Validity of Attributing the Value of an Appreciated Separate Business to Inflation 10.20 Revenue Ruling 59-60: Valuation of Stocks and Bonds 10.21 Revenue Ruling 68-609: Valuation of Stocks and Bonds

179 179 180 183 186 187 188 189 191 191 192 193 195 195 196 198 199 206

PART V

TAXES

239

Chapter 11

Taxes and Divorce

241

11.1 11.2

Introduction Taxes and Divorce

241 242

ALIMONY AND SUPPORT 11.3 General Overview 11.4 Cessation at Death 11.5 Electing Out of Alimony 11.6 Front Loading 11.7 Income-Shifting Tax Planning 11.8 Adjusted Gross Income 11.9 State Tax Law 11.10 Alimony Qualification Rules 11.11 Front-Loading Rule Exceptions 11.12 Child Support

243 243 243 244 244 244 245 246 246 250 250


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CONTENTS

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Changes Relating to a Child Dependency Exemptions Custodial versus Noncustodial Parent Multiple Support Agreements Filing Status Joint Returns Filing as Unmarried Deductibility of Legal Fees Child Care Credit Earned Income Credit Child Tax Credit Medical Deductions Allocating Tax and Refunds between Spouses Innocent Spouse

251 253 253 254 254 255 255 256 257 257 258 258 258 259

PROPERTY DISTRIBUTIONS 11.27 General Overview 11.28 Definitions 11.29 Nonresident Alien Spouse 11.30 Annulments 11.31 Effective Dates 11.32 Basis of Transferee 11.33 Appreciated or Depreciated Property 11.34 Annuity 11.35 Jointly Owned Residence 11.36 Installment Sales 11.37 Liabilities Exceed Basis 11.38 Supplying Information to Transferee 11.39 Transfer of Basis under § 1041 versus Nonspousal Gift Rules 11.40 Taxability and Deductibility of Interest on Interspousal Buyouts 11.41 Marital Residence 11.42 Transfers and Redemption of Corporate Stock 11.43 Passive Activity Loss Carryovers 11.44 Equitable Distribution and Retirement Plans 11.45 Alimony and Support Trusts 11.46 Effect of Deferred Taxes upon Equitable Distribution 11.47 Taxes — Hypothetically Speaking

261 261 261 262 262 262 262 262 262 262 263 263 263

11.13 11.14 11.15 11.16 11.17 11.18 11.19 11.20 11.21 11.22 11.23 11.24 11.25 11.26

263 264 265 268 269 270 271 272 273

PART VI

REPORT AND TRIAL

279

Chapter 12

The Final Stages

281

Introduction

281

12.1


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CONTENTS

12.2 12.3 12.4 12.5 12.6 Chapter 13 13.1 13.2 13.3 13.4 13.5

Working with the Opposing CPA Your Report The Opposition’s Report Negotiations Court Testimony

281 283 285 291 295

Postdivorce Services

298

Introduction Personal Budgeting Financial Management Tax Assistance and Preparation Remarriage

298 298 304 305 305

Appendixes A B C Index

307 Managing Your Investigative Practice Chronology of a Case Sample Reports

309 334 339 513


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PREFACE While the fundamentals remain the same, there is always more that can be done to explain and illustrate this exciting area of accounting. To continue to make this book ever more useful to the hands-on practitioner, and with the benefit of more experience, the following are some of the changes from the first edition: • A revised chapter on divorce taxation • Perhaps most significantly, several additions to the extensive appendix consisting of nearly 40 sample reports on varied types of businesses. It is my belief and intention that the reader will find these sample reports most helpful for generating ideas as to how to approach different investigative assignments and for providing guidance in writing reports. • Revised and improved budget interview form • Business valuation interview forms for general business, medical practices, and law and accounting practices • Job control list form • Reprint of selected articles I have written While it is expected that the investigative accountant practitioner will be the professional who finds the most utility in this book, it is also expected that other fields and disciplines will be well served by this book. The range of users will include: • Public accountants — for insight into this type of work and of course as solid grounding in servicing this field. • Attorneys — the family law practitioner will find this book of great assistance in understanding what the investigative accountant does and should do, as well as in getting an education in the development of the financial aspects of a divorce case. However, it is expected that the nonspecialist matrimonial practitioner might get even greater use out of this book. • Appraisers — especially those who get involved in business valuations and who therefore have a greater need to understand and relate to the accountant practitioners in this field. • Judges — especially those involved in family law will obtain a better understanding of the complexities of investigative accounting (and why we need judicial support for fee applications), and a better understanding of what needs to be demanded of the accounting profession in this type of litigation. • Internal auditors and internal accountants — these practitioners may also find this book useful and relevant to their internal audit function, providing insight into some of the financial distortions that may occur. • Accounting instructors, professors, and students — rather than the ivory tower “everything-is-clean-and-must-balance” situations typically reviewed by the student and addressed by the instructor, this book will lead to a better appreciation of some of the real-world aspects of what business owners will do to increase their after-tax income, hiding it from prying

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eyes. Under the appropriate circumstances, likely at an advanced or graduate level, this book may also serve as a base for instruction for students interested in pursuing investigative accounting. While I have tried to cover virtually all phases of investigative accounting as it pertains to divorce, there is little doubt in my mind that I didn’t succeed. There are certainly situations which I have not yet witnessed, and ways in which business owners familiar with the particular nuances of their business can receive benefits and hide income that I have not addressed. The reality of this type of work is that it is quite dynamic, that there are always new approaches, and virtually every case represents a new learning experience. It is in no small measure due to the constant learning phase that is so very important in doing this work that we must remain ever vigilant in seeing what is there and what is below the surface. June 2001 Bridgewater, New Jersey

K ALMAN A. B ARSON

INTRODUCTION

LAWYERS AND ACCOUNTANTS IN DIVORCE* Alan M. Grosman

The divorce revolution of the 1960s had two principal effects. One was in the enactment in most states of “no-fault” divorce laws, whereby marital breakdown either became the sole ground for divorce, as in California, or where a “no-fault” ground was added to the traditional “fault” grounds for divorce (adultery, extreme cruelty, and desertion), which were made much easier to prove. These changes occurred in part because of a general recognition in society of the fact that marital breakdown rather than the “fault” grounds was really the cause of divorce. This recognition was accompanied by abandonment of the traditional judicial public policy, which had favored saving marriages at all costs and making it quite difficult, if not impossible, to obtain a divorce. Instead, a new judicial public policy was adopted, favoring the view that it was better to bury “dead” marriages than to require unhappy couples to remain married against their will. The other principal effect of the divorce revolution was the adoption in the 42 common-law states of the community property concept of equitable distribution of property upon divorce. This change responded to the generally accepted view that marriage was in certain respects an economic partnership of two equal partners. Equitable distribution of property in divorce had always been a part of the family law of the eight community property states, which viewed marriage as an equal partnership, a concept derived from the Spanish and French laws. The basic community property principle is that all property acquired during a marriage is owned in common, usually belonging to both spouses by halves. That property is termed marital property. Property acquired by either spouse prior to marriage or by third-party gift or inheritance during marriage is termed separate property and is not subject to equitable distribution on divorce. Even in community property states with their theoretical concept of equality between the sexes, the law generally placed the husband in charge of the community property until after World War II. As a result of the changing role of women in U.S. society in the 20th century (and, particularly, since World War II), the entrance en masse of women into the work force on increasingly higher levels, and the development of the civil rights and feminist movements, many changes occurred in the status of women in society. These are reflected in our modern divorce laws. Every one of the 42 common law or title theory states, which derived their family law from England, enacted equitable distribution divorce laws and, in effect, became community property states upon divorce. Prior to that legislative change, whatever property a spouse held title to was his or hers, usually his, Introduction.

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upon divorce. That changed drastically with equitable distribution. Since the enactment of equitable distribution statutes, property acquired during marriage, except for property acquired by third-party gift or inheritance, is subject to a fair division upon divorce, regardless of title. Equitable Distribution. In some states, equitable distribution means an equal division of property. In other states, there is a presumption that the division will be equal. In most equitable distribution states, the property division is based upon a number of statutory factors, the most important of which is the duration of the marriage. Other factors may include the age and physical and emotional health of the parties; the income or property brought to the marriage by each party; the standard of living established during the marriage; any written agreement made by the parties before or during the marriage concerning property distribution; the economic circumstances of each party at the time the division of property becomes effective; the income and earning capacity of each party; the contribution of each party to the education, training, or earning power of the other; the contribution of each party to the acquisition, dissipation, preservation, depreciation, or appreciation in the amount or value of the marital property; and the contribution of a party as a homemaker. Accountants who wish to specialize in valuation of businesses and professional practices for purposes of equitable distribution upon divorce must become familiar with the equitable distribution rules and laws in their jurisdictions. That is not to say they must become a legal authority on the subject, but they must know the major cases in their states and the equitable distribution principles they stand for. The equitable distribution laws are still in a state of flux, with new developments occurring frequently. While accountants must work with and rely upon attorneys for the latest developments, they must know the basics in order to perform well. A considerable degree of uniformity in state equitable distribution laws has developed nationally over the past 20 years. However, differences exist among the states regarding certain equitable distribution issues. For example, states such as Texas have taken the position that professional goodwill is personal to the holder and is not to be treated as a marital asset. In contrast, states such as Colorado and New Jersey have found that a professional practice may have goodwill, which is distributable.1 Other states such as Nebraska have held that professional goodwill may be a distributable asset if the practice has a value independent of the presence or reputation of a particular individual.2 Not surprisingly, courts in common-law states have looked to community property state decisions as precedents as they developed their own equitable distribution law.3 Prior to the advent of equitable distribution, the focus of divorce litigation was on establishing fault grounds for divorce, determining custody and visitation, and fixing the amount and duration of alimony and child support. There were, of course, tax consequences to these pre-equitable distribution alimony/support agreements that required the tax expertise of accountants, but that was all. The situation today is entirely different. Fault now plays a minor role in divorce litigation because of the public policy of ending marriages that have broken down and because divorce is now viewed as akin to the dissolution of a business partnership, with the emphasis placed upon giving each partner a fair share of the proceeds. There has been an increase

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in custody litigation as more fathers seek primary custody of their children and more mothers pursue demanding careers. However, the predominant emphasis in divorce litigation today is on the economic aspects. This is particularly true in cases involving closely held businesses and professional practices. The effect of equitable distribution upon divorce has created a new emphasis upon the economic aspects of the marriage, including valuation and division of marital property as well as tax considerations. This new economic emphasis in dissolution proceedings has created a very important relationship between matrimonial lawyers and forensic accountants, each of whom has complex tasks to perform and both of whom must coordinate their activities to be most effective. A new and fascinating partnership has developed between forensic accountants and matrimonial attorneys to deal with the valuation and tax problems of divorce. The equitable distribution law has facetiously been described as the “Poor Accountants’ Relief Act.” It certainly has led to a new and challenging area of specialization for these members of the accounting profession who have the talent and interest to develop the required expertise. The advent of equitable distribution of property in the 1970s brought with it the often difficult problem of valuation of those assets that are subject to division upon divorce. It also brought the need for attorneys to find and use experts to establish many of the values. This has caused lawyers to reach out for the assistance of accountants in divorce cases as they had never done before. It also led a growing number of accountants to develop a new expertise as forensic accountants, prepared to testify as experts particularly with regard to valuation issues. Just about every divorce case these days involves tax issues, some simple and some complex. The matrimonial lawyer and the client need the help of the accountant in these matters. Accountant/Attorney Partnership.

Assistance by the Lawyer to the Accountant. The matrimonial lawyer should provide the forensic accountant with important information regarding the substantive law and the applicable rules in divorce cases, particularly when complex legal issues are involved. Such issues may involve dates for valuation of assets, which may vary depending upon the type of asset and the type of ownership. They may concern the legal principles to be applied in determining whether a property settlement agreement, a premarital agreement, or a marital agreement should be enforced, set aside, or modified. For example, the law regarding enforcement of premarital agreements containing provisions relating to divorce is unsettled and unclear in many jurisdictions although all states require reasonable financial disclosure at the outset. In some states, an agreement can be set aside if it is unconscionable when entered into. In other jurisdictions it also can be set aside if it is unconscionable when it is sought to be applied. If unconscionability at the inception is the standard in a particular jurisdiction, then it becomes important to determine the value of the assets of the other spouse at that time, a task for the forensic accountant. If unconscionability at the time of divorce is also a basis for setting aside the premarital agreement, then the accountant must marshal the assets and may have to value a closely held business at that time as well. If the particular state has adopted the Uniform Premarital Agreements Act (9B, U.L.A., Master Edition), which provides that it applies only to agreements entered into after its

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effective date, the attorney can assist the accountant in defining the scope of his or her work in valuing a closely held business owned by either spouse. Whether some particular assets are even subject to equitable distribution varies from state to state. For example, most states consider professional licenses and degrees as personal to the holder and not subject to equitable distribution. The majority view is reflected in the leading New Jersey case of Mahoney v. Mahoney.4 In the majority of states, a spouse who has worked to enable the other spouse to acquire a professional license or degree is entitled only to restitution of monies expended to put the degree-holding spouse through professional school. This is sometimes referred to as reimbursement alimony. However, a minority of states consider professional licenses and degrees to be assets subject to equitable distribution, just as pensions are subject to equitable distribution. These states follow the leading New York case of O’Brien v. O’Brien.5 In New York, following the O’Brien decision, McGowan v. McGowan6 held that a teacher’s certification acquired during the marriage was a marital asset subject to equitable distribution. “Celebrity status” is not considered property subject to equitable distribution in most states today. However, in New Jersey, which has been on the cutting edge nationally in equitable distribution decisions over the past two decades, the wife of a comedian was found entitled to her equitable distribution share of his celebrity status.7 Along the same lines, states which do not consider professional licenses or degrees as assets subject to equitable distribution tend not to consider what has been described as enhanced earning capacity, such as the ability of an experienced radiologist to obtain a good salary at a hospital, to be an asset subject to equitable distribution. However, some states and some judges do or may. Attorneys can provide guidance to accountants as to the state of the law and trends to enable them to perform their valuation task more effectively. Even if an asset may be subject to equitable distribution, there may be legal questions about how it is to be treated. If a closely held business was acquired prior to the marriage and has appreciated in value or has declined in value, what share should the nontitled spouse receive, if any? Should the same treatment be given to the appreciation in value of real estate or other “passive” assets acquired prior to marriage? If separate property of one spouse has been commingled with marital property during the marriage, what legal effect should that have? Matrimonial lawyers must give forensic accountants guidance on such issues and developments. As the case moves toward trial, the attorney should keep the accountant informed of the status of the case. Accountants should know when their expert report is due under the local rules. Failure to provide the expert’s report to opposing counsel and sometimes to the court as well in a timely fashion may result in exclusion of that report and exclusion of the forensic accountant as an expert witness at trial. The accountant is usually retained by a client in a divorce case at the recommendation of the attorney for a number of reasons. These include valuation of a closely held corporation or professional practice, marshalling the assets, providing tax advice, preparing an expert report, testifying at trial, assisting the attorney in cross-examining the opposing expert, and helping to negotiate a settlement. The accountant will help the attorney by developing a valuation approach and by explaining the justification for such an approach. Assistance by the Accountant to the Attorney.

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With the help of the accountant, the attorney should develop a theory of the case. Once properly developed, everything should fit into this theory or approach. Many small businesses and professional practices involve some unreported cash. Severe sanctions can be imposed by the court upon clients in divorce cases who underreport their income significantly. Matrimonial judges have a judicial obligation to report litigants guilty of IRS violations to the U.S. Attorney General for prosecution. Most are extremely reluctant to do so, feeling that the people before them have enough problems with their marriage failing; they do not want to add to their problems. However, if there is a trial and facts regarding unreported cash are formally brought to their attention, they may report them. One never knows. This potential exposure to IRS prosecution is a factor leading to settlement of many cases. The wife does not have to threaten her husband with reporting him to the IRS; his lawyer will tell him of his exposure. That is why it is important for the wife’s team to find some of the unreported cash, if possible. Finding the cash is often a very difficult task, but it is one that the accountant is well equipped to undertake. Similarly, some businessmen may engage in fraudulent transfers of their property in an effort to deprive their wives of their fair share of the assets subject to equitable distribution. Such a transfer may be made to a brother or a parent. This does not happen all the time, but it happens. The attorney is ill equipped to unmask such fraud by himself. The accountant can provide invaluable assistance in such an effort and the attorney can help him or her by seeing to it that the accountant gets the required discovery information. No case should be settled without consideration of the tax aspects of the entire settlement. The accountant should review and comment upon the tax consequences of any proposed settlement. The accountant should provide the client with tax advice. This assistance is of great importance to the attorney, who usually is somewhat knowledgeable about taxes, but not a tax expert. Valuation. In many cases, a variety of assets are subject to equitable distribution. Valuation of some of these assets may be a complex process, but it must be done. The equitable distribution process has been characterized as having three steps. In the leading case of Rothman v. Rothman,8 the New Jersey Supreme Court stated that trial judges must first identify the property subject to equitable distribution. Secondly, they must determine its value for purposes of equitable distribution. Third, they must decide how such an allocation can be made most equitably. The first step of listing or identifying the assets subject to equitable distribution may also be described as marshalling the assets. The lawyer can help, but the accountant is far better qualified to marshall the assets, particularly in a complex case. The second step of valuation of assets is a very important area for work by forensic accountants, qualified to value certain assets, particularly closely held businesses and professional practices. Of course, not all assets are appropriately valued by accountants. The best experts to value residential and commercial real estate are real estate appraisers. Specialized pension appraisers, generally actuaries, may be the best experts to value pensions and related retirement benefits, though some accountants do develop expertise in this area and serve as pension valuation experts. Accountants apply many different valuation approaches to valuation, such as the capitalization of earnings method, the “key man” approach, use of buy-sell

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agreements to determine value, Revenue Ruling 59-60, 1959-1 C.B. 237, recent purchase offers, and sales of comparable businesses. Which approach or approaches to take to value a particular business or professional practice is a decision that the forensic accountant must make. Cases rise and fall with the methodology applied by accountants and the documentation they can provide to back up their approaches and conclusions. Their decisions are of critical importance to success in the litigation. Some assets, such as a marital home and commercial real estate, are relatively easy to value. Valuations by two or more independent experts are usually within a close range of one another and tend not to be very expensive. For such valuations, a strong argument can be made for having a court-appointed appraiser because it saves the expense of having two appraisals and the appraiser is likely to be impartial and accurate. The same may be true when it comes to valuing property like motor vehicles, construction equipment, gun collections, stamp collections, furniture and furnishings other than antiques, and other items of personal property. Even these have their pitfalls. Other assets, such as closely held corporations and professional practices, are much more difficult to value. There is less uniformity in appraisals and even in methodology by recognized experts. Valuation of closely held corporations “generally presents the most perplexing problem in the field of valuation.” 9 Few principles are uniformly reliable. Well-qualified experts often arrive at widely different valuation conclusions. Moreover, qualified experts to perform these valuations are few and far between. In addition, such appraisals tend to be costly. Nevertheless, the difficulty of making such valuations does not relieve trial courts from the obligation to value marital property. Heavy equitable distribution cases have the potential of turning into costly battles of experts. Each side may retain its “hired gun” and these experts may produce reports that are designed to gain leverage, rather than to assist in the quest for truth. While the opinion of such experts is theoretically subject to the time-honored crucible of cross-examination during the course of a trial (provided the case goes to a trial), the fact is that most equitable distribution cases are settled and not tried. It is also true that many experts are concerned about their reputations and are unwilling to sacrifice them for the benefit of a client in a particular case, preferring to be known as forthright, truthful, and credible witnesses. One appealing way to solve the valuation problem with regard to closely held corporations and professional practices is for the court to appoint the valuation expert for these assets. This is an approach that many courts have favored. Our courts have the inherent power and often appoint economic expert witnesses to assist them. If the court decides to appoint an expert to value a business or professional practice, neither side can object. In such situations, the parties may be permitted to select the accountant by mutual agreement. Whether selected by the parties or by the court, neither party is bound by the report of an expert so appointed. The expert is permitted to conduct an independent investigation to obtain information reasonable and necessary to complete his or her report from any source, and may contact directly any party from whom information is sought within the scope of the order of appointment. In such cases the parties are entitled to have their attorneys and/or experts attend and participate in any examination by a “Court-Anointed” versus Individually Retained Valuation Experts.

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court-appointed expert. The preferred practice is that the expert is not permitted to communicate with the court except upon prior notice to the parties and their attorneys, who are then to be afforded an opportunity to be present and to be heard during any such communication between the expert and the court. (This rule limiting the expert’s access to the judge outside the presence of the attorneys for the parties is, unfortunately, often honored in the breach, with the court-appointed expert communicating ex parte with the judge and the attorneys for the parties left in the dark.) Under this court-appointed expert procedure, the expert submits his or her report to the court and to the parties at the same time. The parties then are permitted a reasonable opportunity to conduct discovery in regard to the expert’s report, including the right to take the expert’s deposition. Powers of the Court-Appointed Economic Expert. The rules regarding court appointment of economic experts provide some protection to the client against abuse by the court-appointed expert. For example, the rule adopted in New Jersey for appointment of economic experts provides that an expert appointed by the court shall be subject to the same cross-examination as a privately retained expert. The parties are free to retain their own experts, either before or after the appointment of an expert by the court. Although the court-appointed expert rule generally provides that the court shall not entertain any presumption in favor of the appointed expert’s findings, in practice, this is difficult to carry out. The problem is that the court-appointed expert tends to become the “court-anointed” expert. When expert accountants are court-appointed, they tend to assume a position where they call the shots. There is a strong, inherently coercive influence upon the parties to accept experts’ valuations, right or wrong. It is likely, though not always true, that court-appointed experts will be competent appraisers. And courtappointed experts do help settle cases, in part because of the quality of their appraisal in many instances. Almost invariably, the parties feel that it would be a waste of time to hire their own expert, since the court will probably accept the findings of its expert. That expert is impartial, fair, and must be right, even if wrong. The naming of a court-anointed business or professional practice valuation expert may, in practice, involve an improper delegation of judicial authority and responsibility to the expert. The expert then, in effect, becomes the judge. He or she is not just “the arm of the court.” He or she is the court, and moreover, a “judge” from whom there effectively may be no appeal. Suppose court-appointed experts are negligent, biased, or behave improperly in a particular valuation assignment. Suppose they make improper threats of IRS prosecution if their proposed settlement is not accepted. Can an aggrieved litigant obtain relief? Theoretically, yes. Practically speaking, no. An inherently fairer method of valuation of closely held corporations and professional practices is for both sides to have their own accountants make independent appraisals. Valuation differences may be resolved after the exchange of the reports by the parties. It is only when the parties’ independently selected experts have arrived at valuations that are too disparate for the court to come to a reasonable conclusion that it is appropriate to use a court-appointed expert to resolve specific disagreements between the parties’ experts. Forensic accountants who have mastered the art of valuation of closely held corporations and professional practices play a key role in divorce cases involving such assets.

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Financial discovery is the key to success in equitable distribution valuation. Formerly, the right of a party to discovery in matrimonial matters was quite circumscribed for fear that liberal discovery could lead to abuse and harassment. Over the past two decades there has been a significant expansion of the right to discovery in matrimonial actions. The more liberal discovery now permitted in family actions includes the right of one party to serve interrogatories upon the other. In most states, depositions based on oral or written questions may be taken of parties, witnesses, and opposing experts, including a courtappointed expert. In matrimonial matters the attorney can submit a demand for production of documents to the adverse party. While attorneys have standard financial interrogatories and demands for production of documents, these should be tailored to meet the specific information requests of the accountant. Often, rather than having the attorney make a demand for production of documents, accountants will make their own demands, usually by letter, which they will send directly to opposing counsel or have their document request sent by their client’s attorney. The response to the first document request may result in additional document requests, all of which is permissible and in keeping with the discovery rules. Discovery.

In addition, the attorney and the accountant may develop a request for admissions, which is served upon opposing counsel. A request for admissions is a very useful, though seldom used, discovery tool. A party may serve upon the other party a written request for the admission of the truth of any matters of fact such as those relating to the existence of books, documents, or other tangible things and the identity and location of persons having knowledge of any discoverable matter, and the genuineness of any documents described in the request. Copies of documents must be served with the request. Each matter for which an admission is requested must be separately set forth. The matter is considered admitted unless, within 30 days or whatever time period the rules prescribe, the party to whom the request is directed serves upon the party requesting the admission a written answer or objection. If objection is made, the reasons must be stated. The effect of an admission is that the facts admitted are conclusively established for the purpose of the trial. It may be difficult to prove certain facts which are important to a valuation assignment. For example, documents that would prove them may not be readily obtained or may be impossible to obtain. The need to prove such facts may be eliminated by thoughtful use of the request for admission rules. Discovery tools may be employed for a wide range of objectives, including gaining needed financial information about assets and income and valuing a closely held business or professional practice. In general, the scope of discovery is that parties may obtain discovery regarding any matter, not privileged, which is relevant to the subject matter involved in the litigation. If the adverse party opposes a request for discovery, the court will decide whether such discovery must be provided. It is not a ground for objection that the information sought will be inadmissible at trial, if it appears reasonably calculated to lead to the discovery of admissible evidence. The accountant’s valuation task is quite difficult. This is particularly the case when he or she is retained by the wife to try to determine the value of the husband’s business or professional practice. Normally, accountants begin by sending a letter Request for Admissions.

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either directly to the other attorney, or to their client’s attorney to be forwarded to the other attorney. That letter sets forth a preliminary list of documents required. When the husband receives the list, he may or may not cooperate. He may refuse to provide corporate tax returns, business ledgers, and other essential data. The sensible thing for him to do is to have his business accountant provide the necessary data, but he may refuse to do this. He may claim that the data does not exist. When the husband refuses to cooperate in the valuation process, the attorney can come to the assistance of the forensic accountant by filing a motion to compel the husband’s compliance and to take his deposition. A deposition is a hearing where the party being deposed is sworn to tell the truth, can be required to produce documents, and must testify to questions propounded by the other spouse’s attorney regarding the financial matters at issue. Accountants are entitled to be present at the deposition. They can develop questions for the attorney to ask, but they are not entitled to question the witness themselves. The purpose of the deposition is discovery. Questions can be asked that would not be admissible at a trial. Questions can be asked to give the accountants a lead towards obtaining relevant information to perform their valuation task. The same type of questions can, of course, be asked in the form of written interrogatories. The practical problem with interrogatories is that the answers tend to be those of the attorneys for the adverse parties, rather than those of the adverse parties themselves. There is a certain spontaneity to the oral question-and-answer process of a deposition that tends to result in more revealing answers by the adverse party. These may prove quite valuable in the valuation process. Depositions may result in settling the case. The demeanor of key witnesses becomes known and relevant information may be obtained. While depositions are a very powerful discovery tool, they are not without drawbacks. Drawbacks include the facts that depositions are costly, that they may educate the expert witness of one’s adversary and thus enable him or her to improve performance at trial. Taking the deposition of the other party or his expert guarantees that the deposition of your client and expert will be taken. The accountant can play a very important role in assisting the attorney to take the deposition of the opposing party or its expert witness. Accountants know what questions to ask the opposing party and the expert witness of the opposing party. Accountants and attorneys should work together to develop the examination of these witnesses. An effective examination may result in a settlement of the case. It may also result in learning about assets that were undisclosed or barely disclosed.

Depositions.

Safeguards against abuse of discovery are provided in family actions, as in all civil actions, by way of protective order. Upon motion by the party or person from whom discovery is sought, and for good cause shown, the court may make any order that justice requires to protect a party or person from annoyance, embarrassment, oppression, or undue burden or expense, by barring discovery, limiting the scope of discovery to certain matters, and requiring that confidential information not be disclosed. Protective orders have been issued when a party seeks to have an accountant inspect the books and records of a corporation in which the other spouse has a

Protective Orders.

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minority interest. However, the trend in recent years is to permit such inspection and discovery even when the minority interest is 20 percent or smaller. Protective orders may also be issued where a privilege is involved, such as the privilege against self-incrimination and the physician-patient privilege. Though the rules provide for liberal discovery, the adverse party and/or its attorney might seek to block discovery. They might provide no information, irrelevant information, or so little information as to make it impossible for the accountant to complete the valuation. Requests for discovery should be in writing, so that they can be included as exhibits in a motion to compel discovery and to impose sanctions, for which the attorney will prepare a notice. The motion will be accompanied by an affidavit by either the accountant or the client, with a letter from the accountant setting forth what has happened and including as exhibits any writings that substantiate the claim that the adverse party is stonewalling the discovery proceedings. Generally, prior to the hearing of the motion, the adverse party will begin cooperating and will provide the required documentation and information. If this does not happen, the matter will go to the court, which can impose a variety of sanctions for noncompliance: awarding attorneys’ fees to the party making the application; holding the disobedient party in contempt; entering an order that matters or facts relating to the order shall be taken to be established for the purposes of the action in accordance with the claim of the party obtaining the order; prohibiting the guilty party from introducing certain items in evidence; entry of an order striking the pleadings of the disobedient party; or dismissing the proceedings or rendering a judgment by default. Since all of these sanctions can be imposed against the party who resists discovery, application to the court should be made to obtain discovery as required. One cannot wait too long before applying to the court to obtain discovery, because a trial date may be fixed by the court and the case may be tried without necessary discovery if the application to compel discovery is not made in a timely fashion. Some judges will grant an adjournment to enable a party to complete discovery if the other side is at fault. Others could care less and will set the case for trial. If the attorney or the accountant have been negligent about performing their discovery and valuation tasks, this could lead to a malpractice action by their client against one or both. At the very least, it could become an obstacle to being paid in full for their services. Motions to Compel Discovery.

Valuation Problems. Even where the property-owning spouse is relatively cooperative, the accountant’s evaluation is quite difficult. In dealing with closely held corporations, a great deal of skill is required of accountants to make a determination whether there is goodwill and, if so, what it is worth. The attorney can assist the accountant in obtaining whatever information may be available, but ultimately the attorney must rely upon the accountant for an appraisal.

The accountant’s valuation task is much simpler when it involves appraising the business or professional practice of his or her own client. In such cases the client’s accountant is likely to be fully cooperative with the forensic accountant. There will not be a Valuation of Your Client’s Business or Professional Practice.

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problem in obtaining five years of business records, if they exist, as there might be in attempting to value the business or professional practice of an adverse party. The accountant will not have a problem in discussing the business or professional practice with the client. When dealing with an adverse party, that may not be possible, outside of a deposition. Some attorneys refuse to permit their clients to be interviewed by the other spouse’s accountant. When accountants are appraising the business or professional practice of their own clients for purposes of equitable distribution, they can provide the client and the client’s attorney with a preliminary report, which can be evaluated and possibly made more accurate by providing additional data. Valuation Dates. One critical issue in equitable distribution valuations is the valuation date. This is not a simple matter. There is no consensus nationally on this subject. There is considerable confusion within particular states about the date that should be chosen to value different types of assets. In many states, for most assets subject to equitable distribution, the valuation date is the date the divorce complaint is filed. The New York statute provides that the court shall set the date or dates the parties shall use for the valuation of each asset. It further provides that the valuation date or dates may be anytime from the date of the commencement of the action to the date of trial.10 The leading New Jersey case, Bednar v. Bednar,11 involved valuation of a jointly owned motel that had appreciated substantially until its sale eight years after the divorce complaint was filed. The court held that principles of equity required a common evaluation date for all assets involved in a particular case. It added that there was no iron-clad rule for determining the date of evaluation, but use of a “consistent date,” was preferable, such as the date of the filing of the complaint or the time of the trial, depending on the nature of the asset and any compelling equitable considerations. In other states, the valuation date for most assets is the date of the trial or as close to it as can reasonably be achieved. In an increasing number of states, the equitable distribution valuation date depends upon the type of asset or the type of ownership of the asset. In Dobbyn v. Dobbyn,12 where the principal marital assets were investment accounts and securities subject to substantial fluctuation, the court found that the valuation date should be the date of trial. The difference in valuation dates may make a great difference in the valuation. A solely owned asset that had a value when the divorce complaint was filed may be valueless as of the trial date. Needless to say, the accountant and the lawyer must discuss and agree upon the proper valuation date or dates that accountants will use in their evaluations. The Valuation Report. Different accountants have different forms of reports. Some reports are long and complete; others are painfully short, bare-bones reports consisting of a couple of schedules. The form and contents of the report are up to the forensic accountants, of course. However, they should consider their audience, which is composed of nonaccountants and others who may not be that familiar with numbers. They should understand that in all likelihood the judge is not an accountant, the client is not an accountant, and the client’s attorney is not an accountant. The reason for stressing this point is to encourage the forensic accountant to make a report that is easily understood by these key people, who are

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laymen. If these people don’t get it, even a very fine work product may not prove very effective. A narrative report setting forth in plain English the numbers on which it is based is very helpful for the layperson to understand, and more persuasive. An honest, credible, persuasive report is the name of the game. Such a report, backed up by tables, is preferable to one that requires the reader to analyze and understand those tables in order to understand the findings. In each jurisdiction there are rules regarding the date that a valuation report must be submitted to the adverse party. In many jurisdictions this is 30 days prior to trial. If accountants fail to submit their valuation reports on time, and the other side objects, they may be precluded from testifying as experts. While this rule is often honored in the breach, one cannot count on this occurring. Therefore, it is advisable to submit the report within the time required by the local rules. The forensic accountant should be present with the attorney and the client at settlement negotiations. His or her grasp of the numbers and of the implications of proposals by the other side can be very helpful in settling the case. If both sides have accountants, they can often come to an agreement on the value of the assets. Good forensic accountants are not only valuation experts and good witnesses at trial but also good negotiators. Together with the attorney, they can form a very effective team to settle cases without a trial. Thus they should have or develop negotiating skills that are brought to bear on the settlement process. Over 90 percent of all divorce cases are settled prior to trial. That is why the attorney-accountant partnership is so important in settlement negotiations.

Pretrial Negotiations.

If all else fails, there will be a trial. Forensic accountants play a starring role in that trial. They and their attorney partner must carefully review the testimony that will be presented on direct examination and the questions that are likely to be faced on cross-examination. As a witness on direct examination, it is helpful if the forensic accountant prepares some demonstrative evidence, such as a large chart with numbers to explain in the course of his or her testimony. The forensic accountant also should help the attorney to understand the report of the opposing expert and should help in developing an effective cross-examination of the opposing expert. In matrimonial trials the trial judge has wide discretion. In addition to this broad discretion, the trial judge decides the credibility of witnesses. This determination of who is telling the truth and who is lying is very seldom reversed on appeal. That is why the place to win, if at all possible, is on the trial level.

Trial.

Getting Paid. Getting paid is essential and is often difficult, particularly when the accountant (and the attorney) represent the spouse who does not own either the closely held or the professional practice. It is customary for the forensic accountant and the matrimonial lawyer to receive a retainer up front and to bill on an hourly basis for their work. The problem for both is that the retainer they receive may be all the money the nonpropertied spouse will have until the litigation ends and, hopefully, an equitable distribution is made. Accountants who are court-appointed have the best chance of getting paid because the court will enforce its order for payment of its expert. When accountants are not court-appointed and represent the nonpropertied spouse, they must receive a sufficient retainer to cover a substantial amount of their work, or they

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should be very hesitant about undertaking the assignment. If there are assets, which will likely be sold at the end of the case, the accountant may decide to take a chance. Only if they represent the propertied spouse are accountants likely to be paid on an ongoing basis. If a great deal of work must be done by the accountant, which far exceeds the retainer, the attorney may be able to prevail upon the court to order the other spouse to pay some additional portion of the accountant’s fee. From a practical standpoint, this is unlikely. The courts tend to deny attorneys’ fees and accountants’ fees while the case is proceeding, if they have received a reasonable initial retainer, on the theory that these issues should be reserved to the final hearing. Accountants should recognize this reality when deciding whether to accept a valuation assignment from the nonpropertied spouse. Attorneys will be committed to seeing that accountants are paid, but unless they retain the accountants, which is not normally the case, the accountants must ultimately look for compensation from the client who has retained them. NOTES Alan M. Grosman, who represented the surrogate mother in the celebrated Baby M case, is a member of the firm of Grosman & Grosman in Millburn, New Jersey, the author of New Jersey Matrimonial Law (1995), a frequent lecturer on family law subjects, former chairman of the New Jersey State Bar Association Family Law Section, former president of the American Academy of Matrimonial Lawyers, New Jersey Chapter, and editor of the American Bar Association Family Law Quarterly. 1. See In re Marriage of Nichols, 40 Colo. App. 383, 606 P.2d 1314 (1980); Dugan v. Dugan, 92 N.J. 423, 457 A.2d 1 (1983). 2. Taylor v. Taylor, 222 Neb. 721, 386 N.W.2d 851 (1986). 3. The best book to read for an overview of the equitable distribution laws nationally and state by state is by John DeWitt Gregory, The Law of Equitable Distribution (1989). (Warren Gorham ⫹ Lamont, Boston, MA.) 4. 91 N.J. 488, 453 A.2d 527 (1982). 5. 66 N.Y.2d 576, 489 N.E.2d 712, 498 N.Y.S.2d 743 (1985). 6. 136 Misc. 2d 225, 518 N.Y.S.2d 346 (1987). 7. Piscopo v. Piscopo, 231 N.J. Super. 576 (Ch. Div. 1988), aff’d, 232 N.J. Super. 559 (App. Div.), certification denied, 117 N.J. 156 (1989). 8. 65 N.J. 219, 320 A.2d 496 (1974). 9. McCarthy and Healy, “Valuing a Company” 109 (1979). 10. N.Y. Dom. Rel. Law § 236(B)(4)(b). 11. 193 N.J. Super. 330, 474 A.2d 17 (App. Div. 1984). 12. 57 M.D. App. 662, 471 A.2d 1068 (1986).


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PART

PRELIMINARY MATTERS

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CHAPTER

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GETTING STARTED Doctors and lawyers must go to school for years and years, often with little sleep and with great sacrifice to their first wives. — Roy G. Blount, Jr.

CONTENTS 1.1 1.2 1.3 1.4

Who Has Engaged You? Initial Discussions with the Attorney Interaction with Business Appraisers Disclosure and Information Statements

3 4 5

1.5 1.6 1.7

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1.8

Requesting Documentation Work Programs Stipulation versus Court Appointment Recognizing Financial Suicide

6 6 15 18

WHO HAS ENGAGED YOU? The accountant doing divorce work has three ways of being engaged — on behalf of one of the parties, stipulated to by both parties, or court-appointed. Most common is an engagement on behalf of one of the parties to the divorce. Generally, you must take pains to avoid being considered biased and overly subjective. Your value is in being independent and objective, and in maintaining maximum credibility. That credibility can be challenged, and possibly lost, when engaged by one of the two parties in a divorce case. Obviously, if you are representing the nonbusiness spouse, and your job is to investigate the financial affairs of the business spouse, including determining the income and value of the business, one of the challenges to your work and your conclusions will be whether or not you were sufficiently independent, unbiased, and objective. For the accountant, working for one side generally means getting very involved with building up the attack or defense for that one side, and also hearing only, or mostly, one side of the story. On the other hand, you might have the occasion to be stipulated to by both parties. Generally, for this to happen, you must be somewhat experienced, with a favorable reputation so that both of the attorneys involved have either heard of you, or know of you through others, and are comfortable enough to entrust you with the assignment. Alternatively, it may not be so much a reflection of confidence in you, but rather an economical way to approach a case. By using just one expert, neither side is truly bound by any conclusions of that expert, and if the job is reasonably done, it will probably save the marital unit thousands of dollars. In many respects, a court appointment is similar to a stipulation. A court appointment, however, extends beyond merely having the parties (through their attorneys) agree to use you; it is the court (the judge) who has selected you and

1.1

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GETTING STARTED

who has empowered you to do this work. Thus, your position is somewhat stronger in that you have the authority of the court behind you. On the other hand, you are very much dependent upon the degree of support that the judge gives you. Whether stipulated or court-appointed, you are representing not one side, but rather both sides. As a result, you also have no friends; neither side will have any particular loyalty to you. Of course, in theory, since neither side is responsible for hiring you, you are less subject to client pressures toward one particular direction or approach with which you are uncomfortable. That is not to say that you will not receive pressure. You will probably experience pressure from both sides. However, you will also have the opportunity to work closely with two attorneys and to perform with a true sense of independence and objectivity. Working in this type of environment also requires that you maintain as much dual contact as possible; anything in writing must be conveyed to both attorneys. Depending on the particular case, your reputation, and the attorneys’ comfort level with you and with each other, you may even be compelled to avoid communicating with one attorney unless you simultaneously communicate with the other. This perceived need to have both attorneys always in contact will, of course, slow you down, create some obstacles, and make your work a little more difficult and unpleasant. Nevertheless, you may have little alternative. For those who have not had the experience of being stipulated to or courtappointed, quickly dispel from your mind the idea that working for both parties will give ready access to necessary records. You may think you are working for both parties, but the likelihood is that neither of them thinks that way, and in fact each of them probably thinks you are working for the other. Furthermore, in terms of obtaining access to documentation and getting the truth, there is little difference between working for the nonbusiness spouse and working for both parties, and probably little difference even if you were working for the business-owner spouse. If there is something to hide, and if the business-owner spouse would rather tough it out, it is irrelevant whom you represent; you are not going to get cooperation. Similarly, if the nonbusiness spouse is of the mind to lie, distort the situation, exaggerate the standard of living, and the like, it will not matter whether you are representing that spouse, both spouses, or the other spouse because the information you receive will be suspect. Therefore, while being court-appointed or stipulated to may carry the aura of being above it all, you may not get the cooperation of both parties in order to do the classic independent and objective assignment. The reality is that neither party will view the situation in the same light and, in many ways, your work is more difficult than if you represented only one side. A request for an interview of either or both parties will be met with acceptance. However, certainly that spouse’s attorney will want to be present, and there is an excellent chance that the other spouse’s attorney will want to be present. When the attorneys have a certain comfort level with you (and with each other), much of what you need to do can be done without trying to arrange a three-way or four-way conference every time you have a question. 1.2 INITIAL DISCUSSIONS WITH THE ATTORNEY. Among your first steps in dealing with an attorney is to ascertain what records are already in his or her possession. Often, the attorney has records that would be of significant benefit

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to the investigative accountant in getting an overview of the situation and a basic understanding of the magnitude of the financial issues. All too often, because of a lack of communication, those records sit in the attorney’s office unbeknownst to the accountant. Perhaps the best way to handle this situation is to go through those records at the attorney’s office, decide which ones would be a benefit to you, and have copies made. It is important to know the extent of the services that are expected of you. For instance, is the work just an overview or financial consultation, or is it more extensive, including a business investigation, a personal lifestyle investigation, and a business valuation? Perhaps your work will require providing testimony at trial, or tax input and financial consulting relevant to the divorce settlement and its tax ramifications. On the other hand, you may be the one to advise the attorney as to the extent of your involvement. For instance, although everyone recognizes that there is a business involved, you may be the one who determines that a personal financial investigation is absolutely essential in order to evaluate the magnitude of the assets available for distribution. Your initial task might be to do a business investigation, but you might quickly realize, and of course advise the attorney, that significant tax issues exist or are anticipated that will need your expertise. INTERACTION WITH BUSINESS APPRAISERS. When working on a divorce case that involves a closely held business, accountants may be engaged only for the investigative phase, and not for the business valuation. Depending on the attorney, the magnitude of the case, your particular credentials, the credentials of your opposition, and a multitude of other factors, a business appraiser, as contrasted with a CPA, will become part of the team. Certainly, you may be amply qualified and capable of valuing that closely held business; however, it is sometimes desirable to involve disciplines other than the accounting profession. Using an appraiser other than a CPA may be of particular importance if the business has certain peculiarities that are out of the normal domain of most accountants and for which specialized knowledge would be essential. This includes gas and electric utility companies, railroads, airlines, and even farms. Unless you have specialized knowledge in those fields, you and your client would be better served to consult an appraiser with that particular expertise. Trying to put a value on such a specialized business would probably expose you to unwarranted liability. 1.3

1.4 DISCLOSURE AND INFORMATION STATEMENTS. Notwithstanding the likelihood that they are rife with misleading information, misstatements, and outright lies, and exhibit a paucity of usable information, it is vital to obtain the case information or disclosure statements for both sides. Accountants usually obtain disclosure statements from the attorneys involved. These documents list the party’s financial data, including sources and amounts of income, along with assets and liabilities, as well as any interrogatories that have been submitted and returned. Any statements made by the opposing side (and even by your client) must be taken with some degree of skepticism. Despite these types of problems, it is crucial to review whatever documentation exists and become as informed as possible. As suspect as these documents might be, they sometimes contain bits of information that a knowledgeable and skilled practitioner can take advantage of. Look for key names or business relationships, look for indications of ownership

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interests in other business or investment ventures, and look for indications of retirement plans or banking relationships. It is important not to overlook the fact that these documents are sworn statements that are supposed to represent the truth. It could, at least in theory, subject one to legal action if it can be shown that they were knowingly falsely prepared. However, no matter how egregious and blatant the misstatements, and no matter how obvious it is that the presenter of these falsehoods or misstatements must have known they lacked veracity, rarely does anyone suffer legal retribution for this supposed travesty of justice. At the very least, a careful inspection of these documents will give you an overview of the financial complexity of the case and indicate which areas you may wish to target. By all means, do not consider this to be the best source of information nor the basis for going forward; it is merely one source of information that should not be overlooked. 1.5 REQUESTING DOCUMENTATION. To obtain information, one of the first steps is to submit a request for documentation and access to records. The sample records discovery request letter in Exhibit 1–1 should serve as a guide to the documentation you will need to request. Of course, this letter is intended to cover many and varied situations for the purposes of this book and should be modified (usually shortened) as the circumstances of the particular case warrant. Often, this letter will go through the attorney with whom you are working, who will then forward it to the appropriate party. Sometimes, you may end up dealing directly with the other accountant, the business owner’s accountant, or even perhaps the business owner. This often facilitates the discovery process. 1.6 WORK PROGRAMS. The work done in the investigative field, though not as routine as more common accounting work, can lend itself to using a work program. I find the work programs described and presented in this section to be useful under certain circumstances. Frankly, many cases do not lend themselves to the ready use of a work program inasmuch as there are numerous questions, unknowns, and so forth. In addition, the budgeted and actual time columns are not often easily used. It is difficult to project a budgeted time for a certain phase of the work when dealing with a nonrecurring client; you do not have the luxury of spending a day in advance with the client in order to go over a work program and determine a time frame. The actual time elements in this type of work are a problem in that many jobs overlap. Sometimes you will abruptly disrupt one phase of your work because you have come across something else that requires your immediate attention. Also, many jobs of this nature place great time pressure on accountants, and the preparation of a work program, if done properly, can take several hours and additional time to maintain. Therefore, you will often lack the ability to utilize the luxury of a work program, even though it would be desirable from a theoretical accounting point of view. Exhibits 1– 2 through 1– 4 present three work programs. The first work program is for preliminary, continuous work. This phase of work is common to any of the assignments in the investigative area and, therefore, even though part of it is at the beginning and part of it at the end of your work, it lends itself to being placed in one document, Work Program A. Next is Work Program B, for the business

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phase of your work. Use a separate work program for each business investigated; often there are multiple businesses and related corporations. Third is Work Program C, for the personal investigation phase of your work. This includes looking into the financial and banking records of the individuals involved. The freewheeling nature of some investigative work mandates a certain degree of flexibility in how these work programs are handled. They should not be construed to have the rigidity of the by-the-book requirements of a typical audit program. Unlike the standard audit or work program types, with which readers are probably familiar, the work programs herein do not go into any great detail as to what steps are expected to be performed. For instance, in a typical audit program, the steps in the cash function are extremely detailed and voluminous. Included are steps indicating that for each bank account, you are to test-check two months of reconciliations, look at 30 checks each month for endorsement and signature, compare to bank confirmations, and so on. These steps can extend for pages just to cover the cash function. Here, the intent and concept is that the user is expected to understand what is involved in this type of work and to be able to, from a few key words, perform whatever steps are necessary. Furthermore, audit style is not usually applicable in this work.

EXHIBIT 1–1

Sample Records Request Letter

Re: ____________________ Dear ___________________: We have been engaged by __________________ to assist in his/her pending divorce action. To that end, we will need access to and copies of various business and personal financial records of __________________. As to __________________ , please have the following items available for our inspection or copies for our files where so indicated. Unless otherwise stated, the records requested are for the period __________________. 1. Copies of any financial statements prepared internally or externally for any reason. 2. Copies of Federal and State income tax (or information) returns. 3. All books of original entry, including general ledgers, disbursements, receipts, sales, purchase and payroll journals. 4. Copies of any buy-sell agreements and employment contracts. 5. Copies of accountant’s year-end worksheets, including journal entries. 6. Canceled checks, checkbook stubs, and bank statements. 7. Payroll records, including payroll returns, and W-2s. 8. Purchase and expense invoices, paid bills, and charge slips. 9. Loan documents.

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EXHIBIT 1–1

Sample Records Request Letter (continued)

10. Appointment diaries. 11. Copies of year-end aged schedules of accounts receivable and accounts payable. 12. Sales invoices. 13. Inventory records. 14. All papers, closing statements, tax returns, agreements, and contracts related to the sale of __________________. 15. Schedule of equipment (fixed assets), including motor vehicles and depreciation thereon. 16. Corporate and directors’ book(s). 17. Stock register book(s) (since inception). 18. Insurance policies. 19. Copies of any revenue agent’s reports. 20. Copies of any pension, profit-sharing plans, and other employee benefit plans, and the related records, statements, tax returns, and transaction information. As to the personal financial records of __________________ , please have the following available for our inspection or copies for our files where so indicated. Unless otherwise stated, the records requested are for the period _____________. 1. Copies of any financial statements, whether prepared by __________________ or someone else, including, but not limited to, statements used for financing (business or personal), mortgaging, and tax shelter and investment qualifying. 2. Copies of personal Federal and State income tax returns. 3. Copies of savings passbooks, statements, and other indicia of savings. 4. All statements, checks, and other indicia of the use of equity lines. 5. Stock brokerage monthly transaction sheets. 6. Copies of closing statements on any real estate purchased or sold, including at least the sale of ________________ and the purchase of __________________. 7. Canceled checks and bank statements. 8. Schedule of tax-free securities. 9. Personal insurance policies. 10. Support for alleged liabilities to __________________. 11. Copies of automobile, boat, or plane registrations owned individually. 12. All charge account statements and receipts.

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EXHIBIT 1–1

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Sample Records Request Letter (continued)

13. Copies of any revenue agent’s reports. 14. Records in support of rental property income and expenses. In addition, because of what appears to be significant and frequent financial activity (that is, issuance of checks) between ___________ and ___________ , we expect we may need access to the financial records of those individuals/businesses. The above list may not be complete. Additional items may be requested as our inspection progresses.

EXHIBIT 1– 2

Investigative Work Program A Preliminary CASE ____________

N/A 1. Obtain documentation from attorney and/or client, such as interrogatories, tax returns, and financial statements. 2. Set up folder and organize into file sections. 3. Review documentation; make notes of questions to be raised. 4. Conference with attorney and client. 5. Discuss fees and payment arrangements with client. 6. Send records discovery letter requesting the specific information to be reviewed. 7. Contact the other side’s representative(s) by phone to arrange for initial investigative work. Send follow-up confirmation letter.

BUDGETED TIME

ACTUAL TIME

DONE BY

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EXHIBIT 1–3

Investigative Work Program B Business CASE ____________

N/A OVERVIEW 1. Organize approach and know which businesses need to be reviewed. 2. Be sure you have at least three years of business records available for inspection. 3. Do preliminary review of tax returns and financial statements for areas of potential discovery and investigation. 4. Review the general ledger for insight. 5. Compare financial statements to general ledgers to tax returns. 6. Physical inspection of operation. 7. Cash disbursements and purchase journals — overview for standout items. 8. Cash receipts and sales journals — overview for standout items. BALANCE SHEET 9. Cash checks — investigate for endorsements and trace to personal finances. 10. Review petty cash documentation. 11. Review accounts receivable.

BUDGETED TIME

ACTUAL TIME

DONE BY

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EXHIBIT 1–3

Investigative Work Program B Business (continued)

N/A 12. Review bad debts reserve. 13. Inventory — reasonableness, adequacy, and basis for valuation. 14. Prepaid expenses — properly reflected? 15. Loans and exchanges — watch for any washing of funds, related parties, etc. 16. Officer loans — trace all sources of monies in and all dispositions of monies out. 17. Fixed assets — review depreciation methods, accumulated depreciation and current carrying value, and contents of fixed asset account. Verify who uses which vehicles and the business connection of these people. Obtain schedules of all fixed asset accounts — reconcile and analyze. 18. Patents and other intangibles — obtain as much supporting documentation as possible. 19. Security deposits and other assets. 20. Accounts payable. 21. Loans payable — determine disposition of funds, interest rates, and maturity dates.

BUDGETED TIME

ACTUAL TIME

DONE BY

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EXHIBIT 1–3


N/A 22. Payroll taxes payable. 23. Sales tax payable. 24. Equity — thoroughly review any changes in the past several years. 25. Dividends — schedule and ascertain in proportion to stock holdings. 26. Stock record and minutes books — review, analyze, and schedule as appropriate. INCOME AND EXPENSES 27. Sales — analyze and understand extent of major customers and transactions with related companies. 28. Check that all sales are reported. 29. Sales returns and allowances — analyze for unusual transactions. 30. Cost of goods sold — test for unusual postings. 31. Based on cost of goods sold, does magnitude of sales make sense? 32. Officer’s salary — detailed schedule. Reconcile to personal finances analysis.

BUDGETED TIME

ACTUAL TIME

DONE BY

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EXHIBIT 1–3


N/A 33. Other payroll — review for familiar names; tie W-2s. 34. Rent — watch for related party situations. 35. Repairs and maintenance — watch for personal and capitalizable. 36. Insurance — inspect policies; watch for values in excess of book, prepaid. 37. Travel and entertainment — documentation, economic income. 38. Automobile expenses. 39. Telephone expense. 40. Office supplies. 41. Dues and subscriptions. 42. Utilities expense. 43. Professional fees — detailed analysis; watch for indication of major situations. 44. Depreciation — analyze supporting worksheets and methods used, tax vs. economic. 45. Retirement plans — type of plan, allocations, potential asset. 46. Payroll taxes — reasonable? 47. Tax expense — other.

BUDGETED TIME

ACTUAL TIME

DONE BY

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EXHIBIT 1–3


N/A

BUDGETED TIME

ACTUAL TIME

DONE BY

ACTUAL TIME

DONE BY

48. Officer’s life insurance expense — cash value. 49. Employee benefits. 50. Interest expense — reconcile to loans. 51. Fines and penalties — ordinary vs. nonrecurring. 52. Bad debts. 53. Miscellaneous expenses — watch for major items.

EXHIBIT 1– 4

Investigative Work Program C Personal Finances CASE ____________

N/A 1. Review all personal bank records, savings and checking. 2. Review all personal brokerage accounts and other indicia of savings. 3. Reconcile deposits into personal accounts (banks, brokerage, etc.) with known income sources. 4. Determine if expenses from personal accounts approximate lifestyle.

BUDGETED TIME

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EXHIBIT 1– 4

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Investigative Work Program C Personal Finances (continued)

N/A

BUDGETED TIME

ACTUAL TIME

DONE BY

5. Reconstruct standard of living to determine if reported income can account for same. 6. 1040s — review in depth. 7. Compare state income tax returns to federal income tax returns for any variances. 8. Determine if collections (coins, stamps, etc.) exist. 9. Do changes in net worth statement. 10. Prepare personal balance sheet.

STIPULATION VERSUS COURT APPOINTMENT. That CPAs are becoming more and more heavily involved in litigation work is no surprise to anyone in the field. For many of us, the bread and butter of litigation support services is in the divorce field. Whether it be tax consulting, helping to negotiate and structure a settlement, the investigation of cash flow, the preparation of statements for the court, the investigation of a business, the reconstruction of income, or the valuation of a business, the CPA has clearly become the dominant financial advisor in this market. What perhaps is not as clear is the contrast in our involvement when we are court-appointed as compared to being stipulated to by the parties or engaged by one of the parties. There are some very significant differences, and some very important positives as well as negatives that need to be considered by the CPA. The way most of us get involved in this field is through a relationship with one or more attorneys who are involved in divorce work. Some of these attorneys are specialists, some are general practitioners who get a divorce case that merits the involvement of a CPA. Inevitably, that type of initial involvement means representing one side in a divorce action. For 99 percent of us, that is the way it happens. And, for most of us, at least for some time until experience and reputation are built up, that is the manner in which we do this type of litigation support service. Typically, one is approached or considered by both sides either to be stipulated to or to have the sanction of the court only after some experience and favorable reputation.

1.7

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There will be those who will say that in theory there is no difference in how we service these disparate situations. Ours is a fact-finding role and it matters not who engages us—the interaction and results will be the same. Such is not the case. There are, in fact, several significant operational and conceptual differences in how we fill our roles. The interplay among us, counsel and clients, can be dramatically different. Often our level of satisfaction and pleasure (or displeasure) from the specific assignment is based on which of these three roles we have been engaged to fill. Being engaged by one party, sometimes incorrectly referred to as being the advocate of that party, is by far the most common of our roles. We are typically contacted by the attorney or perhaps by the client who was given our name by the attorney. We then meet with the client and the attorney. We either attempt to develop the appropriate defensive role (if we are working on behalf of the business owner) or plan our attacking role (if working on behalf of the nonbusiness spouse). We have an engagement letter with that client and usually tend to develop a good relationship, even if perhaps strained because of the emotions of the litigation. And that relationship usually remains reasonably good — at least until the settlement of the case when the day of reckoning as to our bill arrives. Then perhaps a somewhat different attitude and opinion of our services emerges. That, however, is a subject for another book. It is not unusual to find that attorneys on opposite sides of a divorce case look to minimize the cost of using financial experts. They also look to reduce the likelihood of considerably disparate conclusions as to the level of income enjoyed by a business owner and the value of his or her business. As a result, they may be interested in jointly engaging an expert who will serve both parties rather than either one. Whether by recommendation of these attorneys or by the dominating action of a judge, CPAs are sometimes asked to fill the role of being courtappointed. This is very similar to being stipulated to but is perhaps in a sense a step up from that. Let us deal with the differences between these positions. When stipulated to or court-appointed, we have no friends. It may not be much better when engaged by one party, since the “friendship” can be extremely fleeting. Nevertheless, in the latter, at least for a while, there is some semblance of a normal client relationship. Not so when we are in the middle. Neither husband nor wife is our friend, and to a degree both, especially the business owner (or the party with something to hide), will still view us as the opposition. Both parties may try to cajole us and come across in as sympathetic a manner as possible. On the surface, at least, they may display as much an image of cooperation as possible. Some of us will wind up being lulled into a sense of complacency because of what for us has become a normal situation of establishing warm relationships with various clients. Beware: You may be being played for the fool. At least when engaged by one of the parties, you have a clear sense of to whom your loyalties belong. Relationships.

Depending on the jurisdiction, and the practical workings of your local divorce court system, even telephone calls can be fraught with issues. When you are appointed or stipulated to, you may not even be permitted to talk to one of the attorneys without the other one being either present or on the phone overhearing Attorneys.

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and participating in that discussion. At the very least, that can present an obstacle to the fluid functioning of what you perceive to be your role and the most efficient manner in which to fulfill it. Attorneys tend to be trained advocates — in contrast to accountants, who tend clearly not to be. Do not ever lose sight of the fact that the attorney has a very clear sense of who his/her client is and the role that attorney is supposed to fill. For the most part, it is an absolute loyalty and advocacy of that client’s position. Contrast that with your role in the middle. You may have this quixotic sense of balance and of a functioning that can be the antithesis of the attorney’s thrust. When court-appointed, you have a direct responsibility to the judge presiding over that case. It is most helpful, but not always easily obtainable, to understand what the judge wants. Some are mostly interested in clearing their calendars. They want you to proceed as rapidly as possible and are not terribly interested in explanations as to why there are delays. This is so even though you are their appointed/anointed representative. Some may view you as a necessary evil (do not interpret the word “evil” too literally), foisted upon the system because of the financial complexities involved. Some very much like to avoid having to decide on people’s lives and strongly prefer that someone else force the case to some form of settlement. As the appointed expert, depending on the judge, you might be expected to make considerable strides in that direction. You may even act almost as an arbitrator, as a cudgel to coerce a settlement, as a proxy stand-in for the judge. Clearly, not an easy role to fill. Court.

Typically, when engaged by either side, because of our clear sense of direction, we bring a certain zeal or enthusiasm to the assignment. That sense of attack (or defense) is often not present in an appointed or stipulated situation. In fact, this is one of the areas of concern where stipulated or appointed. An approach that is as forceful as one you would utilize in a one-sided engagement may cause one or the other side to believe that you are not the independent you need to be and are rather working for the adversary. That, in turn, may cause you to hold back. You may hesitate to take certain steps, demand certain records, whatever, which you would do in the normal course of events. Do your best not to allow that to happen —your method of attack needs to be essentially the same. You simply have a much greater and more difficult job in front of you to keep both sides mollified and comfortable with your independence and equanimity. Your Attitude.

Bias. Our role, regardless of the manner of engagement, must be one of independence and manifested by a lack of bias. Nevertheless, in much of what we do, while in a sense of a fact-finding nature, there are many situations requiring a subjective interpretation and determination. Were those four-times weekly dinners at the country club truly business, or was some part or even all of them of a personal nature? If reconstructing income, is there an 8 percent wastage factor, or should it be a 10 percent wastage factor? Is that Mercedes used 85 percent for business or is it more like 75 percent? There are rarely black-and-white answers to these types of questions. However, they are questions that commonly arise in the work we do. In all of the preceding examples, there may be legitimate questions as to which of the alternatives presented, or various shades of gray in between, are appropriate. What you choose will almost assuredly be influenced, at least in

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part, by your client. When stipulated or appointed, you do not have such a client, and you are going to hear both sides of the story, whereas otherwise you may not. Further, you will be compelled to make some conclusion that will assuredly upset one or even both sides. It is rare that splitting it down the middle is appropriate, fair, or even satisfactory to both parties. Getting paid is a most interesting aspect of the differences between being hired by one side, stipulated, or appointed. When hired by one side, you will have an engagement letter, of course, and that side is responsible for your fee. If it is the nonbusiness person, you may have to wait a long time to collect. You may also have problems collecting depending on the success of the financial settlement. However, there is a clear sense of who your client is and to whom you look for payment. When stipulated to, the necessity of an engagement letter is just as important—and perhaps even more important. Since neither of the parties is represented by you, without some explicit understanding, no one party will have a sense of obligation as to your fees. Certainly, being stipulated to is, in a sense, financially more secure than being engaged by one of the parties. After all, there are two parties from which to collect. However, as was stated earlier, you have no friends. Therefore, neither side can be expected to have a sense of loyalty or duty to you, or even care if you get paid. When appointed by the court, you have considerably more power in the sense that there is an order directing your engagement. In such a situation, an engagement letter is often not necessary. However, what accountants, typically the less experienced ones, tend to overlook is that a court appointment is never a guarantee of payment. You may experience collection problems if your fees are unreasonable, or if the case simply runs away with you, or if the money is not there. While a judge may be sympathetic and issue an order directing payment of your fees, the court is never directly responsible for the payment of your fees and cannot assure you of payment. It can only assure you, assuming the judge is an activist and willing to support the experts he or she appoints, that, if the parties have the money, the judge will take a very strong position as to the payment of your fees. However, if the parties do not have the money, you are not going to get paid regardless of the formality of being court-appointed. Fees.

Being Second Guessed. Make no mistake about it: When you are in the middle, you will always be second guessed. Skilled attorneys will repeatedly ask you if you’ve considered this or that approach, did you take this into account, did you overlook that, how did you arrive at this and why didn’t you go in another direction. Keep in mind that that is their job. You may be in the middle, but they are not. You are deeply involved in a tug of war for your mind and soul. You are balanced most precariously in the middle of that rope, with one attorney and his or her client on one side of the rope, and the other attorney and client on the other side of the rope. Sometimes that rope has been split so that on one side, not necessarily pulling together, is an attorney and his or her client, each with different agendas and a different sense of and caring for the truth.

RECOGNIZING FINANCIAL SUICIDE. Financial suicide in a divorce case, whether intentional or unintentional, leaves in its wake such damage, bitterness, 1.8

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and exposure to malpractice actions (to say nothing of uncollectable fees) that practitioners should know how to recognize it. Financial suicide is the financial self-destruction of an individual — and in the context of a divorce, of a couple or family. At times, because of the stress or friction created by divorce (or exacerbated by the divorce litigation), some people act in a manner that undermines them financially. These types of clients are among the most dangerous and least satisfying for an attorney or accountant. Money seems to be no object to such clients — as long as it doesn’t have to be paid on a current basis. Practicality is not relevant; rather, it is the principle of the thing; and there is that attitude that the practitioner is in it together with the client and that you both can go down in flames together. Case Examples.

Let’s review some actual cases to illustrate the problems and

warning signals. Manufacturer. From the beginning, it was clear that this was a middle-class divorce, with relatively little liquidity; the majority of the marital estate consisted of the marital home and a closely held business. There was also a modest profitsharing plan from the business. The client made it very clear in the beginning that any and all discovery was to be resisted no matter how many trips back and forth to the courthouse and no matter how many broken appointments and unnecessary correspondence it created. It became obvious within a short time that there was going to be no compromising and that legal fees were going to exhaust financial resources. CPA. We were warned in advance that this client had been diagnosed as manicdepressive. He went through at least four attorneys, paying retainers each time but leaving each one with a significant balance owing. Money was moved back and forth between accounts in an almost haphazard manner; tax returns weren’t filed; the Internal Revenue Service was after him; and discovery was extremely difficult. Despite significant assets and warnings that it was essential (at least for the sake of his child) to take preemptive actions under the protection of a divorce suit and move assets into his wife or child’s name, he ignored all such advice. In addition, he engaged in a number of risky investments with capital call exposure. He was also in the habit of alienating clients as well as not paying various bills. The result was financial devastation, loss of the marital home, and the near confiscation of virtually all assets by the IRS. Had any of his attorneys taken heed of the warning signals or had the court taken the matter seriously, much hardship might have been avoided.

Despite sufficient income and cash flow, income taxes were not paid for a few years. Instead, money was spent on luxury cars and other adult toys; changing attorneys several times and wasting multiple retainers (and, need I say, leaving each attorney with a large balance due); fighting every motion and making every battle an unending one; fighting for sole custody with an almost insane passion, when any objective individual would have recognized the futility of such action; refusing virtually any level of compromise (demanding his wife’s complete capitulation) on matters of support to such an extreme that even though the experts had agreed on values, the case had to be tried. The result was the total dissipation of the marital estate.

Doctor.

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Doctor (anyone notice a trend?). A long track record of spending with abandon, well in excess of family income, was present, with a trail of creditors filing one suit after another, and the doctor losing each one by default. The doctor owned several pieces of property, all of them mortgaged in excess of their values. He also drove very fancy cars — all leased — and all the leases delinquent. Tax returns were filed with substantial tax obligations, absolutely no withholding or estimated taxes paid, and substantial obligations to the IRS. The doctor’s attitude would not accept any personal responsibility for living beyond one’s means and routinely stiffing everyone with whom he came in contact. The result here was a bankruptcy, with the bankrupt estate having no assets (other than the medical practice) and liabilities in the millions.

There are certainly common threads — gross irresponsibility in fiscal matters and irrational actions as to financial and interpersonal relationships. In each case, every professional with whom these people dealt, after exhausting the retainer, received pennies on the dollar, was unhappy about the client servicing situation (aside from the purely financial issues), and on more than one occasion was threatened with lawsuits for malpractice because of perceived inadequate or incompetent servicing. What can attorneys and accountants do to recognize such situations as early as possible and take the appropriate actions so as to stanch the bleeding? First and foremost, we need to be more selective as to whom we accept as clients. There are situations where the warning signals are flashing and we do not or choose not to see them. An attorney may be unable to withdraw from a case once engaged; therefore, the initial decision as to whether to accept a client or not is of paramount importance. We need to understand the financial position of prospective clients as well as their mental status before we allow them to become clients. We also may need to demand a larger retainer from these clients in order to limit potential exposure; nor should we begin servicing a client while the retainer is being paid on a piecemeal basis. Perhaps an early and more critical overview of the financial situation would highlight this type of exposure. We need to take a much harder (perhaps less empathetic) position with these types of clients. This often means a more candid discussion with the client to underscore the fiscal facts of life and that certain actions or inactions are unacceptable and improvident. It would not be out of line to require psychological testing of prospective clients. Tests may flag certain personality traits that tend to make people financially selfdestructive. Test results may provide a warning against accepting that client, or make you aware of certain risks requiring extra attention, perhaps leading you to manage the case differently. Unfortunately, the “system” is a major player in this tragedy, especially when the case is brought before the court time and time again to mollify an irrational client and to fight fights that are contrary to the best interests of the parties, yourself and everyone involved. Commonsense steps should be taken, and, where appropriate, orders and judgments enforced. Judges, attorneys, and experts may need to be more demanding of such clients to do the “right thing” rather than get wrapped up in the excitement of the battle. Divorce professionals can do a lot more to prevent such tragedies if we would only take a more critical look, earlier on and more often; use common sense; and

Steps to Be Taken.

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try to look out for the overall welfare of everyone — and demand that the system serve rather than abuse the litigants. The alternative, as we have repeatedly seen, is that we all lose, and the general population has more reasons to despise the legal profession.

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2

DEALING WITH THE CLIENT It was partially my fault that we got divorced. I tended to place my wife under a pedestal. —Woody Allen

CONTENTS 2.1 2.2 2.3 2.4

Interview Your Client Conducting the Interview of the Nonbusiness Spouse Conducting the Interview of the Business Spouse Interviewing the Nonclient Business Owner

22

2.5

23

2.6 2.7

24 2.8 25

Review of Initial Disclosure Statements Tax Neophyte Client Nonbusiness Spouse Interview Checklist Business Owner/Spouse Interview Checklist

25 25 26 28

2.1 INTERVIEW YOUR CLIENT. One of the first steps to take upon getting involved in a divorce case, after at least a preliminary overview discussion with the attorney, is to meet with the client. In most cases, it is fairly safe to assume that you will be engaged by the nonbusiness spouse; in our society that generally means the wife. The need for interviewing and gaining insight from your client is essential, regardless of which party has engaged you. Interviewing is equally important if you are engaged by both parties. The approach, of course, is somewhat different depending on whether your client is the business operator or the spouse outside of the business. Essentially, the former is a defensive situation and the latter an offensive (in more ways than one) situation. When representing the nonbusiness spouse, typical concerns are that the spouse will know very little about the business, will possibly have a distorted view of its operation and profitability, and may have been so removed from the business operation that any information received may actually be less than useful; it might even mislead the investigative accountant. All those valid concerns aside, it is still essential to interview the spouse. Even the most distant spouse, simply by virtue of having lived with the business operator, should have some knowledge of the business. The spouse might know the names of one or two major customers, or perhaps know financial or other business relationships. The spouse might be aware of a recent refinancing or frequent trips to some exotic locale, or disclose that their standard of living has been twice what you see as the reported income. Perhaps the spouse was privy to idle comments made by the working spouse/ owner about negotiations to buy the business a couple of years ago at a very 22

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mouth-watering price. Therefore, don’t overlook the importance of interviewing, even when you or the attorney might perceive the client to be the most ignorant of spouses. That spousal interview should be conducted as early in the case as possible. The sooner you meet with the spouse, the sooner you have the opportunity to learn what the spouse knows. This should put you in a better position to understand the nature of the business and perhaps give you the opportunity to make some preliminary inquiries within the industry and with other contacts before you get to the meat of your investigative work. In addition, it is possible that the spouse, without even knowing it, may have access to financial records (tax returns, bank statements, brokerage statements) from which you might obtain information and insight. 2.2 CONDUCTING THE INTERVIEW OF THE NONBUSINESS SPOUSE. Now that the importance of interviewing your client is clear, you need to decide what you are going to ask during that interview, and how are you going to best accomplish the information-gathering process. You may have to literally pull information out of your client. The business-owner client will have a natural reluctance, unless you already have a relationship of mutual trust, to open up for fear of saying things that you are not supposed to know. On the other hand, with the nonbusiness owner client, you may have to overcome an emotional block, a pervasive lack of confidence, or a self-induced belief that your client really knows very little worth telling you. Also, especially with nonbusiness owners, the types of questions you will be asking are often of the nature that person is not used to addressing. Be careful not to overlook the fact that your client, although knowing very little about the business, may nevertheless be an excellent source of initial documentation. Ask, and press if necessary, if the client has access to tax returns and financial statements, business as well as personal. You may be surprised how often some of these are readily available in the marital home. Your client may not think of this. It is your job to elicit a response, and even force the client to think of what paper trail is around. The idea that because you will be obtaining these documents in the normal course of discovery, and need not bother your client, misses the point of what you need to do, and suggests you have one of those unusual cases where cooperation will be cheerfully given. Ask your client to search for (and bring to you) bank statements, canceled checks, savings and brokerage account records, charge slips, invoices in support of bills paid for by cash, and even the second set of books (the real numbers) that had to be kept at home for safekeeping. One of the goals of interviewing your client, especially when there is an issue as to the veracity of the reported income, is to develop an understanding of the couple’s financial lifestyle. Unfortunately, all too much of the lifestyle information you obtain and then use in your work may be undocumented. Nevertheless, by relying to a certain degree on your knowledge of people, spending habits, and reasonableness, this type of information is relevant. It may also be important if your work does not uncover fairly solid, ironclad proof of either unreported income or expenditures unsupported by reported income. Your presentation of your client’s input may constitute a professional’s quantification and support for a client’s testimony. In these types of situations, your client will likely be called upon to testify as to the couple’s lifestyle and spending habits. Even in the absence of substantial documentation, your work in this area will help your client

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DEALING WITH THE CLIENT

in testifying. Of course, ultimately, your client’s credibility on the stand (as well as the other spouse’s lack of credibility) will be a determining factor as to whether your fancy financial analysis is accepted to any significant degree. During the interview, aggressively seek out as much as you can as to the business, and gain as much information about it as your client can muster. Assume that you are dealing with the nonbusiness spouse, who is generally the more difficult one from which to obtain reliable and detailed information. Your mission is to get this person to think about financial matters that are often taken for granted, especially in more halcyon days. For a listing of questions you might ask, see 2.7, the Nonbusiness Spouse Interview Checklist. CONDUCTING THE INTERVIEW OF THE BUSINESS SPOUSE. The interview process is somewhat different when you are representing the business owner. In that case, you are typically dealing with someone with more financial savvy. More than likely, this person has had control over the financial operations of the household for years. Of course, it is not always that simple. You might find that even though the client is the business owner and the moneymaker, earnings are handed over to the other spouse, who then controls the spending, and perhaps even the investing of those funds. If at all possible (and it is), before the interview, obtain copies of business and personal financial statements and tax returns. Thus, you will be in a better, more informed position to intelligently and efficiently conduct your interview. Generally, in representing the business owner, your questioning should focus on obtaining whatever information you can as to the business and its operations. At the same time, however, you need to be aware of where exposure exists and where defensive moves are needed. Be very cautious in this approach. If, for instance, you are dealing with a cash-type business, you can expect your client to swear on every Bible ever printed and on every imaginable family member’s life that every dime is reported. Further, if there is a dime missing from the cash register, it will be blamed on that unreliable and sneaky spouse who grabbed it, or maybe on some overpaid and ungrateful thieving employee. There is always the possibility of some truth in these statements, but the basic, plain facts of life are that (at least from this author’s experience) it is virtually unheard of for the owner of a cash business not to take something off the top. A business that takes in cash income where none of that income goes unreported is indeed rare. That is not to say that such a client is a thief or guilty of fraud. Keep in mind that fraud requires a certain magnitude, besides intent. You may still be able to do a great service to such a client, even if you have to deal with and tacitly acknowledge the existence of unreported income. In fact, it is often those clients who most need your services. There are ways to handle such situations and, generally, practitioners who are more experienced and savvy have a better understanding of the need and the ability to deal with both sides when there are concerns as to unreported income and the potential exposure of both sides. When your client is the business owner, your goals in the interview process are somewhat different than when you represent the nonbusiness spouse. However, many of the questions raised (as to refinancing, spending habits, business sale and acquisition activity, and the like) are the same. Keep in mind that advocacy can be your undoing in this work. You must ask many uncomfortable questions and you must carry with you a certain degree of skepticism as to your client’s

2.3

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2.6 TAX NEOPHYTE CLIENT

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possibly self-serving answers. Do not blindly accept your client’s claim that, although the industry norm is a 42 percent gross profit, his or her business has only a 20 percent gross profit because competition has been strong and your client cannot purchase the goods efficiently. It may be true, but do not assume so just because your client tells you. For a list of questions you might ask, see 2.8, the Business Owner/Spouse Interview Checklist. 2.4 INTERVIEWING THE NONCLIENT BUSINESS OWNER. Even when you are representing the nonbusiness owner, you should still have the goal of interviewing the business owner. Although you cannot force such an interview, it is important that you evidence an attempt to interview the business owner and, to whatever extent possible, document the other side’s refusal. In the author’s experience, you will usually be permitted at least a brief interview, though the business owner’s attorney will often insist on being present and will act as a control (perhaps a polite way of saying “obstacle”) over many of the questions that you may ask. If you do not attempt to interview the business owner, you may operate under certain misconceptions as to various aspects of the business’s operations. Generally, what you do not know, and perhaps what you state erroneously in your report, is of relatively minor consequence. Nevertheless, even minor errors cause embarrassment and raise doubts as to the overall reliability and value of your work product. However, if you have attempted to interview the business owner, and have been denied that benefit, at least you have a very valid defense. Unlike the other side’s accountant, who presumably had unhindered access to the business owner, you were denied the same access. This is an important factor that affects your inherent need to protect your credibility. 2.5 REVIEW OF INITIAL DISCLOSURE STATEMENTS. As mentioned in Chapter 1, when a divorce action is initiated, regardless of the state, some form of financial disclosure must be filed. In New Jersey, it is currently called a Case Information Statement. Other states may refer to it as a Disclosure Statement or a Financial Statement Position. The point is that this type of disclosure is commonplace to divorce cases. It requires both parties to present to the court, in a signed and standardized format, a statement as to, among other things, their costs of living, their income, and their assets and liabilities. It has been the author’s experience that these statements often have as much fiction in them as fact. This is especially so when the business owner provides the data as to income and assets, and even more so if a cash business is involved. It also occurs when the nonbusiness owner has no real grasp of how the marital couple spent money or what their assets are worth, or is determined to get even and pull out every ounce of blood possible. Therefore, because these disclosure statements are of dubious value, it is of particular importance and relevance to develop your own understanding of the couple’s lifestyles and personal budgets. To that end, you will find the sample personal budget format to be of help. See Chapter 13. TAX NEOPHYTE CLIENT. When interviewing nonbusiness spouses, keep in mind that they may have little experience with filing tax returns and little knowledge of tax rules and procedures. They may be facing, for the first time in 10, 20, or

2.6

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more years, the need to address tax return filing responsibilities. Depending on a myriad of financial issues, they may also be facing a tax burden for which they are totally unprepared. For instance, depending on how support payments were structured and worded, applicable state statutes, and many other factors, they may have been receiving taxable support payments for some months or years, and have nothing set aside from the payments to cover tax obligations. They may not even be aware that their support payments are taxable. It is a serious and gross failing of the system that, all too often, an application is made for support when the court orders support but there is no provision for the tax cost of that support. Perhaps nobody considered the taxability of the payments; clearly no one paid attention to the need (assuming the payments are taxable) for that spouse to receive sufficient additional funds to pay quarterly estimated taxes. Be sensitive to this situation, but keep in mind also that if you are brought into the case after it is several months old, interim support payments (often called pendente lite) have usually already been established. If you come on too strong with dire warnings, you may be exposing your client’s attorney to embarrassment. Maybe the attorney who brought you into the case and was responsible for your referral was partially or substantially responsible for this problem. In raising problems and trying to address them, do not overlook the attorney. To the extent appropriate, you need to make your client aware of relevant tax procedures, such as filing estimated vouchers and tax returns, and record-gathering. You may not be the one who will prepare that person’s tax return, but you should still raise certain issues. This nonbusiness spouse is probably going to have an extremely simple return — maybe a W-2, some alimony, and no itemized deductions. Alternatively, if, for instance, the court resolution obligates the spouse to carry the house costs, including the mortgage payments, your client will now probably be facing itemized deduction issues such as mortgage interest and real estate taxes. That return may no longer be so simple and someone needs to address these issues. Even if you are not to prepare that return, it is important you make sure that your client and the client’s attorney are aware of these issues. Typically, this does not present a problem when you are representing the business owner because that person is usually familiar with tax obligations and requirements and likely has an accountant to deal with them. NONBUSINESS SPOUSE INTERVIEW CHECKLIST. When interviewing the nonbusiness spouse, it is important to draw out whatever that person knows about joint personal, as well as business, finances. If at all possible, conduct this interview after reviewing tax returns and financial statements. 2.7

____

1. Do you suspect that there is income in excess of what is reported?

____

2. Did your client make a habit of signing tax returns without looking, or were they actually reviewed?

____

3. Did your client sign those alleged joint tax returns?

____

4. Is your client aware of the existence of safe deposit boxes; and if so, in which banks?

____

5. What does your client know about their banking (business and personal) matters: bank names, savings accounts, brokerage accounts, checking accounts, and the like?

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2.7 NONBUSINESS SPOUSE INTERVIEW CHECKLIST

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6. Who has physical possession of various records? Does your client have bank statements and canceled checks, brokerage statements, and tax returns? 7. Can your client get access (and immediately) to business financial records such as tax returns and financial statements? 8. To the best of your client’s knowledge, what assets do the couple own: real estate, retirement plans, stocks (including names of brokers), vehicles, and so on? 9. Within the past few years, what major expenditures (that is, an addition to the home, large vacations, fur coats, and so forth) did they incur, and does your client have receipts or other proof of them? 10. If, for instance, a boat exists, when was it purchased (and from whom), where is it moored, how often is it used, what size is it, and where has it gone in the last few years? 11. If there are items like jewelry and furs, try to obtain names of stores where they were purchased. 12. Are there collections such as coins, stamps, guns (in that case maybe you should rethink your assignment), baseball memorabilia, and so forth? 13. For virtually every asset, ask your client for dates. As accurately as possible (even if it is only a month or even an approximate time of year), try to find out when items were purchased. This will be extremely important in facilitating your document search. 14. Did they buy or refinance a house in the last few years? If so, there almost certainly has to be a personal financial statement in the possession of some bank or mortgage company. 15. If there is rental property, how many tenants are there, what rent is being paid, and have there been vacancies? 16. When they went out for dinners, shows, and other entertainment, did they usually pay by cash, check or credit card? If by credit card, was it a personal or business card? 17. Did they customarily use a particular travel agent? Did they take frequent and expensive vacations? To where? Get a vacation schedule for the last several years, with as many specific details as possible. 18. Be especially observant as to destinations frequently visited, which might indicate places where bank accounts or other financial arrangements have been established that are totally unknown to anyone else. Also, is your client aware of the existence of a paramour, family member, or close friend in these locations? 19. What does this spouse know about the type of business that you are going to be examining? What does it sell? What type of business is it? 20. Can your client identify the major customers and major suppliers? How long have these relationships existed? Who are the key staff people at these customers and suppliers? 21. Who are the major or key employees working at the company? Get names, positions, and years with the company, and your client’s estimate of how much they are paid.

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____ 22. Is your client aware of any employees having left in the past few years under less than amicable terms? If so, find out who and where they are. ____ 23. Get names of relatives who are working at the company and can be identified through payroll records. Be especially attentive to family members with different last names. ____ 24. Does the other spouse have paramours? If so, get names. This may be very helpful in doing your payroll analysis at the company. ____ 25. As to paramours, find out from your client if this person (or persons) works in the company or in another company with which the business owner might have some type of relationship. ____ 26. Does your client know of offers made in the past few years to purchase the company or of an attempt by the business spouse to sell? Alternatively, is your client aware that the business spouse has acquired or sought to acquire other operations? ____ 27. Remind your client to diligently search the house and any other accessible places in order to obtain financial statements, tax returns, and other financial records. 2.8

BUSINESS OWNER/SPOUSE INTERVIEW CHECKLIST

I. HISTORY AND BACKGROUND ____ 1. Name of company: ____ 2. When founded: ____ 3. Locations: ____ 4. Owners and percent owned: ____ 5. Past owners: ____ 6. Nature of operation: ____ 7. Nature of the products or services: ____ 8. Sales and gross profit by product line: ____ 9. Extent of books maintained: ____ 10. Who maintains the books and where they are kept: ____ 11. Related entities: II. PEOPLE ____ ____

1. Operating officers, functions, and hours worked: 2. Key personnel, duties, time with company, experience: a. Factory: b. Production: c. Sales: d. Marketing: e. Administration: f. Finance:

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2.8 BUSINESS OWNER/SPOUSE INTERVIEW CHECKLIST

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3. If unionized, to what extent, what relations are like, and when contract expires: 4. Extent spouse worked in business: 5. Contact person for our work:

III. OUTSIDE PROFESSIONALS: NAME, ADDRESS, TELEPHONE ____ ____ ____ ____ ____

1. 2. 3. 4. 5.

Business accountant: Business attorney: Financial adviser: Actuary: Divorce advisors: a. Accountant: b. Attorney: c. Appraiser: d. Actuary:

IV. OPERATIONS ____ ____ ____ ____ ____ ____ ____ ____ ____

1. 2. 3. 4. 5. 6. 7. 8. 9.

The process of getting an order: Putting it through the system: Producing the product: Packaging the product: How products are priced: How products are sold: Are products stored or made to order: Typical backlog: Typical finished stock on hand:

V. CUSTOMERS ____ ____ ____ ____ ____ ____ ____

1. 2. 3. 4. 5.

Existing contracts: Key customers: Key customers’ financial stability: Any customers representing more than 10 percent of the business: Any industry or group representing more than 10 percent of the business: 6. Length these customers have been with the company: 7. Are customers local, national, or international:

VI. FUNDS FLOW ____ ____ ____

1. How sales proceeds are realized: 2. Who collects sales proceeds: 3. Does the business receive cash:

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____ ____

4. How frequently and how much: 5. Are all sales recorded:

VII. COMPETITION ____ ____ ____ ____ ____ ____ ____

1. 2. 3. 4. 5. 6. 7.

Major competitors: Are they local, national, or international: Are competitors public or private companies: Size of the major competitors: How long the major competitors have been in the field: Is the industry subject to severe price-cutting and cost pressures: Major industry trade groups and their addresses and telephone numbers:

VIII. MISCELLANEOUS ____ ____ ____ ____ ____ ____ ____ ____

1. 2. 3. 4. 5. 6. 7. 8.

To what extent is research and development an issue in the company: How products are developed: Does the company own patents? If so, elaborate: Adequacy of the present physical plant: Any move anticipated in the near future: Any major technological or ecological problems: Any major governmental or regulatory problems: Any lawsuits (pending or current) or contingent liabilities:

IX. PROJECTION ____ ____

1. Outlook for the next one, two, and several years: 2. Industry trends:

X. FINANCIAL STATEMENTS ____ ____ ____ ____ ____ ____ ____ ____

1. Explanation for significant changes in sales, gross profit percentages, overhead: 2. Explanation for any significant nonrecurring items: 3. Anticipated major expenses/changes for the next one, two, or several years: 4. The company’s capital requirements: 5. Compare key financial elements to industry norms: 6. Competitors or related companies that have been acquired recently (including as many details as possible): 7. Any recent discussions involving the possible acquisition of another company (including full details): 8. Any recent discussions involving the possible sale of the current company (including full details):

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CHAPTER

3

DOCUMENTS A verbal contract isn’t worth the paper it is written on. — Sam Goldwyn

CONTENTS 3.1 3.2

Preliminary Disclosure Comparing Records

31 33

3.3

Overview of the Books and Journals

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PRELIMINARY DISCLOSURE. You have been engaged, you have received your retainer, and now you have obtained, prior to actually beginning the fieldwork aspect of your services, copies of business and personal tax returns and business financial statements. At this preliminary point, you need to start your financial analysis (well before going to the company). As accountants, most of us readily recognize that financial statements and tax returns can provide a wealth of information, informing us as to items previously undisclosed, guiding us in directions that will improve the efficiency of our investigation, helping us make initial judgment calls, and advising both the client and the attorney as to possible financial results. Business tax returns can reveal much about a business, including its approximate size (based on sales volume), the nature of its operations, what its balance sheet looks like, its major expenses, and possibly even the ownership interests. It is, at the very least, a starting point. We might see on business tax returns that there are loss carryforwards; or perhaps it is an S corporation return and will show us the relative ownership interests of each shareholder, or information as to changes in shareholders or changes in ownership percentages between shareholders. Personal tax returns may reveal the existence of bank accounts and stock positions, the likelihood of dealings with brokers, the existence of real estate, and so on. Business financial statements, especially those that give full disclosure, can provide quite a bit of information, including banking relationships, contingencies, and an analysis of the broad types of fixed assets included on the balance sheet. There are, of course, a number of other potential bits of information that one can gather from tax returns and financial statements. The overriding point is that, especially prior to having an opportunity to actually dig into the underlying and original books and records, these returns and statements are an excellent opportunity to gain at least a superficial understanding of the financial lives of these parties. 3.1

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In this preliminary analysis, we need to be aware of comparing the financial statement with the tax return treatment. We may very well find major differences. Of particular interest would be a significant difference in some key financial factor, such as the gross profit percentage, between those two documents. It is virtually guaranteed that when they differ, the gross profit on the tax returns is lower than the gross profit on the financial statements. Often, such variances are nothing more than permitted differences between tax and financial statement treatment. Sometimes, however, the differences indicate improper tax treatment, occasionally as serious as fraud. In virtually all instances of such differences, the financial statements prove to be more reliable and more economically valid. Even when we disregard the tax returns, these differences, especially if they point to serious tax wrongdoing, can be used as leverage in threatening credibility during negotiation and ultimately at trial. Your review of the returns might also indicate that there had to be a capital infusion, or perhaps the sale of an interest, and therefore funds proceeds. For instance, with an S corporation, you might note a change in the ownership interest or perhaps a new owner. This will normally mean that there has been a financial transaction involving the purchase or sale of part or all of an interest. You would certainly want, and would be entitled to, the paperwork supporting any such transaction. You would also want to know the terms upon which the sale occurred. It may bear very significantly on the work you are doing. In another situation, when reviewing a partnership return, you might notice, via the capital account reconciliation, that there was a capital infusion during the year, or perhaps a withdrawal. If an infusion, what was the basis and what was the source of money? If withdrawals, what was the disposition of those funds? All these questions and observations are made possible from a review of tax returns and financial statements, before you have even had a chance to see the books and records or talk to the other accountant or the business owner. Don’t miss this opportunity and don’t take it for granted. Among the initial procedures to follow when you have obtained copies of financial statements or tax returns, even prior to initiating the fieldwork aspect of your assignment, is to prepare a historical spread of the company’s operations, including its balance sheets. By doing this, you can get a much better appreciation of patterns and trends in the business as well as expense anomalies. This multiyear analysis will very quickly help you to appreciate the major expense categories and any unusual or out-of-line changes that have occurred in any of the years. This, of course, will help to better direct your investigation and consequently make you more efficient. For instance, if your review of five years’ profit and loss figures shows a gross profit percentage fairly constant for four of those years, but one of the years has a significantly different gross profit, it may be very important for you to understand why. For good or for bad, does that one year indicate a nonrecurring aberration (in which case you should remove that year from consideration in your calculations), or does that one year, especially if it is the most recent, constitute a harbinger of things to come? Perhaps the office supplies expense was fairly constant for four of those years, but in one year, three times the norm. Certainly, you would zero in on that one year to see if, for instance, the acquisition of computer software might have been buried in that expense category. That is not to say that you would not analyze any of the other years merely because they were consistent, but

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3.2 COMPARING RECORDS

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rather that this preliminary analysis can help to flag a specific expense or year that merits further analysis. The balance sheet analysis works similarly, although a multiyear analysis for investigation purposes is not usually as necessary. Perhaps you might notice a major change in note payable liabilities. Certainly, you would be interested in finding out why the company incurred a large note payable liability, and how the funds were used. Or, the balance sheet may give you such an interesting tidbit as the sudden appearance of treasury stock. In that case, you now have something that may be of great significance in your investigation and analysis. Do not overlook the importance of this initial overview analysis of the company’s operations and balance sheet. Perhaps a review of the financial statements indicates that in one year a fire disrupted the operations of the company for a few months. Certainly, unless you were able to do some fancy reconstruction of what might have been, that year should be deleted in its entirety from any of your calculations and projections about this business’s capabilities. That may not be possible if the fire happened very recently and the company has not yet recovered from it. COMPARING RECORDS. Among the earliest documents you should seek to obtain (including copies for your file) are the financial statements of the subject business. Try to obtain not only the year-end financial statements but also the interim financial statements. Those who practice accounting in the corporate environment, with the tax planning that is part and parcel of that kind of servicing, know that there can be interesting and significant differences between the year-end and the interim financial statements. Also, some businesses submit their interim financial statements to lending institutions and use their year-end financial statements or tax returns for tax purposes. For instance, how do the magnitude of inventory and the gross profit percentage on a 10-month financial statement compare to the year-end statement used as a basis for tax returns? This is perhaps especially crucial when a certified audit is performed at some time other than the tax year end. When the company reports on a year end dissimilar to its tax year, and especially where there has been an audit for lending purposes, the interim financials usually reflect a much healthier, stronger, and more profitable company than the tax year-end financials and tax returns. Compare the financial statements with the tax returns. When you gain access to the company’s records, compare them to the general ledger. Most of the time (fortunately for the reputation of our profession), they will agree. Unfortunately, there are times when they do not agree: the reasons are not discussed in polite company. When you are fortunate enough to be able to deal with the accountant on the other side, make sure the two of you compare the financial statements or tax returns with which you are working. As an example, in representing the wife of a construction–related business owner, and after preparing my report, it became clear that there were obvious and significant differences with the opposing accountant’s report. To the credit of the attorneys involved, we were given permission to meet in an attempt to resolve those differences. We met in my office and had a very polite discussion to address our obvious differences. I took from my files a financial statement as of December 31, 1988, and he took from his files a copy of the financial statement from December 31, 3.2

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1988. I read to him the basis for my inventory of $75,000 and accounts receivable of $150,000, and he looked at me with a blank stare. His financial statement showed an inventory of $25,000 and accounts receivable of $75,000. We then quickly exchanged financial statements. I made an extra copy of both sets so we each had copies. Both financial statements were for the same company, based on the same date, and prepared by the same accountant. However, the profitability was different and the assets were different. The case settled fairly quickly. Of course, there are times when you ask for the interim financial statements and are told that they do not exist. The accountant was not engaged for that type of service and therefore has nothing to supply. That situation occurred fairly recently. It involved a company, again in a construction-related industry, and we asked the business owner’s attorney, the business owner, and the business owner’s accountant for copies of the company’s interim financial statements. Each one of them advised us that there were no such interim financial statements and that it was not their practice to prepare them. The attorney was even nice enough to confirm this in writing, and the accountant told us personally that his firm did not prepare interim statements. The only problem with those representations was that they were all false. We already had copies of some interim financial statements that we had been able to obtain elsewhere. Besides, we had reviewed the accountant’s bills submitted to the company, which very specifically indicated services relating to the preparation of interim financial statements. Clearly, because the accountant must have known what work was requested, done, and billed for, the accountant had blatantly lied to us. Perhaps the business owner and attorney lied also, although the business owner alleged that he did not really pay attention to what the accountant did, and the attorney was probably taking it on third-party representation. Nevertheless, there were interim financial statements, we had some of them, and they showed a significantly more profitable company than the year-end financial statements showed. The investigative accountant must always be vigilant as to the prospect of additional companies, related entities, which might allow the siphoning of income from one to the other and which might represent additional assets, additional income, and also lead to other discoveries such as the concealment of assets. It is not unheard of for there to be companies the spouse knew nothing about and that were not disclosed in any interrogatory or other financial records. We have uncovered such companies by observing the frequency of transactions between the known entity and what was previously thought to be just another customer or supplier, and examining the disbursements to or receipts of funds from this previously unknown relationship. When the existence of such a relationship is discovered, the nature of our work often takes on a renewed vigor. Among other records to be obtained in advance of the actual fieldwork analysis of the subject company are governmental or regulatory body reports and submissions. Many times, most, if not all, of these reports are in the public domain. At least in theory, making the appropriate inquiries should be sufficient to obtain those records. The reality is that personnel at regulatory offices sometimes treat what is supposed to be public information as if it were protected. That hindrance is normally not too difficult to overcome. You may simply have to make a visit to the office of the regulatory body (often in your state capital) in order to obtain those records.

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3.3 OVERVIEW OF THE BOOKS AND JOURNALS

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Usually, these reports are not all that revealing as contrasted with other documentation accountants customarily review. However, items of note do arise on occasion. For instance, in a fairly recent case involving a company in the waste business, one of the more difficult issues to address was the actual ownership interest in the company belonging to the party being investigated. There were some questions as to exactly what that interest was and we observed inconsistencies among different records. Also, because the case involved family, it was unlikely that we would be able to obtain reliable information beyond whatever documentation we could review. The regulatory body reports, which included statements of ownership interest, did not settle this issue, but they certainly strengthened our position because they were inconsistent with other sources, thereby casting further doubt on the credibility of the business owner. We had corporate records showing a one-third ownership interest, tax returns showing a one-half ownership interest, and the regulatory body reports showing a two-thirds ownership interest. All of these were either in the handwriting of, or signed by, the subject party. OVERVIEW OF THE BOOKS AND JOURNALS. Before you get into the actual investigation and analysis of the underlying books and records, spend a little time just going through the company’s disbursements and receipts journals, payroll journals, and so on. This will provide an understanding of the types of books the company maintains and how they are handled, posted, written up, and summarized. Extend this procedure to include the outside accountant’s work papers, including trial balance, journal entries, and schedules. These procedures will acquaint you with the style of the record keeping and with the contents, and will generally help improve the speed and quality of the actual investigation. Perhaps the two best places to start are the general ledger and the disbursements journal. A perusal of the general ledger, especially when the general ledger is posted on a monthly basis, will familiarize the accountant with the types of accounts maintained and the magnitude and frequency of activities therein. Often, the general ledger also includes tidbits of information, such as marginal notes and corrections of previous entries, that the investigative accountant would find helpful. In a similar vein, a review of the disbursements journal will reveal much about how the company spends its funds, the frequency and magnitude of disbursements to the business owner and family, to utility companies, for leases, and even for the purchase of raw material. Certainly, that information is generally readily accessible through the general ledger. However, the general ledger acts as a summary of a month’s activities, whereas going through the disbursements journal might reveal for instance that March’s $3,226 in telephone expenses covered four separate bills. That the company paid four telephone bills is far more informative and useful for our work than merely that the telephone expense exceeded $3,000 for the month. You will then certainly want to know whether any of those phone bills were personal rather than business, or whether they perhaps reflect a phone for another location or another operation that must be taken into account. Similarly, a review of the accountant’s worksheets can be very helpful. Often, they will show corrections of how the bookkeeper or other office personnel posted the records. These corrections are seldom a reflection of any wrongdoing, but merely a reflection of a more accurate statement, a cleaning up of the records by the accountant, or a correction of an innocent or minor mistake (but sometimes 3.3

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not so minor). For instance, you might see in the accountant’s journal entries that a $500 payment for telephone expense was mistakenly classified as office expense and has been correctly reclassified by the accountant. Generally, that is of absolutely no consequence and no relevance to your work. It is not in any case material or an indication of wrongdoing. On the other hand, you might find a journal entry where the accountant “corrected” the bookkeeper’s posting of $5,250 of machinery and equipment, reclassifying it to repairs and maintenance. It is likely that the bookkeeper was right and the accountant is merely taking an extremely aggressive position as to tax deductibility. In that situation, your work becomes a bit easier in that a certain correction has been flagged and brought to your immediate attention. Documentation is as important, and often more important, in this type of work than in any of the other work you do. Because you are dealing with unfriendly situations and divorce litigation, documentation takes on heightened importance and can, by itself, actually win a case for you. Not long ago, in testifying in a fairly modest case involving a small retail establishment, the nature of the retail business and the paucity of certain documentation left doubts as to certain calculations that were integral parts of my report. A key dispute was over the categorization of the type of products sold, because different products had significantly differing gross profit percentages. Because of matters beyond our control, we could not establish a work deck in support of a detailed analysis of the purchases to determine the correct allocation, namely 40 percent of the sales were from product A, 30 percent of the sales were from product B, 20 percent from product C, and 10 percent from product D. Product A had the greatest gross profit margin and product D had the smallest. We had gotten our allocation percentages directly from the business owner; we interviewed him and took careful notes. Of course, when he saw our report sometime later and sat down with an accountant and an attorney, they realized they had a problem with the facts: in our hands, those allocation percentages proved unreported income. Therefore, the business owner testified as to a differing set of percentages, and, no surprise, this cleansed version caused his blended gross profit to be several percentages lower than we had calculated based on our interview with him. It now became one person’s word against another, and he certainly knew his business better than we did. During cross-examination, I had to acknowledge that I had been unable to perform an analysis of the purchases, which would have provided an independent verification of the relative portions of the business that were represented by the differing products. This point was strongly emphasized by the business owner’s attorney because the business owner had testified that a significant portion of his sales came from his lowest profit margin item. From my vantage point on the stand, I could see my client squirming uncomfortably, obviously concerned about my credibility and the sustainability of my proof of unreported income. I also noticed that my attorney had a slight smile on her face, because we had prepared in advance. At the appropriate point, I acknowledged to the other attorney that although I had been unable to verify my percentages by reference to an analysis of the purchases, I was able instead to use other documentation, the company’s own sales records, to support my position and, by the way, I had in my work deck copies of those sales records. The cross-examining attorney at this stage began to

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pale, but had no alternative but to proceed. He went through various pages in my work deck, having me pick dates at random. The judge joined in doing the same thing, with the curiosity on the bench mounting by the minute. I was able to point to page after page in the company’s own records of how this lowest margin item represented, day after day, only about 5 percent of the store’s sales. After reviewing a few of such daily reports, chosen either by me with my eyes closed, or by the cross-examining attorney, or even as a last resort by the judge himself, that part of my testimony was laid to rest. Our position was well established and the judge was convinced that there was unreported income, perhaps even more than I had calculated. The point to consider here is, in one word, documentation. You cannot copy every financial record, every worksheet, every bank statement and canceled check, but certain items warrant being copied, and warrant being part of your permanent file for the case. Try to keep in mind that all too often in investigative work, an item not grabbed now, an item not photocopied now, may be lost forever except in your memory. If you are not sure, play it safe and make a copy of it. This is especially true of financial statements, tax returns, and key bank and brokerage statements. Few things enhance your file as much as a third-party document that proves your point, especially if it also refutes the other side.

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4

PARAMETERS OF THE INQUIRY Marriage: A master, a mistress and two slaves, making in all, two. —Ambrose Bierce

CONTENTS 4.1 4.2 4.3 4.4

Economic versus Tax Issues Business Form Valuation Date Nonmarital Assets

38 39 40 41

4.5 4.6

Tax Fraud When a Business Is Not Involved

NOTE

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ECONOMIC VERSUS TAX ISSUES. The tax legitimacy or illegitimacy of a series of transactions, or the manner in which certain items are handled, is in most instances totally irrelevant to investigative accounting in a divorce action. That is not to say that significant tax improprieties are not relevant; they certainly are, and help to impugn the credibility of the other side. However, our function is to determine the economic reality of a business and the income derived therefrom. For instance, though the tax law (I.R.C. 179) permits yearly write-offs of $17,500 of fixed asset acquisitions, that practice is not economic reality. From an economic point of view, it represents a write-off of a long-lasting asset that is too speedy. On the other side of the equation, although, for instance, a sole proprietorship is not currently permitted a tax deduction for medical insurance premiums on behalf of the owner, the economic reality of the business world is that medical insurance is considered a normal operating expense and would be deductible if that business were operating in the form of a corporation. The accountant’s work does not revolve around whether an item had been handled correctly for tax purposes or even what its tax ramification is. The focus should be on the correct economic and financial treatment of expenses, income, assets, and liabilities. To illustrate that thought, some years ago in investigating a law practice, the author came across records indicating a significantly increased level of rent in one year. In investigating, we found not that rent was paid on behalf of a partner’s personal apartment or for a paramour, but rather for a completely legitimate business purpose. The practice moved in that year and incurred several months of duplicative rent. There was absolutely no question but that it was at arm’s length, it was to an unrelated third party, and it was perfectly legitimate and deductible for tax purposes. However, from an economic point of view and from understanding the operations of the practice, it was also clearly excess and unnecessary.

4.1

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That is, in placing the economic performance of that practice in perspective, the duplicative rent was nonrecurring and not indicative of that practice on a goingforward basis. Therefore, we appropriately removed that excess rent when restating the operations of the law practice. Certainly, some adjustments might be arguable, and might require judgment calls that could be wrong. However, if the business moved during the year and incurred several months of duplicative rent, if an abnormally large receivable turned bad and was written off during that year, if the company was fortunate enough to receive an unusually large and profitable order from one customer that had not occurred in the past and has not occurred since, or if any other unusual or atypical event occurred, the “correction’’ of these in no way suggests that anything was ever treated improperly. These adjustments represent nothing more than removal of items that are not reflective of the company on a going-forward basis. Other examples of nonrecurring items that are not indications of improper treatment or use of company’s assets, but that would require adjustments in our analysis, include: • The cost of moving a business • The buying out of a business owner or partner through the use of deductible payments • The abandonment of assets or leasehold improvements when a company moves • An unusually large, atypical write-off of accounts receivable; a large bad debt • I.R.C. § 179 bonus first-year depreciation • The loading up of asset acquisitions at the end of a corporate year and the resultant impact on the depreciation expense for that year even though those assets may not yet have been put into productive use • A nonrecurring source of income, such as a lawsuit recovery • The expense of defending a lawsuit, if that is not a normal, recurring situation for that business • Repair expenses for damage caused by fire • An embezzlement • Extraordinary legal or accounting fees relating to an acquisition • The depreciation of a building, when it is actually appreciating • A nonmarket-level rent between related parties • A large pension plan or other deferred compensation arrangement substantially for the owner’s benefit BUSINESS FORM. For the most part, the form of the business entity has absolutely no bearing on the nature of the accountant’s work. Whether dealing with a sole proprietorship, limited liability company, a partnership, a C corporation, or an S corporation, the investigative elements and approaches are the same. Of course, unincorporated entities may utilize a draw instead of a salary for the business owner, but it still means making payments from the business entity to the business owner. In virtually all other respects, the operation of a business 4.2

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PARAMETERS OF THE INQUIRY

is not affected by its entity format. Unfortunately, when dealing with sole proprietorships, too often bank accounts are used as much for personal as for business expenditures, which makes the accountant’s work a bit more cumbersome. In any case, it is necessary to determine how various disbursements were posted. Accountants are more likely to see excessive commingling of personal expenditures in an unincorporated sole proprietorship type of entity than in a corporation. VALUATION DATE. An interesting issue in our investigation and ultimate valuation procedure is the determination of the appropriate stopping point, that is, what is/are the valuation date or dates? At first blush, this should be a straightforward and simple question. Our stopping point, the valuation date, is almost always the complaint date. When a complaint for divorce is filed, the clock stops on the perceived matrimonial contribution. Valuation and income determination must be made at that time. While that is the general rule, there are a number of variable and contradictory realities that necessitate far more effort than merely having our work revolve around one particular date. There are multiple issues involved and, as a result, the complaint date is not always the only date of concern. Some states (for example, Colorado) require that the valuation date be the trial date. Issues that require looking beyond the complaint date include matters of support, allegations of a major change in an asset’s value, and whether an asset is active (that is, whether a spouse’s right to share in its value ends at the time of the complaint) or passive (that is, whether each spouse continues to share in it up to the time of the settlement or adjudication). With the downturn in the economy in the late 1980s and early 1990s, we have also seen heightened interest, obviously from the business owner, in having valuations as current to the trial date as possible. This is contrary to the pattern of the preceding several years when, with the growing and improving economy, the business owner wanted to stop the clock as soon as possible. Now, with the justification of a slower economy, there is a concern that an asset that might have been worth $1 million at the time of the filing of the complaint, might, through no fault of the business owner, at trial only be worth $400,000, and that it would be unfair to give the nonbusiness spouse an equitable share of a $1-million asset, which value no longer exists. This only increases the complexity of our work as well as the time and fees involved. Unfortunately, it can also cause accountants’ fees to be out of proportion to the asset being reviewed. Even when we are not faced with concerns of asset diminution, there are still other concerns dealing with the valuation and investigative time frames. For instance, it is unusual for a complaint date to neatly tie into the fiscal year end of a business. If a complaint is filed in May or September and the business involved is on a calendar year, one might suppose that we would bring forward the business’s books and records from the last fiscal year end up to the point of valuation. However, this can be prohibitively time-consuming and expensive, and of little or no real benefit. Instead, if the complaint date is April or May, we can utilize the previous year end and merely update the information in a broad sense to compare, for instance, the revenues up to the complaint date with those at the same time in the previous fiscal year. If the revenues (conceptually, this should be applied to the expenses 4.3

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4.4 NONMARITAL ASSETS

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also) were not significantly different from the prior year, it would be reasonable and efficient not to use the current time for valuation. On the other hand, if the complaint date is in September or October, especially considering that inevitably we would not get in to do this work until subsequent to the year end, it would not be improper or distortive to use the full fiscal year for investigation and valuation. We must maintain sensitivity to the potential for particular and specific timing issues, for instance, an unusual cash flow situation that happens between the complaint date and the chosen cutoff date. In a most bitter case involving a medical practice with a February year end and a July complaint date, the author was representing the wife. The doctor/husband was represented by both his own divorce accountant and, in effect, by the court-appointed accountant, whose bias in favor of the husband became overwhelmingly clear as the case evolved. The February year end prior to the complaint date was tacitly agreed to by all for both valuation and income determination. However, we pointed out to the other two accountants that the practice’s habit of paying the doctor a modest interim salary, with a large bonus in either December or February (depending on tax-planning needs), meant that by July there was an extra $200,000 in the practice’s bank account. And, since those funds were earned during the marriage, it was critical, at least for balance sheet purposes, that they be included in the practice’s book value (or alternatively, as a personal marital asset). Both accountants chose to ignore my input and the facts and instead used the practice’s cash balance as of the previous February when it was near zero. After listening to all the experts, the judge’s decision validated my position. 4.4 NONMARITAL ASSETS. Assets owned prior to marriage, gifts, and inheritances are another complication requiring attention to dates. In most jurisdictions, the value at the time of the marriage, inheritance, or gift is taken out of the marital pot. In most jurisdictions, determining whether the object is a passive asset (such as an outside investor in a distant company) or an active asset (such as owning and operating your own closely held business) is also crucial. This issue must be considered in virtually any divorce case. Be sure from the onset to clarify whether the case involves this type of property. You may need to know the duration of the marriage, as well as which major assets preceded and which were acquired during the marriage. Even for assets acquired during the marriage, it may be crucial to know how ownership came about. Was it an asset that was generated through marital efforts or purchased with marital assets, or was it an asset that was acquired from family gifts or inheritances? In most jurisdictions, there is a significant difference in treatment. Typically, anything acquired during the marriage and generated by marital funds or efforts is available and fair game in a divorce action. On the other hand, anything acquired by gift or inheritance and items that preceded the marriage (provided that any such assets were continuously maintained as the equivalent of separate property) are considered to be outside the marital pot and not available to the other spouse in a marital action. When active assets (such as an interest in a business in which one works) were acquired prior to the marriage or by inheritance or gift during the marriage, one needs to ascertain the increment in value from the time of the marriage, gift, or inheritance to the time of the complaint. Various issues may arise in this exercise, including inflation, the general economy, the economic trends in that type

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of business, the location of the business, and the efforts of either spouse and the extent of compensation derived from the business by either spouse. A case in which I was involved several years ago dealt with a substantial family business that was well into its second generation. The most interesting aspect revolved around the numerous stock positions obtained by the business owner during the marriage through gift and inheritance. During a fairly lengthy marriage, the husband had obtained at least a dozen different stock positions over a number of years through family gifts and inheritances. During the time frame in which he received those stock positions, he initially did not work in the company, and therefore, any appreciation of value during that time frame could not have been attributed to him. He later worked in the company, originally as a subordinate with a relatively lower-ranking position. Both a parent and an older sibling were dominant in the business. As the years progressed, his position improved in terms of responsibility and importance; the parent retired and the older sibling took over that parent’s role in the organization. Later on, the older sibling left and the spouse involved in this case took over the company. More importantly, during the marriage this company grew significantly and at the time of the complaint had a fairly substantial value. A fairly detailed analysis was done to identify each of the stock positions, the respective time frames, the relative role the husband played in the company during those times, the increase (and, in some cases, decrease) in the value of the company from year to year, and the extent that such year-to-year changes could be (arguably) attributable to the husband. The overriding value of this exercise was that, even though there were gaps, in the aggregate it was reasonable and made sense. Frankly, that is all one could hope for in such an unusual circumstance. A practical problem arises when dealing with valuation going back to the time of the marriage — often, the information is dated and hard to come by, or perhaps not even available. Attempting to obtain previous tax returns from the IRS is generally a waste of time inasmuch as the IRS tends to purge its files after a few years. One source is, of course, the company’s stored files; another might be the accountant (or the former accountant or the accountant prior to the former accountant). Sometime in the future, when more companies have transferred virtually all of their sensitive records (such as financial statements and tax returns) onto computer disks or other high-tech storage devices, older documents may be accessible. Presently, we still mostly rely on hard copies for these records, and too often they simply do not exist for more than several years. There is no easy solution to this documentation shortcoming. TAX FRAUD. You may find serious tax misstatements or even fraud. You might notice by a review of the tax returns or financial statements that entertainment expenses seem far too large for the type of business involved. This might ultimately lead you to conclude (and of course you must be able to document your conclusions) that the business owner received substantial or even excessive perquisites, politely called “benefits,” from that business. Going further up the ladder of tax exposure, your work might also lead you to the conclusion that there was significant unreported income. This crosses over from commonplace routine abuse of the system, which generally results in no more than a slap on the wrist and mild interest and penalty assessments, to tax negligence and even fraud. The demarcation is somewhat unclear and ill-defined. Each case is different and that

4.5

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crossover point will vary from situation to situation. However, you know at some point you are dealing with someone who has made significant misstatements as to revenue, expenses, or net income. Therefore, you now have established perhaps a very powerful and very dangerous leverage tool. That is, once you have been able to establish serious tax wrongdoings, especially when the extent of the wrongdoing clearly constitutes significant unreported income and fraud, the parties are generally more amenable to settlement. One would certainly hope that, in the give-and-take of negotiation, your demonstration of the magnitude of wrongdoing would be sufficiently credible with the opposing spouse and attorney that they would recognize the need to settle and avoid a trial and your testimony as to unreported income and fraud. Furthermore, in some jurisdictions (such as New Jersey), the family law judges are under directive from their administrative office to report to the IRS any cases coming before them that have convinced them that tax fraud exists. A pound of flesh may be your client’s goal, but it usually does neither party any good to have one of them vilified in court and proved guilty of tax fraud. Obviously, if any disclosure causes the IRS to step in, it could result in the forfeiture of significant marital assets, the incarceration of the business spouse, and the loss of the potential source of support. Everyone ends up a loser. In the most severe of cases, when, for example, the wife is faced with a husband who refuses to comply with court directives or to propose anything close to a reasonable settlement (especially if the wife is truly an innocent spouse 1), handing him over to the IRS is perhaps the only justice that can be obtained. The assumption there is that the loss of potential support and assets is no worse than the alternative the wife is already facing. Another problem with this leverage tool is that in almost all marital situations where the parties have filed joint returns for some years, the tax fraud club swings both ways. Clearly, the business owner is in store for the brunt of any attack by the IRS and any serious criminal action. However, if the nonbusiness spouse fails the innocent spouse standards, she (assuming joint tax returns) may be held equally liable for all of the unpaid taxes and the responsibility for that fraudulent activity. Therefore, unless you have a client who is truly an innocent spouse (and even then tread carefully; the IRS does not necessarily look at it the same way you do), recognize that you can go only so far with this argument before you put your client in jeopardy. If faced with that situation, and if the ultimate realization is that fraud will be disclosed, that disclosure perhaps coming directly from your client, you should strongly insist that your client use appropriate tax-oriented legal counsel to create a peremptory strike. Line up the conference with the IRS, establish certain ground rules, and bargain for as much protection from prosecution as you can get. It is likely that if you are offering up the actual wrongdoer (the business owner), the IRS, perhaps with little more than a slap on the wrist to your client, would be willing to deal in order to catch the person who has really caused the problem. Do not take this approach without the appropriate legal counsel. Another issue arising from the uncovering and proving of tax fraud and serious and substantial misrepresentations on tax returns is what responsibility, if any, do accountants have to advise the IRS, state tax authorities, and perhaps even banks who relied on fraudulently stated information? In the opinion of this author, we have absolutely no obligation to bring this information to the attention

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of anyone outside the divorce action. Our role is not that of investigator for the government, nor conscience for anyone, nor preparer of the returns or the financial statements. Our role is to assist our client in a divorce action that involves the investigation of business and personal financial affairs. The author further suggests that taking the rather drastic and draconian step of informing the authorities of information uncovered would expose the accountant to legal retaliation. Loss of one’s CPA certificate is possible because of the improper (and even unethical) disclosure of confidential information when there was no obligation to disclose. What the client does is totally another story and not the accountant’s responsibility. However, what do you do when you or the opposing investigative accountant has convincing evidence of unreported income? Advising and leading as necessary, and in conjunction with the other professionals, impress upon any unconvinced attorney and especially upon the clients the dangers and risks involved in taking a case with tax fraud into court. The courtroom is public. While divorce cases have no juries and while, as a practical matter, they usually have no spectators either, the courtroom is open and the court filings become public record. In addition, as already stated, in a number of jurisdictions judges are under directive to report to the IRS any situations where they believe that tax fraud exists. When tax fraud is clearly documented and it is also evident that significant marital assets were obtained through the use of these fraudulently gotten funds, depending on the jurisdiction, the judge may refuse to order equitable division of assets illegally obtained and retained. The court may not feel that it has the authority to grant title or reallocate title to either party when the assets were illegally obtained. The judge may go one step further and refer the case to the IRS. These are not hypothetical or theoretical considerations. Depending on the judge and the jurisdiction, these are very real concerns that will hurt both parties and likely hurt (financially) the attorneys and accountants. By all means, do your best to counsel the parties of the folly of bringing evidence of fraud into court. Unfortunately, all too often business owners have a macho reaction and, in effect, dare you to report them. After all, they have never had to account to anyone for any flaws in the company’s books and records and income reporting. On the other hand, you may be faced with nonbusiness spouses who seek to be vindictive, desiring to obtain every pound of flesh and unconcerned about the economic havoc that may be brought upon the marital unit by such drastic actions. Your job, in tandem with the other accountant if applicable and certainly with both attorneys if possible, is to see to it that calmer and cooler heads prevail. 4.6 WHEN A BUSINESS IS NOT INVOLVED. In accounting services for divorce proceedings, the bread-and-butter case involves a closely held business, regardless of the spouse being represented. There are also many situations, and room for much service, when a business is not involved, but there is financial complexity or significant assets and financial transactions. This is aside from servicing that deals with financial planning, tax consulting, and assistance in the negotiation process. For instance, you might be engaged on behalf of a spouse who is married to a well-paid and high-level employee of a large corporation in which the employee has no real ownership interest. In most such situations, you can expect, if not voluntary cooperation in obtaining documentation from that company, that what you receive has not been distorted, adjusted, or falsified. This issue is always a

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concern when the spouse being investigated has significant control over the source submitting the records. When investigating an individual with significant income, the accountant’s role can be extremely important in establishing whether that income has been properly accounted for. For instance, if this individual receives a paycheck that amounts to $1 million per year, and if withholding is $300,000 per year, that leaves disposable income (addressing here only the salary) of $700,000 a year. For most people, that is more than enough on which to live, leaving something on the table for saving, investing, or diverting. Our role in such a divorce can involve tracing, paycheck by paycheck, the disposition of these funds. Do we know into which bank account or brokerage account they went? From there, do we know how the money was spent? While generally this type of assignment does not present many of the interesting nuances that we face investigating a closely held business, there is still the matter of being able to trace the receipt of funds and then analyzing the personal financial activity of the individual to determine the disposition of these funds. In this type of case, understanding the business and employment habits of the individual can be of great importance. For instance, does this person travel a lot, and if so, to where? If we are not able to trace certain paychecks or parts of paychecks, or the disposition of funds where perhaps large amounts were withdrawn in the form of checks payable to the individual or to cash, it may be financially beneficial to instigate a bank search in the cities or areas to which this business executive travels on a regular basis. We have probably all seen movies where a business person frequents at least one location other than the home office, where a second family exists. While this makes interesting fiction, from our financial perspective there can be more than a touch of reality in considering this potential diversion of marital assets. With a business person frequently in one or two locales, have undisclosed financial relationships been developed? Does the person have bank or brokerage accounts, safe deposit boxes, or even real estate in any of these locations? Such ties are especially likely if the person has relatives or a paramour in any of these locations. Of course, the basic concerns and approaches just described would also apply when the spouse being investigated does not have a business and is not employed as an executive but rather has personal wealth and would be considered an investor. Again, there is the need for accountants’ services in tracing the receipt and disposition of funds. In such situations, it would be extremely important to have a solid understanding of the assets and the sources of income available to the individual being investigated. NOTE 1. I.R.C. § 6013(e).

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THE TARGET COMPANY

II

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CHAPTER

5

DEALING WITH THE TARGET COMPANY Business is a good game — lots of competition and a minimum of rules. You keep score with money. — Nolan Bushnell

CONTENTS 5.1 5.2 5.3 5.4 5.5 5.6

Access to the Opposition Company’s Regular Accountant We’re Clean; There’s No Need to Investigate Working On-Site Working Conditions Walk Through the Business

49 50 51 52 54 55

5.7 5.8 5.9 5.10 5.11

Understanding Internal Work Flow Multiple Companies Multiple Departments, Locations, or Products Divorce Planning Business Walk-Through Checklist

56 57 58 58 60

ACCESS TO THE OPPOSITION. Similar to representing regular business clients, you need to know the pecking order, you need to know who to contact for what records, and who not to overlook in the chain of command. Perhaps even more in this type of accounting work, you must understand who you can and cannot contact and how to best obtain the documentation and information you will need. You may find it helpful to refer to the Business Owner/Spouse Interview Checklist (see 2.8). As early in your involvement in the case as possible, find out who the contact people are. Can you go directly to the company’s bookkeeper or controller and get access to all the records you want (including perhaps the personal financial records of the parties)? Or, to the other extreme, must you first make all your requests through your client’s attorney, who will then have to make the requests through the other party’s attorney, who will then contact the other party, who will then contact the accountant, bookkeeper, or controller? In most cases, the author has not been forced into the absurd extreme of the latter, but in all too many cases, the logical former approach has been denied even though it cuts through many obstacles and makes everyone’s life easier. Making everyone’s life easier ultimately saves fees. Unfortunately, making life easier for everyone, and even saving fees, is not necessarily of any relevance or importance to the party being investigated. Remember, accountants are an unwelcomed, uninvited, unwanted (dare we say despised?) intrusion. Given that, you should not think that common-sense business 5.1

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DEALING WITH THE TARGET COMPANY

approaches to obtaining information and getting your job done have anything to do with your presence in this case. Being able to get information easily, having access to as many records as you want as easily as you want, and allowing you to progress smoothly may very well be the opposite of what the other side wants. This is, of course, especially the case if there is something to hide, if there is unreported income or excessive perquisites, or if any other financial shenanigans exist. Accountants are often so convinced of the sanctity of the search for the ultimate truth that they lose sight of the reality that not everyone wants the truth. Many times, for right or for wrong, the business owner will make (sometimes consciously) a business and financial judgment call that money is better spent obstructing your progress and paying attorney fees (and ultimately the other spouse’s attorney fees and maybe even yours too) for nothing of value, for wasting everyone’s time and for creating extra paperwork for no reason except that saving fees endangers the status quo. If you keep this financial fact of life in mind as you pursue your work, you will better appreciate your real placement in the scheme of things. Therefore, early on, know who you can contact and how to best obtain the information. Refer to the information obtained from the Business Owner/Spouse Interview Checklist (see 2.8) to decide which parties to contact. At the same time, keep in mind that you are an investigator and sometimes that requires that you ignore or sidestep the rigid structuring of how to ask questions or obtain information. Sometimes, you will simply need to ignore what you are supposed to do in order to obtain the information you need and to gain access to records. For instance, maybe you are under strict orders not to communicate directly with the company’s bookkeeper. On the other hand, when you are hot and heavy into doing this work, and you are there on the premises and going through the company’s books and records, who better to answer a question than the bookkeeper who works there 40 hours a week? You might even ask that person innocent questions without intending to violate any ground rules. After all, accountants are used to approaching regular corporate accounts in that manner and are not used to having to deal with many layers of obstruction to obtain needed information. Therefore, what is more natural than to ask, almost as a reflex action, the person most knowledgeable as to most phases of a business’s financial operation. In order to accomplish your goal, you may be compelled to ignore directives that isolate you and take advantage of opportunities that arise. The bookkeeper may be all too willing to talk to you. Other employees on the business premises may be less defensive, may not have been advised to avoid you, and may be of help in understanding and finding information. Be resourceful, assertive, and, while being careful not to violate any actual rules or ethical constraints, keep in mind your need to obtain information. COMPANY’S REGULAR ACCOUNTANT. In many cases, especially when you represent the nonbusiness spouse, and even more so when you represent both spouses, you will inevitably have to deal with the business’s regular accountant. If you are fortunate, that accountant will be every bit as professional and cooperative as your needs dictate (as, of course, you would be were the situation reversed). However, especially when there has been a long-term relationship between that accountant and the business owner, remember that the accountant is getting paid by the business owner and loyalty resides with the source of payment. 5.2

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Thus, you might receive somewhat tainted cooperation. While you know that a fellow accountant would not lie to you, perhaps you are not so sure that you would get the full truth. To be fair, that other accountant may be under strict client instructions to cooperate only so far. In some cases, the instructions may include not cooperating as to specific items. Even when you have had a long working relationship with that other accountant, try to place yourself in that accountant’s shoes and imagine what client pressures you might receive to give half-truths, stall, or be less than fully cooperative. Remember also that the other accountant is not the person you are investigating. While that accountant may turn out to be your adversary in this case, hopefully professionalism will rule and neither one of you will get overly protective of positions. However, if you uncover excessive perquisites, for instance, and especially if you uncover unreported income, that other accountant is now subject to embarrassment, to say the least, from your revelations and possible testimony in court. This, of course, is one of those reasons why, most of the time, you should not represent your own client in a divorce action. When your relationship with the other accountant is more than cordial, regardless of your respective accounting roles in the case, you may be able to make significant and rapid progress in coming to some mutually agreeable understandings as to the level of income and even the value of the business. Do not proceed too quickly in that direction without the clear approval of your attorney. A trait of accountants, some might say a fault, is that they far too often rely on what they believe to be concrete numerical proof and obvious (at least in their eyes) approaches and conclusions. As a result, they might ignore the importance of the attorney’s advocacy and litigation skills. It is definitely rare to get the green light to, in effect, negotiate a settlement. That is the province of the attorney and should be left to the attorney in the absence of explicit approval. When permitted to do so, sharing work papers and approaches may save both of you time and avoid duplication. When you do share work papers, be cautious about sharing those that contain preliminary conclusions or thoughts, as contrasted with those that merely illustrate objective analysis and findings. WE’RE CLEAN; THERE’S NO NEED TO INVESTIGATE. On occasion, you will be told that there is little need to waste time going through the company’s books looking for things that are out of order. Before you even get that far, there may be attempts to dissuade you from coming in and from doing that analysis. For example, there may have been a recent IRS tax examination and the company got a clean report or, if the adjustments were minor, the company may offer to share them with you, including a copy of the examination report. This type of maneuver should be recognized for what it is, a smokescreen that carries absolutely no weight and has no merit. Even if there is nothing wrong with the company’s books and records (see Chapter 4), our function is not the same as that of an IRS agent, although there are similarities in the hunt for items that are personal rather than business. We are looking at this business from an economic operating point of view, not from a tax legitimacy point of view. Therefore, an IRS agent’s findings, especially if there were no (or merely minimal) adjustments, are for the most part irrelevant. On the other hand, if the IRS determined a number of adjustments, then indeed that might be helpful in identifying where to look, and certainly in further 5.3

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bolstering any findings. In no way do IRS findings mean that we need not do our own analysis. WORKING ON-SITE. An issue that often arises early in your attempts at servicing is the matter of where you will be doing your work. Accustomed as accountants are to working at a client’s place of business, you will, of course, desire to work at the subject company’s location. Naturally, that will be the direction of your initial request for records and for work space. Just as naturally, there may be a response advising you that the records will be made available, that there will be complete cooperation, that you should just ask and you will get what you want, but you will not be able to work at the company’s location. You will be offered locations such as the attorney’s office, the accountant’s office, or perhaps even your own office. The company may be willing to bring all the records to you and trust you with them. The last offer, while in some sense appealing because of the time frame latitude it provides, is nevertheless unsatisfactory, as are the other alternatives. It also presents you with the exposure of the responsibility for those records and potential accusations of perhaps taking some, not returning them, misplacing or losing them, and so forth. There are, of course, reasons, some even valid, for denying your request to work at the company’s site. For instance, there simply may not be enough room. This may be the truth. For instance, in investigating a gas station, a small retail store, or perhaps even a solo medical practitioner (with only a receptionist’s desk, a private office that is used during the day for consultations, and an examining room), you very well may have no choice but to accept the need to work elsewhere. Even then, by all means do not ignore the relevance and importance of making a visit to the business. Go see that gas station, note the price of its gas, how many pumps and bays it has, and whether it sells things other than gas. Go to that retail store, estimate how many square feet it covers, note what types of products it sells, and, of course, where it is located. Go to that doctor’s office and see if fees are posted, whether there is an appointment book on display, which should of course be available for past years, and so forth. Lack of working space is often given as the reason you must work elsewhere. Often, that is not an accurate description of the limitations at the place of business because most businesses do have enough room for at least one more person to work, even if under less than ideal conditions. Other than space issues, the company might claim that:

5.4

• Your presence will interfere with the smooth flow of the business. • You will in some way be an obstruction. • They will have to answer questions as to why you are there and that will prove embarrassing. • There is no need for you to be there because they will see to it that all the records are made available to you at some other location. • The company’s regular accountant is going to be there and it will be too crowded. The reality of most of these excuses is that they simply do not want you there because you pose a threat, and because by being there you may very well learn

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more than they want you to. In my years of doing this type of work, I don’t recall a single instance where we presented an obstacle or interference to the smooth operations of any business, nor an embarrassment to anyone. The embarrassment issue is nothing more than a subterfuge because everyone knows why we are doing what we are doing before we arrive. Besides, if that were a real issue, the employees could be advised that we were just another accounting firm or bankers going through records, or possibly even IRS auditors. Being at the company’s location gives you an opportunity to observe and to accomplish what, in all likelihood, would be difficult or impossible to do elsewhere. Goals of mutual efficiency and of a reliable accounting product would suggest that it is simply not practical for a business to remove and box up several years of financial records (including ledgers, journals, payroll records, paid bills, sales invoices, bank statements, and canceled checks) and deliver them to another office. Besides, they then have to set them up there, and unpack them to make them available for you to review, and then repack them when you are finished to return them to the company. It is difficult to make this mass movement efficiently and without misplacing or losing records. It is virtually impossible to do it without forgetting something you will need, and requiring a return visit, a delay, or some extra effort to find. If you were at the company’s site, it would have been found almost immediately. The removal of records is actually more of a disruption to the operation of the business than your presence could ever be. It also wastes time and money. There is a perhaps equally important (sometimes far more important) reason for you to work at the business at least once during your investigation. There is simply no substitute for being where the action is. By being there (and of course by being observant), you gain an opportunity that would not be possible otherwise, namely, to understand the ebbs and flows of the business, its pace, the coordination of people who are there, how often the phone rings, what the office or factory looks like, the location, who walks in and out, how many people could possibly be employed in that small office, and to hear what is only possible to hear when you are there. While you are working there and are listening to the events around you, you may overhear bits of conversations that lead you to a related company, or information about investment situations or dealings of which you need to be aware or a merger or acquisition that is in the offing. One of the main reasons for not wanting you there is that the company’s employees are usually not against you. They may not necessarily be on your side, but they may welcome an opportunity to get even with the boss. This gives you the opportunity to gather information, obtain a certain level of cooperation, and gain access to records that would be impossible without being on the premises and having the cooperation of full-time employees who have intimate knowledge of the company’s records and operations. One reason we always tell our clients never to represent themselves before the IRS in a tax examination is because people talk; we are afraid they are going to open their mouths and say things that will get them in trouble. It works the same way during an investigation at a business; I’ve had bookkeepers, secretaries, and other clerical people just in the normal course of being cooperative make my life easier. Most people help because they are by nature helpful, others do so from distaste for the business owner. To give an example of why it can be so important to work on-site, a couple of years ago, in a most difficult and emotional case, we were compelled to work, at

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least for part of our time doing records analysis, at the accountant’s office. However, we insisted upon and were granted limited time to analyze records at the company’s location. The business was in a construction-related field. It was a very modest set-up, with little to note that would help in the investigative and valuation process. Most of the items we had to deal with, which were observed in a walk-through of the operation, involved equipment, and for that we had a detailed listing of assets and engaged a qualified equipment appraiser. However, by being on-site and walking around a little (on a brief escorted tour by the business owner), we were able to observe that there was a rather substantial section set aside for parts and supplies. Nowhere in the company’s books and records, and nowhere on any tax returns or financial statements, was the existence of the inventory of parts and supplies acknowledged. Yet, it was very obvious just from being there that this asset existed and that it was significant. In our report, we calculated what we estimated to be the extent of that inventory, basing it on a relationship to the year’s purchase of parts and supplies and how many months (or fraction of a month) of parts and supplies it was reasonable for that business to carry. This adjustment not only resulted in a significant increase in the balance sheet but also in an increase in the business’s profitability. Since it was in the practice of expending all those parts and supplies and since it was also in a growth mode, it had for the previous few years understated its income by overstating its expenses. The ultimate proof of our approach was that the business owner’s accountant and business appraiser, in preparing their reports for trial, acknowledged the correctness of our inventory of parts and supplies and incorporated them verbatim in their reports. With some degree of hindsight, one might think that perhaps their willingness to accept our figures suggested our calculations were conservative and that we were too low. Be that as it may, we proved our point, and it would have been unlikely for us to do so had it not been for that visit and walkthrough of the company’s premises. However, the overriding issue is whether you will be allowed to work at the company’s site, not whether you should work there. As to whether you should expend effort and energy (which inevitably translate into cost) to make this an issue, the answer, in almost all cases, is yes. WORKING CONDITIONS. Worksheet privacy and the sanctity of your records can be of concern. While much of your analysis involves repeating selected information from the company’s records and is therefore of relatively little interest to inquiring minds, many times work papers document sensitive issues, interpret the flow of funds, and opine on findings. Your worksheets must be kept unavailable to the other side. You will likely even want to keep your records private from your own side until after evaluating the work and coming to conclusions with which you are comfortable. This need for privacy is another reason why having an associate or partner with you on many jobs is of great assistance. When you leave the room or go to lunch, you must protect your files, even if it means locking them up and then taking time to open them and set up when you get back. Unless you have the explicit permission of the attorney with whom you are working, you must never discuss with the opposition your files, or the status of your work. Especially avoid discussion of your thought processes and your

5.5

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preliminary conclusions. There is a dramatic and distinct difference between the warm cocoon environment we generally have in our customary corporate servicing, where the client is a friend, cooperation is automatic, and litigation is the furthest thing from your mind, and the antagonistic environment of working on a divorce case for the nonbusiness spouse. You are automatically suspect, and cooperation is reluctantly given, if at all. 5.6 WALK THROUGH THE BUSINESS. In an ideal situation, and often even when the situation is not so ideal, there are a number of steps and procedures the investigative accountant should utilize prior to the in-depth analysis of a company’s books and records. For instance, as discussed in detail in Chapter 2, interview both parties. Obtain any information you can from both of them about the business operations, notwithstanding any bias they may expound upon during that interview. Try to learn what you can of the business before you get your hands on the books and records so that you will be better equipped to understand what you are looking at, and so as to be able to use your understanding in the most efficient and productive manner. Then, by all means, visit the location and walk through it. In almost every case, even if with extreme reluctance and even if you are escorted by six of the owner’s most trusted employees, you will be permitted a walk-through, even if it is a somewhat silent and unnarrated tour. This relatively simple procedure usually will give you at least a modest sense of the business, its magnitude, the condition of its plant, how many people work there, what equipment and machinery is used, perhaps the magnitude of the inventory, its pricing structure (when prices are posted typically in a retail or service-type business), how many cash registers are in operation, and so forth. For instance, in a case involving a retail convenience food store, a simple walkthrough gave us insight into the store’s pricing structure, which thereby allowed us to calculate a true (as contrasted to reported) gross profit. Also, we saw two cash registers in operation whereas the owner had advised us that there was only one, and had further supplied us with the register tapes from that one, which perfectly tied into the reported income. Notwithstanding the strength of our testimony relevant to the reconstruction of the gross profit, it was of great benefit and a boost to our credibility to be able to testify that, as part of our function, we went to the store, walked through it, observed two cash registers in action and yet the reported income all came from just one register. Very little can substitute for seeing the place in action. In addition, if one of your functions in the case is to value the business, you might imagine your discomfort on the stand and the weakness of your position if you are testifying as to the value of a business you have never actually seen. For a professional practice, such as a doctor, lawyer, or accountant, you might argue that the books and records speak for themselves and seeing the business is not all that important since it is basically just an office. That may be the case, and at least in those situations you might be able to withstand even a rigorous cross-examination that repeatedly and pointedly brought out that you never saw the business you are testifying on as to value. However, if the case involves a retail operation, a distribution center, a factory, a manufacturing operation, or the like, you should consider it an absolute must (unless you are physically prevented) to see the premises.

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After we interviewed the convenience store owner and had an understanding as to his business and how he operated it, one of my associates, whom the owner had never seen, visited the business unannounced. Besides observing the two cash registers, the condition of the store, the apparent traffic, and the parking capacity of the lot, perhaps the most beneficial aspect of that visit was that we purchased a sandwich, not to enjoy the culinary treat that it might offer, but to thoroughly understand the composition of the business’s products. Using that sandwich as an example, we rushed it back to our office, carefully took it apart and weighed its components on two different postage scales. The purpose here was to determine, using that sandwich as a typical example, how much meat, cheese, and other food items (for example, lettuce and tomato) went into a sandwich. By performing this relatively simple step, we were able to develop a supportive and credible position as to the actual cost of one of the key types of products (sandwiches) sold by this business and were able to compare that cost to the sales price. We were thereby able to determine, with a great degree of reliability, that business’s gross profit percentage. Of no minor importance, our observations contradicted not only the input we received from the owner when we interviewed him as to the contents of his sandwiches but consequently the gross profit margin he realized. None of that would have been possible had we not actually visited the business. Readers will find a Business Walk-Through Checklist in 5.11 to assist in maximizing the benefit of this aspect of discovery. UNDERSTANDING INTERNAL WORK FLOW. Just as in the familiarization process for a regular corporate account, it is important to understand the paper flow and documentation processing of the business (how things get posted, how income is received and recorded, who has authority to do tasks), to the extent you can obtain this information (and to the extent the representations are reliable). It is important in investigative work to obtain this same understanding of the business’s operations. Prior to the actual field work (but likely not until the first visit to the business), make the appropriate inquiries to learn where income comes from, how it is received and by whom, how it is recorded, who can sign checks, what types of records the business maintains and who prepares them, how much is done internally and how much by the company’s accountant, and so forth. For instance, in a medical practice where the doctor is one of several doctors and there is a whole complement of office and clerical personnel, it is likely that none of the doctors has any direct contact with the collection or deposit of money. The likelihood of unreported income in that situation is probably slim. On the other hand, if we are investigating a sole practitioner, with perhaps just one nurse/clerk assistant, the opportunities and likelihood that the doctor receives funds directly without depositing them in the practice’s bank account are much greater. Using these two situations as examples, in the former, it would likely be a waste of time (absent some additional insight or advice to the contrary) to expend much energy and time looking for unrecorded income. The odds are that there simply is none. However, as to the latter, it is advisable to seriously investigate the issue of unreported income.

5.7

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5.8 MULTIPLE COMPANIES

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MULTIPLE COMPANIES. When other companies exist, and if the ownership interests are the same, then it is simply a matter of more work, more companies and sets of books to look at, and more transactions that have to be traced. The manner in which you view these is really no different, there is just more volume. On the other hand, when there are related companies but the ownership interests are different, then additional procedures, considerations, and approaches need to be taken into account in your investigative process. For discussion purposes, let us assume that this divorce involves two companies, both controlled by the wife. In one company, she has a 100 percent interest; in the other company a 50 percent interest shared with a relative, close friend, or business associate, or even a silent money partner that has no active involvement in the company. Since you are representing the nonbusiness spouse, the husband, you have very real concerns as to whether the transactions (assuming there are any) between the companies are truly at arm’s length. If they are not, you would typically find that the 100 percent owned company is being “taken advantage of” for the benefit of the 50 percent owned company. The result, of course, is that your client stands to lose because he has only a marital interest in 50 percent of the second company as contrasted with his marital interest in 100 percent of the first company. Therefore, our concerns here are not merely whether certain expenses were business versus personal, recurring versus nonrecurring, and whether the income is fully reported, but also whether expenses and income are properly allocated between these related but differently owned companies. Specific concerns include: 5.8

• Were the sales of one company redirected to the other? • Did sales from a company or a source that was always the customer of the 100 percent owned company recently appear on the books of the 50 percent owned company? • How do the gross profit percentages of the two companies compare? • Do the gross profit percentages of the two companies appear reasonable under the circumstances considering what they sell? • Does there appear to be any justifiable reason for this second (50 percent owned) company (especially relevant to how long each of these companies has been in existence)? • Did the 50 percent owned company come into existence only recently (implying that its existence is divorce motivated)? • Do the companies share the same premises? • Do they share the same employees? • Assuming “yes” to either or both of the preceding questions, are you satisfied as to how the costs are shared and allocated? • Do job functions, responsibilities, and payroll costs make sense in respect to the two companies? • Do the fortunes of the 50 percent owned company appear to be improving at the same time the fortunes of the 100 percent owned company appear to be worsening?

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• Who is the other (nonspousal participant) owner of the 50 percent owned company (a special concern if it is a relative of the other spouse or an alleged paramour)? • If any interest in the 50 percent owned company was acquired recently (especially as to the spouse’s interest being reduced), for what consideration? When related parties have different ownership interests, other avenues might be pursued that normally would not be used. For example, we might modify a company’s reported figures because of the disparate ownership interests. For instance, is the 100 percent owned company carrying a large accounts receivable (or other type of receivable) from the 50 percent owned company that is far older than normal trade receivables (perhaps a few years old), and is that receivable without interest? Besides strengthening the argument that the alleged 50 percent position might be a disguised 100 percent position with a friend, clearly, a substantial receivable over that period of time might suggest that it was the equivalent of an interest-free loan and that the 100 percent company is owed (and therefore your client stands to gain) what might be a significant amount of interest from the 50 percent company. There is, of course, a potential adverse side to this argument depending on whether the 50 percent company is in any position to pay what it owes the 100 percent company. If not (putting aside whether there was any fiscal mismanagement on the 50 percent company’s side, in some way intentionally depreciating its financial position), then perhaps you must, as to the 100 percent owned company, write off part or all of this receivable as uncollectible, thereby obviously weakening the financial position of the 100 percent owned company. This approach might also have its flip side: does the 100 percent company have a long-term, interest-free payable due to the 50 percent owned company? While that might not help establish additional income for the 100 percent owned company, it might again further strengthen a position that perhaps the other owner in the 50 percent company is a paper facade and that all ownership interest truly resides with the business spouse you are investigating. MULTIPLE DEPARTMENTS, LOCATIONS, OR PRODUCTS. One interesting aspect of our work that can impose subtle variations in our approach to valuation, is the case involving a company with multiple departments, multiple locations, or multiple products. Assuming, of course, that your level of knowledge is sufficient and that the documentation in your investigation provides you with adequate information, you may find that this business would be more profitable (more valuable) by dropping one or more parts of its operation. For instance, if dealing with a chain of retail stores, one of those stores may be a money loser. The assumption here is that it has not only been a loser in the past but will likely continue to be.

5.9

DIVORCE PLANNING. Many times, a divorce action comes as no surprise to either of the spouses. As a consequence, it would not be unheard of for the business-owner spouse to have considered the likelihood of a divorce proceeding and to have taken steps to protect the business through judicious divorce planning. This may be evident when a company has a several-year history of growth

5.10

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5.10 DIVORCE PLANNING

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and strong profitability, and then for the year or so before the filing of the divorce complaint (and perhaps even while the divorce is pending), the company is not as successful. When the year prior to the divorce complaint is considerably weaker than previous years and the year following the divorce complaint has not noticeably improved, it is no mean feat to convincingly argue to a dispassionate and objective judge that indeed this was the result of divorce planning and not just the unfortunate vagaries of the business world. It is difficult to be certain that two consecutive weak years were a divorce planning maneuver planned by the business owner to reduce the value and income of that business. It would be much easier to make this argument if in the year following the complaint the business fully recovered and was back in sync with the previous years. In such a situation, you would hardly need to make the argument that the poor year preceding the divorce complaint was a result of divorce planning. You could simply ignore that year as not indicative of the company on a going-forward basis, an aberration in the company’s financial history. That argument is much more difficult to establish convincingly when two consecutive years are weak (and therefore an indication that sales may really have changed for the worse), or when the accountant’s work begins too soon after the divorce complaint to determine whether there has been only one weak year. In trying to make a fair and objective decision as to whether a weak year preceding the complaint was a result of divorce planning, you might, for instance, look at year-end sales deferrals. In investigating a business in a heavy equipment field, where sales were increasing each year and profitability was reasonably good, we had suspicions as to the legitimacy of the reported figures. One of our first steps was to review the sales activity of the company and track the monthly sales. We found that for each of the two prior years, the last month of the preceding fiscal year had sales running only about one-half of the previous month’s, but the very next month (the first month of the next fiscal year), sales were extraordinarily high. This was among the crudest sales deferral techniques. We were able, with absolute accuracy and ability to document, to show that about $300,000 of sales from the last month of year one were held back and billed in the first month of year two. About $400,000 of sales from the last month of year two were held back and billed in the first month of year three. Year three was just after the divorce complaint. As best as we could tell, this maneuver was both a combination of tax and divorce planning. Proving our point was not all that difficult. Besides the obviousness of the fluctuating sales, the company’s own sales invoices detailed that, notwithstanding the invoice dates, the services were for the previous month. By making these corrections, we increased the company’s profit in year one by $300,000. Since the $400,000 deferred in year two represented the carryover of $300,000 from the prior year, year two’s income went up an additional $100,000, a cumulative two-year adjustment to income of $400,000. As an additional benefit, not only did we significantly increase the reported income of the company but, at the end of year two, we increased receivables by $400,000. Therefore, both the company’s income and its balance sheet were dramatically improved. Unfortunately, not all divorce planning is so blatant and therefore so easily uncovered. What if, by collusion, with cooperation from long-standing customers, the business owner was able to defer sales by, in effect, simply not having them? Under most circumstances, it is very difficult to prove that the company’s reduction or

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lack of sales occurred because the business owner simply turned away business to spite the spouse. Indeed, that would probably be a far-fetched argument. You would have to show (and this is not easy) that the owner did not lose any sales but merely succeeded in deferring them, and therefore had some confidence that those sales would be there. A more likely route would be that another company was established to siphon off sales and income from the subject company. It might even be a new company of which no one on your team is aware. It might also be a company in which the business spouse has, on paper, no apparent interest. To prove this point, you might obtain a title search through the state’s tax department. Regardless, you would have to have some reason to suspect that this company exists or that it is more than an unrelated third party. BUSINESS WALK-THROUGH CHECKLIST. Every business is different and no single checklist can possibly cover all potential situations. However, keeping in mind the need for flexibility, the following points should be addressed when doing a walk-through of the business for purposes of valuation, especially when you are representing the nonbusiness spouse and therefore may not get an opportunity to revisit, to ask further questions, or to leisurely address issues. 5.11

____ The surrounding neighborhood; good neighborhood or bad, heavy traffic flow or light, residential or commercial. ____ The particular block, including access and parking. ____ Local/neighborhood competition. ____ Overall outside appearance and maintenance of the premises. ____ Business suitability within that neighborhood or block. ____ Any particular items of significance, such as railroad sidings next to the building, loading docks, and so forth. ____ General condition and maintenance inside the building. ____ Plaques and other postings in the waiting area, office area, and executive offices, noting any trade associations and the like. ____ Trade magazines in the waiting area and other places. ____ Staff names on doors, directories, telephone listings, and so forth. ____ How and where is the appointment book maintained, and in what format? ____ Observe and note posted prices, fees, and rates. ____ How many cash registers are in view? ____ Condition of office, including quality of furniture and equipment. ____ Quality of factory, plant, or shop layout and appointments, including equipment, furniture, and so on. ____ Number and types of machinery and apparent condition of same. ____ Is the equipment old or apparently state-of-the-art? ____ Approximate magnitude of inventory. ____ Does the business appear to be operating at capacity or is there ample vacant room? ____ Is what you know of owned/leased vehicles and equipment consistent with what you observed?

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5.11 BUSINESS WALK-THROUGH CHECKLIST

____ ____ ____ ____

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Apparent number of employees in various job functions. How busy does the staff appear to be? Are the phones ringing? Is what you know of employees (particularly family and friends) consistent with what you have observed?

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THE BALANCE SHEET Few have heard of Fra Luca Pacioli, the inventor of double-entry bookkeeping; but he has probably had much more influence on human life than has Dante or Michelangelo. — Herbert J. Muller

CONTENTS 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9

Overview Cash Petty Cash Accounts Receivable Inventory Work in Progress Prepaid Expenses Fixed Assets: Property, Plant, and Equipment Notes Receivable

62 63 68 70 77 78

79 81

6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18

Intangibles Accounts Payable Accrued Expenses Loans and Exchanges Loans to Officers, Owners, and Shareholders Loans and Notes Payable Payroll Taxes Withheld Sales Taxes Payable Equity

82 84 85 86 86 90 91 91 92

OVERVIEW. The financial statement presentation has two major components: the balance sheet and the profit and loss statement (the latter often referred to as statement of operations, income and loss statement, and so forth). The balance sheet deals with the company’s assets, liabilities and equity, whereas the statement of operations deals with the company’s income and expenses. The net result of the income and expenses, a profit or a loss, flows through to the balance sheet in the form of either improving the strength of that balance sheet if a profit, or weakening the balance sheet if a loss. Even in the absence of financial statements, the financial situation gleaned from tax returns or from underlying books and records can still be set forth in the same manner. Typically, a balance sheet begins with the initial infusion of capital into the business to get it started. From there, the business, if successful and lasting, will build up receivables and inventory and will acquire and use machinery and equipment, desks and furniture, and so forth. At the same time, the business will also incur accounts payable and perhaps borrow to acquire assets. If the business is successful (if it makes a profit), over time its assets will increase faster than its liabilities, thereby giving the business a positive net worth. Conversely, if the business is unsuccessful, or if its success fluctuates so that in the aggregate it has incurred losses, then its liabilities will exceed its assets. If it was initially capitalized 6.1

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with sufficient funds, that initial capital will get depleted and the business will (from a purely book value point of view) be worth less than when it started. A business’s balance sheet is a reflection of its book value, its assets minus its liabilities. While the balance sheet and the net book value are important accounting concepts, as to the valuation process, they are merely a starting point and almost never a finishing point. All too often, in disclosure statements filed in a divorce, the value of a business is stated at book value or less, as if that were the actual worth of the business. Certainly, that might be true, though it rarely is. The business might be worth more than its book value because of: • Depreciation taken for tax purposes at a rate that exceeds economic depreciation, thereby resulting in unrealistically low values for fixed assets • Land owned by the business for some years that is stated at its original cost, as contrasted with a much greater current market value • The omission or understatement of inventory (not unusual when tax motivation exists) • Receivables not reflected at all or reflected below their actual value. As with inventory, this is often tax motivated • Accounts payable or other liabilities being carried that will never be paid and that remain on the books only because of inertia or the desire not to take them into income (removing a nonexistent liability generally results in realizing income of an equivalent magnitude) • Inventory carried at LIFO (last in, first out) and as a result it is inherently understated (legitimately so, for tax reasons). Of course, the other side of this concern is that the balance sheet’s statement of the business’s net worth could be overstated: • Accounts receivable might be carried on the books without adequate provision for uncollectibility • Inventory may be reflected at values that are not realistic in light of slow moving items or obsolete items that can no longer be sold at their carrying value • Machinery and equipment may be depreciated slower than economic reality. The general point is that we cannot accept a balance sheet as presented as the determinant of business value even if it is an audited (certified) financial statement. Goodwill is virtually never stated in a business’s balance sheet, unless that balance sheet includes an acquisition that occurred at a price above book value. When goodwill has been developed internally over the years, it is probably accurate to say that the financial statements will never reflect that goodwill. Therefore, we must investigate the various components of the balance sheet and determine the extent, if any, of goodwill. To perform this function, we analyze the company’s balance sheet simultaneously with the company’s statement of operations (income and expenses), since the two are inexorably entwined. This chapter analyzes, in depth, the various relevant components that make up a company’s balance sheet. 6.2 CASH. The presence of a cash balance on a company’s balance sheet is simply a reflection that at a certain point in time (the balance sheet date) the

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company had a certain amount of money in the bank. A lot of cash does not necessarily reflect a healthy company; nor does a paucity of cash necessarily reflect a weak company. It must be kept in mind that the statement of a cash balance refers to a particular point in time; the balance changes all the time and at any point in time it can be unusually high or unusually low. In many businesses, the year-end balance is often low because many bills have been paid prior to the year end for tax deduction, thereby depressing the bank account balances. When dealing with an unincorporated entity that does not maintain its own separate set of books including a balance sheet, it is important to ascertain the extent of its cash account balances at any particular point in time. Too often with these businesses we do not have the benefit of a professionally prepared general ledger. Generally, for corporations, partnerships, and business entities larger than a small sole proprietorship (often referred to as a Mom-and-Pop operation), we have adequate records to clearly establish the cash balance at a particular point in time. For our purposes, cash includes funds in a checking account, money market account, CDs, savings accounts, and the like. A number of procedures are commonly employed when investigating and analyzing the cash part of the company’s balance sheet. Performing an overview of the company’s disbursements journal and gleaning an understanding of the cash flow (funds coming in and funds being expended) becomes important in the investigation of the cash accounts. One very important step in reviewing the disbursements from the company is to note all payments to the business owner (depending on the magnitude and frequency, we might note the significant payments only). These can be far more substantial and frequent than mere paychecks. For example, the owner might be taking funds as loans and paying them back later, if at all. Or, the owner may be taking reimbursement for alleged out-of-pocket expenses. Payments could also be reimbursement for other reasons, bonuses, payments on behalf of third-parties, etc. In all cases, we must know how these checks were posted in the company’s books. This investigation can be very important even if the conclusion is that no payments were made to the business owner. The negative implications of there being no payments is of considerable interest. That is, if during a reasonably representative period of time (for instance three months) the business did not write any checks to the business owner (whether it is for salary, loans, or whatever), nor any checks payable to cash which might have been cashed by the owner, then the obvious question is how did the business owner (and, by extension, the business owner’s family) manage during that three-month period? How were personal bills paid, how was the mortgage paid, how was food purchased, and so on? Clearly, some people have the wherewithal to continue, even in the absence of a positive cash flow from that business. However, for most people, the business is the most significant source of income; they generally cannot manage without it, even for a period of a few months. Assuming you find one, two, or several checks per month from the business, you should prepare a schedule noting the date, the check number, the payee, and any other information you can obtain from inspecting the check, such as the bank it was cleared through, the endorsee on back of the check, account numbers listed on the check, and so forth.

Payments to the Owner.

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This schedule of checks to the business owner, or to cash, then serves as a basis for determining the total magnitude of disbursements to the business owner. It is also a basis for tracing checks from the business to the personal bank records. This step is crucial in the work of the investigative accountant: access to not only the business records but also the personal bank records of the individual is an absolutely essential part of the financial investigation of a closely held business involved in a divorce litigation. Your job would almost never be complete without review of the personal bank records. When we compare the personal account deposits with payments from the business we are looking to trace the net paycheck, not the gross amount of pay. That comparison is also helpful when we look at the standard of living to test the reasonableness of stated expenditures, and to test the correctness of income, both as reported and as found deposited in the personal bank accounts. These matters will be discussed in much greater detail in Chapter 9, which deals with personal financial analysis and investigation. As practicing accountants and attorneys well know, a closely held business is often an extension of the owner’s personal finances. One should investigate not only banking documents but also brokerage records and anything else that involves the movement of money. These matters are also discussed in much greater detail in Chapter 9. Tracing the Flow of Funds. Having established the importance of access to the personal records, and assuming that we have gained access to those records, it is important for us to trace the flow of funds. Can we account for all, or nearly all, of the money being drawn out of the business account going into the personal account? Certainly at least some checks have been cashed and therefore you will not see a complete trail. For these checks, consider the amount unaccounted for, and whether possible uses are reasonable in relation to the individual’s lifestyle and financial situation. One or two isolated transactions that may not seem appropriate would probably not be sufficient for us to conclude wrongdoing, unless of course they involved significant amounts. For example, if out of 52 paychecks during the year, we are unable to trace three of them, it would be logical to presume that they were cashed and that, in relation to what we know of their finances, the money was properly used. Thus, unless we have strong suspicion otherwise, we would accept the explanation that checks were cashed and the money was innocently spent. On the other hand, if we find two semiannual bonuses of $20,000 each are unaccounted for, then such an explanation is unacceptable and we would certainly question the whereabouts of that amount of money. One of our functions in divorce work related to the marshalling of assets is determining what assets there are. We accomplish this by investigating until we get a fairly accurate overall picture. In some cases, our roles are more limited. For example, we are asked specifically not to look into the personal net worth but to deal only with a business, or perhaps merely to give tax advice or financial consulting relating to a divorce. In cases requiring more general accounting services, we need to ascertain the correct and legitimate income generated by the business and flowing through to the individual, as well as the business value. We also need to investigate whether funds have been secreted, hidden away from us, perhaps in accounts not known to our client, and whether the statement of net

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worth (disclosure statement or the like) prepared by the other side is materially misleading. Therefore, when we see significant sums of money, we must determine with reasonable certainty where those funds went, that is, how they were disposed of. When reviewing a business’s income flow, an important observation is to what extent, if any, cash is deposited. Many receive at least some income in cash, and often more than they are willing to acknowledge. Depending on the type of records maintained by the business, there are different papers to review and different approaches to take to determine the extent of cash reported by the business. For example, many professional practices maintain day sheets or collection sheets where the day’s receipts are recorded. Sometimes, these sheets separate the collections into three categories: checks, charges, and cash. Assuming at least some veracity to those sheets, we would expect to see a consistent level of cash being recorded. However, recording cash on those sheets does not necessarily mean that it is reported elsewhere. Nothing unavoidably connects those day sheets to the bank accounts or to bookkeeping and accounting records. That is, merely because one set of records, maintained for a specific and important nonfinancial reporting purpose, reflects the receipt of cash, such cash does not always find its way into the bank account and reported figures. Regardless of the types of records maintained, most businesses deposit their income using deposit slips. As a result, there is a trail, a set of documents which reflects the amount and frequency of cash being deposited. The typical deposit slip has a separate listing line-by-line for each check and a box or a line at the top of the deposit slip for cash. When dealing with a typical retail operation, it is pretty much a waste of time to bother with the deposit slip method of determining the accuracy of a business’s reported income. Cash is so prevalent in a retail business that of course it will deposit cash; it is just not obvious that some of the cash is not being deposited. On the other hand, when cash is regularly received, it might be such a small portion of the receipts that it could go unnoticed without a review of the deposit slips. In these situations, the deposit slips should be very illuminating. In a case a few years ago involving an auto body repair shop, where cash obviously was received regularly, our thorough analysis of two years of deposit slips showed that cash represented a fraction of a percent of the total deposits. Our analysis, and ultimate testimony, relevant to this anomaly had a significant impact. How Cash Is Handled.

When multiple accounts are maintained, care must be exercised in arriving at any conclusions regarding the disposition, source, and total magnitude of funds. Many businesses maintain two or more bank accounts for various reasons, including the need to maintain relationships with different banks, having a payroll account besides a regular account, protecting funds in excess of the FDIC insurance limitations, or perhaps for convenience to multiple locations. As a result, it is also not unusual for funds to be moved between these accounts, in a sense artificially inflating the amount of the deposits, which would, at first glance, appear to be the gross revenues of the company. Most of the time, if the books of the business are maintained in reasonably good order, these transactions are easily enough identified and segregated, and Multiple Accounts.

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therefore this financial activity does not present any problems to the investigative accountant. However, when the records are not well maintained, caution must be exercised so that we recognize whether a disbursement from one account is actually one and the same as the deposit into another account. The author has had cases where disbursements and deposits were wrongly represented as that type of wash transaction. In one instance, the amounts disbursed and deposited were not the same. In another instance, there were several days between the withdrawal and the deposit, which was not common practice. In the former situation, some of the funds were being retained by the business owner. In the latter situation, the business owner was borrowing company funds. While perhaps not totally proper, it was more of a tracing nuisance than it was of any great consequence. However, it did lead us to find other accounts through which this money was being used for personal reasons, before coming back to the company into another account, as if it had never left. The reality was that there were more financial events than initially acknowledged. When dealing with certain types of businesses, mainly law firms, there are not only the usual operating bank accounts, but also one or more trust accounts. Typically, client money is deposited and remains in those accounts pending the rendering of services, at which time the funds have been earned and the attorney is entitled to withdraw them. As you might imagine, this type of an account also gives that professional an unusual degree of flexibility and power over the extent of the income reported and certain other transactions. From an accounting perspective, there is often an interesting observation as to the existence of the trust account on a law practice’s books and records: it is not there. For many small firms, the trust account, inasmuch as the funds are not assets of the practice, simply does not exist on the books. While the general ledger, and as a result the trial balance, financial statements, tax returns, and the like, will reflect accounts such as operating cash, receivables, fixed assets, and payables, many times the trust account is not listed. If, however, it is listed correctly, there will be an offset, probably dollar for dollar, reflecting a liability back to the clients. As we all know, the money in a law firm’s trust account, until earned by the practice, does not belong to the firm but rather to its clients. However, as investigative accountants, we know that the trust account also gives a firm the opportunity to play deferral games relevant to reporting income. For instance, it would not be unheard of for a law firm with a substantial fee earned in late December, and with the funds in its trust account, either not to bill that fee until January or perhaps to bill the fee but not transfer the funds from the trust account to the operating account until January. By this simple maneuver, the firm has gained a one-year deferral on the taxability of that income. With a divorce situation, the more important goal may be to understate the practice’s income. This, of course, has the dual impact of reducing both the practitioner’s income and the value of the practice, since valuation is usually tied very closely to income. For law firms that actually keep their books on an accrual basis, this in theory would not happen. On an accrual basis, whether the money was removed from the trust account or not, since it was earned, it would be reflected as income. However, even in an accrual basis system, the recognition of income can be easily avoided by simply not billing it. Then, unless we were to go the further step of

Trust Accounts.

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fully determining and appraising the extent of work in progress (unbilled time), it would still be possible to avoid timely recognition of income. PETTY CASH. Don’t let the moniker fool you; petty cash is often not so petty! It is not unheard of for a business or professional practice to run as much as a few hundred or even a few thousand dollars or more per week through its petty cash account. Ostensibly, the business will need funds available for lastminute purchases, COD deliveries, miscellaneous office supplies, and the convenience of the personnel. In fact, all of these may be legitimate expenditures and the petty cash fund completely virtuous. On the other hand, it might not surprise anyone that often funds dispensed out of petty cash were signed for by the business owner, or perhaps are without signature. What type of documentation is offered for the use of petty cash? Normal expenditures must be accompanied by checks, receipts from independent parties, or other documentation of substance. With a petty cash fund, the documentation is often little more than an internal office chit which actually proves nothing, and often requires no more than a signature affirming its validity. Generally, where we are satisfied that the signature on the chit is an employee’s (who is not a relative), absent a strong reason to believe otherwise, we can be satisfied that the purpose for the use of the funds is legitimate. However, when the chit is signed by the business owner or some close friend, or when a substantial amount of funds have been withdrawn without signed chits, it is possible, if not likely, that this area is being abused by the business owner as another avenue for indirect compensation.

6.3

ACCOUNTS RECEIVABLE. The accounts receivable are usually among the largest assets in almost any business, and in a professional practice they are almost guaranteed to be the largest asset. Therefore, they warrant particular attention. Of course, before you can address accounts receivable, it is helpful to know if they are even stated on the company’s book and records. Many cash-type businesses —virtually all professional practices, and many smaller businesses, especially where inventory is not a major issue — report on the cash basis and often so maintain their books and records. The receivables are reflected on what amount to side records, which are not part and parcel of the company’s general ledger. These records can be in a simple bucket of patient cards, or in a fairly sophisticated computerized run. When the company maintains a full accrual set of books, analyzing the accounts receivable is somewhat easier, but not materially different. The steps remain essentially the same. However, when receivables are on the books, there is a completed set of transactions where you can track the actual sale to the accounts receivable, and from the accounts receivable you can trace to the collections. In a typical cash basis system, this cannot be accomplished so easily. One of the first steps in reviewing accounts receivable is to obtain an aged schedule. It is essential to determine not only the full amount of receivables, but also a good estimate of the amount realizable, that is how collectible they are. Note with particular attention those receivables that are over 90 or 120 days. Keep in mind also what is considered normal for the industry, assuming that type of information is available. This procedure can cut either way. The company may be taking, typically for tax reasons, a particularly aggressive position as to receivables 6.4

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and writing off large amounts of receivables which soon thereafter are collected. Alternatively, perhaps through inertia, lack of attention, or even the need to maintain a greater than correct value for lenders, companies sometimes will carry receivables on their books which should have been written off long ago. In reviewing the accounts receivable, the methodology and the frequency of writing off receivables may come under particular scrutiny. We need to determine whether some receivables were collected but somehow not recorded on the books (of course, further analysis would have to be done to establish a credible position). This might be the case when receivables are collected in cash, typically when the owner makes the rounds and actually collects funds. Sometimes, receivables are collected in the form of barter. For instance, the owner might receive home furnishings and conveniently leave the receivable from the furniture store on the books for some time, and then eventually write it off. If we notice a pattern of receivables written off, especially if from a good and still active customer, the situation could involve merely honest disputes as to the quality or salesworthiness of the product, or it could also be payments by cash or barter. This approach is not an easy one to apply. In dealing with the valuation date, we merely state the appropriate amount of receivables. However, we also need to deal with the company’s income and profitability. Further, when we are dealing with a business which does not operate on an accrual basis, we need to reflect not merely the receivables at the valuation date, but also the change in receivables from year to year. If a business is growing and the receivables are increasing $100,000 per year, there is another $100,000 per year that needs to be reflected in the company’s operations that, because of the cash basis system employed by the company, has not been so reflected. Not to reflect these changes in receivables would, in the operational part of your report presentation (and ultimately in your determination of value based on the company’s operational history), depending on the extent and magnitude of the change in receivables from year-to-year, tend to distort the results of your analysis. Indeed, you certainly cannot simply add the cumulative accounts receivable that you are first giving a life to in your report to the last year of your operational presentation. The information gleaned from accounts receivable can be used for more than merely adjusting the balance sheet and statement of operations. A review of the accounts receivable schedules may reveal one, two, or several customers who would appear to be essential to the company, or perhaps an accounts receivable that is being carried for an unusually long period of time. In the former situation, that information can be very useful in understanding the type of business involved, with its exposures to major customers and involvements that it may have with those customers. It may also suggest the possibility of a related party situation in that many times a company’s largest customer is another company owned by the same or similar interests. That realization might lead you to expand your discovery efforts and to extend the investigation in new directions. Or, your review of accounts receivable (recognizing that you are reviewing receivables, not sales) might reveal that there appear to be no customers of any particular importance to the company. This, too, is important information since it indicates that the company has a well-diversified customer base, and therefore probably not subject to concerns about being too heavily weighted with one or two key customers.

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If you notice large receivable balances being carried for an abnormally long period of time, the obvious concern is about their collectibility. There is also the possibility that you have found a related party situation and the companies just have not bothered collecting from one another. In that situation, the company you are investigating probably should have received interest on that receivable. Depending, of course, on how large the receivable is, this might be an item of note. After all, if a related party owes a million dollars and is carried on the receivable list for a couple of years, even at 8 percent, it represents $80,000 a year of lost income because it is not in the hands of the company being investigated. The impact on the other company is another issue and would have to be addressed in the analysis and investigation of that company. When adjusting a company’s balance sheet for accounts receivable, you should also reflect (either as a direct netting against the receivables, or perhaps separately under the liabilities) the estimated tax burden that the company will incur upon the collection of those receivables. Reconstructing Accounts Receivable. Occasionally, particularly when dealing with a smaller company, we are advised that no receivable records are maintained and therefore the amount of the receivables is unknown and no figure can be provided (and, typically, while the company can be compelled to relinquish whatever records it does have, it cannot be compelled to create records for our convenience). There are, however, alternatives that enable the investigative accountant to determine a reasonable approximation of receivables. For many companies, the level of accounts receivable fluctuates within only a fairly narrow range. Therefore, if we have a trustworthy receivable number for the present (that is, by totaling the open receivable cards or an open invoice file of some sort), we can assume that receivables at the current time are reasonably close to the receivables of several months earlier or of various other previous dates. If sales have been fairly constant (with an emphasis on the past couple of months), as compared to where they were at the time of valuation, then logically the receivables should also be approximately similar. If sales are 50 percent greater, then logically the receivables would be about 50 percent greater. A very basic approach for determining receivables at a specific point in time is to undertake an in-depth analysis of collections for 30, 45, and 60 days subsequent to that date. In some situations, that time frame might need to be extended to 90 days or more. From that analysis, we should be able to ascertain which of those collections represented sales from dates prior to the valuation date. Another approach is to look at the company’s collection experience and extrapolate a figure based on that history. For instance, if your analysis of the company’s sales and subsequent collections suggests that the company routinely collects its receivables in 60 days, then it would likely be reasonable to assume that at any point in time the receivables equal the last 60 days of sales (approximately two months, or one-sixth of a year). Of course, the issues of collectibility, old receivables, potential credit memos, and the like need to be kept in mind. Another approach, generally less satisfactory, is to use industry norms, requiring the major assumption that this business will fit into some published industry norm. Your review of relevant industry information might suggest that the typical company in that industry collects its receivables in 45 days. On that basis, you could calculate 45 days’ worth of receivables based on the annual sales or,

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perhaps more accurately, by using the last 11/2 months’ worth of sales. When using industry norms, you must exercise caution that indeed the company fits within that industry and is somewhat normal. The size of the company might matter with respect to industry standards. For instance, if the information for the industry is broken down by the size of the company, it is best to do as much fine-tuning as possible. Perhaps the industry overall collects in 45 days, but small companies collect in 35 days and larger companies collect in 55 days. This type of information should be used selectively and carefully. In reconstructing receivables, give particular attention to abnormal transactions fairly close to the valuation date. For instance, was there an unusually large sale within the last several days before the valuation date? That event would distort any calculation of receivables based on approximations and recent sales history. That distortion can go in either direction. If this unusually large sale received special terms, you would need to factor that into any calculations so as not to distort an accounts receivable calculation. Alternatively, it is possible that with a large sale, special arrangements might have been made (especially if the company you are valuing is relatively small) to partially or totally prepay it. In that case, the receivables may be far smaller than you would otherwise expect. Provision for Bad Debts. While this issue will also be considered in Chapter 7 dealing with bad debt expense, a few words are necessary relevant to the balance sheet item that is a provision or allowance for bad debts or uncollectible accounts. As cautioned before, the reader should keep in mind that tax propriety (and whether this provision is used at all for tax purposes) is not relevant. We are dealing here with economic reality (or someone’s attempt at interpreting economic reality), and must recognize that whether or not the Tax Code permits a provision for bad debts is irrelevant for our purposes. This account represents an offset to the receivables, a negative asset. Since a bad debt account is virtually unique in its subjectivity, we must determine if its balance is reasonable. That is not to say it need be exact (certainly it probably never can be), nor that we need an ironclad assurance that it is accurate within $100. We need only be convinced that it is reasonable. For instance, we might review past years to determine how closely the provision for bad debts compared to the actual amount experienced. If the company’s actual history was consistent with its provision for bad debts in those years, and if the current (valuation date) approach to determining the reserve for bad debts is consistent with the one used in the past, we can probably accept the figure presented on the company’s financial records. Further, the makeup of the company’s current receivables and sales must be sufficiently similar to those in the past to permit relying on past performance as an accurate barometer of the present. We need to be satisfied that the company’s rationale for writing off bad debts on a provision basis (as contrasted with an actual account-by-account basis) is logical and consistent with the company’s previous economic performance. For instance, is the company’s assumption that 50 percent of all receivables over 120 days will not be collected reasonable? Again, if available, industry norms can be most helpful. It is important to note that industry-based statistics are also helpful in that they give the investigative accountant an independent and unbiased basis upon which to rely. Third party authority is most desirable, as contrasted with the accountant’s opinion standing alone. An accountant’s testimony would

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not be very convincing if it were basically nothing more than that in the accountant’s opinion the company’s approach was unreasonable and the accountant’s approach was superior. When we review a company’s books (and, of course, when receivables have not been maintained as part of those books), it is not unusual for the company (even when it does reflect receivables on its books) not to reflect a provision for bad debts. That is, the company’s books reflect the receivables at 100 percent face value. In most situations, this is probably improper from the perspective of an unbiased view of the company’s financial situation. Even if the company does not reflect a provision for bad debts, we must come to some overall conclusion as to the collectibility of the receivables, and the need for a provision for doubtful accounts. Not to do so would suggest that the receivables are 100 percent collectible. While that is certainly possible, it is a conclusion that should be reached, not an inference that is merely allowed to happen. INVENTORY. In many businesses, the largest or second largest asset on the balance sheet is inventory. For the investigative accountant, it is also perhaps the most difficult balance sheet item to investigate properly. As every accountant practitioner knows, inventory is one of the first places a company looks when it seeks to manipulate the balance sheet. (Generally, this means to understate inventory for tax purposes, and to overstate it for financial statement purposes.) It is a relatively easy matter, in the process of closing out a company’s year in order to prepare its tax returns, simply to pick a number that is actually $10,000, $50,000, or $200,000 less than the true inventory. This will save taxes in an amount commensurate with that company’s tax bracket. It is just as easy to overstate the inventory by similar amounts when the goal is to improve its financial statements (basically to defraud a lender). In both situations we assume that we are not dealing with audited figures but rather those supplied by management without independent CPA verification. Although outside the scope of this book, even in audited financial statements, inventory may be overstated (understatement is not usually a concern when dealing with audited financials) as a result of falsified records or subterfuges deliberately intended to mislead the auditors.

6.5

One of the problems in reviewing the inventory to determine whether it has been accurately stated, is that we often do not have the benefit of verifiable financial evidence for the inventory figures. Unlike assets such as cash (where bank or brokerage statements offer very easy tracing), fixed assets (where there is a depreciation schedule and invoices in support of the acquisition of same), or receivables (where there are sales invoices or accounts receivable detail runs that can be reviewed), inventory commonly has no such records, especially in smaller and medium-sized businesses. Even when there are such records, often no one is acknowledging that they exist, and even the company’s accountant has no firsthand knowledge of their presence and no connection with them. On many occasions, in response to a request for documentation in support of the inventory, I have been advised that it was counted at that time or estimated based on a certain formula, but that no support was maintained and that counting sheets that did exist at one time are no longer available. There is not much that can be done when the records do not (or allegedly do not) exist. Yet, inventory is Support for Inventory Determination.

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a large balance sheet item with a crucial impact on the company’s profitability and, therefore, net income. The most basic way to appreciate a business is to walk the floor. See what is there and, based on that inspection, estimate the extent of the inventory. It might help if your walk-through was unannounced so that, if the business would take precautions, it has not moved goods and hidden inventory from you. In most cases, you simply cannot show up unannounced and expect to walk through the business. However, if you are there doing your work for a few days, it is unlikely that the business could afford the disruption necessary to hide inventory from you. Furthermore, most businesses are unaware that you are going to do this anyway. There are at least two shortcomings to this approach. First, it is done at the current time, as contrasted with the need to address past inventory. That problem can be satisfactorily addressed in a manner similar to that discussed for determining accounts receivable when records are insufficient. That is, if current inventory is $100,000, then, subject to many modifications, inventory was $100,000 11/2 years ago at the valuation date. The other problem is perhaps a more basic one: How many accountants could actually walk through a business and determine the dollar value of the inventory. Relatively few are sufficiently knowledgeable about the particular items of that business and their costs. Even when you have that expertise, in many businesses the nature of the items is such that you might have to spend a considerable amount of time determining how many size 6 1/2 bolts there are as contrasted with 6 5/8 , with 91/4 , and so forth. Many times, the most effective manner to determine the value of an inventory, especially one with many small parts, is to weigh them. Only rarely would you be fortunate enough to have that option. You might consider having an industry expert accompany you in such a company walk-through. Even then you still may be hampered, but at least you have improved the opportunity of getting a realistic count. It is not easy to accomplish, but you might walk through with a camera and snap pictures. Do not expect easy acceptance of that idea by the owner. Even with photos, you may still encounter the same problems in determining value. Finally, many types of businesses and many types of inventories do not lend themselves to such an easy analysis. A walk-through might be a good way to determine the number of cars on a dealer’s lot, but it is merely a beginning for the determination of the amount of finished goods, work in process, and raw materials in a manufacturing operation. Several other methods, other than walking the floor, can be used to determine the inventory of a business: • The reasonableness of the inventory compared to the capacity or floor space of the business. Particularly for a retail store, inventory can be estimated from the size of the store and the nature of the product sold. Of course, inventory will vary with the season. In some businesses you might expect a huge inventory in early December, in other businesses inventory might peak in March, July, or whenever. But knowing those factors, if we were to assume a retail dress store that covered 5,000 square feet, we would question a stated inventory of only $20,000. That amount would be far too low. Of course, that conclusion is not the same as having determined the correct inventory. We know only that what is stated is illogical and clearly understated.

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• Industry standards. As indicated in the preceding item, floor space alone can give you a near guarantee that an inventory is significantly understated but that fact does not really help you determine how much inventory actually existed. Using industry norms, you might be able to determine what the inventory should be. You also need to know the time of year involved and the time of year those industry norms referred to. It is generally much different to view the inventory a few weeks prior to the Christmas buying season as contrasted with just after it, or before and after Mother’s Day. Alternatively, if we are dealing with a manufacturing operation subject to many variables, the industry norm might be to have a raw material inventory to cover 30 days’ production, and typically a work in process and completed goods inventory representing 15 days’ production. As flawed as these measurements might be, they are still better than guessing and they have the strength of providing an independent industry source. • Inventory turnover. This is related to the previous item inasmuch as it requires some knowledge and documentation of what is normal for the industry. Here, however, we are dealing with the number of times a year you would expect the inventory to turn over, that is, how many times per year the stock has to be replaced. For instance, if in the past year a business purchased $1 million worth of product and its average inventory was $200,000 at any time, then its turnover was five times; its purchases were five times as great as the average inventory it carried. The inventory turnover ratio is very commonly used to help management determine the efficiency of its operations. It also helps the investigative accountant to determine, from a quick review of the situation, if the inventory is within reason compared to the sales of the company. It is not all that unusual, in a closely held business, to see an inventory turnover of 20 times a year when the industry norm is eight times. This would suggest that the inventory is significantly understated and appears to turn over more often than it really does. It can also be the perfectly legitimate result of great efficiency expertise exercised by the business owner, who keeps the costs down by minimizing the inventory on hand. We cannot assume merely because the inventory turnover is considerably greater than the industry norm that in fact there is an understatement of the inventory. • End-of-year purchases. One common method of understating inventory is to build it up so that there is ample room to then understate it. The idea is that when the normal level of inventory is perhaps $100,000, there is not much room to understate it for tax purposes. On the other hand, if at the end of the year you buy an extra $50,000 so that the inventory value becomes $150,000, you then have much more room to understate it. (This, of course, assumes the practice is sound and that the business owner anticipates that these goods will be sold in short order.) In this situation, you could state the inventory at, for instance, $80,000 and instead of merely sheltering $20,000 versus the normal $100,000, you succeed in sheltering $70,000 of income because the $50,000 of purchases have been expensed rather than stated as goods on hand (inventory).

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One way to approach the validity of the inventory in this situation is to review the previous month’s (and especially the previous week’s) purchases. Note particularly those that were posted via general journal entry and especially the last-entered invoices. Those items would either be on hand at the end of the year or they should be accounted for in end-of-year sales. Depending on the degree of sophistication of the accounting system, you might even have an inventory printout with which to compare. For example, if on the last day of the year there is a purchase of 45,000 size eight bolts, and if you have further determined that there were no corresponding sales of those bolts within the last couple days of the year, and if the inventory printout detail lists only 10,000 of those bolts on hand, then there is the excellent likelihood that at least 35,000 (and, more likely, all) of those bolts were omitted from the inventory count. • Subsequent shipments. Somewhat the complement to the preceding item, we can sometimes determine the correct inventory, or at least approximate the understatement of that inventory, by analyzing the immediately succeeding sales. Further, this can be done both from the point of view of total volume and, if possible, on a product-by-product level. For instance, if at the valuation date (typically at year end) inventory was stated to be $100,000, and if, for instance, within the two weeks after that date the company shipped $200,000 worth of its products (the cost of the products, not their sales price), and if further it can be determined that sufficient additional inventory was not received in those ensuing two weeks, then it would seem impossible for that company to have sold $200,000 worth of product when it had only $100,000 worth of product on hand. This analysis assumes that the company is selling what it has on hand, as contrasted with anticipatory selling, and that our analysis is valid. In such a case, it is clear that the company almost certainly had another $100,000 of inventory on hand, and since most companies rarely sell all of their inventory, it likely had at least $150,000, if not $200,000, of additional inventory. Of course, in order to be able to do the aforementioned analysis, and virtually any other analysis, it is important that the investigative accountant understand the nature of the company’s business, the type of products it sells, what it does to that product after it receives it, and other matters such as turnaround time, ordering procedures, how goods are recorded when received, and how goods are relieved from the books when sold. In some companies it is not unusual to use two sets of sales invoices. One set, the one that you will more likely be given, is the same as those given to customers. That invoice lists the products sold, the serial number or some other description, and the sales price of the product. However, many systems have a second type of invoice maintained only for the company records, which also includes (in a section typically blocked out for the customer) internal costing. These types of invoices will reflect not only the information just described but also give the cost of that item directly from the company’s records. This provides an excellent source of information as to gross profit and how the inventory should be relieved from the books. We also need to know the method used to track inventory: the FIFO (first-in, first-out) basis; the LIFO (last-in, first-out) basis, the retail method (backing into

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an inventory based on the standard gross profit percentages), a moving average method, or the well-known “what is the lowest number I have to show, and how much can I get away with.” A highly infrequent approach, but one which should be considered in the extreme case, is to attempt an actual current count. When the approaches described above are inappropriate for various reasons (such as, the company is different than it used to be, it has grown substantially, or the other approaches simply cannot be done), the only resolution may be to do an actual independent count. While intriguing, there are, of course, a number of problems with this, not the least of which are getting permission and paying for it. However, if the stakes are big enough and if you can show your need convincingly enough, this is certainly an approach worth considering. The accountant should be especially concerned as to the extent of inventory when the company maintains two different reporting dates. It is not unheard of for a company to set its fiscal year end at different times for tax return purposes than for financial statement reporting purposes. Typically, the reason for this is greater flexibility in balancing tax reporting needs (which generally means reflecting the lowest possible profit), with financial statement reporting needs (which, since the statements go to lenders, generally means reporting the highest possible profit). Absent the flagrant maintaining of two sets of books, or any flagrant, fraudulent misrepresentation in those books, one way of meeting these opposing needs is to maintain two different accounting years, that is, a December 31st year end for tax reporting purposes and a September 30th year end for financial statements. When this situation exists, it is very likely, especially in a growing and profitable company, that those two sets of figures will have significant differences in sales, inventory, and gross profit. Inevitably, the greater sales, the greater gross profit, and the greater inventory will be on the financial statements as contrasted with the tax return. In such situations, the valid set of figures is the one presented in the financial statements. It would be reasonable to assume from the beginning that the tax return figures are not reflective of the company and can be totally disregarded. Pyramids. A complex and interesting problem with inventory is that understatements of inventory, and the resulting need to correct those understatements, tend to have a pyramiding effect. A business that finds need to understate inventory by $20,000 in one year, assuming that it continues on its profitable ways, will likely find need in the following year to understate the inventory by $30,000. Because the business has already understated the inventory by $20,000, it must in the second year make a cumulative understatement of $50,000, so that in the second year it can understate profits by $30,000. This is because the inventory at the end of one year is the same inventory with which you start the next year. In the example just given, year two starts with an inventory that is already $20,000 understated. If, at the end of year two, it is deemed desirable for tax purposes to understate that second year’s profit by $30,000, then $30,000 must be added to the already existing $20,000 inventory cushion, resulting in a cumulative $50,000 reserve. In a growing and profitable company, it is not far-fetched that in a space of five years, the inventory will be understated by $20,000, $30,000, $50,000, $70,000, and $100,000 per year, respectively, which has a cumulative impact of $270,000. Therefore, in such a situation, we would have annual adjustments to

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reported income, annual adjustments to the inventory, and, at the valuation date, a cumulative adjustment to the inventory of $270,000. In determining the extent of unreported income, we must keep in mind the cumulative impact of changes in the inventory. If not monitored carefully, we might wind up with results that are untenable. Because of the complexity of inventory accounting and because of the cumulative year-to-year impact, we may wind up with numbers that are insupportable and illogical if we start out in the wrong direction or with too high of a gross profit. Even the best and most considered approaches need to be rethought. Sometimes it is important to step back, look at your conclusions from a distance, and see whether they are illogical. WORK IN PROGRESS. Work in progress is an asset, a hybrid of receivables and inventory, generally relevant only to professional practices, usually only for law and accounting firms. Except for a truly sophisticated accounting system, work in progress is rarely on the books. That absence does not suggest anything improper, only that reflecting it requires a sophisticated system which many professionals, especially smaller firms, find unnecessary and too cumbersome and expensive to implement. Nevertheless, many professional firms do have work in progress, and in some of those firms, major dollars are involved. Unfortunately, in many law firms, because of either lax billing procedures or the particular nature of the work, it is far too large an asset. It should be rather obvious that law firms and accounting firms have significant work in progress. After all, these professionals are typically busy generating billable hours, which, in many firms, accumulate for at least a month before they are billed. The common practice, generally more so in law firms than in accounting firms, is somewhat lax towards forcing the billing out of work in progress. At the end of any month, it would not be unusual for a firm to have 90 days or more worth of time invested in work in progress. This time has not been billed to a client and therefore is not a receivable. However, it is an asset in that it is time due to be billed. From an accounting point of view, it is inventory or unbilled sales. As with receivables, work in progress must be evaluated for its collectibility or, in a sense, its billability. While aging per se may not be a prominent aspect, work in progress is often even less of an asset than receivables, inasmuch as it has not been billed. In some cases there are good reasons for that lapse. For example, the professional suspects that billing would be a waste of time and therefore is reluctant to do so. Work in progress can be found even in professions where one might least expect it. As an example, depending on the internal bookkeeping practices, a medical practice might have work in progress in the form of patient services that have yet to be billed to the insurance companies. Rather, the forms to be submitted are sitting in a bin, waiting for clerical personnel. In an efficiently run practice, this might be virtually nonexistent. In a less efficient practice, these can amount to as many as 60 or 90 days of services. In some practices, these would have already been billed to the patients, and thereby already reflected on the books (if the books were on an accrual basis) and considered receivables. However, in many practices, especially the smaller ones, these are not treated as receivables in the same sense: they are perhaps not on the patient cards, or are perhaps maintained separately in insurance receivable files. Once billed to the insurance company, they take on 6.6

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more of the classic role of receivables, but until then they are, in a sense, work in progress. It should also be recognized that it is possible to have negative work in progress (depending on how the books are maintained), the equivalent of a credit in receivables. For example, an orthodontic practice with a long-term contract arrangement with patients might have received funds in advance of the services to be performed. The extent of completeness of those contracts must be recognized so that the investigative accountant can either reflect yet-to-be-billed services (services performed in excess of funds received but yet to be billed) or, conversely, the equivalent of a customer deposit (a credit reflecting payments in advance of services yet to be rendered). 6.7 PREPAID EXPENSES. Both accrual and cash basis businesses can have prepaid expenses. If an asset exists, it needs to be stated, regardless of the manner in which the company’s books are maintained. The area of prepaid expenses is often not of concern because its magnitude is typically not substantial, and because it tends to be constant from year to year. However, there is one type of prepaid expense which does warrant investigation: insurance. Unless we are dealing with an expanding or changing business, insurance cumulatively over a few years would likely warrant minimal, if any, adjustment to the profit and loss figures. However, especially where dealing with the escalating cost of malpractice or product liability insurance, or with a large year-end payment on behalf of the following year, there might be a material adjustment affecting one or more years. At the very least, an adjustment at the end of the time frame being investigated would have an impact on the balance sheet, causing us to add what might be a substantial asset: a prepaid expense. To show why a prepaid expense is an asset, let us use insurance as an example. If on December 31, 1995, a practice were to pay its 1996 malpractice insurance bill (and, of course, deduct it as an expense in 1995), 1995’s operations would be distorted by virtue of reflecting an expenditure in 1995 that is on behalf of services to be received in 1996. Viewing this from another perspective, if on January 1, 1996, the firm were to cancel the insurance policy, it would likely be entitled to a refund of nearly all of the premiums it paid just a day earlier. In other words, an asset exists that is available for recovery that has not been expended as yet, and that represents an item of value to the practice. Besides insurance, there is a fairly broad range of what could be considered or should be considered as prepaid expenses. For instance, maintenance contracts, taxes, office supplies, parts and supplies, membership dues, and so on. It matters not whether the expense was created by the intentional acceleration of a payment, or by the regular payment of a normal and routine business expense. The concept is the same: the business has incurred a business expense that has a useful life that extends well beyond the day or the week in which the expenditure was made. For instance, it is not unusual to prepay a maintenance contract for one or even three years. The company will benefit over time from the contract and will not, during that same time, have to pay that expense again. The payment of that maintenance contract should be reflected only partially as a current expense; that is, only to the extent that the maintenance contract is within the current fiscal year. The balance would be recognized for what it is, a prepayment of an expense

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against a future benefit. This approach applies equally to membership dues, longterm subscriptions, a major purchase of office supplies, and so forth. Unless we come across evidence of payments substantial enough to distort operational results, many of these fine points are not worth creating because they are not substantial, and especially in the light of a several-year history of the company, they would have a negligible impact on anything but the balance sheet at the end of that time frame. Even then, the impact might be relatively minor. Prepaid taxes can be a surprisingly large asset, though one would expect, if the accounting records are well maintained, there would be no need to make an adjustment for this type of item. We should not overlook the need to review tax returns when a large overpayment from the prior year is carried forward to the current year but is not reflected in the company’s books. This is appropriate whether they are federal, state, local income taxes, or other types of taxes. These prepaid taxes, overpayments from a prior year, in effect represent either a deposit against a future liability or an item that can be recovered by simply making the appropriate application to the governmental or taxing authorities. For the most part, except where distortions are intended or where a company’s size is changing significantly, prepaid expenses usually impact only the balance sheet, with minimal changes resulting on the statement of operations. FIXED ASSETS: PROPERTY, PLANT, AND EQUIPMENT. If there was any doubt as to the importance of being able to walk through the business, and if the matter of inventory did not satisfy that doubt, then it should be resolved once and for all with the issue of fixed assets. While this may not be much of an issue for a retail store (where racks and some shelving may be the only fixed assets, outside of leasehold improvements), for a manufacturer or a distribution company, it would be very important to see the company so as to better appreciate the physical properties of that business. Walk through and around that business. Compare what you have observed to those assets recorded and maintained on the company’s books and records. A starting point for knowing what is on those books is the company’s (and in many small companies it is the accountant’s) schedule of fixed assets and depreciation. Review that schedule for several years, since it is not uncommon to simply delete fully depreciated assets, even though they are still owned and perhaps of significant value. Many times, older assets, having been fully depreciated, are summarily written off as if they did not exist. That is because, from a tax point of view, we need no longer track them. However, they do exist, the company is getting benefit from them, and they have market value. Thus, a walk-through is important as well as a several-year worksheet review of fixed assets and depreciation. Sometimes the company not only manufactures goods for sale, but also manufactures, in that same able and versatile tool shop, useful goods and machines that are not sold. A manufacturing operation typically has people who not only manufacture goods and understand how to use and repair machines but also manufacture or substantially modify machines to suit their particular needs. When an operation manufactures machines for internal use, the existence of those machines is often totally unstated on the company’s books. Instead of capitalizing the manufacture of those machines by properly allocating labor, parts, and supplies, more typically (for tax reasons if none other), the labor and materials used to make these machines were classified as expenses incurred in the normal 6.8

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course of business. Correcting this accounting shortcoming more accurately reflects the reality of the company’s assets and also removes from the company’s expense structure the cost of making these machines. The result is that the company is more profitable than it showed. We also need to consider whether a company is carrying too many assets. Usually this occurs only with assets that lend themselves to personal use, for instance, furniture or cars. The determination of the business need and propriety of a particular asset is, of course, often a difficult process and is sometimes a subjective one as well. We might notice on a depreciation schedule several thousands of dollars of furniture, but no evidence that the furniture is anywhere on the business premises. One possible answer is that the furniture was purchased for, and is in the home of, the business owner. We may never be sure of that, but we rely on the inference that if the furniture is not at the business, it is probably for personal use. This issue is a bit easier to tackle with vehicles in that they are fairly easy to identify on a specific item-by-item basis. Furthermore, unless in a pool, each car tends to be assigned to and operated by an individual. If the company being investigated is carrying on its books four vehicles, if only two people have a job function that calls for the use of a vehicle, and if no unrelated employee is getting a vehicle as a fringe benefit, then the only logical conclusion is that one or both of these extra vehicles is being used for personal reasons rather than business reasons. One way to confirm such a conclusion is to inspect the repair and gasoline bills for these cars. Try to determine if the repairs were inconsistent with the reported use for the company, if the mileage indicated on the bills was consistent with the supposed usage, if the name listed on the repair bill was the same as the person allegedly using the car, if the gas bills indicated use in a state perhaps across the country (where the business owner’s child happens to be going to college), and so on. Once it has been determined that, using a vehicle as an example, it is a personal asset rather than a business asset, we now remove depreciation, related expenses, and repairs, and perhaps even the interest expense on the note issued to carry that vehicle. All of these adjustments, by removing expenses, yield a commensurate increase in that business’s income. What none of the preceding material has dealt with is the matter of valuing equipment, regardless of whether written off, manufactured internally, or acquired in the normal course of business. It would be easy enough to say that, for machinery and equipment, we need to engage an expert appraiser. The realities are that with smaller businesses, even those having several millions per year of sales, the engagement of a qualified equipment appraiser is simply too expensive, especially when the underlying fixed assets are modest. The only practical approach may be for the accountant to make the appropriate paper adjustments based on, for instance, IRS promulgated lives or some other indication that perhaps a 10-year straight-line depreciation method would be more realistic than a five-year accelerated. This is not to say that either one is correct, but only that, in the eyes of that investigative accountant, it appears to be more reasonable than the tax-motivated depreciation reflected. Depreciation will be dealt with in greater detail in Chapter 8. At times, this area gets even more esoteric; for instance, when a business had the good fortune to acquire fixed assets from the bad fortune of another business. Valuation of Equipment.

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As a result, the company you are investigating may have acquired substantial assets at bargain prices in a distress sale, bankruptcy action, or other fortuitous situation. How does the accountant value these assets? We cannot simply refer to depreciation and make an appropriate adjustment when the starting point was substantially understated. Maybe invoices are available for comparable items. Obviously, the accountant is not an expert in such areas. When it is necessary for the accountant to determine values for machinery and equipment instead of an expert appraiser, sometimes a careful review of insurance policies may be appropriate. Insurance policies may list every major piece of equipment being insured, along with serial numbers and estimated market values. While insurance values are not necessarily the same as actual market values, they are certainly better than nothing and provide an independent thirdparty valuation that is being used for a very specific purpose (that is, insurance), rather than a vague purpose, such as a divorce case. Insurance policies can be a wealth of information, not only by listing values but also by enumerating assets. On more than one occasion, through a careful review of insurance policies, we have found assets that were not previously acknowledged or reflected on any worksheets. Assuming that the business owner operates in a rational manner, the company will not be carrying insurance on assets that no longer exist. Part and parcel with the issue of fixed assets is the depreciation thereon. As an overall concern, merely establishing that assets exist and are held for legitimate business uses does not mean that the depreciation being taken is appropriate from an economic point of view. Further, when adjustments are made to depreciation that extends over a period of time, appropriate changes must be made in each and every subsequent year. In some cases depreciation will be reduced, in other cases it will be increased. That is to be expected, and part of doing the job correctly and maintaining an unbiased viewpoint. See Chapter 8 for a discussion of depreciation. 6.9 NOTES RECEIVABLE. With a receivable in the form of a note, as contrasted with the typical account or trade receivable, we need to determine what relationship, if any, there is between the parties to the note and what was sold or done that caused the company to obtain this note receivable. Unlike accounts receivable, which typically occur in the routine course of business, a note receivable (assuming, of course, that the business being investigated is not in the business of making notes) suggests a more atypical situation where noninventory assets were sold, or some other nonrecurring type of transaction occurred. Whatever the circumstances, it is important that we find out the full details underlying this unusual transaction. If it is something as significant as the sale of part of the operations of the company, then it becomes particularly important to understand the basis for that sale, why it was sold, and how the sales value was determined. This might relate to and assist in the determination of value of the overall company. It may also suggest there are problems, that the company has streamlined, or in other ways changed its operations, so that in the future, it may not be quite the same company, for better or for worse. We must also determine whether this sale was to a related party or at arm’s length. What are the time period and interest of the note? It is possible that the note might be without interest. In that case, in effect, the interest was implicitly factored into the total note. For valuation purposes, that note needs to be discounted using

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a fair rate of return. On the other hand, the lack of interest, assuming that the face value of the note was fair for what was sold, might in itself suggest that the transaction was not at arm’s length. Generally, this means that it was for the benefit of a related party, perhaps for the shareholder or some others in the family. Be especially attentive to whether the payments are being made on the note. Again, both as to the matters of value and looking into related party issues, if note payments are not current, is it because it involves a related party or is it because there is trouble as to the collectibility of that note? If the note came about from the normal course of events, typically perhaps from a large customer who owed a significant trade receivable and who then converted it to a note, you certainly need to understand the situation, and why the note came about. As such, it may suggest a potential problem; the conversion of a trade receivable into a note receivable normally means some problem collecting that receivable on a timely basis and the need for a more formalized arrangement. In that case, especially if payments are not being kept current, there may be an issue as to the true value and collectibility of that note, and as to the viability of that customer in the future. 6.10

INTANGIBLES

The first intangible to address is the potential for goodwill as an asset already on the books of the company. Among the key functions we will be rendering as investigative accountants is the ultimate determination of the value of a business, and what is often an element of goodwill in that value. In most of the businesses we investigate, the balance sheets do not reflect any goodwill. That is because, as we all know, based on accounting principles, the books and the financial statements are cost-based, not value-based. As a result, unless there has already been an acquisition where value is placed (and paid for) in excess of the allocable value of the underlying tangible assets, we will simply not have a business reflecting goodwill. However, there will be the occasion when the business being investigated, on account of the past acquisition of another company, paid for goodwill above and beyond the tangible value of the assets of the company acquired. The proper accounting treatment is to reflect that as goodwill. When that exists, two very important and very different steps need to be taken. We need to inquire as to the origins of that goodwill for purposes that might relate to the determination of the current goodwill; we also need to remove that goodwill from the balance sheet for purposes of our valuation inasmuch as we are now valuing this overall entity, inclusive of that past acquisition. Not to remove that existing goodwill, to leave it in as an existing balance sheet item, would in all likelihood create a double dip. When goodwill already exists on the books, we are presented with something that we usually do not have: a sales transaction of part of the subject company that might be relevant to the current service you are rendering. This could be either one of the best finds for us in assisting in determining goodwill, or just a complete waste of time. One of the problems inherent in our work is that we often take a position that goodwill exists, however, other than in our opinion and perhaps some theoretical analyses, we have no documented, real-world support for our position. Indeed, it would be unusual for that to exist, especially for the smaller company. Imagine our delight when we actually have a situation where goodwill Goodwill.

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has been established in advance, with a transactional history that actually gave recognition to it. Part of our burden has been lifted. When this situation exists, it is very important that our documentation request include support for this transaction and an explanation of how it got on the company’s books. We also need a copy of the contract of sale or other relevant acquisition papers. However, if this transaction occurred several years ago, its utility to us usually is seriously diminished. Companies and economies change, and conditions that lead to the determination of goodwill a number of years ago might not be appropriate in the current environment. Therefore, the more recent the transaction, the more relevant and valuable it is for our purposes. In most situations, if this information is more than several years old, it is irrelevant. Assuming you are representing the nonbusiness spouse, it would not be surprising that in response to your request for documentation of the acquisition of another company, you will be advised those records do not exist, that it was a few years ago, and no one bothered keeping copies of any papers. Of course, such a representation is in all likelihood untrue. Nevertheless, in the absence of evidence to the contrary, we may be stuck with a lack of any appropriate paperwork. One alternative, and here again the nonbusiness spouse’s assistance and knowledge can prove very helpful, is to approach the other side, that is, whoever sold out to the company being investigated. It is certainly possible that the seller maintained the appropriate records, or at least can give some input as to the underlying basis for the transaction. You might also determine whether that seller was under some form of compulsion to sell (such as, ill health, retirement, or financial difficulties), which would suggest a sale at less than fair market value. Although the values stated (assuming that any values are stated) for patent and copyright assets are totally inapplicable to current value, their existence on the company’s books may nevertheless be most telling and certainly warrant further inquiries. How did this type of an asset get on the company’s books? Was it developed internally or was it purchased from the outside? If it was developed internally, what type of work was done and by whom to develop this asset and, of course, how recently? If purchased from the outside, similar to purchasing goodwill, it is important to obtain a copy of the contract or other documentation. A practical problem with attempting to identify the value of patents or copyrights is the more basic difficulty of identifying that they exist at all. In many cases, particularly with small companies and especially when the patent or copyright was developed internally, tax practicalities dictate that expenses relating to the development of patents and copyrights be accounted for as expense incurred in the normal course of business. As a consequence, nowhere on the company’s balance sheet is it reflected that a patent or copyright exists. Therefore, we often would have no way of knowing that such assets exist other than making certain assumptions, or asking the business owner, who may not wish to divulge that information to us. How can we approach this area in some rational and intelligent manner that will give us a reasonable assurance of at least uncovering the existence of these assets if they do exist? Consider the following approaches:

Patents and Copyrights.

• First, recognize that most small businesses do not have patents or copyrights; in many cases even for those that do, there is no substantial value to them.

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So, before we proceed in the search for the Holy Grail, we should at least have reason reason to believe it exists and is worth finding. • Review professional fees. When nothing else is available, a review of the professional fees might reveal expenditures to patent attorneys to obtain or defend a patent or a copyright. The evidence of such legal expense may make this work go much faster and enable us to identify something of substance rather quickly. It need not be legal fees that lead us to the discovery of patents and copyrights; it can be fees to authors, engineers, or others of technical or professional expertise. See Chapter 8 for further discussion of professional fees. • Sources of income. If the company is receiving royalties or similar income, it may own rights or title to an asset. Certainly, if the books and records reflect royalty income or some other “soft” income that is not specifically oriented to a product or service, then the source of that income might originate with a patent or copyright. • Industry expectations. For some industries, it is common, and even expected, for a company to have a patent or a copyright. In these types of fields, the investigative accountant could expect to seek out this asset almost immediately and with deliberate direction. After a patent or a copyright has been found, the next step, which is often outside the knowledge of the investigative accountant, is the valuation of the assets. The more esoteric the asset, the more technical its nature and the industry, the less able is the accountant to determine the valuation of that asset. Only the most specialized CPAs would have the required expertise. ACCOUNTS PAYABLE. In many ways, the analysis of accounts payable parallels the analysis of accounts receivable. Here we are concerned with aging, validity of the liability, possible related party interests and other relationships, and the legitimacy of a cutoff. In reviewing the accounts payable, just as with the receivables, it is helpful to have an aged schedule. Inasmuch as we need to address the validity of alleged liabilities, we need to know how current they are. Old payables may not be payables at all. Too often, the internal bookkeeping or accounting department will carry payables that no longer have to be paid because some other department worked out an arrangement for which a credit was received. Similarly, a payment may have been made that was supposed to be applied against the payables but for some reason instead was posted directly as an expense, circumventing the payables part of the accounting system and in effect doubling the expense. While it is not our role to make wholesale changes, improvements, and corrections to this company’s accounting system and books, we must know what constitutes an accurate statement of that company’s liabilities. If we find an account payable that is 200 days old, while we need not know how that payable has remained on the books, we must, if it is no longer a liability, remove it both as a liability and as an expense. Of course, it is easy for us to question the legitimacy of the stated accounts payable debt and particularly question an old one. It is less easy to rely on the answer we get when we ask the owner, bookkeeper, office manager, or whoever, as to why the item has not been paid and whether it will ever be paid. Depending

6.11

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on who we ask, the answer may be a self-serving attempt to deny a mistake or oversight. When we do not trust the answer we receive, one common sense approach is simply to look at a subsequent time frame. Unless barred from subsequent records, that fortunately is something often not too difficult to do. Typically, we investigate from a point that is from a few months to a few years subsequent to the valuation date. Therefore, it would be reasonable to benefit from hindsight, or subsequent events, to determine whether that payable was ever paid. If, from the vantage point of perhaps another year past that valuation date, a payable that was already a half-year old remains unpaid, then subject to a satisfactory explanation, it may never be paid. Alternatively, it is possible that the liability is no longer carried on the accounts payable schedule. You still need to determine whether it was paid, written-off, or in some other way adjusted. After all, perhaps your suspicion that it was not a true liability was recognized and put into effect subsequent to the valuation date, at which time the liability was in fact written off. In that case, you now have support for your position to make the appropriate adjustments to the payables as of the valuation date. Besides the issues of the aging and legitimacy of the payables, similarly with receivables, the investigative accountant might glean other information, such as who the major suppliers are. Based on the relative volume that these suppliers represent, it may even raise questions as to whether there is some common ownership or other relationship that warrants further investigation. When the relationship is not necessarily at arm’s length, there might be a large payable that will not be paid (it might be the equivalent of equity). Similarly, when a payable is substantial enough and old enough, perhaps it is more like a note and should be carrying interest. Of course, in that case, the other company should have interest income. Again, this is the other side of the issue that was raised in 6.10 dealing with accounts receivable. This author has found, when reviewing the accounts payable of a manufacturer, a substantial payable that had no current activity (which also meant that there was nothing to see when going through the purchases). As a result, we looked further into this previously unknown supplier. As it turned out, this supplier was a company in which the business owner, whom we were investigating, owned at that time an undisclosed 40 percent interest. That discovery was extremely valuable in strengthening our position and providing just the right amount of encouragement to the business owner to negotiate a reasonable settlement. 6.12 ACCRUED EXPENSES. Many of the procedures used in investigating accrued expenses are similar to those employed for accounts payable. However, there is normally no aging involved inasmuch as accruals are typically shortterm, nontrade obligations. The analysis of accrued expenses is somewhat different than payables, and often a more fruitful area for investigation. Especially in companies having a fairly decent and capable internal bookkeeping system, the payables tend to be more accurate, more honest as to actual liability, and more contemporaneous. They are entered as they occur, generally by an unrelated third party who is not looking to deceive anyone. On the other hand, accrued expenses are often done only at the end of the year and often with the help of the accountant, after consultation with the business owner.

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Accrued expenses are often developed to maximize the year’s expenditures and minimize the year’s income. They also sometimes deal with items that are outside the ordinary course of business. By their very nature, they often require input from the business owner or the accountant, as contrasted with the more by-thebook approach of a bookkeeper. As a result, there is often a greater aggressiveness (especially in a profitable year) as to accruals, justifying a certain amount of extra attention. Because of sloppy accounting, the accruals of one year may be carried forward to the next year or even the year after, never being removed from the accrual schedule, and in effect being treated as a perpetual liability. The reality is that accrual either will never be paid, or was paid in the normal course but treated as an expense rather than as a paid account payable. This happens because the bookkeeper or controller is waiting for the accountant to make the appropriate end-of-year adjustments, or because that person was not even aware of the connection between what was paid and the prior accrual. As a result, the company not only carries a liability for an accrual but also has expended the payment. The only way to avoid correcting this situation (which would mean reducing the current year’s expense) is simply to carry the accrual forward as if it were never paid and were still an obligation. In addition, because accruals sometimes reflect an aggressive position motivated by tax savings, they may have been placed on the books to enable the company to deduct expenses that were not yet properly accrued, but rather more appropriately belonged to the first month of the next year. Given the company’s total expense structure, we might not notice such expenses; they might simply not be large enough or remarkable enough to warrant particular attention. However, a specific series of accruals that are posted at the end of the year might allow us to very easily and cost effectively show that the company’s income was artificially reduced. In a sense, what we are trying to do here, as with many of the other aspects of investigative accounting, is to apply in reverse the knowledge that we have learned over the years in helping the closely held business owner avoid taxes. 6.13 LOANS AND EXCHANGES. This account is usually of minor consequence and often a dumping ground for odds and ends. It sometimes continues to exist on the books through inertia; no one wants to take the effort to clean it out and eliminate it from the company’s books and records, often because to do so would mean taking some non-cash flow income into account. However, because the amounts are usually minor, correcting this account, or even investigating it for corrections, is often not worth the effort. For the most part, the investigative accountant should merely determine that nothing of substance has been run through it and at that point leave this account alone. 6.14 LOANS TO OFFICERS, OWNERS, AND SHAREHOLDERS. Typically, this account is used as a temporary waystation for monies loaned to the company by the business owner, generally for the company’s cash flow needs, temporary financing needs, or possibly to remove money from accounts in that person’s name. Money that goes in the opposite direction, as a loan to the business owner, is often an advance against a bonus or salary, an outright loan, or possibly an attempt to strip the company of some extra funds. In some businesses, this is an

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extremely active account, with funds in and out of it on a regular basis, and often in substantial amounts. In general, this account warrants serious attention by the investigative accountant. It is important, for monies advanced to the business owner, to determine where the funds went, the disposition of the funds, into what bank account were they deposited, whether they were not deposited, whether they were used for something we should investigate, or whether they went to a brokerage account. The overall question is where did the money go and for what purpose? Of course, the funds could have been moving in the opposite direction. That is, this type of account can just as often represent the company’s receipt of money loaned to it by the business owner. In that situation, our need for answers is the same, but the questions are different. For instance, what was the source of the funds advanced to the company? We need to trace the bank or other accounts from which the money was withdrawn to put the business owner in the position of loaning the money to the company. A buildup in an officer’s loan account that is a receivable as to the business often means that the business owner has received compensation that has yet to be called compensation. Many business owners borrow from their companies with no real expectation of paying that money back; after all, it is their company and it is their money. This situation has at least two very practical concerns from the perspective of our work. What is being carried as an asset on the company’s books (the officer loan receivable) is not really an asset. Rather, it represents past compensation that should have been expensed. Our “correction’’ of this results in eliminating that asset, with the offset directly flowing through retained earnings. That is the same, in effect, as if the advances to the owner/officer had been treated as compensation when they occurred, and treated as a business expense without the circuitous route through the officer loan account. We must be very careful as to the ownership interest of this owner/officer; if it is 100 percent, then the treatment just described is rather routine and substantially unchallengeable. However, if other than 100 percent, this step is not necessarily the correct one. In such a situation, unless all owners have balances in the loan accounts proportionate to their ownership interests, or unless there is some other substantial reason to justify reclassifying the advances, you may have to leave the loans as is, because perhaps indeed they do constitute legitimate receivables. Of course, the treatment just described (reclassifying the loans against equity) is essentially what we would ultimately have to do when it comes to determining the value of the company and the overall marshalling of the marital assets. After all, if we reflect as a business asset a loan receivable from the officer, then we have the exact reciprocal on the family’s personal balance sheet; the officer owes that same amount to the company, and therefore has a personal liability. The net result in the marital unit is a wash. This type of treatment is the same regardless of the direction of the loan. If it is a loan payable by the business, then reflecting it as a liability on the business means that there needs to be a commensurate receivable on the marital personal balance sheet. There are differences, however, when the ownership interest is other than 100 percent. If the subject party owns only 50 percent of the business and if we further assume that no other loans receivable (or payable) are on the company’s books, Loan as Both a Business and Personal Issue.

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then clearly it would be improper and illogical merely to net it against equity and ignore it on both the business and the personal balance sheets. Using, for instance, a $100,000-receivable on the company’s books, if netted against capital on a business owned only at 50 percent, it would cause the other 50 percent owner to lose his half of that company asset. We have just improved the personal financial position of the party being investigated by 50 percent of the loan. The flip-side is also true: if it is a company payable and therefore a personal receivable, taking the steps just described would eliminate 50 percent of that asset from the personal balance sheet of the subject parties. Therefore, how we treat this particular item is very much related to the subject party’s ownership interest, and less often, when there are multiple owners, dependent upon their respective loans to or from the company. It is important to be cognizant of how your local courts handle disparate assets and liabilities. Most jurisdictions in the United States follow the concept of equitable distribution and virtually all others are community property states. In theory, these two concepts are supposed to come up with comparable results. Equitable distribution entitles each spouse to an equitable share of the assets, “equitable” being defined by the court. Community property in theory means each party is entitled to 50 percent of the net marital assets. In equitable distribution states, depending on many factors (including the length of the marriage and the perceived respective contributions to the marital net worth), businesses are often distinguished from other assets as to the relative percentages assigned to each spouse. It is not unusual, for instance, for only 35 or 40 percent of the value of a business to be awarded to the nonbusiness spouse although that same spouse will get 50 percent of the house, bank accounts, and pensions. Therefore, the way your figures are presented may be helpful in maximizing your client’s yield. Given the realities of the system, strategic planning of your presentation would likely dictate the approach you would take regarding the treatment of such loans, whether receivable or payable. There is flexibility in presentation which gives you the opportunity to assist your client without impairing your independence and objectivity. For instance, assume you are faced with the likelihood that your client (the nonbusiness spouse) will receive only 35 percent of the business but 50 percent of everything else, and the business is carrying a loan receivable from the business spouse. Leaving that loan on the company’s books instead of removing it (and also removing it as a liability on the personal balance sheet) would damage your client’s position since your client, if the receivable were left on the company’s books, might receive only 35 percent of that company asset and yet be responsible for 50 percent of the complementary personal liability. This certainly seems illogical and, of course, can be explained to the court. Of course, if you are representing the business owner, it would probably behoove you to leave the figures unchanged. On the other hand, if that officer loan is a payable on the company books, then the logic and the presentation of what was just described is completely reversed as to the optimum presentation on behalf of your client. At this point, those readers in community property states might have concluded that what was just described is all well and good for those in equitable distribution states, but it is totally inapplicable to community property states. After all, every asset and liability is evenly split. Therefore, it is immaterial whether it

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is a company asset and a personal liability or vice versa, or whether they offset and do not appear at all. If only that were the case! We must not lose sight of one of the major problems in this type of work: the value of that business. While the theory is that, in community property states, the spouses split everything evenly, we must ask ourselves, what are they splitting? It is easy enough to take a bank account or a home with an appraised value (or you sell the home) and split that equally. It is not such a simple matter with a business, particularly one which has to be valued in the first place. How that business is valued and the components of that value (that is, an asset receivable from the owner or a payable due to the owner) can become issues. Also, how are the respective assets and liabilities to be offset? Does the business value get paid out over several years, while the personal assets are in some way netted and distributed immediately? It can make a very big difference as to how you treat a loan to or from an owner regardless of the divorce laws in your respective state. If the value of the business is going to be decided by the court, what is included in that value is extremely important. If the adjudicated value includes a loan receivable from the business owner, depending on which side you represent, it might be quite important as to how the corresponding personal liability is, or is not, reflected. This discussion already referred to advances that constitute a loan receivable by the business from the officer as possibly having been advances against compensation or actual compensation that were perhaps treated in this manner for tax reasons. The business owner may have found it important, as part of the divorce process, to treat these advances as loans rather than compensation. A business owner who takes a bonus of $100,000 must truthfully disclose it as compensation, and greater compensation may result in greater pendente lite support. On the other hand, if that same $100,000 were on the company’s books as a loan (and, even better, if papers were signed evidencing that loan), then that same business owner can truthfully answer that the $100,000 was not income. The fact that the loan will be forgiven and taken into income perhaps a year later, or at some other time conveniently outside of the divorce complaint, is beside the point. The reality of loans from the company to the business owner is that they are often intended as bonuses, with no anticipation or expectation of repayment, regardless of any signed notes or how reflected on the company’s books. However, from the perspective of the investigative accountant, loans to owners or officers are generally not an issue as to compensation. We must deal with compensation to determine what is reasonable, regardless of whether the business owner took more or less than a reasonable amount. Therefore, adding back to compensation an officer’s loan does not change our need to adjust whatever officer compensation figures there are for the proper and reasonable level. Any excess represents corporate income, and any shortfall must be removed from corporate income and attributed to the owner for purposes of valuation. However, sometimes valuation is secondary, and the primary issue is the actual compensation received by the owner. It might very well matter that the business owner received not only $50,000 in salary, but a $100,000 bonus that was disguised as a loan. Yet, even that aspect of compensation is not the end of the issue; there is a more fundamental aspect of owner/officer loans. When dealing with a business owned 100 percent by the subject party, we must not lose sight of (and must be able to explain this to our client, the attorney with whom we are working, and

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perhaps ultimately the judge) the fact that we are dealing with a finite pool from which one can draw. If this business owner’s $100,000 bonus was treated as a loan instead of compensation, that owner’s compensation has been understated by $100,000, and reciprocally that company’s income has been overstated by $100,000. Instead of expensing that loan as compensation, it becomes a nonoperational item and never appears on the profit and loss statement. Except for concerns as to the amount of compensation and how it might affect support and related issues, it is ultimately irrelevant whether the $100,000 is treated as compensation to the business owner or net income to the business. Thus, if we have a pattern of advances to the business owner and no paybacks, so that the officer’s loan account is building up on a regular basis, it would indeed be economically correct to reclass those advances as compensation, in effect increasing that owner’s compensation for each of the past several years. However, we must simultaneously reduce the company’s net income by the same amount. In all likelihood, the net sum of what we have accomplished is zero, other than cleaning up the company’s balance sheet. However, presenting the real level of compensation enjoyed by the business might be psychologically very important, regardless of the impact on the company’s net income or loss. 6.15 LOANS AND NOTES PAYABLE. Usually, this area is innocuous. Most of the time, loans or notes payable to unrelated third parties do not warrant any particular attention, and go through our investigative process untouched. However, several elements of this liability require analysis in the investigative process.

What were the funds used for? Where were they in fact deposited? Were they used to purchase company assets, or perhaps for the personal living room furniture of the business owner? Were these funds used for working capital or the buyout of a previous owner? Most of the time, the virtues of the double entry accounting system will prevent major distortions. For instance, if the loan proceeds never went to the company but instead were retained by the business owner, the credit on the company’s books clearly was to establish a loan payable liability. Instead of the typical debit being to cash, it would have been to a loan receivable from the officer. In such a case, if all aspects of this transaction were handled correctly from a record-keeping point of view, the trail will be easy to follow and your determination of the need for adjustments fairly clear cut. Sometimes however, the majesty of the double entry accounting system is abused. For instance, consider two examples: In the first scenario, the proceeds from a loan taken a few years prior to the investigation went only in part to the company, with most of it going directly to the business owner. At that time, the loan was treated correctly, with the part taken by the business owner treated as a loan receivable from him. However, in the ensuing couple of years, that loan receivable from the business owner was, in piecemeal, written off by expensing it through a combination of adjustments to bad debts and other operating expenses. The time span encompassing my work, which was a few years after the loan, included having the loan still on the books, but there was no longer any sign that any part of it had been given to the officer. While the loan was real, and removing it from the company’s books merely meant transferring it to the personal balance sheet, it did show wrongdoing by the business owner. In addition, as this case turned out, the funds from the loan Use of Funds.

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that were used personally were secreted into a heretofore unknown bank account. Major progress was made in this case when we were able to determine both the impropriety of the treatment of this loan on the company’s books and the undisclosed existence of a significant bank account. In another case, with the business owner having direct control over the company’s books, two years prior to the valuation date a loan was taken from a bank and the proceeds went directly into the pocket of the business owner. On the company’s books, that business owner had made a compound entry reflecting the purchase of some equipment as well as the purchase of parts, supplies, and other normal operating expenses. These were all bogus. The purchases never happened and there was no documentation for them. Interest Expense. If a loan or note payable by the company should not be a company obligation, we also need to adjust the interest expense. To the extent that the note or loan is not fairly a company obligation (from an economic rather than legal point of view), the corresponding interest is not fairly chargeable as an operating expense of the business. While the liability exists, and while the interest expense exists and has been paid, the interest is not a company expense and should not reduce the net income of the company— a very important factor in the determination of value. Financial Statements. Even when note and loan obligations are completely valid, such obligations may help the investigative accountant in focusing attention toward banking relationships that might shed further light. As investigators, we are always interested in comparing financial statements of the business, the individual, and the disclosure statements made by the parties as part of the divorce action. We are often told that statements (perhaps any statements, perhaps just personal statements) do not exist, that none was ever prepared, or that even if they existed, nobody ever kept a copy. When a banking relationship exists, there is also likely to be a financial statement. Especially when there is a loan of any consequence, it is extremely unlikely that it was made without some form of financial statement, business as well as personal. Further, as we all know, the financial statements given to banks, assuming at least a reasonable level of truth, are about as optimistic and generous as possible (of course, with some possible inflation or puffery), and often considerably disparate from that submitted in the divorce action.

6.16 PAYROLL TAXES WITHHELD. Normally, if the accounting system and personnel are competent, this balance sheet item warrants no more than a quick glance. It would be unusual to make adjustments here, other than perhaps changing a debit balance to a credit balance. That is normally of minor consequence and not a step performed by the investigative accountant. When the amount of the liability is unusually large, attention should be given to whether there is not only a tax liability but also interest and penalty liabilities because of late payment or nonpayment of taxes. 6.17 SALES TAXES PAYABLE. As with payroll taxes withheld, evaluating sales taxes payable rarely calls for adjustment by the investigative accountant. Certainly, there may be some fine-tuning necessary in the company’s books to reflect the

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correct liability, but we are interested in the overall picture. If the sales tax liability is off by several hundred dollars, for our purposes it is insignificant. If the company has unreported sales, it may also have unreported sales tax obligations. This is an additional leverage tool, but usually not one of great significance. Normally, this sales tax issue, if it exists at all, pales in comparison to the income tax issue. 6.18

EQUITY

Whether it is called capital, stockholder’s equity, retained earnings, paid in surplus, draw (obviously a negative capital item), common stock, treasury stock (another negative), preferred stock, or whatever, it is all essentially the same: equity of one form or another. In most cases, it is usually the most boring account, or series of accounts, for us to investigate. There are generally no changes other than the annual change in retained earnings or accumulated capital, directly attributable to the net income of the business. However, when there are changes such as the creation of or change in treasury stock, investigation becomes an absolute must. If a business experiences a change in or the creation of a treasury stock account (if incorporated), or the addition of a capital account via a new partner entering the partnership, then it is imperative for us to know the underlying financial facts. Treasury stock indicates that the company purchased the stock of a shareholder, which means that a value was placed on that stock. It may be that value was meaningless for our purposes; perhaps it was a sale under duress, a forced retirement situation, a predetermined book value type of purchase, a sale driven by financial hardship, or whatever. However, that is a separate argument to be made and considered; the overall need to be informed as to the underlying series of events does not change and remains important. Similarly, if a partnership takes in a new partner, we need to know the basis for that partner’s capital contribution. It is highly likely, in virtually all of these situations, that a paper trail exists. Somebody must have decided how much that new partner would have to pay and had some basis for that decision; somebody must have decided what price to pay for that treasury stock and had a basis for that price. Sometimes we observe that treasury stock is on the books and has been there for years. In such a situation, it is unlikely that the existence of that treasury stock will be of much help to us: if too old, the transaction is probably too stale for our needs. However, in a company with a long history, and with a fairly stable asset and income base, it is certainly possible that a treasury stock transaction that happened 10 years ago might still be relevant to the company today. Of course, the current economic environment must be considered as contrasted to what that environment was at the time the transaction occurred. However, if there was a basis at that time for determining goodwill above and beyond the book value of the block of stock that was purchased, then perhaps the logic and reasoning that went into that calculation is still relevant to today’s world. At the very least, it should be considered. Capital.

Stock Register. In almost all closely held businesses, looking at the stock register is a waste of time. Nevertheless, it is an exercise that may need to be done.

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Typically, in closely held businesses, the stock register book is not maintained at all, or alternatively, perhaps it was maintained at the beginning of the formation of the company and then never looked at subsequently. However, the stock register is often maintained when there is a change in stock ownership and certain formalities are desirable. Regardless of any preconceived notions as to whether that book was maintained or not, we need to at least look at it to obtain some level of comfort as to the ownerships expressed therein. There are times when reviewing the stock register book is of great relevance and yields useful information. This is only where the ownership interest is other than 100 percent, or alleged to be other than 100 percent. In a case a few years earlier, we were advised, and the business owner had sworn, that his ownership interest was 41 percent. However, when we reviewed the stock register book, we found a transaction about one year earlier which indicated that business owner had acquired an additional 20 percent of the company, bringing his stock position to 61 percent. This proof made a multitude of significant differences, including the issue of control, total value of the subject stock position, and, of course, the credibility and veracity of this business owner. When going through the stock register book, take pains to actually count the certificates and to insist on accounting for any missing certificates or skipped numbers. Look not just at the certificates but also at the register itself listing each of the certificates and their respective ownerships. Pay special attention to changes, cross outs, and the like. Look for changes in the style of the certificates; maybe a second series was issued. Be aware of the existence of preferred as contrasted with common stock or a second class of stock. Minutes Book. Especially when dealing with a closely held business, the minutes

book is often totally ignored, other than perhaps at the original time of incorporation when the usual innocuous words were inserted in a perfunctory manner. Subsequently, there is no purpose for the minutes book; it is a formality that nobody really needs or wants. Especially with a 100 percent owned company, or one having two or three shareholders who are very close, minutes are an administrative nuisance. All that aside, many companies maintain minutes books. Such maintenance may be no more than for protection in selected situations as to the IRS. In such circumstances, the minutes book is usually useless to us. We do not really care whether there is a Board of Directors resolution authorizing a bonus to the officer or a pension plan contribution. On the other hand, typically in a somewhat larger but still closely held company, a minutes book may be carefully maintained and meaningful. There may be a Board of Directors that has regular meetings for guidance or other purposes. There may be shareholders at odds with each other, dictating the need for more formalized shareholder meetings and the minutes that go along. Wherever these minutes exist, it is very important that we review them, keeping an eye out for removed pages, omitted dates and the like. We need to look for major issues that were discussed, that is, potential mergers or acquisitions, pending law suits, major successes or failures, and the like. Again, this area is usually nonproductive, but is an area that should not be ignored. Though usually not an issue in investigating closely held companies, there are at least three aspects of dividends that warrant attention:

Dividends.

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1. For the company to make dividend payments is both unusual for a closely held company and a sign of a strong financial position and above-average liquidity. The cash availability and liquidity is an element that would speak well of, from one point of view, the company’s value. Dividend-paying ability is also the basis for one approach toward valuation. 2. Dividends are supposed to be paid in precise proportion to one’s respective stock ownership. While this would seem rather obvious, it is one element of a review of the dividends that should not be overlooked. In a case that I handled a few years ago, representing a minority interest in a stockholder’s suit, we discovered dividends being paid by a closely held company to its various stockholders, but not proportionately. Our client, who had no contact with nor input in the company, was receiving considerably less each year in dividends than she was entitled to. If in your investigative work you come across a company paying dividends, and you are representing one of the shareholders, be certain that the dividends are properly paid. 3. As with virtually any source of income, you should be tracing receipts into the personal banking records of the subject parties. However, unlike many dividends that people receive, such as, through mutual funds or through companies with stock reinvestment plans, the dividends paid by a closely held business are not reinvested in the company. They are generally paid out to the shareholders. Be sure to determine where these dividends are going, that is, into which accounts they are deposited. When there are changes in the equity section due to the acquisition of, or merger with, another business, particular attention must be given to such a transaction. It is absolutely critical to obtain as many facts and as much information relevant to that transaction as possible. A copy of the contract, valuation reports, consultant reports, opinion of counsel, and so on are all relevant and all fair game. Was a competitor acquired at book value plus $1 million, which further strengthens the subject company’s position and provides insight into value issues? Was a supplier purchased so as to give the company greater security as to its source of materials and to further vertically integrate the company? These are all major issues that require serious and aggressive pursuit of documentation. In these especially sensitive areas, our search is often thwarted, or at least stalled, by the business owner whose interests run counter to our gaining access to these types of records. It is not unusual in such a case to request the assistance of the attorney with whom we are working. No matter how good we are, there are times when we are just unable to get records without one attorney speaking to the other attorney, going through formal discovery demands, perhaps going to court with motions to compel and threats of sanction before we gain access to what we seek. If faced with such stonewalling, try to determine as soon as you can the need to request assistance from your attorney so as to impress the business owner, through his or her attorney, of the importance of cooperating.

Mergers and Acquisitions.

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7

SALES AND INCOME I’m living so far beyond my income that we may almost be said to be living apart. — e.e. cummings

CONTENTS 7.1 7.2 7.3 7.4

Becoming Well Grounded Seasonality Professional Practices Safe Deposit Box

95 98 99 101

7.5 7.6

Gross Profit and Costs of Goods Sold Challenging Allegations of Unreported Income

102 113

7.1 BECOMING WELL GROUNDED. The life blood of any business is, of course, its revenues, its sales, income, fees, or whatever it is called. Regardless of how clean the books, regardless of whether there is one dollar or a million dollars of unreported income, we must understand the nature of the income of the business: what products it sells, what services it renders, what the company does to generate the revenues. We certainly will not obtain an understanding as comprehensive and complete as that residing with the business owner. Nevertheless, we need to have a working familiarity with the business. We need to know what it sells, to whom it sells, and from where it buys or how it makes what it sells. While this may sound rather obvious, determining sales and income in many situations may be very easy; however, it is not always the simplest of issues. We often have only two firsthand sources of this information, our client and our client’s spouse. If our client is the business owner, our job has been made immeasurably easier. After all, we can always expect full cooperation from our own client. On the other hand, when our client is the nonbusiness spouse, especially when that spouse has been kept somewhat in the dark over the years as to what the business does, and especially where the business is not a simple or routine operation, this information is not so easy to obtain. Even then, our client will probably be able to tell us what the business does. Unfortunately, we may not be getting the complete story; there may be some distortions, and in the extreme cases, there are clients who know virtually nothing about their spouse’s business. In those situations, we normally become somewhat reliant on the business-owner spouse, even if that is not our client. As detailed in Chapter 2, this reliance further emphasizes the importance of interviewing the business owner. However, we must take whatever information we do get with the proverbial grain of salt. 95

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Sometimes we are fortunate enough to obtain the information we need from other sources, such as from trade sources, or from going through the books and records of the business. If we have to first review the company’s records to determine the nature of the business, some time will likely be wasted, and some investigation will likely be nonproductive. That often cannot be helped. If our nonbusiness client knows a trade group to which the company belongs (such as one that had a convention recently, attended by the business spouse or by both), then we know at least something from that alone. The SIC codes on the tax returns are usually of some modest help. Fortunately, most businesses are not difficult to comprehend, at least as to a superficial understanding of what they sell. Part and parcel of understanding the sales of the business is understanding the customer base. We do not always need to know specific names, but we do need to have a more general understanding of their type, for example, whether they are small retail stores or large manufacturers. That basic knowledge needs to be carried at least one step further. It is not enough, for instance, to know that a company manufactures brooms and sells to retail stores. Is one of its customers a major chain? Does that major chain represent an uncomfortably high proportion of that business’s sales? Or are there no major chains among the customers, and does that represent a potential major boon, if and when the company is able to break into that market? Are the customers blue chip companies and therefore not likely to present bad debts, or are the goods sold to a broad range of mom-and-pop businesses that present all sorts of problems? Are there just a few customers, with the potential for domination by one or two major customers and the risk of substantial loss of sales, resulting in a much smaller company? Regardless of the size of the customers and the issue of whether a higher sales volume carries with it a higher or lower gross profit, do any customers represent more than 5 percent of the company’s sales volume? Does the subject company sell to other businesses where unreported cash income is not usually an issue, or does it sell to the general retail public where there is a much greater likelihood of unreported income? Does it collect its revenues in the form of cash, check, or credit cards? Obviously, where a business sells to the general retail public, and where a good portion of its revenue comes in the form of cash, the likelihood (most accountants in the field would say, the certainty) of unreported income becomes much stronger. Where a company’s customers are typically large companies, the likelihood of unreported income is very slight. Even when a company’s products or services are sold to other businesses, we must not assume that since these products or services would typically be deductible expenses for those customers (or in some cases perhaps capitalizable), that such items are always paid for by check. Identify the customers of the subject company. Are they themselves businesses which would be accustomed to receiving cash and paying (generally at a discount) in cash? If we are dealing with a wholesale laundry operation, which counts among its customers a number of restaurants, it would be foolish and naive to think that just because the laundry bills are a deductible expense of the restaurants, they would therefore pay by check. Restaurants deal in cash, often have the need to get rid of some of that cash, and therefore might pay for selected expenses in cash. Further, using the laundry as an example, the laundry bills themselves may give the investigative accountant the ability to determine the correct amount of income generated by that restaurant.

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How are the sales revenues collected? Do revenues come in via the mail each day, are they wire-transferred to the bank, are they collected on someone’s route, or do the customers bring money in the door? When the money comes in through the door, over the counter for instance, or when it is collected on someone’s route, the chances of unreported income are greater. When the person going on that route to make collections is the business owner, the chances of unreported income are greatly increased. What are the recent trends for the business, and is it seasonal or cyclical? Over the past several years, have sales increased, decreased, stayed stagnant, or fluctuated wildly? For this purpose, it is, of course, assumed that we are dealing with a legitimate accrual basis reflection of revenues. Does the business obtain a disproportionate amount of its revenue during the summer, during the holiday season between Thanksgiving and Christmas, in the winter between December and February, or is there no particular peak or valley, but just an approximate year-round constancy? If you know that sales have been steadily increasing, you should be able to isolate your investigation to the last couple of years. Try to determine why there have been steady increases. Try to discover whether they were substantially attributable to an overall economic improvement, whether the business owner has been putting in unusually long hours, whether there have been one or two major customers or projects, or whether a particular technological advance has made this company more competitive or in demand. It is just as important to learn why the company may be in a downward trend. You need to investigate whether the decline has occurred in the last year or two or is a more long-term situation. While most business people would not deliberately reduce income, and while proving it can be most difficult, divorce planning to reduce revenue is not unheard of. When divorce is in the offing, especially when the business owner filed the divorce, or knew it was coming, depending on variables such as the degree to which sales can be controlled and lost sales can be recovered, it is possible that the business’s fortunes will be intentionally downgraded. If so, both the income realized (relevant and very important as to support and alimony), and the value of that business (which is usually determined in relation to income) will be considerably less than the reality. In effect, that business owner has created a temporary reality to serve a very limited and timesensitive function. A problem that arises when addressing such divorce planning is how to prove your point. Without appearing to be an advocate, and without extending yourself beyond reason, how can you substantiate what many would consider a rather far-fetched concept that this prudent business person deliberately lost business to make the business look worse and to deprive the spouse of a fair share? Each case will require serious thought and different approaches. However, there are some common threads to consider and approaches to apply. For instance: • How does the recent downturn compare to the company’s past few years’ history? Is that downturn consistent with what one would have expected or does it seem out of line? • How does that downturn compare to the industry in general, but as specifically as possible to the region in which that business is located (assuming the business is one affected by regional fluctuations)?

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• Look at subsequent events to the extent possible. Did sales turn up shortly after the valuation date, that is, while you were there doing your work? If not, your job has just been made a lot harder. • See if you can isolate whether sales went down only to some customers. For instance, in limited situations you might be able to determine that a major portion of sales are to several key customers, perhaps with whom the business owner has a long-term friendly relationship. Perhaps sales from one or more of those declined in the past year or two. Look at subsequent events and see if the sales recovered. • Do everything you can to determine if there is another company that has helped siphon off sales. Then, if each of the above fails, consider the possibility that the sales decline was not due to divorce planning. Maybe business is just not as good as it used to be. SEASONALITY. Where sales fluctuate dramatically by month or season, you must be particularly wary of a business owner who presents to the court that at the time of the filing of the complaint, business is down 30 percent on an annualized basis compared to the previous year. The owner supposedly cannot afford support and has all sorts of other problems. The reality may be that the reason business is down 30 percent on an annualized basis is that sales do not come in evenly during the year, but that if we compared this year’s sales to last year’s sales for the same months, perhaps the current period is comparable or even better than the prior period. As we all know, wonderful games can be played with a set of facts, depending on how they are applied and who applies them. It is inappropriate for a business that does all of its sales in the summer to argue in April that it is doing terribly when it has yet to come into its selling season. Seasonality is also relevant when we look at the current records of the business (that is, when we are there doing our work, as contrasted with when the divorce complaint was filed and the prior one or two years). It is not unusual in divorce cases for the business owner, from whom the other spouse wants support, to suggest to the court that the business cannot support the extravagant lifestyle they were used to, or that the other spouse alleges they were used to, because things are not as good as they used to be. We must review the current records, compare them to a similar time frame in the prior year(s), and determine whether in fact the current year is appreciably worse than the previous year or two. A recent case involved a veterinarian, who complained bitterly to the court that he could not afford to continue making payment on the support order because business was down 20 percent. Without making this into a major assignment, our first step was to review the past few months of the current year and compare them to the same period from the previous year. Amazingly, revenues, comparing cash collections to cash collections, were virtually identical to the prior year, with a variation of about 1 to 2 percent. In addition, the receivables at the end of that period were approximately the same as the receivables at the beginning of the period, and expenses were approximately the same. Therefore, for all intents and purposes, business during this period was identical to what it was at the 7.2

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same time in the previous year. Furthermore, that previous year was the best year that veterinarian ever had. Fortunately, justice prevailed and the veterinarian’s protestations of poverty fell on deaf ears. Seasonality is also an issue when we are faced with taking a half year’s operations and extrapolating that into a full year for valuation or other purposes. We may be dealing with a July valuation date on a calendar year company, and not be satisfied that we should stop at the prior December or that we should go forward to the succeeding December. If the books are in reasonably good shape, we should be able to use a mid-year point. In such a situation, it is important to know whether the first half of the year is comparable to the second half of the year, and how the current first half compares to the prior year’s first half. For instance, with an accounting firm, the first half of the year is virtually guaranteed to be far stronger than the second half. On the other hand, with the typical toy retailer, the second half of the year is far stronger. It would be folly to take a half year and extrapolate it to a full year when you are aware, or should be aware, of major differences within the year. With a retail establishment, one simple but effective procedure is to go to that store and observe the number of cash registers in operation. Of course, you should do this unannounced, and ideally as early on in your services as possible. It may be beneficial to have someone else do this if you are already recognizable to the business owner. It is not unusual in retail stores, especially when family-run, to maintain two or more registers, one or more of which are for “private purposes” (the income going into those registers never gets reported). The nonbusiness spouse might be aware of this and be able to tell us that there are three registers in operation while the business owner swears that there are only two. It is also possible that of the three registers, one of them is broken, kept in the back of the store, and has not been used for two years. By simply walking through the store, you may get a better and truer picture of exactly what the facts are. 7.3 PROFESSIONAL PRACTICES. When investigating a professional practice, the specific type of practice can make a difference in our approach and in our preconceived notions about the likelihood of unreported income. For instance with an accountant, if the typical client is a corporation or other business entity, unreported income is unlikely. When the practice does a lot of low and moderate income 1040s, perhaps it is not so unlikely. In law, similarly, we would not expect to find unreported income when the practice dealt with businesses or had a specialty such as tax or patent law. However, if criminal law is the specialty, the possibility of unreported income is much greater. In medicine, unreported income is more likely in fields such as psychology and psychiatry, where some people pay in cash because they do not want their insurance records to show psychological treatment. Plastic surgery practices also have unreported income; elective surgery often is not covered by insurance. Secrecy over using a plastic surgeon is also a reason to pay in cash. Veterinarians, of course, might have unreported income because they rarely deal with business entities. Even when the veterinarian treats large animals, and therefore might deal with a business entity such as a farm, cash transactions are possible. Dentists are more likely than most medical practitioners to have unreported income because dental insurance is still relatively less common. As a result, more people pay in cash and no third-party documentation is involved.

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Many professional practices have specific records that are not used for nonprofessional businesses; patient cards or files, or a doctor’s appointment books, for example. These records can be most useful in establishing the true level of income generated. Do the appointment books establish an extremely busy practice, with an average of 100 patients per week? Assuming (and this might be a very big assumption) that we can establish that the average patient generates $80 in fees per visit, and that each of these 100 visits per week is a fee-generating visit (as contrasted with a no-charge visit), then we may have established that the doctor is grossing $8,000 per week. If that same doctor works 50 weeks a year, we should see reported gross revenues of approximately $400,000 per year. This approach is not quite so simple as illustrated, but the logic and concept are valid. Most professional practices are not that simple. For instance, doctors have different rates depending on the type of patient, the type of service rendered, whether a new or an old patient, and so on. Also, doctors often do not charge simply based on an hourly equation, and the increasing volume of business from HMO and other capitation-based sources further distorts a straight per-patient visit calculation. Therefore, reconstructing revenues based on labor could become absurdly difficult, even impossible. This is not to say that this approach is never useful; rather it should be considered and utilized under appropriate circumstances. Other matters modify or hinder the reconstruction: no-charge visits, collection problems and delays, compromised fees, smaller fees accepted from insurance carriers, no-show patients that were not crossed out of the appointment book, cross-outs in the appointment book that are not legitimate, pages ripped out of appointment books, a second set of appointment books, a second office with an appointment book that is not made available, and so on. For virtually any business or profession, the larger the practice, the less likely there is unreported income. While the investigative accountant should not make a blanket assumption based on the nature of the practice, expectations must be realistic, particularly as to accepting the gospel according to the spouse. In most businesses we are able to test the accuracy and reasonableness of reported revenue by comparing it to the revenue to be expected from direct costs. For instance, assume that we know from sample tests or industry data that a cigarette wholesaler has a gross profit of 20 percent (that is, a carton costing the wholesaler $8 is sold for $10, yielding a $2 profit). We can, in theory, simply calculate backwards what sales had to have been to justify the costs reflected on the books. If direct costs (in this example, purchases of cigarette cartons) amounted to $1 million for the year, we know that it would take, at a 20 percent gross profit margin, $1.25 million in sales to justify purchasing $1 million worth of goods. If this business shows sales of only $1.15 million, we may have $100,000 of unreported income. We may also have returns, discounts, swings in margins, poor internal bookkeeping practices, and many possibilities other than unreported income. That issue must be looked into and addressed accordingly. With a professional practice, except for some tangential sales, we do not have the benefit of simple cost-to-sales relationships. We do not have a product with a fairly reliable cost and a fairly reliable mark-up with which to compare. Typically, the greatest and perhaps only significant cost having any relationship to sales is payroll. Professional payroll, as contrasted with support staff, may be the only helpful part. With a small business, the owner’s payroll is even more difficult to use as a barometer for reconstruction of income.

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Each profession has its own peculiarities. For instance, if investigating an accounting practice and you want to test for the possibility of unreported income, you might do a detailed analysis of the outside computer services billings for the preparation of tax returns. You might decide to choose 50 clients listed on the computer print-out billing sheet and then determine if these clients are listed on the receipts journal, where revenue collections are reflected. If some are not, it might mean unreported revenue. It might also mean simply that the bill is not yet paid; or perhaps that payments are reflected under a corporate or business name with the personal name on the computer print-out. In the nonprofessional service area, cost of goods sold is a category of expense in which much time and effort can be spent examining the reported income and reviewing expenditures posted therein for perquisites and other abuses of the system. However, in professional practices, this area usually is not fruitful because, for professional practices, what is sold is labor and therefore the cost of goods sold in reality is payroll. As discussed, using payroll to test the reasonableness of cost of goods sold is only sometimes partially reliable. However, some professional practices also sell product as an adjunct to their main source of revenue. For example, it is not unusual for a veterinarian to sell flea collars, leashes, carrying cages, and the like. Though frowned upon by many in the profession, a chiropractor might sell orthopedic pillows and back supports. Where these ancillary sources of income exist, we might find a fruitful avenue for unreported income. Some practitioners consider this to be additional income that need not be reported. Unlike medical services, no file per se need be maintained, and often no insurance claim will be submitted. One approach is to determine the prices at which the practitioner sells these products as compared to their costs, and then to determine the extent of sales that must have been generated based upon the volume of purchases. Of course, the investigative accountant must allow for use of some of these products in the services rendered to patients. To the extent of such patient use, the revenues generated from those services have presumably been taken into account, and one should not impute income based on the purchase of these products as if they were being sold as retail products. SAFE DEPOSIT BOX. Especially with a cash business, a common issue is the safe deposit box and what is or is not in it. In almost any divorce case where access to the safe deposit box is not immediately preempted, one of the first steps the business owner takes, following the filing of the divorce complaint, is to empty the safe deposit box of any cash. Of course, this is improper and there probably will be some challenge concerning the safe deposit box activity on that date. Regardless of niceties, the plain and basic facts are that people do these things, and no one knows what was in it, or at least no one can prove what was in it. If that business owner cleaned out $1 million in cash, but claimed that the visit was merely to look wistfully at the marriage certificate, there is no proof to contradict that statement. If possible, it would be wise to take legal steps to secure all safe deposit boxes so that an accurate inventory may be taken and not let the other spouse strip them. As we all know, entry into a safe deposit box requires a signature on a standard bank card or form. That becomes part of a bank’s internal records. As a result, even if you cannot determine what was in the safe deposit box, and even if that 7.4

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person swears no cash was in it, at least evidence does exist to reveal, for instance, that the safe deposit box was visited by this business owner three times a week, every week (hopefully except when on vacation) for years. While not proof positive of cash going in and out of that safe deposit box, it is certainly, assuming a cash business, a strong indication that such activity was occurring. Combined with various factors, this may prove to be strong support for your position and an item in your favor as to the relative credibility of the two litigants. In determining where safe deposit boxes exist, the obvious places to look are banks with which either party has had a working relationship. Also, very obviously, where there is an indication of a safe deposit box rental being paid, clearly that bank warrants immediate attention. If the party investigated is especially careful and cagey, there may be a safe deposit box in a bank where no other relationship exists. Unless you had suspicions as to a particular bank, you may never find it. You might need to hire a detective to follow the business owner and see if other banks are visited. GROSS PROFIT AND COSTS OF GOODS SOLD. This chapter is devoted to sales or revenue. While cost of goods sold, or purchases, is obviously an expense, it is so entwined with revenue and so integral to our verification of reported income that it belongs here. As an expense category, costs of goods sold is to be treated like many other expense categories. The point here is that in most businesses, cost of goods sold is the largest single expense category. As a result, it also lends itself to being an excellent place to bury various personal expenses, figuring that they will not be noticed because of the sheer size of the cost of goods account. Therefore, it is important in our investigative work to sample the items posted to this account and determine that they are substantially correct, or that if errors exist they are still business expenses, and that the cost-of-goods-sold category was not used as a dumping ground for perquisites. However, the major thrust in dealing with the cost of goods sold is to use it to determine whether it is reasonable or whether its complement, gross profit, is reasonable. If the industry norm for the type of business being investigated is a cost of goods sold of 42 percent (a gross profit of 58 percent), and the business you are reviewing has a cost of goods sold of 55 percent (a gross profit of 45 percent), you would attack that area with great interest. Why is this business experiencing a gross profit margin that is fully 13 percent worse than the industry norm, and a cost of goods sold nearly one-third higher than expected? One of our failings is that we tend to get overly suspicious, and all too often too quickly assume, using the preceding hypothetical as an illustration, that if a company’s gross profit is less than the industry norm, there must be some shenanigans going on. That is not always the case. After all, the industry norm is comprised of companies doing better and companies doing worse. Maybe the company you are investigating is one that does worse. Perhaps the industry norm reflects a nationwide average, and your company is in a region that is hard to reach and therefore incurs a greater freight cost, thereby inflating the cost of goods sold. Or, perhaps your company is smaller than average and cannot obtain the same volume efficiencies as larger companies, resulting in higher costs. Perhaps the business you are investigating has an unusually high degree of competition, and as a result cannot do as well as the industry norm. Maybe it operates on the 7.5

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lower margin end of the industry, and makes up for its lower margins with a higher sales volume. While we need to be suspicious, we must also recognize that not every abnormal situation is proof positive of wrongdoing. In determining sales using cost of goods sold or gross profit, we obviously need to know what that cost is. To complicate the process, many businesses sell more than one item, and various items often carry with them differing gross profits. As best as reasonably possible, you need to categorize the major components of the sales and determine the typical gross profit or cost of goods for each category. You also need to know the approximate proportion of a company’s total sales represented by each category. With that information, you would be able to calculate a typical weighted average gross profit percentage. When doing this, remember that occasional clearances of slow moving items would depress the average gross profit margin; that discounts and other allowances might similarly lower margins; and that fluctuations occur from year to year. Margins do not always stay constant from year to year. Especially in industries that experience technological advances, margins have a tendency to shrink. Also, margins can change as the sales volume changes. If we compare a company with a large sales volume to one with a small sales volume, with both of them selling the same items, the one with the large volume may have better margins because it is able to buy in volume and thus buy cheaper. On the other hand, one reason the company has a larger volume may be that it discounts to generate that higher volume and is satisfied with the resultant lower margins. You must know which, if either, of these possible situations is correct so that your conclusions will be rational and convincing. In many types of business, particularly service providers, it is futile to attempt to calculate sales from gross profit. In many of these businesses, there are no costs of goods sold in the normal sense and no easy relationship between that type of expenditure and the determination of sales. For instance, if dealing with a professional practice, you might try to determine sales revenue based on payroll, but numerous variables, such as differing hourly rates, different billings to different clients, down-time and the like, will make your margin of error so large that the exercise is meaningless. The goal of this approach is to find something (we refer to it here as “cost of goods sold”) that has a direct connection to and varies in direction proportion with the company’s sales. It might be payroll, the number of hours worked, the wholesale price of goods purchased, the purchase price of raw materials, the volume of water used, and so on. Different businesses within the same industry may even require different approaches. However, most businesses that you will investigate will have some cost factor that can be used to come up with a reliable determination of sales. A number of examples follow. For many of these businesses, Appendix C provides useful information. Brothel. My favorite story (and a true one at that) illustrates how the cost-ofgoods-sold approach works, how ingenuity is important, and how even in a service business where an actual cost of goods sold may not exist, there is some item with a direct relationship to sales. It involved the IRS and a brothel in Atlantic City, New Jersey. Some years ago, during a tax examination of the brothel, in the days before the casinos, some unsung hero in the IRS knew (presumably by

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common knowledge) that part of that brothel’s income was unreported. The obvious question was how to determine the amount. The agent’s solution to this problem was resourceful and entertaining. That agent, either through cleverness or experience, realized that there was a relationship between the number of clients served and the number of towels used. Further, and fortunately, this establishment used an outside laundry service. The agent obtained the bills from that service, determined the number of towels laundered in a representative period of time, and subtracted an allowance for noncustomer use of the towels. The result was a determination of the number of customers served in a specified period of time. Then, perhaps by a stroke of genius or by sweat of the brow, that agent determined the going rate per unit of customer service and multiplied that by the number of customers previously determined. The result was a calculation of the amount of gross revenue, which, when annualized, gave the IRS a workable annual gross revenue figure. Obviously, that figure was considerably greater than the one reported. The case went to court and the IRS’s approach was upheld, a lesson to all of us who aspire to greatness. This type of business is both simple and complex. It is simple in that we all know what it does: it buys alcoholic beverages wholesale and sells them retail. However, investigating its revenue can be complex in that it mixes drinks, it has differing gross-profit percentages for different products, it may also sell food like sandwiches, and it may also have take-out sales at considerably lesser margins. In addition, it will probably have special promotional activities, happy hours, and the like that eat into its standard margins. Besides all that, you need to know whether it is a standard blue-collar bar specializing in draft beer and shots, or whether it caters to an upscale crowd, with imported beers and fancy mixed drinks. Once you have clarified all those points, you can determine sales for categories of purchases, grossing up those items based on the margins realized and, of course, allow for spillage, promotional giveaways and the like. Depending on the degree of owner supervision, you might also need to factor in a percentage for employee theft. The alcohol part of the sales is just one area that needs attention. Typically, bars also sell food such as simple sandwiches and the like. You can determine the gross profit from an analysis of purchases and sale prices of the same items. Usually, that is not difficult since the typical bar does not go through major preparation of the food it buys; it simply puts a sandwich together. Major culinary efforts are not an issue. Also, just as with the liquor area, you will generally be able to obtain fairly reliable trade source information to tell you whether any calculations you make are within reason. Unless your calculations support it, do not assume that the gross profit realized from the sale of food in a bar is comparable to that realized in restaurants. These are two different types of businesses, and you should not use industry standards for one as a basis for calculating income for the other. Finally, even though this is not an element of revenue which we calculate based on gross profit or a relationship to purchases, whenever investigating a bar, make sure that you visit the bar and see what it offers besides liquor and food. Typically, you will find cigarette machines, pinball machines, maybe a juke

Bar.

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box, and possibly other gaming machines. Some accountants are of the opinion that a bar that reported income from these machines would be a unique and singular occurrence. Determine whether these machines are owned by the bar (in which case all the revenues are retained) or whether they are owned by a vending company (in which case typically half the revenues go to the bar). Simply because the machines are not carried on the books does not mean that they are not owned; sometimes they are purchased with cash. From the experience of this author, beauty parlors are one of the most notorious under-reporters of income (especially in proportion to actual revenues) in the United States. It is not unusual to see an operator on the books for only $10,000 per year, and the owner of the shop making about the same, despite the fact that each works maybe 50 hours a week. Ideally, you should be able to reconstruct gross revenues by going to the appointment book and calculating the number of customers at the appropriate rates. However, there seems to be an unwritten law, uniformly followed by virtually every beauty parlor, that appointment books are destroyed either two minutes after they are used up or two minutes before the investigative accountant asks for them. One solution is to deal with the current appointment book, perhaps settling for only the last week or the last month. With that source, attempt to determine the correct revenues for the current time and assume a consistency with the past. An alternative but related approach is a categorical analysis of sales and charges as a basis for recalculating revenues. Among the steps that you would need to take into account would be:

Beauty Parlor.

The typical number of customers served, whether on a daily or weekly or other basis. For this you might use a nonprofessional assistant to sit outside the beauty parlor and count the traffic over a few days (recognize the difference between the traffic on a Thursday or Friday as compared to a Monday or Tuesday). Of course, not everybody who walks into the beauty parlor represents a customer. Similarly, you might calculate it based on capacity— the number of hours open multiplied by the number of operators divided by the average length of service. This, too, is imperfect and you must provide for downtime. The type of service mix. Is it a man’s haircut, a woman’s haircut, a perm, a coloring job, and so forth? Each of these services has a different price and each of these takes a different length of time. The charges and time needed for each of the major types of services offered. With this information properly constructed, you can develop a model as to the average hourly rate earned by the operators. Recognize that, in some cases, an operator in particular demand (such as the boss) might get a slightly higher fee for a particular type of service. This type of business typically sells not only prepackaged goods at standardized markups but also sandwiches and coffee. The correct gross revenues for the packaged goods are fairly easily determined by grossing up the purchases in accordance with the standard markup. However, it requires a little more effort to determine the revenues generated by the sale of sandwiches.

Convenience Food Store.

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Perhaps the best way to do that is to actually purchase a few sandwiches, take them to your office (or perhaps your kitchen), take them apart, and weigh each of the components. You might find that a sandwich has one-fourth pound of meat, one-fourth pound of cheese and various trimmings. By comparing costs to the sales prices of the products, and allowing for such things as lettuce, ketchup, mustard, mayonnaise, and the like, you can thus determine the actual cost of a typical sandwich. Determine if you can, perhaps with the help of the business owner, how sales break down by categories. For instance, does it do 30 percent of its business in sandwiches, 40 percent in packaged goods, and so on? With that information, you could develop a weighted gross profit and, using the company’s purchases, calculate backward to what the sales should have been. Our concern here is not with contractors whose customers are large construction companies that would not pay with cash. Rather, our interest is in the contractor who deals with homebuyers, especially those who want extras outside of their home purchase contract or the contractor who does renovations. Contractor revenues normally come from two sources: labor and a markup on parts. As to the parts, allowing for fluctuations in inventory (assuming that the contractor maintains an inventory), you should be able to determine the portion of revenues generated from these parts by determining the typical markup and applying that to the total purchases during the year. Be sure to subtract purchases that are tools for the contractor. This approach is only for the goods consumed and installed in the work. As for the labor, assuming that payroll is on the books, calculating the total number of hours paid should not be difficult. Also include a calculation or an approximation of the hours worked by the business owner. As to the owner, attempt to differentiate between those hours spent in supervision, which may not be directly billable to any job, and those hours spent working on a job for which a customer can be charged. One way to calculate the number of hours is to take the total pay received by an individual and divide it by the hourly rate. In many cases, that total pay will include an overtime premium. To the extent possible, use only the number of hours actually worked. One aid in determining that number is workers’ compensation reports, where somebody else has already made these calculations. The next issue is, of course, to determine the rate at which various customers are charged. Once that has been factored in, as well as an allowance for downtime, and for paid days off and the like, you can then make a reasonably accurate estimate of the total revenue that should have been generated from the labor paid by the business. Electrical Contractor.

For this type of business venture, the approaches that can be used include determining the number of tables or booths rented and what the rent is for each of them. Of course, you have to determine whether there are vacancies and whether there are multiple-month contract discounts. Most flea markets, just like apartment buildings, experience some vacancy. A good idea would be to walk through the flea market on a couple of occasions to estimate how many vendors there are. Also, recognize seasonality differences. Typically, when we approach the holiday season from mid-November to the end of December, you would expect nearly all the booths or tables to be rented. Flea Market.

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If it is an outdoor flea market, the spring and fall months, and possibly the summer months, will likely have a much greater percentage of locations rented than the winter months. If it is the low end of the flea market business, you will be dealing with an open air lot with tables. Some of these might be rented in an on-the-spot transaction, which is very dependent upon the weather. If the weather is inclement on the weekend, perhaps none of the tables will be rented that day. Therefore, you may also need to factor in information from the weather bureau as to what the weather conditions were weekend by weekend for the past few years in that location. You may also need to factor in holidays, that is, during certain holidays such as Christmas and Easter, perhaps no booths are rented. Garbage Hauler. Nowadays, with the general dominance of the garbage disposal industry by large companies, we see fewer and fewer of the mom-and-pop onetruck disposal companies. Nevertheless, habits and a sense of independence are hard to change. There is still, more often than not, the tendency to have unreported income. As a generalization, haulers have three types of customers: residential, commercial/industrial, and municipal. Those that deal with residential typically will have many accounts, and do a large volume of billing on a regular basis. By the very nature of the volume, as well as the relatively small amounts, those usually are paid through the mails and by check, and therefore do not lend themselves to being pocketed. Municipal-type work usually is represented by the fewest number of transactions, but by the largest single checks. These also do not lend themselves to becoming unreported income because they are always paid by checks payable to the business. Of course, if the business happens to be in the same name as the owner, it is much easier to take such a check and deposit it in a personal account, or possibly even cash it, and totally avoid the business’s record-keeping system. This type of item, though, is generally a bit easier to trace because the payments by municipalities are regular, typically monthly, and generally show up in the company’s books. Also, municipal contracts are, for the most part, public knowledge and as a result, fairly difficult to hide. Typically, the commercial customer accords the greatest opportunity for unreported income. As just related, involving other types of businesses, although we all know the garbage disposal expense for a business is a deductible operating expense, cash-receiving businesses are often willing to pay in cash. Therefore, it is not particularly unusual for restaurant or retail type businesses to agree with the hauling company on a slightly better price in exchange for cash payment. One possible method for redetermining the income is to calculate the amount of revenue generated by each truck for each route by day and compare that calculation to that reported by the business. There are serious drawbacks with this approach because it lends itself to a degree of impreciseness that might leave too wide of a margin of error for comfort. How well this can be fine-tuned, of course, depends on the particular circumstance, just as in so many other aspects of our work.

This type of business generally gets its revenues from three sources: the sale of gasoline, the repair of cars, and the sale of products (typically cigarettes and soda). In a station that is also a convenience food store, the approach for investigation purposes is to look at that part of its operations as a separate business. Gas Stations.

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In theory, this is a very easy item for which to calculate revenues. Unless you are dealing with a station buying bootleg gasoline, its purchases are from major refiners and will be well and easily documented. The invoices directly from the suppliers, typically major gasoline companies, will give you ample detail as to the number of gallons purchased, and will also give that detail by the type of gasoline (unleaded, premium, or some gradations in between). You should also be able to get a printout, typically supplied by the gasoline company, listing each and every delivery, the number of gallons according to the type of gasoline, and the per-unit charge. With this information, the only other question is what were these gallons sold for, that is, the markup. Typically, gasoline stations do not maintain a record of what gasoline was sold for day by day for the past several years or, if those records are maintained, you will never see them. Furthermore, the gasoline companies do not require that they maintain these records nor will they have a copy or a listing of such a history. However, you should be able to determine the typical markup based on a visual inspection on the day you go to the gas station, another reason why you need to visit the business being investigated. When you are there, observe the prices posted and compare them to the most recent delivery invoices. Based on comparing those spreads, you should be able to determine a typical markup. Inquire whether there have been any major changes in the past few months or few years that would make the margins today different than they used to be. Local service stations are subject to potentially large swings in their markups based on local competition, price wars, shortages, and the like. Also, recognize that a 16-pump station with no service bays selling only gasoline and doing two million gallons a year will typically survive on a much smaller margin per gallon than a local service station that has only four pumps and gets a good portion of its revenues from repair work. Once you have determined the typical markup and have calculated the number of gallons purchased, you should fairly easily be able to determine the total revenues from the sale of gasoline. For the most part, inventory fluctuations are irrelevant unless there has been a change in the number of tanks maintained by the station, or a dramatic change in the prices of gasoline; the inventory from year to year can barely change.

Gasoline Sales.

Repair Work. This is far more complicated, does not lend itself to a simple approach, and is much more typical of the problems faced when dealing with a retail type establishment. Similarly with restaurants, you may also be faced with sales tickets that are not numbered. In addition, repair bills typically have elements of labor as well as parts in them. It is necessary for you to attempt to determine how many hours of mechanics’ labor were paid for by the business (putting aside for the moment the issue of unrecorded payroll payments in cash) and, of course, the hourly charge for mechanics in your area, and in particular at that service station. Recognize also the likelihood of some downtime. In addition, you need to make a calculation as to the markup on parts. Determine the comparison between the cost of tires, spark plugs, belts, oil, and so on, as paid by the service station to their selling prices. An added wrinkle in approaching the calculation of revenues in this manner is that many service stations also have what they call “specials.” For instance,

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there may be a flat charge for a tune-up that does not, on any sales invoice, break out a separate charge for the spark plugs and for the labor. Similarly, for perhaps a brake job or for a combination of several items. This makes the calculation of the markup that much more difficult. In this type of a situation, it may be necessary to attempt a reconstruction of the components of the specials so as to be able to determine what, if anything, is typical for the portion of the special represented by product and that portion represented by labor. Admittedly, this is imperfect, but in doing a reconstruction of income where there is unreported income, virtually every method has certain elements of imperfection. Cigarettes and Soda. It is not unusual for gasoline stations to augment their income by the sale of cigarettes, soda, and even candy or other odds-and-ends. This is so even where there is no full-fledged convenience store as part of the station. It is also true where it is a pumper-only station with no service bays. The approach here is similar to that used in other situations involving the retail sale of product: determine the markup, determine the amount of product purchased, and apply the markup to the purchases, thereby backing into a calculated amount of sales.

While not an element in directly determining revenues, as another approach in terms of “proving” the nonreporting of income as well as in balancing your approach and being fair from an economic point of view, recognize that many gas stations pay part of their payroll in cash, off the books. If the owner is willing to pay other people in cash, logically the owner also is getting paid at least partly in cash. To put it another way, if you would cheat the government on behalf of employees, you probably would also cheat the government on behalf of yourself. One approach to estimating the payroll is to determine the hours that the station remains open and then determine how many worker hours would correspond to the number of people working. Also, visit that station on weekends and off-hours and observe who is working. Then try to find these people in the payroll records. Factoring in the going labor rate, you should be able to determine the approximate payroll expense the company should have reflected on its books, and compare that to what is actually there. Be careful that you differentiate between gas jockey labor and mechanics labor. In a case a couple of years ago, we were presented with the tax returns of a pumper-only gas station that was open 24 hours a day, 7 days a week. Other than a modest salary for the sole officer of the company, the total payroll was $26,000 per year. Obviously, the actual payroll was considerably more than that reflected. Finally, though not a function of determining income, when investigating a gas station, keep in mind that it is customary for gas stations to have the equivalent of an escrow account with the fuel company, which is often tied into the gallonage purchased by the station. Further, these funds are placed in interestbearing accounts. The result can be a fairly substantial asset, one that is not always reflected at its current value on the books of the gas station. If there are doubts, it should not be too difficult to obtain proof directly from the gasoline company. Payroll.

Another cash business that has unique considerations and difficulties in calculating income are greenhouses. If possible, try to establish an approach

Greenhouse.

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based on units of product. For instance, can you show that the greenhouse purchased or grew 50,000 azalea plants or sold 500 flats of snapdragons? The number of units grown or purchased, with allowance for loss and damaged goods, is a good indicator of the business’s revenues. However, difficulties include seasonal price fluctuations, different size plants selling for different prices (and there is virtually no way to find out the size of the plants), purchasing stock from a supplier as contrasted with growing it internally, as well as the greenhouse purchasing for cash to make the trail more difficult to follow. One approach might be to look at it from a seasonality point of view, and then extrapolate the results therefrom. As an example, if you can determine that it purchased 10,000 poinsettia plants during the peak Christmas selling season and that they should have sold for $5 each, then gross revenues from those plants should have been at least $50,000. If the revenues reported in the cash receipts journal or equivalent during that time was for instance only $40,000, then you may have determined that there was at least $10,000 of unreported revenue, which represented 25 percent of the actual revenues reported. For our purposes, that might mean that on a year-round basis the extent of unreported revenues is 25 percent of the reported revenues. When investigating a home-cleaning service, if possible, find out how many jobs this company cleans daily, how many days a week it operates, how many people it employs, and its typical charges. Sometimes they operate in a group format, with a van that picks up several workers at a central location and then drives them to various jobs, takes a couple of hours perhaps for each job and then goes along to the next one. The method here is to determine the number of jobs handled in a typical day or week, and then extrapolate that, based upon the typical charges, to arrive at the gross revenues per year that should have been realized. A less reliable approach is to use the labor costs, determine what a typical employee gets paid in a day, how many days’ labor the payroll costs for the year represented, how long it takes an employee to do a job, at what rate, and then of course, factor in how many units of production that employee did and therefore how much revenue was generated. Do not overlook the need to factor in downtime. Home-Cleaning Service.

Another notorious cash business, and one that sometimes receives substantial amounts of money in cash, is landscaping. Homeowners have no particular concern about the deductibility of the payments (unless they are using funds from their own business to pay a personal expense) and therefore are prone to work out a deal where they pay less with cash. Landscaping is another business where a review of the purchases is extremely important to determine sales. Try to ascertain the amount of trees, bushes, and other goods that were purchased during the year. Categorize them as best as possible based on typical selling prices. Using this method, and knowledge as to what the typical markup is, you can then figure out one element of that landscaper’s gross sales, for example, those based on the sale of trees. You can apply this concept to various other elements of a landscaper’s job, such as gravel, plants, railroad ties, sod, and so on. It is obviously crucial when using this approach to know not only the extent of purchases but also the typical markups. Labor is also a factor with landscapers, and for that you would need Landscaper.

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to know the hourly charge, approximately how many hours are involved in a typical job, and how many such jobs were serviced during the year. Alternatively, how many hours of payroll were incurred by that business? A problem with this approach is that typically some or perhaps even all of the laborers employed by the landscaper (assuming this landscaper has any employees) might be paid in cash. The two critical factors in determining the gross revenues realized by a school are the number of students enrolled and the tuition per student. For the most part, this information, even though we are dealing with a private school, is easily obtained. If investigating such a business, finding out the number of students enrolled and the rate charged can be as simple as calling the school and asking. Most of them are more than eager to inform potential students as to how many they already have and, of course, what they charge has to be disclosed in order to attract students. Sometimes this information can be obtained through the yellow pages or through school associations. One should keep in mind when doing the calculation to determine total gross revenues to allow for below-standard tuition, such as for charity cases, multiple siblings, or perhaps a volume sign-up if the school provides industrial and business training.

Private Schools.

A psychologist is one of the easier medical care providers for which to determine income based on the number of appointments. Typically, there is one rate (sometimes different for long term patients) in very fixed measures, such as $100 per 45-minute session. Furthermore, their appointment calendar is normally neatly blocked out in these 45-minute (to one-hour) appointment time slots. Calculating the number of appointments during a representative period of time and multiplying that by the appointment rate should give you a fairly accurate idea of the revenue generated by that practitioner. Allow for some margin of uncollectibility, and for a willingness to accept what the insurance company pays or to compromise between that and the normal, full rate.

Psychologist.

First and foremost with restaurants is the cost of food. Of course, you must know whether this is a diner-type restaurant, a gourmet operation, or a fast-food location. You can determine by industry norms, or by actually testing that company’s costs, what percentage of sales food should represent. You might even need the help of an experienced chef to advise you, for instance, how much chopped meat is necessary for how many hamburgers, and how much waste is expected. Restaurants.

Tablecloths. Perhaps this restaurant uses tablecloths cleaned by an outside laundry service. If it does its laundry internally, you can skip this step. Inspect a representative time period of laundry bills (such as three months) and tabulate from those bills how many tablecloths were washed. Based on your knowledge of the different sizes of tablecloths (which you will need to know), how many people could sit at the tables that those cloths would fit, the average number of people (just because a tablecloth is for a table that seats four does not mean that four people were there), and a multitude of other variables, you should be able to make a reasonable approximation of how many people were served. You also need to know the amount of the average bill. This can vary widely, depending on the proportions in which this place sells breakfast, lunch, or dinner.

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Placemats. If this restaurant uses placemats instead of tablecloths, the concept is the same but the execution is perhaps a bit easier. With a representative sampling, calculate how many placemats were purchased and proceed with your determination of revenues based on the assumption of one placemat per customer. Allow for some waste since a table may be set with four placemats and all four were discarded after only two customers were served. Also, when using placemats, because of the volume involved, be especially cautious that you use a long enough time frame so your results are not distorted by swings caused by a purchase that was not fully consumed.

If laundered, use the same concept just described for tablecloths. If napkins are paper and discarded, use the same concept as described for placemats. Napkins.

Use a sampling of available customer bills to determine a typical sale. You might determine this based on the typical table, or the average per customer, or perhaps the average per customer per type of meal (that is, breakfast, lunch, or dinner). The goal is to determine what a typical customer spent so that you then have a basis for using that number as a multiple against the number of customers you have determined the restaurant served. This approach might also work by determining how many of these bills were purchased. They are usually purchased in the form of pads, and you can use the number of pads times the number of bills per pad in a manner similar to that for napkins or placemats. Again, make sure your time frame is wide enough to even out distortions. This might also work well if the receipts are numbered, though that is a bit unusual in most of the smaller restaurants. Obviously, it is extremely important to visit that restaurant and observe how it works, how the tables are set, and so on. Again, onsite inspection for the investigative accountant (even if not engaged to do the valuation) is important in many, if not all, situations.

Checks and Bills.

These periodicals are typically published weekly or monthly and are often distributed free at various stores. They get their revenue from ads, whether full, half-page, or classified ads. They usually carry a small amount of editorial content, basically serving the shopper to highlight current local store sales and promotions. As you might expect for a business that deals with retail businesses that receive their income in cash, some of the publisher’s income may be received in cash and inevitably some of it may go unreported. To complicate matters, it is also not uncommon for the publisher of a shopper newspaper to receive part of the revenues in barter. For instance, perhaps the ad space was sold to a furniture store in return for a couch and a loveseat. An excellent way to determine revenues for this type of business is to base it on the volume of ads placed in the newspapers. Take a representative sampling of a few weeks or a few months (giving special care as to if and how you include large or small issues, such as during the holiday season or during the summer doldrums). Count the number of ad pages in each issue and categorize them based on whether they are full-page, half-page, or whatever. Do the same for the number of lines of classified ads placed in each issue. Using the established rate chart, you should then be able to determine the gross revenues actually generated. Shopper Newspapers.

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However, there are different rates based on whether it is a one-time listing, a three-time listing, or perhaps a monthly listing with an annual contract. If you can determine what is typical, use it; otherwise, take a conservative approach and assume something less than the full rate. A few years ago, doing one of these investigations, we found that the most effective approach was to bring a portable computer and key in a large volume of data relevant to purchases (coding them appropriately as to the type of item) and then performing a similar function from sales invoices. Using the number-crunching power of the computer, we were able to develop a reliable blended gross profit percentage. As a test of the reasonableness of that gross profit percentage, we compared it to published industry data and found it to be within one percentage point of the industry norm, but interestingly, several percentages higher than that reported by the business. Stationery and Office Supply Stores.

Many used car dealerships use an inventory system that essentially identifies each used car as a separate cost center. That inventory card will reflect the original purchase price of the used car, along with any additional direct costs such as an engine overhaul, new tires, and so on. Those cards will also reflect the price at which the company sold the car. With a sufficiently broad sampling of these cards, you can determine an average gross profit margin. By applying that gross profit margin to the cost of goods sold reflected on the company’s books, you should come fairly close to the reported sales, if all revenues are reported. One of the problems with used car dealerships is that they sometimes sell a car partly on the books, and partly off the books in cash. The buyer believes that he or she is getting a lower price and saving on the sales tax. Also, used cars are sometimes unloaded totally for cash and, if the dealership is doing a large volume, it might treat those cars that are sold for cash as part of a large group that was unloaded to a wholesaler. Using a gross profit concept may enable you to determine more accurately the company’s actual sales. It is important to recognize that some used car dealerships sell a significant amount of their vehicles in the wholesale market, often receiving little more than cost. If the books do not reflect that business you must, in some way, segregate it so as not to distort the results of your methodology. Used Cars.

CHALLENGING ALLEGATIONS OF UNREPORTED INCOME. One of the most difficult allegations to handle in a business valuation or income reconstruction situation is an allegation of unreported income. This section focuses on the situation where one investigative accountant has concluded that unreported income exists and another must question whether a conclusion that unreported income exists is valid. First, it is important to understand that, with the exception of rare situations (that is, where there is a valid detailed second set of books to which the investigative accountant had access), calculations of unreported income are, by necessity, approximations. Therefore, when making a determination as to unreported income by a gross profit method, a lifestyle method, a testing of invoices, or virtually any other approach, there are margins of error. That does not make the calculations any less reliable or the conclusions any less valid. It only means that the 7.6

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actual numbers could be somewhat higher or lower; but, if the calculations were poorly done, the actual number can be much higher or lower. Let us consider some avenues for challenging calculations of unreported income. Sample Tested. Many approaches toward determining unreported income use a sample of a number of invoices or a period of time. It is fair to question whether the sample is reasonable. For instance, did the accountant use one day of sales and then extrapolate that to a full year — multiplying by 365 (which itself may be an error if the business was closed on weekends, holidays, etc.)? Is one day adequate; and even if it is, was that one day representative? Most of the time, one day would not constitute a sufficiently broad sample. Questions to ask include whether the day chosen was a holiday, the day before or after a holiday, a weekend or a weekday, whether the weather was particularly good or bad, and whether normal hours were maintained by the business on that day.

It is common to use a “smell test” of a business’s reported income by comparing certain numbers to industry norms. We might look at gross profits, the amount of payroll, or other measures of the specific business in comparison to industry norms. While that might be useful in getting a first impression as to whether a search (which can be expensive) for the determination of unreported income may be fruitful, it is rare that the procedure can stop at that point. Industry norms consist of businesses doing better than, worse than, and approximately the same as the industry norm. Just because the subject business is not at or near the norm doesn’t necessarily mean there is unreported income. There may be factors such as local competition, poor buying or selling practices, or a propensity (intentionally or unintentionally) to attempt a volume business by selling at lower margins. This business may not be “normal,” and therefore comparison to an industry norm may be inappropriate. Use of an Industry Norm.

One of the more common methods of determining the extent of unreported income is to examine what the business’s real cost of goods sold margin is, compared to what is reported. If there is a significant difference, it often indicates unreported income. But, you can ask, how valid was the sample tested? Did it represent enough invoices, enough products sold, an adequate representation of the company’s products so as to warrant a determination that the business had unreported income? Did it take into account perhaps an annual sidewalk clearance sale that would tend to reduce the company’s overall margin? (A sidewalk sale is often in cash, and the volume of business transacted may not be large enough to depress the overall margin sufficiently to impact an otherwise valid calculation.)

Costs of Goods Testing.

Particularly for manufacturing processes, wastage or shrinkage should be taken into account. Just because it has been determined, with preciseness, that a particular business can turn $2.00 of raw material into $5.00 of saleable product does not mean that its cost of goods sold is 40 percent (or that its gross profit is 60 percent). Wastage or shrinkage might trim a couple of percentage points off the profit, which might have a major impact on a conclusion as to unreported income. Of course, some processes generate scrap, which in turn is sold for cash.

Wastage or Shrinkage.

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Changes in Inventory. Even if a business turns $2.00 of product into $5.00 of sales, did the determination of unreported income based on that calculation take into account, for example, that the business’s inventory increased substantially from the beginning to the end of this year? If that occurred, then it would be inaccurate simply to determine the extent of purchases made by the business and assume that all of those purchases were converted into sales. Some of those purchases wound up as additional inventory at the end of the year and were not used to generate sales. The failure to recognize such an inventory buildup would tend to overstate the unreported income. On the other hand, if the inventory declined during the year, failure to recognize this decline would tend to understate unreported income. One of the inescapable facts of life in many of these businesses is that there is no way to be sure what the inventory was at any point in time. Therefore, it may not be possible to take such fluctuations into account, other than by approximating what they might have been based on some relationship, perhaps to sales. Lifestyle or Standard of Living. At times, many of the tests we normally would employ for the determination of unreported income (or to give comfort that there is no unreported income) are not satisfactory. In those situations, we often employ a standard-of-living analysis to determine if the reported income is consistent with how these people have lived. If the couple live in a $500,000 house and have a lifestyle requiring $200,000 a year, this raises questions if they have only $50,000 a year of reported income. However, keep in mind that the standard of living could have been maintained by ever-increasing levels of debt or family gifts. Also, look for a second job or the spouse’s income. An integral part of this process is to make a determination as to what the costs of living are. How much does this family spend on food, clothing, vacations, and the like? How accurate were these determinations? If the determination of the standard of living is seriously flawed, then conclusions as to unreported income based on these figures may also be seriously flawed.

While it is often impossible and inappropriate to apply a smell test to a calculation of unreported income, sometimes in extreme situations this technique can be utilized to challenge the bigger picture. For instance, even if everyone is reasonably confident that there is unreported income, what if you are faced with allegations that this unreported income is $500,000 a year, and no one is seriously challenging that the standard of living enjoyed by the couple was “only” $100,000 a year more than the reported income? What happened to the other $400,000 per year? There are a multitude of possibilities including gambling, drugs, paramours, and hoarding. But it is also possible that unreported income of such a magnitude —without being able to show how it was spent or where it was accumulated—is so out of line with reality that it must be considered suspect.

Smell Test.

Assume there is unreported income of $500,000 per year, yet a lifestyle requiring only $100,000 per year of unreported income. One explanation may be that the business has significant unreported expenses. For instance, the business may pay some of its employees or handle other expenses on a cash basis. One problem is that many times the business owner will vehemently deny the existence of any unreported income or expenses. It is often more difficult Unreported Expenses.

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for the accountant to determine unreported expenses than unreported income. At what point should your client come clean as to unreported expenses to help deflect the damages of an otherwise valid unreported income calculation? One complication is that some unreported expenses (items purchased in cash) may be products that are resold. Proof of such unreported expenses can increase the extent of unreported income. Worksheets and Documentation. When there are allegations of unreported income, it is reasonable to expect that the person making those accusations (that is, the investigative accountant) has worksheets, calculations, documentation, or other papers to support the allegations. The accountant may prepare a report. Depending on the detail provided, much of the supporting material may be left out. However, there may also be work papers and testing analyses not provided in the report. One way or the other, it should be demonstrable that the process by which the accountant concluded that there was unreported income is replicable.

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8

OPERATING EXPENSES Expenditure rises to meet income. — C. Northcote Parkinson

CONTENTS 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12

Introduction Owner and Officer Payroll Other Payroll Rent Depreciation Retirement Plans Repairs and Maintenance Insurance Travel, Entertainment, and Promotion Automobile Expenses Telephone Professional Fees

117 117 120 122 125 127 130 132 134 136 138 139

8.13 8.14 8.15 8.16 8.17 8.18 8.19 8.20 8.21 8.22 8.23 8.24

Payroll and Other Taxes Officer’s Life Insurance Employee Benefits Interest Expense Fines and Penalties Bad Debts Office Expenses and Supplies Memberships and Dues Subscriptions Utilities Miscellaneous Social Security Numbers

140 141 141 143 144 144 146 146 147 147 147 147

INTRODUCTION. Chapter 7 dealt with understanding and reconstructing the actual revenues generated by a business. This chapter will deal with a somewhat easier element of our work: analyzing what is already on the company’s books and records. In a classic sense, investigative accounting deals with what is in the books and what is not in the books. For the most part, expenses are in the books (except where intelligently and cleverly balanced, with some expenses paid in cash to keep ratios within reasonable proportion). The income aspect of the business is sometimes not in the books and more difficult to analyze. In general, all expenses are approached in the same broad manner: the expense is reviewed and considered for its reasonableness, appropriateness to the business, and whether it is personal and not business in the ordinary and normal course of operations. However, each expense is somewhat different, has certain different considerations and, as a result, there are various ways to approach analyzing such expenses. 8.1

OWNER AND OFFICER PAYROLL. Except for cost of goods sold, which was dealt with in Chapter 7, the single most important expense category that we need to review is compensation paid to the business owner. In a general sense, we simply need to know how much compensation the business owner realizes from the business. That aspect relates to the issue of reasonableness and therefore also 8.2

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to business value, which in turn relates to the amount of support or alimony. It also has a relationship to the standard of living enjoyed by the marital unit. This section deals with the compensation paid to the owner and classified as such on the business’s books and records. Additional compensation taken in the form of perquisites will be dealt with later in this chapter, when reviewing the investigation of various expense categories. This was also dealt with in Chapter 7, as the uncovering of unreported income results in additional owner compensation. In most situations, the compensation paid to the business owner typically runs through the expense category of owner’s compensation. Sometimes, however, you may find it in independent contracting, outside consulting services, or in an overall general payroll category. As long as these are all reported on the personal tax return, they are compensation in the classic sense. However, we must not presume that an expense category called officer’s compensation is the only place such compensation is recorded. All that being said, what do you do with this series of payments? First, it is important to know how the compensation is paid. Is it a weekly payroll, is it monthly, is the owner paid differently than the employees (in the sense of the type of check, the frequency, and so on)? This is also important in understanding how the marital unit lives and its personal cash flow. In many situations, the amount of the paycheck is constant from week to week or pay period to pay period. Once you have determined how compensation is paid, and made a schedule of it, the next step is to trace that compensation (keeping in mind we are dealing with the net pay) to the personal bank records. It is obviously of great concern if you have what you think are the personal banking records and you cannot find deposited therein that business owner’s compensation, or you find deposited therein considerably more than the reported compensation. In doing this tracing function, be especially attentive to bonuses and unusual paychecks. Recurring pay, by its nature, is typically easily accounted for and deposited routinely in known bank accounts. Bonuses, out-of-the-ordinary checks, and the like are more prone to attempts at hiding. Tracing disbursements made payable to the owner involves more than merely finding that they were deposited in bank accounts. We also look at the actual checks for endorsements and other indications of the accounts or other destinations for these funds. When we determine that a particular bonus check (or even a regular paycheck) did not get deposited into a known bank account, by reviewing the check we might actually note where it was deposited. Merely because one is an owner does not mean that person is entitled to compensation from the business as if that compensation were an ordinary and normal operating expense. In a case a few years ago involving an automobile dealership, one issue was the brother of the major shareholder who himself was an officer and shareholder and who received substantial compensation from the business but allegedly did not work there. The overall underlying issue was whether or not this brother worked for the company. We were advised by the major shareholder-owner-brother that of course the other brother worked for the company, put in long hours, and earned every penny he was paid. Our client told us a different story. Our investigation revealed that indeed the other brother did not work for the company, and while we were still unsure as to the reasons for his pay, clearly it

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was not earned and not a legitimate expense of the business. Among the reasons for our conclusion were: • We spent a few days at the dealership doing our investigative work. During that time, we never once observed that brother working there. • In fact, we worked in that brother’s alleged office. If indeed that brother actively worked for the company, we found it rather odd that the office was available to us for several days with no need to juggle schedules and no problems getting access to it. • That office was bare of the normal appointments one would expect in an office, such as pictures of friends or family, decorations on the wall, odds and ends on the desk, and so on. In fact, the desk drawers were completely empty, and a thin layer of dust covered work surfaces, which would not have been present if in fact the office were being used. • While going through various records, we needed to discuss several issues with the bookkeeper; in a rather nonchalant manner, we got around to discussing this brother. This bookkeeper, who had worked there five days a week for the last several years, had never seen him. With a law firm that represents a municipality, it is not unusual for payment to go directly to the lawyer. The work is done on firm time and is an element of that lawyer’s service on behalf of the firm. Nevertheless, this type of pay comes to the officer separately as a W-2 through the municipality, with the law firm making the appropriate offset against the salary for the lawyer. Essentially, the compensation from the municipality is additional earnings of the practice and in turn compensation to that lawyer. Where owner or officer compensation has been reduced dramatically around the time of the filing of the divorce complaint, be especially wary. Do other elements indicate that this reduction has no economic basis and is merely divorce planning? For instance, simultaneously with the reduction in pay, did the travel allowance increase dramatically, or did some outside consulting arrangement fees go up dramatically, or did the company retain more profits than it normally did? From an economic point of view, if the compensation of an owner is reduced, the profits of the business are increased. While this may seem rather obvious, in a divorce the current compensation of that owner is a very important issue, if the owner is attempting to appear poorer by simply taking less salary now and waiting to take the accumulation of profits later. If the spouse being investigated is but one of several shareholders, and especially if not the majority shareholder, the time of the year of the complaint date and valuation in relation to the company’s year end may be very relevant as to officer bonuses. For example, assume you are dealing with a calendar year company that usually gives bonuses in January for the previous year. Further, that the complaint date is in October, and the spouse you are investigating is a 20 percent shareholder. As of the valuation date, only 20 percent of any interim profits or losses would be attributable to the business spouse. Let us further assume that three months later, in January, in the normal course of business the company declared bonuses, and the spouse you were investigating received a bonus representing 50 percent of that year’s income.

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Notwithstanding that the ultimate decision as to bonuses was beyond the control of your business spouse (which may or may not actually be the case) and that the bonuses were declared and paid subsequent to the complaint date, nevertheless, that money was earned (or at least about three quarters of it was earned, maybe more or less depending on the seasonality of the business), by the complaint date. Therefore, you can reflect that portion of the bonus as part of the marital estate, with the remaining business profits as part of the company proper and subject to normal valuation and allocation procedures. Granted, as of the time of the complaint, perhaps no corporate decision had been made to issue such a bonus and, in the strictest sense of accounting, it would not have been accruable at that time. However, assuming that the profits were there (in this example in October), for our purposes it would be reasonable to attribute the appropriate portion of that bonus to the marital estate. Obviously, this is only meaningful where the subject party owns less than 100 percent of the company, and where the bonus for that person is more than his or her percentage interest in the company. If the bonus as a percentage of the available profits was less than that person’s share of the company, the reverse procedure would probably be appropriate, thereby affecting any increment to the company’s book value that you might have attributed from the partial-year profit. 8.3 OTHER PAYROLL. After cost of goods sold, this expense category is often the largest. It is also usually of less consequence than most other expenses. However, we should look in this area for paid employees who do no work, paramours on the books, unreasonable pay levels for different job functions, and, generally, for insight as to who is being paid and how many people are being paid. First, going from the approach of W-2s, determine that you have all the W-2s and that you are able to reconcile the W-2s with the books and records of the company. On more than one occasion, I have had a selected W-2 removed from the group given to me, and if I did not attempt to reconcile them to the W-3 or the company’s books and records, I would never have known that a certain friend was being paid through the business. Therefore, as elementary as this step may seem, do reconcile the records you are supplied to the W-3 or to the overall books and records. Once you are satisfied that the records reconcile, spend some time reviewing the W-2s. Ignore the small amounts, unless you have reason to believe that someone is running a scam with a multitude of small W-2s. (That would be very unusual; suspicious payroll would usually be elsewhere.) Look for larger W-2s, especially keeping in mind the names of friends, relatives, or paramours of whom you might have been advised by the spouse. If you see a bookkeeper or secretary whose job function you know calls for a salary of $30,000, and that person’s W-2 reads $60,000, it is appropriate to determine the reason. Is that extra pay on account of that person’s business job functions or personal functions? Perhaps that person works 70 hours a week and fills the role of two employees, and earns every penny. Or, perhaps that person has a special relationship with the business owner and is not earning, on behalf of the business, any part of that pay. Look at the W-2s not only for names that should be familiar to you but also for addresses. If an address happens to be the same as the one where the business owner is living, maybe (as it did in one case that I was involved in some years

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ago) that person is the paramour of the business owner and possibly not earning those funds. Recognize, of course, that in a big city environment, having people with the same address is not all that unusual. Since some names are fairly common, and since also many times members of the same family work for a company, merely having the same last name show up a couple of times is not necessarily suspicious or improper. Not only should you be looking for the larger W-2s, but also, comparing one year to the next, to W-2s that increased dramatically. A longstanding employee being paid a fair and legitimate wage may become more than just an employee and experience a significant increase in pay. Dramatic changes in pay, generally increases rather than decreases, call for further investigation. In a similar vein, you need to understand the job functions of the various employees. Certainly, in a company with a couple hundred employees, it is unrealistic and unnecessary for you to truly understand everyone’s job function. However, in a smaller company, and even in a larger company where you are pinpointing certain people, knowing their job functions is most relevant. This is another reason for having an onsite presence. If you were advised, for example, that a particular person has an office clerical function, and your investigation shows that there are three people with that function, and yet when you are there at the place of business it is obvious that there are only two people working in the office, it may be that this third person is a paramour with a no-show job. Where the number of employees is not too great, one basic task is to perform a review of the endorsements on the back of payroll checks. For instance, if there are only a few employees, and if you suspect that perhaps there is one too many, review a few months of payroll checks to that individual or to a few of the individuals, and observe the consistency or inconsistency in the endorsements on the back of the same person’s check from week to week. Also see how and where the checks are deposited or cashed. Most people are creatures of habit, and you certainly would expect the handwriting to be substantially the same from check to check for the same person. While few of us are handwriting experts, most of us are knowledgeable and observant enough to know when things are not what they are supposed to be and that perhaps a handwriting expert should be engaged. When you are dealing with a large number of employees, and especially where you are concerned about some serious fabrications within the payroll system, one approach is to list all employees sequentially by social security number. In other words, obtain a printout of all employees organized with the social security number in numerical order. A sophisticated payroll system may be able to do that. If not, then it may pay for you to have your own personnel prepare it for you. This should be a fairly easy procedure, though perhaps a time-consuming one. With a printout in your hand, a fairly quick review will tell you if, for instance, there are two or three consecutive numbers (a very unusual situation unless the company is employing brothers or sisters), or perhaps numbers with a three-digit prefix atypical for that area, or perhaps even numbers that were never issued. The place of issuance of social security numbers can be identified based on the three-digit prefix that begins the social security number. For instance, 070-000000 would indicate that number was issued in New York. Unusual social security numbers may be a cause for investigation, though normally they are simply an indication that somebody has moved during his or her lifetime.

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However, there are also groups of numbers that have never been issued at all. For instance, 955-00-0000 is a nonexistent social security number. Perhaps your clerical assistant made a mistake, perhaps it was entered incorrectly to begin with in the system, or perhaps it is a phony number used to put a nonexistent employee on the payroll. Presented at the end of this chapter is a list of the social security numbers indicating the location of origin and a grouping of numbers that have never been issued. This information was obtained from the Social Security Administration. 8.4 RENT. While not of the magnitude of payroll, rent is generally one of the larger expenses and can have a major effect on profitability. Often, as to the investigative accountant, it is of absolutely no consequence. If rent is paid to an unrelated third party, and if the premises being paid for are used only by the business (as opposed to personal rent, excess space with unreported sublet income, or related party rentals), then this expense category usually requires no adjustment. One step taken to test business-related propriety of the rent expense is simply to determine what is in that expense category. Typically, it is one of the easiest expenses for the investigative accountant to analyze. If rent is $2,000 per month, and if the total rent expense for the year is $24,000, then we can be pretty sure there is nothing in that expense category other than the monthly rent, that is, no second rent for a personal apartment, and no mispostings of something else misclassified into rent expense. With that as a known, we can then determine that, generally, the expense is appropriate. An example where the rent can be completely legitimate yet, as investigative accountants we determine an adjustment is required, is a business that moved during the year and incurred several months’ duplicative rent. While the expenditures are legitimate, perfectly tax deductible, and in no way improper, from the perspective of the business’s profitability and ultimate value, the duplicative rent was a nonrecurring expense, unusual for the business, and not reflective of its true expense structure. Therefore, that excess rent would need to be removed from that year’s expense. Where a company with too much space moves to smaller quarters with an accordingly lower rent, similar treatment might be needed. Without challenging the legitimacy of the previous rent, on a going forward basis, to properly show the profitability and value of the business, we may need to restate the prior years’ expense structure, removing the rent that was actually paid and, in its place, substituting the new lower rent. To do this requires adequate proof that excess rent existed in the past and that the business going forward will be essentially the same, though with a lesser rent expense. The opposite situation is less likely to cause an adjustment, but still needs to be addressed. That is, did the business just move into larger quarters, increase its rent expense, and would prior years require some restatement for that? Normally, the answer is no. Typically, the move to a larger and more expensive location does not mean that the company was in a bargain position as to rent, and that, therefore, its profits were inflated, and that going forward, it would be less profitable. However, we must recognize that if the company now has substantially increased rent, there might be a risk factor to evaluate vis-à-vis the company’s ability to increase its revenues sufficiently to cover the increased rent burden.

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Some situations require a judgment call for which we may not be adequately informed. While the profitability and value of the business may be negatively impacted because it is renting premises at an above-market rate or because total space is well in excess of needs, these may encompass difficult issues relating to contractual lease obligations, the extent of one’s ability to tailor space to needs without the benefit of hindsight, and the practicalities and expenses of moving, and so on. Nevertheless, where the space being rented is clearly in excess of needs, and where that excess is not being sublet at a rate comparable to the cost, greater income and value are potentially available to the business. Certainly a new owner would utilize that saving of rent expense. In a case that I handled a few years ago, I had just this situation, with the advantage of that business having recently moved to new quarters at a substantial rent savings. In fact, the business owner agreed that the prior premises were far larger than necessary with rent far greater than warranted. The move to a new location was entirely motivated by the desire to reduce rent expense and justified in that the business did not need all the space that it was previously occupying. The nature of the business was such that moving a few miles away had absolutely no impact, and its operations were identical subsequent to the move as prior, with the one difference being the company was now saving a substantial amount on rent. For my determination of value, I imputed this newly found rent savings to the previous years. I made it clear there was no suggestion there was a greater income than previously reported. However, for purposes of using the company’s history for determining value, and for purposes of illustrating a complete year’s operations in the present location, it was necessary to reflect what a potential buyer of that business (obviously the essence of determining value) would anticipate. I will readily admit that I am not sure if I would have come to the same conclusions had the business not moved. Not having had the opportunity to observe the business’s operations in its former location, certainly I could never be sure that I would have noted excessive space were it not made obvious by the move. Nevertheless, it is certainly something that one would hope to find. A much more difficult and speculative problem would be presented by your determination, or by repeated owner statements, that space was insufficient and that the company’s recent profitability had been artificially inflated because it was managing uncomfortably in outgrown space. Moreover, the company believes that a move to larger quarters at a substantial increase in rent is imminent. Certainly, that might warrant imputing a higher rent to the existing operation if, in fact, you believe it is true. It would be reasonable under the circumstances to request that this business owner, who is advising you of the insufficience of the space, indicate to you where the company will be moving and show you a copy of the new lease agreement. Assuming that is done, or at least that you are convinced the space is inadequate and a move will be necessary in the short term, then comes the very difficult question as to what that should do to the previous numbers. Clearly, based on the set of facts just described, the business will incur an increased rent expense. All things remaining the same, the company will therefore have less profit. However, why has the business outgrown the space that it is in? If it is growth, it may be reasonable to assume that a move to larger quarters is merely a manifestation

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of that business’ upward growth cycle and that its growing operations will cover, perhaps more than cover, the additional rent. If that were the case, then not only would adjusting upward the past expense be inappropriate, but likely you have already made your determination that the company’s anticipated continued growth is a strong indication of its future profitability and, as a result, value. Given that situation, reducing past profit for a future rent increase would be inappropriate. This type of a financial exercise is very difficult and subjective; it extends us into areas where we need to tread very carefully. Where rent is paid to a related party, typically the owner or a partnership formed with the other owners of the business, we cannot assume that the rent is at arm’s length. For instance, the rent might be too high. There are a number of reasons why this might be, including the need or desire to more rapidly amortize a mortgage, or to draw more money out of the business in the form of rent income for various tax reasons. Though generally unlikely, it might also be to show a less profitable firm, or on account of differing ownership interests that might cause a non-market rent situation, or even inertia from past practices. I have seen rent significantly overstated because it was calculated to cover the mortgage payment. However, the mortgage payments were unusually high because the mortgage term was unusually short. Hence, payments on the mortgage constituted an investment in the real estate (it was, of course, owned by the principals of the business). In effect, the rent was being used to build up equity in the real estate at an abnormally fast pace. When we find a situation where rent is excessive, correction of this situation causes the business to be more profitable and ultimately more valuable. Sometimes the rent is too low, such as with an older piece of property that is free of debt and inexpensive to maintain. This also helps to inflate the salaries of the owners, which might in turn permit higher retirement plan benefits and reflect an apparently more profitable business. Evaluating and, if necessary, adjusting the rent expense becomes much more difficult with a business that pays no rent because it owns its own premises. While this would be highly unusual for a professional practice, it is far more common for a manufacturing or retail operation. In a professional practice, where owners of the practice also own the real estate, it is almost always owned by a separate partnership or corporation. Whether understated, overstated, or fair, the rent is paid by the practice to this other entity. Where a business owns the premises, the business would pay ownership expenses instead of rent. Examples include mortgage interest, real estate taxes, and maintenance expenses. In addition, the business would depreciate the realty; improvements would either be absorbed as operating expenses or capitalized and then depreciated. The appropriate manner of correcting for this economic imbalance is to identify all those expenses and items paid through or on the books of the business that are ownership related (as contrasted with typical tenant expenses), remove them, and in their place insert the fair rent expense. The complexity of this exercise is compounded by effects on the balance sheet. Not only do we remove certain expenses from operations, but we may also be removing assets (and an attendant liability, such as a mortgage) from the balance sheet of the business, thereby very much affecting its book value. These are essential steps if we are to fairly determine the income generated by the business as an operational unit. Unless one is to argue (rather unusual for a professional

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practice or many types of small businesses) that the real estate is an integral, nonseparable part of the business, this exercise must be done. DEPRECIATION. When considering adjustments to the depreciation taken by a business, be very aware of whether you are working from the financial statements or the tax returns. Typically, in most small and even medium-size businesses, there are no differences; if there are any financials, they are simply reflections of the tax returns and there will be no differences in depreciation. However, in medium to larger companies, and especially with capital intensive ones, the tax returns often take the most aggressive position that tax laws permit for depreciation, but the financial statements take a more economic-based rate of depreciation. This both improves the financial statements (often a necessity for financing) and also leaves a greater book value on the balance sheet. Many times, when working from these types of economic-based financial statements, we find little need to make adjustments to the reported depreciation. However, where the calculations come from tax returns, we need to recognize that much tax motivated depreciation is accelerated above and beyond any reasonable economic based level. Also, through the application of Internal Revenue Code § 179, businesses are allowed a limited write-off of fixed assets, often called first-year or bonus depreciation. Depending on the life of the asset involved, a business can get $20,000 extra the first year. When you add accelerated depreciation to that, a business could, with one machine costing $50,000, take perhaps $26,000 of depreciation in the initial year, even if the machine was purchased within the last few months of the year, when the actual life of that machine might dictate depreciation of $5,000. In the second year, that company might be able to take an additional $10,000 of depreciation, bringing the two-year total to $36,000, when the economic actuality might be $10,000. This increases the business’s expenses, reduces its income, and reduces the book value through the effect on the balance sheet. The effect of accelerated depreciation on most approaches to valuation unduly reduces the value of the business. There are currently discussions about a major overhaul of our tax system that would allow an unlimited write-off (or perhaps within certain limits a total writeoff) of all fixed assets, machinery, and equipment and the like in the year of acquisition. The goal is that such write-offs would encourage business to invest in equipment, generating more manufacturing jobs in this country. It is possible that by the time this book is published, this type of major revision of our tax laws might actually be in effect, or some variation thereof. If that becomes the law, our work becomes a bit more complicated. We would no longer be dealing simply with applying adjustments to a depreciation schedule, but in many cases we would have to create that depreciation schedule from scratch, depending, of course, on the extent of records maintained by the business and whether it has any need to reflect a financial statement in accordance with generally accepted accounting principles (GAAP) as contrasted with merely a tax-based financial statement. Even now, many businesses take liberal interpretation as to what they capitalize as compared to what they write-off. It is not unusual to see a business writing off items costing a few thousand dollars with life spans of several years rather than capitalizing and depreciating them over several years. We sometimes hear that depreciation is not a real expense because in theory it does not represent any cash outflow and therefore perhaps should be treated

8.5

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differently, or in some extreme cases even disregarded. As we know, or at least should know, while depreciation per se is not a cash flow expenditure, it is a very real expense for virtually all fixed assets. It may not apply to fine arts on the wall or to buildings on real estate (but even buildings do depreciate, we just may be dealing with an extraordinary long period of time), but it certainly very much does apply to office furniture and fixtures, computers, factory equipment, and so on. They do depreciate, and they eventually need to be replaced. When that replacement happens, the company must then expend or borrow (and later repay) the funds to purchase replacement equipment. Therefore, whether by initial outlay that should be amortized over several years, by a loan that is repaid over a period of time, or by a combination of both, since that equipment does in fact wear out, the expenditure representing the acquisition of the equipment does need to be amortized over a period of time. Depreciation is a real expense. The issue we need to deal with is essentially what constitutes economic depreciation, that is, what would be a fair charge against the company’s operations? Because of the nature of the adjustments (if any) made to depreciation, it must be recognized that it has a multi-year impact upon a company’s operations. For instance, if we determine that in year one the company improperly expensed $20,000 of fixed assets that should have been capitalized, then our correction to year one increases income (and book value) by $20,000, less the appropriate amount of depreciation for that year (part of a year) on that equipment. However, the matter does not stop there. In the following years, we have to reduce the company’s reported income to reflect the economic depreciation on that equipment because it was originally expensed in the year of acquisition, and thus was never reflected as an operating expense for the ensuing years. The impact and treatment is similar if the company took advantage of the § 179 first-year bonus depreciation for $10,000 and we needed to adjust that in the year taken and adjust the following years’ depreciation for the impact that correction has over those years. When dealing with a medium-sized company, especially one that is growing and capital intensive, we may well have the equivalent of a matrix of adjustments from year to year, so that by the time we are finished with our fifth year of analysis, we have not only an add back for that year, but we also have additional depreciation brought forward from years one, two, three, and four. Typically, in a growing company, these adjustments will increase income. While not as much of a current issue, it certainly was several years ago when former tax law allowed, for instance, a three-year amortization of an automobile, no matter how expensive. While that blatant absurdity has been corrected, as mentioned earlier, there is the possibility of new laws to allow the immediate write-off in the year of acquisition of virtually all fixed asset acquisitions. Therefore, we may in the future be revisiting that concept. In a number of situations, there is no justification for any depreciation. For instance, a personal vehicle, a building on real estate which is actually appreciating, or fine art decorating the walls of the business (or perhaps the owner’s home). Furthermore, as to the fine art, in that situation you very well may have an appreciating asset, one that has become extremely valuable, depending on the vagaries of the art market. The point is that art work does not depreciate, unless it was purchased at a peak time in the market and subsequent thereto the

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market softened. Even in that situation, it is not a business asset (unless perhaps we are dealing with a private museum or an art gallery of sorts), but rather an adornment. This type of item has to be considered a nonoperating asset. Any depreciation taken on it must be added back as a nonoperating expense, even if depreciation is economically justified. RETIREMENT PLANS. When dealing with the closely held company, there are only three types of retirement plans of any consequence: profit-sharing plan, money purchase pension plan, and a defined benefit pension plan. A profit-sharing plan is considered a defined contribution plan, and is one in which the company contributes, on a totally discretionary basis, whatever it wishes on a year-to-year basis, within certain limits prescribed by the IRS. These limits are directly related to the compensation of those participating in the plan. The company is under no obligation to make a contribution from year to year, can change it dramatically from year to year, and can stop the plan or modify it at any time without incurring any funding obligations. The second type is a money purchase pension plan, also a defined contribution plan. Essentially, this plan is identical in every way to a profit sharing plan except that, rather than the company having total discretion within certain bounds to make contributions, the company has no discretion. It must make a contribution that is stated at a fixed percentage of the participants’ compensation on a yearly basis. However, this plan can be terminated at any time without incurring a funding deficiency. Both of these types of plans are easy for the accountant to investigate in that they are maintained in an account balance format. This means that each and every participant has a separate account, even if just on paper rather than specifically with funds segregated. Thus, the value of one’s interest in these plans is, absent the need for any particular investigation and analysis, simply a number at the end of any particular year. The third type of plan, the defined benefit plan, has significantly more complexities than the other two. The importance of that difference is that the benefit one receives from this type of plan is determined not by the contributions made to the plan and earnings thereon, but rather by that person’s compensation, years of service, and age. This type of plan, mainly for participants over the age of 50, permits the company to make much larger contributions than it otherwise could. However, it also requires yearly contributions, within certain ranges of flexibility. Except to the extent of that flexibility, the employer has no discretion about these contributions. In addition, these plans typically need the services of an actuary, inasmuch as benefits are calculated in relationship to age, mortality, and projected earnings over time. With the matter of the value of one’s interest in a defined benefit plan, the assumed rate of return and various other actuarial factors weigh upon the value of that benefit. For financial purposes in the case of a divorce, the funds are in the plan and can be segregated and allocated very similarly to the methods used for defined contribution plans. However, the determination of the amount of one’s interest in this type of plan generally requires the services of an actuary. With the appropriate formulae and mortality tables, and experience, the capable CPA can certainly also perform these calculations, though it is the actuary whose qualifications are normally more readily recognized for this type of work. 8.6

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Referring to defined benefit plans, and only to this type of plan, the plan may be underfunded, overfunded, or of course, correctly funded. These possibilities present some interesting wrinkles in our work. For instance, if a plan is underfunded, whether or not stated on the company’s financial statements (it is virtually never stated as a liability on a company’s tax returns), that underfunding must be recognized. This is not an elective contribution situation which the company can decide to forgo. Rather, assuming properly documented through a report from an actuary, an underfunding would indicate that the company has made commitments to certain retirement benefits and has not contributed adequate funds in order to meet its funding obligations for those retirement benefits. Underfunding is not a matter of the company’s not currently having adequate funds in its pension plan to cover the actual retirement payouts that might happen several years in the future. Rather, it does mean that with all figures and financial data stated at present values, the plan has inadequate funds to pay that present value. If it were necessary to pay out benefits to employees at the present time (which might be at a reduced benefit level to employees who have not reached retirement age or do not have an adequate number of years of service), then under those circumstances, this underfunding is a liability which at some future time the company will need to cover. There is also the possibility, and there have been many such cases in recent years, of the plan being overfunded. This may be especially so where extremely aggressive funding positions were taken in the past that perhaps have been scaled back recently because of changes in the maximum funding limitations, or perhaps because of investment portfolio performance that exceeded very conservative actuarial assumptions. In such a situation, the company may have an asset. That is, the company could terminate the plan and recapture that overfunding. However, all is not that simple. The IRS has instituted rather severe penalty taxes for terminating a pension plan and recapturing overfunding. While there are ways to avoid or minimize these penalty taxes (for example, by instituting a replacement plan with the overfunded funds rather than taking it back into the company), for the most part these remedies do not make these monies available to the company. If an alternative is to use these funds to create a replacement plan, then as investigative accountants we need to know what portion of these excess funds would inure to the benefit of the business owner. On the other hand, if the company were to recover these monies and suffer the tax consequences, we need to be able to recognize that potential asset, less the penalty tax burden thereon. That penalty tax burden cannot be avoided by simply bonusing out the recapture as additional compensation to the owner. It attaches directly to the recapture and in essence is an excise tax for which there is no escape if the company recovers the money. There are two aspects of the retirement plan area that we must adequately investigate. First, a retirement plan is rarely if ever a matter of legitimacy, but rather of additional compensation to the business owner. Secondly, we look at the retirement plan contribution as a directional signal towards a potentially large asset; that there is an investment portfolio of some sort that we need to investigate. As to the former issue, the retirement plan can be either an ordinary and necessary operating expense of the business or little more than a tax deferral scheme to benefit the business owner. The former situation is more common where the

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plan has a lot of participants, and the contributions on behalf of owners are not significant. In that situation, the retirement plan is operating as a true employee benefit. Logic would suggest that if the management is not receiving a significant percentage of the total contribution, it must be recognized as an employee benefit and therefore an ordinary and necessary operating expense. Otherwise, management would see its own best interests in eliminating this contribution as an expense and taking the same money as additional compensation. However, where perhaps 60 percent or 70 percent or even more of the contribution is directly for the benefit of management, the plan is probably not truly an ordinary and necessary operating expense that the employees consider an important element of their compensation. Rather, it is a tax preferred vehicle enabling the owners to receive additional compensation. Of course, in many closely held businesses, that is what the retirement plan is. Especially when tax brackets were higher, if a business owner could contribute $100,000 to a retirement plan, with perhaps $60,000 to $80,000 of that for his or her benefit, the tax savings and perception of an employee benefit made the retirement plan desirable. But it was done only because it was a way to get compensated without currently paying taxes on it. In either circumstance, but especially where the plan is nothing more than a fringe benefit for the owner, the deferred compensation benefit from the retirement plan is additional compensation that needs to be taken into account for business valuation purposes and in evaluating the financial strength and ability to support the recipient owner. A retirement plan means that not only are there contributions coming from the company that relate to the company’s income and the owner’s compensation, but also that a trust (or perhaps insurance policies) exists that needs to be separately considered. In the typical retirement plan, there is a separate annual accounting done by either the internal personnel of that company, the company’s outside accountant, or a pension service bureau, which accounts for the assets, revenue and expense flow of that retirement plan trust. For the most part, investigative accountants usually do not have much investigation to do with the retirement plan. Normally the only issue to address is the value of that asset as to the business owner, for the benefit of the marital unit. However, there are times when we actually need to investigate the retirement plan. For instance: • Allocations to the Owner. Where the records are not readily available or perhaps not in adequate condition, we may not have a solid accounting submitted to us with all the information we need. In that situation, we may need to determine on our own as to the percentage allocated to the business owner. • Loans. Just as a business might have an officers loan account, the equivalent might exist with a retirement plan. We need to know if monies were borrowed from the retirement plan, or distributed, and, if so, for what purpose. Our interest, of course, is only in the business owner or family, or someone else where there might be a suspicion that the loan was not strictly at arm’s length and purely for the benefit of an employee participant. Additionally, just as with the officer’s loan account in a business, if there is a loan receivable from this business spouse on the books of the plan, we must recognize that on the personal balance sheet there will be an offsetting liability.

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• Unreported Distributions. While an unusual situation, it is not unheard of, especially where there are relatively few participants and a substantial portion of the plan account belongs to the business owner, for that business owner, typically operating as the plan’s sole trustee, to take a distribution from that plan (perhaps initially as a loan, perhaps not), never pay it back, and also never report it via Form 1099R as a distribution. As a result, it does not show up on a personal tax return, and of course it need never show up on the corporate or business tax return. If this happened a couple years ago, and if we are not careful enough, we might believe that we should be satisfied reviewing only the retirement plan as of the valuation date for purposes of determining the business owner’s share. We would miss that perhaps one or two years ago a withdrawal was made from that owner’s account, reducing the account as to the marital unit, and providing funds for some secreted accounts or other unknown assets. While unlikely, it is not so difficult to accomplish and not too burdensome to analyze for the purpose of uncovering it. The issue of vesting occasionally arises. Vesting means ownership. In retirement plans it is normally stated as a percentage. For instance, if someone with a plan account balance of $10,000 that is 60 percent vested left the company at that time, that person would receive $6,000, and the forfeited portion would stay with the plan and be allocated among the remaining participants. Occasionally, typically where a plan has been in existence for only a couple of years, you will be told that the business owner is perhaps only 40 percent or 50 percent vested, and that only the vested portion should be shown on the personal balance sheet. Suffice it to say that there is probably never a justification for that approach in a closely held business as to a business owner. To posit that the business owner is anything other than 100 percent vested would be to suggest that somehow the owner might leave the employ of the company and lose some portion of the retirement plan benefit. That argument is nonsense. Being the owner, we know that leaving the company, as would a rank and file employee, is an implausibility. The only way termination would really happen would be if that business owner sold the business or if the business failed. If the business were sold, it is a certainty that, especially since the plan assets could not possibly be treated as part of the sale of the business, provisions would be made at that time to terminate the plan, which automatically accelerates vesting to 100 percent for all current participants. Or if the business were to fail, similarly, the plan would be terminated and all participants would then be 100 percent vested. If the business owner were to die or become disabled, at least his or her account would be 100 percent vested. In a closely held business, the owner cannot be other than, in the most valid economic sense, 100 percent vested in a retirement plan account. The situation might be different if you are dealing with a large company and the person under consideration is a relatively minor player. REPAIRS AND MAINTENANCE. As with so many other expense categories, repairs and maintenance provides the opportunity for personal expenses to be paid as business expenses and deducted through the business. This expense area also has the possibility of major expenses, which should be capitalized, instead

8.7

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treated as ordinary and routine expenses incurred and paid in the normal course of operations. The customary review of invoices should certainly help to at least determine whether or not various expenditures should have been capitalized. We need to be reasonable. A few thousand dollars, or even a larger amount of repair bills that recur from year to year, would clearly be a normal operating expense, and should not be capitalized. However, a several-thousand-dollar overhaul of a fully depreciated machine might very well be the economic equivalent of buying a used machine, and therefore obviously should have been capitalized. Sometimes, you might come across a number of either relatively minor expenditures or even slightly larger than that, but perhaps not large enough to cause you, in and of themselves, to seriously consider an adjustment adding back these expenditures as capitalized assets. However, on a closer look, and also perhaps in combination with a walk around the plant/business and/or a discussion with the nonbusiness spouse, it might come to light that these expenditures are in actuality a related series of disbursements relevant to perhaps the creation of a major machine or the renovation of part of the plant or office space, or perhaps the creation of a new room. None of this may be particularly obvious at first glance, but in an overall review of the situation, and in keeping things in context, you might also notice some form of a pattern as to the type of expenditure. One often overlooked way to resolve this is to simply ask the business owner to explain the purpose of these expenses. Alternatively, you might ask the bookkeeper or office manager (never ask the accountant). You may be surprised and get a fairly candid answer advising you that indeed these seven different bills totaling $18,000 were for the establishment of a storage room, with shelving, partitions, and lighting fixtures. Clearly, not a recurring expenditure that should have been written off. The entire series of these expenditures should have been capitalized as a single item. Of course, asking the business owner and other personnel is something that needs to be considered carefully on a case-by-case situation. Sometimes (though for this type of expenditure rarely) you need to be particularly concerned about sensitivities and perhaps even a strategy of attack. Frankly, that is more typical for unreported income and secretion of funds than it is for understanding an expenditure. Some examples of repair and maintenance expenses that might be personal rather than business include: • Painting. Look for the extent of the expense, perhaps the quantity of paint used; if fairly recent, inspect the business premises to see if the paint there looks new. • Roofing. Determine whether the expenditure is consistent with the type of premises leased or owned by the business and whether a physical inspection supports the expenditure. Consider the overall cost and magnitude of product used. • Lawn Maintenance. Determine if the business has a lawn; whether the expense is consistent with the location of the business (that is, most tenants in office buildings have no lawn maintenance responsibilities); what the address is of the supplier of this service (lawn maintenance is normally a localized service; if the residence and the business are a significant distance

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apart, the situs of the lawn care service operation is probably an indication as to the legitimacy of the expense). 8.8 INSURANCE. The insurance expense area can offer a wealth of information. Furthermore, unlike most of the expense categories being analyzed, this area cannot only provide an add-back to income, but also an add-back to the balance sheet. In virtually all the expense categories, even if you uncover significant funds that were not properly business expenditures, the fact remains they were spent and that as an asset they no longer exist. On the other hand, with insurance, one potential adjustment is the creation of prepaid insurance, which constitutes an asset. There are many different types of insurance and much information that can be derived from analysis. As discussed concerning assets and the balance sheet, the investigative accountant might find that a potentially significant asset exists on the valuation date in the form of prepaid insurance. Depending on how insurance was treated and paid from year to year, such a correction of the reported figures would also impact the business’s operating results. For the present discussion, we ignore situations where the treatment by the business was consistent from year to year, since there would be no effect on the operating expenses for any one year. Where inconsistency exists, correction of this item could result in reducing the insurance expense for the year. Alternatively, if the inconsistency went in the other direction, for instance if the insurance were paid early one year and late the following year, we might need to adjust the operating expenses up instead of down. The adjustment, if any, to insurance expense to deal with the matter of prepaid insurance, is generally not the major reason for, nor benefit of, the investigative accountant reviewing this expense area. Where adjustments, add-backs, or whatever are considered, the issue is generally the business justification (or lack thereof) of paying the insurance through the business. For instance, it is not particularly unusual to find life insurance (in an incorporated company often referred to as officer’s life insurance) paid by the business. This is rarely, if ever, an acceptable business operating expense. Furthermore, depending on the type of policy, there might be cash surrender value that is not stated on the company’s books and would thereby call for another balance sheet (asset) adjustment. Digging further into the life insurance area, we would also be looking for information as to who are the owners and beneficiaries of any such policies. Have there been loans against those policies? In contrast to a cash surrender value adjustment upwards, loans would reflect downward adjustments. Furthermore, if there were loans of any significance, for what purpose were the funds used? We also often find personal insurance such as homeowners, automobile, disability, excess personal liability and the like paid through the business. Not every one of these is necessarily an adjustment. For instance, an excess personal liability (umbrella) policy may be merely another business expense because it is necessary in a sense to carry this insurance on the principal because of the likelihood of liability attaching as a direct result of working in the business. Practical reality is a factor we must recognize. Accountants often call this “materiality.” Personal umbrella insurance, as an example, may or may not be argued as a legitimate business expense, but it is relatively inexpensive, and as such does not merit time and effort to argue the fine points of the issue. On the

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other hand, disability insurance could cost the business owner as much as several thousand dollars a year. While there is in a sense no personal benefit from this (until, of course, one is disabled), the question is whether it is a normal and necessary operating expense or a perquisite that should be added back to income. Perhaps one reasonable approach is to consider the magnitude and extent of the coverage, and if not unreasonable, then the cost of such insurance is accepted as just another business expense. Another approach is that the cost of a disability policy is part of the compensation package of the principal. Adjustments are much easier when clearly personal insurance, such as homeowners, a family member’s car, or boat insurance, is paid through the business. Such adjustments are fairly straightforward, but there may be more to the issue than merely adjusting for a personal expense run through the business. For instance, does that homeowners insurance include a jewelry floater? If so, we might find a fairly current appraisal, and thereby have reliable information for a personal balance sheet asset, which might not be easily obtained elsewhere and which might be of significant informational benefit in the case. This area is prone to numerous procedural annoyances such as inconsistencies in posting (sometimes to prepaid expense if that account exists, sometimes just as an expense). Also, partial premium payments hinder the tying of an outlay to a particular policy, while a combined payment for multiple policies with the same due date sometimes further masks the link between a payment and a policy. Because this area is more difficult than most expense areas to adequately analyze, care must be taken to ensure that you gain access to all of the insurance policies. Be especially watchful for references to locations other than the obvious one, where the business office is. Look for multiple locations, warehouse operations, and property listed as being at someone’s home. Also, look for detail as to specific types of property. For instance, vehicles are always listed with serial numbers. Many times, the same is done for machinery in a factory. The estimated insurance values, which most of us believe tend to be inflated, are still values, and theoretically have the approval of the appropriate level of expertise in the insurance company. While a qualified and independent equipment appraiser would provide the best valuation, where that is not available, the insurance policy would be preferable to the opinion of an investigative accountant as to what, for example, a three-year-old conveyer belt system is worth. Review the contents coverage carefully and with an eye towards the extent of inventory coverage. Keep in mind that a number of policies are written to address peak coverage issues rather than just a constant level of inventory. However, if the business is carrying coverage for a million dollars of inventory, yet its tax returns and financial statements (assuming they are consistent) reflect only $200,000 of inventory, you may have adequate proof of a significant understatement of inventory. On the other hand, it is possible that the business operator made a mistake and is carrying too much insurance, or that the inventory coverage relates to an earlier time when inventory was greater but no one made the effort to change coverage to reflect current conditions. These are possibilities, but assuming the business owner operates in a rational and profit-maximizing attitude, it is more likely that there is simply more inventory than that reflected on the books. Also, most explanations, other than a pure mistake, can be tested by alternative means.

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With life insurance coverage, do not overlook the possibility of cash surrender value. This item should be fairly easy to determine with the assistance of the insurance agent (always get it in writing) or by confirmation directly with the insurance company. It is not unusual to pick up a substantial asset in that manner, whether it belongs to the company or to the individual. In almost all cases, you are also dealing with an adjustment to the statement of operations. In relatively few instances can life insurance on the business owner (outside of a uniform, nondiscriminatory minor amount for most or all employees) be considered a necessary operating expense of the business. Moreover, in many situations, especially where life insurance policies have existed for a few years or more, the annual premiums as an expense are often completely offset by a commensurate increase in the cash surrender value of the underlying insurance. 8.9 TRAVEL, ENTERTAINMENT, AND PROMOTION. This is the classic area for lay people when they think of business people getting a personal benefit at the expense of the business. After all, the three martini lunch and the dinner with one’s spouse at company expense are well known folklore. The reality is that, while the promotional area can be very fruitful to the investigative accountant, in many businesses, perhaps most, other areas yield even more fruitful adjustments and add-backs. This is not an area to ignore; it just needs to be put into proper perspective. To thoroughly understand this expense category, we need to review its components and choose items worth further investigation. For example, review the underlying details of an American Express, Master Card, or Visa bill. Does it appear that there is an inordinate number of meals or other entertainment (such as perhaps theater) being charged to the business? There may also be personal clothing, trips, and many other possible expenses, since virtually anything can be charged. The next step, of course, is to determine the business legitimacy of these expenses. Did that doctor really need, for business purposes, to have lunch and dinner at the expense of the practice 26 times in the last month, and at rather expensive restaurants? In determining the business legitimacy for such expenses we ask for support for the business nexus of these dinners. Does the business owner maintain a diary (pretty much required by the IRS)? In a general sense, there are two possible responses when we request such documentation. Either it exists (to some and varying degree), or we are told that it does not exist. If it exists, we certainly need to review it and make our informed determination based on that review. If it does not exist, although the tax law would permit the IRS to completely disallow all those expenditures, our work is not a tax audit, nor is it an effort to determine the tax legitimacy of expenses. Rather, our work is an economic audit, which concerns the economic legitimacy and reasonableness of various expenses. In most businesses, some level of entertainment is reasonable, more in some than in others. Where documentation is lacking or woefully inadequate, it is generally inappropriate to simply, carte blanche, disallow all of those expenses because there is no support and because the IRS would do so. Rather, recognizing that the business legitimately would have to have had some of these expenses, we would need to allow some reasonable level, such as $50 a week or $100 a week, or whatever, per practitioner, owner, or fee generator. Each situation must stand on its own, but reasonableness must prevail.

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Even where documentation exists, and even where it may be about as good as ever seen, and therefore, even where the IRS would have to accept 100 percent of what might be exorbitant promotional expenses, we are not bound by the same thought processes. First, we might be generally more suspicious as to the legitimacy (notwithstanding documentation, which we all know can be created) of the need for any business or professional person to have a promotional meal eight times a week. We may need to evaluate whether that type of entertainment is necessary and reasonable for the business, or whether it is more accurately a manifestation of the nature, personality, and lifestyle of the business owner. We are dealing here with economic reality and compensation as contrasted with tax deductibility. A much harder call is present where promotional expenses such as dinners, lunches, and evenings out, because of the nature of the business and the services of the individual (that is, the business owner is the main salesperson), are such that the expenses are ordinary and necessary for the operation of the business, yet they are so pervasive that they also constitute compensation to the business owner. We might be satisfied through a review of documentation and our understanding of the business that it is reasonable and even expected that nearly every day’s lunch and dinner, as well as activities on the weekends, the country club dues, and the like are all necessary for the functioning of the business, the maintenance of customer relationships, and the development of new business. However, what we should not overlook is that by the nature of their frequency and scope, they may constitute additional compensation (the maintenance of a lifestyle) to the business owner. After all, payroll is a necessary expense of a business, and at the same time constitutes compensation to the recipient of that payroll. The payment of substantial entertainment expenses, while under the scenario described above is indisputably for the legitimate needs and operations of the business, constitutes additional compensation to the person reaping the personal benefits from those expenditures. The problem we have is that, just as we would not add back payroll to the business merely because someone benefited personally, how can we argue that promotional expenses should be added back to the business merely because someone benefits from them? The solution is somewhat of a compromise and hybrid. We have established to our satisfaction that, despite the magnitude and frequency of these types of promotional and entertainment expenses, they are legitimate and necessary for the businesses operation, and that we are dealing here with those expenditures made by the business owner. If incurred by a rank and file employee, assuming no fraud, those expenses are not challenged, no matter how frequent. However, where the benefit is enjoyed to such an extent by the business owner, notwithstanding the business legitimacy of same, what we have here is in a sense another form of compensation, but one which is not subject to add-back for reasonable compensation purposes, nor one which necessarily can be considered compensation on a dollar-for-dollar basis. There should be no add-back to the businesses operations since the expenses are necessary for the business. On the other hand, it is a warranted judgment call to add back to compensation of the business owner some portion, but not all, of these expenditures. Indeed, as an example, eating lunch and dinner several times a week at company expense truly constitutes a form of economic compensation to that business owner. In addition, as to the marital unit, these promotional

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expenses constituted part of its standard of living. Part of that couple’s lifestyle was the ability to eat well, travel well and often, entertain, and so on, at company expense. While those convention trips might have been for legitimate business purposes, they were also vacations that would have been paid for personally had the benefit of the company’s open checkbook not existed. When attempting to determine to your satisfaction whether a trip was business or personal, among the elements to consider are whether that business owner’s spouse (or paramour) went along; whether the children were included; the specific location (resort environment as contrasted with a no-nonsense, innercity location); and the number of days at that meeting. A three-day trip to Paris probably can be accepted as business without looking any further, whereas one week might cause you to go a bit further in your investigation and analysis. Review the specific underlying hard copy documentation. For instance, inspect that documentation to see who signed for those meals. Many times, the business owner’s spouse or even older children have authority to sign, and even have their own cards. While not absolute, where a spouse or child signed for a meal invoice, it is almost certain that it was not business-related. In addition, when reviewing the documentation in order to determine who signed, who went where and for how long, do not lose sight of the importance of knowing whether that companion on the trip who signed as Mr. business owner or Mrs. business owner was indeed the spouse of that business owner. Find out from your client whether he or she ever went on that trip. While the economic result is probably the same regardless of whether it was the spouse or a paramour, the information itself is of value. Proof that a trip was taken with a paramour who traveled as if the spouse adds a little extra to your position and takes away a little something from the other side. When reviewing the area of travel and entertainment, and especially where there are concerns about funds being secreted, be especially attentive to locales that are visited frequently by the business owner. That frequency lends itself to a greater than normal ability to establish some form of presence there, including bank accounts and other financial arrangements. In selected circumstances, you may suggest to the attorney with whom you are working that a search should be done in that distant locale to determine if any bank accounts or real estate are registered in that business owner’s name (or possibly family name). AUTOMOBILE EXPENSES. It is a rare businessperson or professional who does not treat a company owned or company leased vehicle as either 100 percent business or so close to 100 percent that the difference is a token offering to the IRS. Granted, some try to avoid too much aggressiveness in this field and satisfy themselves with only 71 percent (or five-sevenths) of automobile usage as business. Nevertheless, many do not exercise such restraint. It is also just as rare that such a position can be justified. First, and we all know this comes as an annoyance and sometimes even a shock, commuting is not a business expense. However, going to customers or clients, going between offices, running around, and doing various company functions are all acceptable business uses of a car. What percentage is fair for the business owner you are analyzing (as well as others within that company) is another issue. No matter how loudly the business owner complains, what it really comes down to is that the car on the books constitutes additional compensation. While 8.10

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weaknesses in the tax system may permit the business owner to get that compensation tax-free, it is still nevertheless compensation. Again, like the business owner who eats almost exclusively at company expense, were it not for the company supplying the automobile, that business owner and, as an extension, the marital unit would have had to pay for a vehicle. Certainly, the nonbusiness portion of that car represents additional compensation, which must be disallowed and added back to the company’s net income. By understanding the company’s operations, and in particular the functions of the business owner, you can probably derive a reasonable estimate of the business percentage of use. For instance, determine how many commuting miles are involved (the distance from the home to the business); how many days a week does the business owner work (whether there is work on weekends); the number of business locations, and the frequency of travel between them. What are the job functions of this business owner? If of an outside sales nature, rather than inside or telephone sales, then you should expect, legitimately, a very high business percentage. With an outside sales function, even if that person works only five days a week, the business percentage could be 90 percent or more; nothing says that the number of days is truly determinative of percentage of use. Once you establish a reliable percentage of business use, you can then apply your conclusions to the various auto-related expenses and make the appropriate operational adjustments. Expense categories would include gasoline, repairs and maintenance to vehicles, automobile insurance, leasing expense, interest on automobile loans, and depreciation. All of these automobile-related expenses will need to be adjusted. Besides a pure arithmetic allocation of automobile expenses, we also need to look at the reasonableness of the vehicle itself as a business expense. For instance, while an $80,000 car might be appropriate for a doctor to drive, and, in a sense, necessary for someone in that position and economic strata, it would be totally inappropriate for the owner of a retail clothing store (especially if we are talking about a small retail operation as contrasted with a 50 store chain), and especially if the job function requires a vehicle suitable for transporting product. In this situation, we may need to go a couple of steps further than merely reallocating a portion of the expense as nonbusiness. We may need to determine the extent of expenditure for this vehicle (that is, insurance and leasing expense or depreciation) that is in excess of what a corresponding expense would be for a more appropriate vehicle. To the extent of the excess, we are talking about a 100 percent add-back rather than merely a personal use percentage add-back. While this is clearly a subjective decision, and while you would need to leave a margin of error, there are certainly a number of situations where the vehicle is clearly inappropriate for the business, as in the example just given. One way to make the appropriate adjustment is to hypothesize a suitable replacement vehicle, and then impute what that vehicle would likely cost. While typically a more appropriate vehicle would also be more fuel efficient, a recalculation of the extent of gas usage is probably unnecessary, unless you are perhaps talking about a very large number of miles being driven by a very fuel inefficient vehicle. However, the other expenses such as insurance, repairs and maintenance, and depreciation can rapidly add up to several thousands of dollars a year. Be wary of the number of vehicles being carried on the company’s books. Do the business owner’s three children get around thanks to the company’s largess?

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Of course, that logic applies to the spouse as well as the paramour. Generally, where it is an employee in a nonownership position who has a vehicle, there is no challenge; it is either truly necessary or just another method of giving additional compensation. Unless you suspect otherwise, an unrelated nonowner employee is assumed to be compensated at a fair rate, whatever form the compensation takes. Carefully review the hard copy receipts for gasoline charges. You may find a number of them signed by the spouse or the children. You may find some (typically where, for instance, a child is in college some distance away) coming from a service station thousands of miles away. Clearly it was not the business owner who was using the car. Similarly, review the registration forms and repair bills. A repair bill might indicate who brought in the car, and will often indicate the specific car that was being serviced. Many times, even when the company does not carry a spouse’s or child’s car on the books, it will pay for the maintenance expenses of those cars through a company account or having the bills directed to the company. Review these repair bills and see how many cars are being repaired and how often. Even where the service station accommodates by being silent as to the vehicle, you may pick up information from the odometer readings listed on the repair invoices, the time of day brought in and picked up, the name showing up on the invoice, or the particular day the vehicle was brought in (for example, was the business owner with a customer on the other side of the state at the same time the car was being repaired). TELEPHONE. This expense area, often because it is not particularly large, is another one that business owners find rather easy to pay bills through the business, and even to justify having the business absorb that expense. After all, the business owner works for the company 24 hours a day and is always on call, and indeed certainly receives some business calls at home and makes some business calls from home. We all know those arguments, but we also know that the truth falls far short of justifying more than a modest percentage, if any, of the home phone bill as a business expense. There are always exceptions, such as those who have international dealings and therefore often have to make telephone calls at odd hours in order to cross time zones. In those situations, there is a legitimate need of a business phone at home. However, even in those situations, there is often a separate phone at home, specifically designated for that purpose. Furthermore, a perusal of most phone bills typically will give the investigative accountant sufficient insight to determine the reasonableness of those bills as business expenses. In certain limited circumstances, while the phone expenses themselves may be of absolutely no interest to us, there may be a great need to do an in-depth review of the phone bills. Reference here is not to the magnitude of the expense, but rather the several pages of detail that support the telephone bill, specifically, to what locations and numbers were calls made. With the help of the spouse, a detailed review of the locations and numbers called might prove most informative. Usually, this is especially relevant to the business phone. We are not concerned here with whether the calls were made on the personal phone or the business phone, or whether the personal calls were charged to the business, but rather with what calls were made. Were there regular calls to the same number in another city where, to the best of our and the spouse’s knowledge, there was 8.11

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no business reason for the calls to be made. Are there suspicions of financial dealings, a personal relationship or whatever in an area (and it need not be long distance) that would be of interest to us? Granted, this type of exercise can be very time-consuming and is usually not warranted. However, in the exception, a thorough analysis of telephone bills might disclose information about relationships that were not known and could not easily be discovered otherwise. PROFESSIONAL FEES. This type of expense is one which the investigative accountant delves into out of both idle curiosity as to what other professionals are charging, and to determine whether an adjustment to the operational expenses is warranted. When reviewing the professional fee invoices, we are looking for items such as personal expenditures, nonrecurring or unusual expenditures, indications of pending or current lawsuits, and indications of activity that might shed light as to major events such as merger or acquisition discussions or changes in ownership. We might find personal wills and estate planning expenditures expensed through the business, medical bills (they do not necessarily have to be posted as medical expenses or employee benefits), personal tax return preparation, personal litigation-related fees, and so on. Many times, this area is most useful to us for what it reveals about major happenings. It generally does not result in adjustments to expenditures, the adding back expenses as nonbusiness or nonrecurring. Many times it does tell us that, for instance, there are current merger and acquisition discussions that might in turn lead us to further discoveries and to a better understanding of the value of the business. There may be an indication of a lawsuit that would again lead to other discoveries or perhaps to a potentially significant liability. If the suit is in the other direction, perhaps there is a potentially significant asset. Other important items that might be easily flagged through reviewing professional fee invoices include the preparation of an employment contract or shareholder’s agreement, a restructuring of the company, or perhaps the formation of another entity. Often, none of these issues would be apparent from reviewing other expense areas, without the cooperation of the business owner or some additional insight from another party. Also, many times these expenditures are not particularly large. Thus, it is often worthwhile, and sometimes imperative, to do a 100 percent analysis of this area, whereas few other expense categories warrant such scrutiny. The professional services invoices (and even in the absence of invoices, at least knowing who was paid and how much) may lead the diligent investigative accountant into very informative areas. For instance, the business owner may be funding the current matrimonial action with company resources while the nonbusiness spouse is relegated to personal funds, or perhaps to a meager handout from the business spouse or as the court orders to be paid. Finally, as with many other expenses, and especially if there are indications of suit or other unusual activity, there may be a significant amount of professional fees that are nonrecurring or, from an economic point of view, amortizable over a period of a few years. Types of personal expenses that you might find paid as professional fees include:

8.12

• Legal and related fees for the purchase, sale or refinance of the marital home • Will preparation and estate planning

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• Personal lawsuits • Miscellaneous professional services or consulting of a personal nature. PAYROLL AND OTHER TAXES. Under most circumstances, we would not expect this account to yield adjustments. However, there are a number of situations where that expectation will not be met. For instance, especially in a smaller business, the payroll tax expense may be unreasonable in comparison to the gross payroll. Typically, if payroll tax expense is 20 percent of payroll after removing any payroll in excess of the social security tax (FICA) cutoff, then something is likely out of line. The answer may simply be a misposting, or it could also be a prior year adjustment, back taxes, or a correction with the IRS. In the latter situation, if it is of materiality, it may call for an adjustment in how you present the figures. The discrepancy may also be because the owner’s own payroll taxes were never withheld from the pay, but were paid instead by the company. This is normally only an issue as to the FICA. The amount can be fairly substantial, currently around $6,000 a year each from both the employer and the employee for those who earn upwards of $80,000 per year. Having the company pay these taxes is in effect additional compensation to the business owner, and represents expenses that the business has deducted that are not really its expenses. Where a paramour or family member is paid but does not work, or where perhaps that person is working for the company but paid substantially in excess of worth, there is also the added possibility of additional payroll taxes (typically FICA) which should not have been paid by the business. For practical purposes, it must be kept in mind that this type of adjustment in a larger operation is generally insignificant, and even in a smaller operation usually is not more than a few thousand dollars. However, if you have determined that a job is either fictitious or overcompensated, it is a fairly easy adjustment, and totally justifiable. This only applies where the business owner, to whom this initial compensation would have otherwise gone, is already being compensated in excess of the FICA ceiling. If not, then additional compensation to that owner would similarly be subject to this FICA tax and the result would be no increase in payroll taxes. This may not be quite true for a lower level cutoff for state unemployment taxes and of course there are situations where the suspect payroll, if reallocated to an owner, might bring an owner from below the FICA cutoff to above it. The investigative accountant will no doubt be able to handle the various nuances that arise. Besides payroll tax expenses, most businesses incur other taxes and regulatory assessments posted to the tax expense account. As with payroll taxes, review of this expense category normally yields little of interest to the investigative accountant, but sometimes value is received for the time spent. For instance, if a personal property tax on inventory is paid, the company might have assets in locations previously unknown to us. While the existence of assets might be determined through a review of insurance policies, the discovery might also originate from a review of taxes paid for those locations. Although a warehouse tax is not as common now as in the past, it is evidence of the existence of personal property (as contrasted with real estate). Similarly, if a business is paying state income or registration taxes to states other than the obvious one, there might be additional locations or operations elsewhere. It may also merely be an indication that the company has established 8.13

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an inactive corporation in the other state to protect its name or some territorial rights. Until satisfied that it is nothing more than a registration formality, the accountant needs to investigate further. Review of the appropriate state tax returns, for instance, would be appropriate. OFFICER’S LIFE INSURANCE. We all know that, at least in theory, officer’s life insurance is not deductible. Nevertheless, if structured correctly, it can be paid through the business, and even if not structured properly, many small businesses do pay and deduct it. That it is not a legitimate tax deduction is not relevant for our purposes. The issue remains, as with all expenses, whether it is from an economic point of view an ordinary, necessary, and normal operating expense. Officer’s life insurance or partner’s life insurance rarely qualifies. It is protection for the family, the heirs, or other owners against financial loss occasioned by the death of a shareholder or partner. It is more akin to a fringe benefit, which is in a sense additional compensation, or a protective maneuver for value of the whole business or a share in it. As a result, this expenditure is normally an add-back to income for our purposes. Besides viewing life insurance as an expense item for adjustment, it also possibly yields an asset, the cash surrender value. It is not uncommon, again in the small to medium-size businesses, for the cash surrender value of life insurance to be either improperly stated or not stated at all on the balance sheet. A review of the insurance policy, perhaps with confirmation from the insurance agent or company, should be fairly simple and routine, and adequate for determining the extent of cash surrender value. It would not be too surprising to find that a significant asset has been left off the company’s books by virtue of the expense (whether deducted or not) being charged each year to operations without the corresponding recognition of growing cash value. The correction may result in a significant increase in the value of the balance sheet, and generally, it would also be an easily tapped asset. A review of the beneficiary of that policy might also be enlightening. We would normally expect the spouse or perhaps the children. However, if the beneficiary is a trust or some tax vehicle, we should investigate what else might be in that trust. Is there a fund somewhere of value that perhaps was previously unknown to us and the spouse? Besides the issues of nonoperating expenses and possible cash values, the existence of life insurance in a multiple ownership entity might also suggest the existence of a shareholder or partner agreement, often referred to as a buy-sell agreement. While these types of agreements are almost never dispositive as to value, they should never be ignored, nor their potential value to the investigative accountant/appraiser overlooked. In multiple ownership situations, especially where you are valuing a minority interest, and where a majority interest exists, you may be bound by that shareholder agreement. Further, it is also possible that the shareholder agreement is a reasonable one, giving true and realistic values. While it might ultimately be your professional opinion to disregard the values set forth in a buy-sell agreement, that decision should be conscious and deliberate, not a matter of omission and ignorance. 8.14

EMPLOYEE BENEFITS. Almost anything can be an employee benefit, but this category is usually reserved for medical benefits. Typically included are reimbursement of expenses not covered by medical insurance, the medical

8.15

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insurance itself, excess coverage, disability, and sometimes even holiday parties and the like. Generally, unless there are mispostings, you will find only two types of expenses posted to this account: medical insurance and direct payment for the medical care. Notwithstanding the recent trend towards cost sharing between the company and the employee, medical insurance has become such a customary benefit that we would rarely make an adjustment back to income or owner’s compensation on account of such insurance being paid by the company. That approach might be tempered if the company’s policy is to have the employees contribute towards the coverage, but the same demands are not made of the business owner/operator. Even then, it is generally inadvisable to treat any part of this as an add-back, unless the company has enough depth of management so that the investigative accountant can point to other high-level employees who have to share the cost of the coverage with the company whereas this business owner does not. Treatment is not so black and white if we are dealing with disability insurance, which has also become a fairly common fringe benefit, but still may not be considered a standard benefit in that industry or for that person. Furthermore, the magnitude of the benefits and the premiums is an issue. If it is a small benefit policy with modest premiums, and especially if it is provided under the same terms to most or all of the other employees or is part of an overall medical package, then an add-back would be inappropriate. On the other hand, if it is an owner policy with particularly large benefits and high premiums, it would be reasonable to treat that as additional owner compensation. Typically in the smaller to medium-size businesses, where postings to the employee benefits account are not medical insurance, they are almost invariably payments made directly to doctors or reimbursements to the owner for medical expenses. These are almost always for the business owner only. Similar benefits on behalf of staff employees are infrequent and usually only for care necessitated by a work incident. Clearly, all such expenditures on behalf of rank-and-file employees are ordinary and necessary business expenses, but payments for the business owner that represent a greater level of benefit constitute additional compensation. An interesting sidebar relevant to these expenses is addressing what happens to the insurance reimbursements. Under most policy arrangements, medical expenses are reimbursable by the insurance company. If the business is paying for medical care directly, or reimbursing the business owner, and at the same time you do not see credits in that account reflecting the receipt by the company of the insurance reimbursements against those expenditures, then it is extremely likely that the business owner not only has caused the company to pay family medical expenses, but also has personally retained the insurance reimbursements. This revelation is important from at least two perspectives: • The family’s out-of-pocket expenses for medical care are actually less than they appear to be since the insurance recoveries can amount to thousands of dollars. • The “pig” factor has now been raised and may help your position by damaging the other side in the eyes of the judge. You can present this business owner, perhaps earning more income and living much better than the judge, as not only having the company pay all family medical expenses but also

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as pocketing the reimbursements rather than putting them back into the company that paid them. No government employee, including a judge, enjoys seeing someone, especially someone earning more than the judge, take advantage of the system in this way. 8.16 INTEREST EXPENSE. Most businesses have some form of interest expense. Whether it be for financing machinery and equipment, an automobile, working capital needs, a particularly large job, or the buyout of a partner or previous owner, interest expense, in all but the richest companies, can be expected. In most situations, no adjustments need be made for the interest as paid to unrelated third parties for legitimate operating purposes. However, even when that is the case, the investigative accountant must be vigilant for information that can be gleaned from a review of this expense category. As already discussed, relevant to liabilities, investigating interest expenses may also lead to the understanding of the existence of a possible business relationship with a bank or lender. If there is an interest expense, it must be on a liability. If there is a liability, there may be a relationship with that lender above and beyond that liability. Even where only that limited relationship exists, a financial statement was probably submitted to entice the lender to make the loan. The concern here is with personal financial statements, which are a virtual necessity for loans of almost any magnitude to other than large companies. The company’s financial statement will probably be the one that you have seen or will see. (Unless the lender received an interim financial, which, of course, was described as more reflective of reality than the company’s tax motivated yearend financial statement.) The personal financial statement is usually more important for this attack. It is vital that we understand the purpose of the debt on which the interest is being paid. Was it merely for working capital or was it to acquire a piece of machinery? If for machinery, we need to be able to trace the acquisition of that machine to the borrowing. The point is to make sure the borrowing was not done for the purchase of a personal asset to benefit the individual instead of the company. Perhaps the loan was taken to buy out a partner or to pay for the original acquisition of the company. In that situation, the interest expense, though legitimate as an economic and true expenditure, is not a business operating expense. Rather it is the cost of carrying the investment in the company. It must be removed from the expenses to accurately reflect the company’s actual operations. This interest cannot be ignored; it is real and the debt is real. However, it is not an operating expense. Furthermore, depending on how you approach the issue of valuation, you very well may need to be able to state the business’s operations on a debt-free basis. Be careful when doing this not to ignore the existence of the debt. It is one thing to take the position that the business is worth $5 million on a debt-free basis; it is another to ignore the fact that the company, or the owner of the company, is in fact encumbered by $3 million of debt. True, the company may be worth $5 million, but in this example, its value in the marital unit is only $2 million; someone has to be responsible for that debt. When reviewing debt we must also make sure we understand the interest rate and terms on that debt. Although many loans are written with a floating rate of interest tied to the prime rate, there are still many fixed-rate loans in existence. If,

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for instance, the debt carries a 15 percent rate of interest when the going rate is only 10 percent, and the subject company is financially sound enough to qualify for a lower rate of interest, the investigative accountant might decide that in order to reflect what the business should be doing (especially what a prospective buyer would be looking at and therefore an item relevant to value), it is necessary to restate the debt at the going rate of interest. Such a correction presupposes no penalty for premature payoff of that debt. The existence or lack of existence of interest expense on officer or owner loans is a factor. If the loans have a fair rate of interest, the transaction can for this purpose be treated as if with any unrelated party. However, as is often the case, where there is a loan to or from a business owner without interest, special attention must be given to the economic and financial ramifications of such a relationship. If the owner has made substantial loans to the company without interest, the transaction is really additional capital. Conversely, if a company has made substantial loans to the owner without interest being charged, what you probably have is additional compensation to that owner and, of course, additional expense to the company and a reduction of its balance sheet. From an economic point of view, nothing has really changed overall. However, from a valuation point of view, as well as a presentation point of view, the handling of these items may be of significance. FINES AND PENALTIES. Yes, we know that fines and penalties are not deductible. We also know that, notwithstanding such pieties, they are commonly and routinely deducted as operating expenses. From an economic point of view, they indeed are often operating expenses. As an example, it cannot seriously be argued that for a delivery company, traffic and parking tickets are not a normal cost of doing business, regardless of whether the tax laws allow their deductibility. Similarly, the complexities of meeting various federal and state tax obligations on a monthly, semimonthly, and even more frequent basis has become so confusing and overwhelming, especially for the smaller businesses, that some level of penalty assessments relevant to payroll taxes is to be expected. Clearly, without equivocation, such expenses are normal and customary operating expenses and should be allowed. Some fines and penalties are clearly aberrations in a company’s operations, and as such must be removed as operating expenses. If a company took an improper deduction or improperly handled some aspects of its operations so that upon audit the IRS slapped it with a negligence penalty that amounted to several thousands of dollars or more, that should not be allowed as a business expense. Or, perhaps you are dealing with a company subject to regulatory oversight and the realities of the industry are that fines of several hundred dollars are routine. Certainly, those types of fines would be considered operating expenses. On the other hand, perhaps as the result of antitrust action, the regulatory body fined the company $100,000. Clearly, that would be a nonoperating expense. A large fine such as this is a nonrecurring expense, and therefore it is necessary to remove it from the operations (one could amortize it over several years, but that’s another issue) for the sake of normalizing that business’s income flow. 8.17

8.18 BAD DEBTS. Almost all businesses at one time or another experience bad debts. Where we are dealing with a cash-basis reporting operation, such as a

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professional service business, you will probably never see a bad debt expense recorded on the company’s books. Where the books are maintained on a cash basis, you cannot write off a bad debt against income that you never received. This is one of the most difficult accounting and tax concepts for many professionals to accept. When we cause a business to pick up its accounts receivable, we of course must take pains to provide for a provision for uncollectibility. As a result, a thorough reconstruction of several years of operations, reflecting the receivables and changes therein from year to year, is also likely to take into account a certain level of bad debts from year to year. When dealing with a business that maintains it records on the accrual basis, it is rather common to see reflected on those books a bad debt expense. However, except where we are dealing with an audited situation where great pains were taken to ensure some degree of accuracy as to what is considered a bad debt, the reality of how most small to medium-sized businesses write off bad debts is that they are generally either tax-motivated (in which case the greatest amount possible was written off as soon as possible), or financial-statement-motivated (in which case there is either a greater sense of economic reality or debt that should have been written off is held back to improve the financials). It is the investigative accountant’s job to understand how that particular business handled this aspect of its operations. If our concerns are that bad debts were written off under a tax mentality, then we need to look at the level of reasonableness of those bad debts in relationship to the accounts written off. Just as in an ordinary audit step, look at collections for the several months subsequent to the previous year end, or whatever time frame you are considering. If a company took an aggressive stance, it is likely that you are going to see significant recoveries against those write-offs in the several months subsequent to that time frame. If that is the case, and of course assuming we are dealing with substantial enough dollars to make it worthwhile, you should consider undoing at least a portion of those alleged bad debts. Another tax reality is that a company will often allow questionable receivables to remain simply because there is no need to write them off, that is, income has not been strong so the company does not need the extra deductions. That however will change when the company has a good year, and has the need for write-offs. You may then see a large write-off of bad debts. When that happens, it is important to recognize the underlying basis for that transaction and properly amortize that large one-year write-off over the past few years, or if more accurate, pinpoint when the write-off really should have occurred. Where bad debt write-offs are unusually large, although legitimate and properly charged to a particular year, we should still consider whether that bad debt be permitted, for our purposes, to repose where it is. Should we remove it as a nonrecurring expenditure? If that is the case, should we also remove (from the year in which it happened) the sale that generated that receivable which is now being written off? Or, should the sale remain where it was because it was realistically indicative of the company? While the sales will probably continue, the bad debt experience should not recur. These are rather difficult questions and there are no simple answers that can be applied across-the-board. We must be careful that a compression of a several year accumulation of bad debts into one year is not permitted to unduly distort operational results.

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Another problem with the bad debt expense area, discussed previously, is that sometimes a bad debt expense is not what it appears to be, but is the write-off of a previously collected and pocketed receivable. Perhaps a year or two later, after it has become obvious that this customer is simply not going to pay, the receivable is written off as a bad debt. The reality is that the owner received additional compensation, but it is generally extremely difficult to adequately prove that this happened. However, where there appears to be a pattern of write-offs, where there is a single large write-off and you have reason to be suspicious, some alternative steps and tests may be warranted. Perhaps a cursory investigation of the customer is appropriate to find out if it is a solvent business with a good reputation for paying its bills. Or perhaps you can engage in some general office scuttlebutt and find out that this account was always the private domain of the business owner, nobody else serviced that account and nobody else was able to deal with the collection on that account. These thoughts all relate to that all-important aspect of our work: understanding the business. OFFICE EXPENSES AND SUPPLIES. Another often innocuous account, office expenses and supplies, many times lends itself to absorbing all sorts of odds and ends, and often almost anything that cannot be easily classified elsewhere. The testing on this account is similar to that for most of the other expenditure accounts, and the investigative accountant must know what is appropriate and reasonable for that business. Among the personal expenditures that we might find dumped into this account are:

8.19

• • • • •

Household supplies Personal stationery Supplies and software for the home computer Small appliances Various items of furniture

It is also not unusual to see office furniture expensed through this account. A business might furnish an office, with chairs, desks, working tables, and the like and expense all of it through an office supplies account. This type of expensing might also extend itself to doing the same with furniture for the home. Generally, these items are fairly easily recognized by an adequate review of the underlying documentation and invoices. 8.20 MEMBERSHIPS AND DUES. This expense category is often important in two completely different ways. It will tell you which professional and trade organizations the company belongs to so that you have a better understanding of the business and also some direction as to where you might obtain trade information. Also, this expense category sometimes is where meetings and conventions are posted, and these may be as much vacation and pleasure as they are business. When faced with a situation involving meetings or conventions, find out either through the appropriate paperwork, the organization, perhaps the underlying programs or whatever, whether that convention ever happened, and if so, was it two or three days long and did the business owner attend for two weeks.

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For a United States –based operation, attendance at a convention or trade show in France for two days, with the round trip being made in the space of two or three days, is clearly all business and no pleasure. On the other hand, if for that same trade show the business owner was in France (and usually you can tell this from a review of the airplane and hotel bills) for 10 days, then maybe you do have as much of a personal trip as a business trip. However, there could have been a number of legitimate business reasons other than the trade show that required the business owner’s presence in France for that period of time. For instance, the owner might have figured that as long as attendance was important there anyway, it was the appropriate time to visit various suppliers or customers who also happen to be located in or around that area. Before assumptions are made as to whether the trip was mostly personal, some understanding needs to be obtained as to whether there was an additional business purpose. 8.21 SUBSCRIPTIONS. Do we care that the business is paying for $200 a year of personal magazines subscriptions? Not really. However, there is the possibility of some limited benefit from reviewing this area. Most of the time it just is not worth the time and effort (assuming that subscriptions are maintained in a separate account), but the accountant should look at any large item that might warrant attention. Other than that, it might be beneficial for us to know which magazines the business, that is, the business owner, was receiving. For instance, if it was to Aviation Weekly, or to Boating, unless of course those were particularly relevant to the business being investigated, it would be reasonable to assume that the business owner had more than a passing interest in planes or boats. Perhaps he or she owns an airplane or a boat. Of course, in most of these cases you would (or should) have already known that based on input from the spouse, a review of the financial disclosure statement, or by other means. However, sometimes that information is just not that easily available and you may learn of it by knowing the reading habits of the individual. UTILITIES. Similarly with telephone expense, it is not unheard of for a business owner to run personal utility bills through the business. Again, whether these bills are personal or business-related can usually be fairly easily determined by a review of the bills, looking for account numbers, services addresses, and the magnitude of use.

8.22

MISCELLANEOUS. Finally, the quintessential catch-all, the account called “miscellaneous” (and in fancier sets of books, “sundries”). Virtually anything can be posted to this account, including many things that clearly belong to other accounts but are there because someone did not know or care. Normally, we would peruse this account to target large postings. In the absence of such, in the typical case where just odds-and-ends of a relatively small amount are posted to this account, it can be totally ignored. 8.23

SOCIAL SECURITY NUMBERS. Social security numbers are issued by geographic grouping, based on where one lives when applying. Some numbers have not been issued at all. Exhibits 8–1 and 8–2 present the ranges of numbers issued, first in approximate numerical sequence, then in alphabetical order by state. This information was obtained from the Social Security Administration.

8.24

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EXHIBIT 8 –1

Social Security Numbers: Numerical Sequence STATE New Hampshire Maine Vermont Massachusetts Rhode Island Connecticut New York New Jersey Pennsylvania Maryland Delaware Virginia West Virginia North Carolina South Carolina Georgia Florida Ohio Indiana Illinois Michigan Wisconsin Kentucky Tennessee Alabama Mississippi Arkansas Louisiana Oklahoma Texas Minnesota Iowa Missouri North Dakota South Dakota Nebraska Kansas Montana Idaho Wyoming Colorado New Mexico Arizona Utah Nevada Washington Oregon California Alaska

NUMBERS ISSUED 001– 003 004 – 007 008 – 009 010 – 034 035 – 039 040 – 049 050 –134 135 –158 159 – 211 212 – 220 221– 222 223 – 231 232 – 236 232 247– 251 252 – 260 261– 267 and 589 – 595 268 – 302 303 – 317 318 – 361 362 – 386 387– 399 400 – 407 408 – 415 416 – 424 425 – 428 and 587– 588 429 – 432 433 – 439 440 – 448 449 – 467 and 627– 645 468 – 477 478 – 485 486 – 500 501– 502 503 – 504 505 – 508 509 – 515 516 – 517 518 – 519 520 521– 524 525 – 585 and 648 – 649 526 – 527 and 600 – 601 528 – 529 and 646 – 647 530 531– 539 540 – 544 545 – 573 and 602 – 626 574

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8.24 SOCIAL SECURITY NUMBERS

EXHIBIT 8 –1

Social Security Numbers: Numerical Sequence (continued) STATE Hawaii District of Columbia Virgin Islands Puerto Rico Guam, American Samoa, Northern Mariana Islands, Philippine Islands Railroad Retirement

EXHIBIT 8 – 2

NUMBERS ISSUED 575 – 576 577– 579 580 580 – 584 and 596 – 599

586 700 –728

Social Security Numbers: Alphabetical Sequence STATE Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware District of Columbia Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota

NUMBERS ISSUED 416 – 424 574 526 – 527 and 600 – 601 429 – 432 545 – 573 and 602 – 626 521– 524 040 – 049 221– 222 577– 579 261– 267 and 589 – 595 252 – 260 575 – 576 518 – 519 318 – 361 303 – 317 478 – 485 509 – 515 400 – 407 433 – 439 004 – 007 212 – 220 010 – 034 362 – 386 468 – 477 425 – 428 and 587– 588 486 – 500 516 – 517 505 – 508 530 001– 003 135 –158 525 – 585 and 648 – 649 050 –134 232 501– 502

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OPERATING EXPENSES

EXHIBIT 8 – 2

Social Security Numbers: Alphabetical Sequence (continued) STATE Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Puerto Rico Virgin Islands Guam, American Samoa, Northern Mariana Islands, Philippine Islands Railroad Retirement

NUMBERS ISSUED 268 – 302 440 – 448 540 – 544 159 – 211 035 – 039 247– 251 503 – 504 408 – 415 449 – 467 and 627– 645 528 – 529 and 646 – 647 008 – 009 223 – 231 531– 539 232 – 236 387– 399 520 580 – 584 and 596 – 599 580

586 700 –728

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PART

THE PARTIES

III

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CHAPTER

9

PERSONAL FINANCIAL INVESTIGATION I have enough money to last me the rest of my life, unless I buy something. — Jackie Mason

CONTENTS 9.1 9.2 9.3 9.4 9.5

Overview Standard of Living Changes in Net Worth Personal Financial Statements Tax Shelter Issues

153 155 157 159 162

9.6 9.7 9.8 9.9 9.10

Corporation as a Liability Hobbies and Collections Tax Return Analysis State Tax Returns Children’s Tax Returns

163 164 164 169 169

OVERVIEW. Except where your work is for a very limited and specific purpose, it is an absolutely essential part of your services to investigate and analyze the personal financial situation of the marital unit. Although it appears to be occurring less frequently, we have occasionally been curtly advised by either the business owner or attorney that our engagement by the nonbusiness spouse was to determine the business owner’s income and value the business, not to delve into his or her personal financial affairs. Further, because no agreement was given or contemplated as to allowing access to the personal financial records, they will not be made available. Response to such feigned naivete must be immediate and strong. It would be a very rare exception that no personal financial investigation needs to be done. As all business people and professionals know, closely held small and mediumsized businesses are but another facet of the financial persona of the owners. The business is the extension of the individual, and by the very nature of that close relationship and control, the business and the personal financial affairs are, from a financial perspective, two sides of the same coin. When someone owns or controls a business, it is all too easy and common for the financial dealings and relationships between the business and the personal life to mesh. If the business has a working capital deficiency, a common quick fix may be a capital infusion from the owner’s personal financial resources, instead of a bank loan for the business. Conversely, if there is the need for some additional personal funds (for example, to add a pool to one’s home), it is not unusual for that business owner to borrow funds from the business or to take an advance

9.1

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PERSONAL FINANCIAL INVESTIGATION

or a bonus. No formalities, such as board of directors’ approval, are necessary. If the funds are available, they can be and are used between these two financial entities, business and personal. The financial relationship becomes closer yet when the business owner decides to pay the personal phone or utility bills or home repair bills through the business. It also becomes closer when the business deals with cash and some part of its income never gets deposited in the business, but rather finds its way directly to the owner. We have an interest in the personal financial records even where there are no improper or suspicious dealings or perquisites and all income is reported. For example, let us assume that this business owner took a $10,000 bonus in the past year. How can we know for a fact that it was deposited into known family bank accounts? Even where business improprieties are not an issue, the security of the marital funds and the potential concealment of marital funds may be issues. Therefore, the feigned surprise at a request to dig deeply into personal financial records must be immediately countered by emphasizing the importance of that process, without specificity as to what you think you might find or what you are particularly looking for. When asking to review the personal financial records, it is important that to the extent possible you address all aspects of the marital unit’s nonbusiness personal finances. You will need access to all of the family’s bank records, including not just the household checking account but also that extra checking account maintained by the business owner as a personal account, the savings accounts, money market accounts, brokerage accounts, and even the accounts in the names of the children. Except for gifts and their own earned money, virtually all monies in the children’s accounts came from the parents, and possibly even directly from the business in the form of unreported income. As odd as it might seem, the author has on more than one occasion seen income siphoned off from the business and deposited directly into children’s accounts, as if that made the nonreporting of that income protected and undiscoverable. Insist on reviewing these records to cover at least a two-to-three year period. Consider thoroughly whether you need to look at earlier or more recent records to protect against divorce-planning maneuvers. For instance, if the marital problems were fairly well known three years ago, such that you might suspect that either party might have started taking protective steps, such as removing and concealing cash from the marital unit, your financial analysis and investigation should go back at least that far. One very important aspect of a thorough review of the personal financial lives of the parties is to support the veracity of the reported income in comparison to the financial status of the parties and their standard of living. Inconsistencies must be addressed and vigorously pursued, regardless of the direction of the inconsistencies. Clearly, if the marital unit has been living well above the reported income figures or the net worth is inconsistent with the known financial affairs, then there is probably more income than reported. However, the opposite scenario also should raise the investigative accountant’s suspicions. If the marital unit has been living far below its reported income and its net worth appears to be too low, then we need to determine why. If the family unit is spending and living at a level below what it is earning and, of course, allowing for the tax burden on those earnings, significant increases in the marital

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unit’s net worth should result. If those increases have not occurred, one needs to question what is happening with the income that is being earned but not spent. Is it being diverted somewhere, unknown to the other spouse? STANDARD OF LIVING. A basic procedure in the analysis of personal financial affairs is a determination of the standard of living enjoyed by the marital unit. Sometimes the standard of living is obvious; other times it is not so obvious, for example when the unreported income is used for expensive vacations, or purchases that are luxuries. In one case, involving a retail establishment, the standard of living seemed to be fairly consistent with the reported income, but the couple were able to purchase some real estate by paying cash. The source of the cash turned out to be a “money in a mattress” situation. A thorough understanding of how the marital unit lived, what they spent, how they entertained, where and when they vacationed, how many people they were responsible to feed, and so on, bears heavily on determining a reasonable income requirement to sustain that standard of living. In most cases, analysis will show that a standard of living in excess of reported income was sustained by unreported income, not by increasing debt. To develop a reliable estimate of the standard of living, there are two basic approaches, both of which should be applied wherever possible: (1) interviewing the spouse for information; and (2) reviewing the personal financial records to see what flows through those records. When determining what income is available to support the standard of living, do not ignore sources that include borrowings (which you should know of through your investigation of the business or through changes on the tax returns), rent income, notes receivable paydowns (principal as well as interest), and gifts from family members (they should be documented and should not seem out of line). Additionally, consider the proceeds of capital gains transactions, along with interest and dividend income, which have helped support the standard of living, as contrasted with remaining in an account or reinvested. An effective and yet fairly simple way to determine the standard of living is to thoroughly analyze the family’s spending habits for a period of about two years through its checking accounts and, if necessary, money market or savings accounts. In most families, the checking account(s) will be the only source from which living expenses are paid. Transfers from savings to checking, of course, are not directly relevant to expenditures. In doing this exercise, do not overlook payments made by the business that are treated correctly, that is, charged to a loan account or back to the owner as compensation rather than deducted by the business. To do this analysis, you need to obtain the monthly statements and canceled checks for a two-year period. The checkbook stubs or check registers would also be helpful. Make sure that you have all of the canceled checks; it would not be unheard of for some checks to be missing from what you receive. You can verify the completeness of these records by actually counting the number of checks as compared to the number stated on the bank statement. If you know or suspect that checks are missing and your need to determine which ones is worth the extra effort, you can have the checks marked off one by one on the statement to isolate those that have not been supplied. A fair amount of the work in this inquiry can be done easily and with a minimal amount of direction by a junior associate or bookkeeper. In selective situations 9.2

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where you have confidence in your client, typically the nonbusiness spouse, that person might do this work as an opportunity to save fees and become more aware of and involved in the investigation. Set up your worksheets with 10 or 20 columns, and 30 to 40 lines. You will use the columns for separate expense categories, narrowing the focus to suit the particular case. On the left side, your lines will be headed for the months, using a separate worksheet for each year (and it is possible, depending upon the volume of transactions, that you might need more than one worksheet for a particular year). Then, using the check register, checkbook, or canceled checks, fill out your worksheet, categorizing the checks as best as you can (obviously, familiarity with the family’s lifestyle and habits is helpful, as is input from either or both spouses). For instance, you will have categorized checks into columns for food, charge accounts, utilities, mortgage payments, other loan payments, school, and a whole range of expenses. Very importantly, there will be a column for checks made payable to the husband, the wife, or to cash (these can be in the same column, since they are for these purposes effectively the same). As you go through the checks, you will list them one by one in the appropriate columns. Except for specific noteworthy checks (which would generally go in the ever-present “other” or “general” column), there is no need to list the check number or the specific payee. While in certain situations that information might be very important, it usually is not significant for this exercise, and would add substantial time and difficulty to your work. To improve your understanding of family spending habits, when you go from one month to the next you should leave a line blank across the entire worksheet after the last entry of the preceding month. Checks for the succeeding month are started uniformly on the next line in each column. This permits you to segregate expenses by month. In this way, the accountant can get a good month-by-month overview of expenditures, without mixing up the months and lessening the utility of this exercise. For instance, this will help you see easily if for a six-month period there were no checks made payable to cash or to the parties. Similarly, it shows whether no checks were made for charge accounts or telephone bills. If you were to simply list expenses in the appropriate columns, disregarding the months, you would have no more than a run-on listing of expenditures for the year, with no meaningful demarcation between the months. By the time you got halfway through the year, you would be entering July items 30 lines down for some expenses, and perhaps only five lines down in a column for other expenses, eliminating your ability to understand the family’s monthly outlays. We have found this method of analysis to be extremely helpful in many situations. Unreported income or the extreme use of company perquisites may become very obvious when, for instance, we see no utility expenses paid through the family bank accounts; no checks made payable to food or local stores; and, often most telling, no checks made payable to the parties or for cash. We have even seen situations where no checks were made payable for the marital home mortgage. Apparently, the parties decided that the bank’s annual mortgage statement would be adequate proof of payment for deduction of interest and real estate taxes. Indeed, that usually is sufficient support for the tax return deductions. This approach has been helpful where we were aware of (and may have even had proof via receipts and bills) substantial payments for luxury purchases, such

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as furs, jewelry, or expensive vacations. In some of these cases, the existence of the expenditures was proven but the family bank accounts completely lacked evidence of the purchase. The obvious conclusion was that these were paid with additional funds, meaning unreported income. We had, of course, already satisfied ourselves that they were not paid with borrowings, gifts, inheritances, or business funds. As sloppy and illogical as it may sound, we have also found instances where the checking account itself proved expenses that clearly exceeded reported income. The reader might well ask, “If your analysis of the checking account indicated expenses in excess of reported income, would that also mean that there must have been deposits into the checking account (to cover these expenses) similarly in excess of reported income?” The answer is, of course, yes. Other than by borrowings (which we had already discounted), or by the use of a large carryover balance from the prior year (which also was not applicable), there must have been money in the account to cover the checks, and if those checks exceeded reported income, the money in the account had to exceed reported income. A few years ago we had a case where reported family income was around $30,000 a year, but the checking account supported a lifestyle of between $50,000 and $60,000 a year. Further, there were regular weekly deposits into the account in round amounts that exceeded the weekly paycheck. When we asked the business owner to explain these deposits, he advised us that he received a lot of medical insurance reimbursements. CHANGES IN NET WORTH. Somewhat related to the standard of living analysis just described, another helpful procedure, one often employed by the Internal Revenue Service in fraud cases, is the determination of the change in net worth over a specified period of time. The procedure requires that you know net worth at the starting point, which is often a very difficult item by itself. From that point you add the income for the following two or three years, and from that subtract the expenditures over that same time period. The result at the end of the two or three years should be an approximation of the new net worth. There are a number of problems and issues with this theoretically sound concept:

9.3

• You need a starting point. This is not as easy as it may sound, especially with people who typically live in a cash environment. However, with the help of the spouse for whom you are working, and with an adequate margin of error, you may be able to develop a reasonable approximation of the assets that existed a few years back. This would include bank accounts, real estate, stocks, various personal effects, and of course the debts that might relate to them, such as mortgages and unpaid bills. • You need an ending point. This is generally a bit easier, in that your ending point (in divorce work) is the valuation date (give or take the present time). What assets and liabilities presently exist is not always clear, but as with the starting point, this can be addressed. • What was the income during the specified time? For the most part, this should be easy because you rely on reported income. However, even that becomes muddled because your real concern is cash flow, not pure income. For example, if someone sold 100 shares of a stock and had a gain of $1,000 but

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the cash proceeds from the sale of that stock were $10,000, for purposes of this changes in net worth statement we are dealing with a $10,000 cash flow. Of course, the disposition of that stock is an issue, but that would be for the uses of the funds. In the broadest sense, a change in net worth analysis looks at the sources and disposition of cash flow. • You need to know what was spent during that time frame. This information is perhaps the most difficult to obtain. Frequently, many expenses are undocumentable or nearly so. You must base numerous calculations on estimates and common sense, as well as input from one or both spouses. For instance, food expense can vary greatly. A middle-class family of four can easily spend from a few hundred dollars a month to over $1,000 a month on food, depending on what they eat, how often they eat out, whether there are any particular dietary restrictions, whether they shop at a supermarket or a convenience store, and so on. This difference obviously can be several hundred dollars a month, several thousand dollars a year, and substantially more over a few years. There is no easy answer to this, though discussions with the parties and perhaps the canceled checks may help you make reasonable estimates. • Is the amount spent on clothing large or modest? That amount may vary significantly with the ages and growth rates of the children. If you estimate expenditures on food and clothing, and then add the documented total of credit card expenditures, the problem is that you do not really know how many of the same food and clothing expenses went through the credit cards. If you double count expenditures, you will assume a lifestyle greater than reality, and your final net worth calculation will be too low. That error might also cause you to conclude unreported income where none actually exists. In doing a net worth test, you must also recognize that you are not interested so much in the changes in net worth from the beginning to the end as you are in the changes in cash flow. For instance, if the couple owned the same residence at the beginning of this period as at the end, and if during that period the house increased $50,000 in value, for purposes of our changes in net worth, there was absolutely no increase. The reason is that a house appreciating in value does not represent a cash flow income or expenditure during that time frame. Similarly, if a stock went up or down in value, that is not relevant to our purposes. However, if that house or stock were sold, we would be very much concerned about the net proceeds and their disposition. Those proceeds should have increased a bank account, been used for a replacement purchase, or in some other way expended or invested. This analysis should cover a few years in order to smooth out any significant year-to-year fluctuations, and also to give a broader base, which lends greater credibility to your work and conclusions. You must also consider the possibility of cash flow generated from borrowings, whether from a bank loan, a refinance, drawdowns on a home equity line, or simply the use of credit cards. Similarly, you must not ignore paydowns of debt, whether from normal income, the sale of assets, or the refinance of other debt. If you perform this part of your work correctly, there should be a reasonably close correlation between the starting point net worth plus cash flow during the test period, less cash expenditures during the test period, and your “known” net

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worth at the end of the test period. Of course, if the results are not close, you have at least two possibilities: (1) significant flaws in your approach, and (2) unreported income. In either case, it would be advisable to carefully rework your figures and perhaps have someone else take a look to verify your approach and conclusions. If you had strong suspicions of, and reasons to believe the existence of, significant unreported income, and if your understanding of their lifestyle was that the unreported income was not expended, then indeed there should be a discrepancy between what the numbers should show and what they actually show. If there is not, then unless you have made a serious error in believing the existence of unreported income or unless they have spent much of it in ways not reflected in your analysis, you most certainly need to rework your approach. If there is a significant discrepancy and yet you have no reason to believe there is unreported income, then perhaps there is something seriously fundamentally wrong with your understanding, and maybe there is unreported income. There are, of course, a number of other possibilities, including inheritances, both spouses working (which you forgot to take into account), particularly large purchases, or a large sale of something that was overlooked. As suggested, one of the problems with this approach in determining unreported income is that there can be unreported income, but if it is expended to maintain a lifestyle or in other ways secreted, your net worth test may prove nothing. PERSONAL FINANCIAL STATEMENTS. It is fairly routine to obtain a business financial statement or balance sheet; most businesses have them, and even those that do not usually have at least a tax return with a balance sheet. Obtaining a personal financial of the person being investigated is not so routine. As we all know, personal tax returns do not provide anything close to a personal balance sheet and many people, even those in business, do not routinely prepare or have them prepared. On the other hand, virtually everyone who applies for a loan or a mortgage, seeks to refinance an existing loan, or has a small or mediumsize business that seeks financing, has cause to prepare a personal financial statement. Obtaining a personal financial statement often gives us insight that is not readily obtained elsewhere. When we investigate a marital unit, especially on behalf of the nonbusiness spouse, personal financial statements can be difficult to secure. We may be told that they do not exist, that no one can find them, that no one kept a copy, or that no one recalls whether one was ever prepared. Besides the reluctance to disclose anything, the fear is that a personal financial statement can be far more candid about the couple’s financial worth than the disclosure statements supplied to the court or any other statements that we would normally obtain. When one is seeking financing, you would expect that person to put forward the best possible financial face. As a result, financial statements used to obtain financing are often far more honest than those presented in a divorce. Of course, puffery is not unheard of. Some people blithely inflate their personal financial position when preparing a financial statement. Nevertheless, it is their financial statement, often signed, and certainly used to entice a lender to commit funds. Consequently, even if they are inflated, even if they are outright lies, and even if they have no utility in your investigation, if nothing else, they are still embarrassing and damaging to the credibility of the other side. 9.4

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It is amazing how blunt and arrogant some people can be before a judge when confronted with financial statements that seriously contradict their divorce disclosure statements. Even where the financial statements support our determination of net worth and values, spouses sometimes tell the judge straight out that the financial statement was prepared for a particular purpose, as, of course, the divorce disclosure statement was too, and that everyone knows that you have to be generous (lie) on these financial statements. I have witnessed such testimony on more than one occasion and found the typical judicial reaction to be restrained disdain, cautioning the party that admitting that one’s personal financial statement was fraudulently prepared does not sit well with the court. As already indicated, the existence of personal financial statements is often denied. It may be acknowledged that they once existed but no one remembers them or has copies. However, rarely need the investigative accountant be limited to voluntary compliance. As long as the accountant and the lawyer are working as an effective team, there are several avenues to pursue, typically including appropriate discovery demands or subpoenas: • The marital home mortgage. A filled-out personal financial statement is a routine requirement to obtain a mortgage. If the mortgage was obtained within the last couple of years, that lender might be an especially valuable source of a personal financial statement. • Home equity lines, refinances, and second homes. Just as with the home mortgage, home equity lines typically require personal financial statements. Similarly, a number of people have second homes. Do not limit yourself merely to the lender for the marital home. Also, refinances have been fairly common in the last several years, and those situations also create the need for personal financial statements. • Security dealers and other financial investments. While not as common as with mortgages, someone heavily into the stock market may have prepared a financial statement, perhaps even an abbreviated one, in order to qualify for a certain style of investing. For instance, for the more exotic and risky investments such as commodity trading, it is possible that the brokerage house asked for a personal financial statement. • Try to uncover the business’s banking relationships. Assuming any substantial borrowing by the business, the business owner would almost certainly have been required to submit a personal financial statement along with the business’s financial statement. Additionally, the business might deal with two or three banks, especially if it has multiple locations or substantial lines of credit. Therefore, despite the inconvenience and expense of a subpoena for personal financial statements, it will often be well worth the effort. This is especially true where there are strong suspicions of concealed funds, where the lifestyle is significantly in excess of the reported income, and where there are substantial business interests. When you cannot obtain a personal financial statement, and therefore need to develop one on your own, do not concentrate only on assets; remember the liabilities too. For instance, if you find monthly payments on behalf of a debt, or that interest expense is being deducted on the personal return, or otherwise being

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paid, do not overlook the obviousness that there is a debt attached to that interest expense. With someone dealing heavily in the stock market, debt might also include a balance due to the broker on a margin account. That might be hard to overlook, since the stocks that you are going to use as assets on the balance sheet are on the same statement that lists the margin account liability. Nevertheless, take pains not to gloss over liabilities. However, when one of the parties states that liabilities exist, but they are not corroborated by regular payments to a bank or other recognized lender, it is reasonable to insist upon documentation. All too often in divorce cases there will be an alleged liability to a family member, but no evidence of that debt in the form of any type of ongoing repayments. Such debts are, of course, quite suspect and require extra efforts to substantiate. Insist upon proof that funds came out of that family member’s bank account or “mattress,” and then tie that alleged transaction (withdrawal) to the corresponding receipt of those funds by the spouse whom you are investigating. In many cases, these alleged transactions will have no support. They will have allegedly happened years ago and no one has the records anymore. The lack of ongoing payments will typically be explained by, “We have an understanding that it will be paid back when I can afford to do so.” As a fact finder, the investigative accountant can, of course, question the legitimacy of this debt and its lack of support. Even if we conclude that the debt is unsupportable and not a true liability, we should include at least a footnote as to that debt, to indicate that we did not simply ignore it. When drafting a personal financial statement, do not overlook the possible existence of IRAs or other retirement and pension plan account assets. Look at personal tax returns for the past several years to see if there were deductions taken for contributions to IRAs and look at business tax returns to see if deductions were taken for contributions to retirement plans. Also, remember the possibility that perhaps prior to owning the current business, this business owner was an employee (often a high-ranking employee) in some other company and had earned a pension plan or some other retirement benefit from that company. It is very possible that benefits not yet received will remain in that plan until this person reaches age 65. It is not all that unusual for a business owner of perhaps age 50, who founded the company 10 years ago, to have 10 or 15 years of past service in another company with a fairly substantial retirement benefit available in the future. This type of asset is often overlooked even where the individual drafted the financial statement. Also, in preparing a personal financial statement, do not overlook the possibility of a tax refund receivable or tax liability payable. The combination of withholding, estimated taxes, and carryovers or shortfalls from the prior year may at any time be excessive and create a tax refund receivable, or insufficient and create a tax liability payable. The suggestion here is not that the investigative accountant attempt to do a partial year tax return for the marital unit, but rather that based on the numbers as known, the accountant should consider whether the amount of taxes paid is significantly less or significantly more than what would be reasonably necessary for the income for that year. It is not unusual to have withholding taxes too low during the year, with higher end-of-the-year payments so that an adequate amount is ultimately withheld. In such a case, a midyear valuation point would probably have a tax underpayment. It is also

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possible that withholding has been too large, that estimated payments are too high, or that a previous year’s payments created a refund which was carried forward to the current year so that a refund is likely. These assets or liabilities are often overlooked when developing a personal financial statement. The tax liability referred to here is not the potential tax that would be due if the assets were liquidated. That matter is usually outside the function of a personal financial statement used in a divorce. To include it is actually misleading and confusing to the reader. Such a potential tax burden is too remote and hypothetical to be a practical consideration, given the purpose of the financial statement in divorce work. Imputing a tax on an asset that will not be sold, but rather is going to be a setoff in the divorce against another asset is not logical. If taxes need to be taken into account, that should be done as adjustments after a tentative division of assets based on gross values (any direct liabilities would be subtracted). However, exceptions may be appropriate for certain assets, such as stock options. TAX SHELTER ISSUES. Like the potential tax refunds or balances due discussed in 9.4 relative to a personal financial statement, the investigative accountant should take careful note of personal tax situations where tax shelter or similar investments have built up passive activity loss carryforwards (losses that have not yet been deducted because tax rules did not permit it and that are waiting for a future event which would allow the deduction), and/or negative capital accounts because write-offs were taken in excess of investment. While the 1986 Tax Act made investing in tax shelters much less attractive, it did not eliminate them, nor did it eliminate other passive investments. Many such shelters remain from the mid-1980s and reflect interests, negative capitals, and continuing writeoffs, or even gains. The tax shelter area (including for the purposes herein, most passive activity situations) is still very alive as to its ongoing year-to-year impact on taxes. It would not be unusual for you to investigate someone who has significant tax shelter investments, loss carryforwards, and negative capital accounts. That situation requires that you consider the extent, if any, to which you factor in these potential tax recapture issues, that is, the latent tax burden due to the negative capital accounts. If you are representing the nonbusiness spouse, and have the typical situation where these shelters are in the name of the business spouse, you may be told that the underlying assets have no value. This issue is very difficult to address; it is often outside of the realm of the accountant, and it would in theory require far too great a cost to appraise compared to the value of the property. Worse, you may be advised that there are significant tax liability issues to be addressed. While there may be elements of truth to these arguments, or to parts of these arguments, they must be scrutinized carefully. As to the liability aspect of the existence of tax shelters, putting aside any question of intrinsic underlying value, consider: 9.5

• While perhaps a morbid way to address this issue, a step-up in basis upon death is particularly relevant if we are dealing with the divorce of an older individual. Under current tax law, assets get stepped up to current market value at the time of death. While that value is included in the estate, the “gain” realized by that step-up in basis is not recognized for tax purposes

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9.6 CORPORATION AS A LIABILITY

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•

•

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and escapes taxation forever. The absolute lowest value for an asset is zero. Therefore, at death in the hands of the deceased, that property, instead of a negative basis, obtains at least a zero basis; it might even get stepped up to a positive basis. Therefore, the potential tax liability that could occur upon liquidation or termination of the interest is gone. Granted, this only works at death, and while there are many potential obstacles in the interim (for example, the partners cause a foreclosure on the property, resulting in forcing the issue at that time), it is still a possibility. Even if the federal tax has to be paid at some point, a state tax, if relevant, can be avoided or reduced if the owner of that tax shelter were to move prior to the triggering event to a state with low taxes or no income tax at all. Again, many factors intrude, but the idea is not far-fetched, and a number of states, some very popular with retirees, would be a logical and perhaps even likely move. The tax issues involved relate to potential, latent, hypothetical, or possible taxes, rather than defined, certain, and imminent ones. The argument that there is a greater-than-average likelihood of IRS audit and disallowance because of tax shelter write-offs relates to a similarly hypothetical problem. Depending on a multitude of tax and financial variables, it is possible, perhaps even reasonable and likely, that as various tax shelters cross over from paper losses into paper profits (the realization of phantom income), the adverse tax impact of those paper profits can be offset by purchasing new passive activities that would generate losses. When considering potential tax problems, it should not be overlooked that the passive activity loss carryforwards will provide significant, or not so significant, losses to offset future income (if it happens). As a strong counter to the income recapture against negative capital accounts argument, it must also be kept in mind that where the losses have not been currently deducted, but are rather carried forward awaiting the occurrence of similar passive income so that they can be used, there is nothing to recapture. The IRS cannot recapture deductions you have not taken. Therefore, to that extent, negative capital accounts do not represent potential tax recapture, nor potential for an IRS attack. Finally, while indeed there may be some validity to the recapture argument, if and when that happens, it will obviously be in the future. What the tax brackets will be, what the personal financial situation of the party involved will be, and what other sheltering alternatives will be available, are, of course, all unknown at the present.

CORPORATION AS A LIABILITY. A tricky issue that may arise when analyzing the personal financial affairs of a couple going through a divorce, and developing the personal balance sheet, is whether a corporation can be a negative asset, a liability. If we are dealing with a corporation which has lost money and is in a deficit position, owing creditors more than it owns, and if personal guarantees on the liabilities are not present, at least in theory, your client or your client’s spouse could walk away from the corporation, abandon it, and owe nothing. The question here is whether it is appropriate to impute a personal obligation from a limited liability situation where there is absolutely no legal obligation to 9.6

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cover a corporation’s deficit. The straight and cold financial answer is almost always that as to a personal balance sheet, a corporation can be no less than zero, that is, the corporation’s deficit cannot become the individual’s deficit, assuming, of course, that no personal guarantees are involved. However, there are situations where that may not be acceptable. Your client or your client’s spouse may be in a position where, despite the legal ability to walk away from a corporation, perhaps other financial considerations, for instance, another company, may dictate that the corporation’s liability be made good. Or, perhaps the liabilities are to family members, assuming that the loans have been established to be legitimate, and it is out of the question to simply walk away. Like personal guarantees, you must not overlook that certain tax obligations may carry through from the corporation to the officers or owners. When it comes to items such as withholding taxes or sales taxes, there is clearly a personal obligation involved, with no shielding via the corporate structure. On the other hand, corporate income taxes, franchise taxes, and payroll tax expense, except the withholding portion, almost always go no further than the corporation. 9.7 HOBBIES AND COLLECTIONS. A collection is at times overlooked by the accountant, but rarely by the spouse, particularly when such a collection is rather valuable. While very few investigative accountants are qualified to value collections, we must certainly be able to recognize that they exist and to assist in quantifying the extent of the asset. One would think that the existence or nonexistence of a collection would be rather obvious. While that certainly is true in most cases, it is also possible that the accountant will forget to ask the spouse and, in the absence of digging for that information, it will never come up in conversation. Fortunately, we should be able to uncover such a collection even without asking the spouse. For instance, a review of the business and personal insurance policies should indicate whether there is special coverage for a collection. A further benefit of finding such insurance coverage is that the amount of coverage will give some idea of the extent of the collection. While we all recognize that insurance coverage is not always synonymous with value, it at least gives some quantification and is from an independent third party. You might also learn of the existence of a collection by your analysis of the expenditures, both business and personal. Checks payable to coin dealers, auction houses, a mail order operation that deals in collectibles, or anything else of magnitude or regularity may indicate the existence of a collection. Recognize that sometimes collections are extremely modest and are truly more of an inconsequential hobby than something of monetary value. During your general review of disbursements, you may have come across payments for a safe deposit box. How large are those payments? How large is the safe deposit box? An unusually large one would suggest that it holds a collection or jewelry (or perhaps a lot of cash). Find out if your client/spouse is aware of the existence of this safe deposit box and if so, what is in it. TAX RETURN ANALYSIS. In the sense of understanding the financial situation of the parties involved, their income, and lifestyle, and in getting some initial insight into what you might expect and for what you should be looking, a basic review and analysis of their personal tax returns for the past few years can be most illuminating. Furthermore, a tax return constitutes a document which 9.8

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the parties have sworn represents the truth. This is a procedure that should be fairly comfortable and routine for all investigative accountants. Most accountants are rather familiar with tax returns and thoroughly understand the various forms and contents. Facing Page. Start your analysis of the personal returns with the front page of the form 1040. A number of important items can be observed there. While we often take this information for granted, the investigative accountant should view it with inquisitive eyes.

• Address. Note whether the address on the return is the marital residence or some other address, such as the business. It may also be a post office box, or even perhaps someone else’s address. If it is not the home, the nonbusiness spouse probably never saw the refunds. Certainly, if the address is any other than the marital home or the business, find out why. • Social Security Numbers. An easy and obvious task is to ensure that the numbers on the return are the same as the numbers that you believe to be correct. Do not take even such a basic item as a social security number for granted. • Dependents. The number listed should give you at least an idea as to how many mouths have to be fed and the cost of living for that marital unit. Also, are other family members being claimed as dependents? • Wages. Who is getting paid, how much are the wages, and from what companies do they come? Do both spouses work, or only one? How many businesses are represented by the W-2s, and are any of them related or under the control of one of the spouses? Do any of the W-2s suggest the existence of a retirement plan or pension account, especially if it is a governmental W-2? • Tax-Exempt Interest. For the last several years, it has been required, though it is perhaps as often breached as honored, that tax-exempt interest income, even though not taxable, must be reflected on one’s tax return. Assuming something is stated there, find out the details, and where those assets are maintained. • Retirement Plan Distributions. Even if rolled over and not taxed, is there an indication that one of the parties received a retirement plan distribution or rollover from an IRA? If so, what happened to the money, where was it deposited, or how was it used? Also, what was the source, and is there more? • Miscellaneous Income. A general and vague catchall that might suggest the existence of certain assets or sources of income. • IRA, SEP, and Keogh Deductions. Obviously, these assets exist. Of course, you must find out how large they are and where they are located. While not as replete with information for the investigative accountant as page 1 of the 1040, a fair amount of information can be learned from page 2: Page 2 of Form 1040.

• Tax Credits. Are there credit carryforwards that, in effect, constitute a marital asset? From which assets or from what ownership source were these credits derived?

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• Withholding Taxes Via Form 1099. If there is evidence of withholding tax from Forms 1099, then obviously assets exist upon which dividends are paid and from which taxes are withheld. • Estimated Taxes. Rather basic, but if there is an indication of estimated taxes being paid, the investigative accountant needs to have made sure that he or she was able to trace the source of the funds that paid those estimated taxes. • Tax Balance Due or Refund. Similar to estimated taxes, if a balance was due, how was it paid and from what account? If a refund was due, where was it received/deposited; or was it left in as a carryforward against taxes for the following year, which would constitute an asset? Schedule A. Even though this schedule has in recent years become far less of a treasure trove of information than it used to be (by the elimination of the deductibility of sales tax, personal interest, and the institution of a 2 percent floor for miscellaneous deductions), it still remains a required stop on the tax return tour.

• Medical Expenses. Of course, from what source were they paid? But in addition, since almost any client the investigative accountant represents will be covered by medical insurance, if the expenses are significant and the reimbursements therefore significant, where were those reimbursements deposited? • State and Local Income Taxes. Did these come only from withholding, or were they paid directly via estimated taxes? Do they represent a balance due from the prior year? From what account were they paid? Which state’s taxes are being deducted? It may seem silly to ask, but besides the known home state, are there other states for which taxes are being paid, which might indicate sources of income and/or assets, or at least a nexus with their existence elsewhere? • Real Estate Taxes. For which properties are these being paid? The investigative accountant needs to have a comfort level that the real estate taxes represent property of which we are already aware. There may be additional property, perhaps a vacation lot or house in another state, for which taxes are being paid but yet to be disclosed. • Personal Property Taxes. On what property, and in what state, are these taxes paid? • Mortgage Interest. Of course, on what property is the mortgage being paid, and what is the balance due on that mortgage? Especially if the mortgage was taken out fairly recently, you need a copy of the financial statement that was used to obtain that financing, as well as to know how any proceeds from that mortgaging were utilized. • Points. Points indicate a recent refinancing. Again, this is a potential source of a personal financial statement as well as a potential source for funds freed up upon the refinancing. Find out if your client is even aware of this refinancing. You may be surprised how many times the business spouse will complete a refinancing, including forging the other spouse’s signature, and the nonbusiness spouse is totally unaware of it.

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• Investment Interest. Obviously, investment interest is an indication that a margin account or some other liability related to an investment exists somewhere. That also means that there are investments, and probably an ongoing relationship, with a securities dealer. • Contributions. This is usually of value only if it gives you an opportunity to raise doubts as to the other spouse’s integrity. Is there support for the contributions deducted on the personal return, or does it seem to be a pack of lies? Of course, it might be your client who is not so innocent. • Casualty Loss. We usually do not see this type of deduction unless it is significant enough to meet the 10 percent of income threshold. What asset was damaged or lost? Where was it, what was its value, and how much, if any, was recovered through insurance? If there was insurance, have the proceeds been received, and where were they deposited? Was the asset replaced? • Miscellaneous Expenses. Is the existence of a safe deposit box indicated, are business expenses being deducted, are investment expenses being deducted? This schedule lists the details supporting interest and dividend income. It can be a very important source of information.

Schedule B.

• Detail. This form lists specific sources of interest (that is, banks, bonds, or brokerage houses) and dividends (that is, brokerage houses, mutual funds, and money market accounts). It is imperative that the investigative accountant utilize this information to assist in marshalling the marital assets as well as understanding potential sources and uses of funds. • K-1 Flow-Through Situations. The existence of interests in trusts or estates, S corporations, or partnerships may be discovered by seeing evidence of such through interest or dividend income flow-throughs from those entities. • Was the question concerning the existence of foreign accounts answered at all or in the affirmative? If so, it is very important to obtain full disclosure. Reference here is to a side or supplementary business rather than the main object of the investigative accountant’s labors. That is, we are assuming for this purpose that there is something in addition to the specific business being investigated (if that business were an unincorporated entity which would show up as a Schedule C on the personal tax return). Schedule C.

• Additional Source of Income. The mere existence of a Schedule C in addition to the main source of income for this marital unit is an indication of a source of income that needs to be reviewed. It may be little more than an elaborate hobby, but that evaluation must be made from a point of knowledge rather than ignorance. • Additional Income. Just as your investigation of the main business may result in add-backs, adjustments, and so on, so too there may be similar results to this Schedule C. In that case, the actual marital and disposable income might be more than meets the eye. • Keogh. One reason for the existence of some of these side Schedule Cs is to enable the creation of a Keogh plan to increase retirement plan deductions. If it was not obvious from the facing page of the 1040, look for it here.

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• Bank Accounts. The existence of a side business might also suggest the existence of an additional bank account if funds and operations of that business are kept segregated from other assets of the marital unit. Schedule D is an indication of activity involving brokers, security dealers, and possible flow-throughs from other investments where capital transactions have occurred. Schedule D.

• Brokers. Activity evidenced on this schedule suggests the existence of some kind of a financial relationship with at least one stockbroker. It means that there may be a brokerage account that needs to be reviewed. If owned securities are not deposited with a broker, where are they? Are they in a safe deposit box? • Asset. It is likely that not only were stocks sold, but that others were retained or purchased with the sales proceeds. Therefore, you might expect assets to exist and that their values might be substantial. • If securities or similar assets were sold, the proceeds could be significant. If so, how were the funds used? Where did they go? Schedule E covers much information, reflecting rental properties and flow-throughs from partnerships, S corporations, estates, and trusts. Schedule E.

Rental Property

• The existence of rental property, of course, tells you that an asset exists which must be valued and included in the overall financial picture. • There is probably a mortgage on the property. If so, and especially if a recent mortgage, obtain a copy of the financial statement (or application) that was prepared to obtain that financing. • What is the cash flow or shortfall generated by that property, that is, income less principle amortization plus depreciation? • Is the income from all the rental units reflected on the return, or is some of the rent unreported? • Where is this rental property located? Is there a possibility of additional assets in some distant location? • Especially if a recently acquired property, you will want copies of the closing papers so as to determine what funds had to have been used to purchase the property and the source of those funds. If recently refinanced, what funds, if any, were released, and what was their disposition? Partnerships and S Corporations: K-1 Flow-Throughs

• By virtue of the K-1 flow-throughs, obviously investments exist in partnerships or S corporations. In that case, you should know more details, including the extent of the investment, the level of activity in that investment (is the investment passive or is it an active business), and the financial strength of that business or investment. You may need to extend your investigation to these entities.

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• There may be liabilities attached to these investments. It would not be unusual in a partnership investment for personal liability to exist aside from anything on the partnership’s books and records. In a simpler partnership, there may be no formal books and records. • Is there a cash flow or drain from any of these businesses? Simply having income or losses does not mean that there is a cash flow or drain. • Are there passive activity loss carryovers that, in a sense, constitute a tax benefit (asset) that can be utilized in the future? Trusts and Estates

• Specifically, what estates or trusts exist, what kind of income flow is generated from them, and how did the interest originate as to the people involved? Often, we will find that these assets are not marital, and therefore not directly an issue as to value. • Even if the trust or estate is not marital, the income flow therefrom may be relevant to the ability to pay support or the need for it. This, of course, may vary from state to state. • An interesting approach relevant to income from nonmarital estates and trusts, and any other income from a source outside of the marital estate, is that in some sophisticated situations, the party receiving this type of income takes pains to keep it segregated, that is, by placing it in a separate bank account or other vehicle preserving the nonmarital nature of the fruits of the trust or estate. However, it is the rare individual who also takes the same pains to see to it that the tax burden on that income is similarly paid for out of separate funds. Usually the tax burden on nonmarital income is nevertheless paid for out of the marital estate. If we are dealing with substantial income, it would be fair to attribute back to the marital estate the extent of the tax burden, plus earnings thereon, during the time span in which the marital estate was burdened by the taxes on income, the benefit of which it was not able to receive. 9.9 STATE TAX RETURNS. For the most part, there will be nothing particularly new or different in the state tax returns that you have not found through the federal returns. However, you may find tax-exempt interest income on the state tax return that does not appear on the federal, notwithstanding the requirement that all interest income be reflected on the federal return even if not taxed. This may lead you to the existence of additional assets. CHILDREN’S TAX RETURNS. Especially where there are concerns about unreported income or the concealment of marital funds, always obtain copies of the children’s tax returns, as well as the children’s bank and investment records. Except to the extent that these funds were gifts from other family members, or earnings the children generated themselves, any money in the children’s names must have come from the parents. It is not unusual, for very legitimate reasons (such as college and tax savings), to place money in children’s names. It is sometimes also done in a divorce context, thinking that such transfer will remove the money from the marital estate. It does not.

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It is also amazing how many times intelligent people will take unreported income and place it in a child’s bank account, thinking that it somehow shields the money from an IRS attack for unreported income. Some people seem to believe that this is an improvement over taking unreported income and depositing it in bank accounts in their own names. Just as you would investigate the bank records of the parties involved in the divorce, you should apply the same procedures to the financial records of the children.

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PART

VALUATION

IV

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CHAPTER

10

VALUING A CLOSELY HELD BUSINESS Everything exists, nothing has value. — E.M. Forster

CONTENTS 10.1 10.2 10.3 10.4

Overview There Is Value, and Then There Is Value Business Structure Understand the Business and the Industry

173 175 178 178

METHODS OF VALUATION

179

10.5 10.6 10.7

179 180

10.8 10.9 10.10 10.11

Revenue Ruling 59-60 Revenue Ruling 68-609 Industry Comparison: Price-to-Earnings Ratio Industry Comparison: Rules of Thumb Recent Sales Capitalization of Income Discounted Future Earnings (or Cash Flow)

183 186 187 188

10.12 10.13 10.14 10.15 10.16 10.17 10.18 10.19

10.20 10.21

Buy-Sell Agreement In-Place Value Liquidation Value Discounts Premiums Enhanced Earnings Power The Old Double Dip Validity of Attributing the Value of an Appreciated Separate Business to Inflation Revenue Ruling 59-60: Valuation of Stocks and Bonds Revenue Ruling 68-609: Valuation of Stocks and Bonds

NOTES

191 191 192 193 195 195 196

198 199 206 238

189

OVERVIEW. Part and parcel of investigating a closely held business in a divorce situation is the valuation of that business, or an interest in that business. There are certainly times when valuation will not arise, and there are times when the valuation will not be done by the investigative accountant. Nevertheless, in a divorce case where one of the parties owns a significant interest in a closely held business, the value of that business is almost always at issue. It may very well be the accountant’s job not only to investigate the business and determine income but also to value it. This chapter provides an overview of the valuation process and concepts. To more fully understand business valuation, readers are strongly encouraged to consult one of the several excellent books on that topic. While arguments are raised that accountant training is not valuation oriented, the reality is that there are few professionals more qualified to value a closely held business than an experienced accountant. Most accountants do not have a formal education in economics and finance relating to valuing businesses or

10.1

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VALUING A CLOSELY HELD BUSINESS

doing formal investment return analyses. On the other hand, few other professions are as intimately involved in the finances of businesses and learn as much about how businesses operate, what motivates people to sell, how the selling process works, and how deals are structured. That is not to say that an accountant with two years of experience is qualified to do a business appraisal, but neither would an associate with two years’ experience in a business appraisal company be qualified. The use of an accountant is also a very cost-effective approach to the valuation of a business. With a relatively small business, the services of an investigative accountant are a necessity to sort out financial details that are not reflected in the financial statements or tax returns. It may simply be impractical and too expensive to also engage a separate business appraiser who similarly has to obtain familiarity with the business, review the accountant’s reconstructed figures, and then do the valuation. This is not to say the appraiser could not do an effective and qualified job; rather that, for a small business, it is probably overkill. As already stated, the investigative accountant is an absolutely integral part of the business investigation and valuation process. It must be recognized that with the rarest of exceptions, one cannot accept the financial statements or tax returns on their face as a suitable starting point for valuation. The services of an investigative accountant become absolutely essential to generate a reliable set of financial figures and data. Much of this book has been devoted to explaining why, even where absolutely nothing wrong has been done, the financial statements or returns of a business cannot be accepted at face value. They almost always require investigation and some degree of restatement. Therefore, the starting point in any business valuation is to have an investigative accountant review the books and numbers and report back as to their reliability for determining value and income. When the financial life of the business has been restated to the extent necessary, and only at that time, that business is ready for valuation. Common sense must always prevail. No matter how elaborate the valuation approach, no matter how sophisticated and detailed the explanation, no matter how many pages devoted to explaining every detail of the valuation process, the results must make sense. No matter how skilled, the appraiser cannot take a corner grocery or two-person construction company that, after all adjustments, has net income of $50,000 per year, and adjusted book value (without goodwill) of $100,000, and attribute a value of $1 million. An issue that arises fairly often in the valuation of small- to medium-sized closely held businesses concerns the use of pretax versus after-tax income. Simply put, it does not matter. The accountant-appraiser should feel free to use either before-tax income or after-tax income in the valuation process, as long as it is recognized what approach is being used and that the appropriate valuation considerations, multiples, capitalization rates, discount factors, and so on, are applied. It does not matter whether you value a business that shows a net income before taxes of $500,000 using that before-tax income or whether you first impact it for taxes and then value it based on after-tax income. It is the same business and only the starting point to valuation has changed. Logically, the capitalization rate or other factors being used will be different depending on which set of figures is used. A problem that does arise often is that, depending on matters of convenience, the same multiple is applied indiscriminately to both before- or after-tax income.

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The difference can be rather significant. The tax impact can easily lower reported income by a factor of 30 percent to 40 percent. In an oversimplification, if the income to be capitalized with a multiple of 5 is $100,000 before tax, and only $60,000 after tax, the use of a 5 multiple applied indiscriminately to both figures results in values of $500,000 and $300,000 — a 67 percent variation. Another tax issue centers on unreported income. When dealing with a cash business where unreported income is common and notorious, should income taxes be imputed to the adjusted and reconstructed bottom line? The business owner has never paid taxes on that full amount, never will, and as a practical matter, no one who buys that business would either. Although this is at times a difficult argument to put forward in a court of law, where there may be some lingering belief that since it is required, all income is reported, the reality of operating a cash business is that it is next to impossible (or at least rather time consuming and expensive) for any governmental body to be able determine accurately the true revenues. It is relatively easy in a cash business to keep some of the revenues for yourself and very simply not report it, and not deposit it into the company’s bank account. To suggest that this does not exist would be naive, and to suggest for valuation purposes that a prospective buyer would, in some way, value this type of business based on its full income minus the appropriate amount of tax on that income, would be nonsense. Therefore, while some form of a reduced tax rate (to reflect that only some of the income is reported) might be justified, the best approach under the circumstances is to base the valuation on reconstructed pretax income. This way, we do not have to deal with the issue of how much tax will or will not be paid. Additionally, we are also dealing more accurately and more realistically with how the market actually values any such business. For the most part, with small and medium-sized businesses, prospective buyers look to the pretax income generated, not after-tax income. This concern is not so easily addressed when we have to deal with the ability of one’s spouse to pay alimony and child support. With a wife earning a reported $30,000 plus an additional unreported $70,000 a year, and a husband who stays home and raises the children, should that wife’s income be considered $100,000 as if fully taxed, or something greater to realize that the full amount will never be picked up as taxable income? My suggestion is that again we deal with the pretax realization of income. Especially to the extent that any payments would be deductible alimony, the use of pretax income would not present a burden. To the extent that payments are going to be child support, those funds will almost certainly come out of unreported income. 10.2 THERE IS VALUE, AND THEN THERE IS VALUE. Typically, most people assume that when it is necessary to value a business, a clear and unequivocal determination has been made — we need to determine the value of a business. However, a very important step still needs to be taken. We need to determine the appropriate “standard of value” for the matter at hand. Is it fair market value, fair value, intrinsic value, liquidation value? Further, are we valuing the entire business entity, a majority ownership interest, or a minority ownership interest, and if a minority, what size minority? All of these points can be very important in how the business valuator proceeds and, certainly, in how the business valuator concludes. Let us briefly address these various terms of art.

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Fair market value perhaps is the value most commonly thought of or intended when the intent is to value a business. The classic definition of fair market value has long been immemorialized along the lines of: Fair Market Value.

The price at which a business would change hands between a willing seller and a willing buyer, neither under any compulsion to sell or to buy, and both equally informed of all relevant facts.

Furthermore, the reference to price in that definition is universally agreed to mean a cash price — money up front. This is the standard of value common to most divorce cases, although various jurisdictions have evolved their own style of what they consider fair market value, sometimes mixing in elements of other standards of value so as to bring a sense of equity above and beyond pure valuation theory to the matter at hand. This is also the standard of value we typically see for gifting and estates. In most ways, fair value is generally the same as fair market value. However, commonly the major difference is that as to a minority interest (and we will discuss this further below), a lack of control discount is not applied. There is also some question as to whether a marketability discount should be applied (assuming that it is appropriate at all for the specific matter at hand). Fair value, which is usually the standard of value utilized in a shareholder oppression suit, calls for the determination of value as if various oppressive actions did not occur. Fair Value.

Value to the Holder. This is not necessarily a “real value” in the sense of a theoretically correct approach to value theory, but rather takes into account the specifics of the situation and of the specific owner, to determine the value in the hands of that owner. This may have elements of sweat equity; it also may reflect that the business provides a living wage (or better) to the owner, the value of which in his or her eyes transcends what a third party would pay or consider to be value. Value to the holder sometimes is applied in divorce cases and indeed may be the driving force behind what someone would require to sell his or her interest in a business, regardless what the so-called market might dictate.

In concept, investment value is somewhat similar to value to the holder. Investment value is generally applied to mean the value to a particular investor or group of investors — as contrasted with value to a wide range of (or the ultimate hypothetical) investors. This type of value brings into play aspects and issues of interest or relevance to a particular investor, rather than to the general investing public. Generally this means that additional value may be placed on the business entity by that individual, value in excess of what a dispassionate hypothetical investor would consider. Investment Value.

In some sense, intrinsic value is similar to investment value, but calls upon the valuator to be more analytical and factual — it is a less personal sense of value. When (if) this approach to value is adopted by a sufficient number of investors, intrinsic value can become fair market value. We see intrinsic value used by stock analysts when they argue that the market doesn’t yet appreciate the real value of a company or, conversely, when they argue that the market has

Intrinsic Value.

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grossly overvalued a company. These analysts will then refer to the intrinsic value of a company as being the “real” value that the market just has not caught up with yet. This is not really a standard of value, but depending on the nature of the assignment, a buy-sell agreement may very well be the most important method of valuing the business entity. It also could be totally irrelevant. Typically, in a divorce context, because of the generally overriding issue of equity, especially where the party whose interest is being valued is a majority shareholder or at least a significant shareholder (and for these purposes partner can be used in lieu of shareholder) in a family business, a shareholders agreement is often disregarded. This is especially so if it has not been used in the past, if the amounts are unrealistic, if it is essentially a death buyout plan, and the like. However, in a nondivorce situation, a shareholders’ agreement may carry great weight — after all, it is a contract. Nevertheless, even if the valuation proceeds under the provisions put forth in that shareholders’ agreement, it is not a standard of value.

Buy-Sell Agreement.

There are times when the most accurate reflection of value of a business entity, or perhaps what might be called the best and highest use, is that of liquidation value. While not that common when we, as business appraisers, are called upon to value businesses, there are situations where liquidation value must be considered. Typically, this would be where the business is not earning (after providing reasonable salaries for those working the business) a fair and reasonable market-required rate of return on its assets (sometimes also referred to as its equity or investment). For instance, perhaps we are considering an oldline manufacturing company producing a product that is in much less demand than it used to be, or with a very inefficient plant — with the result being that the pieces are worth more than the operating unit. This concept might be applied to various kinds of start-up companies requiring major investments but showing no return. The difference there is the matter of potential. If there is potential, prospects for turnaround in the near future, then there may be a significant value. However, in the absence of those future prospects, an unprofitable situation with few if any expectations of future profits is probably most accurately valued via a liquidation approach. There are, in a broad sense, two types of liquidation value: an orderly liquidation and a forced (or distress) liquidation. The names are reasonably descriptive. An orderly liquidation suggests a reasonable time frame during which the assets of a business are sold off in a planned, orderly fashion so as to maximize the resultant yield, or value. Generally, when reference is made to liquidation value, this is what is considered. However, it is also possible to be addressing a forced liquidation. This would be more typical where there are outside forces mandating a fast realization of whatever cash can be generated from the assets of a business. Or, perhaps the business is operating at such a loss that the greatest value is found in forcing a liquidation, even at relatively distressed prices. Attempting to maximize the value of the underlying assets might require the stretching out of the liquidation process over a time frame creating worse losses. Needless to say, under virtually any concept of value, a forced liquidation is the lowest value one would realize from a business. Liquidation Value.

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This approach to value means that we are expressing a value on the entire entity rather than on part of same. This means that we approach value from a control point of view (as contrasted with valuing it from the point of view of a noncontrolling interest) and thus make the appropriate adjustments to reflect what an owner of the entire entity, in a purely arm’slength third-party arrangement, would consider.

Valuing the Entire Business Entity.

Valuing a Majority Interest. The approach here is very similar to that described immediately above as to valuing the entire entity. The only significant difference tends to be that a controlling interest may have a value greater than merely the respective percentage ownership interest. That is, if a business is valued at $1,000,000, the value of a 60 percent interest may be more than $600,000. That is because of something called a “premium for control.”

This aspect of valuation becomes potentially far more complex and problematic. On one hand, valuation theory does not change, and we need to approach value for a minority interest as we would approach it for virtually any other interest. However, a minority or noncontrolling interest does not have the ability to direct how the company performs various functions (that is, hires people, the compensation it pays its personnel, what expenses it pays). Need we say more? Value —yes, but what is this thing called value? Valuing a Minority Interest.

10.3 BUSINESS STRUCTURE. The investigative accountant needs to recognize that in a corporation the owner/operator is on the payroll, typically as officer’s salary. On the other hand, in an unincorporated business, whether sole proprietorship or partnership, there is no line for owner or partner compensation; it is simply all or part of the bottom-line net income. While from an economic point of view there is no difference, procedurally, we must not overlook that the owner or partner is entitled to a fair compensation, even though none is stated as such in the business’s expense structure. Most sole proprietorships and many partnerships are operated less formally than a corporate entity, and are also often less well capitalized than most corporations. The informality should not bear on the valuation process, other than it might reflect upon the quality and depth of the financial records maintained by the business. The capitalization of the business generally should also not matter since the buyer is going to bring its own capital into the business. If it is purchasing the business in its entirety, it will acquire receivables, equipment, and payables in virtually, from an economic point of view, the same manner it would acquire them from a corporation. Adequacy of working capital might be an issue in that, depending on how the business was run, it may be rather minimal and funded in some way through the business owner’s own pocket. Overall, the difference in valuing an incorporated as contrasted with unincorporated entity is a nonissue. UNDERSTAND THE BUSINESS AND THE INDUSTRY. Before simply putting several years of financial information into a report and coming to a considered determination of value, it is important to gain at least a rudimentary knowledge of the business and its industry. This is not to suggest that only an expert in that particular field can or should value the business, nor that you need to know

10.4

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enough about the business to run it. But as the investigative accountant, you may need to know the difference between a primary care physician and a hospitalbased radiologist, or the difference between a specialty steel manufacturer and a steel tank fabricator, and so on. Further, you should understand the macroeconomic difference between the overall industry, the marketplace, and the environment of a main street retail store as compared to a mail-order house. While it should be obvious that different economic forces impact these businesses, you cannot always tell that was understood by some of the reports that you read; sometimes you can tell it was clearly not understood. As the investigative accountant, you must make an effort to understand some of the underlying factors in the business, what its industry is about, what it sells, how it makes that product, who it sells it to, what are some of the pressing concerns of that industry, how important is the community in which it is located to its ongoing success, what governmental regulatory burdens weigh on that business, what its major competitive threats are, whether it is threatened by technological obsolescence, and so forth. Some of this information can be obtained through discussions with the business owner (Exhibits 10–1 to 10–3, sample business valuation interview forms, can be found at the end of this chapter); some can be obtained by relatively simple inquiries of industry sources, publications, and the like. In virtually every case at least a modest amount of this information must be obtained. Evidence in your report that your knowledge and understanding extends beyond the financial statements and tax returns is very important to your credibility and the weight your report will carry. Before determining valuation, an integral part of both investigation and valuation is to place several years (five is common but not absolute) on a spreadsheet. This is done for both the balance sheet and the statement of operations, accompanied by detailed supporting schedules as appropriate. Similar treatment will be given to any adjustments that were made by you as a result of your investigation and analysis, so that the ultimate result is a multiyear adjusted view of the business as it actually operated, as contrasted with how it reported its operations. Depending on the needs of the case and the adequacy of the financial information available, you might not restate several years of balance sheets, but only the balance sheet as of the valuation date. However, the statement of operations for several years often has to be restated if it is to be used for valuation, as well as to understand the income flow of the business. Once this multiyear view of the adjusted operations of the company has been accomplished, along with the underlying understanding of the business and its industry, you will be able to apply the appropriate skills and techniques to place a reasonable value on that business. METHODS OF VALUATION

Internal Revenue Service Revenue Ruling 59-601 is perhaps considered the definitive word on valuation from any governmental body. It is an all-encompassing pronouncement that, in effect, tells the user to take into account everything of relevance and apply logic and common sense to arrive at an appropriate conclusion as to the value for a closely held business. This ruling, unlike Revenue Ruling 68-6092 (see 10.6), contains no formula or step-by-step approach that would easily lead to a valuation. Rather, it takes a 10.5

REVENUE RULING 59-60.

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broad approach to valuation and requires an understanding of the fundamentals of valuation and finance in order to use it meaningfully. This ruling and Ruling 68-609 are reprinted in 10.19 and 10.20. However, to illustrate why Revenue Ruling 59-60 requires a broad understanding of the business and its place in the economic world instead of providing a simple, step-bystep approach to valuation, consider that this ruling requires the user to weigh all relevant factors including: • The nature and history of the business • The general economic outlook as well as the outlook for the specific industry encompassing the business • The financial condition of the subject company • The earnings capacity of the company • The dividend-paying capacity of this company (an approach not often taken for a closely held business) • Whether the business has any goodwill (often the biggest area of dispute in any business valuation, especially for a closely held business) • The percentage of the company being considered for valuation • The market price of similar companies that are traded on stock exchanges (another aspect of valuation often inapplicable to closely held businesses, especially smaller ones) REVENUE RULING 68-609. This is the often-used and often-abused formula approach to valuation. The virtue of this ruling, its step-by-step format and simplicity, is also its major fault. Because it was promulgated by the IRS, and because of its relative simplicity of application, this approach to valuation has become widely known and widely used in valuing closely held businesses for various purposes, including divorce. Essentially, this ruling utilizes the following eight steps:

10.6

1. Determine, without regard to goodwill, the adjusted balance sheet of the business. 2. Determine the adjusted and normalized statement of operations for the business. 3. Provide a reasonable compensation for the owners of the business. 4. Subtract an appropriate return on investment (between 8 percent and 10 percent according to the revenue ruling; proceed with caution here) against the remaining income. 5. What remains in the statement of operations is the before-tax excess income (if any). 6. Depending on how you interpret the revenue ruling, you either apply the appropriate capitalization rate (between 15 percent and 20 percent according to the revenue ruling; again proceed with caution), or you first apply a tax factor and then the appropriate capitalization rate. 7. The result of applying the capitalization rate to the excess income is the determination of goodwill. 8. To the above determined goodwill, you add the adjusted book value of the company (item 1 above). The result is the value of the company as a whole.

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As procedurally simple as the above appears, a number of issues present problems: • Reasonable Compensation. In virtually all valuations, except for those based purely on book value or a multiple of gross revenues or units of sales or production, where the business’s income is relevant to the value of that business, the issue of reasonable compensation is very much a concern. The concept is that the business should be burdened only with the appropriate and fair compensation for all of its employees, including the owners, based on what someone of similar experience, skill, and capability would get paid in an arm’s-length transaction in the geographical area where the company is located. In other words, what would the business have to pay if it were to hire an outside party to replace the current ownership to perform the same functions? That hired help would not receive the extra profits, if any. They belong to the owners. Determining a fair compensation level can be a difficult task. You need to factor in the job responsibilities, the number of hours worked, the number of roles filled, whether the current owner brings any particular expertise to the business, and, no small measure, even if you know all those factors, the so-called fair rate of compensation in the general marketplace for that type of person. To refine it even further, consider what the fair compensation is in that particular market area. In a broad sense, this type of information is available, albeit with shortcomings. For instance, the Robert Morris Associates annual statement studies, listed in the bibliography, states officers’ compensation as a percent of sales for various businesses. Therefore, you might determine that, for a particular business, the average officer’s compensation might be 5 percent of sales, and then apply that rate to the business you are investigating, and treat any compensation above that as excess (the IRS’s concept of a return on investment or a dividend rather than compensation). Any shortfall would need to be made up by imputing that additional expense to the business as part of your adjustments. Of course, you are relying on a statistical base for which you have relatively little information, and the figures used are generally business owners themselves and, as a result, those numbers are probably somewhat above the going market rate for a truly unrelated, independent third party. You might also use the compensation surveys done by publications such as INC Magazine, or perhaps compensation analyses done for specific industries by trade groups. Even then, you still face issues such as regionality, the amount of experience, and the number of hours worked. • Return on Investment. The Revenue Ruling suggests a return on investment range of 8 percent to 10 percent. Besides being a very narrow range, it is also one that is stated in a revenue ruling that is intended to encompass a wide range of different businesses and was promulgated over 25 years ago. Ideally, the rate of return to use is the one that is typical for that industry. A basic problem with that relatively simple idea is that reliable information is often not readily available. What is available typically shows major fluctuations from year to year, which would suggest a certain level of unreliability. Furthermore, since the numbers presented are taken from the reported figures of

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closely held businesses, which have a tendency to report figures in varying ways, the margin of error on any such publicly available information can well be several percentage points in either direction. In the absence of having information as specific as the return on investment rate for that industry, a suitable substitute rate to use is one that reflects what would be expected as a reasonable rate of interest on the funds invested in the subject company. With interest rates as low as they currently are, 10 percent or so might be the appropriate figure; several years ago, when the prime rate was at 20 percent, the appropriate rate of return was much higher. • Pretax versus After-tax. The Revenue Ruling refers to capitalizing the net income of the business, but does not define net income relative to whether it has been burdened by an income tax. I have seen opinions expressed as to the propriety of either approach, some people believing that the Revenue Ruling was intended to be applied to before-tax income and others believing after-tax income. In the author’s opinion, the Internal Revenue Service’s reference to net income was intended to mean after-tax income, which would seem logical based on the language used as well as the suggested capitalization rates placed in context with the times. The Revenue Ruling suggests capitalization rates between 15 percent and 20 percent, meaning a multiplier of between 6 2/3 and 5 times net income. In the roughest sense, the multiple is equivalent to a price-earnings ratio, which is used for publicly traded companies. Here, however, under the Revenue Ruling, first you have to subtract from the income a return on the investment, then you have to add back to your conclusion the book value of the company. If the IRS had intended for this multiplier to be applied to before-tax income, in effect, with the tax rates at that time being what they were, that multiplier of 5 to 6 2/3 before tax income would suggest an approximately 10 times multiplier against after-tax income. Since book value is also added to this figure, the pre-tax argument would mean that the IRS was treating closely held companies as having about the same market capitalization multiples as the average company traded on public markets at that time. That seems highly unlikely. Regardless of one’s position, ultimately it should not matter. Ideally, a business is worth what it is worth, regardless of whether you determine that value by applying some factor to before-tax income or after-tax income. The question becomes what factor to apply. That is the difficult, subjective, and experience-based judgment call that needs to be made. • Capitalization Rate. The capitalization rate is the inverse of the multiplier. A capitalization rate of 20 percent means to divide by 20 percent, or to multiply by 5. If, after all the above steps, you determine that the subject income is $100,000, and if you apply a 20 percent capitalization rate, you are stating that the goodwill element is worth $500,000. This Revenue Ruling suggests capitalization rates of between 15 percent and 20 percent, which means a multiplier of between 6 2/3 and 5. The multiplier is another way of saying, in effect, “How many years up front am I willing to pay for the soft value (goodwill) of this business; how long of a payback am I willing to accept?” The Revenue Ruling range is obviously very narrow and is not intended to cover all situations. After all, it is logically impossible for such a narrow

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range to cover the myriad of different businesses that need to be valued. The investigative accountant can expect to be involved in situations where the risks and uncertainties might warrant a 100 percent capitalization rate, a multiple of just one times excess earnings. Or, where because of a near certainty of continued income and growth (perhaps due to a franchise or some particularly advantageous position), a capitalization rate of 10 percent (a multiplier of 10) would be appropriate. If you are dealing with a larger closely held company, one that might be suitable for listing on a stock exchange and has a track record of profitability or is in a particularly attractive line of business, the capitalization rate might be significantly less. If there are comparable companies with significant multipliers, and your company has solid expectations of substantial continued growth and profitability, the market might reward such a company with a multiplier (a price-to-earnings ratio) of 20. In those types of situations, the investigative accountant needs to proceed cautiously and probably also recognize that the Revenue Ruling approach may not be the best one. If it were appropriate, the capitalization rate feasibly might be as low as 5 percent, a multiplier of 20. Putting aside this discussion of large company multiples for consideration later in this chapter, when dealing within the confines of Revenue Ruling 68-609, how does one determine the appropriate capitalization rate, the multiplier? Unfortunately, there is no easy all-purpose answer nor any approach or formula that would lead to a documentable conclusion. It is very much a matter of a subjective interpretation. A sense of the practical, often honed by experience, and an understanding of the conceptual approaches to valuation play important roles in determining an appropriate capitalization rate. INDUSTRY COMPARISON: PRICE-TO-EARNINGS RATIO. Comparing the subject company to industry peers is very helpful to the accountant doing a business valuation. To use the price-to-earnings ratio approach there must be companies publicly traded at known prices to which to compare the subject company. If that exists, clearly it makes this among the best of the approaches to valuation. Unfortunately, when dealing with closely held companies, especially the smaller ones, this approach can be extremely difficult to utilize. It requires at least one company, preferably a few companies, that are publicly traded, and that are sufficiently comparable to the subject company to make a comparison meaningful. Typically, publicly traded companies are larger than most of the closely held companies with which you will be dealing. Of course, there will be times when you are dealing with a closely held company doing several million dollars and more of sales, large enough to qualify for public listing, though among the smaller of the companies listed. Also, closely held companies usually have a narrower product focus, that is, less diversity, than publicly traded companies, making comparisons that much more difficult. There are other factors, such as geographical dispersion and depth of management, that weigh negatively in the issue of comparing a closely held company to publicly traded ones. Because of these reasons, this comparison can become a difficult one, especially for the smaller and more specialized closely held companies. Assuming that these obstacles can be overcome, or perhaps that they are nonexistent, the first step is to attempt to identify companies in the same, similar, 10.7

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or related industries, and then try to further refine that identification to those that are comparable. For this aspect of your work, you might: • Ask a friendly stockbroker to send a research report of the industry, a general market survey or study of the industry, or printouts from Standard and Poor’s or Value Line. • Go directly to a computerized database (which, of course, would entail a fee of at least a few hundred dollars), typically based on the SIC classification, which has faults in itself because of the weaknesses in the utilization of these codes, especially among smaller companies. • Seek out trade organizations that would be able to give information relating to publicly traded companies within their industry. • Ask the owner of that business, or clients in similar businesses, to identify the major competitors, customers, and suppliers in that field, and obtain information in the public domain relating to those companies. Even after you locate companies that are at least in the same industry, practical issues as to their true comparability are still present. If the company you are investigating is doing $5 million a year in sales and the one comparable company you have been able to locate is doing $5 billion a year in sales (putting aside the likelihood that the larger company is far more diversified and perhaps comparable only as to a division), could it be said that, where the sales of one are a thousandfold greater than the other, the two are truly comparable? Perhaps, if you had a few companies that were comparable in terms of product, even if they were all substantially larger in size, you might have a reasonable basis for comparison purposes. But if you have only one company and it has such a substantial difference, it is questionable whether you have established any basis for comparison. Assuming that you have been able to find a few comparable companies (and it is greatly desirable to have a few rather than merely one), you need to look at these companies from as many angles as possible to determine how they compare to the subject company, and to further understand how their strengths and weaknesses relate to those companies’ price-to-earnings ratios. Further, you need to make detailed comparisons of these publicly traded companies to the subject company. For instance, compare depth of management, market share, geographical diversity, product diversity, sales growth rates, net profit growth rates, gross profit and net profit relationships, return on capital, and adequacy of capitalization. All of this information is readily available on most publicly held companies. You then need to determine the price-to-earnings ratios of the various comparable companies. It is not unusual to find a fairly wide divergence in such ratios. You might find that five publicly traded companies have price-to-earnings ratios of 12, 16, 17, 19, and 28. That is nearly a 150 percent range in market capitalization rates among these companies. It is hoped that your financial analysis will give you insight into the reasons for these differences. You would also want to compare market capitalization to book value. For instance, a company that had a particularly bad year might as a result have an extraordinarily high price-toearnings ratio because the resultant market capitalization is little more than its book value. A high price-to-earnings ratio might also be indicative of a company with a strong growth track record and with expectations of continued growth, and therefore a willingness of the market to pay a much greater multiple for that

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company’s stock. Taking all these factors, and others, into account, you need to compare the subject company and these various publicly traded companies in an effort to determine a reasonable price-to-earnings ratio. In the preceding example, we might drop the highest ratio, which is clearly out of line with the others, leaving four in a fairly narrow range, and then take their average, resulting in a price-to-earnings ratio of 16. This would suggest that were the subject company truly comparable overall to these four companies, it would justify a price-to-earnings ratio of 16. Depending on whether the subject company appears to be better or worse than these, you would need to estimate a reasonable price-to-earnings ratio. Relevant factors might be considered as follows: • General Marketability Discount. The companies to which you are comparing are all publicly traded, but your subject company is not. That generally warrants a discount inasmuch as being public means that these companies have already established themselves, there is a ready market for their stock, and they have gone through the expense of going public. The company you are investigating is at somewhat of a disadvantage. • Various Specific Issues. Somewhat of a catchall; perhaps the subject company has a better gross profit or a better growth record than the comparable companies. That might warrant a premium. Alternatively, if these items are worse, we would expect a discount. The subject company might have had an unusually good year that stands out; using the price-to-earnings ratio approach without taking into account this factor might greatly distort values. In such a case, to moderate an otherwise absurdly high value, a discount might be necessary. The other side of the coin is that an unusually bad year, which is not expected to be a harbinger of things to come, would suggest that a premium is warranted (without which the value might come in well below book value). • Premium for Control. The price-to-earnings ratios that you have developed for the publicly traded companies are typically based on 100-share blocks being traded on the open market, which are clearly minority interests. You need to address the size of the block of stock of the company you are valuing. If it is for the entire company, it would be appropriate to apply a premium to any price-to-earnings ratio that is based on a minority interest. On the other hand, if your bases for comparison are transactions involving mergers, acquisitions, and takeovers of publicly traded comparable companies, then you are probably making comparisons to controlling blocks of stock and what the market has placed as a price-to-earnings ratio on such. In such cases, no premium is warranted for a controlling interest since your comparison base is already that of a controlling interest. If you are valuing a minority interest and, as indicated, your comparison base is a controlling interest price-earnings ratios, then you would need to impute a minority interest discount against it. There are at least three broad issues that need to be kept in mind when using a price-to-earnings ratio approach as applied to a closely held company: • The price-to-earnings ratios as stated on the stock market are based on aftertax earnings. You must make sure that you apply your chosen price-to-earnings

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ratio to the after-tax earnings of the subject company, or at least apply the average tax rate experienced by these comparable companies to your subject company in coming to your conclusions. • The price-to-earnings ratio approach yields an all-inclusive value. Unlike the Revenue Ruling 68-609 approach, you do not determine goodwill and then add book value. The conclusion arrived at with the price-to-earnings ratio is for the entire company inclusive of goodwill, if any. Therefore, not only may you not add back the book value, but you should also recognize that, depending on relative book values and how strong the current year was, it is possible that the price-to-earnings ratio approach applied to a weak year would yield a value that is less than the book value of the company. That would usually suggest that you may need to use a different valuation method, unless you believe the company is actually worth less than the sum of its parts. • The price-to-earnings ratio approach, and for that matter virtually any approach, is extremely difficult to use when dealing with a company with the potential for explosive growth. If the company being valued is on the cutting edge of some technology, scientific discovery, or some other esoteric advance, traditional valuation approaches may not be relevant. For instance, how would one determine the value of a new bio-tech company that has no earnings, but is working on a blockbuster drug that could overnight make that company worth hundreds of millions of dollars? INDUSTRY COMPARISON: RULES OF THUMB. This is one of the most disparaged of the approaches to valuation. Yet in limited circumstances it can also be among the most useful and appropriate. In effect, a rule of thumb approach to valuation suggests to the user not to bother with any fancy, economic-based approach to valuation; forget price-to-earnings ratios and Revenue Rulings. Everyone knows this business trades at 21/2 times gross profit, or one times gross receipts, or four times net income before compensation to the owner. Because these comparisons are overly simplistic and because their blind application does not require a college degree, they are often deemed without merit in the art of valuation. Unfortunately, that attitude overlooks the fact that rules of thumb have developed simply because those familiar with the industry have determined by experience and investment that this type of approach is valid. If indeed businesses trade using a rule of thumb approach, if people are willing to commit their money and other people are willing to sell their assets based on this type of approach, regardless of how simplistic, it has proven its relevance. Who are we to say that because it does not require 20 pages of technical explanation it is an invalid approach toward valuation? However, one must use a rule of thumb cautiously. For instance, is the rule one that once existed but due to changing economics is no longer applicable? Is it applicable, in general, to one type of business, but not to the specific one being investigated? Is the rule suitable only for businesses of a certain size, and the company you are investigating is too large or too small for the rule to work? Typically, rules of thumb apply to service businesses, sometimes to retail businesses, but not to manufacturers or distributors. For instance, you might see a rule of thumb approach for an accounting or medical practice, a franchise operation, or a gas station. You would rarely, if ever, see one applied to a plastics manufacturer or a distributer of cable wire. Further, you will never see a valid 10.8

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rule of thumb based on a multiple of gross revenues applicable to a manufacturing operation. Use of a rule of thumb approach based on a multiple of gross revenues assumes for that business a certain constancy and transferability as to the nature of the work. Further, and very importantly, it assumes that one can rely on the gross revenues to be an accurate barometer of the expected profitability of that business. While often true with a professional practice, with many retail businesses, and with various services businesses, it is rarely true with a manufacturing operation where, even within the same industry, there are very wide ranges as to relative profitability and often little relationship between a company’s gross revenues and its profitability. As with all approaches to valuation, rules of thumb need to be used carefully, particularly when the multiplier is based upon gross revenues. The potential for distortion can be extreme. When the rule of thumb uses a multiplier of net income, it is very important that there be a clear definition as to what constitutes net income. For instance, is it before or after reasonable compensation to the business owner? RECENT SALES. Another excellent method, at least in theory, is to base your valuation on a comparison to a recent sale of some part of that business. Unfortunately, the realities are that there are several inherent problems in any attempt to use this approach:

10.9

• The first problem to overcome is that most closely held businesses have no sales, recent or otherwise, with which to compare. For instance, an accountant who has 100 closely held businesses as clients will probably see in 10 years of practice no more than a dozen or so sales transactions involving unrelated parties purchasing part or all of the stock of any of those clients. Therefore, in doing a divorce investigation, the chances of finding a usable sales transaction are very slim. • Even in the relatively few cases where ownership was sold, they were not sales transactions in the true sense of the word. Typically, they were sales or transfers between related parties, that is, family members. In such a situation, it is likely that the transaction was not done at arm’s length; it was probably done at some discount. In a sense, this might help in that the transaction is probably at the absolute minimum value, from which one could only go up. • Even if the transaction was at arm’s length with an unrelated party, you still may never be able to find out the real sales transaction terms. Quite often, the sale of a closely held business is structured to optimize tax benefits for the buyer, the seller, or both. For instance, to avoid goodwill, which to the buyer would be tax-deductible only over 15 years, the deal might be structured to minimize the amount of goodwill and instead attribute whatever it can to fixed assets, which are, of course, fully deductible to the buyer over a relatively short period of time. Also, many times there are consulting contracts, which may or may not really require consulting services. If consulting services will be required, then they are perhaps not fairly included in the sales price. Sometimes, part of the sales price is simply unstated; especially in a cash business, money is paid under the table. • Even if you do indeed have a true arm’s length sales price, was it for a comparable interest in the business? Are you valuing as part of this divorce

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action a majority or controlling interest in the company, and was that recent sale, which you are fortunate enough to have information on, that of a minority interest? Or is the reverse the case? If the blocks of stock are not comparable, the comparison may have no validity. • Even if you find a business with a sales transaction and that transaction did not involve family, and it was completely aboveboard with all the terms clearly defined and nothing disguised for tax purposes, and was for a similar block or portion of the stock, you then need to question whether the sale was motivated in some way by pressures that would put the seller at a disadvantage. Was it a situation that involved the imminent retirement or ill health of the seller? In such a case, the pressures to sell and the inability to exercise any true leverage as a seller, might have created a bargain sale situation for the buyer. That does not yield a true measurement of fair market value. After all, the concept of fair value for our purposes is what an informed buyer would pay an informed seller, neither of whom is under any compulsion to buy or sell, and both of whom are equally knowledgeable of the relevant factors of the business. 10.10 CAPITALIZATION OF INCOME. An approach to value less often used by the accounting profession, but in great favor with the appraisal profession, is that of the capitalization of earnings (in a broad sense, somewhat similar to the Revenue Ruling 68-609 approach). One simplified version of the formula for this approach is:

V=

I ⳯ ( 1 + G) Rⳮ G

V = value of the company I = most recent or normalized income G = the expected growth rate of the net income of the company R = the total rate of return that a prospective buyer would require As indicated, there is a similarity between this approach and that of the Revenue Ruling, with perhaps the major difference between them being that the Revenue Ruling uses historical earnings as a basis for assuming a value. The capitalization of earnings approach requires a projection of future income and then capitalizes that future in order to determine the value. Theoretically, a capitalization of future earnings is a better approach. Except when buying the pieces, one buys a business for what it is expected to yield in the future, not for what it benefited the owner in the past. The use of past income, however, is considered of merit because it provides a certain comfort level as to what the future might portend. A major problem with using future income is that it has not happened yet; it requires a projection. Everyone who has read investment projections, or financial packages that include projections of what prospective investors may expect, or projected financial statements used for the launch of a new business for financing purposes, knows that projections of future income are notoriously inaccurate. A large company, with a substantial market share and the ability to engage economists and others intimately familiar with the industry and the company, has

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trouble projecting income. A relatively small company, with perhaps negligible market share control, and certainly without the big budget to engage specific industry specialists, can hardly be expected to make an accurate projection of the future. Nevertheless, for all of its faults, this approach is considered a valid one and is commonly used. To illustrate, consider the valuation of a company that currently has a net income (of course, as properly adjusted) of $500,000. It is expected that its income will grow at the rate of 10 percent a year, and that an investor would require a 25 percent return. The value of that business would be determined as follows: V = $500,000 ⳯ (1 + .10) = $500,000 (1.1) = $3,670,000 .25ⳮ.10 .15 Besides the problem with making a reliable projection of the future, when employing this approach one must be careful as to the variables used. For instance, a slight change in the anticipated growth rate from 10 percent to 15 percent would have a dramatic impact on the value, illustrated as follows: V = $500,000 ⳯ (1 + .15) = $500,000 (1.15) = $5,750,000 .25ⳮ.15 .10 As you can see, a very modest change in the growth rate assumption results in a dramatically different value, in this case, a difference of over $2 million. The development of the risk rate to use begins with analyzing the risk-free rate at the time of the valuation. For instance, one would refer to the 90-day Treasury bill rate, the one-year Treasury bill rate, and the five-year Treasury note rate. For our purposes, treasury instruments are considered as risk-free as any investment possibly can be. From those rates, one might then determine that, for instance, 6 percent was the appropriate risk-free rate. Since it is clear that investors expect a greater return when they invest in a company, and that historically for public companies that rate is several percentage points greater, we would expect a rate of return of perhaps 12 percent or 13 percent. Further, since we are dealing here with a closely held company with less predictability as to future income and profitability, one would anticipate a greater risk rate than just described. Depending on many factors, and much subjective determination, the appraiser might conclude that a prospective investor would require a 25 percent or 30 percent or more rate of return. DISCOUNTED FUTURE EARNINGS (OR CASH FLOW). The discounted future earnings approach, which is generally more popular with appraisers than with accountants, and which is also difficult to apply to a small and mediumsized closely held business, determines value based on discounting a business’s future earnings stream. Alternatively, cash flow may be used in lieu of earnings. In essence, this is a variation on the capitalization of earnings approach, which again has similarities to the Revenue Ruling 68-609 approach. Moreover, while the use of projected future income has much in its favor (prospective buyers looking at a business for what it will yield in the future, not for what it has done in the past), we are still faced with the speculative exercise of determining income in the future. 10.11

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The formula to be used is: V=

冱

Ei (1 + r) i

V = the value of the business Ei = the earnings in the “i”th year r = the rate of return or capitalization rate required (the discount rate) Obviously, in order to make use of this approach, you need to make a determination as to an approximated projected future income flow, as well as a determination of what a required rate of return for a hypothetical prospective buyer would be. As to the projection of future income, you would normally assume a modest growth rate, or perhaps virtually none, but rarely would you assume substantial continued growth. The geometric results of a significant continued growth would eventually make the company larger than the U.S. economy in its entirety. While it is desirable to project the earnings as far into the future as possible, the reality is that, after a few years, the reliability of any such projection becomes that much more doubtful. Further, after discounting for present value, the difference that might result from refining any such calculation becomes insignificant. Therefore, as a practical matter, projecting perhaps just five years, with an assumed constancy thereafter, is an often used approach. The other major variable that needs to be determined is the discount rate, or the required rate of return. Essentially, this is a matter of risk and investment alternatives. Similarly, as to the approach used in the capitalization of income, we need to consider what rate of return an investor might demand to invest in this type of business. To illustrate how this might work, consider a company that, after all adjustments, is currently yielding a pretax annual income of $100,000. It is projected that the income for the next five years will be $120,000, $150,000, $170,000, $180,000, and $190,000, with an assumed constant level of $200,000 thereafter. Using a 30 percent discount rate, the value of that business entity would be calculated as in Exhibit 10–4.

EXHIBIT 10–4 Year 1 2 3 4 5 6 and beyond

Discount Rate Calculations Income

Discounted Value

$120,000 150,000 170,000 180,000 190,000 200,000

$ 92,307 88,755 77,377 63,024 51,172 $138,116 $510,751

The total value of this business entity would thus be approximately $511,000.

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If this business has assets that are not considered necessary operating components in order for it to generate the revenue stream that it does, then those assets should be treated separately and added to the value thus determined (similar to subtracting liabilities that are not considered operating components). As an example, if there is $500,000 in the business’s bank accounts, but it needs only $100,000 for operations, the excess $400,000, which the present business owner could remove from the business for personal use without impairing the business’s earnings flow, must be added back to the above value to reflect the reality of this business. Of course, the interest income from this excess cash must not be used in the above-determined annual earnings flow. Those earnings must be based on operations exclusive of nonoperating assets. BUY-SELL AGREEMENT. A shareholder’s agreement, or a buy-sell agreement, is often structured for convenience, protection of existing shareholders, protection of, or from, heirs, and various other factors that have no relationship to real valuation. Absent a true valuation within the body of the buy-sell agreement, it cannot be considered an appropriate method of valuing a company. However, if dealing with a minority stockholder, especially when a majority stockholder exists (as contrasted with a number of minority stockholder positions with no single one controlling), even if the agreement is absurd as to value, from a legal point of view we may be restricted to that value. That, however, is a legal issue, not one to be determined by the accountant. For a majority stockholder, it is rare that a buy-sell agreement would be considered determinative of value. Sometimes, the values in a buy-sell agreement are grossly inflated because the agreement is based upon a death buyout, funded by life insurance. That is not necessarily a fair value; the shareholders may have decided how much life insurance they could afford and then used a value based on that. If there is no comparable life buyout with similar numbers, then it is unlikely that a death-based buyout figure has any true validity as to value. 10.12

10.13 IN-PLACE VALUE. Sometimes, no matter which way you approach the value of a business, it is just not yielding enough income, in excess of a fair compensation and a return on the underlying investment, to warrant a determination of goodwill. However, you know that this business, as an operating entity, as a whole, is worth more than the sum of its parts. In other words, notwithstanding the absence of traditionally determined goodwill, there is some inherent value, going concern value, in the business that someone would pay to own this operating business. In a sense, you are dealing here with an incremental value attributable to having a turnkey operation, that is, one that the buyer can walk into without having to establish a new business from ground zero. Assuming that the business is one that would have a prospective buyer, the in-place value approach posits that because all the parts are in place — the people assembled, trained, and working; the machinery debugged and operating; customers on line; a functioning business existing; telephone, utilities, and rental space obtained and available; some form of name recognition in the market and a phone number that customers can call—a buyer would pay more than merely the sum of the parts in order to be able to walk into an ongoing operating business without having to suffer through the start-up phase. This is the in-place value.

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The obvious problem is trying to quantify this value. One approach is to estimate what the set-up and start-up costs would be for someone to begin a business like this from scratch. Such costs would include locating a place of business, getting a lease on that property, locating and buying the appropriate equipment and furniture, hiring and training the appropriate personnel, compensating this entrepreneur for doing all this, and covering the losses or lesser profits that would be incurred during the time this new operation was becoming a fully operative business. In addition, the time value of money (or the opportunity cost of forgoing potential new business while establishing a new operation) would be an issue inasmuch as the existing business is already generating an income, whereas this hypothetical new entity will require time and capital to get to that point. Assuming you have been able to reasonably quantify the preceding combination of factors, you have an estimate of what it would cost to start this business anew. The in-place value of the existing operation should be somewhat less. Assuming that there is validity to the calculation described, it would be unlikely (unless lost opportunity costs or time pressures were great) that one would be willing to pay full freight to acquire an existing operation as contrasted with starting a new one. If, after taking all factors into account, you need to pay an existing business the same amount that would enable you to create it from ground zero, why not start your own business? If there is a franchise operation in the same or similar type of business, another approach toward determining in-place value involves making inquiries as to what it would cost to get established as a franchise operation. Again, use a lower figure as a determinant of in-place value. All other things being equal, a franchise is generally a more valuable form of business format, especially for a start-up situation, than a nonfranchise because of established procedures and a recognizable name. Therefore, that nonfranchise business would probably be worth somewhat less. Of course, in approaching the in-place value in this format, you need to take into account what the franchise start-up costs do and do not include, that is, machinery and equipment, the location, certain rights as to the leasehold, and so forth. LIQUIDATION VALUE. The ultimate adverse value of a business, often the only one acknowledged by the business owner in a divorce case, is that which would be left upon liquidation. It is without question and without exception the last resort and the least likely approach to value. It assumes that there is not only no value to this business continuing, but that its highest and best value would be realized by shutting it down and walking away with whatever is left. This approach further argues (and indeed a liquidation value approach is an argument) that there are time pressures compelling a near-term liquidation and the consequent realization of whatever can be salvaged under the circumstances. Needless to say, this approach to valuation is appropriate only in the most exceptional and dire of situations. What makes this type of valuation particularly damaging is that its very nature requires selling off pieces of the business for less than face value. Thus, receivables will not be recognized at full value; inventory will probably be sold at a discount; and machinery and equipment, to say nothing of office furniture and fixtures, will be unloaded at whatever the used equipment market will bear. 10.14

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Unfortunately, in most cases, we also need to factor in that the payables will be paid off at face or near-face value. The assumption here, of course, is that the business, even going through the liquidation process, has a positive net worth and that there will be minimal success in working out a discounted arrangement with suppliers and other creditors. Further, in most cases involving closely held businesses, any bank loans and other lender liabilities would almost certainly have been personally guaranteed. Therefore, subject to market conditions and the hard-balling abilities of the business owner (which may not be directly relevant or available to you as a factor for this type of valuation), liabilities will probably be accepted at close to full value. To illustrate how this type of drastic approach might play out, consider Exhibit 10–5.

EXHIBIT 10–5

Sample Liquidation Value

Asset or Liability

Face Value

Discount

Cash Accounts receivable Inventory Prepaid expenses Furniture and fixtures Machinery and equipment Leasehold improvements Accounts payable Accrued expenses Taxes payable Notes payable Costs of liquidation

$ 100,000 500,000 300,000 20,000 50,000 300,000 100,000 (600,000) (150,000) (50,000) (100,000)

0% 20% 50% $2,000% 40% 20% 100% 10% 0% 0% 0%

Total adjusted book value

$ 270,000

Net realizable liquidation value

Realizable Value $ 100,000 400,000 150,000 18,000 30,000 240,000 240,000 (540,000) (150,000) (50,000) (100,000) $ (50,000)

$1 48,000

10.15 DISCOUNTS. In addition to the approaches to valuation enumerated above, there are certain ancillary concerns. Depending on the circumstances, there may be the need for a discount, for a premium, or for some other potential adjustment to what otherwise was determined as the value of the business. By far, the most common of these areas is discounts. There are at least two broad and general types of discounts common to the valuation of closely held businesses in divorces, as well as a third similar concern. A discount too often utilized is that the asset lacks marketability. It is not unusual in divorce practice to see the investigative accountant employ a marketability discount against the otherwise determined value, especially if representing the business owner. The argument is that there is a thin market for the stock of the company; it would require time, effort, and expense to sell it; it has very thin depth of management, and so on. While all of these points may in fact be true, it is this author’s opinion that marketability discounts per se are appropriate only in the true exceptions.

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In many of the valuations done in divorce, indeed in many of the valuations done for closely held businesses, the approaches used must be recognized as having been developed for closely held businesses. Therefore, those approaches implicitly, in their very structure, have provided for whatever typical marketability discounts might be appropriate for a closely held business. To use an approach that was intended for closely held businesses, and to then further impact valuations thereby determined with a discount because the subject company has features inherently common and normal for a closely held business, disregards the reason for the existence of that valuation approach and takes a discount twice. It is first implicit and unstated within the body of the valuation approach; the second time, it is specifically stated as a separate item. If the approach used is one of a rule of thumb, the same logic applies. That approach has developed over time to simplify the valuation of smaller and even medium-sized closely held businesses. This is not to say that in some extreme situations a marketability discount would not be appropriate. For the most part, however, we should expect the appraisal approach to factor in most of these types of issues in the development of the capitalization rate (or the multiplier). Indeed, if a business would be particularly and unusually difficult to market, then perhaps instead of what might otherwise have been a 20 percent capitalization rate (a multiple of five), it would have been more appropriate to use a 331/3 percent capitalization rate (a multiple of three). Another common type of discount is a minority interest, or a lack of control, discount. In theory, even a 50 percent interest, especially if there is another matching 50 percent interest, represents a lack of control situation. The concept here is that if one does not control a company, especially a closely held company, it is possible that the value of that interest is less than its pro rata share of the whole. A minority interest, or one with a lack of control, is at a distinct disadvantage in relationship to a controlling interest as to the ability to determine the direction of a company, the level of salaries, the hiring and firing of employees, the treatment and handling of company assets, and so forth. As a consequence of this lesser level of power, it would not be unusual to expect that a 20 percent interest in a company would sell for somewhat less than 20 percent of the value of the company taken as a whole. Minority interest, or lack of control, discounts often range (assuming that they are being considered at all) between 10 percent and 40 percent. Greater discounts typically are appropriate only in limited and unusual situations. When the business is going to be sold, the application of a minority interest discount or premium (see 10.16) is inappropriate inasmuch as all shareholders can be expected to receive their respective proportionate shares upon the sale or liquidation of the business. The issues of discounts and premiums presuppose an ongoing operating business. A third area of potential discount is not so clearly defined, but it involves the issue of whether some form of a discount would be appropriate when the business has engaged in significant and repeated under-reporting or nonreporting of income. In theory, there are the looming potential IRS and state liabilities because of underpaid taxes. Depending on the circumstances and the magnitude of what is involved, there will also be potential negligence and fraud penalties, and increased interest assessments. Again, depending on the magnitude of the problem, the statute of limitations might have the customary three years or

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several years to run. If the problem goes so far as the nonfiling of tax returns, or, as often is the case, the late filing of tax returns, the statute of limitations might have many more years to run. It does not even begin to run until the returns are filed. Added to all that are the potential income tax liability concerns and, depending on the particular circumstances, potential Department of Labor and state sales tax assessments. While all of the preceding may exist in theory, it is questionable whether in practice any of those potential liabilities would ever come to the fore. The logical reality of the situation is that, especially with matters that have existed for years, improper treatment of tax obligations and flaunting of tax rules will likely continue for years, even forever, in the same manner that they have in the past, without any of the taxing authorities ever intruding. This is especially so if returns have been filed; it is less so if returns have not been filed. Therefore, absent a reason to believe that the previous procedures and the impunity with which the business has been able to operate would change, it would be inappropriate to impute a tax liability (let alone penalties and interest) to the situation where none has ever been paid before and none is likely to be required in the future. Similarly, again barring any reason to expect retroactive change, this situation should not weigh negatively as to the value of the subject business. 10.16 PREMIUMS. Just as some situations may call for the application of one or more discounts, others may call for the use of a premium. For the most part, there is really only one premium that has any common application in divorce work: the premium for a controlling interest. Section 10.15 centered around the discount for a lack of control or a minority interest. This is justified in some cases because an interest that is less than controlling is sometimes worth less than its pro rata share. On the opposite side of the equation, a controlling interest is sometimes worth a premium over its pro rata value. As a controlling interest, that block of stock represents the ability to direct the company, determine compensation, and do almost everything that a minority interest cannot do. In many ways, a premium for control is the complement of the discount for lack of control. Obviously, if you are dealing with a 100 percent interest in a company, there is no premium for control. The premium for control logically cannot raise the value of that block of stock to exceed the value of the company in its entirety. Nor can it ignore the existence of the minority interest, meaning that it must leave some reasonable and appropriate value remaining to the other stock interest(s). 10.17 ENHANCED EARNINGS POWER. Finally, in a sense relevant to valuation, but only as to divorce work, there is the concept, not necessarily widely accepted, of enhanced earnings power. There are probably variations on what this means. For the most part, it suggests something of value that exists related to the marriage, or that has been developed during the marriage, but is perhaps not clearly separable, or even saleable. It is a value of sorts and may need to be recognized to have equity in the divorce-motivated valuation. The point is that in extenuating circumstances, the normal valuation approaches would simply not be fair to the nonbusiness spouse. As an example, a business may have no goodwill, but may still enjoy an enhanced income level that requires some recognition. Typically, a business, or the necessary skills and experience to establish that business, develop over the years of the marriage. The couple are often together

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while the business evolves, matures, and grows to its currently lucrative position. From an economic point of view, it is clear that the groundwork was laid over the years, allowing the couple to establish the necessary contacts, develop the necessary expertise, and mature to the point of benefiting jointly from the business. In some situations, the groundwork may have been such that at some point (perhaps close to the filing of the complaint) the business was primed to experience a very large increase in profits, just at the time that conventional and traditional treatment of a spouse’s marital interest in that profit source was about to cease. Often, the nature of the business and the type of work done by the businessowner spouse is substantially identical prior to the complaint as it is subsequent. Generally, when income and the business’s fortunes improve dramatically around the time of the complaint (or shortly thereafter), the only logical explanation for the magnitude of increase experienced is that the business had all of the necessary components in place, had built up the necessary pool of intangible assets, level of experience, reputation, and following for it to realize the fruits of the years of effort put into building it up and making it capable of generating the substantial dollars that it later produced. Therefore, the true income potential of the business, which was developed entirely during the marriage, would appear to be a normalized income level higher than the income level attained during the last few years of the marriage. Because both spouses made their contributions to this new higher level of income currently being realized, they are entitled to share in what in effect is a marital asset. This asset, the business’s enhanced earnings power, actually existed at the time of the filing of the complaint. A business’s income rarely increases greatly overnight. The reality behind such a dramatic change is that the business is moving out of its development and maturation phase and entering a profit-making phase. Years of invested efforts are now materializing in the form of sharply enhanced income. THE OLD DOUBLE DIP. A recurring issue in divorce litigation where one of the parties owns (an interest in) a business is whether the interplay between support and business valuation creates a double dip to the favor of the nonbusiness spouse — the one on the receiving end of the payments. The issue here is that commonly business valuation includes a determination as to what the reasonable compensation is for the business owner. It is not unusual for that determination to conclude that the actual compensation taken by the business owner is in excess of reasonable compensation. That excess becomes a factor in determining the value of the business — which in turn becomes a factor in determining how much the nonbusiness spouse receives as part of equitable distribution. However, at the same time, the lifestyle enjoyed by the couple, and the figure that is typically used for determining ongoing support obligations, is that of the total compensation received by the business owner. Does this create a double dip for the benefit of the nonbusiness spouse to the detriment of the business owner spouse? There is no double dip. Further, it is not inequitable for support to be based on total compensation, notwithstanding that some part of that compensation may be in excess of “reasonable compensation.” There are a number of reasons why the double-dip argument is defective. 10.18

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• It is possible, and many times not unusual, to value a business based on its gross revenues, or perhaps some form of units of production — without ever addressing the issue of the compensation or benefits received by the business owner. Particularly in professional practices, it is fairly common to consider valuation based on the revenues generated by the business rather than by the net income or compensation received by the owners. There are solid and valid reasons for such an approach — including the greater reliability of the integrity of the top line (revenues) as compared to the bottom line (income or compensation to the owners). After all, how one runs a business or practice can be a very personal type situation, with some burdening a business with perquisites, or perhaps having a style of operations (whether leaner or fatter than might otherwise be the case) that another might not consider necessary or appropriate. By dealing with the top line, we eliminate these issues as well as judgment or value calls as to whether certain expenses are necessary, recurring, personal, or not. • Relating to the preceding, there is a fairly substantial body of evidence to support that there is a distinct relationship, a direct correlation, between the sales price of the business and its revenues — a relationship every bit as strong as the relationship between the net income/compensation received from the business and the value of same. As such, no determination is, or needs to be, made as to reasonable compensation — and again value can be determined irrespective of compensation. In such a situation, the concept of a double dip does not exist. • Assuming of course that the business continues as successful as it was in the past, the owner’s compensation will continue and will not in any way be depleted, despite any buyout of the spouse’s interest in that business. In reality, as we have seen most typically, that is exactly what happens. Notwithstanding any equitable distribution buyout obligation, compensation continues as it was in the past (often fluctuating and often increasing), and the value of the business remains. Thus, even when value was determined in reference to reasonable compensation, with support being based on total compensation, it is not unfair in that there is no depletion or diminution of the underlying asset (the business). • Notwithstanding what one might feel the buyout does to the ongoing business, the reality of the marital lifestyle is that in most situations, the standard of living was fueled and maintained by the total income drawn from the business, not from some calculated “reasonable compensation” level. Thus, it would seem to be inequitable to attempt to establish a support level predicated on a lower hypothetical reasonable compensation level that is not reflective of how the couple or family lived. Assuming that such is a logical and fair approach, to then try to take the offsetting value (for those who are concerned about a double dip) out of the value of the business and therefore out of equitable distribution would, frequently, leave no value to the business. After all, in many cases there is little income left in the business because the owners take out virtually everything. That depletion of a business’s income does not make it worth less or nothing — it is an artifice often dictated by a desire for a standard of living, available cash flow, tax issues, or other reasons.

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While there is, for some, a compelling argument in favor of recognizing this possible double dip, it is not supported by the realities of the business and financial world. 10.19 VALIDITY OF ATTRIBUTING THE VALUE OF AN APPRECIATED SEPARATE BUSINESS TO INFLATION. Matrimonial attorneys and valuation specialists

frequently see situations where one of the parties had an interest in a business at the time of the marriage, which has increased during the marriage through gifts and/or inheritances. In the divorce action, they need to deal with the value of that business both at the time of the marriage and the divorce complaint, and perhaps at other times as well (for example, at the times of the gifting or inheriting of various positions). As a result, it is not unusual to be faced with multiple valuation dates of a closely held business. This creates issues such as whether records are available going back to these earlier valuation dates, especially where there has been piecemeal acquisition of assets and positions in a company. One interesting wrinkle regularly raised (by the spouse with the interest in the business) is inflation. Simply put, if one spouse owned a business at the time of the marriage worth $200,000, and if at the time of the complaint it is worth $1,000,000, a first impression would suggest that $800,000 is in the marital estate. However, if we were to apply the impact of inflation on the original $200,000, that by itself would cause the value of that asset to be worth, say, $900,000 at the time the divorce complaint is filed. Therefore, in this example, only $100,000 would seem to be in the marital estate. This is compelling logic for the business owner. The initial premise is that when one of the spouses has an interest in a business at the time of the marriage, the value at the time of the marriage is generally not in the marital estate. Further, if that asset appreciated during the marriage, and if that appreciation can be shown to be the result of the efforts (active working) of this spouse, that appreciation is included in the marital estate. Perhaps not as clear, and where states differ, is to what extent, if any, passive inflation should be applied to the starting valuation figure and removed from the valuation arrived at as of the date the divorce complaint is filed. Basic Premises.

Why the Inflation Argument Is Debatable and Tenuous. In my view, the direct connection between inflation and the appreciation in the subject company’s value is certainly debatable and at best of tenuous linkage. Here are reasons arguing against assuming this linkage.

First and foremost, we are dealing with an asset requiring active and constant management and involvement, not a bank account or some minor interests in a Fortune 500 company requiring no attention or activity by either of the parties. According to the inflation argument, the value of the business would increase in lockstep with inflation, regardless of the extent and value of the work efforts of the owner, regardless of whether that owner was there daily, took a several-year sabbatical, managed the business well, or managed it poorly. Without active management, the likelihood is strong that the business value would have deteriorated. Active Ownership/Management.

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Recognizing a value that has increased in tandem with inflation assumes a guaranteed rate of return on the initial value, that rate of return being inflation. The reality is that with a closely held business (with its risks and requirements of active day-to-day management) there is no guaranteed rate of return — whether from inflation or otherwise. Without active involvement, there would likely be no rate of return.

Return on Investment.

We need only point to events of the past few years. For a while we enjoyed an extended bull market, with significant appreciation in prices of stocks. Then we had a bear market, mostly in technology stocks. All of this has been at a time when we have enjoyed relatively low inflation. Certainly, inflation has little correlation on the appreciation of stocks. Again, adding inflation on top of a starting valuation in a marital dispute is unsupported by the empirical evidence. The Current Investment Situation.

Inflation fluctuates and over a long period of time has fluctuated dramatically. It is probably a truism that there is absolutely no correlation between the rate of inflation and the work effort or success of a business owner/manager. Regardless of the rate of inflation, the owner will attempt to maximize the business’s income and value. The active stewardship of a business is totally distinct, separate from, and unconnected to inflation. Fluctuating Rates of Inflation.

Research Studies Contradict the Inflation Argument. According to a study by Firstenburg, Ross, and Zisler, there is actually a negative correlation between inflation and the Standard & Poor’s 500 stock index return.3 That is, an increase in the inflation rate in the long run results in a decline in stock values, other aspects of the process being constant. This is contrary to the argument of taking into account inflation in the valuation of an interest in a closely held business. According to a study by Dr. Zvi Bodie, less than 24 percent of the variation (either up or down) in annual stock market returns can be explained by the forces of inflation.4 In other words, slightly over 76 percent of the change in the return on investments and stocks is due to factors other than inflation. That study goes on to further debunk the inflation impact argument.

While some states may take a different approach (that is, requiring a determination of the extent of the appreciation that can be attributed to inflation versus the extent that can be attributed to active involvement), the reality is that the inflation argument is a weak one. Furthermore, efforts to distinguish between the portion of the appreciation attributable to inflation and that attributable to work efforts, other than perhaps by some simplistic arithmetic approach, are inevitably fraught with significant subjective interpretations.

Conclusion.

10.20

REVENUE RULING 59-60: VALUATION OF STOCKS AND BONDS

In valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value, must be considered for estate tax and gift tax purposes. No general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock. However,

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the general approach, methods, and factors which must be considered in valuing such securities are outlined. Sec. 1. Purpose. The purpose of this Revenue Ruling is to outline and review in general the approach, methods, and factors to be considered in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes. The methods discussed herein will apply likewise to the valuation of corporate stocks on which market quotations are either unavailable or are of such scarcity that they do not reflect the fair market value. Sec. 2. Background and Definitions. .01 All valuations must be made in accordance with the applicable provisions of the Internal Revenue Code of 1954 and the Federal Estate Tax and Gift Tax Regulations. Sections 2031 (a), 2032 and 2512(a) of the 1954 Code (sections 811 and 1005 of the 1939 Code) require that the property to be included in the gross estate, or made the subject of a gift, shall be taxed on the basis of the value of the property at the time of death of the decedent, the alternate date if so elected, or the date of gift. .02 Section 20.2031-l(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sells both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. .03 Closely held corporations are those corporations the shares of which are owned by a relatively limited number of stockholders. Often the entire stock issue is held by one family. The result of this situation is that little, if any, trading in the shares takes place. There is, therefore, no established market for the stock and such sales as occur at irregular intervals seldom reflect all of the elements of a representative transaction as defined by the term “fair market value.” Sec. 3. Approach to Valuation. .01 A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases. Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgement and reasonableness must enter into the process of weighing those facts and determining their aggregate significance. .02 The fair market value of specific shares of stock will vary as general economic conditions change from “normal” to “boom” or “depression,” that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future. The value of shares of stock of a company

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with very uncertain future prospects is highly speculative. The appraiser must exercise his judgement as to the degree of risk attaching to the business of the corporation which issued the stock, but that judgement must be related to all of the other factors affecting value. .03 Valuation of securities is, in essence, a prophecy as to the future and must be based on facts available at the required date of appraisal. As a generalization, the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries represented. When a stock is closely held, is traded infrequently, or is traded in an erratic market, some other measure of value must be used. In many instances, the next best measure may be found in the prices at which the stocks of companies engaged in the same or a similar line of business are selling in a free and open market. Sec. 4. Factors to Consider. .01 It is advisable to emphasize that in the valuation of the stock of closely held corporations or the stock of corporations where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors, although not all-inclusive, are fundamental and require careful analysis in each case: (a) The nature of the business and the history of the enterprise . . . from its inception. (b) The economic outlook in general and the condition and outlook of the specific industry in particular. (c) The book value of the stock and the financial condition of the business. (d) The earning capacity of the company. (e) The dividend-paying capacity. (f) Whether or not the enterprise has goodwill or other intangible value. (g) Sales of the stock and size of the block of stock to be valued. (h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter. .02 The following is a brief discussion of each of the foregoing factors: (a) The history of a corporate enterprise will show its past stability or instability, its growth or lack of growth, the diversity or lack of diversity of its operations, and other facts needed to form an opinion of the degree of risk involved in the business. For an enterprise which changed its form of organization but carried on the same or closely similar operations of its predecessor, the history of the former enterprise should be considered. The detail to be considered should increase with the approach of the required date of appraisal, since recent events are of greatest help in predicting the future; but a study of gross and net income, and of dividends covering a long prior period, is highly desirable. The history to be studied should include, but need not be limited to, the nature of the business, its products or services, its operating and investment assets, capital structure, plant facilities, sales records and management, all of which should be considered as of the date of the appraisal, with due regard for recent significant changes. Events of the past that are unlikely to

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recur in the future should be discounted, since value has a close relation to future expectancy. (b) A sound appraisal of a closely held stock must consider current and prospective economic conditions as of the date of appraisal, both in the national economy and in the industry or industries with which the corporation is allied. It is important to know that the company is more or less successful than its competitors in the same industry, or that it is maintaining a stable position with respect to competitors. Equal or even greater significance may attach to the ability of the industry with which the company is allied to compete with other industries. Prospective competition which has not been a factor in prior years should be given careful attention. For example, high profits due to the novelty of its product and the lack of competition often leads to increasing competition. The public’s appraisal of the future prospects of competitive industries or of competitors within an industry may be indicated by price trends in the markets for commodities and for securities. The loss of the manager of a so-called “one-man” business may have a depressing effect upon the value of the stock of such a business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business, and the absence of management succession potentialities are pertinent factors to be taken into consideration. On the other hand, there may be factors which offset, in whole or in part, the loss of the manager’s services. For instance, the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager. Furthermore, the loss may be adequately covered by life insurance, or competent management might be employed on the basis of the consideration paid for the former manager’s services. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager’s services in valuing the stock of the enterprise. (c) Balance sheets should be obtained, preferably in the form of comparative annual statements for two or more years immediately preceding the date of appraisal, together with a balance sheet at the end of the month preceding that date, if corporate accounting will permit. Any balance sheet descriptions that are not selfexplanatory, and balance sheet items comprehending diverse assets or liabilities, should be clarified in essential detail by supporting supplemental schedules. These statements usually will disclose to the appraiser: (1) liquid position (ratio of current assets to current liabilities); (2) gross and net book value of principal classes of fixed assets; (3) working capital; (4) long-term indebtedness; (5) capital structure; and (6) net worth. Consideration also should be given to any assets not essential to the operation of the business, such as investments in securities, real estate, etc. In general, such non-operating assets will command a lower rate of return than do the operating assets, although in exceptional cases the reverse may be true. In computing the book value per share of stock, assets of the investmenttype should be revalued on the basis of their market price and the book value adjusted accordingly. Comparison of the company’s balance sheets over several years may reveal, among other facts, such developments as the acquisition of additional production facilities or subsidiary companies, improvement in financial position, and details as to recapitalizations and other changes in the capital structure of the corporation. If the corporation has more than one class of stock outstanding, the charter or certificate of incorporation should be examined to ascertain the explicit rights and privileges of the various stock issues including: (1) voting powers, (2) preference as to dividends, and (3) preference as to assets in the event of liquidation.

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(d) Detailed profit-and-loss statements should be obtained and considered for a representative period immediately prior to the required date of appraisal, preferably five or more years. Such statements should show: (1) gross income by principal items; (2) principal deductions from gross income including major prior items of operating expenses, interest and other expenses on each item of long-term debt, depreciation, and depletion if such deductions are made, officers’ salaries, in total if they appear to be reasonable or in detail if they seem to be excessive, contributions (whether or not deductible for tax purposes) that the nature of its business and its community position require the corporation to make, and taxes by principal items, including income and excess profits taxes; (3) net income available for dividends; (4) rates and amounts of dividends paid on each class of stock; (5) remaining amount carried to surplus; and (6) adjustments to, and reconciliation with, surplus as stated on the balance sheet. With profit and loss statements of this character available, the appraiser should be able to separate recurrent from nonrecurrent items of income and expense, to distinguish between operating income and investment income, and to ascertain whether or not any line of business in which the company is engaged is operated consistently at a loss and might be abandoned with benefit to the company. The percentage of earnings retained for business expansion should be noted when dividend-paying capacity is considered. Potential future income is a major factor in many valuations of closely held stocks, and all information concerning past income which will be helpful in predicting the future should be secured. Prior earnings records usually are the most reliable guide as to the future expectancy, but resorting to arbitrary five or ten year averages without regard to current trends or future prospects will not produce a realistic valuation. If, for instance, a record of progressively increasing or decreasing net income is found, then greater weight may be accorded the most recent years’ profits in estimating earnings power. It will be helpful, in judging risk and the extent to which a business is a marginal operator, to consider deductions from income and net income in terms of percentage of sales. Major categories of cost and expense to be so analyzed include the consumption of raw materials and supplies in the case of manufacturers, processors, and fabricators; the cost of purchased merchandise in the case of merchants; utility services; insurance; taxes; depletion or depreciation; and interest. (e) Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid in the past. Recognition must be given to the necessity of retaining a reasonable portion of profits in a company to meet competition. Dividend-paying capacity is a factor that must be considered in an appraisal, but dividends actually paid in the past may not have any relation to dividend-paying capacity. Specifically, the dividends paid by a closely held family company may be measured by the income needs of the stockholders or by their desire to avoid taxes on dividend receipts, instead of by the ability of the company to pay dividends. Where an actual or effective controlling interest in a corporation is to be valued, the dividend factor is not a material element, since the payment of such dividends is discretionary with the controlling stockholders. The individual or group in control can substitute salaries and bonuses for dividends, thus reducing net income and understating the dividend-paying capacity of the company. It follows, therefore, that dividends are less reliable criteria of fair market value than other applicable factors. (f) In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the

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ownership of a trade or brand name, and a record of successful operations over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value of the tangible assets exceeds the net book value of such assets. (g) Sales of stock of a closely held corporation should be carefully investigated to determine whether they represent transactions at arm’s length. Forced or distress sales do not ordinarily reflect fair market value nor do isolated sales in small amounts necessarily control as to the measure of value. This is especially true in the valuation of a controlling interest in a corporation. Since, in the case of closely held stocks, no prevailing market prices are available, there is no basis for making an adjustment for blockage. It follows, therefore, that such stocks should be valued upon a consideration of all the evidence affecting the fair market value. The size of the block of stock itself is a relevant factor to be considered. Although it is true that a minority interest in an unlisted corporation’s stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock. (h) Section 2031(b) of the Code states, in effect, that in valuing unlisted securities the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange should be taken into consideration along with all other factors. An important consideration is that the corporations to be used for comparisons have capital stocks which are actively traded by the public. In accordance with section 2031 (b) of the Code, stocks listed on an exchange are to be considered first. However, if sufficient comparable companies whose stocks are listed on an exchange cannot be found, other comparable companies which have stocks actively traded in an over-the-counter market also may be used. The essential factor is that whether the stocks are sold on an exchange or over-thecounter, there is evidence of an active, free public market for the stock as of the valuation date. In selecting corporations for comparative purposes, care should be taken to use only comparable companies. Although the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar, yet it is obvious that consideration must be given to other relevant factors in order that the most valid comparison possible will be obtained. For illustration, a corporation having one or more issues of preferred stock, bonds, or debentures in addition to its common stock should not be considered to be directly comparable to one having only common stock outstanding. In like manner, a company with a declining business and decreasing markets is not comparable to one with a record of current progress and market expansion. Sec. 5. Weight To Be Accorded Various Factors. The valuation of closely held corporate stock entails the consideration of all relevant factors as stated in section 4. Depending upon the circumstances in each case, certain factors may carry more weight than others because of the nature of the company’s business. To illustrate: (a) Earnings may be the most important criteria of value in some cases whereas asset value will receive primary consideration in others. In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public; conversely, in the investment or holding-type

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of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued. (b) The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type the appraiser should determine the fair market value of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets. The market value of the underlying assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capitalized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal such as earnings and dividend-paying capacity. Sec. 6. Capitalization Rates. In the application of certain fundamental valuation factors, such as earnings and dividends, it is necessary to capitalize the average or current results at some appropriate rate. A determination of the proper capitalization rate presents one of the most difficult problems in valuation. That there is no ready or simple solution will become apparent by a cursory check of the rates of return and dividend yields in terms of the selling prices of corporate shares listed on the major exchanges of the country. Wide variations will be found even for companies in the same industry. Moreover, the ratio will fluctuate from year to year depending upon economic conditions. Thus, no standard tables of capitalization rates applicable to closely held corporations can be formulated. Among the more important factors to be taken into consideration in deciding upon a capitalization rate in a particular case are: (1) the nature of the business; (2) the risk involved; and (3) the stability or irregularity of earnings. Sec. 7. Average of Factors. Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings, and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance. Sec. 8. Restrictive Agreements. Frequently, in the valuation of closely held stock for estate and gift tax purposes, it will be found that the stock is subject to an agreement restricting its sale or transfer. Where shares of stock were acquired by a decedent subject to an option reserved by the issuing corporation to repurchase at a certain price, the option price is usually accepted as the fair market value for estate tax purposes. See Rev. Rul. 54-76, C.B. 1954-1, 194. However, in such case the option price is not determinative of fair market value for gift tax purposes. Where the option, or buy and sell agreement, is the result of voluntary action by the stockholders and is binding during the life as well as at the death of the stockholders, such agreement may or may not, depending

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upon the circumstances of each case, fix the value for estate tax purposes. However, such agreement is a factor to be considered, with other relevant factors, in determining fair market value. Where the stockholder is free to dispose of his shares during life and the option is to become effective only upon his death, the fair market value is not limited to the option price. It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts, to determine whether the agreement represents a bona fide business arrangement or is a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth. In this connection see Rev. Rul. 157 C.B. 1953-2, 255, and Rev. Rul. 189, C.B. 1953-2, 294. Sec. 9. Effect on Other Documents. Revenue Ruling 54-77, C.B. 1954-1, 187, is hereby superseded.

10.21

REVENUE RULING 68-609: VALUATION OF STOCKS AND BONDS

The purpose of this Revenue Ruling is to update and restate, under the current statute and regulations, the currently outstanding portions of A.R.M. 34, C.B. 2, 31 (1920), A.R.M. 68, C.B. 3, 43 (1920), and O.D. 937, C.B. 4, 43 (1921). The question presented is whether the “formula” approach, the capitalization of earnings in excess of a fair rate of return on net tangible assets, may be used to determine the fair market value of the intangible assets of a business. The “formula” approach may be stated as follows: A percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five) immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period and the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the period. This amount (considered as the average annual earnings from intangibles), capitalized at a percentage of, say, 15 to 20 percent, is the value of the intangible assets of the business determined under the “formula” approach. The percentage of return on the average annual value of the tangible assets used should be the percentage prevailing in the industry involved at the date of valuation, or (when the industry percentage is not available) a percentage of 8 to 10 percent may be used. The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high. The above rates are used as examples and are not appropriate in all cases. In applying the “formula” approach, the average earnings period and the capitalization rates are dependent upon the facts pertinent thereto in each case. The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less than five years, and

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abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business. See Lloyd B. Sanderson Estate v. Commissioner [1930 CCH ¶ 9386], 42 F.2d 160 (1930). Further, only the tangible assets entering into net worth, including accounts and bills receivable in excess of accounts and bills payable, are used for determining earnings on the tangible assets. Factors that influence the capitalization rate include (1) the nature of the business, (2) the risk involved, and (3) the stability or irregularity of earnings. The “formula” approach should not be used if there is better evidence available from which the value of intangibles can be determined. If the assets of a going business are sold upon the basis of a rate of capitalization that can be substantiated as being realistic, though it is not within the range of figures indicated here as the ones ordinarily to be adopted, the same rate of capitalization should be used in determining the value of intangibles. Accordingly, the “formula” approach may be used for determining the fair market value of intangible assets of a business only if there is no better basis therefor available. See also Revenue Ruling 59-60, C.B. 1959-1, 237, as modified by Revenue Ruling 65-193, C.B. 1965-2, 370, which sets forth the proper approach to use in the valuation of closely held corporate stocks for estate and gift tax purposes. The general approach, methods, and factors, outlined in Revenue Ruling 59-60, as modified, are equally applicable to valuations of corporate stocks for income and other tax purposes as well as for estate and gift tax purposes. They apply also to problems involving the determination of the fair market value of business interests of any type, including partnerships and proprietorships, and of intangible assets for all tax purposes. A.R.M. 34, A.R.M. 68, and O.D. 937 are superseded, since the positions set forth therein are restated to the extent applicable under current law in this Revenue Ruling. Revenue Ruling 65-192, C.B. 1965-2, 259, which contained restatements of A.R.M. 34 and A.R.M. 68, is also superseded.

EXHIBIT 10–1

Business Valuation Interview Form

Name of Company:

_________________________________________________________

Address:

_________________________________________________________ _________________________________________________________

Phone:

___________________________ Fax: _________________________

Web Site:

_________________________

Home Address:

_________________________________________________________

(review web site — print highlights for file)

_________________________________________________________ Home Phone:

_________________________________________________________

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EXHIBIT 10–1

Business Valuation Interview Form (continued)

Entity Form: C Corporation: ___________________

Partnership: __________________________

S Corporation: ___________________

Sole Proprietorship: ___________________

Date and state of incorporation or formation: _________________________________ Date of formation if business existed prior to incorporation: _____________________________________________________ For corporations: Describe any stock other than common ______________________________________ _____________________________________________________________________________ Purpose of Valuation: Divorce ___________________________________

Gifting ______________________

Partner or Shareholder Litigation ___________

Estate Return ________________

Other Commercial Litigation ________________

Purchase or Sale ______________

If litigation, parties to the litigation: __________________________________________ Valuation as of:

_____________________________

_____________________________

_____________________________

_____________________________

If multiple valuation dates, explain reason:

__________________________________________________ __________________________________________________

Whom are we to contact for access to records: __________________________________________________ Who on the staff is aware of this appraisal? ____________________________________ ____________________________________ Do they know the reason? ____________________________________________________ If no, shall this assignment remain confidential? ________________________________ ********** Description of company’s products or services: _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1

209


List owners/shareholders with percentages and history of ownership:

Name

Percent Ownership or Number of Shares

Time Frame Owned

Consideration Paid*

___________________

_________________ __________________ __________________

___________________

_________________ __________________ __________________

___________________

_________________ __________________ __________________

*Provide supporting documentation (i.e., contract, gift tax return) for such consideration.

Key dates and events in company history: _____________________________________________________________________________ _____________________________________________________________________________ List each location and the primary activity at each (i.e., executive office, factory, etc.) Location (obtain copies of all leases)

Activity

Owned by Owned by Leased from Company Shareholder Unrelated Party

_____________________ _______________ _________ ___________

______________

_____________________ _______________ _________ ___________

______________

_____________________ _______________ _________ ___________

______________

Is office site owned by business owners(s) or other related parties? ______________ If NO, go to the next section. Form of ownership? __________________

Age of building: __________________

Total square feet in building: _________

Subject’s % of ownership: __________

Amount of space occupied by subject business: ______________________________ Is there a lease? ____________ If yes, provide a copy. Monthly rent paid by the business: _________________________________________ Mortgage balance: ___________ (as of __________ ) Monthly payment __________ Fair rental price: _____________ If office not owned by business owner(s) or related party. Landlord __________________________________________________________________ Square feet ______________________

Monthly rent _________________________

Lease expires _____________________

Option to renew? _____________________

Provide a copy of lease.

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EXHIBIT 10–1


Describe business location (What is surrounding area like?): _____________________ _____________________________________________________________________________ _____________________________________________________________________________ Describe the community in which business is located: ___________________________ _____________________________________________________________________________ _____________________________________________________________________________ List all related parties (subsidiaries, affiliates, relatives, or other) with whom the company does business: Name of Related Party

Percent Common Relationship Ownership

Nature of Business Between These Entities

_____________________ ___________ __________ ______________________________ _____________________ ___________ __________ ______________________________ _____________________ ___________ __________ ______________________________ ********** Provide information on key members of management:

Name

Approx. Years Weekly With Hours Position/Title Age Health Company Job Responsibilities Worked

_____________ ____________

___ ______

________ __________________ _______

_____________ ____________

___ ______

________ __________________ _______

_____________ ____________

___ ______

________ __________________ _______

_____________ ____________

___ ______

________ __________________ _______

_____________ ____________

___ ______

________ __________________ _______

Discuss any specific and particular concerns as to key position staffing (imminent retirement of key individuals, health problems of key individuals, or any other key personnel concerns). _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1

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Discuss any special issues regarding the above management personnel. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Discuss compensation arrangements with any of the above. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Describe any contingent (i.e., commission-based) compensation arrangements with any employees. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Does any employee have an employment contract? If so, provide a copy of each such contract. _____________________________________________________________________________ Are there any shareholders agreements (in draft or signed)? If so, obtain copies of all such agreements. _____________________________________________________________________________ Is there life insurance carried by or paid for by the company on any key personnel (other than a de minimis group term arrangement)? If so, provide full details, including first page (with amount of coverage, owner, type of policy, payment terms) of all policies, including cash surrender value information. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Does the company have a Board of Directors that includes outside/independent personnel? If so, provide details as to who these individuals are. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ **********

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EXHIBIT 10–1


Breakdown of sales by product line: Percent of Sales

Product* (include brief description)

Gross Profit Percentage

_________________________________________________ ____________ _____________ _________________________________________________ ____________ _____________ _________________________________________________ ____________ _____________ *If available, obtain past few years’ analysis of sales by product line and gross profit margins.

What is the size (in dollars) of the market, by product? Product

Total Market

Market Share of Subject Company

_________________________________________

______________

__________________

_________________________________________

______________

__________________

_________________________________________

______________

__________________

Provide a brief discussion of the market for the products, and whether it is growing or not: _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ How reliant is the company on just one or two suppliers? _____________________________________________________________________________ _____________________________________________________________________________ Are any products proprietary? Does the company have patents, technology, or expertise that precludes some level of competition or copying? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ (If patents or copyrights exist, obtain documentation in support of same, including when those expire.)

Are sales cyclical? If so, provide explanation. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1

213


Describe any restrictions or limitations on the company’s ability to distribute its products: _____________________________________________________________________________ _____________________________________________________________________________ How are sales/receivables collected (cash, check, charge — and by whom and where)? _____________________________________________________________________________ _____________________________________________________________________________ ********** Description of company’s customer base: _____________________________________________________________________________ _____________________________________________________________________________ Describe geographic area from which customers come: _____________________________________________________________________________ _____________________________________________________________________________ Are there one or two major employers in the area? _____________________________ If yes, who and likely impact on customer base? ______________________________ List any customers representing 10 percent or more of sales in any of the past three years: Customer

Sales Volume or Percent of Sales

Year

_______________________________________________ _________________ _________ _______________________________________________ _________________ _________ As to above customers, if profit margins were atypical, describe: _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ As to each of the above customers, briefly explain the relationship and potential exposure to losing the customer: _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1


Briefly describe customer loyalty and how price-sensitive customers tend to be. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ How competitive is pricing; how does the company determine what to charge? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ What is the extent of bid jobs as a percent of sales volume? _____________________________________________________________________________ As to bid jobs, are they essentially won by low bid? _____________________________________________________________________________ What is the company’s extent of sales volume to governmental agencies? _____________________________________________________________________________ _____________________________________________________________________________ Are sales in any way reliant on political positioning or who is in power? If so, explain. _____________________________________________________________________________ _____________________________________________________________________________ What does the company do to promote and advertise its products? (Obtain samples of brochures and marketing literature.) _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Do government regulatory bodies routinely have an impact on how the company operates? _____________________________________________________________________________ If yes to the above, explain, including indicating which regulatory bodies. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1

215


Does the company have any foreign operations? If so, are any in particular jeopardy because of currency issues or political stability? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Are foreign sales significant to the company? If so, are there concerns because of currency or political issues? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ ********** Provide information as to competitors.

Name of Competitor

Location

Approximate Size/Sales Volume

Privately Held*

Publicly Held†

________________________

______________ ____________

__________

_________

________________________

______________ ____________

__________

_________

________________________

______________ ____________

__________

_________

*What information can we obtain? †Obtain annual reports

How do company’s products compare to those of the competition? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Is capacity an issue? Discuss ability of company to grow. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Is the company facing any anticipated substantial capital or repair expenditures? If so, describe. _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1


How up-to-date and sophisticated is the company’s management information systems? Is a major improvement or expenditure anticipated for data processing equipment upgrading? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ How is it anticipated the company will pay for or finance such capital expenditures? _____________________________________________________________________________ _____________________________________________________________________________ What is the extent of the company’s credit lines and ability to borrow? _____________________________________________________________________________ _____________________________________________________________________________ Within the last three years, has the company applied for credit and been denied same? If so, explain. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Are any of the company assets or liabilities nonoperational (i.e., not necessary for the normal operations of the company)? If so, describe. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Is the company or any of its principals involved in any litigation or facing any contingent liability or asset issues (i.e., lawsuit damages or recovery, long-term obligation under a contract, deferred compensation, etc.)? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ What are the major technological trends or concerns of the industry? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1

217


What are the major environmental concerns of the industry? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Describe significant research and development efforts and issues, including extent of financial commitment in this area. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Are there any major threats to the company’s continued success/operations? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Are there any major potential boons to the company’s future and operations? _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Discuss expectations for the next year, next two years, and longer as to the company’s prospects. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ ********** Discuss any stock rights, warrants, or options. _____________________________________________________________________________ _____________________________________________________________________________ Discuss the company’s dividend history. _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10–1


Are there any plans to sell part or all of the company to a private investor or to go public? If so, provide full details. _____________________________________________________________________________ _____________________________________________________________________________ If any portion of the company was sold or acquired within the last 10 years, provide all details and obtain copies of all contracts and other documentation. Date of Such Sale or Acquisition

Individual or Company Involved

Nature of Transaction

Extent of Interest Consideration Involved Paid

____________

__________________ ____________ ________________ _____________

____________

__________________ ____________ ________________ _____________

____________

__________________ ____________ ________________ _____________

Describe any offers or attempts to sell the company in the past 10 years. (How far did negotiations go, what was offered, what documentation exists, why was the offer not accepted?) _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ ********** Professional Advisors Accountant: _________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ Attorney: ___________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ Management Consultant: __________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________

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EXHIBIT 10–1

219


Be sure to obtain the following financial records: Item to Obtain

Years

Check If Have It

Financial Statements — Year End Financial Statements — Interim Forecasts or Budgets Tax Returns — Business Tax Returns — Personal Financial Statements — Personal Have we done a walk-through? This interview done by:

_____________________________________________ _____________________________________________

on: _____________________________________________ interview of: _____________________________________________ at: _____________________________________________ Who else was present:

_____________________________________________ _____________________________________________

EXHIBIT 10 – 2

Business Valuation Interview Questionnaire for the Legal/Accounting Practice of _____________________

Name of Practice:

_________________________________________________________

Address:

_________________________________________________________ _________________________________________________________

Phone:

___________________________ Fax:__________________________

Web Site:

_________________________

Home Address:

_________________________________________________________


_________________________________________________________ Home Phone:

_________________________________________________________

Entity Form: Sole Proprietorship: ______________

Partnership: __________________________

Corporation: _____________________

LLC: __________________________________

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EXHIBIT 10 – 2

Business Valuation Interview Questionnaire for the Legal/Accounting Practice of _____________________ (continued)

Date and state of incorporation or formation: _________________________________ Date of formation if business existed prior to incorporation: _____________________________________________________ For corporations: Describe any stock other than common ______________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Purpose of Valuation: Divorce ___________________________________

Gifting ______________________





If litigation, parties to the litigation: __________________________________________ Valuation as of:

_____________________________

_____________________________

_____________________________

_____________________________

_____________________________

_____________________________

If multiple valuation dates, explain reason:

__________________________________________________ __________________________________________________ __________________________________________________

Whom to contact for access to records:

__________________________________________________

Who on the staff is aware of this appraisal? ____________________________________ ____________________________________ ____________________________________ Do they know the reason? ____________________________________________________ If no, shall this assignment remain confidential? ________________________________ ********** Describe the type of practice: _________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10 – 2

221


List owners/shareholders with percentages and history of ownership: Percent Ownership or Number of Shares

Name

Time Frame Owned

Consideration Paid*

___________________

_________________ __________________ __________________

___________________

_________________ __________________ __________________


Key dates and events in practice history: _____________________________________________________________________________ _____________________________________________________________________________ List each location and the primary activity at each: Location (obtain copies of all leases)

Activity


_____________________ _______________ _________ ___________

______________

_____________________ _______________ _________ ___________

______________

If less than five years at present location, address of previous location: _____________________________________________________________________________ Where and when was practice originally established? ___________________________ Is office site owned by practitioner(s) or other related parties? ___________________ If NO, go to the next section. Form of ownership? __________________

Age of building: __________________



Amount of space occupied by subject practice: _______________________________ Is there a lease? ____________ If yes, provide a copy. Monthly rent paid by the practice: __________________________________________ Mortgage balance: ___________ (as of __________ ) Monthly payment __________ Fair rental price: _____________ If office not owned by practitioner or related party: Landlord __________________________________________________________________ Square feet ______________________

Monthly rent _________________________

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EXHIBIT 10 – 2


Lease expires _____________________

Option to renew? _____________________

Provide a copy of lease. Describe office location (What is surrounding area like?) ________________________ _____________________________________________________________________________ _____________________________________________________________________________ Describe the community in which practice is located: ____________________________ _____________________________________________________________________________ Describe geographic area from which clients come: _____________________________ _____________________________________________________________________________ Are there one or two major employers in the area? _____________________________ If yes, who and likely impact of client base?__________________________________ ___________________________________________________________________________ List all related parties (subsidiaries, affiliates, relatives, or other) with whom the company does business: Name of Related Party



_____________________ ___________ __________ ______________________________ _____________________ ___________ __________ ______________________________ _____________________ ___________ __________ ______________________________ ********** For each professional in the practice, provide the following information: Name

_________

_________

_________

_________

Professional society memberships _________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

States licensed to practice

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EXHIBIT 10 – 2

223


Specialized certifications

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

Associate practitioner(s)

_________

_________

_________

_________

Terms of employment

_________

_________

_________

_________

Terms of compensation

_________

_________

_________

_________

Buy in provisions

_________

_________

_________

_________

Is there a written contract? (Provide copy)

_________

_________

_________

_________

Discuss any specific and particular concerns as to key position staffing (imminent retirement of key individuals, health problems of key individuals, or any other key personnel concerns). _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Discuss any special issues regarding the above management personnel. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Discuss compensation arrangements with any of the above. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Provide details as to number and extent of employees: nonowner professionals: paraprofessionals:

F/T _____

P/T _____

F/T _____

P/T _____

general office: F/T _____

P/T _____

Explain extent of P/T: ______________________________________________________

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EXHIBIT 10 – 2


List all full-time and part-time employees: Full Time Relationship Typical Work Years with Name (if any) Week Job Functions this Practice __________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Part Time Relationship Typical Work

Years with

Name (if any) Week Job Functions this Practice __________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ ********** The office is normally staffed during these hours: M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ Typical fee structure

existing client: ____________

new client: _________________

Typical hourly rates

partners: _________________

other professionals: ________

paraprofessionals: ________

secretaries:_________________

Does any one client represent 5 percent or more of practice revenue? If so, provide details. Client ______________

Nature of Services _______________________

Percentage of Revenues _________

Years _______

___________________

______________________________ _____________ __________

___________________

______________________________ _____________ __________

___________________

______________________________ _____________ __________

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EXHIBIT 10 – 2

225


What percentage of new clients are from: accountants/lawyers: __________

bankers: ________________

insurance personnel: __________

existing clients: _________

Does any one referral source account for 5 percent or more of practice revenue? If so, explain. Source

Percentage of Revenues

Explanation of Relationship

________________ ___________

______________________________________________

________________ ___________

______________________________________________

________________ ___________

______________________________________________

________________ ___________

______________________________________________

Are there any contractual relationships that provide the practice access to facilities or referrals? If so, describe. _____________________________________________________________________________ _____________________________________________________________________________ ********** What is the approximate balance of unbilled time (WIP) (and specify the as-of date)? _____________________________________________________________________________ _____________________________________________________________________________ Frequency and time lines of WIP relief:_________________________________________ _____________________________________________________________________________ What method is used for recording client financial transactions? _________________ What percentage of services are paid for by: Check:

_______________

Cash:

_______________

Credit Card:

_______________

TOTAL

100% _______________ _______________

Do you send statements?______________________________________________________ If yes, approximately how many per month? _________________________________ What percentage of your charges do you collect? _______________________________

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EXHIBIT 10 – 2


Who is in charge of collections? _______________________________________________ Describe any marketing or advertising currently being used and its costs: _________ _____________________________________________________________________________ Do you consider it to be effective? _____________________________________________ For how long has this been used?______________________________________________ Do you expect to continue this level of expense?________________________________ What is the overall condition of the practice’s equipment? Are any significant expenditures anticipated soon? _____________________________________________________________________________ _____________________________________________________________________________ ********** Are you or the practice involved in any litigation or threat of litigation? If YES, please explain: _____________________________________________________________________________ _____________________________________________________________________________ Have you ever been sued for malpractice or paid a claim? If YES, please explain: _____________________________________________________________________________ _____________________________________________________________________________ What are the practice’s expectations for the next few years?_____________________ _____________________________________________________________________________ Is there any other information that should be disclosed regarding your practice? Please explain. _____________________________________________________________________________ _____________________________________________________________________________ ********** Professional Advisors Accountant: _________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________

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EXHIBIT 10 – 2

227


Attorney: ___________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ Management Consultant: __________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ ********** Be sure to obtain the following financial records: Item to Obtain

Years

Check If Have It

Financial Statements — Year End Financial Statements — Interim Forecasts or Budgets Tax Returns — Business Tax Returns — Personal Financial Statements — Personal Have we done a walk-through?

_____________________________________________

This interview done by: _____________________________________________ on: _____________________________________________ interview of: _____________________________________________ at: _____________________________________________ also present: _____________________________________________

EXHIBIT 10 – 3

Business Valuation Interview Questionnaire for the Medical Practice of _______________________ DR. _____________________________________________________

Name of Practice:

_________________________________________________________

Address:

_________________________________________________________ _________________________________________________________

Phone:

___________________________ Fax:__________________________

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EXHIBIT 10 – 3

Business Valuation Interview Questionnaire for the Medical Practice of _______________________ (continued)

Web Site:

_________________________

Home Address:

_________________________________________________________


_________________________________________________________ Home Phone:

_________________________________________________________

Entity Form: Sole Proprietorship: ______________

Partnership: __________________________

Corporation: _____________________

LLC: __________________________________

Date and state of incorporation or formation: _________________________________ Date of formation if business existed prior to incorporation: _____________________________________________________ For corporations: Describe any stock other than common ______________________________________ ___________________________________________________________________________ Purpose of Valuation: Divorce ___________________________________

Gifting ______________________





If litigation, parties to the litigation ___________________________________________ Valuation as of:

_____________________________

_____________________________

_____________________________

_____________________________

If multiple valuation dates, explain reason

__________________________________________________ __________________________________________________

Whom are we to contact for access to records: __________________________________________________ Who on the staff is aware of this appraisal? ____________________________________ ____________________________________ Do they know the reason? ____________________________________________________ If no, shall this assignment remain confidential? ________________________________ **********

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EXHIBIT 10 – 3

229


Describe the type of practice: _________________________________________________ _____________________________________________________________________________ Describe the typical patient:___________________________________________________ _____________________________________________________________________________ Most common types of procedures:

____________

____________

____________

How many surgical procedures are performed each week? _____________________________________________________________________________ _____________________________________________________________________________ List owners/shareholders with percentages and history of ownership:

Name

Percent Ownership or Number of Shares

Time Frame Owned

Consideration Paid*

___________________

_________________ __________________ __________________

___________________

_________________ __________________ __________________

___________________

_________________ __________________ __________________


List each location and the primary activity at each: Location (obtain copies of all leases)

Activity


_____________________ _______________ _________ ___________

______________

_____________________ _______________ _________ ___________

______________

_____________________ _______________ _________ ___________

______________

If less than five years at present location, address of previous location: _____________________________________________________________________________ Where and when was practice originally established? ___________________________ Is office site owned by practitioner(s) or other related parties? __________________ If NO, go to the next section. Form of ownership? __________________

Age of building: __________________



Amount of space occupied by subject practice: _______________________________

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EXHIBIT 10 – 3


Is there a lease? ____________ If yes, provide a copy. Monthly rent paid by the practice: __________________________________________ Mortgage balance: ___________ (as of __________ ) Monthly payment __________ Fair rental price: _____________ If office not owned by practitioner or related party: Landlord __________________________________________________________________ Square feet ______________________

Monthly rent _________________________

Lease expires _____________________

Option to renew? _____________________

Provide a copy of lease. Describe office location. (What is surrounding area like?) ________________________ _____________________________________________________________________________ _____________________________________________________________________________ Describe the community in which practice is located: ____________________________ _____________________________________________________________________________ _____________________________________________________________________________ Describe geographic area from which patients come:____________________________ _____________________________________________________________________________ _____________________________________________________________________________ Are there one or two major employers in the area? _____________________________ If yes, who and likely impact of patient base? ________________________________ ___________________________________________________________________________ List all related parties (subsidiaries, affiliates, relatives, or other) with whom the company does business: Name of Related Party



_____________________ ___________ __________ ______________________________ _____________________ ___________ __________ ______________________________ _____________________ ___________ __________ ______________________________ **********

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EXHIBIT 10 – 3

231


For each doctor in the practice, provide the following information: Name

_________

_________

_________

_________

Professional society memberships _________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

_________

Residency hospital (years)

_________

_________

_________

_________

Internship hospital (years)

_________

_________

_________

_________

Medical school degree at (year)

_________

_________

_________

_________

Undergraduate degree at (year)

_________

_________

_________

_________

Professional memberships

_________

_________

_________

_________

Associate practitioner(s)

_________

_________

_________

_________

Terms of employment

_________

_________

_________

_________

Terms of compensation

_________

_________

_________

_________

Buy in provisions

_________

_________

_________

_________

Is there a written contract? (Provide copy)

_________

_________

_________

_________

States licensed to practice

Board certifications

Hospital affiliations

Discuss any specific and particular concerns as to key position staffing (imminent retirement of key individuals, health problems of key individuals, or other key personnel concerns). _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10 – 3


Discuss any special issues regarding the above management personnel. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Discuss compensation arrangements with any of the above. _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Provide details as to number and extent of employees: nurses:

F/T _____

P/T _____

nonowner doctors:

F/T _____

P/T _____

insurance processors:

F/T _____

P/T _____

general office:

F/T _____

P/T _____

Explain extent of P/T: ______________________________________________________ List all full-time and part-time employees: Full Time Relationship Typical Work Years with Name (if any) Week Job Functions this Practice __________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ Part Time Relationship Typical Work

Years with

Name (if any) Week Job Functions this Practice __________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10 – 3

233


The office is normally staffed during these hours: M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ Doctor’s normal hours in office. If same as above, indicate “same”: Doctor _______________ M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ Doctor _______________ M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ Typical hours patients are seen in office. If same as above, indicate “same”: M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ Typical hours of hospital rounds: Doctor _______________ M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ Doctor _______________ M ____ Tu ____ W ____ Th____ F ____ Sa ____ Su ____ ********** Approximate number of new patients per month: ______________________________ How many patients are seen in a day/week/month, and what is the typical length of appointments? _____________________________________________________________________________ _____________________________________________________________________________ How many patient visits are there per year?

______________________________

What is the source for this figure?

______________________________

Obtain a copy of the source for several years. Are patients seen once, or are follow-up visits common? _____________________________________________________________________________ What is the approximate breakdown between treating adult men, adult women, and children? Percent _______________ Adult Men Adult Women Children

_______________ TOTAL

100% _______________ _______________

How many emergency patients are seen each month?

Existing patients? ________ New patients? ___________

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EXHIBIT 10 – 3


Are emergency patients included in new patient figures? ________________________ How many active patient files? _____________

Source of this figure: _____________

In what form are appointment records maintained (i.e., books, schedule, etc.), including surgeries? (Obtain access to most recent two or three years of such records.) _____________________________________________________________________________ _____________________________________________________________________________ What percentage of new patients are from: other doctors: _______________

existing patients: _______________

marketing: __________________

other sources:__________________

Does any one referral source account for 5 percent or more of practice revenue? If so, explain. Source

Percentage of Revenues

Explanation of Relationship

________________ ___________

______________________________________________

________________ ___________

______________________________________________

Are there any contractual relationships that provide the practice access to facilities or referrals? If so, describe. _____________________________________________________________________________ _____________________________________________________________________________ ********** Typical fee structure

existing patient: __________

new patient: _______________

What is the typical copay? Dollar amount $ ______________

Number per day/week/month ______________

Is copay received for each patient visit? ________________________________________ If not, explain:_____________________________________________________________ Do you accept insurance assignments? _________________________________________ How often/promptly do you process insurance claims? ________________________ What is the approximate balance of unbilled insurance based revenues (and specify the as-of date)? _____________________________________________________________________________ _____________________________________________________________________________

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EXHIBIT 10 – 3

235


Do you send statements?______________________________________________________ If yes, approximately how many per month? _________________________________ What percentage of your charges do you collect? _______________________________ Who is in charge of collections? _______________________________________________ What method is used for recording patient financial transactions? _______________

What percentage of services are paid for by: Check:

_______________

Cash:

_______________

Credit Card:

_______________

Approximate Number of Relationships ____________________________

Insurance: Patient carrier payments:

_______________

____________________________

HMO or capitation:

_______________

____________________________

PPO or other:

_______________

____________________________

Medicare/Medicaid

_______________

TOTAL

100% _______________ _______________

Does the practice sell product? ________________________________________________ If yes, describe what is sold. ________________________________________________ How is it purchased? _______________________________________________________ How is it priced? ___________________________________________________________ How is it paid for? _________________________________________________________ How much is sold in a typical week?_________________________________________ What records are maintained? ______________________________________________ ********** Describe any marketing or advertising currently being used and its costs: _________ _____________________________________________________________________________ Do you consider it to be effective? _____________________________________________ For how long has this been used?______________________________________________ Do you expect to continue this level of expense?________________________________

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EXHIBIT 10 – 3


What is the overall condition of the practice’s equipment? Are any significant expenditures anticipated? Soon? _____________________________________________________________________________ _____________________________________________________________________________ What is the approximate value of the drugs and/or supplies on hand? _____________________________________________________________________________ Are you or the practice involved in any litigation or threat of litigation? If YES, please explain: _____________________________________________________________________________ _____________________________________________________________________________ Have you ever been sued for malpractice or paid a claim? If YES, please explain: _____________________________________________________________________________ _____________________________________________________________________________ What are the doctor’s expectations for the next few years? _____________________________________________________________________________ Is there any other information that should be disclosed regarding your practice? Please explain: _____________________________________________________________________________ ********** As to veterinary practices: A.

B.

What types of animals does the practice treat? Type of Animal

Percentage of Business

______________________________

_____________________________________

______________________________

_____________________________________

______________________________

_____________________________________

Does the practice board animals? __________ If yes, describe ______________ ______________________________________________________________________

C.

Does the practice make house calls? __________

D.

How many animals does the practice see in a day? __________ **********

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EXHIBIT 10 – 3

237


Professional Advisors Accountant: _________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ Attorney: ___________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ Management Consultant: __________________ Firm: _________________ Phone: __________________ Address: _____________________________________________________________________ Is this individual aware of this appraisal? ____________________________________ ********** Be sure to obtain the following financial records: Item to Obtain

Years

Check If Have It

Financial Statements — Year End Financial Statements — Interim Forecasts or Budgets Tax Returns — Business Tax Returns — Personal Financial Statements — Personal Have we done a walk-through?

_____________________________________________

This interview done by: _____________________________________________ on: _____________________________________________ interview of: _____________________________________________ at: _____________________________________________ also present: _____________________________________________ _____________________________________________

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NOTES 1. 2. 3. 4.

Rev. Rul. 59-60, 1959-1 C.B. 237. Rev. Rul. 68-609, 1968-2 C.B. 327. Firstenburg, Ross, and Zisler, Institutional Investor, _____. Bodie, Zui, Journal of Finance, _____.

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PART

TAXES

V

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CHAPTER

11

TAXES AND DIVORCE The hardest thing in the world to understand is the income tax. — Albert Einstein

CONTENTS 11.1 11.2

Introduction Taxes and Divorce

241 242

ALIMONY AND SUPPORT

243

11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 11.11 11.12 11.13 11.14 11.15

243 243 244 244 244 245 246 246 250 250 251 253

11.16 11.17 11.18 11.19 11.20 11.21 11.22 11.23 11.24 11.25 11.26

General Overview Cessation at Death Electing Out of Alimony Front Loading Income-Shifting Tax Planning Adjusted Gross Income State Tax Law Alimony Qualification Rules Front-Loading Rule Exceptions Child Support Changes Relating to a Child Dependency Exemptions Custodial versus Noncustodial Parent Multiple Support Agreements Filing Status Joint Returns Filing as Unmarried Deductibility of Legal Fees Child Care Credit Earned Income Credit Child Tax Credit Medical Deductions Allocating Tax and Refunds between Spouses Innocent Spouse

253 254 254 255 255 256 257 257 258 258 258 259

PROPERTY DISTRIBUTIONS 11.27 11.28 11.29 11.30 11.31 11.32 11.33 11.34 11.35 11.36 11.37 11.38 11.39 11.40 11.41 11.42 11.43 11.44 11.45 11.46 11.47

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General Overview 261 Definitions 261 Nonresident Alien Spouse 262 Annulments 262 Effective Dates 262 Basis of Transferee 262 Appreciated or Depreciated Property 262 Annuity 262 Jointly Owned Residence 262 Installment Sales 263 Liabilities Exceed Basis 263 Supplying Information to Transferee 263 Transfer of Basis under § 1041 versus Nonspousal Gift Rules 263 Taxability and Deductibility of Interest on Interspousal Buyouts 264 Marital Residence 265 Transfers and Redemption of Corporate Stock 268 Passive Activity Loss Carryovers 269 Equitable Distribution and Retirement Plans 270 Alimony and Support Trusts 271 Effect of Deferred Taxes upon Equitable Distribution 272 Taxes —Hypothetically Speaking 273

NOTES

276

INTRODUCTION. Taxes are commonly thought of as the accountant’s territory. Indeed, they usually are. Unless you are particularly proficient in the tax ramifications of divorce, be sure to have your client engage a tax-expert CPA. Tax planning can be of great importance and assistance to the parties, particularly when representing the nonbusiness owner who often did not previously have an accountant or a working familiarity with finances and taxes. 11.1

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As part of negotiating financial issues, you must understand the standard of living necessary for your client and also be able to structure how much of that will be paid by alimony (taxable) and how much of it will be paid by child support (nontaxable). If you are representing the business owner, who will inevitably be the payor of these expenditures, then your role is to understand how much that person can afford to pay and the impact that would have (playing off deductible versus nondeductible expenses) on that person’s standard of living and tax return. The magnitude of the property settlement also plays a role. Typically, the nonbusiness spouse will be the recipient of a property settlement, which will provide funds to invest and possibly a house, which will generate tax deductions. You need to be familiar with the rules involving not only alimony deductions but also the front-end load and recapture rules. Make sure to understand what constitutes child support and what is necessary in order for payments to be treated as alimony. It will be helpful to look at the entire picture from dispassionate eyes — to realize the need to play off the likelihood of a spouse remarrying and alimony (probably) stopping at that time versus child support that continues until the child is emancipated. Be particularly careful as to changes in payments that are in any way tied to a child’s age. Where you might have particular concerns about the payor possibly going into bankruptcy, keep in mind that, for the most part, alimony and support payments survive bankruptcy (although they can be modified), whereas property settlements are erased in bankruptcy. Understand also that for the most part, custody equals the right to the exemption unless there is a written waiver. In addition, recognize that qualified domestic relations orders (QDROs) accord much room for tax planning and the shifting of tax obligations. If structured properly, they will give either spouse the opportunity to take money out of a retirement plan without penalties, something that the business owner and original pension owner normally cannot do prior to the appropriate retirement age. Judicious tax planning can make QDROs a most effective vehicle for helping both sides. Keep in mind that transfers of property are substantially tax-free events when between spouses, regardless of whether divorce-related. When related to a divorce, this tax-free exchange of property can be an extremely powerful tax device. Property and monies can exchange hands between divorcing spouses without concern that such a transaction will create an immediate tax burden. This is so even, for instance, if one spouse buys out the other’s interest in a house by paying cash for (part of) that interest. The payment of cash is not a taxable event. Notwithstanding the lack of immediacy on the tax front, it would not be true to say that a transfer of property is not a tax-related issue. There is a vast difference between one spouse walking away with $500,000 in cash and the other with $500,000 of stock that has a basis of $100,000. TAXES AND DIVORCE. No matter how nicely the settlement is done, the overriding importance is that it be affordable and meet the needs of both sides. Recognize that an arrangement which is just too good for our client may, barring some financial windfall to the other side, cause a breakdown of communications and a failure to meet the obligations. In that case, you have really helped set your client up for return trips to court. With these cautionary comments in mind, what follows is a detailed analysis of the tax laws as they pertain to divorce-related issues. 11.2

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ALIMONY AND SUPPORT GENERAL OVERVIEW. These sections deal with matters relevant to alimony and support, taxability and deductibility, child support and dependency, and other nonproperty transfer issues. Alimony, also called separate maintenance or support, is a monetary transfer between spouses. Although the tax rules are gender-neutral, historically the payor has been the husband and the payee the wife. Internal Revenue Code § 71(a) contains the rules for the includability in the recipient’s gross income for the recipient of alimony. I.R.C. § 215 similarly addresses the issue of the deductibility by the payor of such payments. The use of alimony provides the parties, usually involuntarily, with the ability to shift income between them. Prior to 1986, this maneuver was of much greater benefit because of the greater disparities in tax brackets. Despite the reduced number of (federal) tax brackets and an ability to rise into the upper bracket rather quickly, there nevertheless remains a value in income-shifting. Nor can we ignore the possibility of a return to wider and higher tax brackets in the future. In a sense, the recipient spouse is receiving “earned” income (although not generally recognized as such in the code) by virtue of having rendered service to the marital unit. As a result, that spouse is given credit for, in some way, contributing to that marital unit’s overall earning power. Alimony is specifically treated as earned income for purposes of qualifying as income for which an IRA contribution can be made.1 Current law refers to that which came about from the Tax Reform Act (TRA) of 1984,2 as modified by the Tax Reform Act of 1986.3 “Old law” generally refers to anything prior to the 1984 act. There are some rather significant differences in the tax treatment of alimony, as well as property distribution, between the current and the old law. Even though we are well into the new law, many divorces predate the current law, where payments are currently being made and are subject to the law in place at the time of those divorce agreements. The Tax Reform Act of 1984 did not retroactively or prospectively, with minor exceptions, impact on arrangements made prior to it. Prior to the TRA 1984, in order for payments to qualify as alimony and therefore be deductible by the payor, they had to be “periodic” and “in discharge of an obligation of support.” These requirements were repealed by the TRA 1984. Similarly, TRA 1984 eliminated the requirement that spouses needed to be separated in order for payments made pursuant to a decree of support to qualify as alimony. Treas. Reg. § 1.71-1T(b)(A-9) indicates that payments made pursuant to a decree of support (although not for a decree of divorce or separate maintenance) qualify as alimony even if the spouses are living in the same household. 11.3

CESSATION AT DEATH. TRA 1984 also made it a requirement that in order for payments to qualify as alimony, such payments must cease upon the death of the payee spouse.4 The 1984 act required that such a provision be explicitly stated in the divorce or separation instrument. Fortunately for the authors of those instruments (many of whom are not overly familiar with the tax rules), and also for the practicalities of the matter, the 1986 act eliminated that as an explicit written requirement within the document, requiring only that alimony payments must 11.4

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cease upon the death of the payee and that if this is required under applicable state law, the provision is satisfied. Additionally, while payments under a “pendente lite,” or temporary order, have always been considered alimony, a recent Tax Court decision (Gonzales v. Commissioner, T.C. Memo 1999-332) resulted in such payments as not being considered alimony. The case dealt with a temporary order that failed to state expressly whether unallocated payments for the support of the payee spouse and the couple’s infant child ceased at the payee spouse’s death. The Tax Court therefore held that since the unallocated support order was both modifiable and temporary, the state court might have reduced the paying spouse’s payments rather than terminate them altogether (so the payments weren’t alimony). 11.5 ELECTING OUT OF ALIMONY. One of the more interesting and possibly progressive provisions of the 1984 act was that the parties to the divorce had the rare ability to elect out of alimony treatment (but not vice versa).5 That is, the parties could provide within the divorce or separation agreement that payments that might otherwise qualify as alimony were not to be treated as such. Note that there is no comparable provision that would allow them to go in the other direction; that is, payments that would not qualify as alimony cannot be elected to be treated as alimony. FRONT LOADING. The 1984 act also provided what has become known as “antifrontloading” rules—I.R.C. § 71(f), revised by the 1986 act. These rules were intended to discourage taxpayers from creating disproportionately large frontend payments, while being able to treat them as tax-deductible. In a sense, this restricted the ability to disguise property settlements as alimony. The 1984 act had a $10,000 de minimis threshold with a six-year test. The 1986 act changed those two aspects, making it a much more livable, although still problematic, provision. Under the 1986 act (according to which this provision was retroactive to the 1984 act), if the total alimony paid in year one exceeds the average annual alimony paid in years two and three by more than $15,000, the excess is recaptured in year three. The alimony paid in year two is treated similarly. It is noteworthy that the de minimis threshold was raised to $15,000 and the six-year test was shortened to a three-year test. The entire recapture, if any, is in the third year. Unfortunately, except for death and remarriage, no exceptions exist so as to mitigate the antifrontloading rules in the case of hardship. For instance, if the payor spouse were to become disabled or unemployed in the third year, and as a result was unable to continue payments in the third year, notwithstanding the very legitimate reasons, that payor could have significant recapture (which is taxable income) in that third year. The payee spouse would potentially have a significant deduction in the third year, contra to the recapture experienced by the payor spouse. 11.6

11.7 INCOME-SHIFTING TAX PLANNING. There are many tax planning opportunities relevant to the paying of alimony, including its deductibility and its tax includability. This is one of the relatively few “generous” areas in the Tax Code where there is considerable latitude allowed to shift income between two parties, giving them the opportunity to balance their respective tax obligations. Where there are differences in tax brackets, the ability to shift income from a high bracket to a lower bracket obviously saves the parties (as a combined unit) money.

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Keeping in mind that this is not a particularly voluntary exchange of funds (certainly a key factor in allowing such “at will” income shifting), nor one that generally has year-to-year flexibility, how can we use tax-bracket disparity (the higher-earning spouse paying money to the lower-earning spouse) to save what used to be a harmonious marital unit money? If, as an example, the recipient spouse needs $20,000 for adequate support, plus an additional $5,000 to cover the taxes that would be incurred on that support since it is taxable, it would require the payor spouse to pay $25,000 to the payee spouse. However, the higher-bracket payor spouse might realize a tax savings of $9,000 from the payment of $25,000, thereby costing that person only $16,000 out-of-pocket. The result is that $16,000 out-of-pocket by the payor yields $20,000 net into the pocket of the payee. In a sense, income was created by the judicious use of the tax brackets. There are, of course, a myriad of possible situations, including where (perhaps because the payor has significant tax-free income) the payor is actually in a lower tax bracket than the payee. In such a situation, so as to avoid the payee having taxable income that would, in effect, cost the (former) unit net taxes, it is possible to have some or all of the payments from the payor classified either as child support (if there are children involved — recognizing that child support is neither deductible nor taxable) or, alternatively, the spouses can elect to opt out of what would otherwise be deductible alimony. Each case must be tested on its own merits. Subject to various qualifications, spouses are given the flexibility to designate whether an alimony payment is to be treated as income by the recipient and a deduction by the payor, or whether those payments are to be treated as nonalimony for income tax purposes. This type of an election can be made annually for each year’s payments and need not be made until after the taxable year has ended (because the election is made on the tax return for each year).6 Although of generally limited benefit, this does offer limited opportunities for tax planning. Of course, it requires that the two spouses be on reasonably amicable terms. If a payment is classified as alimony, the source of the funds for the payment is not relevant as to its deductibility by the payor nor as to its taxability to the recipient. It matters not whether alimony (as long as it is alimony) is paid out of wages, interest or dividend income, savings, tax-free income, or the sale of property. The nature of the source of the funds used to pay it is irrelevant. 11.8 ADJUSTED GROSS INCOME. Although alimony is a tax deduction — a deduction from income — it is better than that from a tax perspective. Alimony, as to the payor, is a deduction from gross income in arriving at adjusted gross income. This can be far superior to merely another itemized deduction. As a consequence, it helps to reduce that all-important adjusted gross income figure upon which much of the recent tax changes are based. For instance, the limitation on miscellaneous itemized deductions (I.R.C. § 67) is based on those deductions exceeding 2 percent of one’s adjusted gross income. Alimony, as an item that reduces adjusted gross income rather than as an item of itemized deduction, is not only excepted from that 2 percent limitation but also reduces the base upon which the 2 percent limitation is calculated. More important, this aspect can be quite beneficial to higher-income taxpayers subject to the 36 percent tax bracket and, in addition, a phaseout of itemized deductions and the dependency exemptions. This became even more so with the creation of a 39.6 percent surtax bracket. The phaseouts are calculated in reference

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to adjusted gross income. Therefore, whatever can be done to reduce adjusted gross income, for instance alimony, is of paramount tax benefit. Because of the various current tax revisions affecting higher-income people, it might be advisable for the payor/spouse not to request (thereby making it a negotiable item from a tax perspective) the dependency exemptions for the children of the marriage. Note that the alimony “deduction” is permitted even in the absence of itemized deductions; it is available to those who use the standard deduction. STATE TAX LAW. Although unlikely, a determination may need to be made as to whether a payment is considered alimony for federal tax purposes, independently of the determination of whether such payment is considered alimony for a specific state’s (tax) laws. The 1984 act eliminated the requirement that for payments to be considered alimony, they must be in the form of a discharge of a marital obligation imposed under local law. This was done to provide a uniform federal standard, in an effort to eliminate the administrative difficulties arising from differences in state laws. Therefore, the definition of what constitutes alimony for federal tax purpose is not dependent upon state law.7

11.9

11.10 ALIMONY QUALIFICATION RULES. It is not sufficient merely to indicate that a payment is alimony in order for it to be treated as such. The code prescribes various requirements that must be satisfied in order for payments to be classified as alimony from a federal tax perspective. First, payments will qualify as alimony only if they are made under a divorce or separation instrument that includes:

• A court decree of divorce or separate maintenance, or a written instrument incident to such a decree.8 • Any other court decree requiring one spouse to make payments for the support or maintenance of the other spouse.9 • A written separation agreement entered into by the spouses.10 Clearly, the requirements are that, for deductibility, there must be a written instrument. Making payments deductible is synonymous with making the receipt of them taxable. Payments made prior to the time of a decree or agreement being made effective and committed to writing do not qualify as alimony for tax purposes. Nor do voluntary payments qualify as alimony, even if made out of good intentions because of concerns that the recipient spouse does not have sufficient income to maintain a reasonable standard of living. Second, payment must be for the benefit of the payee. Payments must be either received by the payee/spouse or made to a third party on behalf of the payee/ spouse.11 Payments to third parties that are for the benefit of the payee/spouse qualify as alimony only if the third-party payments are made in compliance with provisions of the divorce decree or separation agreement.12 Typically, these may include payments of rent, clothing, medical, or food bills, and payments for education, vacations, and the like. Confusion often arises as to the payment of housing costs on behalf of the payee spouse. Where an unrelated third party is paid rent on behalf of the payee spouse, it is clear that such payments constitute deductible alimony to the payor and taxable alimony income to the payee. If the payor is paying the mortgage of

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a house owned by the payee/spouse (irrespective of the payment of real estate taxes and other types of expenses), such payments are also alimony. They are taxable to the payee spouse, who in turn may have deductions for mortgage interest, real estate taxes, and the like. However, where the payee/spouse resides in a residence owned by the payor/spouse, the payments made by the payor are not alimony inasmuch as they constitute the payment of a legal obligation as to that property. Of course, the payor/spouse would still be able to, subject to various tax rules, deduct the mortgage interest and real estate taxes. It is not unusual for the marital residence to be retained in joint name pending some future event, such as the emancipation of the dependent children. In such a situation, if the payor spouse pays the mortgage directly, half of the payments would qualify as alimony and half of the payments would not. The payments that would not qualify as alimony would, to the extent that they represent same, be available to be used as deductions for mortgage interest and taxes. As to the payee spouse, the half of the payments that qualified as alimony deductions to the payor would constitute alimony income to the payee, but the recipient would also receive a proportionate deduction for mortgage interest and real estate taxes. Often a divorce agreement provides that the obligation to pay alimony will terminate on the death of the payor/spouse; that is, that the estate will not have an ongoing obligation to pay such alimony. In order to protect the payee/spouse from such a cessation of alimony payments, divorce agreements at times provide for a life insurance policy on the payor’s life, with the payee/spouse as the beneficiary. Such agreements also often provide that the payor/spouse is the one to pay the premiums on the policy. Such payments of premiums are treated as alimony, but only if the payee/spouse is the owner of the policy.13 If the payee spouse does not own the policy in total or is only a contingent beneficiary, such payments are not alimony. In order for the payment of such a policy’s premiums to be deductible, the policy must be assigned to the recipient soon–to–be–ex-spouse. Further, the payor spouse must surrender all incidents of ownership, including the right to borrow. If that is not desirable, or in any other way presents a problem, a relatively simple alternative is to provide for the payor/spouse to pay a somewhat increased amount of alimony directly to the payee/spouse, leaving it to the payee/spouse to make the payments of the premiums on that policy. The result is the same, but the qualification somewhat simpler. Thus, the onus of making premium payments is relegated to the payee/spouse. Third, payments must be in cash or equivalent. Under I.R.C. § 71(b)(1) and Treas. Reg. § 1.71-1T(b), payments must be in cash (checks, money orders, and the like constitute cash for this purpose) to qualify as alimony. The transfer of services for the execution of a debt instrument (that is, giving a note to the payee) does not qualify as alimony. Fourth, payments must terminate upon the death of the payee.14 There can be no requirement to make any payments after the death of the payee that in any way constitutes a substitution for the alimony payments that were made while the payee was alive. If an agreement calls for such payments to be made, none of the alimony would be treated as such for tax purposes. The requirement to make substitute payments would cause all the payments to be classified as a property distribution rather than alimony payments.

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There is no prohibition against payments continuing upon the payee/spouse’s remarriage or the payor/spouse’s death. In either event, if the agreement so provides, alimony payments can continue with the tax treatment unimpaired. While the payor’s estate is not entitled to an alimony deduction for the payments, under I.R.C. § 682(b), such payments are treated as distributions to an estate beneficiary. Therefore, if the estate has distributable net income, the estate takes a deduction for the distribution and the payment is includable in the payee’s income as a distribution (comparable to alimony income). Fifth, payments can vary in amount or be contingent. Alimony need not be in a fixed or constant amount. An agreement can provide for variable payments, such as 26 percent of the payor/spouse’s net income; or for contingent payments, that is, payment to be made only upon the receipt of certain income. Subject to substance-over-form issues, this can give the parties the opportunity to manipulate alimony. For instance, if alimony is to be a certain percentage of rents of a particular property, it may be possible to adjust the rents of that property up or down to meet certain requirements and needs. That, however, brings to the fore one of the problems in the practical application of this approach to alimony. That is, if alimony is to be a percentage of one’s income of any kind, then the question arises as to what constitutes income. If it is to be 20 percent of the net income from one’s unincorporated business, who is going to sit in judgment as to what constitutes a legitimate or proper expense to offset against the gross revenues of such a business and thereby make the ultimate determination of the net income and, as a result, the alimony to be paid? It is an area that simultaneously offers tax planning and abuse opportunities. It should not be utilized lightly. Sixth, the rules that provide for a recapture of alimony (the antifrontloading rules) operate on a basis of three calendar years. These three calendar years begin with the first calendar year (the first postseparation year) in which the payor/ spouse makes payments to the payee/spouse. The next calendar year after that becomes the second postseparation year, and the calendar year after that becomes the third postseparation year. Alimony payments made in the third postseparation year are compared to those payments made in the first and second postseparation years. If the payments made in the first and second years, as compared to those in the third year, are found to be excessive, the aggregate of such excess is then recaptured in the third postseparation year. Recapture occurs only in the third postseparation year. Prior year returns need not, and cannot, be amended for such recapture. This recapture not only causes the payor/spouse to realize income in the third postseparation year, but also enables the payee recipient-spouse to deduct the amount of the recapture from his or her gross income, also in the third postseparation year. There is no further or additional recapture and this entire matter ceases in the third year.15 Obviously, the critical issue here is the definition and determination of what constitutes excess payments. The determination is made by comparing payments made in each of the first three years. To the extent that alimony payments made in the second postseparation year exceed those made in the third postseparation year by more than $15,000, such excess is considered as being in and for the second postseparation year.16 To the extent that alimony payments made in the first postseparation year exceed the average of alimony payments made in the second

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postseparation year (reduced by the excess for such year) and third postseparation year by more than $15,000, again this excess is treated as being for the first postseparation year.17 As an illustration of the preceding, consider: W agreed, in a divorce agreement, to make alimony payments to H over a six-year period as follows: $80,000 in year one, $50,000 in year two, and $20,000 annually in years three through six. The excess alimony amount for year two is the excess of $50,000 (the amount paid in year two) over the sum of $20,000 (payments made in year three) and $15,000 (the threshold amount). Thus, out of the $50,000 paid in year two, $15,000 ($50,000 less the sum of $20,000 plus $15,000) is treated as excess alimony in that year and must be recaptured in year three. In determining the recapture amount for year one, only $35,000 ($50,000 paid in year two less the $15,000 excess for year two) will be treated as alimony paid in year two. The excess alimony amount to be determined for year one is the excess of the $80,000 paid that year over the sum of $35,000 (the amount treated as being paid in year two) plus $20,000 (the amount paid in year three), and that sum is divided by two (the average of the alimony payments made or allowed in years two and three) plus $15,000 (the threshold amount). Therefore, out of the $80,000 paid in year one, $37,500 ($80,000 less $27,500 plus $15,000) is treated as excess alimony for that year and is recaptured in year three. In year three, W recaptures and includes in income $52,500 ($37,500 for year one and $15,000 for year two). Conversely, H is entitled to deduct that same $52,500 in year three. Note that this does not affect the deductions ($80,000 in year one and $50,000 in year two) taken by W nor the like amount of income reported in those years by H. The impact is solely isolated and limited to year three. Seventh, in order for payments to be considered alimony, the spouses must not live together. If spouses are legally separated under a decree of divorce or separate maintenance, they may not be members of the same household at the time the payments are made.18 There is a one-month departure “allowance” as de minimis for this purpose. A dwelling unit formerly shared by both spouses, namely, the marital home, is not considered two separate households for this purpose, even if the spouses physically separate themselves within the dwelling unit.19 This separate household requirement does not apply if the parties are separated under a voluntary separation agreement or support decree. Eighth, the divorce instrument must not designate the payments as payments that are not taxable to the payee spouse and not deductible by the payor spouse. The Tenth Circuit in Schutter (CA10 12/19/2000) 86 AFTR 2d 2000-7292) has affirmed a Tax Court holding that monthly payments were not alimony even though the divorce instrument in question did not specifically designate the payments as nonalimony. The case dealt with an agreement which provided that all transfers of property, including monthly payments of $20,000, were to be subject to the provisions of Code § 1041 and reported on both spouses’ income tax returns “as a nontaxable event.”

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The Tenth Circuit said the language of the agreement was unambiguous. It clearly made known that the monthly payments constituted a division of marital assets and not alimony. Nevertheless, practitioners should use the statutory language to produce a more certain result for the spouse who will benefit from nonalimony treatment and to avoid having to litigate the issue. Last, in order for payments to qualify as alimony, the spouses must not file a joint return. This requirement is, for the most part, nonsense. If the parties were to file a joint return, the payor’s payments as deductible alimony would be completely offset by the payee’s receipt of same as taxable income. FRONT-LOADING RULE EXCEPTIONS. Like virtually all tax rules, these also have exceptions. Four situations are exempt from the front-loading rules:

11.11

1. Temporary support payments made pursuant to a court order (often referred to as pendente lite).20 2. If the recipient spouse marries during the first three years and the payments cease on account of such remarriage.21 3. If either spouse dies during the first three years and the payments cease because of that death.22 4. If payments vary in amount because they are determined by a preexisting (stated in the divorce or separation agreement) formula based on a fixed portion of income (that is, a certain percentage) from a business, property, or from compensation for employment or self-employment.23 This is permitted only if the variable payment agreement is effective for a minimum of three years. As a tax-planning maneuver, this last exception suggests a number of interesting possibilities. The way the law is written, this percentage of income can be of either net income or gross income (such as gross rental income). There are many situations where gross rental income can be controlled or at least largely directed. This can accomplish a number of goals that can create the equivalent of a frontloading situation and yet avoid the recapture provisions. Of course, one concern (besides the age-old tax issue of substance over form) would have to be an economic one: Would maneuvering to avoid taxes also allow the payor/spouse to avoid paying any alimony? Unfortunately, the recapture rules are fairly inflexible. There is nothing in the Code that provides for an exception from these recapture rules if the calculation of excess payments results because, as an example, in year three the payor becomes disabled or loses a job and can no longer make payments. In such a situation, regardless of the consequences, there is a recapture. It is hoped that Congress will see its way to modifying this potentially onerous situation. CHILD SUPPORT. As with payments on account of property settlements, payments on account of child support are not alimony and as a result are not deductible by the payor; 24 nor are they income to the recipient.25 Therefore, it is very important to be clear as to what the intent is as to alimony versus child support and then to address it intelligently from a tax perspective so that those intentions are met. While parties do have the option of opting out of alimony (if mutually agreed to), they do not have that option in the reverse direction. That 11.12

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is, they may not affirmatively elect to treat as alimony payments what would not otherwise qualify, that is, child support. Where the divorce decree or separation agreement specifically allocates a portion of the payments as child support, only that amount in excess of the amount fixed as child support can be treated as alimony. A payment can be child support for tax purposes even though the parent may no longer have a legal obligation under state law to support that child, such as for the support of an adult child.26 Payments for child support need not be numerically fixed. The use of the word “fixed” means that the total of the amounts paid can be precisely allocated between alimony and child support. If a divorce decree requires that H pays the college tuition costs of the children, it is sufficient to fix those tuition payments as child support. In the absence of clear language that would enable a reader to specifically and definitively ascertain the portion of the total payment that is child support, the entire payment is treated as alimony. This is so even if it would appear from “common sense” that the payments were intended as child support. There must be language specifically precise so as to clearly characterize a portion of the payment as child support. For instance, an agreement might state that if W makes monthly payments of $3,000, she is relieved of all support obligations for the child of H and W. Even though it would seem logical that at least part, if not all, of those payments were intended as child support, the entire $3,000 is treated as alimony because it cannot be determined from the agreement how much of each payment is for child support. Merely the act of the payment relieving or covering all support obligations is not the same as saying that the payment is for child support obligations, Similarly, payments that are made for the “support and maintenance of a family,” without more specification, will likewise be treated entirely as alimony. CHANGES RELATING TO A CHILD. This area gets considerably more complicated when payments made to a spouse change and when that change (reduction) is on account of a contingency “relating to” a child.27 Perhaps more difficult to ascertain is when the change (reduction) occurs at a time that can be “associated with” a contingency related to a child.28 A simple illustration would be: H agrees to pay W $4,000 a month for the rest of her life. The payments are reduced by $1,500 a month when their only child, who is living with W, reaches age 21 or graduates from college, whichever is later. In this example, it is rather simple and clear. The reduction of the payments to $2,500 a month is a reduction based on the happening of a contingency related to a child. Therefore, from the very beginning, only $2,500 of each $4,000 monthly payment is treated as alimony. To avoid this type of a problem, careful attention must be given to constructing the agreement and the payment terms therein to avoid an obvious or not so obvious connection with the contingency of a child as to any change in payments. The burden of proof, to show that a reduction in the payment is not on account of a happening or a contingency “related to” a child, or that the payments have not or were not contemplated to be reduced at a time that could be “associated with” a contingency related to a child, falls upon the taxpayer attempting to claim those payments as an alimony deduction. In one sense, the Code’s implied “associated with” test is rather simple. If a reduction of payments occurs not more than six months before or after the date 11.13

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a child attains age 18, 21, or the local age of majority, that reduction is considered to be associated with a contingency related to a child. This is fairly easy to address: Simply plan for the payments to avoid those narrow time slots. For example, a divorce decree provides that H is to pay W $2,500 a month for the first 10 years and $1,000 a month thereafter. The age of majority in their state is 20. Their child is currently age 12. The reduction will occur when the child reaches the age 22 (which is not stated but numerically determinable). Since that reduction occurs more than six months after the child attains the age of 20, this reduction is not treated as “associated with” a contingency related to a child (nor is it considered related to the child since there is nothing specifically in the agreement that ties the change to the child’s reaching, in this case, age 22). Therefore, with a little bit of effort, when only one child is involved, avoiding the child support “trap” is fairly simple. It is far more complicated when there are two or more children involved. Where payments are to be reduced on two or more occasions that occur not more than one year before or after a different child attains a certain age (between the ages of 18 and 24, with the measuring age being the same for each child), a portion of the payments will be treated as associated with a contingency related to a child. It is possible to avoid the first situation described but to become trapped within this more complicated area. For example, assume that there are two children, Cain (born on July 4, 1981) and Abel (born on October 31, 1983). There are two reductions, the first occurring on January 1, 2002, and the second on January 1, 2006. At the time of the first reduction, Cain is age 20 years, 5 months, and 28 days. At the time of the second reduction, Abel is age 22 years, 2 months, and 1 day. Using Cain’s age at the time of the first reduction, the range of time one year before and one year after that first reduction is from ages 19 years, 5 months, and 28 days to 21 years, 5 months, and 28 days. Using Abel’s age at the time of the second reduction, the two-year range of time for the second reduction is from 21 years, 2 months, and 1 day to 23 years, 2 months, and 1 day. Since there is an overlap between these two ranges, then both reductions are treated as child support payments. The overlap is from 21 years, 2 months, and 1 day to 21 years, 5 months, and 28 days. As a result, the two reductions are considered to represent child support, leaving only the net after those two reductions as deductible, taxable alimony. Avoiding the application of this test by spacing the reductions so that their ranges do not overlap is not very difficult with the appropriate amount of foresight. In our example, the first reduction could be made at an earlier date or the second reduction at a later date, so that the ages of the two children at the time of the reductions are more than two years apart. If the first reduction were to occur on August 1, 2001, Cain’s age would be 20 years, 0 months, and 28 days; the end of the two-year range for him would be 21 years, 0 months, and 28 days. The result is no overlap. This problem also could be avoided by planning one of the reductions to occur either before one of the children reaches age 18 or after one of them reaches age 24. These ages are outside of this test’s time span and therefore would not be subject to this calculation. If a payment is designated in the separation or divorce instrument as being partly for child support and partly for alimony, and if the actual payment made is less than the required amount, the payment is first allocated to child support (causing a lesser deduction than perhaps expected by the payor).29

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The ability to structure alimony payments and child support, with the almost infinite variety and almost entirely at the discretion of the two parties involved (subject, of course, to certain judicial oversight and economic realities), lends itself to flexible tax planning. Subject to all sorts of variables, sensitivities, and egos, and depending on the current tax brackets, alimony payments can be structured to equalize incomes, to perhaps provide income in a year where it would help one party more than the other or where the other party needs a larger deduction, or to where the dependent exemption may be better used by one party than the other. (For example, with the recent phaseout rules for higher earners, it may be better to have the lower earner take the exemption.) DEPENDENCY EXEMPTIONS. A parent is entitled to claim a dependency exemption for a child if that taxpayer provides support for that child. There are similar rules involving other relatives; however, this analysis is focused solely on the matter of children and divorce. A $3,000 exemption for someone in the 28 percent tax bracket is worth a tax savings on the federal level of $840. The general rule to claim a dependency exemption is that the parent must provide more than half of the child’s support for that year and the child must be either less than 19 years of age or a full-time student under the age of 24.30 The term “student” is defined in I.R.C. § 151(c)(4). If a child is older than age 19 and is not a student, a deduction is still available to the parent who provides over half the child’s support, as long as the child’s own gross income during the year is less than the current exemption amount.31 Only one dependency exemption is allowed for any one child, and there is no partial exemption. Therefore, when parents are divorced, separated, or are filing separate tax returns, there is a need to determine which parent is going to receive the exemption deduction. The general rule requiring that the spouse claiming the exemption provide more than half of the support is overridden by a blanket exception in favor of the parent who has custody of the child. In the typical situation where the wife gets custody of the child, barring a written agreement or other written direction to the contrary, regardless of the financial implications, the wife is the one who gets the exemption.32 The custodial parent rule is also effective, even in the absence of a written instrument, when the parents have been living apart at all times during the last six months of the calendar year.33 The custodial parent, the one who has custody for the greater portion of the year, is entitled to the dependency exemption. Even this rule requires that both parents, in the aggregate, have custody of the child for more than half the year and, in the aggregate, furnish over half the child’s support during the year.34 11.14

CUSTODIAL VERSUS NONCUSTODIAL PARENT. There are three situations where the noncustodial parent is allowed to take the dependency exemption for the child: 11.15

1. When there is a pre-1985 divorce or separation agreement in effect, and it has not been changed to be subject to the current rules. 2. The custodial parent transfers the exemption to the noncustodial parent. This requires a written declaration. 3. A multiple support agreement is in effect.

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As long as the custodial parent is entitled to the exemption, and therefore has the right to waive it, parents can decide between themselves who will take the exemption. The custodial parent need only sign a written declaration releasing the claim to the exemption.35 The noncustodial parent must also attach that declaration to his or her tax return for the first year claimed and a copy of the declaration for each subsequent year the exemption is claimed.36 The transfer of the exemption may be for all future years, a single year, or a specified number of years.37 The Tax Court recently held in Miller (114 TC 184 (2000)) that a noncustodial parent who did not attach to his return a Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, signed by the custodial parent, was not entitled to claim dependency deductions. The deductions were barred even though a permanent order of a divorce, which the noncustodial parent attached to his return, awarded him the dependency deductions for his children. The court order didn’t satisfy the express requirements of Code § 152 (e)(2)(A). Noncustodial parents who obtain the right to claim dependency deductions by court order or under a separation agreement should have the custodial spouse sign Form 8332 at the time the order is finalized or the agreement is entered into to ensure the ability to claim the deductions. Custodial spouses, however, may not want to agree to an open-ended release of the dependency exemptions in case the noncustodial spouse does not keep child support payments current. MULTIPLE SUPPORT AGREEMENTS. A multiple support agreement is relevant when no one person provides over half of a child’s support, but a group of individuals collectively provide over half of that child’s support. In that case, one of the members of the group can claim the exemption, provided that he or she provided more than 10 percent of the child’s support.38 In addition, each member of the group would have to have been able to claim the dependency exemption for that child, independently of the multiple support arrangement, if that member had provided over half of the child’s support.39 Generally, this means a relationship or residence test. The members of the group who are eligible to claim the exemption, but who deferred to the one person who they agreed would take the exemption, must file a waiver (Form 2120) releasing their rights to claim the exemption.40 If the divorce decree or separation agreement was in effect prior to January 1, 1985, the rules under prior law are to be applied to any instruments executed before that date.41 A pre-1985 instrument can be amended to apply the current rules.42 11.16

11.17

1. 2. 3. 4.

FILING STATUS.

There are four filing categories:

Married filing a joint return Married filing separate returns Head of household Unmarried (single)

If the taxpayer is married on the last day of the taxable year (December 31), it determines his or her filing status eligibility. If married, taxpayers may file only either a joint return or separate returns. If unmarried on the last day of the

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taxable year, the party may file as a single taxpayer or as head of household, if certain requirements are satisfied. JOINT RETURNS. Two individuals must be married in order to file a joint return.43 A couple who is married on December 31 are treated as married and may file a joint return for the entire taxable year. It is common that during the period pending a divorce, a couple may have many reasons for not wanting to file jointly and also may be living apart. They remain married for tax purposes unless either:

11.18

• A court decree of separate maintenance exists, or • The abandoned spouse rule applies.44 A separated couple who is treated as married for tax purposes cannot file as single individuals. They must file either jointly or as married filing separately. The issue of a decree of separate maintenance can be a surprising and disconcerting one if we are dealing with a time frame within the pendency of a divorce action. Unless the abandoned spouse rule applies, in order to file as a single individual (which is generally more favorable than filing as married with separate returns), there must be a decree of separate maintenance in effect. A decree of separate maintenance is a court order to live apart; it has nothing to do directly with the payment of support. In Boettiger v. Commissioner (31 T.C. 477 (1958), acq., 1959-1 C.B. 3), the Tax Court found that the lower court decree did not constitute a decree of separate maintenance because it provided only for the payment of support. Therefore, for tax purposes, a couple is considered still married for filing purposes where the court has issued an order only for temporary alimony, alimony pendente lite, or an interlocutory decree. FILING AS UNMARRIED. A married person is eligible to be treated as not married for filing purposes (therefore eligible to file as head of household if other requirements are met) under the abandoned spouse rule, if the following four conditions are met: 11.19

1. The individual files a separate tax return. 2. The individual lived apart from the spouse for the last six months of the taxable year.45 3. The individual paid more than half the cost of maintaining his or her household for the taxable year.46 4. That household is the principal home of the individual’s dependent child for more than six months of the year. 47 In order to qualify for head of household filing status, an individual: • Cannot be married on the last day of the year (or qualifies under the abandoned spouse rule). • Must maintain a home for a child for over half of the year (that home being the principal place of abode for that child); • Must pay over half the expenses of maintaining that home.48 In order to be eligible for head of household filing status, a parent need not be eligible to claim the child as a dependent unless the child is married.49

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To qualify as a child’s principal place of abode, a residence must be where the child actually resides, occupying the residence (the parent’s residence) for over half the year.50 A temporary absence does not interfere with the occupancy test. For instance, illness, education, business, vacation, military service, and a custody agreement do not, by themselves, preclude such time from counting toward the greater-than-half-the-year requirement.51 Temporary absences will not prevent the taxpayer from being considered as having maintained the household for the child, as long as it is reasonable to assume that the child will return and that the home is being maintained (at least in part) in anticipation of such return. Even where the child is away for more than half the year (such as at college or boarding school), the principal place of abode is generally considered with the parent. Therefore, that parent is able to claim head of household tax treatment. An unmarried child need not be a dependent under I.R.C. § 152 in order for the parent to qualify for head of household status.52 However, all of the other requirements must be satisfied. If a widow lives in her home with her two adult sons, both of whom are employed and file their own separate individual income returns, obviously she cannot claim either son as a dependent on her individual income tax return. However, since she provides over half of the housing costs for her two sons, she qualifies for head of household filing status. If the child is married, however, the parent must be entitled to claim the child as a dependent in order to qualify for the head of household filing status.53 Besides the usual support test for claiming the child as a dependent, in this case the child must also not file a joint return with his or her spouse.54 In addition, the child must be under 19 years of age or a student under 24; or the child’s gross income for the calendar year must be less than the current exemption amount.55 DEDUCTIBILITY OF LEGAL FEES. In general, legal fees paid in connection with a divorce or separation are considered to be personal expenses, and therefore not deductible.56 However, some portion of the legal fees may be deductible as an expense incurred relative to the determination, collection, or refund of a tax. As a consequence, legal expenses that are related to the tax effects of agreements or of alimony or the tax impact of child support and property settlements are deductible. The spouse receiving alimony payments can deduct the portion of legal fees applicable to the determination of the negotiation process relevant to the alimony payments. This is so because alimony is taxable income. This is also true for legal fees relevant to the recovery of alimony arrearages or to the increase alimony payments. Legal expenses incurred in an attempt to reduce alimony payments are not deductible.57 As part of a divorce settlement, it is not unusual for one spouse (often the husband) to agree or be compelled to pay the other spouse’s legal fees. In such an instance, the payor/spouse is not allowed a deduction for those legal fees, even if those legal fees were for tax advice. The reason is that the fees being paid are not those of the person paying the fees; one cannot deduct for payments on behalf of someone else (with the exception, of course, of a joint tax return). To avoid this problem, again in the typical situation, the husband would pay his ex-wife in such a way that it is characterized as additional alimony (keeping in mind the issues of deductibility and recapture); the wife then picks it up as alimony income and deducts it as an expense relevant to the production of 11.20

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alimony. This is not necessarily an even swap; care must be taken as to who benefits and to what extent. To ensure this deductibility of legal fees and to prove one’s position upon audit, it is necessary to obtain, from the attorney involved, in writing, a reasonable allocation of legal expenses incurred in connection with that divorce. That allocation needs to distinguish between the nondeductible advice (such as the obtaining of the divorce, child custody issues, and so on) as contrasted with advice relevant to tax issues, such as alimony and the tax aspects of property transfers.58 Where an allocable portion of legal fees is not deductible as tax advice, but is allocable to effort spent in a capital investment matter—for instance, defending title to assets or obtaining such assets — then that portion of the fees may be added to the basis of such assets. In this way, those fees gain the equivalent of deductibility by being applied against an ultimate disposition.59 Of more recent vintage, and with some logical basis in support, there is the issue of the deductibility of legal (as well as accounting and other professional) fees relevant to a divorcing spouse’s interest in a business. Often when a business is involved, the biggest portion of the legal and other professional fees are related to protecting, defending, and valuing the interest in that business. This is especially so when that business is income producing, often the major income-producing asset of a marriage. It is not uncommon, when a business is one of the assets being fought over in a divorce, that business is the source that pays all the legal and accounting bills, treating them in the normal course of business as if they were ordinary and necessary deductible expenses. It must be recognized that such treatment carries with it an element of audit risk. Nevertheless, there is an argument to be made that indeed such expenses are for the preservation of an incomeproducing asset and are inexorably entwined with the ongoing conduct of one’s business. As a natural extension, the argument would be that all such expenses are deductible as ordinary and necessary expenses. That issue has not been adequately accepted to the extent that it could be expected to prevail under all circumstances. 11.21 CHILD CARE CREDIT. When parents are married, the child care credit is allowed only if the parents file a joint return.60 If a couple is considered married for tax purposes (that is, not single, not qualifying under the abandoned spouse rule, and so forth), the filing of separate returns (regardless of the reason) would preclude either spouse from claiming the child care credit. The parent eligible to claim the dependency exemption for a child is the only one (subject to a few exceptions) entitled to claim the child care credit for that child.61 Also, since the credit is allowed to the custodial parent, obviously only one credit for any one child can be claimed. Even if the custodial parent does not take the exemption for the child, perhaps because it has been transferred to the noncustodial parent by agreement, or perhaps because there was a pre-1985 agreement in effect, the custodial parent is nevertheless entitled to the child care credit.62 11.22 EARNED INCOME CREDIT. In virtually all ways, the tests and the rules for eligibility for the earned income credit are the same as for the child care credit.63

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11.23 CHILD TAX CREDIT. The Taxpayer Relief Act of 1997 (TRA97) created a new credit available to parents, effective 1998. This credit is in addition to the already existing child care credit. The credit is available with respect to each child for whom the taxpayer can claim the dependency exemption and who is a child or other direct decedent of the taxpayer (stepchild or foster child also qualifies), and is under the age of 17. The credit is $400 per qualifying child in 1998 and $500 per qualifying child in 1999 and subsequent years. It must be kept in mind that this credit is phased out for those filing joint returns with adjusted gross income (AGI) above $110,000, single filers, and head of household filers above $75,000. For those married filing separately, it is phased out with AGI above $55,000. For those dealing with divorce, this new child tax credit raises certain planning issues that must be addressed. Note two very important aspects of this credit as referenced above —you can claim it only if you are entitled to the dependency exemption, and it is phased out above certain income levels (levels far lower than those at which the dependency exemption itself is phased out). Therefore, in tax planning this aspect of divorce, there is much disincentive to granting the dependency exemptions to a high-earning spouse since that spouse would likely not be able to avail him- or herself of the credit because of the phaseout; and giving that person the exemptions would then prevent the lower-earning spouse from claiming the child tax credit. MEDICAL DEDUCTIONS. In general, all medical expenses paid by either parent for the medical care and treatment of a dependent child are eligible for the medical expense deduction. Even when dealing with separated or divorced parents, in most such situations, either of the parents can deduct medical payments made on account of the child, regardless of which parent claims the dependency exemption. The deduction, however, cannot be transferred from the payor/spouse to the other spouse. This applies to divorced or separated parents only if one of them is entitled to the dependency exemption under the custodial parent rule or under one of the exemptions to this rule.64 If, in accordance with the divorce or separation agreement, the payor spouse pays the other spouse’s medical costs directly to the provider of the medical care, this type of third-party payment is treated as having been made “on behalf of” the payee/spouse. It is, therefore, treated as an alimony payment, deductible as alimony by the spouse paying the medical expenses, and taxable as income to the spouse on whose behalf such payments were made.65 Of course, the spouse on whose behalf payments were made is now entitled (subject to the usual rules and the current 7 1/2 percent threshold) to claim such as a deductible medical expense. 11.24

ALLOCATING TAX AND REFUNDS BETWEEN SPOUSES. When a husband and wife file a joint tax return, and a refund is due for that year, and they subsequently become separated, divorced, or in some other way less than domestically amicable before the refund check is received, the question may arise as to who is entitled to the refund and to how much. The overpayment/refund belongs to the spouse whose income and tax payments created the overpayment.66 A joint return does not create a joint interest in an overpayment, because it does not convert the income or the tax payments of one spouse into the income or tax payments of the other spouse.67 11.25

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The preceding is simple enough conceptually; the problem is applying the concept in calculating the portion of an overpayment, or perhaps deficiency, or other tax attributes attributable to each spouse. Each spouse bears a proportionate share of the tax liability and is “entitled” to the appropriate payments made through respective withholding taxes and a proportionate share of the amounts paid via estimated tax payments. A spouse is entitled to a refund in the amount by which his or her payments exceed his or her share of the joint tax liability. Revenue Ruling 80-7, 1980-1 C.B. 296 provides the formula to assist in the determination of such allocation. Essentially, this ruling utilizes a “separate tax” approach in which each spouse’s share of the joint tax liability is determined in the same ratio as the amount of tax each spouse would have been liable for, compared to the total of such liability, if both spouses had filed separate returns. In a sense, each spouse is “compelled” to be treated as having filed separately (as married filing separately, not as singles), with income and deductions segregated and specifically allocated to each spouse. This result, while generally similar proportionately to their respective income ratios, rarely exactly tracks that way because of various nuances in the tax law. Assume that such a couple, with their taxes calculated as if they had filed as married but separately, has H with a separate tax of $5,000 and W with a separate tax of $10,000. Therefore, their combined separate taxes of $15,000 would be attributed one-third to H and two-thirds to W. That same ratio is applied to the joint tax liability in determining how much of the liability is the responsibility of each. After making such a calculation, each spouse’s share of the joint tax liability is then compared to each spouse’s actual contributions made toward the payments of that joint tax liability (generally withholding taxes). In that fashion it is then determined who is to receive what share of the refund. Note that if the refund is less than what one of the spouses is entitled to, the entire refund goes to that spouse. But absent any agreement between the spouses, there will be no tax recovery by that “shortchanged” spouse. Under any circumstances, the government (IRS) is not responsible for one spouse’s tax “obligation” to the other. When estimated tax payments are involved, it is often difficult to trace the true source of the funds. In the absence of any agreement or clear evidence as to a respective spouse’s share of the estimated taxes, the formula just described is applied to determine each spouse’s share of the estimated tax payments made. Net operating losses and other tax attributes are treated in the same manner as the respective tax liabilities described previously. The allocation rules and formula discussed previously are to be used in this situation.68 11.26

INNOCENT SPOUSE

When a husband and wife file a joint income tax return, each spouse generally is jointly and severally liable for the full amount of tax on the couple’s combined income, including any additional tax, interest, and/or penalties (except the civil fraud penalty, which can be imposed only on the spouse who actually committed fraud) assessed by the Internal Revenue Service as a result of an audit. Consequently, the IRS can pursue either spouse to collect the entire tax— not just the portion attributable to that spouse’s income. Relief from Liability on a Joint Return (Innocent Spouse).

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Included in the Internal Revenue Service Restructuring and Reform Act of 1998 (the ’98 act) are three provisions that lessen the severity of joint and several liability. The first eases the requirements for an individual filing a joint return to qualify as an “innocent spouse” and therefore avoid liability for the other spouse’s tax deficiency. The second permits joint return filers who are widowed, divorced, legally separated, or have lived apart for at least one year to make an election to limit their liability for deficiencies on a joint return. The third provides “equitable relief” for those individuals not meeting the criteria for obtaining relief under the other two provisions. Under the ’98 act, a joint return filer can elect to seek “innocent spouse” relief from liability for a tax understatement attributable to all of the other spouse’s erroneous tax items, such as unreported income or disallowed deductions. Under the old rules, innocent spouse relief was available only where an understatement of tax was “substantial” and where the items of the other spouse resulting in the understatement were “grossly erroneous.” By eliminating these criteria, the new guidelines are much simpler and fairer. To qualify under the new guidelines, an electing spouse must show that he or she did not know about the understatement and that there was nothing that should have made him or her suspicious. Furthermore, the circumstances must make it inequitable to hold the electing spouse liable for the tax. The relief is available even if the couple is still married and living together. As under prior law, community property law is not considered in determining innocent spouse relief. “New and Improved” Innocent Spouse Relief.

Separate Liability Election. In certain cases, a spouse can elect to limit his or her liability for any deficiency on a joint return to that spouse’s allocable portion of the deficiency. The election can be made only if the spouses are no longer married (divorced or widowed), are legally separated, or lived apart for the entire 12 months before the election was made. If an election is made, the tax items that resulted in the deficiency will be allocated between the spouses as if they had filed separate returns. For example, an electing spouse generally will be liable for the tax on any unreported income only to the extent that he or she earned the income. Community property law is not considered in the determination of separate liability. The election will not provide relief from a spouse’s tax items to the extent that the IRS proves that the person claiming relief actually knew about those items when he or she signed the return, unless he or she can demonstrate that the return was signed under duress. Also, relief is not available where the spouses transfer assets in a jointly contrived fraudulent scheme, that is, to protect the transferred assets from being used to satisfy a particular spouse’s tax obligation. Equitable Relief. The ’98 act also provides for equitable relief in certain cases where a joint return filer does not qualify for either the innocent spouse or separate liability election. A joint return filer may be granted equitable relief if, taking into consideration all of the facts and circumstances, it would be unfair to hold him or her liable for any unpaid tax or deficiency. Equitable relief would be available, for example, in a situation where a spouse did not know, and had no reason to know, that funds intended for the payment of tax were instead used by the other spouse for that other spouse’s benefit.

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In order to seek relief under any of the aforementioned rules, a requesting spouse must file Form 8857 no later than two years after the IRS commences collection action against him or her. If the IRS began its collection efforts on or before July 22, 1998, the date of enactment of the ’98 act, the requesting spouse will have two years from the date of the IRS’s first collection action after July 22, 1998. How and When to Make Election or Request Equitable Relief.

The Tax Court has jurisdiction to decide the limits of your liability if you make either an innocent spouse or separate liability election (but no jurisdiction exists to determine equitable relief). Consequently, should an individual be denied relief under either election, the individual may petition the Tax Court for review. The petition generally must be filed within 90 days following the date on which the IRS mails a notice of determination to the individual. However, the Tax Court will lose jurisdiction over a claim for innocent spouse relief or separate liability to a U.S. district court or the U.S. Court of Federal Claims that acquires jurisdiction for a refund suit pertaining to the same tax year(s) filed by either spouse. Additionally, except for termination and jeopardy assessments, any IRS levy and/or collection activities are barred until the 90-day period for petitioning the Tax Court has expired or a Tax Court decision has become final. Judicial Review.

PROPERTY DISTRIBUTIONS GENERAL OVERVIEW. Under current law, no gain or loss shall be recognized on a transfer of property from an individual to, or in trust for the benefit of, a spouse or a former spouse, but only if the former spouse transfer is incident to a divorce.69 Section 1041 of the Internal Revenue Code was intended to counteract the problems arising from the tax laws prior to 1984, where transfers of appreciated property between spouses incident to divorce were a taxable event. Specifically, a husband transferring his corporate stock to his wife pursuant to their divorce had to pay tax on the difference between his cost basis and the fair market value at the date of transfer. Furthermore, the wife received a stepped-up cost basis to reflect the fair market value at the time the property was received.70 The House Committee Report on TRA 1984 71 noted that tax law regarding the treatment of transfers between spouses is often unclear and resulted in much litigation. The committee also noted that in many cases, spouses giving up the appreciated property did not report the gains to the government, yet the spouse receiving the appreciated property often sold it and used the stepped-up basis. Thus, the government was losing substantial revenues. To counteract these problems, I.R.C. § 1041 was introduced. 11.27

DEFINITIONS. To qualify as a transfer incident to divorce, the transfer of property must occur within one year after the cessation of the marriage or be related to the cessation of the marriage.72 For transfers beyond one year, they cannot occur more than six years from the cessation of the marriage and must be related to the cessation of the marriage to qualify for § 1041 treatment. The term “related to the cessation of marriage” means the transfer is pursuant to a divorce 11.28

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or separation agreement. Furthermore, any transfer beyond six years from the cessation of marriage is presumed not to be related except where transfers were prevented due to legal or business hindrances.73 NONRESIDENT ALIEN SPOUSE. The nonrecognition rule of § 1041 does not apply where the spouse receiving property is a nonresident alien. Therefore, any spouse making a gift or transfer incident to divorce to a nonresident alien spouse shall pay tax on any built-in gain of the property transferred, similar to the law prior to 1984.74 However, with resident alien spouses there are potential gift tax consequences with transfers greater than $10,000. 11.29

11.30 ANNULMENTS. Annulments that terminate a marriage are considered the same as divorces for the purposes of § 1041, Treas. Reg. § 1.1041-1T(a)(A-8). EFFECTIVE DATES. Section 1041 took effect for transfers after July 18, 1984, the date of the Tax Reform Act of 1984.75 A special provision of the act applies to transfers before July 19, 1984, but after December 31, 1983, wherein both spouses could elect to have § 1041 apply. The election involves a consensus of both spouses to have a tax-free exchange and transfer of basis. A divorced couple also can agree to have § 1041 apply to transfers after July 18, 1984, pursuant to divorce or separation agreements created prior to that date. However, the election must apply to all assets transferred after July 18, 1984. A piecemeal election for particular assets is not available.76 11.31

BASIS OF TRANSFEREE. The transfer of property between spouses or former spouses incident to divorce is treated similar to gifts. The transferee receives the transferor’s basis, I.R.C. § 1041(b), and neither recognizes a gain or loss at the time of the transfer.

11.32

APPRECIATED OR DEPRECIATED PROPERTY. Whether the property transferred under § 1041 is appreciated or depreciated in value, the recipient will acquire the basis of the transferor. Recapture rules of I.R.C. §§ 1245, 1250, and 1254 will not apply at the time the transfer is made, but apply when the transferee sells his or her interest in the property.77 11.33

ANNUITY. Where an annuity is transferred incident to divorce or separation, the transferee steps into the shoes of the transferor. If there is any unrecovered investment basis in the annuity, the transferee will use up the basis in the same manner as the transferor.78 11.34

JOINTLY OWNED RESIDENCE. In a transfer of one-half interest in a jointly owned residence from one spouse to another, the recipient spouse can use the entire joint cost basis when he or she sells the house. If monies are exchanged to or from the spouse keeping the home from or to the spouse relinquishing the home, no gain or loss is recognized by either because the exchange, including the funds, is treated as a gift.79 The spouse keeping the home, therefore, does not receive an increase in basis from buying out the other spouse. 11.35

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11.36 INSTALLMENT SALES. Transfer of an installment obligation to a spouse or former spouse will not accelerate any deferred gain except where the installment obligation is transferred to a trust.80 11.37 LIABILITIES EXCEED BASIS. Section 1041 basis transfer extends to situations where liabilities exceed basis in the property transferred, except where the property is transferred to a trust.81 For example, assume that Spouse A owns a rental home that has an adjusted basis of $50,000 and a $60,000 mortgage. As part of the divorce agreement, Spouse A must transfer the property to Spouse B. No gain or loss is recognized by Spouse A; Spouse B’s basis in the property is $50,000, the same as Spouse A.82 Or assume the same facts, except Spouse A transfers the property to a trust set up for the purpose of settling the divorce. Spouse A will have to recognize a $10,000 gain ($60,000 liability less the $50,000 basis) on the transfer to the trust; the basis in the trust becomes $60,000. SUPPLYING INFORMATION TO TRANSFEREE. The transferor/spouse must supply the transferee/spouse with sufficient records to determine the basis of property transfers qualifying under I.R.C. § 1041. The information reporting requirement extends to include the potential for investment tax credit or § 179 expense information.83 For example, assume that Spouse A owns a commercial building that qualified for historical rehabilitation credits. The credit will be recaptured proportionately over a five-year period if, within five years of the credit qualification, the property is sold or its use becomes nonqualifying.84 Suppose, as part of the divorce, Spouse A is required to transfer this property to Spouse B, and at the time of the transfer the rehabilitation credit qualifying date is less than five years old. If Spouse B sells the property, he or she will be subject to an investment credit recapture. Spouse A need only supply the facts, namely, cost, date of purchase, original date of credit, amount of qualified expenditure, and rate of credit. The onus is on Spouse B to interpret the tax ramifications of holding or changing the use of the property. He or she should seek professional advice on this matter. Other properties to be concerned about under this requirement are those that had been used in business and on which the taxpayer received special business tax treatment, such as § 179 expenses or investment tax credits. 11.38

11.39

TRANSFER OF BASIS UNDER § 1041 VERSUS NONSPOUSAL GIFT RULES.

Although transfers between spouses or ex-spouses incident to a divorce are treated as gifts, there are four differences the practitioner should be aware of between gifts to spouses or ex-spouses and gifts to others: 1. In a gift to a nonspouse where the property’s current value is less than the cost, the lower current value is the basis to the transferee.85 2. Where the liabilities attached to a nonspousal gift exceed the basis of the property, the transferor must recognize income to the extent the liabilities exceed cost. The basis to the transferee becomes the transferor’s cost plus any taxable gain recognized.86

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3. Gifts of more than $10,000 (indexed after 1997) a year to any nonspouse must be reported to the IRS on a gift tax return. Interspousal gifts are exempt from this filing.87 4. Where installment obligations with deferred gains are gifted to a nonspouse, the transferor must recognize the remaining gain at the time of the gift.88 In all of these situations, where the gift or transfer is made directly to a spouse or former spouse incident to divorce, no gain or loss is recognized and the transferor’s basis becomes the transferee’s basis. 11.40 TAXABILITY AND DEDUCTIBILITY OF INTEREST ON INTERSPOUSAL BUYOUTS. A recent Tax Court decision (T.C. Memo 1997-196; Gibbs v. Commissioner)

was, in the author’s opinion, surprisingly taxpayer-adverse as to the taxability of interest on the buyout by one spouse of another’s interest in the marital estate. In Gibbs, the Tax Court found that interest received on account of equitable distribution time payments were taxable to the recipient. The taxpayer-favorable contra to this decision was Seymour, 109 TC No 14 (1997), which clarified the deductibility of the interest by the payor — to the extent that the interest could be traced to liabilities which in turn could be traced to specific assets or group of assets. To the extent that those assets were the type where interest expense relevant to carrying same would be deductible, such deductibility was permitted. Further, in the alternative, where capital assets were involved, the interest was considered to be additional basis in that property where the interest was not deductible on a current basis. It is certainly questionable whether the framers of § 1041, in the rational way in which this section approaches and therefore facilitates the division of marital assets by removing significantly all of the immediate tax issues, had intended to cause interest that might be paid over time to be considered taxable to the recipient. Further, since, unlike a standard commercial transaction, there is no right of the IRS to impute an interest factor where interest is unstated in a long-term § 1041 buyout, it would seem that the intent was clearly to minimize the tax complications that so often distort how taxpayers and their advisors approach what should otherwise be a straight economic deal. Nevertheless, Gibbs does make it clear that the current position is that where interest is stated in a series of equitable distribution payments, that interest will be taxable to the recipient. This would appear to be a fairly easy issue to avoid — assuming that it is desirable to avoid explicitly indicating interest. Protective language in the agreement as to the interest not being intended as taxable may be of some help — but it is certainly by no means assured that such language would carry any weight with the IRS. Likely it will not. However, interest also can be factored into the agreement by taking the interest into account and then stating the agreement payment terms without expressing that any of it is interest. This complicates the situation a bit (especially as to the possibility of prepayment) but is a way around creating taxable interest income in the context of equitable distribution payments. However, Seymour also clearly raises the issue that depending on to which assets the interest is attributable, it can be deductible (or at least added to the basis) by the payor. For instance, if the payments were to split up a stock portfolio, the interest expense on same would be considered investment interest. It is not clear from Gibbs or Seymour if it is necessary for the interest to be taxable to

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the recipient in order for the payor to be able to deduct it. However, it would not be surprising if that were the IRS’s position. 11.41

MARITAL RESIDENCE

Sales after May 6, 1997

The Taxpayer Relief Act of 1997 radically changed the treatment of a sale of principal residences. Old law (§ 1034 and old § 121) is discussed following this section. Generally, an exclusion of up to $250,000 ($500,000 in case of taxpayers filing a joint return) of gain realized is allowed on the sale or exchange of a principal residence for a taxpayer who owned and occupied the home as a principal residence for at least two years of the five year periods prior to the sale date.89 In the case of joint filers not sharing a principal residence, each spouse may exclude up to $250,000 provided he or she would have been eligible as separate filers. When a single taxpayer who is otherwise eligible for the exclusion marries someone who has used the exclusion within the two-year period prior to marriage, he or she can still exclude up to $250,000 after marriage. Once both spouses satisfy the eligibility rules and two years have passed since the last exclusion, the couple may then exclude up to $500,000. The exclusion is available once every two years after the previously excluded sale event. Exception to the two-year rule applies when there is a change of home due to employment, health, or other types of involuntary circumstances. Under these circumstances, the two-year period is prorated and multiplied by the appropriate exclusion amount. For instance, if the move happens eight months (240 days) after prior eligible sales, the taxpayers would apply 240/730ths of the $250,000 (or $500,000 for married joint filers).90 General examples:

• The Moores bought a home for $100,000 in 1980. On September 1, 1997, they sold the home for $450,000 at a gain of $350,000. Assuming the home was used as a principal residence by both for two out of the past five years, the Moores will exclude all of the gain. • Assume Mrs. Moore buys the house above prior to marriage in 1980. On December 1, 1997, Mr. Moore sells his previously owned home that satisfied the ownership and use requirements and excluded a $50,000 gain. They marry on June 1, 1998, and move into Mrs. Moore’s home. The home is sold on July 25, 1998, at a gain of $350,000. Since Mr. Moore used his exclusion within the two years of the marital residence sale, only $250,000, the amount applicable to Mrs. Moore, of the $350,000 gain is excludable. • Assume on December 1, 1998, the Moores sell the home because Mr. Moore is required to move due to a job transfer. The exclusion is $375,000 ($250,000 attributable to Mrs. Moore plus 365/730 [one-half] of Mr. Moore’s $250,000). Code § 121(d)(3)(B) has alleviated many of the problems that couples going through a divorce faced under old § 1034 by allowing Divorced or Separated Couples.

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the ownership and use requirement of both spouses to extend to the spouse who remains in the home after separation or divorce agreements. As demonstrated in the old law segment §§ 1034 and 121 to follow, this area of controversy regarding the spouse that leaves has been litigated extensively with mixed results. The 1997 act states that a divorce or separate maintenance agreement granting use of house to one spouse is needed in order for the departing spouse to extend the use requirements for the gain exclusion. For instance, let’s assume Mr. Deets leaves the marital home on June 1, 1998, and files for divorce on September 1, 1998, and a decree of separate maintenance is issued on November 1, 1998, granting the use of the home to his wife. In a literal interpretation of § 121(d)(3)(B), Mr. Deets’s use requirement is suspended for the period from June 1, 1998 (when he left the home) until November 1, 1998, date of the separation agreement. After November 1, 1998, his use requirements are consistent with those of his ex-wife (or estranged wife). What about the person or couple who has a home where there is more gain than the exclusion? There are no routine options in this matter, and the § 1034 rollover is no longer available. This new rule was not intended to aid the highnet-worth individual but is a significant tax break for the middle class. Sales prior to May 7, 1997 Tax-Free Rollover of Profit (Old Law). The tax-free rollover provisions of § 1034 apply only where the home sold is the taxpayer’s principal residence. To take advantage of the tax-free rollover, the taxpayer must purchase a replacement residence that costs more than the old residence, and it must be purchased and used within two years either before or after the old home was sold. For example, assume the Pragers purchased their first home on January 1, 1980, for $75,000, and on January 1, 1990, they sold it for $175,000. The gain on the home is $100,000. On June 30, 1990, they purchased a replacement residence for $185,000. Since the purchase price of the new residence is greater than the selling price of the old, and the new residence was purchased and used within the two-year period, the Pragers are subject to the tax-free rollover provisions of § 1034. Note that in a qualifying sale and purchase as illustrated, the taxfree rollover was mandatory.91 This was repealed with the Taxpayer Relief Act of 1997.

Gain is split when a jointly owned home is sold by divorcing spouses. The husband and wife split the proceeds and any gain equally, and the rollover provisions of § 1034 will apply to each spouse separately.92 For example, in our previous example involving the Pragers, assume that as part of the couple’s divorce in 1990, they sold their home. The gain of $100,000 is divided equally— $50,000 for each spouse. If each purchased a replacement home for more than $87,500 (one-half of the old home’s selling price) within the twoyear period, both parties qualified for the tax-free rollover treatment of § 1034. If Mr. Prager purchased a replacement home for greater than $87,500 and Mrs. Prager did not, Mr. Prager will qualify for the tax-free rollover and Mrs. Prager will not. Sale in a Divorce Situation (Old Law).

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Title Transferred to One Spouse (Old Law). If one spouse keeps title to the jointly owned residence after the divorce, he or she inherits the basis that both had while married.93 As part of a property settlement, consideration is frequently given to one spouse for half of the home. Section 1041 dictates that in such a case the spouse who keeps the home in exchange for giving up property (cash or other) pursuant to a divorce receives no step-up in basis in the home, but rather assumes what was formerly both spouses’ combined old basis.94 For example, assume that as part of their divorce in 1990, Mr. Prager gave up his one-half interest in their home, and Mrs. Prager gave him $87,500 consideration. In 1991, Mrs. Prager sells the home for the same $175,000. Mrs. Prager’s basis is still $75,000 and she must buy another house within two years for $175,000 or more to avoid tax on the $100,000 gain. The practitioner should be clear on these rules when property settlements are set forth in a divorce. In the above example, Mrs. Prager, in order to pay Mr. Prager the $87,500 for his half, could have borrowed $87,500 from the bank as a second mortgage, and there may have been an existing $60,000 first mortgage on the property when it was sold, leaving $27,500 of cash to Mrs. Prager after the sale. If she couldn’t afford or failed to replace the property within two years, there may be a $28,000 tax (assuming a 28 percent tax bracket), thus leaving her with no net proceeds. Joint Title Kept after Divorce (Old Law). If both spouses continue joint ownership of their marital home after a divorce, one spouse will inevitably move out of the home. A spouse who leaves has given up the home as a principal residence. Therefore, the tax-free rollover of the home may be available only to the remaining spouse.95 For example, assume in the case of Mr. and Mrs. Prager that on January 1, 1989, Mr. Prager moved out of the home to a rental apartment as part of their separation. As part of the divorce settlement in 1990, both kept title to the home. On January 5, 1991, they sold their home for the same $175,000. Mrs. Prager is eligible for the tax-free rollover, but Mr. Prager is not. He must pay tax on his onehalf of the $100,000 gain. He is not eligible for the rollover provisions of § 1034 because he left his principal residence on January 1, 1989, and replaced it with a rental apartment. Alternatively, assume that Mr. Prager moved out January 1, 1989, and simultaneously bought a condominium for $100,000, and further suppose the marital home was sold on December 1, 1990. In this case, Mr. Prager was eligible for the tax-free rollover provisions because he replaced the old residence with a more costly residence (as to his half) within the two-year period. In the Young case, the court agreed with the IRS that when Mr. Young abandoned his marital home and moved into a rental apartment, the rental apartment became his new principal residence. Therefore, when the marital home was sold, Mr. Young was not allowed the rollover of gain. This rule often surprises people, but Tax Court cases have held the rollover rules under § 1034 to be quite rigid. There is general agreement that when a spouse leaves involuntarily (in our example, the separation), that person has not abandoned the home as a principal residence. The common example is where an employee, on account of a job, is temporarily transferred and then moves back. The IRS has contended that the

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home is no longer the principal residence, but the courts have found otherwise.96 As an analogy, when does a separated or divorced spouse abandon the home as the principal residence? There is an argument that when a spouse leaves the home due to divorce or separation, it is as involuntary as a temporary job transfer, except that the spouse has no intention of returning. Despite this argument, it was better divorce tax planning if the spouse remaining in the home took title to the home where practical and marital assets are divided, giving the absent spouse credit for giving up home ownership. Taxpayers over age 55 could exclude up to $125,000 ($62,500 in the cases of a separate return by married individuals) of the gain from the sale of a principal residence.97 The taxpayer (either one or a joint return) must have reached age 55 before the time of the sale; and during the five-year period prior to sale, the home must have been owned and used as a principal residence by the taxpayer for periods aggregating three years or more.98 The exclusion of the gain was a one-time election for up to $125,000. Thus, if a taxpayer over age 55 has a gain of $55,000 and makes the election, he or she cannot make the election again for the remaining $75,000.99 Taxpayers Over 55: General Rules (Old Law).

The determination of marital status was made on the date of sale. If the spouses were legally separated under a decree of divorce or separate maintenance prior to sale, then they are not considered married on the date of sale.100 The Tax Relief Act of 1997 superseded the old law even if the over 55 exclusion had been used prior. Marital Status.

11.42

TRANSFERS AND REDEMPTION OF CORPORATE STOCK

The asset of greatest value in many marital estates is often a closely held corporation owned by either spouse. Often, in order for the husband and wife to split assets in an agreed amount, part of such split may be tied up in a corporation. Therefore, one of the spouses will have to incur an outlay of cash to relieve the obligation. Common Problems.

One consideration is for the corporation to redeem stock. This could be costly. If the divorce or separation agreement legally requires a redemption by the owner/spouse, the corporate redemption could be construed as a dividend to the owner/spouse even though the buy-out of the other spouse falls under the rules of § 1041 (tax-free transfer). Hence, the monies drawn from the company to buy out the nonowner spouse will be construed as a taxable distribution to the owner spouse.101 Conversely, the proceeds would be tax-free to the nonowner spouse. If the nonowner spouse receives stock as part of the divorce and if the redemption is not required by the divorce or separation instrument, the stock redemption can become taxed as a capital gain transaction to the selling spouse if he or she meets the requirements of § 302(b). To meet the § 302(b) requirements, the redemption should be delayed until after the divorce decree is final and the selling spouse can have no corporate ownership interest after sale, and he or she cannot be related to any remaining shareholder.102 If these requirements are not Stock Redemptions.

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met, the redemption is a dividend taxable to the selling spouse without a deduction for basis. One exception, when the redeeming spouse is related to a remaining shareholder, is attainable if he or she retains no interest in the corporation after the redemption in any capacity including being an employee or officer, and he or she does not acquire an interest in the company for 10 years after redemption. The spouse must file an agreement to notify the IRS commissioner if he or she acquires an interest within the 10 years.103 Tax-Planning Tips Related to C Corporations

• The divorce agreement should stipulate the transfer of stock from one spouse to another with no obligation of the other spouse or the corporation to redeem shares. When the spouse’s shares are ultimately redeemed, he or she alone is taxed on the redemption. • In this situation, the practitioner should be sure that the redeeming spouse meets the requirements of §§ 302(b) and 302(b)(3). • Where one spouse is required to buy out the other’s stock and lacks personal funds, a corporate loan may be used by the acquiring spouse to pay the other. Be warned, however, that the loan must be properly documented with a reasonable rate of interest and a fixed term, otherwise the loan could be construed as a dividend.104 • If both spouses are shareholders, and the husband, for example, is required to buy out the wife as part of the divorce, the monies paid to the wife are tax-free to her and do not increase his basis.105 Therefore, to equalize taxes, that should be taken into account in providing for an equitable (or other) allocation between spouses. PASSIVE ACTIVITY LOSS CARRYOVERS. Where an individual gifts an interest in a passive activity such as limited partnerships or rental properties, the basis of such interest immediately before the transfer shall be increased by the amount of any passive activity losses allocable to such interest when there is a carryover of unused passive losses.106 However, is the rule the same for transfers between spouses? For example, assume that in January 1998, John purchased a limited partnership interest for $100,000. The 1998 loss for the partnership was $25,000 and is deemed to be a passive activity loss. The unused loss was carried over to 1999 because there was no passive activity income to offset the loss. In January 1999 John gifts his interest to his son. His son’s basis in the partnership interest becomes $100,000 — $75,000 basis ($100,000 ⳮ $25,000) plus the $25,000 passive loss carryover. John, on the other hand, gets no loss in 1999 on the dispositionof the passive activity.107 This assumes that the fair market value of the investment is equal to or greater than $100,000. Senate Finance Committee Report on TRA 86, at 725 n.12. § 1041(b) prescribes interspousal transfers to be treated as gifts, but states further that the basis of the transferor becomes the basis of the transferee.108 There are no known exceptions to this rule on transfers between resident spouses. In this example, John’s adjusted basis, prior to the gift, is $75,000 ($100,000 investment less the $25,000 loss), despite the suspended passive loss carryover 11.43

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of $25,000. If John transfers his partnership interest to his ex-wife pursuant to their divorce instead of to his son, does John’s ex-wife use a basis of $75,000? What happens to John’s suspended losses? In a literal sense, suspended losses do not enter into the calculation of basis to the transferor of property; they are separately tracked. The Senate Finance Committee’s report on TRA 86 discussed gifts and the treatment of suspended losses. Experts are not in agreement that the gifts comment relates to transfers incident to divorce or between spouses under § 1041 and that the suspended losses of the transferor spouse get added to the basis of the transferee spouse. Although there have been no Revenue Rulings on this issue to date, it is clear in § 469(J)6 that the donor’s basis in the gifted passive activity is increased immediately prior to gift by the suspended losses. Therefore the donee spouse would not be changing the basis because the suspended loss has been added to the donor spouse’s basis prior to gift. 11.44 EQUITABLE DISTRIBUTION AND RETIREMENT PLANS. Another major asset involved in a divorce is one’s interest in a retirement plan. Many times the retirement plan is the major source of liquid assets available when married couples divorce. However, there are usually restrictions and tax consequences when retirement distributions are made from plans. The nonparticipant spouse generally would prefer to receive other marital assets because he or she receives the monies or property immediately and often without tax consequences. Qualified Domestic Relations Order (QDRO). Many qualified plans contain an antiassignment or alienation rule that prohibits the transfer of plan assets to a third party or restricts preretirement withdrawals.109 In 1984, I.R.C. § 401(a)(13)(B) was added to counteract the antiassignment and alienation rules solely for the purpose of facilitating the financial split in a divorce. A QDRO is a court order that relates to marital property rights, child support, and alimony. It establishes an ex-spouse’s right to receive (as the alternate payee) a portion of a participant spouse’s benefits under a retirement plan. A QDRO must include four things:

1. The name and address of the participant and alternate payee 2. The amount or percentage of benefits to be paid to the alternate payee or alternative methods of computing the percentage 3. The number of payments or period to which the order applies 4. A listing of each plan to which the order relates110 A QDRO cannot require the plan to alter the form of benefits or the time in which they are payable.111 However, a QDRO can require a plan to pay the present value of accrued benefits to the alternate payee on or after the participant reaches the earliest retirement age, regardless of whether the participant is required to be separated from service to be entitled to a distribution.112 Generally, an early distribution from a qualified plan is subject to a 10 percent penalty.113 Distributions under a QDRO are excepted from this penalty. Be aware that any amounts paid to an alternate payee under a QDRO are includable in the recipient’s gross income.114 In 1984, the Retirement Equity Act (REA), Pub. L. No. 98-397, provided, however, that lump-sum distributions received by an alternate

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payee from a qualified plan can be rolled over into another qualified retirement plan or an individual retirement account (IRA). A lump-sum distribution means that the entire participant’s plan asset balance is distributed within one tax year.115 A rollover is a tax-free transfer from a qualified retirement plan to another qualified plan or to an IRA. The transfer must be made within 60 days of the distribution. Under REA, an alternate payee is a spouse, former spouse, child, or other dependent who is recognized by a QDRO as given a right to receive plan benefits.116 The person receiving direct benefits normally pays the tax. However, under TRA 86, an amendment was introduced where, if the alternate payee is other than the participant’s spouse or ex-spouse, the participant will pay the tax.117 For example, if the QDRO specifically names a participant’s son as the alternate payee, the participant will pay the tax, not the son. In addition, those QDRO funds cannot be rolled over by the son. The transfer of one spouse’s interest in an IRA to the other spouse or former spouse’s IRA under a divorce or separation instrument is not considered to be a taxable transaction.118 Thus, pursuant to such agreement, the funds can be easily transferred. The recipient spouse, upon transfer, bears the ultimate tax consequences when he or she withdraws the monies for personal use. IRAs can be treated essentially the same as qualified retirement plans, but they are not the subject matter for a QDRO. Unlike funds received from a QDRO from a qualified plan, funds received from an IRA are not excepted from the 10 percent premature distribution penalty tax.

Individual Retirement Accounts.

11.45

ALIMONY AND SUPPORT TRUSTS

Alimony Trusts. In a divorce situation, there are often elements of distrust between the divorcing parties in the area of money management. A husband may believe that his wife cannot manage money properly and would spend all of her equitable distribution frivolously. On the other hand, the wife may feel that the husband cannot be trusted to make timely alimony or support payments. One way to alleviate this sense of insecurity is the use of a trust. An alimony trust (or I.R.C. § 682 Trust) provides a guaranteed amount to be paid to an ex-spouse. An agreed-upon sum is set aside in a trust. The income, plus or minus any shortfall or overage to satisfy the alimony requirement, is paid out of the trust. When the alimony obligation is completed, the trust principal reverts back to the maker of the trust. The income from this kind of trust is taxed to the receiver of the alimony or the beneficiary.119 Since alimony is deductible, the shifting of income through the use of trusts accomplishes the equivalent. Once a husband, for example, transfers trust monies to a designated alimony trust, he no longer pays taxes on the earnings. He does not get a deduction, however, for the transfer of money to the trust. For example, suppose Mr. Money is required to pay $15,000 a year in alimony for 10 years. Instead of paying this amount, he sets up a $150,000 trust, with his ex-wife as beneficiary, and invests the funds. Mrs. Money will receive $15,000 a year and pay tax on the earnings of the trust. Mr. Money pays no tax and accomplishes the same goal as if he paid the annual alimony directly, where he would have $15,000 of interest income and a $15,000 alimony deduction. If the trust, in a given year, earns $13,000, however, and distributes $15,000, Mrs. Money will

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pay tax on the $13,000 amount because the beneficiary pays tax on the distributable income of the trust.120 On the other hand, if the trust earns $17,000 in a given year, Mrs. Money will pay tax on $15,000 because the beneficiary income is limited to the amount of the distributed income. The remaining $2,000 is taxes to the trust directly. At the end of 10 years, the remaining principal in the trust reverts back to Mr. Money. If a parent is legally obligated to support a child, the income of a trust set up for the purposes of providing said support will be taxable to the maker of the trust.121 If the trust continues beyond the parent’s legal obligation to provide support, the taxable income and tax obligation transfers to the child beneficiary. Support Trusts.

11.46

EFFECT OF DEFERRED TAXES UPON EQUITABLE DISTRIBUTION

Fair Equitable Distribution. A divorcing couple can have assets of $1 million, for example, but when the assets are divided in a divorce, the contingency for future tax liability is sometimes ignored. For example, assume that the marital assets and cost bases for Mr. and Mrs. Falk are as follows:

1. Rental property 2. Marketable securities 3. Cash

FMV $300,000 200,000 $1,500,000 $1,000,000

Cost Basis $100,000 50,000 $500,000 $650,000

Suppose the divorce agreement calls for Mrs. Falk to get the cash and Mr. Falk to get the rental property and marketable securities. This distribution is not truly equal. Mr. Falk is left with assets that have a potential gain of $350,000. If all were sold by him, the federal tax liability would be as high as 39.6 percent, or in excess of $100,000. Therefore, Mrs. Falk received more than Mr. Falk from a tax viewpoint. On the other hand, Mr. Falk may not sell those assets for years, or may die with his estate receiving a step-up in basis. Furthermore, how much should a present allocation calculation take into account taxes that may be years away? The practitioner should be prepared to consider the tax effects of distribution and negotiations should set forth tax implications. New Jersey courts, for example, have been inconsistent in taking into account the tax implications of marital assets. In one case, the court decided that taxes deducted from a marital balance sheet on the potential tax gains of the assets is improper. The court indicated that the tax contingencies were “too speculative” to permit a value deduction.122 However, the court did decide that the deferred or hypothetical taxes should be considered in the equitable distribution. Assets to Consider.

The following is a list of common assets that have tax

implications: • Closely held businesses. Often there is substantial value and little cost basis. If one spouse is required to buy out the other, there is generally no tax cost to the selling spouse and no basis increase to the buying spouse.

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• Retirement plans. These are fully taxable to the recipient if funded by the employer or are from pretax employee monies, such as a 401(k). Often a spouse will be granted a percentage interest in the other spouse’s plan, expressed as a dollar value, and the participant spouse will pay this from other marital assets (the value offset method). In this instance, no tax is paid by the recipient spouse, but the tax issue should be considered as some form of credit to the participant spouse. • Rental properties or second homes. Tax contingencies may be relevant. • Marketable securities. Tax contingencies may be relevant. • Cash value of life insurance policies. If surrendered prior to death, a tax is paid on the difference between the investment in the policy and the cash surrender value. Although the presentation of a partial balance sheet offset by potential deferred taxes is not acceptable in many state courts, the practitioner should nevertheless keep in mind these potential liabilities when negotiating a fair settlement. It is also important to appraise the settlement package in its entirety; a potential tax burden accepted as part of receiving one asset might be compensated for by the other spouse accepting a different asset with a similar potential tax burden. Structure the broad settlement first, then refine it by dealing fairly with the tax ramifications. 11.47 TAXES — HYPOTHETICALLY SPEAKING. A somewhat constant concern in divorce litigation is whether, and if so to what extent, to take into account hypothetical (some might call theoretical) tax liabilities on assets being subjected to equitable distribution. There would be no difference, by the way, were we dealing with a community property state and the dividing up of those assets. Even in a relatively simple divorce, there may be assets such as cash in the bank, marketable securities, pension or other retirement plan benefits, and the marital home. It does not require that much more of a complex situation to then add in such assets as investment or rental real estate, an interest in a closely held business, and stock options. And we haven’t even yet considered complex items, such as net operating loss carry forwards, passive activity loss attributes, assets with negative basis, and the like. With the exception of the first item — cash — each and every one of these assets is likely to carry with it certain tax issues, in most cases tax burdens, and in some cases possibly even tax benefits (where the cost or basis is greater than the current value). This section’s purpose is not to provide the reader with a tax technical analysis of the various types of tax concerns and how to plan to minimize the taxes or avoid them. Rather, it discusses the pros and cons of the subjective issue of the degree of consideration appropriate to be given where there are latent tax liabilities attached to various assets — and where, as a result, the dividing up of assets is more complex than merely giving each party an equal (or otherwise determined percentage) dollar value of assets. As a brief and simple illustration of the importance of this issue, consider the following all-too-common hypothetical: You have a simple marital estate, consisting of some cash, stock, a house and a pension. It has been agreed that the assets will be divided equally. The proposal was as shown in Exhibit 11.1.

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EXHIBIT 11.1

Proposed Asset Distribution

Assets Cash Securities House Pension

Husband $ 10,000 50,000 1 240,000

Wife $100,000 1 200,000 1

TOTALS

$300,000

$300,000

On one hand, the above gives each party equal value. On the other hand, that is misleading because the tax issues were not taken into account. The cash has no tax issues; the securities, while having a value of $50,000, only cost $30,000, leaving a gain of $20,000 — and an estimated tax burden on that gain of $4,000; the marital home, while it has appreciated significantly, because of the new tax law, is free and clear of a tax burden; and the pension is totally taxable, which carries with it an approximate tax burden expected to be about 35 percent — $84,000. Therefore, giving the wife the house and some cash, equalizing the husband’s combination of cash, securities, and pension, leaves all the tax burdens with the husband. Do any standards in the accounting profession require the expression of the latent tax liabilities? The answer is, kind of. If we were to prepare a financial statement in accordance with American Institute of CPA (AICPA) promulgated standards, it would be required to reflect the potential tax burdens attachable to these assets. That is, AICPA standards require, in the presentation of a personal financial statement stated at market values, that there is an assumption of a realization of said values at that time, thereby requiring a calculation and expression of the extent of the estimated taxes. That might be all well and good as a theoretical approach to the presentation of a financial statement. However, it is not necessarily realistic in the context of a divorce and the sense of equity that we need to address. Let us discuss the various issues as to reflecting the full extent of a tax burden. Clearly, subject to negotiations and whatever other factors play into the role, some part of the tax burden can be factored into a settlement. Taxes Should Not Be Taken Into Account

• The estate tax laws in this country can provide substantial tax burden relief via the step-up to market value at death, along with the estate exclusion — and possibly even no estate tax. Why factor in a tax burden that may be totally, or partially, eliminated/avoided if the asset is held until death? • Refinancing various properties is at times a possibility, meaning that an appreciated asset represents an opportunity to borrow against same, taking out cash, and thereby giving you the benefit of use of the value of that asset without having to sell it and incurring a tax burden. This doesn’t avoid the tax, but it can defer it for quite some time — and a tax deferred is, to a degree, a tax avoided. • Taxes are due when a property is disposed of or sold (transfers between spouses being an exception). If the sale of the asset is uncertain, or better if

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it is unlikely, then when the tax burden will be experienced is uncertain, as well as the amount of the tax. Even using today’s tax rates could be misleading because tax rates do change. Of course, this is not to ignore that if the asset is expected to be sold soon, especially if it is being sold for purposes of generating liquidity for the divorce action, then it is appropriate to take into account the attendant taxes. • Arm in arm with the uncertainty of when the tax will be experienced (to say nothing of whether it will be experienced) is the time value of money. If the tax burden is likely years away, why should one spouse receive the benefit of reducing what is deemed to be received by him or her by a tax that, if to be paid at all, will not be paid for many years? • Assets and items of tax consequence usually do not exist in a void. That is, there may be other assets, perhaps having losses, which can be used to offset the asset under consideration here with a gain. Therefore, it is possible to reduce or eliminate a tax on an appreciated asset by disposing of it and a loss asset in the same year. • Are taxes in some way comparable to commissions? It is the current standard in New Jersey that commissions related to the sale of a home are not a factor in determining value. If it is not considered appropriate to reduce the value of a house for hypothetical commissions to be incurred upon a potential distant sale, why should taxes be considered any different? • An installment sale will stretch the tax burden out over some period of time and might even reduce the tax burden. (It can also increase it.) This is another facet of the time value of money issue. • For those a bit more sophisticated, there is also the possibility of swapping or exchanging an existing property for another — often referred to as a like kind exchange. In this manner, one may avail him- or herself of tax deferrals. Taxes Must Be Taken Into Account

• Simply, it is unfair to ignore a tax burden that you know is there and that will happen at some point in time. If there is a gain, it is fairly certain that there will be a tax or an offset against another asset with a loss, the using up of a tax benefit. Either way, there is a cost — a tax— to this asset. • The act of determining value assumes some form of asset sale so as to realize that value. If there is such an assumption, and the value is predicated upon its theoretical sale or fair market value, the tax that would be incurred were one to realize such value should be taken into account. • It is a fairly common and accepted approach, at least as to the value of a retirement plan benefit, that it is appropriate to factor in the tax burden attached to the pension benefit. Why should other assets be treated differently? • The AICPA requires that personal financial statements, when stated at market value, must reflect the tax consequences of such market value. If that is the standard by which the AICPA requires such presentations, shouldn’t that therefore be the standard by which parties going through a divorce need to reflect the true values of their assets?

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Certainly there is no simple or single answer. And what may be fair in one situation may not necessarily be fair in another. Ultimately, all technicalities aside, it would seem that being fair is perhaps the most crucial issue here — and that, of course, is a subjective call. NOTES This chapter was coauthored by Kalman A. Barson, CPA/ABV, CFE, CVA, and by Leonard M. Friedman, CPA/ABV, CBA, CVA, with technical assistance by Theodore S. Spritzer, CPA. 1. I.R.C. § 219(f)(1). 2. Pub. L. No. 98-369. 3. Pub. L. No. 99-514. 4. I.R.C. § 71(b)(1)(D). 5. Treas. Reg. § 71-1T(b)(A-8). 6. Treas. Reg. § 1.71-1T(b)(A-8). 7. Treas. Reg. § 1.71-1(b)(2). 8. I.R.C. § 71(b)(2)(A). 9. I.R.C. § 71(b)(2)(C). 10. I.R.C. § 71(b)(2)(B). 11. I.R.C. § 71(b)(1)(A). 12. Treas. Reg. § 1.71-1T(b)(A-6). 13. Treas. Reg. § 1.71-1T(b)(A-6). 14. I.R.C. § 71(b)(1)(D). 15. I.R.C.§ 71(f)(1). 16. I.R.C. § 71(f)(4). 17. I.R.C. § 71(f)(3). 18. I.R.C. § 71(b)(1)(C). 19. Treas. Reg. § 1.71-1T(b)(A-9). 20. I.R.C. § 71(f)(5)(B). 21. I.R.C. § 71(f)(5)(A). 22. I.R.C. § 71(f)(5)(A). 23. I.R.C. § 71(f)(5)(C). 24. I.R.C. § 215(b). 25. I.R.C. § 71(c)(1). 26. Emmons v. Commissioner, 36 T.C. 728 (1961). 27. I.R.C. § 71(c)(2)(A). 28. I.R.C. § 71(c)(B); Treas. Reg. § 1.71-1T(c)(A-16). 29. Bodin v. Commissioner, 47 T.C.M. (CCH) 143 (1984); Hau v. Commissioner, 46 T.C.M. (CCH) 471 (1983). 30. I.R.C. §§ 151(c)(1)(B), 151(c)(3), 152(a). 31. I.R.C. § 151(c)(1)(A). 32. I.R.C. § 152(e)(1). 33. I.R.C. § 152(e)(1)(A)(iii). 34. I.R.C. § 152(e)(1)(B). 35. I.R.C. § 152(e)(2)(A). 36. I.R.C. § 152(e)(2)(B); Treas. Reg. § 1.152-4T(a)(A-3). 37. Treas. Reg. § 1.152-4T(a)(A-4). 38. I.R.C. § 152(c)(1)(3), Treas. Reg. § 1.152-3(a). 39. I.R.C. § 152(c)(2).

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40. I.R.C. § 152(c)(4). 41. I.R.C. § 152(e)(4). 42. I.R.C. § 152(e)(4)(B)(iii). 43. I.R.C. § 6013(a). 44. I.R.C. § 7703(b). 45. I.R.C. § 7703(b)(3). 46. I.R.C. § 7703(b)(2). 47. I.R.C. § 7703(b)(1). 48. I.R.C. § 2(b)(1). 49. I.R.C. § 2(b)(1)(A)(i); Rev. Rule. 55-329. 50. Treas. Reg. § 1.2-2(c)(1). 51. Treas. Reg. § 1.22(c)(1). 52. I.R.C. § 2(b)(1)(A)(i); Rev. Rul. 55-329, 1955-1 C.B. 205. 53. Treas. Reg. § 1.2-2(b)(3)(i). 54. I.R.C. § 151(c)(2). 55. I.R.C. § 151(c)(1)(A). 56. Treas. Reg. § 1.262-1(b)(7). 57. Hunter v. United States, 217 F.2d 69 (2d Cir. 1995); Sunderland v. Commissioner, 36 T.C.M. (CCH) 116 (1977). 58. Rev. Rul. 72-545, 1972-1 C.B. 179. 59. Gilmore v. United States, 245 F. Supp. 383 (N.D. Cal. 1965). 60. I.R.C. § 21(e)(2). 61. I.R.C. § 151(c)(1); 21(b)(1)(A). 62. I.R.C. § 21(e)(5). 63. I.R.C. § 32(c). 64. I.R.C. § 213(d)(5), 152(e). 65. I.R.C. § 71(b)(1)(A). 66. Rev. Rul. 74-611, 1974-2 C.B. 399. 67. Dolan v. Commissioner, 44 T.C.. 420 (1965). 68. Rev. Rul. 86-57, 1986-1 C.B. 362. 69. I.R.C. § 104(a). 70. United States v. Davis, 370 U.S. 65 (1962). 71. Pub. L. No. 98-369. 72. I.R.C. § 1041(c). 73. Treas. Reg. § 1.1041-T(a)(A-7). 74. I.R.C. § 1041(d). 75. TRA 1984, § 421(d)(1). 76. TRA 1984, § 421(d)(3); Treas. Reg. § 1.1041-T(e)(A-17). 77. Treas. Reg. §§ 1.1245-2(c), 1.1250-3(a)(3). 78. Pub. L. No. 98-369. 79. I.R.C. § 1041(b)(1); Godlewski v. Commissioner, 90 T.C. 100 (1988). 80. I.R.C.§ 453B(g). 81. I.R.C. § 1041(e). 82. Treas. Reg. § 1.1041-1T(d)(A-12). 83. Treas. Reg. § 1.1041T(A-14). 84. I.R.C. § 50(a)(1)(A). 85. I.R.C. § 1-15(a). 86. Treas. Reg. § 1.1001(c). 87. I.R.C. § 6019(a).

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88. I.R.C. § 453B. 89. I.R.C. §§ 121(a), 121(b)(1) and 121(b)(2). 90. Code § 121(b)(3). 91. Treas. Reg. § 1.1034-1(a). 92. Rev. Rul. 74-250, 1974-1 C.B. 202. 93. I.R.C. § 1041(a). 94. Godlewski v. Commissioner, 90 T.C. 20 (1988). 95. I.R.C. § 1034(a); Houlette v. Commissioner, 48 T.C. 350 (1967); Young v. Commissioner, Tax. Ct. Mem. Dec. (CCH) ¶ 41, 961 (1985). 96. Clapham v. Commissioner, 63T.C. 505 (1975); Trisko v. Commissioner, 29 T.C. 505 (1957). 97. I.R.C. § 121(b). 98. I.R.C. § 121(a). 99. I.R.C. § 121(b)(2). 100. I.R.C. § 121(d)(6). 101. Rev. Rul. 69-608, 1969-1 C.B. 43. 102. I.R.C. § 302(b)(3). 103. I.R.C. § 302(c)(2)(B). 104. I.R.C. § 7872; Pierce v. Commissioner, 61 T.C. 424 (1974). 105. I.R.C. § 1041. 106. I.R.C. § 469(j)(6)(A). 107. I.R.C. § 469(j)(6)(b). 108. Treas. Reg. § 1.041-1(d)-A(11). 109. I.R.C. § 401(a)(13). 110. I.R.C. § 414(p)(2). 111. I.R.C. § 414(p). 112. I.R.C. § 414(p)(4). 113. I.R.C. § 72(t). 114. I.R.C. § 402(a)(9). 115. I.R.C. § 402(e)(4)(A). 116. I.R.C. § 414(p)(8). 117. I.R.C. § 402(a)(9). 118. I.R.C. § 4086(d)(6). 119. I.R.C. § 682(a). 120. I.R.C. § 652(a). 121. Treas. Reg. § 1.682(b). 122. Orgler v. Orgler, 273 N.J. Super. 372 (App. Div. 1985).

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PART

REPORT AND TRIAL

VI

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CHAPTER

12

THE FINAL STAGES An expert is one who knows more and more about less and less. — Nicholas Butler

CONTENTS 12.1 12.2 12.3

Introduction Working with the Opposing CPA Your Report

281 281 283

12.4 12.5 12.6

The Opposition’s Report Negotiations Court Testimony

285 291 295

INTRODUCTION. The investigative accounting work is done when, to the extent possible, you have tied up various financial issues, you have made your determinations as to the existence of unreported income and its magnitude, you have delved into industry sources for information and comparables, and you have done the valuation and arrived at various conclusions. Although at this point much of your work is obviously done, some of the best is yet to come. You may still have to deal with the opposing accountant, develop your report, prepare for trial, and ultimately even testify in court. Each of these elements of your work requires different skills and abilities. 12.1

WORKING WITH THE OPPOSING CPA. In most divorce cases, you will be only one side of the investigation/valuation process. This assumes you are not working as the stipulated or court-appointed accountant. Even then, you will potentially have opposition since, as mentioned previously, in those types of situations, you really have no friends despite your perception of what you might be doing. Thus, you can expect that at some point there may be the need or benefit for you and the other accountant to compare notes. In some limited situations, whether through obstinacy or the refusal to spend more money, the other side may not have an accountant and you may find yourself going up against perhaps just the business owner or the nonbusiness spouse. Regardless, when there is another accountant involved, you need to concern yourself with how you will be interacting with that person. The first issue you have to deal with is whether you know this other accountant or appraiser and if so, what your relationship is. Hopefully, the two of you know each other at least enough to respect one another and even better, you have possibly already dealt with each other in a satisfactory manner. When you have that type of relationship, your mutual interplay can truly be a service to your respective clients. On the other hand, if neither one of you trusts the other; if past 12.2

281

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dealings have been stressful; if either or both of you are jockeying for position with the attorneys involved and therefore trying not only to look good, but make the other one look bad; then clearly trying to work together will probably result in further polarizing each of you, and as a result, through you, your clients. Perhaps the situation is such that you are representing the business owner and your position is that the business is worth $500,000, and the other accountant representing the nonbusiness owner posits that the business is worth $2 million. If neither one of you is willing to listen to the other and see what might be obvious errors, misinterpretations, or unreasonable bias, then out of selfish self-interest neither one of you will be able to permit yourself to back down at all. Your face-saving defenses could cause you to place obstacles in the way of potentially compromising on the numbers and drawing the two parties closer together. The clients and the attorneys look to their experts to be reasonable as to value and to display some sense of candidness as to the defensibility of your value positions. If your ego has blinded you to the appropriateness of a compromise, you will be taking an untenable position that will serve no one. Before you can begin this open dialogue with the other accountant, you, of course, need to get clearance from your attorney (as does the other accountant from the opposing attorney) that this type of dialogue would be acceptable and not counterproductive to the attorney’s aims. In most situations, you can expect a green light. Therefore, and certainly in no small measure because none of your conclusions are binding, it does help to move the process along, ultimately saving everyone time, aggravation, and fees. Once you have the green light, but before you meet with the other accountant, make sure that you have a solid handle on your numbers. You do not need command of your files as if you were going to trial; you need not have every aspect of your discovery and conclusions committed to memory. On the other hand, you are going into a meeting where you are supposed to be offering as much as you are expecting the other accountant to offer, and therefore, each one of you is entitled to expect that the other enters this meeting informed as to the pertinent positions and conclusions and with something to contribute to the meeting. One of the problems in this type of meeting is the degree of honesty or openness you can offer. On the one hand, you certainly do not want to lie or mislead. On the other hand, unless cleared in advance by your attorney (and it would be rather unusual), you are also not to reveal weaknesses in your position or give away the store. Again, if you know the other accountant well and have a mutual respect and trust, your respective honesty with each other along with various qualifications of your position (such as, this is tentative and not agreed to by anyone as yet) will go far in making the meeting fruitful and at the same time not embarrassing either one of you or locking either one of you into an uncomfortable position. Again, depending on such factors as experience and mutual compatibility, as well as on how much free rein your attorneys have given you, the two of you might be able to walk out of this type of meeting with a mutual agreement as to such items as value and income. I have personally seen this work very effectively in a few cases when the expert representatives of the other parties were people with whom I had dealt and with whom mutual respect was established. As a result, we were able to candidly discuss our positions and arrive at satisfactory conclusions as to value and income. In no small measure, progress was able to be made

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rather quickly because, when we opened our discussions, each of us leading with our ballpark estimates of value for the businesses, it became obvious that our numbers were rather close, although we represented opposing sides. That is a clear and immediate acknowledgment by each party that reasonable attempts were made to be fair, and that neither one is taking a biased advocacy position. With that type of a starting point, it is relatively easy for progress to be made. If we had started out considerably disparate, then either we would have quickly come to an understanding as to what significant areas of disagreement existed that caused us to be so far apart, or we would have very quickly seen that one or both of us had taken positions that appeared to be too advocacy oriented. Even then, the meeting could still have been salvaged if the two of us had come to an understanding as to where we significantly disagreed and perhaps had gone back to our fieldwork analysis and tried to eliminate that area of disagreement. For instance, if the disagreement had involved the determination of unreported income, with the party representing the business owner concluding no unreported income, and the other, representing the nonbusiness spouse, concluding significant unreported income; a frank dialogue between the two of us should have resulted in an understanding of how we could have arrived at such different conclusions from allegedly the same set of facts and records. Perhaps one of us would have convinced the other, or, perhaps one or both of us would have realized that we needed to take a second look at some previously established approaches and conclusions. It would be reasonable to expect that the two accountants described above would be able to conclude such a meeting (or series of meetings) with perhaps a brief letter acknowledging their areas of agreement, or perhaps, though not likely, a letter acknowledging their areas of disagreement. Having permission of the attorneys in advance, the two of them could go as far as to perhaps conclude in a joint letter that they agree that the value of the business approximates a certain figure, and further, that the income enjoyed by the business owner is a certain figure. A step such as this accomplishes much, and, assuming that the process with their respective clients and attorneys does not fall apart at this point, probably represents a major step forward in resolving the financial aspects of the divorce process. 12.3 YOUR REPORT. Assuming that the mutual assessment of the situation with the opposing CPA has not worked, or perhaps, that it just never was a possibility, you will need to prepare a written report. Your report needs to be logical, unbiased, and professional. It should not be full of colloquialisms or slang, nor should it be rife with subjective interpretations and vague conclusions. This is not to say that you will not have any interpretive issues. That is expected in almost all cases, and is certainly something you will need to recognize as a normal outgrowth of this type of work. However, there has to be an orderly and logical process that leads you to any conclusions, and the degree of subjectivity and interpretation needs to be kept to a minimum. Your report should include at least a minimal amount of narrative and observations; enough to show that you understand the business and its general background, and that you are in a position to explain the logic of your work, rather than merely a person engaged to slap together a few pages of financial statistics. While the report should not be a litany of gripes and complaints about how poorly the other side conducted itself, the lack of cooperation, and so forth, it is not

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unreasonable for you to briefly expound upon major issues and obstacles that may have some impact on your report. For instance, perhaps you were not permitted to walk through the plant or to interview the business owner. You should recognize that inserting qualifying concerns in your report may obviously cause one to argue that, with those concerns and lack of information, perhaps you were not qualified to reach the conclusions you did. On the other hand, omitting important limiting aspects (as the two just described), especially considering that this is a written report that is finding its way into litigation and may eventually become part of a court record, can be dangerous. You need to protect yourself and forcefully bring out the point that you tried to obtain additional insight, but it was deliberately withheld from you. Your report should also give sound financial, statistical background to the reader. It should include, as appropriate under the particular circumstances, several years of balance sheets, statements of operations, your adjustments and explanations thereto, and a clear summary of your conclusions. Where possible and appropriate, it would also be helpful to cite from independent, third-party, authoritative sources so that the report becomes more than merely your work and your interpretation. It is beneficial as to your credibility if you can illustrate that you relied upon independent authorities to round out your information and support your conclusions. It is not unusual in these types of cases to prepare your report initially as a draft, and to submit it to your attorney and your client. The concept here is to give your side the chance to see where you are going, and at the same time for you to get feedback so that you have a chance to eliminate any technical inaccuracies, factual mistakes, and the like. For instance, assume your report involves a manufacturing operation, and you have stated therein that it was founded by the current business owner in 1975 in New Jersey. However, you are inaccurate; it was founded jointly with the present business owner and a former business owner (who was bought out 15 years ago), and it was in 1976 in Pennsylvania, and the business moved to New Jersey in 1980. The reality is that none of those errors will have any bearing on your work or conclusions. However, together, they make your work look sloppy and might give the other side the opportunity to question the accuracy of your work in general, based on the innocuous errors as described. Submitting your report in draft gives you the opportunity to debug it. Once you have gotten the needed feedback, and you have appropriately revised and polished your report, you then issue the final report, discarding and destroying all previous drafts. There is nothing secretive or untoward about this procedure. The fact is, the drafts were only that and you anticipated they might need corrections. Leaving drafts around only tends to weaken the strength of your final product. A policy that I would suggest you implement is that of a mandatory cold review of all these reports. It is common procedure in the better accounting firms that all financial statements (or at least at the review and certainly at the audit level) must go through an internal cold, or technical, review process, so as to ensure that the report meets the firm’s technical requirements and complies with the American Institute of CPA’s disclosure and report-writing rules. While there are no rigid dicta of the same authority as to litigation-related reports, it is simply a good idea within your office to subject these reports to this type of review.

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Such a review should be done by someone who is familiar with litigation work, who has done work of this nature before, who has written reports, and who has testified. You want someone who knows where the pitfalls are and what is necessary for a report that will very possibly subject the writer to cross-examination in a court of law. This process gives you feedback from someone who has not been so intimately involved with the case. You might get suggestions that perhaps you are too biased, that there are aspects of your report that appear to be without foundation, that various conclusions do not flow logically from the support given, that you were too conservative or too aggressive in your approach toward valuation, and so forth. Also, you may be challenged in this cold review process to prove certain statements or to explain why you chose to perhaps ignore a prior transaction. You will find that, if done correctly, the cold review process will probably not add more than about one partner hour to the total job cost, and may save you from great embarrassment and professional damage. To assist the reader in establishing the appropriate procedures. (See Exhibit 12–1.) THE OPPOSITION’S REPORT. Remember, you are not the only one preparing a report. In most cases, you can expect that the other side will have your counterpart, and that he or she will also be preparing a report. At some point in time, often heavily dependent upon your particular state’s discovery rules, you can expect to get a copy of the other side’s report, just as, of course, they will get a copy of yours. Normally, one of the first steps your attorney will take upon receiving the other side’s report is to run a copy of it and send it to you with a cover letter briefly requesting you to review it, comment upon it, and be prepared to discuss with your attorney the major areas of difference. At this point, you start going through the opposition’s report and have what is, for most accountants, an unusual experience. The other side’s report, which in all likelihood is significantly different than yours, may take a contrary position as to the extent of income and the magnitude of value; a conflict in fundamentals typically limited to litigation cases. You will now need to defend your position, justifying your determination of greater income than reported or conversely that the income was substantially as reported, as well as justifying a much larger, or a much smaller, value than that espoused by your opposition. You will also be faced with the possibility, depending of course on the severity of differences, that maybe you made a mistake, or worse, several mistakes. You will also need to (probably will want to) critique the opposition’s report. You can be assured that exactly these types of steps are being taken on the other side as to your report. Certainly, the first thing you need to do is to understand where the two of you disagree, focusing on the major issues. Review your records and thought processes (and possibly also your sources of information), to give yourself a comfort level or reassurance that you had logic and basis for your conclusions, and that you were right, or at least substantially right. You may also find that the other side made a couple of good points and that maybe you were wrong in some part of your report. It is strongly suggested that you acknowledge same, not necessarily in writing that would be discoverable, but rather in a discussion with the attorney with whom you are working, and possibly also your client. Many times, it is not so much a matter of whether you are absolutely right or wrong, but rather whether it seems that the interpretive issues leave room for more than one approach

12.4

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EXHIBIT 12–1

Matrimonial (and Other Litigation) Report Preissuance Review Checklist

This checklist is to be prepared by the report writer and then submitted to a reviewer for a final inspection. Client: ______________________ YES 1.

Is the report in our standard format sequence? Does it contain the table of contents, accountants report letter, narrative introduction, balance sheet information, profit and loss information, adjustments, explanation of adjustments, additional information and statistics, valuation approaches, conclusion as to value, statement of independence and limitation, statement of assumptions and qualifications of the appraiser?

2.

Does our letter clearly state: The purpose of our assignment, specifically what was valued? The as-of date? The type of value (usually fair market value) The conclusion?

3.

Does the narrative and introduction give adequate insight into the subject company? Its history? Management? Key personnel? Key products? Major issues and concerns? Outside financial forces impacting the company? The company’s future prospects? Its sensitivity to seasonal or cyclical factors?

NO

N/A

EXPLANATION

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Matrimonial (and Other Litigation) Report Preissuance Review Checklist (continued)

YES Its competition? 4.

Does our report detail any limitations and/or restrictions placed upon us?

5.

Does the narrative appear to be reasonably unbiased?

11.

Are our adjustments adequately explained and is our documentation for these adjustments adequate?

12.

If there are no or only a few adjustments, was this area adequately addressed?

13.

Was the balance sheet adjusted and if not, why not?

14.

Do the adjustments appear to be reasonably unbiased?

15.

If there is a conclusion as to unreported income, does it appear we have adequate support for such a conclusion (gross profit, deposits, standard of living . . . )?

16.

If it was concluded that unreported income does not exist, were reasonable efforts made to ascertain whether that seems logical?

21.

Was outside industry source information used, and if not, why not?

22.

As to the outside industry source information, was it adequately referenced and does it appear appropriate and reasonable for the subject company?

NO

N/A

EXPLANATION

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EXHIBIT 12–1


YES 23.

If ratio analysis was used, was it applied correctly (versus merely filling up paper) and explained?

31.

If the subject company has significant fixed assets, should an equipment appraiser have been used?

32.

Was reasonable compensation addressed, and was it adequately researched/is there adequate support?

33.

Was there adequate recognition as to the depth of management — key man type risks?

34.

Was the choice of the use of before tax vs. after tax net income figures appropriate?

35.

Was more than one method of value used?

36.

Were the methods of valuation used reasonably explained and the choice or weighting logical?

37.

As to certain variables (discount rates, cap rates, etc.)— were they adequately explained?

38.

If less than 100% of a company was valued, was the matter of a discount or a premium addressed?

39.

Were there any sales of interests in the subject company, and if so, were they referenced in our report?

40.

If a buy-sell agreement exists, was its impact considered and referenced?

41.

Was subsequent information used?

NO

N/A

EXPLANATION

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289


YES 42.

If the answer to the preceding was yes, what is the comfort level that it doesn’t impair our conclusions?

43.

If there is a conclusion of value that is less than adjusted book value, does it appear to be reasonable?

44.

If our conclusion was no goodwill, should liquidation value be considered?

51.

Is there a concern that the type of business and/or location is out of our field of expertise and unduly exposing us?

52.

Was the business site visited?

53.

If the answer to the preceding item is no, what is the comfort level as to the valuation and the position on the stand?

54.

Was the report cleared with the client as to its factual accuracy?

55.

Is the report readable to the layperson (judge, attorney, client)?

56.

Should graphs be used for visual impact and to assist the reader?

57.

Does the conclusion pass the smell test — would you buy it/sell it or recommend such to a client?

58.

Are you aware of anything subsequent to our valuation date that is of significant import as to the subject company that might render our conclusions illogical?

NO

N/A

EXPLANATION

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EXHIBIT 12–1


YES 61.

Is the file in good order — is it ready for trial?

62.

What is the status of money due to us from our client — should we be holding up the report and pressing for money?

71.

Were the personal financial records analyzed?

72.

Are you satisfied the personal financial situation is consistent with our findings?

80.

DOES THE REVIEWER BELIEVE THAT THERE IS ANYTHING SERIOUS ENOUGH TO REQUIRE HOLDING UP THE PROCESSING AND ISSUING THE REPORT?

NO

N/A

EXPLANATION

Report Writer Who Prepared This Checklist

Reviewer Who Reviewed This Checklist

or position, and that maybe the other side has not only some logic and validity, but perhaps a better argument than yours. This candor is very important. What you do not need is to mislead your side, defend yourself out of ego and fear, and go forward based on your recommendations, notwithstanding that you already know (or at least should know), based on the strength of the other side’s report, that there are major weaknesses in your presentation. Assuming that you have not been shown to be substantially incorrect, it is now your task to critique the opposition’s report, contrast the major areas with yours, deal with the key issues, point out the objective versus subjective areas, and make necessary modifications to your report, based on now having the benefit of seeing this case from another viewpoint.

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It is helpful to keep in mind, when critiquing your opposition’s report, that you are dealing in most situations with a fellow CPA. You should be cautious as to the nature and harshness of your criticism. Try to put yourself in the shoes of the opposition, and in fact, you will probably have to because there will be a similar exercise going on at the same time with you as the target. How would you feel if the criticism attacked you personally rather than the issues? Stay with the issues, and the bigger picture. Wherever available or possible, support your critique with documentation or third-party support of your position. Remember, there is a good chance that the two of you will run into each other in the future, and perhaps even a better chance that the two of you will run into each other on the stand later on in this case. If the two of you are $10,000 a year apart in the amount of income realized by the business owner, there is probably nothing worth pursuing. On the other hand, if starting with just this $10,000 difference in income you have used an eight-times-multiple of income for value and your opposition has used a two-times-multiple, and of course assuming that there was enough income to make this whole thing worthwhile anyway, clearly your focus is to be able to justify your eight-times-multiple, and to be able to clearly illustrate the weaknesses in your opponent’s use of a two-timesmultiple. And, before you jump into it too quickly, recognize if perhaps your eight-times-multiple was against after-tax income while your opponent multiplied before-tax income by two. If that is the case, you are not quite as far apart as you first thought. Dealing with the issue of reports, I would like to present two tips to the reader: • Maintain a control list of all the jobs you have done in the litigation area. This should include not only the matrimonial work but anything involving minority stockholder suits, partnership dissolutions, and even nonlitigation situations where reports were developed for similar issues, such as valuation. Your list, preferably in alphabetical order by client, should also give you some indication of the type of work performed and the extent of the report (whether it was a valuation, a lifestyle investigation, or whatever). You will find this to be an excellent reference source. • Maintain a separate file drawer with copies of all of your reports, as well as copies of any of your competitors’/oppositions’ reports. You will find this to be a very helpful and invaluable resource for simplifying the preparation of future reports and for reference. As to your oppositions, it will sometimes serve as assistance in an attack if you can show that they approached a situation one way one time and another way another time, when the situations were similar enough so that the different approaches can only be attributed (in your interpretation) to whomever they were representing. As you do more and more of this work, this report file drawer will take on significant proportions. NEGOTIATIONS. Although there is no law that requires you to be involved in the negotiation process, as your experience and reputation develop, and of course depending very heavily on the attorney with whom you are working, you can expect to be asked to assist in the negotiations, to develop a proposal, to counter a proposal, to assist in thrashing out differences, and so forth. Certainly, in the bigger and more complicated cases, your input from a financial and tax 12.5

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point of view would be considered crucial. Your role in these negotiations will cover various facets, not just determining the matter of income and value, but also assisting in balancing compromises, living needs, tax impact, cash flow realities, liquidity needs, and, if the negotiations do not work, the candid appraisal of respective positions going into trial. As to these negotiations, absent a clear indication otherwise, it is the attorney who leads. The attorney is the one who is trained in the divorce process from a legal point of view and who is generally more accustomed to the negotiation process than is the accountant. Do not overreach, and do not cause and make visible strategy differences between you and the attorney with whom you are working. Also, recognize that there are very few absolutes in this type of work; no matter how right you are or think you are, some of it just does not matter. These are very personal and emotional situations, requiring much patience on your end, as well as the recognition that justice is often best served when it is compromised rather than when a clear-cut victory is sought. You must realize that this is not a personal issue. Other than your ego and your personal satisfaction in seeing to it that the job is done right, it is only a job. Even though you are representing the nonbusiness spouse, and everybody knows how unreasonable and hostile the business owner has been throughout the case as to you and your role in negotiations, this is insignificant. Maybe it will mean something if it ultimately goes to trial and that person becomes an unsympathetic litigant in the judge’s eyes. For negotiation purposes, you and the attorney are not dealing with a situation that is personal to you, but rather, one where your expertise is necessary to work out the right financial arrangements. One of the practical problems that arises in negotiations is the matter of liquidity. Unless this is an unusual case where there are no concerns about cash flow and financing (or perhaps to the other extreme, an exceedingly simple case where all you need to do is split up a small bank account, sell off the house, and say good-bye), there can be a multitude of finance-related issues that will require great effort and patience on your part. There may be $1 million in the marital estate, but, for instance, it might consist of a $500,000 house with a $300,000 mortgage, a business with a value of $600,000, a pension with a value of $100,000, a couple of cars and other personal effects worth $50,000, and $50,000 in the bank. How are you going to equitably share this pool of assets, proceeding under the assumption that it is going to be a 50/50 sharing? Clearly, the business owner is going to keep that $600,000 asset, which by itself represents greater than 50 percent of the total. The owner is also probably going to keep one of the cars and maybe is adamantly against giving up the $100,000 retirement plan benefit and some of the other personal effects. Also, the business owner needs at least some of the cash for personal working capital. On the other hand, the nonbusiness spouse clearly is going to receive the house, but what if this spouse does not want it? Moreover, with the $300,000 mortgage the nonbusiness spouse may not be able to afford or want to remain in that house, and therefore is going to have to sell it. If the house is going to be sold, besides addressing the issue of whether or not the $500,000 value placed on it is real in today’s market, what about the tax consequences on the sale of that house? Will this be one of those situations when there will have to be a term payout from the business owner to the nonbusiness spouse? In that case, are you going to structure it to be taxable or nontaxable? A term payout in general calls for interest on

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that payout which, as a practical/emotional issue, may be very difficult to sell to the soon-to-be former spouse who will be paying it. The financial issues continue to get more difficult. Besides the term payout for the property settlement part, what about the alimony and the child support issues? Consider not merely how much is needed and the tax allocations between alimony and support, but when you combine the cash outflow on the term payout with the cash outflow on the alimony and support, how affordable are those payments in relationship to the income flow of the business owner? It is all well and good that the nonbusiness spouse is entitled to a share of the property and support, but if you cannot work out a settlement that is manageable from a cash flow point of view to the person who will still be making the payments, your best efforts will be self-defeating. It does not do either side much good when an arrangement is financially onerous to the extent that the person having to make the payments is doomed from the beginning to be unable to make those payments. You are inviting repeated visits to court, continued strife between the parties, worsened lives of the children involved, and likely, merely a delay in dealing with the hard issues. This is not to say that the nonbusiness spouse should capitulate to the exaggerated doomsday wailings of the business spouse. On the other hand, there is just so much that anyone can do before the financial arrangements become untenable. Other issues that need to be addressed include collateral and life insurance. If we are dealing with the term payout of a property settlement, it is reasonable and fair for the receiving spouse to insist upon some form of a guarantee of payment. A paper guarantee or judicial order are worth about as much as the paper on which it is written without the right intentions, or, alternatively, without collateral. There are few things as certain to guarantee payment as the appropriate attachment/lien against something that is needed by the person making the payments. Whether it is a lien on a business (the receivables, inventory, the underlying property, or the stock), or on real estate, or whatever, it is important to give the receiving spouse some protection for these payments. Another sense of protection is life insurance. While this would not protect the recipient if the payor was disabled, skipped or changed jobs, at least in the ultimate situation of death, if the insurance proceeds are irrevocably for the benefit of the recipient spouse, that too is another layer of protection. Will it be necessary to sell or refinance some property in order to accomplish part of a property settlement? Refinancing can be an attractive alternative if the rates are right and the equity is there, since it can possibly avoid the recognition of a large capital gain at that time. On the other hand, with the past few years’ decline in real estate values, you may not be in a position to recommend refinancing; the equity may not exist. Of course in that case, selling might not create any positive cash flow either, except to the extent that it might relieve the parties of a negative cash-flow asset. Depending on the particular situation, you may need to do some number crunching to evaluate the trade-off between, for instance, a smaller property settlement with a larger alimony or child support arrangement, as contrasted with the nonbusiness spouse receiving perhaps a much larger property settlement and potentially forgoing alimony or support. There are advantages and disadvantages to almost any arrangement, and each case must stand on its own merit. A

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property settlement in a divorce is completely tax-free. This can make getting a larger settlement much more attractive than receiving alimony. Of course, as to the person making the payments, property settlements are nondeductible. As a trade-off, maybe the former spouse making the payments would be able to pay somewhat less because this spouse will not get a tax deduction for it, whereas the person receiving it is willing to receive less since the receipt is tax-free. When payments are made over time, the interest that the recipient might insist upon can be imputed into the settlement so that there would be no challenge as to the possible taxability of any interest. Furthermore, as to the payor, the interest would not be tax deductible and, therefore, there would be no reason not to word the settlement so as to include the interest as simply additional property settlement payments. In most situations, the payments on account of a property settlement are not protected in the case of bankruptcy. You can make a very good arrangement, have the payments structured to be tax-free, and have all your work go down the drain a year later when the payor declares bankruptcy. To the contrary, alimony and child support are generally not relieved in bankruptcy. Therefore, you may decide that the payments need to be in someway protected and that alimony or support is the ideal protection. Of course, that too is not ideal, in that while bankruptcy does not erase those payments, a drastic reduction in the payor’s level of income can. Obviously, there are no foolproof situations unless the parties have sufficient funds to be able to cleanly walk away from each other at the time of the divorce. Another possibility in attempting to negotiate a settlement, especially when the arrangements prove to be difficult and when liquidity is not optimal, is to have the spouses continue to share in the ownership of property or possibly even income participation of certain assets. Recognize that this is perhaps the least desirable situation in almost all divorces. The parties obviously were not getting along as husband and wife; what makes you think they will get along as financial or business partners? Nevertheless, there will be situations where this is the only possible and logical financial arrangement that can be made. You may have the parties sharing ownership of the marital home, with the custodial parent living there until the children reach majority. At that point, perhaps the house will be sold and the proceeds split. Of course, as to the noncustodial parent, when that happens, any potential gain is going to be taxable since the house will not have met the principal residence requirement for a tax-free deferral. It is much more difficult if you are considering some form of joint ownership or giving the nonbusiness spouse some particular interest in the business spouse’s company. It would be very difficult to construct an arrangement that would allow a nonbusiness spouse to retain an interest in a company when the business spouse controls it and draws a salary. Without restrictions on the business spouse, it would be a hollow victory and probably a worthless asset. With restrictions on the business owner, you may wind up hamstringing the operations and accomplishing nothing but more litigation. For instance, if the restrictions are strong enough, what is to ultimately stop that business spouse from opening up another company and siphoning off business to the new entity? It is easy to say that this is improper, or perhaps even an illegal move, and that you are sure you would be able to prove fraudulent transfer. Even if you could, you are talking about another legal battle dragging on for years and with substantial expenses.

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Ultimately, in some situations you might just have to accept the fact that you cannot settle. Not every case settles, but most do. When this reality sets in, you then have to be ready for trial. COURT TESTIMONY. Being an expert witness in court is truly a unique experience. It is also, many times, a vivid illustration of why many accountants do not do this type of work. The typical series of events in testifying begins by first going through a direct examination conducted by your attorney. This is a rather comforting experience, often well rehearsed, and of course conducted by an ally. If you do not do well under direct examination, it is time for you to walk out of the court and not look back. Unfortunately, the direct examination may lull you into a certain false sense of complacency. Once your attorney is finished with direct examination, the other attorney then asks you questions. This wonderful experience is called cross-examination. It is here, particularly if the cross-examination is conducted by an informed and skilled practitioner, that accountants fully appreciate how important preparation, fact-finding, and tying up all ends are. It is also what convinces some accountants never to do this type of work again. In order to be effective and perform well in a courtroom, you need to be extremely well prepared, even to the extent of rehearsing and possibly even roleplaying with the help of your attorney. It is not improper to go through expected questions and your answers with your attorney in advance of trial. This is not to suggest that you be told what to answer and how to answer, but rather that you understand what types of questions may be asked of you and that you are prepared to answer them honestly and to the best advantage for your side. Know your report inside and out, and be very comfortable and familiar with your files and the papers therein. Besides being very familiar with the file and your own work, make sure you are just as familiar with the work product of your associates/staff. Assuming that you used other people, you will need to make an extra effort to be sure that you understand and are in command of their work, and are in a position to use and explain it while testifying. Make sure your work decks are in good order. Sometimes this organization requires that you have a key or index telling you where each item is; this is especially so in larger and more complex cases. Bring one or two extra bound copies of your report with you. The judge might be most appreciative to receive one to assist in following along with the testimony. This, of course, will vary depending on the jurisdiction and the particular procedural rules of each court. While most of this book’s readers probably will not find this an issue, again depending on the jurisdiction, it is not unusual that when you go to the stand to testify, you are first required to state some kind of an oath or affirmation; you are sworn in. While this is fairly common, it may raise constitutional and/or religious problems. My suggestion to you in responding to these personal issues is one that I have found very effective and nonconfrontational in virtually all cases: make a request to take an affirmation rather than an oath. It is virtually identical, but it does not require a Bible or a courtroom statement of allegiance to some deity. Another integral part of preparing for court is to assist the attorney in preparing for the cross-examination of the other side. You can be assured that the other party will be doing the same thing. It is important, especially where the attorney 12.6

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is not especially strong in finances and where the matter is complex, to assist that attorney in thoroughly understanding the opposition’s report, where the weaknesses are, and what questions to ask. Show up in court on time, and maintain your patience. In many situations, you will need to maintain an extra level of patience because of the delays that are too often inherent in the court system and the manner in which examinations are conducted. Interruptions happen, and people sometimes do not understand what you think is rather obvious. Maintain a professional demeanor. Dress in a professional manner, typically a suit for a man and a dress for a woman. Be sure to speak clearly and explain the issues in basics so that they are understandable to all. You must assume that no one else (with the exception of the other accountant) understands accounting and tax issues, and that regardless of how intelligent and skilled all the other parties are, your particular field is arcane to them and requires simple and basic explanations so that all can follow. Be sure to bring with you a couple of copies of your most current résumé. Basically, the purpose of this is to have in writing something that will give the judge and the other side an understanding of your qualifications. You can expect to be asked, during the opening part of your direct examination, to run through your qualifications, and it is possible that the other attorney might even do an examination on certain aspects of your qualifications. The issue here is whether, in the eyes of the other attorney and the judge, you will qualify as an expert, or whether they will just tolerate you and allow you to testify, even though no one has really acknowledged that you are an expert. The manner in which you present yourself on the stand is very important. To the best of your ability, do not advocate. Granted, everyone knows you are on one particular side (unless stipulated to or court-appointed), and that, whenever possible, you will likely take the position that favors your client. Nevertheless, it is absolutely imperative that your testimony proves to all that you are being as fair, evenhanded, and unbiased as possible. Demonstrate that you are following the facts rather than your client’s emotions. Even more important than merely not advocating is the absolute rule of not lying. If you made a mistake, admit it. Do not try to cover up a mistake with a lie. Everyone makes mistakes; not everyone lies. If you get caught in a lie, you will be lucky if all it does is damage you in the eyes of the attorneys present. At worst, you could be charged with perjury, possibly have your license revoked, create great stress for yourself within the profession and the legal community, be summarily dismissed from the case, and likely barred from future testimony (at least before that particular judge). You will, of course, also likely end the possibility of collecting whatever is left of your fee. Recognize that the matrimonial court is a fairly small community of attorneys and judges. They all talk to each other and they all know each other. The attorneys who are prominent in the field will know of your reputation fairly quickly. And, when you have a poor reputation, those who do engage you are often the ones you should avoid. In addition, your reports become semipublic knowledge, with other accountants and attorneys keeping a dossier on you and your reports, just as you should keep one on your opponents. An item that comes up on occasion is the matter of whether you are working on a contingency basis. We all know that as CPAs we do not work on a contingency basis, perhaps with the exception of a tax case. Clearly, working on a contingency

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basis would totally eliminate the possibility of being objective. In a divorce matter, the practical aspect when working for the nonbusiness owner spouse (often meaning the wife) is that you will typically go into trial owed a substantial amount of your fee. Above and beyond the retainer, you may have received nothing, and may be awaiting the settlement of the case in order to get the balance of your fee. Does that make you in effect working on a contingency basis? It is a question you can expect to be thrown at you, and you should be prepared to answer it. Certainly, the nature of working for the nonbusiness spouse is such that you will often have to wait for your fee. If you do the job correctly and with honor, there should be no challenge as to your objectivity, and you should be able to dispel any suggestions that setting your fees and then collecting them are in some way contingent upon the position you espouse.

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POSTDIVORCE SERVICES Being asked whether it was better to marry or not, he replied, “Whichever you do, you will repent it.” — Diogenes Laertius

CONTENTS 13.1 13.2 13.3

Introduction Personal Budgeting Financial Management

298 298 304

13.4 13.5

Tax Assistance and Preparation Remarriage

305 306

INTRODUCTION. The investigation is through, the valuation is done, your report has been prepared and submitted, and the trial is over. However, depending on the outcome of the case and your client, you may find yourself with additional accounting opportunities. If your client was the nonbusiness spouse, and typically lacks established ties to an accountant or other financial advisor, there should be many opportunities for postdivorce servicing from a tax and financial perspective, assuming, of course, that the financial condition and profile of this divorce client now fit your consulting or tax client requirements. This chapter deals with the situation in which your client was the nonbusiness spouse who, for the first time, needs tax and financial consulting advice. If your client was the business owner, regardless of whether you or the prior accountant does the ongoing servicing, it is expected that this type of servicing is more or less the routine servicing that you are used to doing in your practice. When the client is the nonbusiness spouse, you must be sensitive to the fact that in the past this person very likely had no direct contact with the accountant. If the client did, it probably was only as the nonearning spouse in a subordinate (from a financial perspective) fashion or from a record-gathering point of view. Now this person represents a financial entity. As a result, there will be a number of areas in which your services may be in demand.

13.1

13.2 PERSONAL BUDGETING. Perhaps the first financial step you should take with this new client is to help set up a personal budget. See the sample personal budget format, developed specifically for divorce cases, presented in Exhibit 13–1, for a list of issues your client should consider. The role that the accountant plays here is to have this new financial entity, this person who just came out of a divorce, get on solid ground and be financially secure, as much as the after-divorce financial facts of life will permit. Your client 298

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may need help in terms of controlling expenditures, something as simple as establishing a budget format for funds coming in and how to spend them, obtaining and properly using credit cards, and perhaps obtaining mortgaging or other financing. Although there are a considerable number of servicing opportunities here, the reader must be careful: in your zeal to do the right job, and probably in combination with your client’s unfamiliarity with professional fees (outside of the divorce that was just finished), your fees may build up far faster and to a far greater extent than your client can afford. Make sure your client understands that expenses cannot exceed income. With the help of a personal budget (see Exhibit 13–1), sit down with your client, go through the expected expenses, and compare them to the expected income. Keep in mind the logical need to keep a reserve (after all, alimony payments do not always come on time). Remember things that are important but often taken for granted, such as medical insurance and income taxes.

EXHIBIT 13–1

Personal Budget PER MONTH

Principal home

— Mortgage/Rent

PER YEAR

$ _______________ $_______________

— Second mortgage

_______________ _______________

— Home equity loan

_______________ _______________

— Parking fee

_______________ _______________

— Real estate taxes

_______________ _______________

— Maintenance charges (condo/co-op) _______________ _______________ — Insurance

_______________ _______________

— Electric and gas

_______________ _______________

— Oil

_______________ _______________

— Wood

_______________ _______________

— Telephone

_______________ _______________

— Cable TV/Dish

_______________ _______________

— Repairs and maintenance

_______________ _______________

— Water and sewer

_______________ _______________

— Garbage removal

_______________ _______________

— Snow removal

_______________ _______________

— Lawn care

_______________ _______________

— Exterminator

_______________ _______________

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POSTDIVORCE SERVICES

EXHIBIT 13–1

Personal Budget (continued) PER MONTH — Service contracts on equipment

Second home

PER YEAR

$ _______________ $_______________

— Appliance replacement

_______________ _______________

— Furniture replacement

_______________ _______________

— Mortgage/Rent

_______________ _______________

— Second mortgage

_______________ _______________

— Home equity loan

_______________ _______________

— Parking fee

_______________ _______________

— Real estate taxes

_______________ _______________

— Maintenance charges (condo/co-op) _______________ _______________ — Insurance

_______________ _______________

— Electric and gas

_______________ _______________

— Oil

_______________ _______________

— Wood

_______________ _______________

— Telephone

_______________ _______________

— Cable TV/Dish

_______________ _______________

— Repairs and maintenance

_______________ _______________

— Water and sewer

_______________ _______________

— Garbage removal

_______________ _______________

— Snow removal

_______________ _______________

— Lawn care

_______________ _______________

— Exterminator

_______________ _______________

— Service contracts on equipment

_______________ _______________

— Appliance replacement

_______________ _______________

— Furniture replacement

_______________ _______________

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EXHIBIT 13–1

301

Personal Budget (continued) PER MONTH

SAVINGS — PERSONAL

PER YEAR

$ _______________ $_______________

SAVINGS — COLLEGE FUND

_______________ _______________

Credit card paydown

_____________________ _______________ _______________

Credit card paydown

_____________________ _______________ _______________

Credit card paydown

_____________________ _______________ _______________

Credit card paydown

_____________________ _______________ _______________

Student loan

_____________________ _______________ _______________

Other loans

_____________________ _______________ _______________

Other loans

_____________________ _______________ _______________

Other loans

_____________________ _______________ _______________

Federal income taxes

_______________ _______________

Self-employment and Social Security taxes

_______________ _______________

State income taxes

_______________ _______________

Personal auto ________ — Payments

_______________ _______________

— Insurance

_______________ _______________

— Maintenance

_______________ _______________

— Gasoline

_______________ _______________

— Replacement

_______________ _______________

Personal auto ________ — Payments

_______________ _______________

— Insurance

_______________ _______________

— Maintenance

_______________ _______________

— Gasoline

_______________ _______________

— Replacement

_______________ _______________

Commuting expense

_____________________ _______________ _______________

Commuting expense

_____________________ _______________ _______________

Food at home

_______________ _______________

Household supplies

_______________ _______________

Toiletries and cosmetics

_______________ _______________

School lunches

_______________ _______________

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EXHIBIT 13–1


Restaurants

PER YEAR

$ _______________ $_______________

Clothing

_______________ _______________

Hair care

_______________ _______________

Domestic help/maid

_______________ _______________

Medical — unreimbursed

_______________ _______________

Counseling — unreimbursed

_______________ _______________

Dental and orthodontic — unreimbursed

_______________ _______________

Eyeglasses and contacts

_______________ _______________

Prescription drugs

_______________ _______________

Nonprescription drugs and vitamins

_______________ _______________

Insurance

Boat

— Medical insurance

_______________ _______________

— Disability insurance

_______________ _______________

— Life insurance

_______________ _______________

— Long-term care

_______________ _______________

— Personal umbrella

_______________ _______________

— Valuables (floater)

_______________ _______________

— Payments

_______________ _______________

— Insurance

_______________ _______________

— Maintenance

_______________ _______________

— Fuel

_______________ _______________

— Slip rental

_______________ _______________

Club dues and memberships

_______________ _______________

Sports, hobbies, and collecting

_______________ _______________

Tapes and CDs

_______________ _______________

Music lessons

_______________ _______________

Dance/Gym lessons

_______________ _______________

Parties — Kids

_______________ _______________

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EXHIBIT 13–1

303


Camps

PER YEAR

$ _______________ $_______________

Vacations

_______________ _______________

Private school

_____________________ _______________ _______________

Private school

_____________________ _______________ _______________

College tuition and expenses

_____________________ _______________ _______________

College tuition and expenses

_____________________ _______________ _______________

Adult education

_______________ _______________

Day care

_______________ _______________

Babysitting

_______________ _______________

Dry cleaning/laundry

_______________ _______________

Entertainment

_______________ _______________

Alcohol

_______________ _______________

Tobacco

_______________ _______________

Newspapers

_______________ _______________

Magazines and books

_______________ _______________

Postage

_______________ _______________

Allowances

— Personal

_______________ _______________

— Spouse

_______________ _______________

— Children

_______________ _______________

_____________________ _______________ _______________ _____________________ _______________ _______________ _____________________ _______________ _______________ _____________________ _______________ _______________ Alimony

_______________ _______________

Child support

_______________ _______________

Parent support

_______________ _______________

Gifts

— Own family

_______________ _______________

— Others and affairs

_______________ _______________

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EXHIBIT 13–1


Temple/Church membership

PER YEAR

$ _______________ $_______________

Contributions

_______________ _______________

Legal and accounting

_______________ _______________

Financial planner/advisor

_______________ _______________

Computer expenses

_______________ _______________

Lottery tickets

_______________ _______________

Pets

Miscellaneous

— Food

_______________ _______________

— Medical care

_______________ _______________

— Insurance

_______________ _______________

— Miscellaneous

_______________ _______________ _______________ _______________ _______________ _______________

FINANCIAL MANAGEMENT. In the more well-to-do situations, especially where your client is not interested in, or perhaps is next to incapable of, controlling personal finances, you may get into much more of a financial management position, including writing checks, handling bills, and other facets of financial life to the extent that you effectively control that person’s financial affairs. Most of us are not called upon to do these types of services and are not familiar with them. Still, for those with wealthy clients, this can become a lucrative part of your practice. You might be asked to assist a client in making a decision as to whether to take out a mortgage on a new house. It is not unusual in a divorce situation for your client to sell the house that had been a joint residence, or seek a new home. When this happens, a decision needs to be made as to whether to take a mortgage, and if so, how much. In cases involving large settlements, it is possible that your client will be able to afford to purchase the house outright or with a minimal mortgage. Issues to be considered include the extent of liquid assets that would remain if no mortgage were taken, the desire or indifference to avoiding debt, the writing of another check each month, the mortgage rate, and what alternative uses your client would make of the funds that were made available if a mortgage were taken. As mentioned, there is the possibility of investment advising. I strongly caution accountants against that role; very few of us are familiar enough with the various investment vehicles, nor do we do it as a living. In addition, many of us simply are not good investors. As a practical issue, in virtually all cases to my knowledge, our malpractice insurance does not cover investment advisory services.

13.3

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You would probably be best served, as would your client, if you took an active role in assisting your client in locating one or two (depending on the size of the funds) investment advisors/brokers/counselors. Your role would then be to monitor the investment performance, being a buffer and a watchdog in case of any clear wrongdoings, but keeping clear of the investment decisions. If the funds warrant, and if it serves your client, you may find that perhaps a semiannual conference with your client and the investment advisor would be beneficial. Very importantly in this vein, be wary that your client is probably susceptible to people trying to sell one form of investment or another. This is especially the case when your client, the nonbusiness spouse, is the wife who had years of financial protection from the real world and is not familiar with the investing process and dealing with advisors. It is important that you act as some form of a buffer, assuming that this is a role you are willing to accept. Make sure your client understands that you are not going to fill the role of an investment advisor, but merely act as someone who will evaluate the situation from a financial and tax point of view, and whose compensation is not predicated upon whether your client purchases anything. 13.4 TAX ASSISTANCE AND PREPARATION. A basic type of service that you are probably long familiar with for many other clients is annual tax return preparation. This may be the first time in years that this formerly married person has had to deal directly with an accountant, and you will need to educate this new client on record-keeping needs and certain basic tax issues. You will also need to deal with the deductibility of your fees in the divorce case, and possibly the matter of the sale of the marital home and the related tax burden that may arise therefrom. In most ways, once you have gotten past the initial divorcing process, this tax assistance role will be one that you customarily fill for many other clients. Do not overlook the likely need for some estate planning assistance, including the preparation of a will. Your client should get in touch with a capable attorney to help prepare the will. If it is within your expertise or the expertise of other partners in your firm, see to it that you also address the issue of estate planning, or similarly direct this need to a suitable cooperating accountant or attorney. You may also have to deal with the rather sticky situation of joint tax issues that are perhaps no longer joint. This would normally apply only in the year of the divorce. The marital status of your client on the last day of the year is all that is relevant as to the filing of the return. If this person is divorced, and therefore single, on December 31, the client will file for the year as a single individual (or perhaps as head of household). While this is rather clear-cut, there may be several lingering joint tax issues that are not so straightforward. You may be put into a situation where you need to deal with the allocation of estimated taxes that were paid during the year for both the former spouses, mortgage interest and real estate taxes on a jointly owned marital home that were paid during the year, and even credit carryforwards or net operating loss carryforwards from that year or prior years that perhaps now have to somehow be allocated between the parties. Inevitably, you will probably have some interaction with the other spouse, as well as the other spouse’s accountant, and almost certainly, if this interaction does not go smoothly, with the IRS. You may wish to take as aggressive a position as possible in order to get whatever estimated tax payments, deductions, and credits you think you can on your

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client’s behalf. Before you go too far, check with your client in regard to personal interests and how much of a stomach your client has for a battle. REMARRIAGE. Finally, you need to deal with the consequences of a client who considers remarriage. From your vantage point of having worked with this client before, through the first (or perhaps it was not the first) divorce, and of course from your experience in general in dealing with divorces, you will probably want to advise your client to enter into some form of a prenuptial (also referred to as antenuptial) agreement. The effectiveness of this varies from jurisdiction to jurisdiction, but the basic rule is that if it is to be effective and enforceable at all, it requires full disclosure by both parties as to their respective financial ownership interests and involvements, their net worths, including details, and a lack of pressure or coercion as to the signing of this agreement (that is, on the eve of the wedding is not acceptable). In addition, each party must have individual legal counsel. It may be unromantic, but that is not your decision to make; it is your client’s. In the absence of this type of agreement, it is possible that all or most of the assets that you and your client fought so hard to obtain will be thrown back into the pot if there is another divorce. In the absence of a prenuptial agreement, it would at least be advisable to insist that your client keep whatever assets are solely owned individually without transferring them into a joint name, and not commingle new funds (except to the extent those new funds are generated directly from the old funds). This is very important in terms of protecting the now-premarital financial estate. It is also advisable that you have your client frankly discuss finances with the soon-to-be new spouse. In addition, again as unromantic as it may sound, your client needs to decide who will inherit the estate upon death. In the absence of certain specifics, or worse, in the absence of a will, whatever the state laws are will probably come into play. As to remarriage, discuss with your client the timing of same. If the two soonto-be spouses have approximately equal income, and if the marriage is going to occur close to the end of the year, from a purely tax/financial point of view, you may strongly urge that your client not marry until January 1. Based on the present tax structure, if the parties have comparable income, they are almost guaranteed to pay more income tax as a married couple than they would as singles. To carry this one step further, in such a situation, they may do better off tax-wise by staying single and living together. This is also a practical issue for the older clients when marriage might reduce their combined social security benefits. These may be delicate issues, and may fly in the face of certain religious or personal standards. Again, that is not your decision; it is your client’s. Your role is to bring up the possibilities and your client is responsible for making the choice.

13.5

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PART

APPENDIXES A.

Managing Your Investigative Practice

B.

Chronology of a Case

C.

Sample Reports

D.

Bibliography

II


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APPENDIX

A

MANAGING YOUR INVESTIGATIVE PRACTICE CONTENTS A.1 A.2 A.3 A.4 A.5

Dealing with Attorneys Attorneys as Clients Money Issues Assessing the Client Client Relationship

309 309 310 318 319

A.6 A.7 A.8 A.9

Operational Common Sense Using Staff Associates Staff/Personnel Issues Past Jobs List

324 325 326 329

DEALING WITH ATTORNEYS. Practically all the CPA practitioners I know in this field rely on attorneys for substantially all of their business. After all, nearly everyone who contemplates divorce contacts an attorney first. Very few think of contacting their accountant first (even those who are in business), and those who are not in business would rarely do so. The attorney as the source of business in this discipline cannot be overemphasized. A.1

ATTORNEYS AS CLIENTS. Maintaining relationships with attorneys is not much different than maintaining relationships with any other business client. Indeed, the key word here is “client.” In divorce work, although the person going through the divorce is our client, the practical reality is that our ongoing client is the attorney. Unless your divorce clients come to you again, they will be your clients only once, although they might become an ongoing tax or business client. On the other hand, the attorney who brings you the case stands to become a longterm, rewarding client, likely to represent repeat business, similar to a corporate business account for which you might do quarterly or annual servicing each year. An attorney who refers one divorce client a year (depending, of course, on the nature of the case and the style of your practice), represents the equivalent of an ongoing business client yielding from $5,000 to $30,000 yearly in fees. Doing the job right is normally the only thing you need to accomplish in order to maintain and retain that relationship, but it does not hurt to be able to reciprocate. However, nearly all practicing attorneys recognize that it is far less common for the accountant to refer a divorce client to an attorney than vice versa. The reason is simple: those considering a divorce tend to consult an attorney first, rather than an accountant. An exception might arise when a business client (likely because of a close financial relationship with you) mentions that he or she is considering a divorce and asks for your recommendation as to attorneys to interview. This gives you an opportunity to reciprocate. Move with caution, however, because a recommendation is considered a reflection on you. Do not, merely for the sake of a quid pro quo, refer a client to an attorney about whom you have doubts. To do so would A.2

309


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MANAGING YOUR INVESTIGATIVE PRACTICE

in all likelihood do you double damage: you may very well lose a regular business client and alienate the attorney, thereby ending that relationship. A.3 MONEY ISSUES. Let’s face it, as much as we may like the challenges of divorce work, we are in it to make a living. Therefore, we need to intelligently address the myriad of financial issues relevant to divorce practice.

A basic rule is you do not take on a case, you do not even begin work on a case, until the retainer check, along with the written retainer agreement, is in hand. We might make some exceptions to this otherwise inviolate rule, but we will address that later on. Frankly, this concept is not a bad idea to apply across the board for all kinds of accounting services. However, the reality for the typical accounting and auditing client is that our profession has a long way to go before a retainer for a routine recurring-type client is generally accepted. However, for special assignments for one-time clients, in doing litigation work, retainers are the norm — they are expected, and you should not leave home without one. Do not rely on assurances that the money will be forthcoming shortly. Don’t invest your valuable time for a litigation client who, outside of this litigation, has no relationship with or involvement with your office. You are being asked to take on a more difficult than average assignment, a client with whom you have no relationship, in a situation where fees can build up rapidly. Furthermore, if you are representing the nonbusiness/nonmoney spouse, the unfortunate reality of divorce practice for accountants in many areas is that, after the retainer, there may be a long dry spell until you see Mr. Green again. How much of a retainer is another issue, one that often will depend on your specific market, what your peers are charging, what your experience and reputation are, and perhaps even how much you really want that case — and along with that, how much you are willing to risk not getting paid anything else. There are no hard and fast rules in terms of determining the retainer amount, but it is not unreasonable to think in terms of two to three days of partner time to be paid upfront. Depending on your hourly rate (and we will discuss that later), you might be looking at anywhere from $4,000 to double that, or more, as a retainer. Unless you are either a trailblazer or looking to achieve a high volume of low-billed writeoffs, for the most part you probably will hew to something in the vicinity of what the going rate is in your business community. The concept of a retainer needs to be flexible. For instance, you might establish a norm of $5,000 as your base retainer for a typical divorce case. However, if, in the round of qualifying questions that go into you determining whether to accept this case, extra complicating issues come to your attention, before you commit to a figure, you need to evaluate the situation and call for a greater retainer. Increased retainers generally are required for investigating cash businesses, multiple businesses, where multiple valuation dates are involved, and for particularly large or complicated businesses. In addition, you might consider larger retainers where the time frame is short, if the client perhaps has a reputation for changing professionals, or if the nature of the work is such that not only will significant time be required, but it will be disproportionately partner time. All that being said, under what conditions or situations might you consider accepting a divorce job with no or perhaps a much smaller than normal retainer? The theoretical easy answer is under no circumstances. The reality is that you’ve Retainers.


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got to run your practice the best way you see fit. Perhaps you know you’ve got some excess payroll capacity (an oddity in this day and age); you see it as excellent training opportunity (I don’t buy that one at all); the potential in this case is substantial but funds for a retainer are simply not available (this one might be, but if the potential is that great, there are usually ways for the people to come up with a retainer); you really want to work with this attorney, it’s your chance to break into the big time (again, this might be real, but my experience is the big time attorneys usually are the best ones for seeing to it that you get a fair retainer). What about the retainer agreement? (See Exhibit A–1) Should you consider working without a retainer agreement or engagement letter? Again, but perhaps this time even more so without exception, the answer is no — you do not do this work without an engagement letter. You might be able to justify working without a retainer — and after all, maybe this new client is really a nice person and you want to do him or her a favor. That’s okay if it’s a conscious decision. However, I don’t know of any excuse for a client being unwilling to sign an engagement letter. It is important that the basics of your relationship with that client be explicitly understood, particularly in litigation matters. Without an engagement letter (and frankly, even with an engagement letter — but at least then you can counteract it), you will hear from a client that the retainer was the full extent of your fees, or perhaps you were doing this on a contingent basis, that you were going to do certain things, that you had promised to meet certain time frames or deadlines, and the like. Think of an engagement letter as your litigation safety net — it is for your protection, use it. There is a difference of opinion as to how detailed an engagement letter should be. Some will tell you it should be as reasonably brief as possible, outlining just a few items and nothing more. Others will tell you it should be several pages long, covering almost everything under the sun. Frankly, either way is okay — as long as the vitals are covered and as long as you have a signed engagement letter. Some of the basics that should be in every engagement letter include: • A brief indication as to the case or the matter on which you are being engaged • At least a brief statement as to what you are going to deliver (that is, a business valuation) • Your retainer requirement • Your fee requirement — making it clear in whatever language you want that there is more to paying you than just a retainer • Your payment terms • Certain rights you have if the client doesn’t pay • A place for your client to sign, acknowledging the terms Some of the other items that you might consider include: • A fair amount of detail as to the type of work you expect to be doing • Your client’s responsibility in terms of providing you with information and documents • A lot of self protective and disclaimer-type paragraphs • A fee-inflation protection paragraph • A lawsuit/cost-of-collection protection paragraph • Provision for your client to pay you by credit card


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EXHIBIT A–1

Sample Engagement Letter

Re: Investigation and Valuation of ______________________ Dear ________________ : You have requested that (accounting firm) investigate ______________________ , and render an opinion as to the income of __________________ , the personal net worth of ___________________ , and the fair market value of ___________________ , as at ________________ . For the purpose of our opinion, fair market value is defined at the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of all relevant facts. Before preparing our opinion, we wish to outline our understanding of the terms of our engagement and the approach we will follow in performing the above services. We understand that you require this opinion for the purposes of the alimony, support and equitable distribution issues relating to your pending divorce action. It is understood that _________________________ is not being engaged to perform an audit as defined by the American Institute of Certified Public Accountants, but rather the necessary tests of financial records that will be performed for the purpose of issuing a valuation report, and not a statement regarding the fairness of presentation of the financial statements of the above business. Certain values, derived from reports of others, and which are so designated, may be included in our report. We take no responsibility for those items. Nor do we take responsibility to update the report or disclose any events or circumstances occurring after the date of the report. In the event sufficient records and/or documentation cannot be supplied to ___________________ , no such valuation report will be issued. Our approach will likely include: a.

a review and analysis of the financial activity of __________________ ;

b.

a review and analysis of the personal financial activity of __________________ ;

c.

discussions and correspondence with management (to the extent we are given access) and other professional advisors to augment our knowledge of the operations of ___________________ ;

d.

a review of relevant published market data and other public information available to us. We will describe any such information that we consider important in our valuation report. Our report will not include any other market or similar surveys and our assessment will therefore provide only a general indication of the past performance and future prospects of ___________________ ;

e.

presentation to you of our preliminary findings following the completion of our valuation study, including at that time an explanation of our valuation approach and reasons for our conclusions;

f.

preparation and delivery of our final report thereafter.


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EXHIBIT A–1

313

Sample Engagement Letter (continued)

This appraisal will be subject to, at least, the following contingent and limiting conditions: 1. Information, estimates, and opinions contained in this report are obtained from sources considered reliable; however, we have not independently verified such information and no liability for such sources is assumed by ______________ . 2. All facts and data set forth in the report are true and accurate to the best of our knowledge and belief. We have not knowingly withheld or omitted anything from our report affecting our value estimate. 3. Possession of this report, or a copy thereof, does not carry with it the right of publication of all or part of it, nor may it be used for any purpose without the previous written consent of _____________________ , and in any event only with proper authorization. 4. None of the contents of this valuation report shall be conveyed to any third party or to the public through any means without our express written consent. 5. No investigation of titles to property or any claims on ownership of the property by any individuals or company has been undertaken. Unless otherwise stated in our report, title is assumed to be clear and free of encumbrances and as provided to the appraiser. 6. The various estimates of value presented in this report apply to this appraisal only and may not be used out of the context presented herein. Any other use of this report may lead the user to an incorrect conclusion, for which ____________ assumes no responsibility. 7. The appraisal of fair market value reached in this report is necessarily an estimate. An actual transaction in the shares may be concluded at a higher value or lower value, depending on the circumstances surrounding the company, the appraised business interest and/or the motivations and knowledge of both the buyers and sellers at that time. ______________________________ makes no guarantees as to what values individual buyers and sellers may reach in an actual transaction. 8. It should be specifically noted that the valuation (unless specifically stated otherwise) assumes the business will be competently managed and maintained by financially sound owners, over the expected period of ownership. This appraisal engagement does not entail an evaluation of management’s effectiveness, nor are we responsible for future marketing efforts and other management or ownership actions upon which actual results will depend. 9. No opinion is intended to be expressed for matters that require legal or other specialized expertise, investigation or knowledge beyond that customarily employed by accountants/appraisers valuing businesses. 10. It is assumed that there are no regulations of any government entity to control or restrict the use of the underlying assets, unless specifically referred to in the report and that the underlying assets will not operate in violation of any applicable government regulations, codes, ordinances or statutes.


314

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11. Valuation reports may contain prospective financial information, estimates or opinions that represent our view about reasonable expectations at a particular point in time, but such information, estimates or opinions are not offered as predictions or as assurances that a particular level of income or profit will be achieved, or that specific events will occur. 12. We assume that there are no hidden or unexpected conditions of the business that would adversely affect value, other than as indicated in this report. 13. Hazardous substances, if present, can introduce an actual or potential liability that will adversely affect the marketability and value of a business. Such liability may be in the form of immediate recognition of existing hazardous conditions, or future liability that could stem from the release of currently nonhazardous contaminants. In the development of the opinion of value, no consideration was given to such liability or its impact on value. We have not taken into account any and all future environmental considerations and potential liability. It is possible that additional contingent and limiting conditions will be required, and the client agrees that all conditions disclosed by us will be accepted as incorporated into the appraiser’s report. The validity of our reports is predicated on the extent to which full, honest and complete disclosure is made by all parties. In completing this engagement we will necessarily rely on information and material supplied by you. Therefore, in order for us to render a report, we require that you confirm in writing (by your signature to this letter) that you have no information or knowledge of any facts or material which would reasonably be expected to affect our conclusions except as you have disclosed to us. It is our intention to perform this engagement as quickly and affordably as possible, but these services take a reasonable amount of time to render. We will make certain that the appropriate personnel in our firm renders those services that will comply with the level of expertise required by this engagement. It is agreed that you will pay us a retainer of $______________ , and that our fee will be based upon services rendered at the rate of $__________ per hour for the services of _____________________ ; $ per hour for _____________________ ; and $__________ to $____________ per hour for the services of our staff, together with actual costs (telephone calls are chargeable time). Hourly rates are charged portal to portal from our office. It is expected that we will perform research through computer or other databases, and that we may be required to purchase research materials relating to this engagement. These and other such costs will be billed to you at our cost. It is further agreed that as the retainer is consumed, we will bill you for additional advance sums, and that the continuation of our services is contingent upon prompt payment of our billings. Invoices for services, which will be presented approximately monthly, will be paid within twenty (20) days from the invoice date. OPTIONAL In the event that prompt and full payment of our invoices would present an undue hardship (not merely an inconvenience), it is understood and agreed that, after the retainer is consumed, you will make monthly payments of at least $________ toward any outstanding balance.


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Since it is considered unethical for us to perform these services on a contingency basis, it is important that our fees be paid promptly. The appearance of independence is of considerable importance for our firm to maintain our credibility, and therefore, we reserve the right to stop providing services at any time there is a balance due our firm beyond 30 days. In the event we continue to provide services, we do not waive our right to stop at a later date. For services rendered after ___________________ , the above-stated fees will increase as follows: for __________________ to $________ per hour; for ___________________ to $________ ; for staff to between $_________ and $________ per hour. Each year thereafter, these fees will increase approximately ___%. OPTIONAL Within 15 (fifteen) days of signing this engagement letter, with our assistance, you will apply to the ___________________ Bank (or such other bank of your choosing) for a line of credit dedicated to the payment of our fees. This line will be used beginning 60 (sixty) days after your retainer is exhausted, for all billings beyond those paid for by your retainer. You will submit such bills to the bank within thirty (30) days after your receipt of same. After 60 (sixty) days from billing, the bank will pay us and charge your line of credit. OPTIONAL If, at any time during our engagement or thereafter, there is a balance outstanding, owing and due to us for more than 150 days, we are hereby authorized to lien your interest in ___________________________________________________________________ . Said lien shall be evidenced by the appropriately drafted written instruments, prepared at our expense and signed by you. Except to the extent that payments are made directly by you or on your behalf, interest, at the rate of 18% (eighteen percent) per annum (11/2% per month), will accrue on any balance (after utilization of the retainer) not paid within 60 (sixty) days of the invoice date. In the event a balance is owed to us at the cessation or settlement of this action, it is agreed that said balance, including interest, shall be paid within 30 (thirty) days of such cessation or settlement, out of the proceeds from the distribution of assets or as otherwise reasonable. If it becomes necessary for us to initiate collection or legal action in order to timely collect our fees, it is understood and agreed that you will be responsible for and pay all reasonable costs of collection, including attorney fees. Reasonable attorney fees will be considered to be up to 331/3 percent of the outstanding balance. Venue for collection or suit will be ______________________________________________________ . It is further agreed that, if any of the above-mentioned fees are assessed and paid by your spouse, you will receive a credit in that amount. ______________________ reserves the right to withdraw from this engagement at any time for reasonable cause. It is not our intention to withdraw. In the event there is an outstanding balance, we further reserve the right not to make a court appearance in this matter. All work papers created by _______________________ will remain in our possession. In the event of a withdrawal we would be liable only to return those materials and documents supplied by the client and the unused portion of the retainer.


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The undersigned _______________________ gives the right to discuss this matter with the client’s attorney, accountant, other individuals so designated by the client and any professional colleagues of the appraiser from whom professional information is sought. This engagement letter, at our option, will be considered null and void if a signed copy and retainer are not received by us by _________________ . Kindly sign and return the enclosed copy of this letter along with our retainer. Very truly yours, ____________________________ I, ________________________ , hereby agree to the above terms. _____________________________________________ Signature

_____________________________ Date

There is at least one more upfront financial issue for us to discuss — your hourly rate. We are all in this business to make money. Litigation is a specialty, and divorce work is a specialty within litigation. As a general statement, specialties call for premium rates. Such is the case in divorce work. Again, what constitutes a premium rate will vary by geography. It will also vary based on the size of your firm, the amount of experience you have, the crowd in which you run, and even the depth of your staff. (If you can blend the work at different levels, you probably can justify a higher rate for yourself.) Anyway you look at it, however, the rate for this work must be appreciably higher than the rate for regular accounting or tax work. If the going rate for partners’ time in your area for normal work is $200 per hour, you probably should be charging $220, $250, or even $300 per hour. (Your experience and the market for which you are shooting will be major issues here.) This work is not only a specialty, but divorce work brings with it much aggravation and a greater risk than average in terms of not collecting your fee if you have to wait for a settlement. Thus, all the more reason why premium rates are mandatory. Premium rates need to be used not only for partners, but for all personnel. Again, I am not aware of any standard or rule of thumb, but I suggest that a 20 to 40 percent premium on everyone’s rates, across the board, is reasonable, appropriate, and competitive for divorce work (and litigation work in general). One final word about hourly rates — especially for those of you who are heavily experienced and on the frontier of hourly rates. You very well may run into situations where your rates are as high or even higher than the attorneys with whom you are working. Sometimes that situation is ignored; sometimes it generates comments, either from the client, the attorney or both. You have a few ways to deal with this issue: • Simply and briefly acknowledge that it exists and leave it alone. • Explain that you are highly experienced and are obviously worth it.


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• Suggest that the attorney raise his or her rates. • Lower your rates as a special consideration to the attorney (and make sure the attorney is aware of this favor). • Increase your rates even more to teach them a lesson. Retainers and premium billing rates are only part of the necessary procedures. What good are those rates and how likely are you to collect after the retainer if you don’t bill? Therefore, you need to bill divorce clients regularly — in general, monthly or as appropriate for the buildup of work in progress. Your client needs to be aware that the fees are mounting, and if the client is able to make ongoing payments, all the more reason why billing must be kept current. Holding back until the end, which inevitably will cause clients to feel an element of shock, is inexcusable — and endangers your ability to collect your full fee. As to how much detail to provide in your bills, that’s a rather personal decision. I generally provide just a brief overview with as few details as possible, simply because it is easier and quicker to prepare a bill in that fashion. Some clients find that acceptable; others insist on more substantial detail — who did what, when, at what rates and for how many hours. Simply put, do what’s appropriate and best for you and your clients. When it comes to money issues, all the above is kind of the easy stuff. Let’s deal now with the matter of collecting it. All too often in a divorce case or in a shareholder suit, when you are working for the noncontrolling/nonbusiness/ nonmonied spouse (in this society it tends to mean the wife; or in a shareholder suit, the minority shareholder), you often have to wait an inordinate length of time (that is, to the settlement of the suit, the collection of funds, and when hell freezes over) to get any money after the retainer. There are several ways to improve this situation or to respond to it. • Be more selective about the cases you are willing to accept — generally, that means don’t accept anyone who can’t pay on a current basis. (While this is an idea with some serious merit, it essentially locks you out of half the market and many opportunities to work with really good people and to accomplish some satisfying results.) • Demand bigger retainers. (Obviously, there is a limit to what you can do in this area before you simply price yourself out of the market.) • Press harder and more frequently to get paid. (This one too has its practical limits and, taken too far, will alienate just about everyone.) • Stop work if money is not forthcoming. (See comment above; also if unreasonable, this might expose you to malpractice issues if you wind up stranding a client at a crucial time.) • Press the attorney with whom you are working vigorously to petition the court to compel the monied spouse (assuming there is one) to come up with more money. (While this also applies to the attorney, and therefore is for the good of you both, depending on the jurisdiction, it is often nigh on to impossible to get some judges to order interim fees.) • Charge interest on overdue balances. (An easy one to do on paper, often difficult to actually collect, but certainly worth considering. Obviously, this doesn’t speed up the collection—it merely kind of pays you back for waiting.)


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• Place liens on whatever assets you can. (This is very effective when you can do it; very difficult to do while trying to maintain a somewhat amicable relationship with the client; it also can present issues with attorneys with whom you are working.) • Fire the client. (This is a variation on stopping work and in limited and selected circumstances is certainly warranted.) When all else has failed, the case is over, you have not been able to secure a lien or other superior method of payment, your client owes you money and is not willing or able (or a combination thereof) to pay, you are faced with the same type of issue that you are faced with any other client: namely, do you walk away or do you sue? It is my personal feeling that all too many accountants have been unreasonably and unnecessarily nearly traumatized by horror stories of collection actions backfiring into malpractice suits. Make a judgment call as to the situation and, if you are satisfied with what you did, sue for collection. You are entitled to get paid, and there are times when the only language that a client (perhaps now former client) understands is that four letter word: sue. Typically, you will call the client or send letters, maybe you will have your office manager or controller do this, and you will try very hard to get the client to pay. You might even suggest or be open to the client offering to pay a discounted amount and/or over time. It is my personal belief that if you are faced with little other practical choice, a reasonable offer and compromise is preferable to suing. Be logical; if you go to collection or suit, you are probably going to lose 25 to 33 percent of whatever negotiated amount to which you agree. In addition, emotions will run higher, antagonism will be greater, it will take longer, and, if you actually go to suit, there will be no end to the aggravation of trial, the lost time preparing for same, cooling your heels in court, and eventually testifying. We know the client owes you the money, you did your job, he or she has the money to pay, and there is no justifiable reason to settle for anything other than 110 cents on a dollar. All that may well be, but if you don’t settle, even if you persevere in a suit and collect 120 cents on a dollar, unless you also are going to collect all the costs of suit, you probably will lose a significant slice of that for which you were suing, plus you will have wasted your time. In addition, there is the all too real possibility of a judge doing his or her own version of Let’s Make a Deal. When it comes to getting paid, divorce practice is just like any other facet of accounting service practice, only a bit more difficult. It requires client selectivity, careful monitoring of a client, persistence, and follow-up. What you charge is often not as important as how you effectuate collection. If done reasonably well, even with the inevitable write-offs, courtesies, discounts, and credits (and even allowing for time value of money for those cases that drag on), divorce practice can be a profitable niche. ASSESSING THE CLIENT. It is not unusual to be contacted by an attorney asking you to meet with him or her and the client and then to be engaged to assist in the investigation of a business, the analysis of the personal financial lives of the parties, and the valuation of the business. Often you are told that this business has been generating a comfortable income for years and that there is probably some unreported income. You know that you would like this job, that you can handle it, and that you could probably come up with some interesting A.4


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revelations as to unreported income and do a really ace job on the report and valuation. However, it is important to try to determine, with help from the attorney if necessary, how your client is planning to pay you. This will also help the attorney with whom you are working understand how he or she will be paid. Even if the client or the spouse’s business has supported the family in a very comfortable style for years, and although there is probably unreported income, none of that guarantees that there are funds or assets from which to pay you. Of course, you are told not to worry because the marital home is worth $400,000, with a mortgage of only $100,000, and your client, the nonworking spouse, is going to get the house. Those who have done accounting work for a few years, especially through the real estate recession of the late 1980s and early 1990s, know all too well how illusory that sense of well-being is. Maybe there is only a $100,000 mortgage on that house, but what is the house really worth in the present economy? From your point of view regarding getting paid, you are interested in liquidity and the house does not represent liquidity. CLIENT RELATIONSHIP. Probably the best part and the worst part of divorce practice is dealing with the clients. You really have no choice; there are few cases without clients. And there are truly some very good clients and many situations where you can accomplish much for which you can be satisfied and proud. On the other hand, you are getting involved with people at some of the worst and most tension-filled times of their lives. A good/decent person at that time certainly can be difficult as a client. Someone who is not necessarily all that nice to begin with (and depending on whom you listen to, in divorce actions, there appears to be no shortage of people who are simply not nice) makes that situation often intolerable. How do we minimize the potential problems, and what are some of the procedures we should be employing in divorce practice? Let us first deal with the matter of client acceptance. Based on over 20 years experience, handling hundreds of divorce cases, I can share with you that there are two ways to accept clients: A.5

1. You can take anything that comes in the door. 2. You can pick and choose. Please take your time to carefully digest that brief bit of wisdom. Let’s deal with the selection process. A basic reality is that, many times, you simply will not know just how good or how bad of a client a person is going to be until you have had that person as a client for some period of time. Nevertheless, there are certain telltale signs warning you not to accept this client: • Blood-splattered clothing —I have found this one to be a good barometer as to client acceptance. • Maniacal fervor —I don’t know about you, but I find zealots to be very difficult people. • You are the third accountant to be engaged — what was wrong with the other two, and what makes you think you are so special? • This client is on his or her third attorney — see above. • The client has come to you not through an attorney but rather through your website, an article you wrote, an ad in the newspaper, the yellow pages —


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this is not an automatic avoid, but experience tells me to be extra careful when the source is not an attorney. • The attorney who is making the referral. This type of insight comes from experience, but referrals from some attorneys are golden, from others pyrite. • During your first interview, the potential client comes across as the victim of every attorney, accountant, and government secret agent. For such a person, there never can be justice. • Your prospective client was recently released from a maximum security facility. In the client selection process, it is very important that a firm establish certain conflict check procedures. How detailed and elaborate such procedures are, of course, will vary depending on your firm. A sole practitioner does a conflict check every time he or she considers a potential client. A small firm, especially with only one main player in the divorce field, probably can accomplish conflict checks easily by circulating a simple memo or making a few internal telephone calls. On the other hand, a larger firm, especially one with several people involved in the divorce field, needs to have a much more formal procedure — and it has to be in writing. As soon as you are contacted to consider handling a case, you need to get the vital information (that is, who is the potential client, what is his or her business, who else might this person be in business with, where does this person live, who are the attorneys involved). It is advisable, unless you are absolutely sure you have no conflict, to consider halting the discussion with the referral source at the very onset until you have had a chance to check out the potential for conflicts. With the information just described, you would circulate a memo (a preestablished form is easiest to handle) to all your partners (and perhaps even lower down), soliciting a positive or a negative response. Depending on the state of your internal communication system, you might do this by e-mail. However your firm handles a conflict check procedure, it is obviously important that it go through such a process. There are some subtle areas of potential conflict that are not necessarily considered as such by every practitioner. This includes tax clients, corporate/business clients, certain attorneys, clients of certain attorneys, and so on. Some of these subtle potential conflicts need to be considered: • It’s a regular client of the firm. Say if your firm does a mix of services, including not only litigation/divorce work but also handling regular corporate/ business and tax clients. Inevitably, some of these clients are going to be involved in divorce. As a result, especially when your expertise in this area is recognized, you will be approached by them, or possibly even their attorneys, to handle the accounting/financial aspects of their divorce. The general rule in such a case is you decline. You can help the parties a little, but even then at the risk of alienating one or both of them. However, when it comes to the more serious involvement such as investigating and valuing a business, if it is a regular client of your office, most of the time it is inadvisable to get involved. Some of the problems that arise include the fact that typically you have done joint returns, meaning therefore both spouses have been your clients, so how can you represent one against the other? If it is a


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business client, just how clean are those records? How can you possibly prepare a report and/or testify as to perquisite add-backs (let alone cash) as to which you have already issued financial statements and/or tax returns? Just doing the normal reasonable compensation adjustment issue might give the opposition the reason to challenge, from a tax point of view, whether you were “allowing” your client to take an unreasonable compensation in contravention to the tax laws and, even though this client is only one of a hundred, and from our CPA standards you are clearly independent, in a divorce action, you will not be viewed as independent. • One of the attorneys is your client. Despite some thinking to the contrary, attorneys are subject to the U.S. Constitution. Thus, most of them file tax returns, and most of those who do file tax returns rely on CPAs to prepare them. You very well may be one of those CPAs. What happens when you are the one who prepares the tax returns for an attorney who is representing a spouse going through a divorce and wants you as his or her expert; or you are asked by the other attorney to be the expert, in effect “against” your attorney client? Most of our peers believe this is in no way an obvious issue. If you are working with the attorney who is your client, you certainly will not have a problem per se with the spouse going through a divorce; you may have a perceived problem as to your independence because you are working with an attorney who is your client. In all likelihood, unless that attorney is a very substantial client for your office, the potential for conflict, perceived or real, will be rather minimal. It might be a little more difficult if in effect you are working “against” your attorney client by representing the spouse who is represented by the opposing attorney. Good attorneys have no problem with this — they understand you are going to do a professional job, and in fact, they may welcome you in that position if they value you. On the other hand, some attorneys will perceive such a situation as rendering you biased, believing you have a natural inclination to favor (avoid antagonizing) your attorney client. • The attorney is a major referrer. This one is even more subtle but potentially more dangerous than the preceding illustration. What if the attorney with whom you are working represents a very significant portion of your divorce work? I have been involved in situations where my CPA opponent relied on a particular attorney for a very substantial (that is, 30 to 50 percent) of her divorce work. When that accountant is working with that firm, just how independent could that accountant possible be? While this issue tends not to be pressed all that often, it is truly a potentially major area for conflict and lack of independence. • It is a tax client. This usually is not a big issue. However, most of the time with married people, both of them are tax clients since we tend to do joint returns. If that is the case, there might be some question as to whether it is appropriate for you to represent one of these people in a divorce action (that is, valuing his or her business when you are not the accountant for the business but only do the personal tax returns) because of the argument that both of these people are your clients and thus it would be inappropriate to represent either of them in a divorce action. It is my understanding that clearly this would be forbidden by ethical constraints for attorneys, but not so for


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accountants. Nevertheless, the perception of a conflict may present an issue. I am not suggesting that you decline all such assignments, only that you recognize that there is the potential for challenge as to your independence. • The client is an attorney with whom you have done business. Let us assume that an attorney who has referred you business in the past (divorce cases or whatever) is now getting divorced, and you are asked to value his or her law practice. Does it make a difference if you are valuing that law practice on behalf of the attorney or on behalf of the spouse? It would seem to me that if the valuation is on behalf of the attorney, it would be possible, although likely a bit remote, to seriously question your independence. Yes, you have received business through this attorney and thus have a relationship. On the other hand, unless the volume of business you have received is so substantial that it would indeed bring into question your independence, you probably would be all right on this one. However, if you are being asked to value the practice on behalf of the spouse, while clearly you would not have a conflict in the sense of being independent, it is difficult to understand why you would go and do a valuation for the other spouse against someone who has been a business referrer. • The client is a neighbor. There is probably no real conflict here, assuming that the neighbor relationship is one of simply being neighbors. However, you are probably in a no-win situation when representing a neighbor. If you are working on behalf of the neighbor who is going to remain in the house, you now have a client in an emotional situation next door to you, who probably feels it is his or her right to drop in at any time to discuss the case. And what if the case does not go the way you would like, and what if your valuation isn’t the “winning” one? Of course, you could be doing the valuation on behalf of the spouse who is no longer in that house. This might even be a worse situation — now you may have an enemy living next door to you. Do you really want to have to clean up your spilled garbage pail every collection day? • The client is one of your partners. This one is a real piece of cake. One of your partners is getting divorced and, to save on expert fees, you are implored to do the valuation of your practice on behalf of your divorcing partner. After all, you do valuations all the time, you really know accounting practices, so who better (and who cheaper) to do the valuation? I think this one ranks up there in the world of big conflicts, with an implicit flashing neon sign warning you to stay away. However, let me slightly modify this nearly absolute prohibition. You may be faced with a situation where one of your partners is getting divorced, and you have a good working relationship with the expert engaged by your partner‘s spouse. As long as you are not going to do a report, and as long as you are not going to get involved in court, you may be able to do your partner (and thus of course yourself and your firm) a service by facilitating the valuation process for the other expert, negotiating with him or her and attempting to arrive at a mutually agreeable compromise on value. Anything more than that, tell your partner to go buy a dog. Accountants are naturally reluctant to allow another accountant to gain financial intimacy with our client. We are concerned about losing the client, which is a possibility. The way to address this issue is to make sure (if it was


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a good job) that your client knows that you were responsible for bringing in the other accountant. Furthermore, throughout this accountant’s involvement, continue to maintain a close relationship with the client (even if you cannot fully bill). In addition, you should be able to render assistance by preparing or supplying certain schedules and analyses for the investigative accountant. This is no different than sharing an audit of your regular accounting client when you do not perform audit work and need to bring in someone else. One of the aspects of divorce work that clearly differentiates it from more traditional accounting work is that in the latter, there is an ongoing relationship, somewhat in the form of an annuity. Litigation/divorce work are all one-shot deals (except for those considerate clients who repeatedly get themselves into lawsuits or believe that if getting divorced once made sense, doing it twice or three times makes even more sense). However, in this type of work, in one sense you do have a recurring client — the attorney is sort of a proxy for the client. If a good corporate client for your firm brings in $10,000 per year in fees, then maybe it is not unreasonable to look at an attorney who brings you one or two divorce cases per year, and does that on a recurring basis year after year, as in a sense your litigation client. Just as client selection is important, it is advisable to give some attention to the concept of attorney acceptance. Some attorneys are absolute pleasures to work with, some kind of neutral, and others downright unpleasant. In many ways, this is no different from typical business clients — you have got to pick and choose with whom you are willing to work, and how much aggravation you are willing to accept. The first two types are relatively easy — you are going to accept work from them. There is no logical business reason not to. However, some attorneys have a reputation of being simply impossible to deal with; some are even downright dishonest, unethical, or conduct themselves in a fashion that is dangerous to all those with whom they come in contact. Generally, you will need to make that a conscious effort to avoid those. Some of these attorneys are difficult and perhaps even dangerous to work with, but represent significant and interesting cases. For the experienced practitioner who understands the risks and knows enough to cover him- or herself, it might be a reasonable and prudent risk to work with such attorneys. You may choose to work with an attorney who has a reputation for being abrasive, even abusive to everyone and unreasonably demanding. However, avoid those who are unethical. “Difficult” attorneys may attract certain high-income complex cases that are worth accepting. On the other hand, avoid the attorney who has taken apart your report in the past and submitted pieces, or has misrepresented you in court, or has a reputation for ripping off clients. It is likely that in every “community” (which might mean a big part of a state), there are going to be one or two or even a few such attorneys with whom you are better off not being associated. One final word on mediating a husband-wife corporate client situation. Based on actual experience, I can relay to you a situation not long ago where both husband and wife were truly and deeply involved in the business, and were getting divorced. That divorce action had the potential to destroy the business (a good corporate client of mine) and wreak financial havoc on them. They accepted my offer to serve as a financial mediator. With knowledge and consent of their


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attorneys, and keeping their attorneys fully in the loop, I met with them several times over several months to help resolve substantially all of the financial issues— including how much each was going to get paid out of the business, resolving the handling of certain expenses, and the eventual division of the business operation. On one hand, it was a very successful service, effectuating a mostly peaceful and minimally painful split of the business, along with substantially preserving the martial estate. On the other hand, perhaps in part because of the strain of trying to keep an even hand between the two of them, I succeeded in losing the business. Of course, that might have happened naturally anyway as a matter of one or both of them severing all ties to the “old world” after the divorce or by the financial destruction of the business operation if I didn’t step in. In almost any type of services situation, and even more so in divorces, you can do only so much in picking your clients. At some point, you will have picked the wrong client and you will have some really interesting war story to tell your peers. OPERATIONAL COMMON SENSE. One of the most important qualities accountants can offer is simply common sense. Most accountants certainly have adequate technical training and competence for much of this type of work. Putting aside the issue of personality and courtroom demeanor, the following basic rules, revolving around common sense, are extremely important in doing this work well and gaining a reputation that will continue to generate more work on a regular basis:

A.6

• Return phone calls. Remember that attorneys often face pressing deadlines that can be the source of much tension. As to the client, this experience is very personal and emotional, and not merely a business transaction. Further, clients know you only from this particular case and will judge you accordingly. • Do not practice law. Do not usurp the role of the attorney. Expect clients, especially nonbusiness spouses, to try to play you against the attorney and seek your opinion as to different aspects of the case, even as to matters of law. The CPA is not the attorney, and even if you think you know the law, remember that it is the province of the attorney. • Do not be too optimistic. Do not tell the client that any degree of winning is a sure bet. The word “winning” is often inapplicable to the divorce process because there are usually no winners. What is fair is not necessarily what will happen. An optimistic assessment of the situation is something your client will remember as a semi-guarantee. • Keep the attorney informed. In addition to returning calls, be mindful of the need to initiate certain communication to ensure that the attorney with whom you are working is aware of progress, obstacles, and concerns. If you are not getting cooperation (for example, as to discovery requests), your attorney can emphasize to the opposing attorney the importance of client cooperation. Last-minute surprises are as unwelcome to the attorney as they are to you. • Bill regularly. Do not accumulate your time over several months and than hit your client with an unexpectedly (from your client’s perspective) large bill. • Keep a good calendar. Be sure to schedule any follow-up or subsequent activity you need to attend to, and keep yourself informed (or course, with the


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attorney’s help) as to important due dates (when your report must be submitted, when depositions and trial are scheduled). • Use staff and use them well. Some of the work we do is basic investigation and number-crunching. Some of that can be done adequately by support staff at lower rates, which will keep the total fee down. • Maintain your professionalism. There is often pressure to take the most proclient position you can. There is certainly room in most situations for professional latitude, but you must always maintain professionalism and a sense of objectivity in order to do the job correctly and to maintain credibility. • Take a step back and evaluate the situation. Look at the situation in its entirety and consider whether it is time to stop working and discuss the practical problems you are facing. For instance, if you are representing the nonbusiness spouse, you may realize that, despite your client’s desires, the income and the assets are simply not there and that proceeding further would be a waste of time and money. In representing the business owner, you have perhaps concluded that the exposure is too great, the value substantial, and a spirit of compromise is in order. USING STAFF ASSOCIATES. Assuming that you are not a sole proprietor with no staff to help you, the issue usually comes up as to whether to bring a partner, staff associate, or junior employee with you on an investigative assignment. There are a number of reasons to include another person: A.7

• It tends to shorten the time needed to get the job done. • It spreads the work, making it more efficient within your office. • Some work can be done by a junior-level person without a manager or partner involved. • With two people, you have the opportunity to discuss the case and share ideas. • There is a greater ability to secure and protect your files and guarantee privacy. • It provides a back-up person who is familiar with the case if questions are raised in your absence, or if additional field work is necessary but inconvenient for you at that time. Whether to use staff associates in this type of work, although warranted, is more of a judgment call than usual in the routine-type commercial work. Considering the sensitive issues involved and the need to be prepared for litigation (although there are usually many types of work a junior employee can handle), be careful to use the appropriate mix of experience and sophistication. When you give your employees some free rein, they must understand the work and have sufficient experience to recognize that this is not a routine audit. If you are not going to spend your own time reviewing the company records, be sure to send someone who has a thorough understanding of this type of work and an appreciation of the need to dig, to look under the surface, and tie up all the ends. For example, a less experienced person might review a check cut on the company’s books to the business owner, observe that the check was endorsed by the business owner, and consider that to be a completed step in his or her work.


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The experienced investigator, on the other hand, might observe that the business owner’s endorsement included a bank account number of which he was previously unaware. STAFF/PERSONNEL ISSUES. Unless you are an absolute purist, when doing divorce work, sooner or later, you need to accept the fact that you will increase the volume of what you do and improve your personal efficiency if you bring staff into the equation. Using staff is one of those love/hate relationships, and often we just do not have acceptable alternatives. However, if you want to do more of this work and make more money than is possible just on your own personal labors, you need to take advantage of the capitalist system and make a profit off the sweat of the proletariat. There are many issues involving hiring and using staff, ranging from the conceptual to the practical to the absurd. In no particular order, allow me to present you with what I consider to be several of the key issues to be addressed in a divorce practice. A.8

• Previous experience level. Some of my peers have hired accountants fresh out of school and, with no experience, make them dedicated to the litigation department. I personally believe that is a mistake — an accountant is much more effective in litigation work (particularly divorce work) when that person already has had a few years experience getting to understand businesses from the perspective of being on the side of the business owner rather than against him or her. Spending serious time working with business owners to reduce/shelter income gives you a true appreciation of what is involved, accounting systems, some of the games that are played, and where to look for the family jewels. How can someone with no experience do a good job investigating a business and uncovering perquisites, let alone unreported income? • Dedicated staff vs. the bullpen. Once we have experienced staff involved, I believe this one is a clear-cut decision, assuming that you have enough staff to make this a choice. I want people working on my litigation cases who are substantially dedicated to litigation work. (If you have the volume and the luxury, they should be exclusively dedicated to litigation work.) • Down time. This one to a degree relates to the preceding item. If you are going to use specialists, and there are lulls in the business, you may find that you are not getting as much pure production (billable hours percentage) out of litigation-dedicated staff as contrasted with a bullpen accountant. Accept that as reasonable under the circumstances, and charge the premium fees that this type of work deserves. Then you can breathe a little more comfortably with only 1,900 billable hours a year from that staff person. • Gender. Presumably we can agree that there are two genders. In most of the work we do, gender is not, and indeed should not, be an issue. However, in divorce work, I strongly recommend that you have a team that includes both genders. Because of the personal and emotional issues involved in this type of work, there are times when you will be much better served by having a female handle the account; and other times you will be better served by having a male handle the account. Some people going through the divorce process want to have nothing to do with the opposite gender. Considering


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what some people have endured in their marriages and what they are subjected to in the divorce process, that is really not surprising. • Experience level. When doing a classic audit, you probably have the lowest junior handle the bank reconciliation and petty cash; you step up the level of experience for someone to test receivables; and then perhaps go real heavy when it comes to an area like inventory. That kind of stratification usually is not easily accommodated in divorce work. There are certainly many times when you will want to make use of a junior-level person, figuring that there is a lot of basic accounting record review, checking account analysis, and simple bill vouching. However, you are going to be faced simultaneously with the need to fill up a full day in the field, and some of the work is going to be far more difficult — perhaps looking for unreported income or really understanding various invoices that will be vouched; and, of course, making decisions as to what is worth spending time on and what is not. Because of the difficulties of this work and the exposure, when in doubt, err on the side of using a heavyweight rather than a lightweight. Do not overestimate a junior staff’s ability to understand what is involved, otherwise you will get a straight audit mentality approach that in effect says that since there is a bill here proving the expense, it must be legitimate. • Auditor or tax person? You know that you want someone who is inquisitive, but do you want the classic organized work mind of an auditor or the conniving thought process attitude of a tax person? I don’t have a definitive answer for you, but if forced to make a choice, especially in divorce work, I think that a tax person will do you better than an audit person. To have that staff work as meaningfully and as profitably for you as possible, you need to invest time and effort in that staff and you need to make sure that each staff person understands some of the truly interesting and difficult nuances of this type of work as contrasted with normal client servicing. This brings into play such issues as personality, personal presence, maturity, and discretion. • To chat or not to chat. With the typical accounting client, a certain amount of chitchat is good for the relationship and natural within the context of servicing that account. Also, since you are working with and for that client, there tends not to be anything in particular causing you to be overly concerned about conversations with that client and his or her personnel. It is a different situation on an investigative case. The staff must understand that if we are investigating a business while representing the nonbusiness spouse, it is extremely important how we conduct ourselves, whom we talk to, and what we say. There are similar concerns even if we are working for the business owner — usually only a select few (if any) of that person’s employees are aware of what is going on, the magnitude of same, or specifically what we are doing and why we are doing it. It takes a certain style and maturity to be able to draw a target’s employees into a revealing discussion. • Overlapping. Considering the nature of a litigation case — with its nonrecurring aspects, often limited window for access to records, potential for embarrassing mistakes — you need to be willing to endure more overlap between you and your staff than you would in a typical commercial account. That is, do not hold back in having your lead staff on an assignment participate


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with you in selected conferences and interviews. Even if you have to eat that time, the work product probably will be much enhanced. In the long run, this will be a profitable use of your personnel. • Training. There is, of course, the obvious need for training or continuing professional education as a general item and specifically for any area of practice. Litigation work is no different, particularly as to such technical areas as valuation. Also consider seriously having at least one senior staff person learn how to write reports. You are ahead of the game if you have a good report writer already. However, all too often we see bright capable people who may do a lot of excellent work but have no idea of how to write a report, the flow of language, the need to make things clear and understandable to the reader, and who even have astoundingly poor grammar. You will save yourself a lot of time and aggravation if you can count among your senior personnel a good report writer. Allow me to briefly illustrate why staff needs direction. • Lots of deposits, totaling far in excess of reported income. The staff’s first impression was that this was a slam dunk, we had proof of major unreported income. The problem was there were multiple bank accounts, and what that staff was looking at was merely the movement of money between accounts, creating the illusion, but not the reality, of much income. • Travel and entertainment documentation. In the best sense of an audit, the staff came across solid documentation proving the expense. End of story. However, was it a business expense or was it personal? It turned out, of course, that much of it were personal expenditures — it is just they were well documented. • On the move. The company being investigated moved during the year. Everything was in order, all expenses were accurate and reasonable and with unrelated third parties; and the rent on both ends was to unrelated third parties. Therefore, the staff determined that no adjustments were necessary. However, what about nonrecurring expenses and what about three months of duplicated rent expense? • I’m just too good. A retail store with a cash register tape that tied perfectly to sales. There is such a thing as too good to be true. What about the second cash register? These are but four actual examples of situations where very competent and capable accounting staff did what they thought was the job but missed the essence and spirit of why we are there. Make sure that whatever staff you use — seniors as well as juniors — understands what we are there for, what we are trying to find, and the importance of looking outside of the box. Perhaps the ultimate issue in having the right personnel for any aspect of our practice, indeed for any aspect of most businesses, is the matter of succession. In the traditional accountant-client relationship, transition, while it has a number of issues, tends not to be all that difficult or complex — generally revolving around personality. This is generally also true for even many of the aspects of the “modern” accounting firm. It is not quite that easy in the litigation field. On one hand, virtually every job we do in litigation is a one-time job, and therefore virtually


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every client we have is a one-time client — to which no transition/succession is possible. On the other hand, we need to recognize that in many senses, the proxy for the ongoing client relationship in litigation work is with the attorney who refers the business. Just as a client might provide you with $10,000 a year of fees, an attorney may refer you one litigation case per year — and thus is the equivalent of that $10,000 a year regular accounting client. Succession within your firm as to the work you are doing in the litigation field basically means being able to transfer the referral base — transfer the relationship so that attorney will feel comfortable referring to someone who probably was your employee and now perhaps has become your partner and is taking over your “book” when you retire. While perhaps somewhat more difficult than the normal accounting client transition issue, it is something that can be attacked logically and methodically and, assuming, of course, technical competence, is a matter of almost routine human relationships. In addition, and too often overlooked, just as you may face transitioning a client from you to another partner in your firm, you also may have that transitioning need within the client itself from one generation to the next. In some ways it is even easier with a law firm — if you have established yourself with that firm and have a good relationship with one of its major players, perhaps the person in your firm who will be succeeding to you is a good match (if nothing else at least by age) with other attorneys in that firm, including those who might succeed to the litigator with whom you have a relationship. Make it a point to go out of your way to secure these interrelationships. Do not keep a good promotional lunch/dinner to yourself — bring along a senior-level person of your litigation department whom you are looking to become the next in your firm to run with the litigation work. If your firm’s culture is such that you are overly protective of these relationships, you will not be able to transition your litigation work. PAST JOBS LIST. One of the more useful and practical tools in doing a volume of litigation work — which some of us address early on, and others of us stumble onto after a while — is maintaining a list of all the jobs you have worked on. Of course, merely compiling a list, while of some interest, is not sufficient. The list also needs to provide useful information. Tied in to maintaining this list is maintaining a file (which over time will become several file drawers) of reports you have done and reports that your peers have done. There are a number of benefits from/reasons for maintaining this type of list: A.9

• It helps to put in perspective what you have done and in how many cases you have been involved. • It is a useful tool for refreshing yourself as to how you approached situations in the past in cases where you might be coming across that same situation again. • You may be able to use boilerplate language, schedule formats, and other elements of past reports to facilitate the preparation of current reports. • By using past reports (and developing your format as you go along), you will ensure a greater uniformity and consistency between your reports. • When you get that prospective telephone call, you will be able to (with assuredness and perhaps even specificity) indicate that you have done a certain number of that type of investigative or valuation job in the past.


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• At times you will need to be able to produce either copies of reports or at least case names or docket numbers — perhaps in the qualification process of being accepted as an expert. • It may prove handy as material to develop a speech and also for presenting case studies/war stories in a speech presentation. Maintaining copies of as many reports of others as you can get can be very useful. • You may find formats, styles, wording, and other elements of others’ reports that are worth adopting for your own. (There is nothing wrong with learning from others.) • Particularly where a peer advocates a little too subjectively, having past reports may enable you to challenge his or her credibility by showing a built-in bias in favor of the side he or she is representing. For instance, in divorce practice, does your opponent tend to always lowball a number when representing the business owner and highball the number when representing the nonbusiness spouse? Exhibit A–2 is an example of a past job listing format that I maintain and that probably will be helpful in your practice. I have tried to make it both abbreviated and informative — often two contradictory goals. Presented is a lead sheet, which includes the various codings, as well as a second and third sheet. I would like to bring several aspects of this list to your attention. Going from left to right: • I use the first column, to the left of the client name, to indicate either NR (no report prepared by us) and/or A (appointed by a judge — with the judge’s name after the client’s in parentheses). It is helpful to know on which cases you have not prepared a report — you might have worked on them, but there is no specific work product to reference. Being able to identify those cases to which you have been appointed by a judge is also helpful in that one appointment tends to beget another. It is helpful to be able to respond when asked as to which judges have appointed you on which cases. • The next column is the all-important client’s name — in alphabetical order, based on the easiest way to identify that assignment. In divorce, typically it would be the last name of the client. In a commercial litigation case, it probably would be the name of your client (regardless of whether your client was the plaintiff or defendant). If it was perhaps just a valuation (that is, for gifting or estate purposes), you probably would use the company’s name as the client. • The next two narrow columns are used to put a T (meaning there was a trial and therefore what you did is of public record), and/or a U (meaning that there was a determination there was unreported income). • The next series of columns are there to help easily identify the no-divorce cases. In my practice, the main volume of investigative and valuation jobs are divorce-related. Therefore, everything on my list is from a divorce case— other than those that are indicated otherwise. For my purposes, I have identified my nondivorce work (investigation and/or valuation) as taking one of three forms:


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—Partner/Shareholder Disputes. These are commercial divorces and in many ways (generally the major exception is the lack of access to personal financial records of the other side) are the same as a divorce case. —General Valuation. This might be valuations done for estate planning, gifting purposes, merger and acquisition work, whatever. Generally these are nonlitigation situations. —Commercial Litigation. These often do not involve business valuation and are typically matters such as fraud and embezzlement audits, lost profits claims, and various other business litigation situations. • Other accountant’s report. There is nothing sacred here about the use of the word accountant — it just as well could be experts of any sort. The function here is to have a listing of who was your opposition in each case. It is hoped that you also have a copy of all those reports. It is a good idea to get a sense for who on a regular basis tends to be your competition. • The key at the top right of the exhibit pertains to the next narrow column. The purpose here is to try to quickly and easily identify the nature of the business being investigated or the type of service. This is also very useful when, for instance, an attorney calls and asks you if you have ever done a divorce case involving a medical practice. Using the coding I have suggested, where M stands for medical practice, you can easily scan this list and be able to respond that you have done perhaps over 20 or 30 medical cases. There is nothing magical about the coding I have used — use what is best in your practice. A few codings are not industry specific. These include N for net worth — where the predominant aspects of our servicing was to develop a net worth of the individual or couple rather than worrying about a business. Also, S, where the standard of living was the key issue. Similarly for F— funds flow — since some of our cases require proving what happened to the money. There is no valuation issue involved here, there is no standard of living, but it is a matter of who did what to the money. Finally, more recently I have also added FLP, for family limited partnership. This is where the dominant issue for our control purposes was the valuation of an entity for a FLP. • The last column is used to give a bit of a description to identify the specific business type. For instance, I referred above to the use of M to indicate a medical practice. That is good for a quick sense — but then you are going to want to know a bit more. Was it a family practice, a vascular surgeon, or a cardiologist? Keep this type of list updated regularly — every time you get a new case is ideal. Of course, when you first get a case, you do not know various aspects, so you will need to update the list later.

332 Partner/ General Shareholder Valuation, Commercial Dispute M&A Litigation

Other A/C Report

M A N C L S F V E FLP

-

Specific Business Type

Medical Accounting Net Worth Construction Law Standard Living Funds Flow Vehicles Eatery/Restaurant/Food Family Limited Partnership

1:25 PM

Nonmatrimonial

T = Trial (report public record) U = Unreported Income

Matrimonial & Investigative Jobs — (Update-___________ )

10/22/01

NR = No Report by Us A = Appointment (Judge)

EXHIBIT A–2

Barson App.A (307-333) Page 332

EXHIBIT A–2

Partner/ General Shareholder Valuation, Commercial Dispute M&A Litigation

Nonmatrimonial

Matrimonial & Investigative Jobs — (Update-___________ ) (continued)

Other A/C Report

Specific Business Type

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333

Barson App.B (334-338)

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APPENDIX

B

CHRONOLOGY OF A CASE Below is a hypothetical, but thoroughly likely, scenario of how an investigative assignment might proceed. This involves a matrimonial case where the accountants are contacted by an attorney to represent the wife. Day 1 Attorney contacts us by phone with an interesting matrimonial job and feels that our services are needed. Day 2 We issue a letter to the attorney advising of our requirements in terms of fees, time frames, and record discovery (without getting specific). Day 10 Not having received a reply, we follow up by telephone and discover that the client (the wife, in this case) has not yet made a decision. Day 20 The wife decides to engage us and asks the attorney to proceed. The attorney then contacts us and a brief conversation ensues. It is agreed that we will meet the wife, in the normal course of our interview function, to initiate our services. We call the wife to arrange for an interview. She is not in and we leave a message. Day 22 The wife calls us back and advises that she’s having second thoughts about working with her present attorney and would like to wait on further arrangements. We call the attorney, who is out at a trial. We leave a message. Day 24 The attorney calls us back, indicates that he is aware of the wife’s situation, and encourages us to be patient. Day 35 The wife calls us to say that she has decided to stay with the present attorney, has advised the attorney of her decision, and would like to meet with us. We schedule an appointment for four days later. Day 36 We prepare our standard engagement letter to present to the wife when we meet with her. We also prepare and mail our standard records discovery letter to the appropriate parties, asking for access to various books and records of the business to be investigated. Day 38 We receive a call from the wife, advising that because of a personal problem, she cannot keep the following day’s appointment and would like to reschedule it. I am not in the office at the time, so she leaves a message for me to call. Day 39

I call the wife and reschedule the appointment for three days later.

Day 42 During our conference with the wife, we give her the engagement letter and ask that she review it and, within the next couple of days, return a signed copy along with a retainer. We also contact the husband’s attorney to 334


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follow up on our records request letter and to obtain access to the books and records of the business. She is not in, but will return our call. Day 44 Not having received a return call from the husband’s attorney, we follow up with another telephone call. We also call the wife’s attorney to advise him of our progress. Day 46 The husband’s attorney calls and suggests that we be patient because some issues need to be clarified and mutual discovery obstacles exist. We call the wife’s attorney to pass along this response. Day 55 We pursue discovery by calling the wife’s attorney. He’s out and will return our call. Day 57 The wife’s attorney calls us and advises that there is progress and that we should be able to begin our work soon. Day 65 The wife’s attorney calls with the go-ahead to contact the husband’s attorney. We do so; she’s unavailable; we leave a message to return our call. Day 68 The husband’s attorney calls and advises that she has no objection to our investigating the business, and that we should contact the husband’s accountant to arrange the details. We do so immediately. The accountant is not in; he will return our call. Day 70 The husband’s accountant calls us and explains that although he knows we are involved in the case, he has no idea which records we want to see. Apparently, he never received a copy of our letter to the husband’s attorney. We send him one immediately. Day 73 We contact the husband’s accountant to follow up on our records discovery letter, and schedule an appointment with him. The earliest date that is mutually agreeable and allows time to gather the records is approximately two weeks later. [Note that over 70 days have elapsed between first being contacted and finally establishing a date to begin our fieldwork, which is 87 days after the initial contact.] Day 83 We call the husband’s accountant and reconfirm our appointment scheduled for day 87. Day 86 The husband’s accountant calls to inform us that not all records have been gathered and there is an unavoidable conflict. We reschedule the appointment for six days later. Day 92 We arrive at the husband’s business to begin our work and find that only part of the business records we have requested are present, and none of the personal records. His accountant has no control over these records (often the case) and the husband is not available. We begin our work and, before leaving, leave a list of follow-up items and necessary records. Day 93 We send a follow-up letter to all parties concerned, advising of our additional record requirements and requesting a return date. Day 97 We make the necessary telephone calls to follow up on our request to return and resume our investigative work. We follow up these telephone calls with written requests, for the record.


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Day 101 The husband’s accountant calls and we arrange to resume our investigative work on the next mutually available dates —13 days and 16 days later. Days 114 and 117 We work for two days at the husband’s business. Since some records are still missing, we need to schedule a final (?) return visit. Day 118 We contact the husband’s accountant to schedule a return visit five days later. Day 123 We work at the business and, except for a few follow-up questions, complete all fieldwork. Day 124 We send correspondence to resolve pending questions, requesting a prompt reply. We also call the wife and schedule another interview to discuss various findings and obtain her input since we now have solid information. Day 132 Having received no reply to our follow-up questions, we call (and confirm it in writing) the husband’s accountant, who promises prompt cooperation. Day 139

Replies to our questions are received.

Day 143 We have a conference with the wife, discuss our findings, and get further details from her. Day 150 Before putting our preliminary findings in a report, we contact the wife and her attorney to discuss those findings. Day 152 The wife’s attorney calls to report current attempts at negotiating a settlement and suggests delaying our draft report. Day 170 We call the wife’s attorney to inquire as to settlement negotiation status. He is unavailable but will return the call. Day 171 The wife’s attorney calls to report that settlement discussions are continuing, however there will be no activity in this case for at least a couple of weeks. Day 190 The wife’s attorney calls. Settlement discussions have broken down, so our draft report will be necessary. Day 195

We complete the preliminary draft of our report.

Day 196 After the first transcription, the report is edited, polished, and returned for retyping. Day 198 The preliminary draft report is ready. We mail it to our client and her attorney. Day 206 Both the wife’s attorney and the wife call us to schedule a conference. The date is set for nine days later, the first date available for all three parties. Day 210

The court date is set for day 241.

Day 215

We have a conference with the wife and her attorney.

Day 217

The preliminary report is revised and submitted for typing.

Day 219

Our report is edited and polished.

Day 220

Our report is finished and issued to our client and her attorney.


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337

[Note that 220 days have passed (over seven months) despite exercising due diligence and without any extraordinary or unusual delays caused by either side. We have now submitted the report. The husband and his attorney and expert have yet to review the report, critique it, and use it in any negotiations.] Day 238

The court date is scheduled for day 272.

Day 265 The husband’s attorney contacts the wife’s attorney, indicating that she wishes to depose me. On the same day, the wife’s attorney calls me to determine my schedule. The date must be coordinated with not only the wife’s attorney and the husband’s attorney but also, most typically, with at least one or two of the husband’s experts. In some cases the husband and the wife might also attend. Day 266 The wife’s attorney sends me a letter confirming our previous telephone conversation (copy to husband’s attorney). I issue a similar letter confirming my side of the conversation and suggested dates. My letter explains that my fee for the deposition must be prepaid. Day 270 There are multiple telephone calls between numerous parties to establish a deposition date. The issue is mutually deferred pending the scheduled court date two days later. Day 271 day 276.

The court date is rescheduled (to accommodate case status) for

Day 276 The attorneys meet in the judge’s chambers, receive a tongue-lashing, and are pressured to settle. No movement results. The court date rescheduled to day 299 (the first available date on a crowded court calendar). Day 278 Multiple calls resume in order to establish a deposition date, which is set for six days later. I remind all that my fee for the deposition must be prepaid. Day 283 Two of the parties involved in the deposition call to advise that something has come up, they cannot attend, and therefore the depositions must be postponed. Day 285 Multiple telephone calls are made to rearrange the deposition date. Various parties are unavailable and calls will have to be returned. Day 287 Calls are returned. More calls are made to establish a mutually agreeable date for depositions. The date is established for eight days later. Again, I mention that my fee for the deposition must be prepaid. Day 290

I receive an attorney’s trust account check for my deposition fee.

Day 295

My deposition.

Day 299 The court date is rescheduled to day 325. There were too many cases originally scheduled for this date and most do not settle, forcing postponements. Day 313 Telephone calls continue in order to establish a conference in an attempt to negotiate a settlement. Day 314 Return calls to establish settlement conference date, which is set for five days later. Day 319 Conference with wife and husband, both attorneys, and both experts.


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Day 325 The attorneys advise the judge of some progress and movement towards settlement. The court date is rescheduled (court calendar is crowded) to day 352. Day 326 Telephone discussion with wife’s attorney on various matters involved in this case. Day 329

Telephone calls with attorney and wife on various matters.

Day 333

Telephone calls with wife’s attorney.

Day 339

Negotiations.

Days 341 to 351 Frequent and multiple telephone calls between numerous parties to discuss the fine points and schedule and reschedule pretrial conferences and negotiation settlements. Day 352

Case settled.

This is a very real chronology of a typical case, although the frequent, intentional stalling was not included. It illustrates what is involved from the time the investigative accountant is first contacted, to the time the case is settled. Barring any serious complications or stalling by either side, this can easily take one year. All the calls, conferences, and correspondence described are typical for virtually any case. A bigger case will generally involve more time, but a smaller case will not require less time. For instance, when there is an attempt to prevent you from entering the business to begin your investigation, you can probably add six months to a year to the time frame described. Other causes of lengthy investigative cases are substitution of a new attorney or investigative accountant, postponement for illness or vacation of one or more of the parties involved, or delays when the trial judge is replaced.

Barson App.C (339-512)

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Page 339

APPENDIX

C

SAMPLE REPORTS CONTENTS C.1 C.2 C.3 C.4 C.5 C.6 C.7 C.8 C.9 C.10 C.11 C.12 C.13 C.14 C.15 C.16 C.17 C.18 C.19 C.20 C.21

Introduction The I. Shade Accounting Practice The Tavern with the Green The Upscale Beauty Salon Case Complex Iron & Steal Corporation Brokerage Firm: Security Ain’t What It Used to Be Chiropractic Practice of Dr. Manny Pulate Modern Renovations, Inc. Convenience Food Store: Never on Saturday Food Emporium Marginal Crane, Inc. Bust Your Gut Deli A Cruller for Your Thoughts: The Cuppa Jo Donut Shop The AC-DC Contractor Ideas, Inc. 2 Bays UP RV VU The Really Green Greenhouse Cold Cash Trees R Us A Lawyer, A Lawyer, My Kingdom for a Lawyer Manufacturers Associates Northern Stairway Manufacturers

339 341 343 345 349

C.22 C.23 C.24 C.25 C.26

354 359 364

C.27 C.28

368 371 376 378 380 383 389 390 394 395 398 404 411

C.29 C.30 C.31 C.32 C.33 C.34 C.35 C.36

NOTE

Keeping You Healthy Is Our Most Important Service An Apple a Day Is Not Enough The Poor Office Supply Store The Unsaintly Tainted Paint Store Analysis of Rupert Flowthru’s Personal Checking Accounts, 1987 Through 1992 On the Verge Psychotherapy Center Would You Buy a Used Car from This Man? Pleasant Valley Animal Hospital Bush v. Bush, Pollen Heaven, Inc. No Cash? No Problem Aby Sent v. Ons Ite, Cash Cow Enterprises The Good, the Bad, and the Restaurant Izor v. Izor, Visual Reality Isadore v. Isadore, Izzy’s Pasta Chocolate v. Chocolate, Jackin Box Manufacturing Co., Inc.

418 425 429 434

437 444 451 453 456 460 465 482 495 500 507 511

C.1 INTRODUCTION. The purpose of this appendix, which contains almost 30 sample reports, is to provide the reader with examples of how investigative reports might be presented, how the investigation and discovery process can yield interesting and varied results, and how there are ample opportunities and methods of reconstructing income when the records are inadequate and/or cash is involved. In every case, the reports are based on actual divorce cases, though names have been changed, and certain liberties have been taken to simplify the presentation and to otherwise modify some of the details and narrative, again so as to ensure a certain anonymity. In some cases, these sample reports have been adapted from case study articles that appeared in FAIR$HARE — and I thank Ron Brown, Editor of FAIR$HARE, and Aspen Law & Business for their permission to use the following reports: Cold Cash; Would You Buy a Used Car from This Man; AC-DC Contractor; Trees R Us; The I. Shade Accounting Practice; Bust Your Gut Deli; The Poor Office Supply 339


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Store; The Convenience Food Store; The Upscale Beauty Salon; The Tavern with the Green; 2 Bays UP RV VU; and The Really Green Greenhouse. In some cases, I have intentionally omitted certain pages of an introductory nature, additional support, and a cover letter to the attorney inasmuch as I felt that, in light of other reports included herein, such detail would be unnecessary and repetitive. It is my hope and expectation that other accountants will find these reports helpful in attacking the investigative phases and income discovery aspects of cases in which they may be involved. The following types of businesses are presented: Accounting Practice (see C.2) Bar (see C.3) Beauty Parlor (see C.4) Brokerage Firm — Iron and Steel (see C.5) Brokerage Firm — Securities (see C.6) Chiropractor (see C.7) Construction: Asbestos Removal (see C.8) Convenience Food Store (see C.9) Crane Rental (see C.10) Deli (see C.11) Donut Shop (see C.12) Electrical Contractor (see C.13) Game Developer (see C.14) Gas Station (see C.15) Greenhouse (see C.16) Ice Wholesaler (see C.17) Landscaper (see C.18) Law Firm (see C.19) Manufacturer of Labels (see C.20) Manufacturer of Stairs (see C.21) Medical Practice: General Practitioner (see C.22) Medical Practice: Radiation Therapist (see C.23) Office Supply Store (see C.24) Paint Store (see C.25) Personal Funds Tracing (no business) (see C.26) Psychologist (see C.27) Used Car Dealer (see C.28) Veterinarian (see C.29) Wholesale Flower Supplies (see C.30) Landscaper (see C.31) Strip Mall (see C.32) Restaurant (see C.33) Medical Practice (see C.34)


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C.2 THE I. SHADE ACCOUNTING PRACTICE

341

Pasta Manufacturer and Retailer (see C.35) Manufacturer of Specialty Packaging Boxes (see C.36). 䊳

C.2 THE I. SHADE ACCOUNTING PRAC TICE. It is not often that we get to do a matrimonial investigation of an accounting practice. However, every so often, even those who make a one-second appearance for the Oscars or the Emmys are proved to be as mortal and flawed as everyone else. In theory this should be about the easiest business for us to investigate; we know exactly how it works and we generally have a pretty good idea of what it is worth. This particular investigation involved a sole practitioner, substantially constituting a general practice, servicing various small businesses and tax clients. Fortunately for our need to believe in the integrity of our so fragile profession, this case mercifully did not involve unreported income. However, as is evidenced in Exhibit C–1, a number of adjustments were necessary. Interestingly, after making all adjustments in both directions, the net result was relatively minor—a reduction in expenses (increase in income) ranging between $4,000 and $14,000 per year.

EXHIBIT C–1

I. Shade Accounting Practice Comparative Schedule of Adjustments to Operating Expenses

Payments to J. Restin — Note 1 Nonrecurring legal fees — Note 2 Travel, meals, and entertainment, IRS limitation addback— Note 3 Travel, meals, and entertainment — Note 3 Rent — Note 4 Change in accounts payable — Note 5 Other fringe benefits — Note 6 Health insurance — Note 7 Depreciation — Note 8 Secretarial payroll — Note 9 Net Adjustments

1990

1989

1988

$(26,400)

$(31,400)

$(38,900)

—

—

1,178

594

(5,185)

3,558

(3,253) —

(2,746) (12,985)

(5,456) 12,985

2,399

11,715

6,832

(3,000) 5,008 (5,000) 25,000

(3,000) — — 23,500

(3,000) — — 22,000

$ (4,068)

$(14,322)

$ (7,166)

Explanation of Adjustments to Operating Expenses Note 1: Payments to J. Restin. In mid-1985, Mr. Shade purchased Janet Restin’s accounting practice. The acquisition was structured so that the payments to Ms. Restin would be deductible by Mr. Shade. However, those payments are for the


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acquisition of a practice — in effect, an investment. Therefore, even though these payments represent a true economic and cash outlay by Mr. Shade, they are not considered operating expenditures of the ongoing practice. In 1988, Mr. Shade incurred $5,185 in legal fees in defending a lawsuit. Even though this was truly a cash flow loss and an expenditure of the practice, it is considered a nonrecurring expense not indicative of the practice on a going forward basis. Note 2: Nonrecurring Legal Fees.

Two adjustments are necessary in this area. First, the operating expenses presented herein, from the tax returns, reflect only 80 percent of this expense category as the result of IRS limitations. Regardless of artificial IRS dictated adjustments, it is necessary to reflect the economic reality of the practice’s expenses. Second, by a review of supporting documents, we determined that a significant portion of the travel, meals, entertainment, and similar promotion-type expenses were not necessary for the economic functioning of the practice. Note 3: Travel, Meals, and Entertainment.

Note 4: Rent. In 1988, on account of a landlord-tenant issue, Mr. Shade did not pay nearly $13,000 of rent expense. This expenditure eventually was paid in 1989. As a result, from an economic standpoint, 1988 expenditures were significantly understated and 1989 significantly overstated. Note 5: Change in Accounts Payable. Accounts payable referenced here are exclusive of unpaid rent, which is treated separately. On December 31, 1988, the extent of Mr. Shade’s unpaid bills was $6,832 more than at the end of 1987, and at the end of 1989, another $11,715. At the end of 1990, the bills had increased another $2,399. To reflect the economic reality of the practice, it was necessary to adjust for the changes in accounts payable.

In addition to other adjustments, there were approximately $3,000 per year of other types of nonpractice operating expenses (such as disability insurance for Mr. Shade and other relatively minor expenditures that were not recurring practice expenditures). Note 6: Other Fringe Benefits.

In treating Mr. Shade as an employee and equating his operation to virtually any corporate operating structure, it was necessary to impute health insurance for 1990. (This expense was already reflected in the operating expenses for 1988 and 1989.) Note 7: Health Insurance.

In 1990, the practice deducted approximately $5,000 of depreciation (permitted under Internal Revenue Code § 179) in excess of what would be a more accurate economic depreciation. Note 8: Depreciation.

Through 1990, Mrs. Emily Shade worked full-time in the accounting practice as a secretary — without compensation. In order to determine Mr. Shade’s income, it is necessary to impute the cost of a replacement secretary. Note 9: Secretarial Payroll.


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C.3 THE TAVERN WITH THE GREEN 䊳

343

C.3 THE TAVERN WITH THE GREEN. Whether it is called a bar, tavern, saloon, or something altogether different, the essential basics of a business establishment that sells alcoholic beverages are the same. Although profitability and operating style may vary dramatically and ambience can be as different as an unfinished basement is from the Waldorf, what these operations have in common is that their income flow is, for the most part, in cash. Furthermore, with the rare exception of a well-run, relatively large operation having sufficient controls and third-party oversight, the very nature of the operation and the personnel involved in these establishments facilitates the heading south of some part of the business’s revenues. It thus becomes the enviable task of the investigative accountant to ascertain the true gross revenues of this pillar of the community — and, as a direct result, to restate its profitability and the income received by its owner/operator. Fortunately for the seekers of truth, in most such situations, it is not all that difficult to arrive at a reasonably reliable and usable figure. It must be recognized that any such figure, because of the very nature of what we are dealing with as well as the nature of the processes by which we have to make our calculations, is itself only an estimate. Depending on the magnitude of the operation, it is reasonable to expect that even the most expertly completed investigative accounting analysis can be no more accurate than to come within a range of several thousands of dollars of revenues per year. As with investigative accounting reconstructions of income in general, there needs to be a reasonableness to the approach and a reasonableness to the conclusions. By the very nature of the need to approximate figures, extremes should be avoided — in other words, if a reasonable range for a selling price of an item is between one dollar and one dollar and fifty cents, unless there is particular reason to do so, neither the one dollar nor the one dollar and fifty cents extreme should be used. In the particular case from which this report was developed, we were dealing with a basic blue-collar-type bar located in an urban area. The bar was wellestablished and had a loyal, if somewhat bleary-eyed, following. Ownership and management were one and the same, though the nature of the number of hours the bar was open did, of course, mean that there were times when ownership was not present and hired help was in charge of the till. The bar also had a cigarette machine, juke box, and bowling game machine. The machines were not owned by the bar but rather the income was split between the bar and the vending company. By visiting the bar, we were able to determine the nature of the surrounding neighborhood, noting the limited amount of parking and the relatively heavy traffic flow on the street. We also saw that the bar served food (representing about 10 percent of its sales) — generally simple sandwiches. In order to reconstruct the true revenues of this business, we needed three broad elements of information: the purchases/cost of goods sold; the typical sales prices; and the sales mix. The cost of goods sold was, for the most part, readily available by a routine analysis of the purchases. The sales prices were in part available by simple observation and in part obtained by asking questions of the owner. The product mix was in part (a very slight part) obtained by analyzing the purchases and to a substantial degree obtained by interviewing the owner. Unless the responses from the owner were clearly out of touch with reality, we accepted his input. Our analysis, which is detailed in Exhibits C–2 and C–3, clearly supported the existence of significant unreported income.


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EXHIBIT C–2

Tavern with the Green Cost of Sales Percentage Analysis

Item Description Beer (sold at bar) Beer (by the case) (take-out) Mixed drinks Shots Food and sundry Supplies

Percentage of Total Business 60% 15 7.5 7.5 10.0 N/A

Unit Sale

Cost of Sales %

Unit Cost

$ 1.35

$

.46

16.00 1.50 1.50 Various N/A

$11.00 .55 .40 Various N/A

Weighted Average Cost of Sales %

34.0%

20.4%

68.75 36.67 26.67 40.0 N/A

10.3 2.8 2.0 4.0 05.0

Total Cost of Sales Percentage

44.5% 44.5%

To be conservative — to allow for a margin of error, for free drinks and wasted food, and for allegations of robberies — we added 15 percent of the calculated cost of sales (or 6.7 percentage points) to derive a cost-of-sales of 51.2 percent (a gross profit of 48.8 percent). This contrasted sharply with the greater than 75 percent cost of sales Tavern with the Green alleged on its tax returns and financial statements, a cost of sales extremely high for this industry. In addition, the above did not take into account the proceeds derived from the various leased machines maintained on the premises. This facet of the business’s operations represented a no cost/pure profit cash flow, which was entirely unreported. EXHIBIT C–3

Tavern with the Green Calculation of Adjusted Income (all figures rounded) 1990

Income before taxes and adjustments — as reported Additions: Unreported sales* Owner’s salary† Subtraction: Unreported payroll‡ Adjusted Income Before Owner’s Compensation

$ 13,000

1989 $

2,000

1988 $

1,000

150,000 16,000

175,000 16,000

154,000 18,000

(45,000)

(45,000)

(45,000)

$134,000

$148,000

$128,000

*In reconstructing Sales, we worked “backward” from Cost of Sales. † This was simply the reported draw of the owner. ‡ We were able to determine, from interviews of the business owner as well as observations of the premises, that several employees were paid in cash, “off the books.” These employees included a cook at approximately $325 per week, a fulltime bartender at $230 per week, and three part-time bartenders at $40 each per day, averaging $300 per week. This payroll approximated $45,000 per year.


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C.4 THE UPSCALE BEAUTY SALON CASE

EXHIBIT C–3

Tavern with the Green Calculation of Adjusted Income (all figures rounded) (continued)

Cost of sales — as reported Sales — based on cost of sales being 51.2% Additional income from the cigarette machine, jukebox and bowling game (estimated) Total Calculated Gross Sales Reported Gross Sales Unreported Gross Sales

䊳

345

1990

1989

1988

$223,535

$234,030

$213,956

436,592

457,090

417,882

4,000

4,000

4,000

440,592 290,963

461,090 286,295

421,882 267,428

$149,629

$174,795

$154,454

C.4 THE UPSCALE BEAUTY SALON CASE. The case study to be illustrated in this section involves a beauty parlor operation. We were called in to determine the income realized by the beauty parlor owner in a situation involving what was obviously a cash business and where the reported income for the owner over a period of a few years was typically between $10,000 and $20,000 per year — less than what many of the full-time employees were reporting. With a beauty parlor, sales receipts, if existent at all, would be in the form of slips filled out by the operators and then handed in to the owner for his/her own internal control purposes. As might be expected, it was alleged that none of these records existed. To compound the issue, despite what you might believe to be common knowledge with regard to the existence of an appointment book (which would be useful in reconstructing income), such a book allegedly did not exist either. Therefore, all that was left for us to use in determining income were the bank deposits. They, of course, were insufficient in that they show only the income that is desired to be shown, not the receipts that never get into the company books. One approach taken here that did not directly involve us as accountants was the utilization of a detective to monitor the amount of traffic going into the beauty parlor over a several-day period, for a few hours to several hours each day. That observed volume of traffic helped to support the level of traffic the spouse (who knew much about this business) indicated existed. With those two sources of information, we were able to proceed to reconstruct the income. We visited the beauty parlor to look at the premises and to observe the number of operators working, the number of chairs being used, the nature of the operation, and the prices that were posted. With the added assistance of our client, who was able to fill in numerous details, we were able to reconstruct an approximate scenario of the number of customers per hour, the average time it took to service these customers, the average income for the various services, and the amount of time each of the services required. After allowing for downtime when there would be no customers to service, we were able to reconstruct what we felt was a reasonable approximation of the true volume of the operation. Our procedures and conclusions are illustrated in Exhibits C– 4 and C–5.


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EXHIBIT C– 4

1) Hours:

Upscale Beauty Salon Vital Statistics

70 hours per week Monday through Friday Saturday

8:00 A.M. to 8:00 P.M. 8:00 A.M. to 6:00 P.M.

2) Haircutters are paid 50 percent of the gross revenues they generate and generally work 8- to 9-hour shifts, servicing 8 to 10 customers per day. 3) As per our client, 70 percent of clients were women, 30 percent men. 4) As per our client, typical demand for services was: (A) 60 percent of clients get a haircut [90 percent of men (or 27 percent of clients) and 60 percent of women (or 42 percent of clients)]. (B) 11 percent of clients get hair coloring. (C) 20 percent of clients get a permanent. While there for these services, 20 percent of clients also purchase supplies and 10 percent also get a manicure. 5) As per our client, with costs verified by our visual inspection, services typically took time and cost as follows: (A) Woman’s haircut (42 percent of clients) — 40 minutes — $16.50; (B) Man’s haircut (27 percent of clients) — 30 minutes — $13.00; (C) Hair coloring, including trim (11 percent of clients) — 75 minutes — $50.00; (D) Permanents, including trim (20 percent of clients) — 105 minutes — $65.00; (E) Manicure (10 percent of clients) — 25 minutes — $8.00; (F) Retail sales of beauty supplies (20 percent of clients) — 5 minutes — $6.50.

EXHIBIT C–5

Upscale Beauty Salon Reconstruction of Income

During the time frame subject to this case, the Salon employed six full-time and two part-time (equivalent to one full-time) hairdressers, in addition to the owner. It maintained hours as per 1) above. Therefore, to reconstruct the actual volume: Salon open 6 days per week ⳱ 312 days per year Less holidays closed ⳱8 Operational days per year ⳱ 304 Salon open 12 hours per day (Monday through Friday) and 10 hours on Saturday. Less idle and downtime assumed of 2 hours per day (Monday through Friday) and 1 hour on Saturday.


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C.4 THE UPSCALE BEAUTY SALON CASE

EXHIBIT C–5

347

Upscale Beauty Salon Reconstruction of Income (continued)

Results in 59 operational hours per week/9.833 hours per day. 304 days ⳯ 9.833 hours per day ⳱ 2,989 operational hours per year. 42 percent of clients pay $15.50 for 40 minutes of services ⳱ $23.25 per hour ⳯ 42 percent

⳱ $ 9.76 per hour

27 percent of clients pay $13.00 for 30 minutes of services ⳱ 26.00 per hour ⳯ 27 percent

⳱

7.02 per hour


⳱

4.40 per hour


⳱ $07.43 per hour

100 percent

The average hour generates 10 percent reduction for conservatism

28.61 02.86

Adjusted average hour

$25.75

Employees are productive as follows: ⳱ 6

6 full-time hairdressers — fully Owner — assumed

1/ 2

⳱

productive

2 part-time hairdressers — assumed to be nonproductive (fill-ins, cleanup, etc.)

1/ 2

⳱ 0 61/2

Total Full-Time Producers

Each producer works an 8-hour day, 5 days per week ⳱ 40 hours per week per producer. Since the Salon is open 70 hours per week, 6 1/2 producers working 40 hours each is the equivalent 3.7 producers (40 divided by 70 ⳱ .5714 ⳯ 61/2 ⳱ 3.7). The reconstruction of gross revenue under this analysis is calculated as follows: 2989 hours ⳯ $25.75 per hour ⳯ 3.7 producers ⳱ $284,777. Additional services and sales to customers that do not intrude on the utilization of operational hours above are as follows: 10 percent of clients pay $8.00 for a manicure 2,989 hours at 4.53 customers per hour (see above) ⳱ 13,540 customers ⳯ 10 percent ⳱ 1,354 at $8.00

⳱ $10,832

20 percent of clients pay $6.50 for supplies 13,540 customers (see preceding) ⳯ 20 percent ⳱ 2,708 at $6.50

⳱ 17,602

Additional gross revenue 10% reduction for conservatism

28,434 02,843

Adjusted additional gross revenue

$25,591

Therefore, under this approach, reconstructed gross revenues are $284,777 Ⳮ $25,591 ⳱ $310,368 *

*

*


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A detective was engaged to count customers entering the Upscale Salon. He did so on five (5) days during June and July, watching for a total of 21 hours and 40 minutes and observing 158 customers (an average of 7.3 per hour) enter the Salon. Details are shown in Exhibit C–6. EXHIBIT C–6

Day Saturday Tuesday Thursday Monday Saturday Total

Upscale Beauty Salon Customer Count

Date

Customers

Elapsed Time

Average Per Hour

June 15 June 18 June 27 July 1 July 13

56 15 26 34 27

7 hours 3 hours 4 hours 5 hours, 15 minutes 2 hours, 25 minutes

8 5 6.5 6.5 10.8

158

21 hours, 40 minutes

7.3

For conservatism, we delete the highest day, July 13. That leaves 131 customers in 19 hours, 15 minutes — an average of 6.8 customers per hour. If we further assume a 33 percent reduction to allow for the possibility that some people entering the Salon may not have been customers, there results a net of 4.53 customers per hour. Prior illustration indicated that 42 percent of clients pay $15.50: 42 percent ⳯ $15.50 ⳱ $ 6.51 weighted value per customer 27 percent of clients pay $13.00: 27 percent ⳯ $13.00 ⳱

3.51 weighted value per customer

11 percent of clients pay $50.00: 11 percent ⳯ $50.00 ⳱

5.50 weighted value per customer

20 percent of clients pay $65.00: 20 percent ⳯ $65.00 ⳱ 13.00 weighted value per customer 100 percent

The average customer generates 10 percent reduction for conservatism Adjusted average customer

28.52 02.85 $25.67

The reconstruction of gross revenue under this analysis is calculated as follows: 2,989 hours ⳯ $25.67 ⳯ 4.53 customers ⳱ $347,576 As per the above, additional gross revenue (manicures and supplies) is $25,591. Therefore, under this approach, reconstructed gross revenues are: $347,576 Ⳮ $25,591 ⳱ $373,167

*

*

*


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C.5 COMPLEX IRON & STEAL CORPORATION

349

The two methods above yield reconstructed gross revenues of $310,368 and $373,167— an average of approximately $341,800. This contrasts sharply with reported revenue of $171,150 and would suggest that the magnitude of unreported income is approximately $170,000 per year. Based on our reconstruction of gross revenue, and the commission-type payroll system used by the Salon, unreported wages were approximately $70,000. Therefore, it was our conclusion that income was underreported by $170,000 of revenue less $70,000 of related payroll expenses, for a net understatement of $100,000. An interesting aside to this case was that, shortly after it was settled, the owner of the beauty parlor, now free and single, was interviewed by a local newspaper doing a human interest article on local businesses. He eagerly volunteered to the reporter that he netted somewhere in the vicinity of $100,000 per year from the beauty parlor operation. Clearly, another illustration of the validity of the investigative accounting approach toward reconstructing income. 䊳

C.5 COMPLEX IRON & STEAL CORPORATION. One of our more interesting cases involved proving that a fairly newly established company that might otherwise be out of the reach of our client was in fact merely a replacement for, an alter ego of, the predecessor company, which, conveniently, went bankrupt. Our client’s future financial security rested on our ability to prove whether or not the new company was nothing more than the old company with a fresh coat of paint. We spent a fair amount of time at the company, going through a volume of its books and records, both of the old and of the new companies. The idea was to show, if this was the case, that as one company phased itself out, the other phased itself in. There were also matters of customers identification, banking relationships, employees, and reports to third parties. It was our conclusion that a series of fraudulent conveyances did in fact occur in which the assets of Complex Iron & Steal corporation were conveyed without fair consideration to Simply Steal Company, Simply Steal More Company, Inc., Maria Simply, and Thurgood Alloy. Our opinion was based upon our review and analysis of selected books and records (including general ledgers, disbursements journals, customer records, and canceled checks) of all three companies; such review performed at their offices. In summary fashion, we have detailed the basis for our findings below. The areas in which we found evidence of and support for the claim of a fraudulent transfer include:

1. The transfers of funds from Complex Iron & Steal Corporation (CIS) to Simply Steal Company (SS — prior to its incorporation in April 1993), to Simply Steal More Company, Inc. (SSM — from its incorporation), and to Maria Simply and Thurgood Alloy. 2. The continuity and sameness of customers from CIS to SS to SSM. 3. The virtual interchangeability of the business conducted by CIS and SS and SSM in selected customer situations and our resultant conclusion that the three companies were, from an operational point of view, in effect one and the same. 4. The drastic decrease in CIS’s sales occurring simultaneously with the significant increase in SS’s (or SSM’s) sales while in the same line of business.


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5. The extent of activity between CIS and SS and SSM as evident in their general ledgers. 6. The continuity of relationship and note arrangements with Whitewater Mistrust Company that imply that, for credit purposes, Whitewater Mistrust treated SS (SSM) as the successor to the business and one and the same as CIS. 7. That SS (and SSM), to a significant degree, utilized the same employees as did CIS. 8. The manner in which a bank account of CIS was closed out in the July and August 1993 period. 9. The utilization and presentation of a joint financial statement combining the operations of CIS and SS into one financial statement, prepared by the defendants. 10. The utilization by SS for D&B purposes of the credit and corporate history of CIS. The shareholders/officers/partners of the subject companies, as per the tax returns, were as shown in Exhibit C–7.

EXHIBIT C–7

Shareholders/ Officers/Partners

Complex Iron & Steal Corporation Maria Simply Cambridge Simply

60% 40%

Simply Steal Company Maria Simply Chanchal Simply Lauren Simply

50% 25% 25%

Simply Steal More Company, Inc. Maria Simply Chanchal Simply Lauren Simply

50% 25% 25%

Transfer of Funds Between Complex Pipe & Steal and Simply Steal and Maria Simply.

The predominant reason for our conclusion that indeed CIS fraudulently conveyed assets to and for the benefit of SS and its successor SSM was obtained through our analysis of the flow between the companies and through the hands of Maria Simply. In specific detail: On November 30, 1992, CIS check No. 7852 in the amount of $25,547 was issued to Maria Simply for the purchase of a personal car. These funds were carried as a loan by CIS to Ms. Simply. On December 28, 1992, CIS check No. 7879 in the amount of $101,000 was issued to Maria Simply as a loan. As with the preceding check for the purchase


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of a car, this loan was carried on the books of CIS as a loan receivable from Ms. Simply. The reverse of this check was endorsed, “Pay to the order of Simply Steal Company for deposit only.” On March 8, 1993, CIS issued check No. 1057, payable to Maria Simply in the amount of $100,000. The endorsement on the back read, “Pay to the order of Whitewater Mistrust for deposit only Simply Steal Company.” On April 26, 1993, CIS check No. 1098 in the amount of $9,453 was paid to Maria Simply. This check too was labeled as payment of a loan and carried on the books of CIS as a loan receivable from Ms. Simply. This was, as best as we can determine, the amount necessary to close out the bank account (Whitewater Mistrust Co.) of CIS. In the general ledger of CIS, Maria Simply had two loan accounts maintained on her behalf — No. 109 (due to/from Maria Simply) and No. 115 (Loans Receivable). These accounts had relatively low dollar value activity for all of 1991 through September 1992. Beginning in October 1992, the level of activity increased significantly. Posted to those accounts was a $50,000 check, No 7760, in October 1992 (apparently reduced by a $25,000 reimbursement the following month) to Maria Simply. On November 30, 1992, $25,547; on December 28, 1992, $101,000; on March 8, 1993, $100,000; and on April 26, 1993, $9,453. The latter four items were detailed above. At the time that the activity in the general ledger of CIS ceased, in approximately August of 1993, CIS had an outstanding balance receivable from Maria Simply of $271,662. As best as we have been able to determine, Ms. Simply has not repaid these loans, and therefore, CIS still has an asset in excess of a quarter million dollars. In an effort to determine whether or not SS (SSM) had the same customers as, and whether there was any correlation with, the customers of CIS, we reviewed (on a limited test-check basis) the accounts receivable subsidiary ledgers of the three companies to determine the specific customers with which each dealt and the frequency and volume of activity as evidenced in those ledgers with those customer. If it were determined that there was a continuity of customers between CIS, SS, and SSM, that would imply the three companies operated in effect as one and the same business. We reviewed the accounts receivable subsidiary ledgers that extended from approximately 1990 through 1994 for the three companies. These ledgers, depending on the volume and frequency of activity with any one customer, have one to several pages per customer, in alphabetical order, detailing the sales activity with such customer. We reviewed the CIS accounts receivable subsidiary ledger at random, noting various customer with a significant volume of activity. We then went to the subsidiary ledger of SS to see if those same companies had activity with the latter and, if so, during what period of time. In every such case, we noticed a relationship of activity with the same customer between both companies that would strongly indicate, considering the sameness of the business purpose and activity of both Customer Activity.


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companies, that in fact SS was merely and extension and continuation of CIS. As examples: Noelle Corporation of Williamsport, Pennsylvania. CIS had regular, approximately monthly, sales activity with this company in 1991 and 1992, reaching, especially in 1992, weekly posting proportions, with that activity coming to a complete halt in February of 1993. SS, starting in November of 1992, began having approximately weekly postings to its account with Noelle Corporation. Those postings continued and accelerated in many cases to greater than one time per week, throughout 1993 and into 1994. Aid & Abet, Inc., of Trenton, New Jersey. The subsidiary ledger for CIS indicated monthly and, toward September of 1991, weekly postings to the Aid & Abet account. This frequency in volume of activity continued into 1992, when it abruptly came to a halt. However, the sales activity with Aid & Abet was continued on the SS books into 1993 and 1994. Can Steal Corporation of Brooklyn, New York. This is another customer with which CIS had in its accounts receivable subsidiary ledgers regular, often weekly, postings during 1991, well into 1992, continuing to near the end of 1992, at which point these postings ceased. SS Corporation began significant activity with the Can Steal Corporation in July of 1992 — in a time frame very close to when CIS ceased its activities. Again, the frequency and volume of activity with Can Steal Corporation through the SS books continued through 1993 and 1994. Tintin Nabulation Corporation of Philadelphia, Pennsylvania. This is another customer of CIS with frequent (at least monthly and at times weekly) postings. These went on for 1991, into 1992, decreasing in frequency around July of 1992, and then ceasing by the end of 1992. This same customer, throughout 1993, conducted a significant volume of business with SS Corporation. Sit Steel of Dayton, Ohio. CIS began significant activity with this customer in November of 1991 and continued on a varying, though often weekly, posting basis through most of 1992 until approximately September, when the volume of business with this customer ceased. In August of 1992, SS started having approximately monthly postings of activity with Sit Steel. These activities continued into 1993, despite the absence of such business with CIS. In addition, the accounts receivable subsidiary ledger of SS prior to incorporation was continued as is subsequent to incorporation. Clearly, this is another example that Simply Steal Company and Simply Steal More Company, Inc., were one and the same. In the process of reviewing the general ledgers of the companies for the 1991 through 1994 time frame, we noted that there was a direct correlation between the change (decrease) in sales volume of CIS and the change (increase) in the sales volume of SS/SSM. Exhibit C–8 presents, in chart form, the respective sales of the three subject companies (rounded to the nearest thousand dollars) by month for the period from March 1991 through December 1994 — all the figures obtained directly from the general ledgers of the companies.

Sales Volume.


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EXHIBIT C–8 Month March 1991 April 1991 May 1991 June 1991 July 1991 August 1991 September 1991 October 1991 November 1991 December 1991 January 1992 February 1992 March 1992 April 1992 May 1992 June 1992 July 1992 August 1992 September 1992 October 1992 November 1992 December 1992 January 1993

353

Complex Iron & Steal Corp. et al. Sales Volume CIS

SS/SSM

Month

CIS

SS/SSM

$0,684,000 377,000 307,000 477,000 210,000 269,000 231,000 437,000 251,000 202,000 273,000 387,000 883,000 330,000 398,000 410,000 143,000 218,000 153,000 85,000 82,000 54,000 27,000

$0,001,000 41,000 61,000 16,000 92,000 64,000 65,000 43,000 0 0 5,000 66,000 48,000 39,000 8,000 28,000 107,000 311,000 255,000 330,000 384,000 364,000 547,000

February 1993 March 1993 April 1993 May 1993 June 1993 July 1993 August 1993 September 1993 October 1993 November 1993 December 1993 January 1994 February 1994 March 1994 April 1994 May 1994 June 1994 July 1994 August 1994 September 1994 October 1994 November 1994 December 1994

$0,006,000 2,000 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

$0,729,000 889,000 932,000 1,046,000 1,193,000 554,000 718,000 1,264,000 1,274,000 1,397,000 783,000 1,311,000 987,000 975,000 1,288,000 1,409,000 1,347,000 1,133,000 1,143,000 1,075,000 1,357,000 995,000 985,000

It is our conclusion from the preceding, especially taking into account (as described previously) the identical nature of the sales operations of all three companies, and the great similarity (if not total identicalness) of the customers of the companies, that the sales of CIS were deliberately permitted to decrease and cease simultaneously with and for the benefit of a commensurate increase for SS/SSM. Financial Statements. CIS’s financial statements refer to the company’s having related party transactions. As an example, a footnote in the December 1992 financial statements indicated that CIS shares offices and personnel with SS, a related company. Further, the footnote indicates that amounts due from SS (to CIS) “are payable upon demand, without interest.” The company issued combined financial statements as of December 31, 1992 — statements that combined the balance sheets and the income and expenses (operations) of CIS and SS. This constituted one financial statement, representing the financial position and operations of both. The situation of issuing a combined financial statement for two separate companies is highly unusual — except when those two companies are being held out to the public, to creditors, and to suppliers as one operation and/or as having a relationship or affiliation that is extremely close and/or when it is intended that either or both companies be presented to the readers of the financial statements as augmenting and supplementing each other — in effect, operating as one functional entity, even though for record keeping, legal, tax, or other reasons this single operational entity is divided into two or more units.


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Whitewater Mistrust Company operated as the lead bank for CIS for 12 years. Notes were routinely received from and paid back to Whitewater on a virtual monthly basis during various periods of time. In reviewing the general ledgers, we noted the long history of banking relationships between CIS and Whitewater, a relationship that ceased (as per the general ledger of CIS) in approximately May of 1993. At the time, as evidenced by CIS’s general ledger, CIS ceased operations, owing Whitewater $175,000. At virtually the same time, beginning in May of 1993, SS’s general ledger began an account labeled “Notes Payable” (to Whitewater Mistrust Company) — an account that did not exist in prior years. Simultaneously with the cessation of activity between Whitewater and CIS, such activity in like and increasing dollar volume began with SS. In addition to the preceding, we noted that, on May 29, 1993, Simply Steal Company issued its check No. 436 in the amount of $175,000 to Maria Simply. That check was endorsed on the back, “Pay to the order of Whitewater Mistrust for payment of loan due by Complex Iron & Steal Corp.,” and it was signed by Maria Simply. Clearly, there is a direct connection between the three companies and, in fact, Simply Steal represents merely the continuation of Complex Iron & Steal Company. This is even to the extent that SS paid off the obligation of CIS — though the flow of funds went through the hands of Ms. Simply. Relations with Whitewater Mistrust Company.

We have in our possession a copy of a Dun & Bradstreet report dated October 10, 1993, in the name of Complex Iron & Steal Corporation. This report indicates that the company was started in 1963, that it has an SIC (standard industrial classification) code number of 5051, and that its chief executive was Maria Simply. We are also in possession of a D&B report dated July 30, 1994, for Simply Steal More Company, Inc., with the same Duns number. This D&B report indicates that the company started in 1963 (this despite the fact that, as per the company’s tax returns it was actually started in 1983 — however, 1963 does coincide with the start of CIS), and that the company has an SIC code of 5051 (the same as that of CIS). In addition, the D&B report refers to Simply Steal Company as having a subscriber number the same as CIS. It also lists the chief executive of the company as Maria Simply. Further, this report states, “Business started 1963 by Maria Simply as Complex Iron & Steal Corp. . . . [O]n April 17, 1963, subject acquired all assets and assumed the liabilities of the predecessor corporation. Maria Simply has been the sole stockholder since 1963.” It is our opinion that these Dun & Bradstreet reports are another element in the irrefutable connection between Complex Iron & Steal Corporation and Simply Steal and Simply Steal More Company, Inc.—a connection that is to such an extent that to the world these three companies were one and the same. Dun & Bradstreet Reports.

䊳

C.6 BROKERAGE FIRM: SECURITY AIN’T WHAT IT USED TO BE. In a most interesting case that took us deep into the bowels of New York City’s legendary Wall Street, we were called upon to determine the actual compensation realized from a small brokerage (broker/dealer) operation. Clearly, this did not involve matters of unreported income, and in fact, in accordance with the rules of the supervising regulatory body, this company’s financials were even audited annually.


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However, there were suspicions that our client wasn’t getting the most honest or complete answers when the matter of income was raised. Also, this company was in a rapid growth mode, and it was easy enough to give financial information that was a year or so stale that was no longer reflective of what this company was doing. The company, operating under the name of “Trade Till You Drop,” was owned and run by its two equal and active shareholders — Mr. Yuri Putz and Ms. Dawn Kall. Between the two of them, with the combination of trading for customers and doing their own proprietary trading, they had built up a very profitable small operation. Small here meant only a few million in sales — small by Wall Street standards. Putz and Kall had managed to garner substantial salaries for themselves and to live the good life — which included limousines, shows, frequent dinners out, and first class treatment all around. To a degree, considering the atmosphere in which they operated, these were somewhat necessary operating expenses for their business. Of course, it didn’t exactly hurt that it made things very comfortable for them. Our investigation of their operations (see Exhibits C–9 and C–10) revealed that it was important to take a look forward to what was happening so as to give us the ability to effectively negate their cries that business was not good and that their income was quite precarious. The point here was that in the first six months of the fiscal year immediately following the year in which our investigation would normally conclude, we were able to observe that they had purchased over $200,000 worth of equipment and furniture and an additional $100,000 or more in the following six months. From the invoices we inspected, we were able to ascertain that this constituted an expansion that would handle an additional 12 brokers. Clearly, Putz and Kall anticipated continued substantial growth.

EXHIBIT C–9

Putz v. Putz Trade Till You Drop Statements of Income Years Ended December 31,

Net sales Expenses Salaries and wages Commissions Rents Taxes Repairs Depreciation Errors Floor brokerage Quotes NASD fee Equipment rental Employee welfare Dues and subscriptions

1994

1993

$05,936,065

$03,709,626

1,573,559 1,066,557 121,498 124,808 64,737 62,576 256,352 150,401 299,321 11,885 18,922 138,093 21,787

1,306,731 578,627 69,499 64,991 42,192 39,733 62,854 57,355 140,027 6,483 14,589 61,454 8,774

1992 $01,620,579 344,124 359,448 85,585 39,893 14,315 34,792 (2,015) 144,784 140,071 5,195 7,447 46,271 5,886


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EXHIBIT C–9

Putz v. Putz Trade Till You Drop Statements of Income (continued) Years Ended December 31,

Insurance Miscellaneous expense Office expense Postage Professional Telephone Travel Utilities Meals and entertainment Lunches Life insurance Other Moving Unrealized loss Total Operating Profit Before Shareholders’ Compensation

EXHIBIT C–10

1994

1993

1992

12,321 27,771 173,852 12,008 41,817 232,346 151,099 22,281 160,492 49,722 27,799 5,767 4,965 13,029

2,838 11,711 77,682 5,991 22,910 100,630 76,897 11,419 98,177 29,293 16,475 17,095 — 6,275

9,359 6,039 15,742 1,901 20,978 50,085 25,253 6,265 37,190 18,004 5,830 21,316 20,476 —

4,845,765

2,930,702

1,464,234

$ 1,090,300

$ 1,778,924

$ 1,156,345

Putz v. Putz Trade Till You Drop Adjustments to Statements of Income Years Ended December 31,

Description Salaries — Note 1 Payroll taxes — Note 2 Errors — Note 3 Employee welfare — Note 4 Office expense — Note 5 Telephone expense — Note 6 Travel — Note 7 Meals and entertainment — Note 8 Moving expenses — Note 9 Life insurance — Note 10 Rent — Note 11 Depreciation — Note 12 Total Adjustments Operating Profit Before Shareholders’ Compensation (as reported) Adjusted Operating Profit Before Shareholders’ Compensation

1994

1993

1992

$00,276,482 27,648 164,720 27,904 72,418 67,482 31,682 42,774 4,965 27,799 (14,502) (13,990)

$00,184,376 18,438

$00,095,218 9,522

15,474 19,872 16,475 (66,501)

10,047 20,476 5,830 (50,415)

715,382

188,134

90,678

1,090,300

778,924

156,345

$11,805,682

$11,967,058

$11,247,023


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Explanation of Adjustments

In our investigation of the company’s records, in particular our analysis of the payroll, it was discovered that both Mr. Putz and Ms. Kall had placed various paramours on the payroll in no-show jobs. Our analysis revealed the situations shown in Exhibit C–11.

Note 1: Salaries.

EXHIBIT C–11

Putz v. Putz, Payroll Years Ended December 31,

Rachel Joli Biff Chuck Total

1994

1993

1992

$0095,200 43,041 91,369 0046,872

$0022,372 69,816 27,115 0065,073

$000,00— 47,609 12,842 0034,767

$ 276,482

$ 184,376

$

95,218

Relevant to the preceding adjustment, since the above were in no-show jobs, we also need to add back the payroll taxes with which the company was unduly burdened. These payroll taxes, had the company maintained an appropriate payroll structure, would not have existed. For ease of presentation, it was assumed that the unnecessary payroll taxes amounted to 10 percent of the subject payroll. Note 2: Payroll Taxes.

In 1994, the company experienced an abnormal and nonrecurring situation when it changed clearinghouses. As a result of the change, there was a short time frame during which serious paperwork errors occurred that caused the company to suffer a significant one-time loss. Subsequent thereto, the matter was rectified and is not anticipated to recur. Note 3: Errors.

In 1994, there were several unusual postings into this account, which further investigation revealed were not legitimate business expenses. These were as shown in Exhibit C–12. Note 4: Employee Welfare.

EXHIBIT C–12

Putz v. Putz, Postings into Account

Description

Amount

Chantilly’s Leather Place The Wyoming School for Wayward Angels Dr. Weethez Hans (a world renowned plastic surgeon)

$004,372 12,746

Total

010,786 $027,904 027.904

In 1994, the company went through a significant expansion, adding several desks and computer terminals. A significant number of these Note 5: Office Expenses.


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expenses were treated as operating expenses rather than the nonrecurring capitalizable expenditures that they were. In 1994, as part of its expansion, the company modified its telephone system. We found that a significant number of the renovations of the telephone system were expended as telephone expenses rather than treated as capital expenditures. We have therefore added back such expenditures that were inappropriately treated as operating expenses. Note 6: Telephone.

Consistent with a number of the other expense categories wherein we found nonrecurring and/or personal expenditures, such was the case with travel expenses. Our analysis of this account revealed that, while it appears all the expenditures posted thereto were for travel, a significant number of these expenses were unjustified and clearly appeared to be for nonbusiness/personal travel. Note 7: Travel.

Note 8: Meals and Entertainment. Consistent with the norm in this field, the shareholders displayed a heavy reliance on entertaining customers and maintaining a high goodwill profile. We recognized this as normal and at the same time realized that it was of significant economic benefit to the shareholders, who were the ones substantially personally benefiting from the expenditures and use of corporate funds for this purpose. Nevertheless, because the expenditures were normal and necessary for the promotional requirements of this type of business, we made adjustments herein only for those items we believed to be clearly nonbusiness in nature.

In both 1994 and 1992, the company allegedly incurred moving expenses. These expenses are nonrecurring in nature and are not reflective of the company’s operations on a going forward basis. In addition, it appears that in 1992, because the company itself did not move, the expenses were for the personal benefit of two or more of the paramours of the shareholders of the company.

Note 9: Moving Expenses.

Inasmuch as life insurance is not a required business expense, but for this company is intended solely for the purpose of buying a deceased shareholder’s interest in the business, we deemed this expense not to be a business expense. Note 10: Life Insurance.

Because the lease contained a rent concession that allowed the company to pay a reduced level of rent until 1994, we made an adjustment to reflect what would have been paid had the concession not existed. This is necessary in order to reflect a normalized level of expenses and thus the true economic profitability of the company. Had this rent concession not existed, the rent paid by the company would have been $136,000 for each of the years involved. Note 11: Rent.

For 1994, as described in notes 5 and 6, we reclassified various office and telephone expenditures as capital rather than operating expenses. However, although they are not operating expenses as such, it was necessary to provide a reasonable allowance for depreciation thereon. It was determined that a five-year life, straight-line basis, with half a year for 1994, was appropriate.

Note 12: Depreciation.


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C.7 CHIROPRACTIC PRACTICE OF DR. MANNY PULATE 䊳

359

C.7 CHIROPRAC TIC PRAC TICE OF DR. MANNY PULATE

For the past 12 years, Dr. Pulate’s practice has been located in a two-unit building on a busy street. Our analysis revealed that he typically saw between 30 and 40 patients a day, three days a week, working approximately 12 hours each of those three days. There were as few as 20 to 25 patients on some days and as many as 50 on some other days, with 35 patients per day as an average. The industry mean is 111 patient visits per week. Based on our review of the daily cash receipts sheets, Dr. Pulate had approximately 105 patient visits per week. The typical patient visit takes approximately 15 minutes and cost $15 in 1979, $20 in 1982, $25 in 1984, and $30 in 1986. Mrs. Heidi Pulate advised us that Dr. Pulate grossed well in excess of $100,000 a year, despite a reported gross volume on his tax returns of between $70,000 and $75,000 per year. Dr. Pulate purchases and resells various products, such as supports and vitamins, and apparently does not report the income from these sales. Mrs. Pulate advised us that he would often purchase these products with money orders so as to avoid reflecting such purchases and that these products were typically sold at a standard keystone-type 100 percent markup. Mrs. Pulate further advised us that insurance checks that were issued to patients and endorsed by the patients over to Dr. Pulate were typically not reported inasmuch as they were substantially untraceable to the doctor. Checks issued from attorney trust accounts to Dr. Pulate where payment was made from the proceeds of collections on behalf of patients went similarly unreported. These allegations were supported by our analysis of the daily receipts sheets. Based on our review of Dr. Pulate’s lease and the premises, it would appear that there is an additional element of unreported income: rental income. He sublets the upstairs of the building in which he is located. We do not know the extent of his subleasing, but based on the differential in the lease between what Dr. Pulate has to pay if the upstairs is not sublet and what he has to pay if it is sublet, it would suggest to us that this subleasing income approximates $500 per month. With regard to the issue of unreported income, Mrs. Heidi Pulate supplied us with copies (from 1983 and 1984) of checks from insurance carriers made out to patients that were endorsed to Dr. Pulate and from attorney trust accounts payable to him. It is by no means clear whether these represent all such checks. However, the checks that were presented to us were traced to the daily cash receipts sheets maintained by the doctor. In 1983, we traced 17 such checks that totaled $14,239 and found that only three of them, totaling $3,429, were recorded in the daily sheets. As to 1984, we were supplied with eight such checks totaling $2,627, and found only one of them, for $688, reported in the daily cash sheets. In addition, we discovered a pattern of checks being entered in the daily cash sheets, subsequently being removed by an indication on the sheets that the checks were to be deleted, and then not being picked up as income. In addition, although we were unable to do a thorough analysis and workup of the standard of living of Dr. and Mrs. Pulate, a preliminary review of information supplied to us by Mrs. Pulate indicated the likelihood of substantial unreported income. She summarized all the checks written on the joint checking account in 1985. Our analysis of same indicated that there were approximately $32,000 worth of checks issued for “normal” living expenses. In addition, as advised to us by Mrs. Pulate, the couple averaged approximately $400 per month Introduction and Observations.


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for groceries expenses, $150 per month for massages (Mrs. Pulate’s hobby), and $60 per week for child support of Dr. Pulate’s child from a prior marriage — all of these paid in cash or with money orders. These brought total living expenses to approximately $42,000 per year. Furthermore, there were gaps — items that should be expended did not show up in the checking account. We also believe Dr. Pulate had out-of-pocket expenses. Therefore, it would appear clear that the standard of living maintained by the parties, based on 1985, is at a very minimum in the range of $50,000 to $60,000 per year — in stark contrast to reported net income of less than $30,000. (See Exhibit C–13.)

EXHIBIT C–13

Pulate v. Pulate Chiropractic Practice of Dr. Manny Pulate Summary of Income and Expenses

Gross receipts (as per tax returns)

1986

1985

1984

1983

1982

1981

$75,722

$70,523

$71,258

$69,291

$74,705

$72,072

Advertising and promotion Depreciation and amortization Auto expenses Professional fees Rent Utilities and telephone Office expenses Bad debts Other expenses

3,760

6,611

7,596

1,999

5,731

5,514

9,613 1,943 3,216 8,200 3,646 4,776 5,907 11,282

8,425 2,933 434 7,600 3,818 4,724 — 08,460

10,409 4,305 325 9,120 2,609 3,044 — 07,375

10,600 2,365 967 8,780 1,800 3,485 — 07,281

8,709 2,668 595 8,052 1,316 3,527 — 07,803

5,051 1,747 362 7,320 1,243 2,038 — 09,000

Total Expenses

52,343

43,005

44,783

37,277

38,401

32,275

$23,379

$27,518

$26,475

$32,014

$36,304

$39,797

1982

1981

Net Profits (as per tax returns)

Reconstruction of Income

Adjustments Unreported income Unreported expenses Advertising and promotion Depreciation and amortization Auto expenses

Note 1 Note 2

1986

1985

1984

1983

$57,000

$48,000

$39,000

$37,000

(8,000)

(7,000)

(5,000)

(5,000)

$21,360

$20,733

(3,000)

(3,000)

Note 3

—

3,000

4,000

—

2,000

2,000

Note 4

6,108

3,968

5,944

6,105

4,016

569

Note 5

1,443

2,433

3,805

1,865

2,168

1,247


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Reconstruction of Income (continued)

Professional fees Rent Bad debts Total Adjustments Net Profit (as per tax returns) Adjusted Net Profit

Note 6 Note 7 Note 8

1986

1985

1984

1983

1982

1981

2,500 1,000 05,907

— 400 000,—

— — 000,—

— — 000,—

— — 000,—

— — 000,—

65,958

50,801

47,749

39,970

26,544

21,549

23,379

27,518

26,475

32,014

36,304

39,797

$89,337

$78,319

$74,224

$71,984

$62,848

$61,346

Explanation of Income and Expense Adjustments

Mrs. Heidi Pulate supplied us with copies of daily receipts summaries. We made a detailed analysis of same for the years 1981 and 1982. We found that the actual cash received as noted on those daily sheets totaled $92,805 in 1981 and $96,065 in 1982. These compared with the reported gross revenues on the tax returns of $72,072 in 1981 and $74,705 in 1982 — representing an understatement of gross revenues of $20,733 and $21,360, respectively. In addition, as best as can be determined, these daily cash summaries did not include other income, such as income realized from the sale of products (that is, supports and vitamins) and the silver content residue from the X-ray solutions, sales that represented additional understatements of income. We compared these figures to the median and mean gross revenues of chiropractors as reported in the Demographic and Professional Characteristics of ACA Membership—1987 Annual Survey and Statistical Study (by the American Chiropractic Association, Department of Statistics). We found that Dr. Pulate’s actual receipts, as calculated from the daily sheets for 1981 and 1982, were extremely close to the reported gross medians — his 1981 gross revenues of $92,805 comparing to the $92,000 reported by the ACA; and his 1982 gross of $96,065 comparing to the $95,500 reported by the ACA. Therefore, along with various other measurements, such as standard of living and volume of patients, we determined that there had been a consistent and significant pattern of unreported income in Dr. Pulate’s practice. Inasmuch as the recalculated amounts for 1981 and 1982 very closely approximated the industry’s median revenues for those years (see Exhibit C–14), in our addback to income, rounding to the nearest thousand dollars, for the years 1983 through 1986, we adjusted the reported gross revenues upward so as to coincide with the median gross revenues as reported by the ACA. It should be noted that the mean revenues (a pure arithmetic average) were higher each of the years by between $20,000 and $30,000 per year; we used the lower (the median) number. As to 1985, when the ACA did not have comparable figures available, considering the consistent pattern of growth evidenced by the numbers for the other years, we took an approximate average between 1984 and 1986 in order to determine the 1985 addback. Note 1: Unreported Income.


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A review of the expense structure of the practice made it clear that certain expenses were not reflected. These included, for example, expenses relating to X-ray usage and related supplies. This observation was consistent with our discussions with Mrs. Pulate as to the manner in which Dr. Pulate would pay certain expenses with money orders and in cash so as not to have them reflected as expenses on the books. We estimated the amount of such unreported expenses. Note 2: Unreported Expenses.

Note 3: Advertising and Promotion. This is an expense category that also includes entertainment and related promotional-type activities. Based on our experiences with other medical practitioners and with a view toward reasonableness of this expense in light of the magnitude of the practice, we estimated amounts we believed to be personal/nonbusiness to bring these expenses in line with the reality of the practice’s needs.

This expense was grossly out of line for the size of the practice. A review of the tax returns indicated that an automobile was being depreciated over a three-year life and that improvements to the office were being depreciated over a five-year life (in 1985 and 1986). We added back the entire amount of the auto depreciation (for a substantially office-bound practice, there is very little business justification for the use of a car), and we added back half of the amortization of the leasehold expenses in 1985 and 1986 to allow for a more reasonable 10-year amortization. In addition, with regard to the auto depreciation, even if some depreciation were to be allowed, the tax-motivated three-year life had no basis in economic reality. Note 4: Depreciation and Amortization.

Considering that Dr. Pulate has a single office practice with very little need for automobile usage, the magnitude of expense put through the business was clearly inflated and represented significant personal usage. We accepted $500 per year for business usage. Note 5: Auto Expenses.

In 1986, this expense increased nearly $3,000 from the prior years — and was clearly out of line with what would be normal. Our analysis showed that $2,500 was for a retainer to Dr. Pulate’s matrimonial attorney — Georgia Kahlo — clearly a personal-type expense.

Note 6: Professional Fees.

In December 1984, Dr. Pulate signed a lease for his premises that called for rent in the amount of $600 per month if the upstairs was not sublet and $800 per month if it was sublet. It is clear that no more than $600 per month represents actual rent expense for the practice and that anything above that is a nonbusiness expense, relating to real estate activities rather than the chiropractic practice. Therefore, we have disallowed as a business expense the amount of the rent in excess of the base lease.

Note 7: Rent.

Inasmuch as the nature of the tax reporting of this practice was on a cash basis — income being reported only as collected and expenses deducted only as paid — the concept of a bad debt is an incongruity. If income is not reflected until received, there can be no bad debt. No support was made available for this expense, but Mrs. Pulate advised us that she believes it was in

Note 8: Bad Debts.


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reality an aborted investment in precious stones. In any case, this bad debt expense is not a legitimate expense of the business and, even if it were, it is clearly a nonrecurring expense.

EXHIBIT C–14

Comparisons to Industry Norms* Gross Revenues

1986 1985 1984 1983 1982 1981

Net Income

Median*

Mean*

Dr. Pulate (Reported)

Median*

Mean*


$132,350 N/A 110,182 106,333 95,500 92,000

$166,391 N/A 140,558 126,294 120,009 110,314

$75,722 70,523 71,258 69,291 74,705 72,072

$60,500 N/A 50,833 50,552 42,500 41,900

$74,670 N/A 66,308 59,074 53,270 50,527

$23,379 27,518 26,475 32,014 36,304 39,797

Net Income as % of Gross Revenues

1986 1985 1984 1983 1982 1981

Gross Revenues per Patient Visit

Median*

Mean*


Median*

Mean*

Dr. Pulate (Reported)†

45.7 N/A 46.1 47.5 44.5 45.5

44.9 N/A 47.2 46.8 44.4 45.8

30.9 39.0 37.2 46.2 48.6 55.2

$26.16 N/A 21.82 21.06 18.95 18.25

$30.25 N/A 24.58 23.40 20.85 19.69

$13.77 13.05 12.46 12.84 12.98 12.86

* Source — Demographic and Professional Characteristics of ACA Membership — 1987 Annual Summary and Statistical Study; by the American Chiropractic Association, Department of Statistics. † Assumes (in line with discussions with Mrs. Pulate and our review of the daily receipts sheets) that Dr. Pulate has an average number of patient visits. N/A — Not available

In comparing both the gross revenues and the net income that were reported on Dr. Pulate’s tax returns to those as reported by the chiropractic profession in general, even disregarding the higher average numbers evidenced in the mean and instead using the lower ones evidenced by the median, it is clear that there is something either seriously wrong with the reporting of the income. We are convinced that it is the latter situation — that is, that there is significant underreporting of income. As best as we can determine from a visual observation of his practice, from interviews with Mrs. Pulate, from our review of the daily cash receipts pages, and from our experience and knowledge of common practices in the industry, Dr. Pulate seriously and significantly underreported his gross revenues. To further clarify and quantify the questionableness of the reported numbers, using the ACA study, we calculated the median and the mean gross revenues per patient visit and compared same to that based on the reported gross revenues on Dr. Pulate’s tax returns. In recent years, his returns would suggest that he was Commentary on Comparison to Industry Norms.


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realizing approximately 50 percent of the national norm. Furthermore, the returns seemed to indicate that going back a few years, when the national norm was approximately $18 to $19 of income per patient visit, his was under $13 per patient visit. Also, as is evident above, whereas there has been a consistently increasing pattern in the gross revenues per patient visit as reported by the ACA (which makes sense in light of continually increasing medical fees), Dr. Pulate’s reported gross revenues per patient visit show virtual total stagnation from 1981 through 1985 and then a very modest (less than 6 percent) increase in 1986. Clearly, suggesting that Dr. Pulate recognizes less than $14 per patient visit in 1986, when his price structure was between $20 and $30 for a typical 15-minute visit, makes a mockery out of the reported numbers. 䊳

C.8 ABRAHAM V. ABRAHAM, MODERN RENOVATIONS, INC. Introduction and Observations. Modern Renovations, Inc. (the Company) is in the business of asbestos removal and has obtained the necessary license from the State of New Jersey. The business office is located on the first floor of the home of the Company’s president, Coleman Abraham. The Company was incorporated in September of 1987, received its license to do asbestos removal in approximately March of 1988, and was first able to obtain jobs in approximately April of 1988. The Company obtains nearly all of its work through bidding. Approximately 9 percent of its jobs are obtained through governmental agencies, such as the State of New Jersey, which sets strict rules as to the size jobs the Company can bid on. The Company bids on up to 300 jobs per year. Bid size started at $35,000 per job and had grown to $200,000 per job by July of 1990. A major consideration with an asbestos removal company operating in New Jersey is the limitation set by the State Department of Building and Construction (DBC). During the first one to two years, the Company did not realize a profit because its fixed expenses were high for a low-volume company — not atypical for this type of industry. Also, variable expenses, such as removal costs, labor, taxes, and materials — are often not cost-effective with small jobs. However, this initial proving period is necessary in order for the Company to show its ability to handle increasingly larger jobs. The job size limitations as set by the DBC are based on factors that include the size jobs that have been performed effectively in the past and manpower currently in force. It is not until a company has proved itself to the satisfaction of the DBC that it is permitted to bid on jobs of the size that would enable it to realize a profit. Employee turnover is of great concern in the industry because of the nature of the business — dealing with asbestos. To date, Modern Renovation has had a high, but reasonable, rate of turnover, one not so severe that jobs could not be completed. While the primary business of the Company is removing asbestos, some jobs require reinsulation, which is usually subcontracted out. The reinsulation portion of a job often cuts into the profits a company can earn, especially on smaller jobs (under $50,000). As a company grows, the subcontracting costs can be more easily absorbed. The Company presently is in a position to absorb these costs in a more cost-efficient manner. Competition in the industry is high because there are a great many asbestos removal companies. Also, other than the break-in period, which is often not fully


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appreciated beforehand, there are relatively few skills necessary to qualify to place oneself in this industry. The main threshold to cross is a training period that is available to anyone. A company must develop a high degree of experience and efficiency to be able to outbid other companies vying for the same jobs and be able to do so at a profit. Modern Renovations appears to have grown to such a position. The operating results for 1990 showed a net loss after our adjustments of approximately $10,500. (See Exhibit C–15.) Part of this loss can be attributable to a $200,000 job started in August of 1990 and ending October 31, 1990, for the Department of Unreported Gratuities. It was explained to us that a job like this one should have been quoted at $350,000. The $200,000 quote was the Company’s job size limit set by the DBC at that time. Management felt it imperative to secure an increase in its rating and, therefore, severely underbid this job. As a consequence, results for the year ended October 31, 1990, were considerably poorer than expected. Notwithstanding the particular circumstances of this large, unprofitable bid, it is reasonable (based on actual historical operational results, continued and increased competition, and the likelihood that this type of low-balling to “buy” up the scale of job sizes will be repeated) to utilize the October 31, 1990, operational results as the appropriate yardstick for determining the Company’s breakeven point and future profitability.

EXHIBIT C–15

Abraham v. Abraham Modern Renovations, Inc. Balance Sheet October 31, 1989 Unadjusted Balance Sheet

Cash Accounts receivable (net) Other current assets Total Current Assets Machinery and equipment at cost Less accumulated depreciation Total fixed assets Total Assets Accounts payable Payroll taxes payable Accrued officers salary Accrued office salary Other accrued expenses

$ 36,739 114,839 3,978

Adjust. Number

Increase (Decrease)

Adjusted Balance Sheet $ 36,739

1 5 4

83,000 51,000 19,048

248,839 23,026

155,556

308,604

28,095

28,095

(7,425)

(7,425)

20,670

20,670

176,226

329,274

7,506 15,983 90,000 35,000 82,350

7,506 15,983 231,600 35,000

3 2, Net 7

141,600 -0(1,700)


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EXHIBIT C–15

Abraham v. Abraham Modern Renovations, Inc. Balance Sheet October 31, 1989 (continued) Unadjusted Balance Sheet

Adjust. Number 6 8

Increase (Decrease)

Adjusted Balance Sheet

12,000 8,000

100,650

Current portion of long-term debt Loans payable

32,179 13,425

32,179 13,425

Total Current Liabilities Long-term debt

276,443 54,521

436,343 54,521

Total Liabilities

330,964

490,864

Common stock Deficit

1,500 (156,238)

1,500 (163,090)

Total Stockholders’ Deficit

(154,738)

(161,590)

$176,226

$329,274

Total Liabilities and Stockholders’ Deficit

Statements of Income Year Ended October 31, 1989, and Inception to October 31, 1988 1989

1988

$510,949

$107,320

Direct Costs Purchases Labor Subcontracting Removal costs

62,418 112,558 82,479 24,439

23,307 8,958 5,134 4,174

Total Direct Costs

281,894

041,573

60,000 18,200 14,255 5,494 18,790 6,600 59,016 33,191 16,096 29,062 1,172 7,441

30,000 21,000 4,349 1,931 6,177 7,700 32,382 5,183 5,100 1,985 -02,216

Sales

General and Administrative Costs Officers’ salaries Office salaries Auto, truck, and travel Depreciation Payroll taxes Rent General insurance Bonding Office expenses Plans, licenses, and permits Interest Other costs


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Statements of Income Year Ended October 31, 1989, and Inception to October 31, 1988 (continued) 1989 Bad debts Total Overhead Net Income (Loss)

1988

63,700

-0-

333,017

118,023

(103,962)

(52,276)

83,000 10,000 (70,400) 19,048 63,700 (12,000) 300 (2,300)

-0(10,000) (71,200) -0-0-01,400 (5,700)

$(12,614)

$(137,776)

Adjustments 1 2 3 4 5 6 7 8

Sales Labor Officers’ salaries Patent Bad debts Insurance Rent Interest expense

Adjusted Income (Loss)

Explanation of Adjustments to Balance Sheets and Statements of Income

Approximately $83,000 of sales were omitted from the financial statements for the year ended October 31, 1989. Adjustment No. 1.

Approximately $10,000 of wages to laborers in the first year of operation were not paid until 1989.

Adjustment No. 2.

During the initial start-up phase, Abraham and Erin worked approximately 35 hours a week from November 1987 to May 1988 and 40 hours a week from June 1988 to October 1988. A fair wage to each officer would be $20 an hour for the period November 1987 to May 1988. For the remaining period, June to October, Abraham’s managerial wage was determined at a 50 percent premium over the labor wage ($30 an hour), and Erin remained at the laborer’s wage of $20 per hour. Ira worked 40 hours per week from approximately June 1988 through June 1989. Thus, officers’ salaries for 1988 would be as shown in Exhibit C–16. Adjustment No. 3.

EXHIBIT C–16

Abraham v. Abraham — Officers’ Salaries

Abraham: 30 weeks of 35 hours @ $20 an hour and 22 weeks of 40 hours @ $30 an hour Erin: 30 weeks of 35 hours @ $20 an hour and 22 weeks of 40 hours @ $20 an hour Ira: 19 weeks of 40 hours @ $20 an hour Less: as expensed Adjustment — for the year ended October 31, 1988

$ 47,400 38,600 015,200 101,200 030,000 071,200 071,200


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EXHIBIT C–16

Abraham v. Abraham — Officers’ Salaries (continued)

For the year ended October 31, 1989: Abraham: 52 weeks of 40 hours @ $30 an hour Erin: 52 weeks of 40 hours @ $20 an hour Ira: 33 weeks of 40 hours @ $20 an hour

62,400 41,600 026,400

Less: as expensed

130,400 060,000

Adjustment — for the year ended October 31, 1989

$070,400 070.400

Modern Renovations entered into a licensing agreement for a clean air machine during the October 31, 1989, fiscal year. There was litigation pending, asserting that no patent actually existed. In May 1991, the Company received a letter from the State of New Jersey mandating the use of this equipment. The agreement was that the original $25,000 paid in December 1988 was “valid” until July 1, 1992, at which time Modern Renovations must pay $10,000 a year for use of this equipment. The expense for the year ended October 31, 1989, is 10/42 of $25,000 or $5,952. Thus, the addback for this year is $25,000 minus $5,952, or $19,048. Adjustment No. 4.

A job performed in Hades was incorrectly deemed uncollectible. However, the problems and delays in collecting same warrant a discount of 20 percent. The result is an addback of $63,700 to the Income Statement and $51,000 to the Balance Sheet. This receivable remains uncollected and may indeed be uncollectible. Documentation as to its uncollectibility remains inadequate, and therefore we continue to reflect it at its discounted value. Adjustment No. 5.

An audit of Workers’ Compensation insurance for the year ended October 31, 1989, resulted in an assessment of approximately $12,000. Adjustment No. 6.

As per a letter submitted by a realtor, and our visual inspection, it was deemed that a fair rental value of the space occupied by the Company would be $6,300 per year. Adjustment is for the difference between the $6,300 and the amount reported. Adjustment No. 7.

Despite the failure of the Company to pay interest on loans from stockholders, for economic purposes such loans must bear interest for the purposes of our report.

Adjustment No. 8.

䊳

C.9 CONVENIENCE FOOD STORE: NEVER ON SATURDAY FOOD EMPORIUM.

In a case this author had a few years ago, involving an appetizing food store with some food convenience features, we experienced the problem that we often face in a cash type of business: severe doubts as to the legitimacy of the reported income and accounting records inadequate to determine what would be the correct income/sales. This is, at the same time, one of the plagues of the investigative


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369

accountant and one of the joys — it makes the work that much more interesting and challenging. In this case, we were faced with a Northern New Jersey middle-class family of five, the wife not employed outside the home, and ostensibly the family living on the husband’s reported income that ranged over a several year period between $20,000 and $25,000 per year. This factor alone — the “pig” factor — strongly suggested that there was far more than met the eye. The nature of the operation was such that there was no such thing as a sales receipt, with the possible exception of when an office party or some other catered event was provided with food; but even in those cases, allegedly the company kept no sales records. Therefore, to the extent there was sales information, it was merely deposits that went into the bank. This is not all that unusual in small cash businesses. The company’s accountant, a family member no less, mentioned to us when we walked in that he felt we would find our jobs very easy because the company had recently been audited and the IRS found nothing of any consequence. What was not stated to him, but was thought by us, was something to the effect of “Undoubtedly the IRS’s problem is that they audited the books — what needs to be audited is what is not in the books.” And that truly is the essence of what needs to be done when investigating a cash business. That is, what is in the books is the easy part — but what is not in the books is what is going to make or not make your case. We did, of course, do the normal investigating of the company records, and we did find a few thousand dollars per year of clearly personal perquisites taken by the business owner. However, there was nothing there that was particularly exciting and nothing that would raise the standard of living more than a few thousand dollars a year. Our solution to this dilemma was to spend a little time walking around the store, writing down the sales prices of various of the company’s products. We got these sales prices right off the posted numbers on the wall, on the counters, and from asking. It must be kept in mind that we were forced to deal with current (at that time) sales prices rather than the sales prices of a year or two years prior, which actually represented the period of time that we were trying to investigate. The reason is that, as indicated above, there were no records of sales prices or sales receipts that could be relied upon. However, the current prices were still quite usable — provided we used current cost figures. That was our next step. We went to the current bills to determine the direct costs at current prices to compare to the sales prices we had just determined. By going through these steps, we were able to do a fairly detailed analysis of various types of products that were sold by the store and determine from the company’s records what its costs were for these items. In addition, because there was food preparation involved in various of the products (but not all), we asked the people behind the counter and the business owner to give us information concerning the extent of losses resulting from cutting, trimming, and shrinkage upon cooking, as well as information about any spoilage problems. One other complication was that, without any usable sales analysis with regard to what was sold, it was very difficult to determine how much of each of these products, with significantly varying gross profit percentages, was sold. In the absence of such information, we were able to determine an approximate sales mix by working up numbers based on the amount of product purchased. Using the purchases in relationship to each other, as a rough approximation of what the


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sales would have been in relationship to each other, put us in the position of being able to arrive at usable conclusions. Exhibit C–17 is the illustration of this reconstruction that concluded that unreported income approximated $60,000 per year. EXHIBIT C–17

Never on Saturday Food Emporium Gross Profit Percentage Analysis Sample of Items Sold Gross Profit

3 lb. chicken — dressed poultry

Sales Price

Cost

$

%

Share of Total Sales

Weighted Gross Profit

61.6%

16.5%

10.2%

$ 5.00

$ 1.92

$ 3.08

Corned beef — per pound — allowing for 40% shrinkage upon cooking

9.00

3.67

5.33

59.2

12.3

7.3

Bagels — per dozen

2.40

1.40

1.00

41.7

10.4

4.3

Stuffed cabbage

1.40

.95

.45

32.1

4.6

1.5

Chopped liver — per pound

4.50

2.25

2.25

50.0

13.1

6.5

Nova — allowing for 30% waste upon cutting

16.00

11.64

4.36

27.3

4.2

1.1

Lox— allowing for 30% waste upon cutting

16.00

10.07

5.93

37.1

7.5

2.8

—

—

—

40.0

31.4

12.5

All other items (gross profit assumed) AVERAGE GROSS PROFIT

46.2% 46.2

Based on the above sample, the average gross profit was approximately 46 percent. To be conservative, and to allow for a margin of error, we discounted that by 10 percent. That resulted in a gross profit of 41.4 percent and its complement, the cost of sales, of 58.6 percent as shown in Exhibit C–18. EXHIBIT C–18

Reconstruction of Sales

Cost of sales as reported

1988

1987

1986

1985

1984

$234,053

$228,354

$215,895

$215,450

$195,026

Sales necessary to incur these costs at a 58.6% cost of sales

399,408

389,688

368,422

367,662

332,809

Sales as reported

337,955

329,067

305,362

305,606

281,157

Unreported Sales

$ 61,453

$ 60,621

$ 63,060

$ 62,056

$ 51,652


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C.10 MARGINAL CRANE, INC. 䊳

371

C.10 MARGINAL CRANE, INC.

In April of 1990, Emily & Sam Margin purchased Evening Hours Crane Service, Inc. (Company) for $3,500,000. The Company provides a variety of services related to the use of cranes in real estate construction and road and bridge construction, and provides cranes to contractors with or without a crew. The cranes are rented on a daily, weekly, or monthly basis. The rental rate varies, depending upon the size of the crane needed for a particular job and the length of time rented. The year prior to the Margin’s ownership, the Company’s reported revenues were approximately $2.3 million. In the first year of the Margin’s ownership (the year ended May 31, 1991), its revenues rose 89 percent to approximately $4.35 million. Revenues rose an additional 24 percent to $5.4 million for the year ended May 31, 1992. (See Exhibits C–19 to C–22.) A number of issues had to be addressed, including sales deferral games, unstated inventory (discovered by a walk-through), and significant appreciation in equipment values.

Introduction.

EXHIBIT C–19

Margin v. Margin Marginal Crane, Inc. Balance Sheet as of May 31, 1992

Current Assets Cash Accounts receivable Officer loans Other current assets Total Current Assets

$0,199,901 841,082 63,932 0,002,420 1,107,335

Property and Equipment Land Building and improvements Crane equipment Truck and automotive equipment Machinery and equipment

170,000 690,664 3,874,230 178,190 0,100,400

Total Less: Accumulated Depreciation

5,013,484 1,558,148

Net Property and Equipment

3,455,336

Restrictive Covenant and Goodwill Total Assets Current Liabilities Accounts payable Current maturities of long-term debt Accrued expenses Income taxes payable Total Current Liabilities Long-Term Debt — Net of Current Maturities Total Liabilities

0,231,430 $4,794,101 4,794,101 $0,458,825 566,433 117,096 0,073,400 1,215,754 3,443,825 4,659,579


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EXHIBIT C–19

Margin v. Margin Marginal Crane, Inc. Balance Sheet as of May 31, 1992 (continued)

Stockholders’ Equity Capital stock Retained earnings

44,597 0,089,925

Total Stockholders’ Equity

0,134,522

Total Liabilities and Stockholders’ Equity

EXHIBIT C–20

$4,794,101 4.794.101

Margin v. Margin Marginal Crane, Inc. Adjustments to Balance Sheet

Unadjusted book value at May 31, 1992 Additions to book value: Sales for May 1992 not billed until June 1992 (adjustment No. 1) Less: Income tax effect (at 40%) Fair market value adjustment of Crane Equipment (adjustment No. 3) Receivable from Marginal Sisters — on account of expenses paid by the Company (adjustment No. 7) Less: Income tax effect (at 40%)

$134,522

$273,000 (109,200)

919,662

Parts and supplies inventory— existent but unstated — estimated at the average of one month’s purchase of equipment parts Less: Income tax effect (at 40%)

21,600 (008,640)

12,960

35,138 (014,055)

21,083

Subtractions from book value: Officer’s loan receivable Book value of goodwill and restrictive covenant (from purchase of company in 1990)

(63,932) (231,430)

Adjusted book value at May 31, 1992

EXHIBIT C–21

163,800

$956,665 956.665

Margin v. Margin Marginal Crane, Inc. Comparative Income Statements Years Ended May 31, as Reported 1992

1991

Total Revenues

$5,322,241

$4,123,885

Direct Costs Wages — crew Payroll taxes

1,174,506 106,220

997,518 111,324


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EXHIBIT C–21

Margin v. Margin Marginal Crane, Inc. Comparative Income Statements Years Ended May 31, as Reported (continued)

Union funds Building maintenance Depreciation — crane, truck, and building Equipment parts Equipment rentals Equipment repairs Fuel Trucking Insurance Utilities Total Direct Costs Administrative Expenses Officer’s compensation Other salaries Advertising and promotion Bad debts Office supplies Professional fees Other taxes Telephone Commissions Interest Amortization Other

1992

1991

462,281 28,364 998,286 421,651 465,436 84,086 97,077 59,692 171,156 11,430

367,471 33,633 559,862 238,861 521,480 86,019 75,166 84,137 274,199 8,485

4,080,185

3,358,155

71,905 93,900 22,747 299,119 43,073 15,232 7,914 52,684 35,415 432,717 10,577 —

70,847 100,303 20,219 34,189 33,228 16,498 15,610 30,584 8,800 427,127 10,252 (3,098)

Total Administrative Costs

1,085,283

0,764,559

Total Expenses

5,165,468

4,122,714

$1,156,773

$111,1,171

Income Before Taxes

EXHIBIT C–22

Margin v. Margin Marginal Crane, Inc. Adjustments to Income Statements Years Ended May 31 Adjustment No.

Income before taxes Adjustments: Deferred sales Officer’s salary Depreciation of crane equipment Unsupported expenses Personal bills

1992 $156,773

1991 $

1,171

1 2

42,000 71,905

231,000 70,847

3 4 5

459,831 57,466 15,365

459,831 — 10,947

373


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EXHIBIT C–22

Margin v. Margin Marginal Crane, Inc. Adjustments to Income Statements Years Ended May 31 (continued) Adjustment no.

Personal bills Expenses paid on behalf of Marginal Sisters Parts and supplies

1992

1991

6

7,150

6,489

7 8

15,500 015,233

6,100 019,905

$841,223

$806,290

Adjusted income before reasonable compensation and income taxes

Explanation of Adjustments to Income

A review of the Company’s monthly billings for the years ended May 31, 1992, and May 31, 1991, showed that significant amounts of sales were deferred from each year-end into the following year — a tax deferral scheme. Approximately $231,000 of May 1991 income was reflected as income in June 1991; and $273,000 of May 1992 sales were reflected in June 1992. The adjustment to income is as shown in Exhibit C–23.

Adjustment No. 1.

EXHIBIT C–23

Margin v. Margin Adjustment to Income May 31, 1992

Deferred billing May 1991 into June 1991 Net increase in deferred billing for May 1992 into June 1992 Total Adjustment to Sales

1991 $231,000

$042,000 $ 42,000

$231,000

Adjustment No. 2. For the purposes of valuation, officer’s salary must be adjusted to reflect a fair level of compensation. We have added back the officer’s compensation taken. The determination of reasonable compensation is pending further information. Adjustment No. 3. We received a report from Mr. Maury Michael valuing the Company’s crane equipment. The difference between the valuation report and the value reflected on the Company’s books has been added back to income evenly for the years ended May 31, 1991, and May 31, 1992. Of note is that an insurance report prepared in October 1991 reflects a value for the same equipment in excess of $1 million more than the appraised values as per Mr. Michael. We have used the far more conservative values expressed by Mr. Michael. Had we used the


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375

insurance company’s values, it is our belief that the ultimate value of the Company would be increased by in excess of one million dollars. The adjustment is illustrated as shown in Exhibit C–24.

EXHIBIT C–24

Maury Michael Fair Market Value As Per Appraiser

Insured Value

Appraised values Book value

$3,372,000 $2,452,338

$4,385,000 $2,452,338

Appraised Value Increment

$0,919,662 0,919,662

Insured Value Increment

$1,932,662 1.932.662

Adjustment No. 4. A review of the cash disbursements journals for the years ended May 31, 1991, and May 31, 1992, indicated various expenses for which no support in evidence of same exists, and which appear to be nonbusiness and for personal expenses. Exhibit C–25 is a summary of same:

EXHIBIT C–25

Summary of Cash Disbursements Journal Years Ended May 31, 1992 1991

1) Checks to “Cash” endorsed by Sue Margin and charged to commissions 2) Checks written to Sue Margin and charged to commissions 3) Check to Becca Margin charged to equipment rental Total Adjustment

$18,666

$

—

13,800

—

25,000

—

$57,466

$

—

A review of the cash disbursements journal (see Exhibit C–26) and related documentation revealed personal expenses of Emily Margin charged as business expenses.

Adjustment No. 5.

EXHIBIT C–26

Cash Disbursements Journal Years Ended May 31, 1992 1991

1) Check to Danielle Ashley for “Trees and Bushes” for the Margin marital home 2) Personal telephone bills 3) Checks for personal utilities

$ 4,215 4,800 3,350

$

— — 2,800


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EXHIBIT C–26

Cash Disbursements Journal (continued) Years Ended May 31, 1992 1991

4) Estimated personal portion of gasoline expenses 5) Checks to Emily Margin charged to equipment parts expense Total Adjustment

3,000

2,800

—

5,347

$15,365

$10,947

Adjustment No. 6. There were various checks drawn to Sam Margin and charged to office expense or repairs and maintenance. These totaled $7,150 in 1990 and $6,489 in 1989.

Our review of the Company’s books, as well as the books of Marginal Sisters, Inc., indicated that various expenses (for example, insurance) of Marginal Sisters were paid by Marginal Crane. Adjustment No. 7.

The Company’s books do not reflect an inventory of parts and supplies, and the existence of same was denied. However, our inspection of the premises indicated an alcove in the shop, with shelves containing parts and supplies. It is our estimate that the Company’s inventory approximates an average month’s purchases (a 30-day stock).

Adjustment No. 8.

䊳

C.11 BUST YOUR GUT DELI. There are times when the simplest and most obvious step can be the most valuable in an accounting investigation. Although there are certainly many situations in which insight, experience, and cleverness make the difference, sometimes it’s as simple as going to the place being investigated and buying one of its products. We had such a situation not too long ago involving a basic deli-type operation. This was a store that catered to a breakfast and lunch crowd, getting most of its income from the sale of sandwiches as well as coffee and various small grocery items. As is (unfortunately ?) the norm with a cash business such as this, the existing bookkeeping/financial records are usually of dubious merit and veracity. It is extremely important for us, as investigative accountants, to understand what is not in the books. During our interview of the business owner, he explained to us how much product goes into his sandwiches. Subsequently, independently and unannounced, we visited his store and purchased a few sandwiches. This was done by someone he had not seen before. Then, tempting as it was to devour those delicacies, they were rushed back to our office, where they were promptly dismantled and weighed on two separate postage scales. From there it was a relatively simple matter of calculating what his cost was of the items that went into the sandwiches. We used that as a model for determining, at least as to the sandwich portion of his business, the gross profit derived therefrom. We were able to determine the gross profit from other parts of his business in somewhat simpler methods, which are in part illustrated in Exhibit C–27.


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C.11 BUST YOUR GUT DELI

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Another element of this on-site investigation that should be of interest to the reader was the difference of opinion as to the number of registers in operation at the business. The wife had told us there were two registers — the proceeds of only one being reported, the other a source of unreported income. The husband had acknowledged that he had two registers but that one was inoperable. Further, he supplied us, at our request, with the cash register tapes (from the allegedly sole operable register). These tapes very neatly (some might say too neatly) tied into his reported income. Our physical visit to his premises revealed that two registers were in active operation — and as a result, there was absolutely no doubt in our minds that we did not see one set of register tapes. EXHIBIT C–27

Bust Your Gut Deli Reconstruction of Cost of Goods Sold Cost Margin

$2.50

51.6%

40%

20.64%

N/A

N/A

72.0%

15%

10.80

.35

.60

58.3%

15%

8.75

336.00

21.0%

6%

1.26

13.50 1.35

15.05 1.85

89.7% 73.0%

2% 3%

1.79 2.19

1.20

1.51

79.5%

10%

7.95

80.0%

9%

Cost A) Sandwich — (typical sandwich as per purchase and weighing) Roll Meat 5 oz. or .3125 lbs. @ $2.65 Cheese .5 oz. or .03125 lbs. @ $2.65 Tomato, lettuce, oil and vinegar Cost of sandwich

.18 .83 .08 00.20 01.29

Sale price B) Potato chips and packaged cakes: Margin is fixed C) Soda D) Coffee: 80 packages yielding 560 cups 80 pots 560 cups @ 3¢ a cup Milk 1 oz. for 75% of the cups ⳱ 420 ⳯ 2¢ an oz. Sugar Total Cost

39.50 16.80 8.40 06.00 70.70

Sale price — 560 cups @ .60 E) Cigarettes Carton Pack F) Milk (Averaged) G) Grocery and Sundry Total Cost Error Rate and Wastage Allowance Reconstructed Cost of Goods Sold

% of Weighted Total Cost Business Average

Sale Price

07.20 60.58

6% of Cost

03.63 64.21% 64.21%


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EXHIBIT C–27

Bust Your Gut Deli Reconstruction of Cost of Goods Sold (continued)

Reconstruction of Sales Total Cost of Sales April 1990 through December 1990 Cost of Sales percent as adjusted

$132,855 00.6421

Reconstructed Sales Sales as Reported

206,907 177,853

Unreported Sales

029,054

Annualized — Rounded

038,700 038,700

Total Cost of Sales January 1991 through April 1991 Cost of Sales percent as adjusted Reconstructed Sales Sales as Reported Unreported Sales Annualized — Rounded

$ 51,624 00.6421 080,399 070,252 010,147 $030,400 030.400

It was, therefore, our conclusion that there was approximately $30,000 to $40,000 per year of unreported income. 䊳

C.12 A CRULLER FOR YOUR THOUGHTS: THE CUPPA JO DONUT SHOP. To dunk or not to dunk — that is the question. At least, that’s what the sign might have been in this local donut and coffee shop. The operation itself was pretty straightforward — the company’s business was to bake donuts, muffins, crullers, and the like, and then sell them, as well as coffee, at retail. Obviously, cash was not an issue, it was the issue (see Exhibit C–28). One of the problems with this operation was that it was exceedingly difficult to attempt to reconstruct what sales should have been based on cost of goods sold. It was known that the baking operation was not controlled very well, that product was often wasted, that depending on who was baking, batches would be done more or less efficiently. There was no benchmark cost of goods sold that could be relied upon to reconstruct sales. Other methods had to be employed. Fortunately, from our perspective, the standard of living maintained was grossly inconsistent with the reported income. As an example, Carina Cuppa, who ran the operation, drove a luxury car at a lease cost of $742 per month. The problem was, the lease payments didn’t show up anywhere on the company’s books or in her personal checking account. The lease was being paid for in cash. There were other similar problems — including the family utility bills and vacations being paid for with cash-purchased money orders.


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C.12 A CRULLER FOR YOUR THOUGHTS: THE CUPPA JO DONUT SHOP 379

EXHIBIT C–28

Cuppa v. Cuppa T/A Cuppa Jo Donut Shop Comparative Statements of Income 1993

Sales Cost of Sales Food purchases Direct payroll Supplies Advertising Franchise fee

$ 695,775 127,556 102,891 25,214 34,789 034,093

1992

100.0)% 18.3 14.8 3.6 5.0 04.9

$ 695,703 121,971 87,778 25,240 32,985 032,324

1991

100.0)% 18.5 13.3 3.8 5.0 004.9

$ 659,475 147,949 104,148 25,794 32,899 032,240

100.0)% 22.4 15.8 3.9 5.0 004.9

Total Cost of Sales

324,543

046.6

300,298

045.5

343,030

052.0

Gross Profit

371,232

053.4

359,405

054.5

316,455

048.0

58,085 16,338

8.2 2.3

54,705 51,616

8.3 7.8

49,319 51,616

7.4 7.8

4,492

0.6

6,027

0.9

6,039

0.9

11,121 1,488

1.6 0.3

7,539 1,488

1.1 0.2

7,128 1,240

1.1 0.3

5,148 33,993

0.7 4.9

5,148 33,426

0.8 5.1

7,648 37,822

1.2 5.7

1,291 81,542 74,282 1,105 3,773 9,533 14,648 18,916 8,004 27,333

0.2 11.7 10.7 0.2 0.5 1.4 2.1 2.7 1.2 3.9

1,071 51,447 80,500 1,975 1,177 5,558 21,174 18,393 9,154 22,233

0.1 7.8 12.2 0.3 0.2 0.8 3.2 2.8 1.4 3.4

667 25,560 60,800 2,684 1,004 6,604 6,858 18,021 8,075 24,844

0.1 3.9 9.2 0.4 0.2 1.0 1.0 2.7 1.2 3.8

3,218

0.5

1,716

0.3

2,718

0.4

231

—

2,451

0.4

2,948

0.4

Expenses Register shortages Depreciation General expenses Cleaning and maintenance Group insurance Casualty insurance Rent Laundry & uniforms Indirect payroll Officer salary Office expense Premium expense Professional fees Repairs Payroll taxes Real estate taxes Utilities Nonfranchise advertising Officer life insurance Other (income) expense Total Expenses Net Income (Loss) Before Taxes and Adjustments

(5,735) 367,806

$ 003,426

(0.8) 052.9

0.5)%

(2,788) 374,010

$ (14,605)

(0.4) 056.7

(2.2)%

1,100

0.2

322,695

048.9

$ (6,250)

(0.9)%


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EXHIBIT C–28

Cuppa v. Cuppa T/A Cuppa Jo Donut Shop Comparative Statements of Income (continued) Adjustments and Reconstruction of Net Income 1993

Net Income (Loss) Before Taxes Adjustments: Register Shortages — Note 1 Register Shortages — Note 1 Depreciation — Note 2 Depreciation — Note 2 Officer Life Insurance — Note 3 Officer Salary Adjusted Net Income Before Officer Salary

$

3,426

57,085 (6,958) 16,338 (20,901) 231 0074,282 $ 123,503

1992 $ (14,605) 54,705 (6,597) 51,616 (20,901) 2,779 0080,500 $ 147,497

1991 $

(6,250)

49,319 (6,595) 51,616 (20,582) 3,399 0060,800 $ 131,707

Note 1: Register Shortages. At 8 percent of total sales, register shortages are abnormally high. Further, we have been advised that such shortages are largely the result of shareholder abuse. As a result, the amounts reflected in the statements of income should be removed and replaced by more reasonable and realistic amounts. Most cash businesses experience register shortages, typically caused by theft, ring-up errors, and the like. Based on the store’s volume and number of counter employees, as well as input from industry sources, a more reasonable level would be 1 percent of sales.

The depreciation reflected in the statements of income was computed using the accelerated tax methods allowed by the IRS. These amounts should be removed and replaced by amounts computed using the straight-line method of depreciation and written off over their respective economic lives rather than the more liberal tax lives. Note 2: Depreciation.

Note 3: Officer Life Insurance. This expense should be removed since it is a cost to ensure that the Company will be compensated for the loss of a key employee. It is not an operating expense. 䊳

C.13 THE AC-DC CONTRAC TOR. In a case that was particularly interesting with regard to the reconstruction of income, we were dealing with an electrical contracting business that did a significant amount of work on new home construction and for extras and improvements to homes either under construction or already in existence. The nature of the work as it applied to doing home improvements and extras was that it often came from, and was paid for, by the homeowner. As a consequence, a fair amount of income of this business was realized in cash — some of it not reported. Notably, there was a total absence of cash being deposited into the company’s bank account for 1989, with deposit slips from the previous year not available to us.


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The nature of the business, its operations, and the records maintained were such that using a customary gross profit approach toward reconstructing income would not have been appropriate in that the cost of goods sold (the other side of the gross profit) was not terribly significant or relevant in a business that was substantially labor-intensive. Even where the cost of hard goods was substantial, there was not necessarily a relationship between those costs and a discernible sales price with a resultant determination of gross profit, because the size and/or cost of the product often had little or no bearing on the amount of labor that was involved to put it in place. Also, additional services were involved in many cases, services that had no relationship to the product that needed to be purchased but that were included in one comprehensive bill. The approach that we determined to be appropriate was to use the company’s labor as a basis for determining what its gross sales should have been. The first element in this approach was to determine the number of hours worked by the relevant laborers during a representative period. For that, we used the company’s payroll records and had that augmented by the workers’ compensation auditor’s reports. We used only the actual hours worked, factoring out any 11/2 multiple for overtime premiums. We also asked the business owner himself how many hours he served in a laborer’s function and used the figure he supplied. There was also some basic logic to the numbers he gave us for himself in that they started out at the earlier history of his business (when there were fewer employees) at a fairly high number of hours in a labor function and then significantly decreased over the ensuing few years as his business matured and his labor force expanded. That relationship gave us some comfort that, within a reasonable range, the number of hours he was telling us he worked in that type of service was reasonable. Now that we had the hours, we needed an idea about what the people would generate in sales volume. Unfortunately, the company’s records were not particularly illuminating, providing no usable pattern for information. The owner, while willing to talk to us, was of no help here in that he indicated that there was no typical hourly rate that he billed his men out at, and that he kind of just factored in a fair total labor rate when he either bid or estimated a job, or actually did the billing at some later point. Therefore, as a basis of reference, we went to clients and outside parties to find out what — under the particular circumstances of the nature of the work involved and the location in which it was being rendered — would be a typical charge for an electrical contractor laborer. As to the hourly rate used by us for the business owner himself, we determined that a somewhat higher rate would be called for, in that it would be reasonable to expect that either as a master electrician or in a supervisory role he would be billing himself, even if not expressed explicitly, at a higher rate. Next, again with input from outsiders, we determined what a fair downtime percentage would be to reflect that, even if he paid his laborers for 40 hours in a week, they might only work 35 of those hours and be nonbillable/nonproductive the other five. In addition, part and parcel of the operation included selling materials — not only was labor involved but products had to be purchased and installed. We again used outside sources and, based on that, determined that a reasonable markup over the direct costs of those materials would be 20 percent. Thus, as illustrated in Exhibit C–29, with the combination of the labor hours expended by the employees and by the owner, factoring in an hourly rate, and


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adding to that the materials that were sold with a reasonable markup thereon, we were able to recalculate (with a degree of comfort that our numbers were realistic) what the true gross sales were — and, therefore, by subtraction, the amount of unrecorded income. We also had to factor in a changing inventory. The inventory issue raised significant complexities in that we also had a situation where for tax purposes no inventory was reflected at all, whereas for financial statement purposes there was an inventory, but it was not a reliable one. Therefore, we had to make estimated allowances for what might have been purchased during the year (which was expensed on the company’s records and would show up as a cost) versus what was retained at the end of the year and, therefore, not yet sold. Considering that the company was going through a significant growth phase, it would be fair to say that not all of what was purchased was sold (that is, the inventory was increasing) and, therefore, we could not simply take what was purchased, add on 20 percent and assume that was what was sold.

EXHIBIT C–29

AC-DC Contractors Reconstruction of Gross Income YEAR ENDED DECEMBER 31, 1989

1988

1987

1986

$260,046 (26,260) (11,073)

$148,660 (20,630) (6,000)

$ 73,317 (13,750) (1,190)

$ 51,249 (10,420) —

Electrician payroll Less: overtime premium, vacation, sick, and holiday pay of electricians

222,713

122,030

58,377

40,829

21,155

10,983

005,001

003,675

Payroll for electrician labor Average hourly cost

201,558 0008.06

111,047 0007.00

53,376 0005.95

37,154 0005.50

Electrician Hours Available for Labor Total payroll Less: officer secretarial

Electrician hours available for labor Less: estimate of downtime — 10%

25,007

15,864

8,971

6,755

002,501

001,586

000,897

000,676

Productive electrician hours Estimated hourly rate

22,506 000,021

14,278 000,018

8,074 0015.50

6,079 000,014

Revenue generated by electricians

472,626

257,004

125,147

085,106

Hours worked as electrician by officer Estimated hourly rate

200 000,030

1,000 000,028

2,000 000,026

2,500 000,024

Revenue generated by officer

006,000

028,000

052,000

060,000

Total revenue generated by labor

478,626

285,004

177,147

145,106


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C.14 IDEAS, INC.

EXHIBIT C–29

383

AC-DC Contractors Reconstruction of Gross Income (continued) YEAR ENDED DECEMBER 31,

Material billings — at cost plus estimated 20% profit markup Less: Annual marginal (increase) decrease in inventory (at cost) — estimated Reconstructed revenues Reported revenues Unreported revenues

䊳

1989

1988

1987

1986

350,443

256,502

145,722

109,106

(25,000)

(15,000)

(10,000)

804,069 731,863

526,506 483,593

312,869 253,457

249,212 197,990

(5,000)

$ 72,206

$ 42,913

$ 59,412

$ 51,222

C.14 IDEAS, INC. Introduction, Background, and Observations. Ideas, Inc., is a broker of educational products and games. A customer will typically develop an idea for an educational game or similar product and, with the assistance of Ideas, further develop the concept and then request Ideas to submit a proposal. Most of the manufacturing is then done through companies in Europe with which Ideas has established long-term close relationships. Such customers — typically educational publishing companies in the United States — go through a similar process with perhaps one or two other brokers. Primary responsibility for a multitude of facets of Ideas, including sales and manufacturing contact, rests with Amelia Lane (100 percent shareholder) as well as with a key employee, Morris Monroe. There are relatively few other employees, as much of the work is subcontracted out. A key element in evaluating this business, in terms of its operations, its future, and the ultimate determination of value, is the impact that a major contract (The World As We Knew It) had on the company’s recent operations. Starting in 1989, Ideas began negotiations and discussions with Friends of Cartography to develop a new game. This contract potentially represented in the vicinity of $4 million of sales (and, in theory, potentially more with reprints) for Ideas — fully double its total annual sales volume at that time. As a consequence, Ideas committed a substantial portion of its efforts, management attention, and expense toward acquiring this order, with the intent of making Friends of Cartography a fixture in its stable of clients. These significant efforts continued from 1989 into 1990 and, in October 1990, Ideas received an order from Friends of Cartography in the amount of $3.75 million. As originally promulgated, Ideas would have profited very substantially not only from this sale but also from the prospects of an expanded and continued relationship with a potentially very significant customer. However, the originally anticipated profit margin of 11 percent — which is half to one-third of the typical profit margins experienced by Ideas — had shrunk considerably, attributable to delays in placing the order, the decline of the U.S. dollar vis-à-vis the European Community Unit (ECU) (the denomination in which the original manufacturing


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costs were quoted), the apparent 40 percent reduction in the volume of the order placed, and general cost pressures in developing and modifying a successful bid. As best as we can determine at this time, the Company does not face any residual benefit from this game (in the form of reprints) inasmuch as the product appears to be a failure. We were advised, and reviewed correspondence from Friends of Cartography indicating, that they’ve canceled future manufacturing on the product. Therefore, what was initially anticipated to represent nearly $500,000 of profit for Ideas actually only contributed approximately $200,000 toward the company overhead. Based on discussions with Ms. Lane and a review of the company operations, it is clear that, in retrospect, not only was the “World” job much less profitable than hoped, but also it likely represented a negative to the company because of the significant overhead expenses incurred to make the job work and the time and effort expended to obtain the job and manage it. In addition, not the least of the issues is that it appears that Ideas intentionally (for the expectations of greater rewards) de-emphasized, to its short-term detriment, contacts and new product development with many of its other customers. This action clearly has had a negative effect on the company’s operations over the past couple of years. The impact of the preceding on Ideas’s future is less obvious. However, in our interviews with Ms. Lane, she did express to us that she believes her company is tops in its field, with an excellent reputation and the ability to get into every publisher. It would appear, based on this company’s history prior to Friends’s “World” job as well as on Ms. Lane’s own explanation of her perceived reputation and contacts, that the company’s recent adverse financial results, a direct result of a poorly executed job with Friends, are not indicative of Ideas’s reasonable and expected prospects going forward. Further, it would appear that the emphasis and concentration placed on the Friends job was not detrimental to Ideas (other than in the short term) with regard to its contacts, relationships, and ability to generate business. As a consequence, in order to understand this company’s going forward prospects and profitability, we found it necessary to attempt to view Ideas with the Friends “World” job excised from its operations or, alternatively, to use the pre-“World” time frame, leapfrogging over 1990 and 1991, projecting the company’s likely operations going forward. We have attempted to do so and illustrate such in this report, shown in Exhibit C–30 and Exhibit C–31.

EXHIBIT C–30

Lane v. Lane Ideas, Inc. Operating Statements For the Years Ended December 31, 1991

1990

1989

$3,560,645 3,126,501

$2,072,911 1,556,332

$1,984,145 1,546,331

Gross Profit

434,144

0,516,579

0,437,814

General and Administrative Expenses Officers’ salaries Professional fees Outside services and payroll Rent and utilities

165,405 24,526 104,222 26,332

226,976 64,507 789 28,523

— 221,183 6,232 28,398

Gross Receipts Cost of Goods Sold


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C.14 IDEAS, INC.

EXHIBIT C–30

385

Lane v. Lane Ideas, Inc. Operating Statements (continued) For the Years Ended December 31,

Telephone Repairs and maintenance Advertising and marketing Insurance Medical reimbursement Travel and entertainment Payroll taxes Interest and service charges Vehicle expense Vehicle lease Office expense and postage Depreciation Total Operating Expenses Net Operating Income (Loss)

EXHIBIT C–31

1991

1990

1989

14,161 7,502 19,406 25,062 17,559 126,231 13,057 19,207 23,085 8,534 17,433 0,007,674

13,993 2,604 10,860 19,474 2,400 85,256 17,653 4,427 14,718 — 19,831 0,004,836

12,220 5,461 8,477 17,653 — 56,483 — 3,540 11,403 — 22,966 0,004,880

619,396

516,847

398,896

$ (185,252)

$5,16,(268)

$

(38,918

Lane v. Lane Ideas, Inc. Adjusted and Reconstructed Operations For the Years Ended December 31, 1991

Operating Income (Loss) Adjustments: Officers’ compensation — Amelia Lane — Note 1 Outside services — Amelia Lane — Note 1 Professional fees — Amelia Lane — Note 1 Professional fees — Note 2 Medical reimbursement — Note 3 Insurance expense — Note 4 Automobile expense — Note 5 Automobile leases — Note 5 Travel and entertainment — Note 6 Interest — Note 7 Total Adjustments Adjusted Operating Income — before compensation to Amelia Lane — based on actual operations Adjusted Operating Income had Ideas been able to realize the 11% margin on “World As We Knew It”— Note 8

$(185,252)

1990 $

(268)

1989 $ 38,918

105,194 48,786 8,900 10,115 17,359 5,662 5,947 4,267 12,623 13,000

84,000 29,700 — 3,511 2,400 6,268 2,616 — 12,788 —

— 87,119 — — — est. 5,000 est. 2,000 — 8,472 —

231,853

141,283

102,591

46,601

141,015

141,509

$191,601

$191,015

$141,509


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Notes to Adjustments to Operations

Before we can determine the true profitability of a company, we must add back to the net operations the extent of officer’s compensation taken by the officers/shareholders. In the years 1989 through 1991, to differing degrees, Ms. Lane’s compensation was posted as either officer’s compensation, outside services, or professional fees.

Note 1: Officers’ Compensation.

In 1991, the Company paid $8,865 for legal fees to Kerry Barber relevant to the divorce action and $1,250 in fees relevant to a neverimplemented retirement plan. These expenses are either nonbusiness or nonrecurring. In 1990, the Company paid $3,511 of legal and related fees involving a corporate reorganization. Although this latter expense appears to be legitimate, it is not an ongoing or normal operating expense and, therefore, needs to be removed in order to understand the Company’s operations.

Note 2: Professional Fees.

We have added back the medical reimbursements paid by the Company to or for Ms. and/or Mr. Lane. These are clearly not business expenses but rather payment of personal living expenses of the Lanes.

Note 3: Medical Reimbursement.

Note 4: Insurance Expense. For 1990 and 1991, we added back the personal/nonoperational insurance (such as life insurance) that constituted additional benefits to the Lanes. For 1989, we estimated that amount.

For 1990 and 1991, we added back 50 percent of Ms. Lane’s auto-related expenses, including leases. For 1989, we estimated that amount. Note 5: Automobile Expenses.

As a normal part of its operating expenses, the company incurs substantial travel- and entertainment-related expenses. In 1991, we estimated that the personal/nonbusiness portion of the expenses paid by the business represented approximately 10 percent of the total. For 1989 and 1990, since the company’s procedure for handling personal expenses was different in those two years, we estimated this personal aspect to constitute 15 percent of the expenses in those years. A separate issue, not added back herein but addressed later in this report, is that a portion of the company’s Travel and Entertainment expenses, while clearly legitimate as to its business nexus and while not subject to add back to reflect the company’s profitability, nevertheless does, to a degree, constitute economic compensation to Ms. Lane. Even if the expenses are viewed as appropriate and legitimate business expenses, Ms. Lane’s resultant ability to charge a significant portion of her food as business expenses, although not constituting additional corporate income, does constitute economic income to her inasmuch as she does not need to incur such in her normal living needs. Note 6: Travel and Entertainment.

Based on operations in 1989 and 1990, the company’s normal interest expense is $3,000 to $5,000. The financial statements in 1991 reflect $19,207 of interest expense — on what appears to be an average outstanding loan balance of about $50,000. Clearly, the interest expense is inconsistent with the debt carried by the company and abnormal as to the Company’s operations and Note 7: Interest.


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C.14 IDEAS, INC.

387

needs. Further, in the absence of the “World” job, this company would have likely not incurred interest expense in excess of the average $3,000 to $5,000. Therefore, for purposes of this report, we have allowed $6,207 (a 12 percent rate on the $50,000 debt, with the adjustment forced to a round number), resulting in an addback of $13,000. Note 8: Operating Income. Had the company been able to realize its anticipated 11 percent margin on the “World” job (which is the margin that it originally projected and upon which it based its job estimates and calculations; and is also a margin that is only one-half to one-third of that of its normal jobs), the compensation available to Ms. Lane would have approximated $190,000. Further, that “normalization” of Ideas’s operations illustrates the company’s fairly constant profit expectations — near the $200,000 level in 1990 and 1991.

EXHIBIT C–32

Lane v. Lane Ideas, Inc. Determination of Normalized Operations For the Years Ended December 31, 1991

1990

1989

Operating Expenses — Unadjusted Less: Adjustments

$619,396 (231,853)

$516,847 (141,283)

$398,896 (102,591)

Normalized Operating Expenses before compensation to Amelia Lane — but after travel and other overhead expenses attributable to “World”

$387,543

$375,564

$296,305

Exhibit C–32 indicates that, exclusive of compensating Amelia Lane, Ideas’s operating expenses (overhead) probably approximate $300,000 per year. In 1989, with nearly $2 million in sales (none of it from “World”), Ideas had $296,000 of overhead. Much (all?) of the increase in 1990 and 1991 is attributable to “World.” On a normalized basis, selling between $1,500,000 and $2,000,000 annually, overhead would likely approximate $300,000 to $350,000. Ideas’s normalized gross profit, for the two most recent years, based on sales exclusive of Friends “World” job, appears to be between 37 percent and 40 percent (see Exhibit C–33). It is possible that in 1990 and 1991, with most efforts directed toward “World,” only the more profitable jobs were accepted, thereby somewhat distorting margins. Therefore, it is our conclusion that Ideas, with gross sales in the $1.5 to $2.0 million range (as it was in 1989 without “World”), would likely maintain an average gross profit margin of approximately 38 percent on the first $1.0 million (as was actuality in 1990 and 1991), and would probably accept an average gross profit margin of approximately 20 percent on additional sales in order to build up its gross volume and spread its overhead over a broader base of sales. Conclusion.


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EXHIBIT C–33

Lane v. Lane Ideas, Inc. Determination of Normal Gross Profit For the Years Ended December 31, 1991

Unadjusted Gross Sales Cost of Goods Sold Gross Profit Gross Profit Margin Without Friends of Cartography “World As We Knew It” Gross Sales Cost of Goods Sold Gross Profit Gross Profit Margin

1990

$3,560,645 3,126,501

$2,072,911 1,556,332

$1,434,144

$1,516,579

12.2%

24.9%

$0,826,904 0,502,298

$0,934,411 0,581,769

324,606

352,642

39.3%

37.7%

Because of the inherent weaknesses in using 1990’s and 1991’s results (because of the abnormally large and abnormally unprofitable Friends of Cartography “World” job), as discussed in various parts of this report, it was necessary to attempt to determine what the normalized operations of this company are, and then from that point to determine and express numerically a projection of normalized operations. As illustrated in Exhibit C–34, on a going forward basis, a gross sales volume of $1,500,000 (75 percent of the 1988 pre-“World” time frame level) would yield a profit before compensation to Ms. Lane of $180,000. Alternatively, at a sales volume of $2 million, which was the level achieved in 1989 and which likely is the level that this company can expect on a normalized basis, that “bottom line” would approximate $230,000. EXHIBIT C–34

Lane v. Lane Ideas, Inc. Projection of Normalized Operations

Gross Sales Cost of Goods Sold* Gross Profit* Overhead Projected Profit — Before Compensation to Amelia Lane

A

B

$2,000,000 1,420,000

$1,500,000 1,020,000

580,000 0.350,000

480,000 0.300,000

$1,230,000

$1,180,000

*Cost of Goods Sold was determined to be at 62 percent (38 percent gross profit) for the first $1,000,000 and 80 percent (20 percent gross profit) thereafter.


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C.15 2 BAYS UP RV VU 䊳

389

C.15 2 BAYS UP RV VU. Most of us use them everyday, we almost take them for granted, and directly or indirectly they represent a huge part of our national production and employment. This report deals with the automobile — in particular a typical service station, with a few pumps and two operating bays. This common operation represents another opportunity for the investigative accountant to develop an approach particular for just one type of business. We were recently involved in investigating such a business. In part through our understanding of the standard of living, we suspected that there might be unreported income. Our review and analysis of the payroll highlighted that there were weeks when (if we were to accept the payroll records on their face) there were no gas jockeys working. The records further showed that none of them worked overtime or on the weekends — and that therefore the owner and his mechanic in theory would have had to cover all those time periods (physically an impossibility). In addition, the mechanic had been paid the same pay for at least five years, and that pay was below the norm for a mechanic in the area. In order to give us a comfort level as to the payroll, we made unannounced visits to the station on a Friday evening, a Saturday, and a Sunday. From these visits we were able to determine that there were gas jockeys (generally teenagers) working at the station who weren’t on the books and therefore were logically paid by cash. We also did a detailed analysis of the income and related direct costs for 1990 and 1991. With regard to the gasoline sales, it was our conclusion that those were substantially accurate and fully reported. However, as to the other sales, service, and accessories, we were faced with invoices that were not numerically sequential (they were unnumbered) and, therefore, we had no assurances that all sales were accounted for. The method of recording the sales (as detailed by the company’s accountant) was that he took the invoices that were given to him and taped them, thereby recording the income of the business. That was appropriate and valid as long as he was given all the invoices. In order to enable us to arrive at supportable conclusions about income and direct expenses, we performed a detailed analysis of several months of service and accessory invoices during the 1990 and 1991 time frames. We traced to the purchase invoices the costs of specific sale items. A number of the invoices indicated that the jobs were “specials,” which were stated at one all-inclusive price. Of the invoices we sampled, the accessories costs amounted to 53.0 percent of their retail selling price; labor represented 24.1 percent of the total selling price; and “specials” represented 40.8 percent of the total invoices. Specials were far more labor-intensive than other sales — approximately 75 percent labor, with the remaining 25 percent representing accessory sales. Our reconstruction of sales thus proceeded as follows. EXHIBIT C–35

Reconstruction of Sales

• Total accessory and labor sales • “Specials” @ 40.8% • Net non-special accessory and labor sales • Labor @ 24.1%

1990

1991

$168,317 068,673

$185,655 075,747

99,644 024,014

109,908 026,488


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EXHIBIT C–35

Reconstruction of Sales (continued) 1990

• Parts sales

1991

75,630

83,420

• Parts costs @ 53.0%

$ 40,084

$ 44,213

• Calculated total amount of “specials” • Labor factor @ 75%

$ 68,673 51,505

$ 75,747 56,810

• Accessory and parts portion of “specials” sales • Accessory and parts sales (above)

17,168 075,630

18,937 083,420

• Total accessory and parts sales

092,798

102,357

• Costs should be 53% • Costs as per books and records

49,183 070,630

54,249 075,571

$ 21,447

$ 21,322

• Difference

Exhibit C–35 indicates that there was $21,447 of costs of goods sold in excess of what could be accounted for based on our reconstruction of the operations of the company in 1990 and that there was $21,322 in 1991. Since we determined that these costs represented 53 percent of the sales that they generated, the presence of these “excess” costs translated into additional sales (unreported) of $40,466 in 1990 and $40,230 in 1991. As our investigation brought out, there was a certainty that there was unreported payroll in the form of pumpers working in the evenings and on weekends. It was also a near certainty that the mechanic received part of his pay in cash. We estimated that the gas jockeys/pumpers represented approximately $5,800 of unrecorded payroll and that the mechanic received $100 a week for 52 weeks a year above his reported pay, amounting to $5,200 for the year. The total unreported payroll, therefore, amounted to approximately $11,000 per year. Based on our reconstruction of operations, we estimated that unreported income amounted to approximately $40,000 per year. Because approximately $11,000 per year of that unreported income went to cover unrecorded expenses, it was our conclusion that the net unreported income to the benefit of the owner was approximately $29,000 per year. 䊳

C.16 THE REALLY GREEN GREENHOUSE. Cash businesses are always among the more difficult, and more interesting, assignments for an investigative accountant. One such case that presented difficulties in the reconstruction of sales involved a greenhouse operation that had both retail and wholesale aspects to it. What compounded the problem was that the greenhouse had poor records and had changed accountants in the past couple of years, and the key people to whom we would normally direct our questions had a gross lack of useful documented data. There were the normal concerns and suspicions we had when dealing with a cash business and believing that we might have a problem. The situation crystallized when we discovered that some of the greenhouse’s major suppliers, for which we came across many bills, could be found nowhere in the company’s disbursements


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391

journals. These suppliers were being paid in cash, and the payments were not being recorded in the company’s records. It is a basic truism that when a business uses cash income to pay for purchases in cash and does not record those purchases, there is unreported cash income being realized by the business. The question, of course, is how much. To further compound the problems with this type of a business, we did not have any truly usable gross profit percentage from which to back into a sales figure — and, even if we did, we also had the major problem that a significant portion of the purchases went unrecorded. As a consequence, using the recorded purchases and a reconstructed gross profit number to back into a reconstructed sales number would also be wrong. In this situation, it would significantly understate the sales and, as a consequence, understate the unrecorded income. What we did was to take a two-pronged approach toward the determination and reconstruction of the sales of the business. This took the form of a broad sales reconstruction approach and a narrower seasonal approach. In the broad approach, we used what records we were able to derive, plus assistance from the wife, plus assistance from other knowledgeable parties, and purchase data from which to calculate the volume of sales. Then, item by item, product by product, we made a rough determination of what the sales were for each type of product sold during the year—by volume and then by price. We multiplied the results to determine what the categorical sales were for the year. We then compared the results of our reconstructed sales approach to the reported sales for the year and arrived at a tentative determination of the magnitude of unreported income. In the narrower seasonal approach, we selected a short time frame (from the middle of November through the end of December). Based on the company’s own reports of fees paid for propagation of poinsettia plants and the purchase of evergreens, we calculated what the sales during that six-week period would have been based on those purchases. To ensure reasonableness, and as a conservatism factor, we used only the wholesale prices for the poinsettias (retail would have been higher), and we used only those two items — assuming no, or at least disregarding any other, sales. Our conclusions based on this seasonal approach again supported that there was significant unreported income. Our next step was to discount the seasonal approach under the assumption that, with seasonal peak sales, there was a greater opportunity not to record income. Therefore, it may not have been totally indicative, on a proportionate basis, of the entire year. Of course, this discounting was done after the unreported income for that seasonal period was annualized to equate to a full year. Further, there was another major selling period during the year (Spring) and, therefore, we felt reasonably confident that discounting annualized unreported income of one peak period was fair. We then averaged the two conclusions (the broad approach determination of unreported income and the discounted seasonal approach) to arrive at our conclusions as to the magnitude of unreported income. Besides various other adjustments typical in these situations, we also gave the company credit for a significant amount of unreported cash expenditures. This was important so as to fairly reflect not just the cash income that did not get reported but also the cash expenses that, even though they were not recorded, were legitimate business expenses. Overall, as illustrated in Exhibits C–36 to C–38, the level of unreported income was quite significant.


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EXHIBIT C–36

The Really Green Greenhouse Reconstruction of Revenue — Broad Approach Years Ended December 31, 1989

1988

1987

1986

1985

Product Poinsettias Propagation — number of plants

66,000

66,200

66,150

72,200

72,950

Average wholesale price

4.42

0,0004.17

0,0003.93

0,0003.71

0,0003.50

$0,291,720

$0,276,054

$0,259,970

$0,267,862

$0,255,325

Pumpkins (estimated)

4,000

4,000

—

—

—

Christmas wreaths, etc. (estimated)

4,000

3,800

3,600

3,400

3,200

37,200

35,1002

33,1002

31,2002

Poinsettia sales volume

Christmas trees Beddings — flats and hanging plants, impatiens, begonias, tomatoes, etc.1

39,4002

530,000

472,000

445,000

420,000

2,6002

2,3002

2,0002

Lilies, tulips, etc.

15,0002

14,113

14,0002

13,5002

13,0002

Geraniums

53,000

50,000

47,000

44,000

41,000

6,000

5,000

4,500

4,000

3,500

53,000

50,000

47,000

44,000

41,000

150,000

150,000

142,000

133,000

125,500

Pots — ceramic and clay

11,000

10,000

9,000

8,000

7,000

Plant sprays and powders

11,000

10,000

9,000

8,000

7,000

stones, etc.

53,000

50,000

47,000

44,000

41,000

Revenues as reconstructed

$1,224,620

$1,163,167

$1,092,770

$1,050,162

$1,990,725

Mums Shrubbery and roses Perennials3

3,5002

500,000 3,000

Azaleas

Retail sundries

Gravel, sand, peat moss fertilizer, wood chips,

1 Based

on inventory at December 31, 1987, of 125,000 flats at wholesale price of $4 per flat.

2 No

information is available for this year. Therefore, amount shown is based on the year(s) for which we have data.

3 Based

on inventory of 75,000 pots at December 31, 1987.


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393

C.16 THE REALLY GREEN GREENHOUSE

EXHIBIT C–37

The Really Green Greenhouse Reconstruction of Revenue — Seasonal Approach Years Ended December 31,

Poinsettia revenues Christmas wreaths and tree revenues Total Revenues reported November 16 through December 31 Unreported revenues — for six and a half weeks

EXHIBIT C–38

1989

1988

1987

1986

1985

$291,720

$276,054

$259,970

$267,862

$255,325

043,400

041,000

038,700

036,500

034,400

335,120

317,054

298,670

304,362

289,725

178,406

237,788

178,650

170,641

172,687

$156,714

$ 79,266

$120,020

$133,721

$117,038

The Really Green Greenhouse Conclusion as to Unreported Revenues Years Ended December 31, 1989

Reconstruction of revenue — Broad Approach $1,224,620 Reported revenue 0.918,771

1988

1987

1986

1985

$1,163,167 0.709,023

$1,092,770 0.591,363

$1,050,162 0.468,572

$0,990,725 0.445,164

Unreported revenues (A)

0.305,849

0.454,144

0.501,407

0.581,590

0.545,561

Unreported revenue — Seasonal Approach

156,714

79,266

120,020

133,721

117,038

Extrapolated to full year

⳯8

⳯8

⳯8

⳯8

⳯8

Annualized unreported revenues

1,253,712

634,128

960,160

1,069,768

936,304

Discounted to reflect peak period Unreported revenues (B) Average of approaches A & B above — Unreported revenues

50%

50%

50%

50%

50%

0.626,856

0.317,064

0.480,080

0.534,884

0.468,152

$1,466,352

$1,385,604

$1,490,743

$1,558,237

$1,506,856


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C.17 COLD CASH. One of our more unusual cash-type cases involved a wholesaler of ice. The Chill Out Company’s business was to buy ice from an ice “manufacturer” and then to wholesale it to stores (such as supermarkets) and local businesses (such as bars). The sales that were to the major supermarket-type stores for the most part did not present a problem in that the stores paid by check. However, where it was the local bar or another type of local small store operation, payment would often be in the form of cash. It was rather obvious when we did our preliminary review of the tax returns of the business that there was unreported income — various numbers just did not make sense. We were also advised by our client to expect that there was a significant amount of unreported income. To satisfy ourselves as to the real income, we reviewed all the purchase invoices from Chill Out’s suppliers for a one-year period. The company had two major sources from which it purchased packaged ice. Chill Out then stored the ice in the equivalent of a refrigerated warehouse for the period of time that it kept that ice before it was delivered to its customers. Management boasted to us that the system was a very modern one and wastage was virtually nonexistent. Therefore, whatever was purchased was quickly turned around and sold within a very short period of time. Further, also based on input directly from management, inventory was fairly constant and a relatively minor issue. Based on the invoices from the two suppliers, we were able to determine the total number of eight-pound bags purchased during the year. Eight-pound bags were important in that they represented, both in volume of bags and dollar volume, by far the largest product sold by Chill Out. Based on the company’s sales records, we were then also able to determine the number of eight-pound bags of ice reported as sold. What we found, as illustrated below, was that there was a significantly greater number of bags purchased than allegedly sold. We attributed that difference to unrecorded cash sales. To determine that magnitude, we used the higher pricing realized by Chill Out, inasmuch as the lower discounted price was given to the larger customer with a large volume. The higher price level was charged for the smaller volume purchasers, the ones typically to pay the company in cash. Because of limitations in the company’s record keeping, our testing procedures were only done with the eight-pound bags. Since there were other products sold— such as 50-pound bags, blocks of ice, and, to a lesser degree, in the off-season, firewood — we were confident that the magnitude of unreported income based on the eight-pound bags was a conservative determination. Our analysis showed that during the tested fiscal year, the Chill Out Company recorded sales of 145,764 eight-pound bags of cube ice. A review of the company’s suppliers invoices, summarized below, showed that 217,278 eight-pound bags of cube ice were purchased during this same period. Chill Out’s inventory declined from $15,874 to $12,968 during the year as per the company’s federal corporate tax returns. The company’s accountant repeated management’s advice that the shrinkage of inventory was insignificant, due to refrigerated trucks and the icehouse designed and constructed by the company. Because the excess purchase of eight-pound cube ice could not be explained by an increase in the inventory level or shrinkage of the product, we concluded that the 71,514-bag shortfall in sales represented cash sales that were unrecorded by the company. (See Exhibit C–39.) These bags sold for 70¢. Thus, there was at least $50,000 of unrecorded cash sales for one 12-month period.


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C.18 TREES R US

EXHIBIT C–39

395

Summary of 8-Pound Ice Purchases

Nice Ice Co.

Fried Ice Co.

Total 8-lb. Bags Purchased

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

5,085 4,607 4,881 5,046 6,339 14,204 26,530 18,181 11,720 4,361 2,320 004,862

7,145 1,273 3,946 5,735 4,390 13,045 30,068 23,200 7,200 5,800 4,330 003,010

12,230 5,880 8,827 10,781 10,729 27,249 56,598 41,381 18,920 10,161 6,650 007,872

TOTALS

108,136

109,142

217,278

Purchases

Sales

Units Purchased Less Units Sold

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

12,230 5,880 8,827 10,781 10,729 27,249 56,598 41,381 18,920 10,161 6,650 007,872

6,735 3,065 6,560 6,015 6,319 13,157 42,185 28,250 15,495 8,910 3,050 006,023

5,495 2,815 2,267 4,766 4,410 14,092 14,413 13,131 3,425 1,251 3,600 001,849

TOTALS

217,278

145,764

071,514

8-Pound Bags — Purchases v. Sales

䊳

C.18 TREES R US. We recently were faced with the investigation of a truly homegrown business with a near total absence of any kind of bookkeeping or accounting system. This was a landscaping business that serviced a limited, relatively affluent area, run by the owner/operator with just a few employees. There was effectively no normal bookkeeping write-up of the company’s income or expenditures. The most reliable information available came in the form of various purchase invoices (from nurseries and the like) and the owner’s notes (suspect as they may have been) as to who his customers were, what he was charging them, and who owed him money. In addition, his payroll was entirely in cash and entirely unreported.


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To get a better understanding of the business, we interviewed Mr. Harry Lawnder, the owner, and had him explain to us how he priced a job, how he charged for the labor involved, how he marked up the trees he purchased, and how he charged for himself. We also interviewed Mrs. Elana Lawnder, to get her perspective as to who was on the payroll and (keeping in mind the seasonal nature of this type of work) what she knew about the number of weeks and number of hours per week the individuals worked. As to the physical operation, there was basically no place of business other than a rented garage-type facility near the marital home. We had Mr. Lawnder supply us with a handwritten list of his customers and what he charged them. That handwritten list came fairly close in total dollars to the funds deposited in his bank account. However, when we compared the details of that list to the limited number of sales invoices that were available, we noted that in several cases the sales invoices were for considerably more money than he wrote on his list and that we had invoices for customers who were not on the list. With regard to the issue of labor, Mr. Lawnder had advised us that he paid his people (keeping in mind that none of this was reported) $10 per hour and that he only charged his customers $10 per hour — so that therefore he made no profit on his labor. Aside from the illogicalness of this, we were also able to locate one sales invoice wherein the labor element was separately stated (none of the other invoices detailed labor) — and on that invoice the labor was stated at $20 per hour. For conservatism and to allow for downtime, we assumed an average, realizable rate of $15 per hour. During our interview of Mr. Lawnder, we asked him to assist us in determining how much profit he expected to net from a custom landscaping assignment. He demonstrated how he would estimate a typical job. His example was a newly constructed home, which needed 25 large trees, 40 medium-sized bushes, 100 small-sized bushes, 8,000 square feet of sod, and other peripheral items, such as mulch, piping, gravel, and the like. (See Exhibit C– 40.)

EXHIBIT C– 40

Trees R Us Reconstruction of Income Gross Profit Method Total Units

Charge Per Item

Total Charge

Cost*

Gross Profit %

Large trees

25

$300.00

$ 7,500

$192.35

35.9%

Medium-sized bushes

40

80.00

3,200

60.80

24.0%

100

30.00

3,000

19.42

35.3%

75

33.33

2,500

8,000

.20

1,600

Item

Small-sized bushes 75 yards of top soil Sod (square feet) Mulch Pipes Gravel Total materials

1,500 300 00,500 $20,100


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C.18 TREES R US

EXHIBIT C– 40

397

Trees R Us Reconstruction of Income Gross Profit Method (continued) Total Units

Item

Charge Per Item

Total Charge

Gross Profit %

Cost*

Machine usage (tractor) 12 days @ $200 per day

2,400

Labor — 480 man hours @ $10 an hour

4,800

Additional profit markup (per Mr. Lawnder) 10%

02,700

Total job

$30,000 30,000

*Costs were determined by our investigation and analysis of numerous purchase invoices.

EXHIBIT C– 41

Reconstruction of Income

Total purchases of direct materials (per invoices) Profit margin*

1989

1990

$202,884

$193,265

30%

30%

289,834

276,093

Calculated gross sales based on direct product purchases Labor charge: 4 workers in 1989, 31/2 in 1990 (inclusive of Mr. Lawnder) for 40 72,000

63,000

Machine charges: 75 days in 1989, 70 in 1990 at $200 a day

hours a week for 30 weeks @ $15 an hour

15,000

14,000

Additional markup of 10% as per Mr. Lawnder

037,700

035,300

Reconstructed gross sales

414,534

388,393

Reported gross receipts

322,349

293,890

Unreported gross revenues Unreported wages† Net unreported income

92,185

94,503

036,000

030,000

$ 56,185

$ 64,503

* Mr. Lawnder supplied us with copies of selected sales invoices from 1989. Our analysis of same, in conjunction with available purchase invoices, illustrated that the customary gross profit for virtually all plants (for example, rhododendrons, azaleas, and junipers) was 40 percent. In conjunction with our analysis of the components of a landscaping job (detailed above), we concluded that a reasonable and conservative gross profit was 30 percent. † Mr. Lawnder paid his employees in cash. He advised us that he had three fulltime helpers during the 30 weeks of his season in 1989, and the equivalent of 21/2 in 1990, and that he paid them $10 an hour.


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EXHIBIT C– 41

Reconstruction of Income (continued)

Employees Hours worked per week Number of weeks in work year Rate per hour Total Wages

䊳

1989

1990

3 40 30 00,010

21/2 40 30 00,010

$36,000

$30,000

C.19 A LAWYER, A LAWYER, MY KINGDOM FOR A LAWYER. One of our more interesting and yet civilized investigations involved digging into the financial affairs of a prominent and long-established law firm in a nearby community. Unreported income was not an issue, but significant perquisites existed and other adjustments were required. Among the issues to deal with were the reconstruction of accounts receivable and work in progress, and the determination of reasonable compensation (for purposes of valuation, which will not be part of the illustration herein), as well as fair market rents on premises owned by a related real estate partnership. (See Exhibits C– 42 to C– 43.)

EXHIBIT C– 42

Kelsey v. Kelsey Sue, Badger & Frye Comparative Income Statements (Income Tax Basis) Years Ended December 31, 1993

1992

1991

1990

Revenue Fee income

$2,619,978

$2,108,822

$1,864,799

$1,348,992

Client cost recovery

0,071,948

0,045,918

0,020,547

0,013,121

Total Revenue

2,691,926

2,154,740

1,885,346

1,362,113

Administrative Expenses: Associates salaries

247,049

179,266

317,810

175,309

Other wages

380,768

333,803

323,285

246,323

Profit sharing

221,726

192,700

165,185

104,450

Payroll taxes

53,864

52,662

42,754

41,013

Supplies and services

60,746

49,677

43,768

46,207

Telephone

47,929

42,506

34,592

30,911

7,525

9,312

10,129

8,116

24,911

10,470

12,890

32,574

Automobile Travel and entertainment Advertising and listings

14,855

9,894

8,017

4,493

Library

11,837

12,165

13,895

12,897

219,583

75,000

74,400

29,900

18,120

14,709

13,925

11,131

129,626

106,639

114,693

76,371

11,656

12,263

6,871

12,010

Rent Dues and subscriptions Insurance and claims Other taxes


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C.19 A LAWYER, A LAWYER, MY KINGDOM FOR A LAWYER

EXHIBIT C– 42

399

Kelsey v. Kelsey Sue, Badger & Frye Comparative Income Statements (Income Tax Basis) (continued) Years Ended December 31, 1993

1992

1991

1990

Professional fees

28,057

23,576

16,681

19,130

Repairs and maintenance

15,221

5,141

4,279

6,629

Donations

8,275

13,488

9,794

12,526

Utilities

11,020

8,198

7,553

8,714

Employee benefits

26,300

17,979

15,946

3,523

Postage

23,210

22,691

24,660

20,060

Outside services and commissions

13,246

11,964

13,735

28,101

9,451

1,909

6,662

96

Seminars and conferences

30,060

23,127

15,009

7,271

Interest

26,629

22,677

9,635

11,824

0,066,522

0,056,557

0,054,310

0,048,036

1,708,186

1,308,373

1,360,478

0,997,615

$1,983,740

$1,846,367

$1,524,868

$1,367,498

Miscellaneous

Depreciation Total Expenses Operating Income Before Partner Compensation

EXHIBIT C– 43

Kelsey v. Kelsey Sue, Badger & Frye Adjustments to Comparative Statements of Income ADJ #

Operating Income

1993

1992

1991

1990

$0,983,740

$0,846,367

$0,524,868

$0,364,498

160,140

138,730

88,636

61,816

Adjustments: Partners’ Keogh contributions

1

Partners’ life and disability insurance

1

22,700

30,100

20,114

20,175

Rent

2

85,583

(29,000)

(29,600)

(74,100)

Real estate taxes

3

11,656

12,263

6,871

12,010

Utilities

3

11,020

8,198

7,553

8,714

Depreciation

4

13,151

19,131

19,975

17,736

Moving expenses

5

12,029

—

—

—

Other wages

6

0,25,672

0,024,146

0,022,075

0,016,760

$1,325,691

$1,049,935

$1,660,492

$1,427,609

Adjusted Operating Income Before Partner Compensation


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Explanation of Adjustments Adjustment No. 1 1993

1992

1991

1990

$1122,700

$1130,100

$1120,114

$1120,175

$1160,140

$1138,730

$1188,636

$1161,816

Premiums paid to Metropolitan Bankers Insecurity, Provident Dismember and Accident, and Fidelity Mutual Benefit Partners’ share of Keogh Contributions

Adjustment No. 2. Since the firm’s office facility is owned by the partners of the firm, it is necessary to ensure that rents are based upon fair market rates in the locations of the firm’s offices. The firm was located, until March of 1993, on Mediation Street, and moved to Gallows Avenue in April of 1993. A conversation with a local commercial real estate agent indicated that a fair rent for the Mediation Street office from 1990 to 1993 would be $16 a square foot (gross rental rate) and that a fair rental for the Gallows Avenue office in 1993 would be $18 a square foot (gross rental rate). The adjustment for fair rental is as shown in Exhibit C– 44.

EXHIBIT C– 44

Adjustment for Fair Rental 1993

Rent expense as reported

1992

$ 219,583 1,625*

Square feet — Mediation Street Fair rental rate (gross) Mediation Street rental Square feet — Gallows Avenue

$

74,400

$

29,900

6,500

6,500

6,500

0000,016

0000,016

0000,016

0026,000

0104,000

0104,000

0104,000

N/A

N/A

N/A

—

—

—

18

Gallows Avenue rental

75,000

1990

16

6,000†

Fair rental rate (gross)

$

1991

0108,000

00 00N/A

00 00N/A

00 00N/A

Total Fair Rental

$ 134,000

$ 104,000

$ 104,000

$ 104,000

Rental Adjustment

$

$ (29,000)

$ (29,600)

$ (74,100)

85,583

*⳱ 1/4 of 1993 times 6,500 square feet †⳱ 3/4 of 1993 times 8,000 square feet

Adjustment No. 3. Since the gross rental rate in Adjustment #2 includes real estate taxes and utilities, those items have to be added back to income. The adjustment for real estate taxes and utilities is as shown in Exhibit C– 45.


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EXHIBIT C– 45

401

Adjustment for Real Estate Taxes and Utilities 1993

1992

1991

1990

Utilities

$1111,020

$1118,198

$1117,553

$1118,714

Real estate taxes

$1111,656

$1112,263

$1116,871

$1112,010

Adjustment No. 4. The firm utilized depreciation methods that are prescribed and accepted for income tax reporting but that are generally shorter of useful life and more accelerated than economic reality. We used the Internal Revenue Service’s Asset Life Guidelines and determined that furniture and fixtures had an estimated useful life of eight years and office equipment an estimated useful life of six years. We also used a half year’s depreciation in year one. For automobiles, we used a useful life of four years and the straight-line method. The adjustment for depreciation is as shown in Exhibit C–46.

EXHIBIT C– 46

Adjustment for Depreciation

Depreciation as reported:

1993

1992

1991

1990

$2266,522

$1156,557

$1154,310

$1148,036

As calculated: Furniture: 1990 Cost 1991 Cost 1992 Cost 1993 Cost Equipment: 1990 Cost 1991 Cost 1992 Cost 1993 Cost Automobiles: 1990 Cost 1991 Cost 1992 Cost 1993 Cost

$

76,179 72,193 112,134 198,721 63,794 72,193 74,167 106,036

8,824 10,666 12,913 19,429 9,644 12,031 12,129 15,579

54,502 54,502 72,514 98,648

18,363

Total Depreciation as Calculated

0053,371

0037,426

0034,335

0030,300

$1113,151

$1119,131

$1119,975

$1117,736

Adjustment for Depreciation

11,832 11,638 12,384

The firm moved its facilities in April 1993 and thus incurred moving expenses that are nonrecurring. The items shown in Exhibit C– 47 were found to be related to moving expenses in 1993: Adjustment No. 5.


402

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SAMPLE REPORTS

EXHIBIT C– 47

Items Related to Moving Expenses

Christine Group Fatima Moving

$ 2,956 0009,073

Total Moving Expense Adjustment

$0012,029 0012.029

Adjustment No. 6. The other wages expenses included payroll for several of the partners’ children. Based on our interviews of the partners and our review of payroll records and job functions, it was clear that these were income-shifting maneuvers with no economic justification. Such payroll was as shown in Exhibit C– 48.

EXHIBIT C– 48

Payroll Expenses

Boydam Sue Melissa Badger Deepa Frye Karl Kelsey Total

EXHIBIT C– 49

1993

1992

1991

1990

$0004,732 8,241 3,822 0008,777

$0005,498 7,582 7,050 0004,016

$0007,652 6,905 7,518 0000,0—

$0008,327 — 8,433 0000,0—

$1125,672

$1124,146

$1122,075

$1116,760

Kelsey v. Kelsey Sue, Badger & Frye Determination of Adjusted Book Value As of December 31, 1993

Unadjusted Book Value Per Tax Return (Partners’ Deficit) Add:

Accounts Receivable Unbilled Work in Progress

Subtract: Accounts Payable Accrued Wages Income Taxes Adjusted Book Value December 31, 1993

$ (184,050)

(Note A) (Note B)

507,000 420,000

(Note C) (Note D) (Note E)

(16,000) (14,000) (269,000) $0443,950 0443.950

As stated previously, we were unable to verify the amount of Accounts Receivable. In addition, we were supplied with two amounts for receivables at December 31, 1993 — $553,494 and $459,807. Our discussions with the bookkeeper led us to conclude that the lower amount does not include recoverable advanced costs. Therefore, $533,494 was used. Subtracting an estimated 5% bad debts reserve of $26,674 leaves approximately $507,000 in accounts receivable at December 31, 1993 (see Exhibit C– 49).

Note A.

Note B. Since the actual extent of unbilled work in progress (WIP) at December 31, 1993 is unknown, we had to interpolate a balance based on each billable


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403

employee/partner’s billing frequency and billing rates for 1993. Exhibit C–50 illustrates our calculation:

EXHIBIT C–50

Work-in-Progress Calculation 1993

Attorney S.O. Sue

I. Badger

E. Frye

G. Kelsey

O. Camembert

L. Cheddar

J. Boursin

L. Whey

S. Curd

Billing Frequency 1/ 2 1/ 2

Monthly Hours Quarterly Rate

Quarterly

3/ 4 1/ 4

Monthly

Monthly

Hours Rate

Hours Rate

Hours Rate


Quarterly

1/ 2 1/ 2

Hours Rate

Quarterly Hours Monthly Rate

Monthly

1/ 2 1/ 2

October November December

Hours Rate


Remainder Quarterly (Paraprofessionals)

Hours Rate

Total Interpolated WIP

00,0285 95

00,0219 $,111195

00,0257 $,111195

$0036,148

1/ 2

Q

$127,075

$120,805

$124,415

12,208

1/ 2

M

00,0109 $111,125

00,0132 $,111125

00,0137 $,111125

$113,625

$116,500

$117,125

$0047,250

00,0300 $,111190

00,0158 $,111190

00,0208 $,111190

$0044,955

3/ 4

Q

4,680

1/ 4

M

$

$127,000

$114,220

$118,720

00,0163 $,111140

00,0196 $,111140

00,0162 $,111140

$ 22,820

$127,440

$122,680

00,0210 $,111100

00,0152 $,111100

00,0156 $,111100

$121,000

$115,200

$115,600

00,0248 $,111115

00,0246 $,111115

00,0235 $,111115

$128,520

$128,290

$127,025

$0027,025

00,0185 $,111100

00,0156 $,111100

00,0131 $,111100

$0023,600

1/ 2

Q

6,550

1/ 2

M

$0022,680

$0015,600

$118,500

$115,600

$113,100

00,0386 $,111177

00,0389 $,111177

00,00359 $,111177

$129,722

$129,953

$127,643

$0087,318

00,0101 00,0068 $,111177 $1111177

00,0071 $,111177

$0009,240

1/ 2

Q

2,734

1/ 2

M

$117,777

$115,236

$115,467

00,0466 $,111155

00,0425 00,0406 $,111155 $.1111155

$125,630

$123,375

$122,330

$1271,335


404

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SAMPLE REPORTS

EXHIBIT C–50

Work-in-Progress Calculation (continued) 1993

Attorney

Billing Frequency

October November December

Jill Jackann — Estimated WIP(*) Total Calculated WIP (Rounded) Costs Advanced October–December Less 5% Reserve Net Calculated WIP

Total Interpolated WIP 16,000 $ 427,000 15,000 442,000 (22,000) $2420,000

* Jill Jackann, because of the nature of her real estate practice, does not submit time reports. Billings and collections are made at closings. However, her fees are obviously earned over a period of time prior to closing. We used the $16,000 average monthly collection for Ms. Jackann for the period October 1993 to December 1993 as a fair and reasonable WIP determination.

Accounts payable were specifically identified by a review of invoices and amounted to approximately $16,000. Note C.

Accrued employee wages were calculated to be approximately $14,000 at December 31, 1993.

Note D.

An income tax factor of 30 percent was applied to the net of the sum of the receivables and WIP less payables and accruals. Note E.

䊳

C.20 MANUFAC TURERS ASSOCIATES

Manufacturers Associates (the Company) is a manufacturer of labels, with a concentration of customers in the food-processing and consumer products areas. The company has been in existence for in excess of 30 years (with present ownership and management having taken over the operation during the last 15 years). The company operates out of leased premises with a secure long-term lease that is at approximate fair market rental rates. Its customer base is concentrated between North Carolina and Connecticut along the Eastern seaboard, going inland to encompass areas including Tennessee, Pennsylvania, and New York State. Three of its customers each represent between 8 and 12 percent of the company’s sales. Ownership and management are synonymous, with all shareholders actively involved in the company’s day-to-day operations. Operations are controlled by the following personnel:

Introduction and Observations.

Shana Escanaba: Ms. Escanaba owns 58 percent of the company and is nominally Chief Executive Officer and President. The reality of her involvement with the company is that, in part due to conflicting business interests, she is at the company on an average of less than two days per week. Esther Rivka: Ms. Rivka owns 21 percent of the company and works full-time, in charge of the shop operations and the factory floor. David Phillips: Mr. Phillips owns the remaining 21 percent of the company and is responsible for the company’s art and development department.


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C.20 MANUFACTURERS ASSOCIATES

405

Management indicated to us during interviews that it considers prospects for the future to be reasonably strong with no serious negatives in view (see Exhibit C–51). Concerns about potential environmental issues regarding inks being used are considered to be minor, with expectations that the industry will continue to develop more environmentally benign inks so that there are no true issues as to future continuity of business and profitability. Concerns were expressed as to the company’s ability to continue to grow and expand, and particularly to take on new lines within the confines of the present location and with the present equipment. Management felt that although acquiring new equipment by itself would not present any obstacles, they were not so confident as to their ability to expand much further, believing that a move, or at least a second location, would be needed.

EXHIBIT C–51

Escanaba v. Escanaba Manufacturers Associates Comparative Statements of Income For the Years Ended December 31,

SALES COST OF SALES Beginning inventory Material Labor Subcontractors Fringe benefits Factory expenses Repairs and maintenance Utilities Fixed expenses Interest/depreciation included in above Less ending inventory

1993

1992

1991

$5,001,841

$5,001,630

$4,170,455

254,417 1,914,840 958,071 73,380 147,368 347,732

246,436 1,949,268 825,930 44,376 154,383 328,602

239,869 1,514,647 680,248 53,687 106,057 325,631

69,536 83,324 327,248

80,474 80,997 322,473

35,269 81,782 287,281

(289,901) (465,636)

(283,684) (254,417)

(276,782) (246,436)

TOTAL COST OF SALES

3,420,379

3,494,838

2,801,253

GROSS PROFIT

1,581,462

1,506,792

1,369,202

$0,188,498 139,439 41,054 44,884

$0,142,404 109,334 40,654 36,754

$0,162,895 96,456 32,314 195,127

96,127 156,750

96,370 151,689

-0118,339

SELLING AND ADMINISTRATIVE COSTS: Selling salaries Customer service Fringe benefits Travel Meals and entertainment Commissions


406

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SAMPLE REPORTS

EXHIBIT C–51

Escanaba v. Escanaba Manufacturers Associates Comparative Statements of Income (continued) For the Years Ended December 31, 1993

1992

1991

16,249 313,377 82,558 66,191

21,323 279,792 65,333 72,082

14,039 211,700 60,444 54,186

Other selling expenses Management salaries Clerical salaries Office supplies Travel, meals, and entertainment Other administrative expenses Depreciation Interest

7,961

10,069

9,802

22,080 201,044 88,857

21,405 214,056 69,628

26,127 186,200 90,583

TOTAL SELLING AND ADMINISTRATIVE COSTS

1,465,069

1,330,893

1,258,212

$1,116,393

$1,175,899

$1,110,990

OPERATING PROFIT

EXHIBIT C–52

Escanaba v. Escanaba Manufacturers Associates Adjustments to Comparative Statements of Income Adjustment No.

OPERATING PROFIT

1993

1992

1991

$116,393

$175,899

$110,990

ADJUSTMENTS ADDITIONS: Officer’s salary— Shana Escanaba

1

150,600

140,000

81,400

Depreciation adjustment

2

68,596

92,056

79,750

Insurance on personal vehicles

3

12,000

11,004

10,000

Personal auto leases

4

30,333

33,733

21,074

Officers’ life insurance

5

12,922

11,365

—

Nonemployee compensation

6

14,273

12,770

13,200

Personal use of telephone

7

2,400

2,400

2,400

Family payroll

8

25,273

23,182

19,883

Personal bills

9

15,870

11,713

2,885


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EXHIBIT C–52

407

Escanaba v. Escanaba Manufacturers Associates Adjustments to Comparative Statements of Income (continued) Adjustment #

1993

1992

1991

REDUCTIONS: Reasonable officer’s compensation Annual accounting fees

1

(42,000)

(39,000)

(35,000)

1

(15,000)

(14,000)

(13,000)

ADJUSTED OPERATING INCOME BEFORE INCOME TAXES

$391,660

$461,122

$293,582

Explanation of Adjustments to Comparative Statements of Income

For the purposes of presenting the company’s true economic operations, officer’s salary must be adjusted to reflect a fair level of compensation (see Exhibit C–52). In this situation, the proper reflection of officer’s compensation is of particular significance. Therefore, we have first added back the actual officer’s salary and then subtracted a reasonable officer’s salary. The Executive Salary Survey was used to determine an average salary that would be paid to Shana Escanaba, the chief executive officer. Based on our discussions with Ms. Escanaba and our review of various corporate and personal records, it has been determined that she spends approximately one-third of a week on the company’s operations. Hence, we have “allowed” as an officer compensation only one-third of what otherwise would have been determined. Our position is further buttressed by the fact that Ms. Escanaba is also a partner in an accounting firm and owns and is active in the management of two other businesses. Because accounting fees were not charged to the company for the period 1991 to 1993, it was also necessary for us to impute same. As further support for Ms. Escanaba’s limited work time spent on behalf of Manufacturers Associates, we noted the following vacations taken by her in 1993 as shown in Exhibit C–53.

Adjustment No. 1.

EXHIBIT C–53

Vacations Taken by Ms. Escanaba

Location Vail, Colorado No A Vail, Colorado Bridal Vail, Colorado Isla Verde, Puerto Rico Vail, Colorado Nantucket Island, Massachusetts

Dates of Vacation January 14 – 22 February 4 –15 March 10 – 22 March 22 – April 1 April 12 – 16 July 12 – August 4

TOTAL KNOWN VACATION DAYS IN 1993

Days 9 12 13 10 5 24 73 73


408

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SAMPLE REPORTS

The adjustments are as shown in Exhibit C–54. EXHIBIT C–54

Adjustments

Shana Escanaba’s salary as per financial statements Reasonable salary: One-third average compensation for a chief executive officer in the Company’s gross sales range Reasonable accounting fees

1993

1992

1991

$150,600

$140,000

$81,400

42,000 15,000

39,000 14,000

35,000 13,000

The depreciation method used in preparing financial statements is the same as that used on the company’s returns. This method uses accelerated depreciation with lives of three to five years on automobiles and five to seven years on factory equipment. This method is not based on the economic useful lives of the related assets. Exhibit C–55 is a schedule of depreciation using Internal Revenue Service useful life guidelines: 5 years on automobile, 11 years for factory equipment, 7 years for computer equipment, and 10 years for leasehold improvements. Adjustment No. 2.

EXHIBIT C–55

Alternative Calculation of Expense —Years Ended December 31

Autos 1991 1992 1993 Less portion deemed personal to officers

Depreciable Cost $28,375 25,768 63,268

1993 $

-0-09,154

l(4,000)

Net Auto Depreciation

Equipment

Depreciable Cost

1991 1992 1993

$1,098,516 1,152,598 1,267,535

1992 $

-09,154 -0l(4,000)

1991 $ 5,675 -0-0l(3,000)

$05,154

$05,154

$02,675

1993

1992

1991

-0-0115,229

$ -0104,781 -0-

$ 99,865 -0-0-

-0004,246

4,246 00 0- 0 -

-000 0- 0 -

$119,475

$109,027

$099,865

$

Computer 1992 1993 Total Equipment and Computer

$29,724 29,724


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EXHIBIT C–55

409

Alternative Calculation of Expense —Years Ended December 31 (continued)

Leasehold Improvements 1991–1993

Depreciable Cost $78,192

1993

1992

1991

$007,819

$007,819

$003,910

132,448

122,000

106,450

Adjusted Depreciation Depreciation per financial statements Adjustment

201,044

214,056

186,200

$068,596

$092,056

$079,750

Our review of 1992 insurance policies revealed that auto insurance premiums are paid by the company on behalf of the owners and other related parties. Total 1992 auto insurance premiums for automobiles used by Shana Escanaba, David Phillips, and Esther Rivka were approximately $13,000, of which $11,000 is deemed personal use based on similar percentages as used in Note 4 below. For years ended December 31, 1993, and December 31, 1991, we approximated the personal insurance costs based on the 1992 review results. Adjustment No. 3.

A review of Automobile Leases indicated a number of vehicles are being leased by Manufacturers Associates but are being used for nonbusiness purposes. The adjustments for these leases are as shown in Exhibit C–56.

Adjustment No. 4.

EXHIBIT C–56

Adjustments for Leases Years Ended December 31,

Auto/User

Personal Portion

1993

1992

1991

Adjustment Amount Mercedes Benz Shana Escanaba Porsche 911 Shana Escanaba Lincoln Limousine Shana Escanaba Datsun 300ZX David Phillips Cadillac David Phillips Oldsmobile Esther Rivka Oldsmobile Esther Rivka

90%

$10,377

$10,377

$ 3,459

100%

8,606

8,606

2,983

100%

5,340

1,332

—

100%

—

3,609

4,823

75%

3,496

3,815

3,815

10/90%

300

3,780

3,780

40%

02,214

02,214

02,214

$30,333

$33,733

$21,074


410

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SAMPLE REPORTS

We would specifically point out that Ms. Escanaba, who drives almost no business miles for the company, has at her disposal, and at company expense, a Mercedes Benz luxury sedan, a Porsche 911 sportscar, and a Lincoln limousine. Adjustment No. 5.

Officer’s life insurance was deemed personal and thus added

back to income. Adjustment No. 6. Steuben Von Himmler, husband of the former company owner,

is being paid certain amounts of compensation as per an agreement between him and Shana Escanaba. This compensation is not an ordinary and necessary business expense and thus is added back to income. Adjustment No. 7. A review of 1993 telephone bills indicated that there were numerous personal bills for the officers paid for by the company. An amount of $200 per month was deemed the average personal usage and is added back to income from 1991 through 1993.

It was noted that various family members of Shana Escanaba and David Phillips were on the payroll of the company. (See Exhibit C–57.) We were able to determine that, in all cases, these were no-show jobs.

Adjustment No. 8.

EXHIBIT C–57

Company Payroll Years Ended December 31,

Ann Escanaba Jenna Escanaba Phillip Phillips Chardonnay Phillips

1993

1992

1991

$10,000 10,000 2,975 000- 0 -

$ 8,100 8,100 3,275 01,600

$ 7,800 7,800 2,475 000- 0 -

22,975 02,298

21,075 02,107

18,075 01,808

$25,273

$23,182

$19,883

Add payroll taxes @ 10% TOTAL ADJUSTMENT

Adjustment No. 9. We found in our review of the paid bills files for the years ended December 31, 1991 through December 31, 1993, that various personal expenses (in addition to others detailed herein) were paid by the company on behalf of Shana Escanaba, David Phillips, and Esther Rivka. These items are as shown in Exhibit C–58.

EXHIBIT C–58

Personal Expenses

Payee 1) Samurai Reinsurance Escanaba — Personal Insurance 2) Free World Travel Phillips — Travel

1993

1992

$ 9,000

$ 6,000

737

800

1991 $

— —


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C.21 NORTHERN STAIRWAY MANUFACTURERS

EXHIBIT C–58

Personal Expenses (continued)

Payee 3) Third World Travel Escanaba — Personal travel 4) Union Jersey Association Rivka — Country Club Total Adjustment

䊳

411

1993

1992

1991

3,658

2,028

—

02,475

02,885

2,885

$15,870

$11,713

$2,885

C.21 NORTHERN STAIRWAY MANUFACTURERS. Northern Stairway Manufacturers (NSM) is a manufacturer of wooden stairs and railings and related parts, almost exclusively for the home construction industry. A significant majority of its sales are to construction companies in New Jersey, Pennsylvania, and Virginia, with a minority of its sales going into the rest of the Northeast and across the country. In part because of the narrowness of the field of its sales product, there are relatively few competitors for the type and quality of product that NSM produces. Benjamin Fredrich’s role in NSM is one not uncommon to an entrepreneurial business owner. That is, he controls and is directly involved in most phases of the company’s operations. He is the Chief Executive Officer, determining the company’s direction and the markets in which it will maintain its position. He determines what products it will sell and to whom it will sell them. Fredrich is responsible for maintaining NSM’s banking relationships. He also oversees the sales force and often takes a direct hand in the factory, being on the floor and viewing the product as it comes off the equipment. This extends to making modifications to the equipment, fine-tuning the production line, and overseeing the raw product, final product, and inventory control areas. Fredrich also directs collection efforts. To perform these functions, Fredrich’s typical workweek consists of approximately 80 hours — between 12 and 14 hours a day, Monday through Saturday, and a few additional hours on Sunday. In line with the preceding, and again not uncommon for a closely held business, there is a rather thin depth of management in NSM. Outside Fredrich, there is no employee capable of fulfilling more than a few of the various roles that he handles, especially those involving managerial direction of the company and control of the product and factory. Notwithstanding the existence of several shop foremen, each with responsibilities in different areas, Fredrich still spends time on the shop floor and still fills a role as the overall shop/factory foreman and manager. The wide variety of products manufactured by the company (all relating to stairs and railings, and all in wood), including spare parts, spirals, circulars, production stairs, and so forth, makes it difficult for any one individual to have control and understanding of the full process. The industry is relatively sparse as to companies specializing in wooden stair production and is segmented, generally along regional lines. Fredrich feels that few, if any, companies have the ability to produce the variety of stairs and ancillary products produced by NSM. The source of the raw product, being the lumber commodities market, is an open and competitive area and one with easy access to anyone in the industry. Prices and, as a consequence, to a degree, profitability, are subject, of course, to the vagaries of the lumber markets.


412

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SAMPLE REPORTS

The risk of increased competition exists to a modest degree from foreign imports that have attempted to introduce alternative products. This type of competition does not as yet appear to present a serious threat because of the uniqueness and high desirability of wood. There is, however, the growing threat of competition within the wood product area through companies newly establishing themselves in free-trade zones. At this time, the extent and significance of any such competition cannot be reasonably determined. NSM sells its products through the efforts of three full-time salesmen, in addition to Fredrich. The salesmen have between two and over 10 years’ experience in this type of product line. They sell directly to builders, the ultimate customers of NSM. Because of a number of factors, including transportation and issues of timely delivery, sales are typically concentrated in the region in which the company is located. Notes to Reconstructed Statements of Operations Note 1: Commissioned Sales. This temporary element of the operations of the com-

pany represented brokered sales wherein NSM acted as a middleman for selected sales in the international market. NSM did no handling of the sales or the products involved, filling the role solely of a broker netting commissions from the transactions. As is evidenced through the financial statements of the September 30, 1990 year end, these sales no longer exist (see Exhibits C–59 to C–61). Therefore, the net profit from these sales must be removed from the operations of the company to properly reflect what the continuing operations of the company are and what a prospective purchaser would expect. These sales are no longer, in part because competition from Libyan and Ethiopian sources adversely affected the U.S. market. EXHIBIT C–59

Fredrich v. Fredrich Northern Stairway Manufacturers Comparative Balance Sheets

ASSETS Cash Accounts receivable Inventory Other current assets Total Current Assets Other assets Land Building and improvements Machinery and equipment Trucks and autos Furniture and fixtures Accumulated depreciation TOTAL ASSETS

September 30, 1990

September 30, 1989

$0,067,768 591,896 190,620 059,697

$0,072,882 265,904 240,095 026,212

909,981 2,737 74,552 803,234 674,645 262,876 199,490 (894,756)

605,093 21,546 74,552 744,743 610,945 160,188 71,605 (729,061)

$2,032,759

$1,559,611

LIABILITIES AND STOCKHOLDER’S EQUITY LIABILITIES Accounts payable $0,499,782

$0,328,392


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EXHIBIT C–59

Fredrich v. Fredrich Northern Stairway Manufacturers Comparative Balance Sheets (continued) September 30, 1990

September 30, 1989

Mortgage payable — current Notes payable — current Accrued expenses Exchanges and other current liabilities

16,800 136,966 190,947 —

15,300 139,561 97,606 10,061

Total Current Liabilities Due to officer Mortgage payable — long term Notes payable — long term Other liabilities

844,495 — 175,432 462,201 1,500

590,920 12,381 192,793 310,960 1,500

TOTAL LIABILITIES

1,483,628

1,108,554

STOCKHOLDER’S EQUITY Capital Retained earnings

25,734 0,523,397

25,734 0,425,323

0,549,131

0,451,057

$2,032,759

$1,559,611

TOTAL STOCKHOLDER’S EQUITY TOTAL LIABILITIES AND STOCKHOLDER’S EQUITY

EXHIBIT C–60

Fredrich v. Fredrich Northern Stairway Manufacturers Comparative Statements of Income for the Years Ended

INCOME Sales — manufacturing Sales — commissioned Sales — Net Cost of goods manufactured Cost of commissioned sales Cost of Sales

September 30, 1990

September 30, 1989

$3,937,655 0,027,586

$2,173,915 0,497,062

3,965,241

2,670,977

2,621,028 0,022,857

1,665,302 0,355,356

2,643,885

2,020,658

GROSS PROFIT ON MANUFACTURING AND COMMISSIONS

1,321,356

650,319

Selling expenses General and administrative expenses

295,793 0,847,392

199,767 0,397,153

1,143,185

0,596,920

$1,178,171

$1,153,399

Total Operating Expenses OPERATING INCOME

413


414

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SAMPLE REPORTS

EXHIBIT C–61

Fredrich v. Fredrich Northern Stairway Manufacturers Reconstructed Statements of Operations for the Years Ended

OPERATING INCOME ADJUSTMENTS Commissioned Sales — Remove Income — Note 1 Commissioned Sales — Remove Expense — Note 1 Salaries — Remove Benjamin Fredrich — Note 2 Salaries — Remove Ann Fredrich — Note 2 Salaries — Subtract Reasonable Salary to Benjamin Fredrich — Note 2 Rent — Remove Interest on Realty— Note 3 Rent — Remove Real Estate Tax— Note 3 Rent — Remove Depreciation on Building and Improvements — Note 3 Rent — Remove Land Rent — Note 3 Rent — Remove Sublet Loss (Income) — Note 3 Rent — Reflect Sublet Net Income — Note 3 Rent — Subtract Fair Rental — Note 3 Perquisites — Remove — Note 4 Officer Life Insurance — Remove — Note 5 Sales Cutoff Correction — Note 6 Gain on Sales of Equipment — Remove — Note 7 Bad Debts — Remove Recovery— Note 8 Tax Exam Interest — Remove — Note 9 Tax Exam Interest — Reallocation — Note 9 Tax Exam Interest — Allocate New Jersey— Note 10 Depreciation — Annual Adjustment — Note 11 Depreciation — Vehicle Adjustment — Note 12 TOTAL ADJUSTMENTS ADJUSTED NET OPERATING INCOME (LOSS)

September 30, 1990

September 30, 1989

$178,171

$ 53,399

(27,586)

(497,062)

22,857

355,356

152,295 24,300

38,445 14,575

(152,600)

(91,800)

44,845 43,730

48,070 31,218

32,610 6,000

28,117 6,000

7,826

941

23,328 (165,000) 15,000

15,613 (149,500) 10,000

9,977 (121,800)

4,220 121,800

(7,503) — 50,335

— (16,930) —

(7,000)

(8,000)

(1,100)

(1,200)

10,000

9,000

19,000

—

(20,486) $157,685

(81,137) $(27,738)


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415

In a closely held business such as NSM, officers’ compensation can, for all intents and purposes, to the extent that profits exist, be whatever the stockholders decide it will be. From an operational point of view, and with regard to what a purchaser of this business would anticipate, the operations should only be burdened by a reasonable compensation level. As a consequence, we added back the salaries of Benjamin Fredrich and Ann Fredrich, and then subtracted a reasonable salary level for a company in the housing industry, based on the volume of sales.

Note 2: Officers’ Salaries.

Note 3: Rent and Real Estate. NSM owns the land on which, and the building in which, it operates. This ownership tends to distort the true economic operations of the company by mixing in elements of realty ownership (interest on mortgage, real estate taxes, depreciation on the building, and improvements) with the manufacturing operation of NSM. To properly reflect operations, we removed from the expense structure of NSM the interest on the mortgages, real estate taxes on the property, depreciation taken on the building, and major improvements (all of which would be a landlord’s economic burden rather than a tenant’s), and also added back the nominal land rent being paid to Benjamin and Ann Fredrich. In addition, during the period of time covered by this report, the company was in the position of having more space available than needed. As a consequence, it sublet varying amounts of its available space. To properly reflect the true operations of the company and so as not to allow the company’s operations to bear the full burden of a fair rental for space in excess of its true needs, we added back losses or subtracted income that resulted from this sublease and then adjusted same for the true income (after removing as expenses the allocated portion of interest and taxes, which we have adjusted for a few lines preceding). As an offset to adding back the financial elements of ownership of the realty, we charged the operations for what a tenant would pay — a fair rental on the premises.

We added back to income an estimated amount of executive perquisites that were personal to the owner rather than of operational expense necessity to NSM. Note 4: Perquisites.

Note 5: Officer’s Life Insurance.

This item was added back as a nonoperational

expense. In October of 1989, through a bookkeeping error, $121,800 of September 1989 sales (but none of the related expenses) were posted to the general ledger. As a consequence, an adjustment is necessary to increase the income of fiscal year ended September 30, 1989, and, for a like amount, decrease the income for the following year. Note 6: Sales Cutoff Correction.

We removed as nonoperational the gain realized by the company on the sale of equipment. The company is not in the business of selling equipment and, therefore, any gains or losses from the disposition of equipment cannot be considered indicative of the operations of the company.

Note 7: Gain on Sale of Equipment.


416

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SAMPLE REPORTS

In the year ended September 1989, there was the unusual recovery of $16,930 of a bad debt previously written off. This bad debt was written off several years prior — and the nonrecurring/extraordinary nature of its recovery is not an item appropriate for inclusion in the operational results of the company. Note 8: Bad Debts.

Included as an expense in the September 30, 1990, year end was $50,335 of interest due as a consequence of the culmination of an IRS tax examination going back to 1984 and 1985. Inasmuch as this interest expense is not properly the burden of just one year, we removed it and in its place reallocated that interest, on an estimated basis, over the past several years. The logic for same is that if the tax that should have been paid was in fact paid in the proper year, the company would have been without that sum of working capital for all these years and, to replace same, would have had to incur the interest expense that it is now paying. Note 9: Tax Exam Interest.

Similarly to the preceding Note, an allocation was made of the estimated amount of interest that would be payable to New Jersey based upon the impact of the above-referenced IRS tax examination on the New Jersey corporate tax.

Note 10: Tax Exam Interest of New Jersey.

Note 11: Depreciation Annual Adjustment. This represents an estimate of the amount

by which the tax-based depreciation taken each year exceeded the economic depreciation that would have been taken. Note 12: Depreciation of Vehicle. In 1990, the company acquired a “luxury” car and through the improper use of depreciation of same, expensed approximately $19,000 more of depreciation than is economically justified as a business expense.

EXHIBIT C–62

Fredrich v. Fredrich Northern Stairway Manufacturers Reconstructed Stockholder’s Equity September 30, 1990

STOCKHOLDER’S EQUITY ADJUSTMENTS Patent — Note 1 Accrual for New Jersey Impact of Tax Exam — Note 2 Accrual for Federal Impact of Tax Exam — Note 3 Office Renovations Expensed — Note 4 Estimated Increment of Asset Economic Value over Book Value — Note 5 Tax (Cost) Benefit of Above Adjustments — Note 6

$549,131

As of September 30, 1989 $451,057

(2,577)

(3,861)

(17,600)

(16,500)

— 27,000

(105,000) —

130,000

110,000

(42,097)

(15,042)


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EXHIBIT C–62

417

Fredrich v. Fredrich Northern Stairway Manufacturers Reconstructed Stockholder’s Equity (continued)

Real Estate — Note 7 Remove Land, Building and Improvements Add Accumulated Depreciation on above Remove Liabilities on above Stockholder’s Equity— Adjusted — Excluding Real Estate

September 30, 1990

As of September 30, 1989

(848,385)

(789,894)

223,977 357,932

191,366 402,793

$377,381

$224,919

Notes to Reconstructed Stockholder’s Equity

It is believed that there is no economic value to the patent being amortized. Thus, we removed it as an asset (see Exhibit C–62).

Note 1: Patent.

Note 2: Accrual for New Jersey Impact of Tax Exam.

This liability was not reflected

on NSM’s books. The impact of the results of the Federal Tax Exam (tax and interest) have been fully accrued by the September 30, 1990, year end. However, this exam was ongoing for several years, and it was anticipated during those years that there would be a significant tax burden ultimately determined. Therefore, it is appropriate to impute this assessment for the September 30, 1989, year end. This accrual amounts to approximately $62,000 of tax and penalties and $43,000 of interest as of September 30, 1989. Note 3: Accrual for Federal Impact of Tax Exam.

This represents the addback of major renovations done to the office (and still in progress) in the fiscal year ended September 30, 1990, which were expensed as repairs and maintenance. Note 4: Office Renovations.

Note 5: Increment of Asset Economic Value. This represents an estimate of the extent (as of September 30, 1989 and September 30, 1990) that the economic value of NSM’s assets (vehicle and equipment; excluding realty) exceed their taxdepreciated book value.

We utilized a flat 30 percent tax rate to reflect either the tax cost of equity increases to the extent that such increases would be taxable or the tax benefit of equity reductions to the extent that such reductions would be deductible. Note 6: Tax Cost/Benefit.


418

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SAMPLE REPORTS

We removed the land, building and improvements, accumulated depreciation thereon, and relevant mortgages thereon, so as to exclude from the manufacturing operation the real estate portion of its balance sheet. These elements of the balance sheet are not essential for the operations of the company and, as discussed in detail in the Notes to Reconstructed Statements of Operations, if the company were put into the position of being a tenant, these assets and related liabilities would not need to be part of the balance sheet.

Note 7: Real Estate.

䊳

C.22 KEEPING YOU HEALTHY IS OUR MOST IMPORTANT SERVICE

We were engaged to determine the income of Dr. Rebecca Healing. To that end, our review was to include access to all books and records of ventures in which Dr. Healing has a material interest and also to her 1988 personal income tax return. These ventures are The Healing Group, P.A., the partnership known as Healing & Dealing, and the Laboratory Services Group. The Healing Group, P.A., is the main source of income for Dr. Healing. We were given access to certain of its books and records (see Exhibit C–63). Refer to Notes, especially Numbers 4, 5, 7, 10, 11, 14, and 15. We were refused access to the cash receipts journals and accounts receivable cards. These latter items are essential to verifying the accuracy of recorded income. Inasmuch as we could not so verify income, we can express no opinion as to its accuracy as recorded, except to refer to our notes explaining the problems, errors, and misrepresentations we found with the recorded expenses. Healing & Dealing owns the medical building in which The Healing Group (besides the Laboratory Services Group and others) operates. We were able to review its checkbook and 1988 information return. Inasmuch as 1988 was the first year of rental operations for this partnership, an accurate determination of the income it yields to Dr. Healing is difficult. Based on 1988, it appears that, before depreciation (which, in a real estate venture is a tax benefit, not an actual economic expense), Dr. Healing may realize a positive cash flow of approximately $5,000 per year. We were given a mutilated copy of what was allegedly Dr. Healing’s 1988 personal income tax return. This copy has been rendered almost totally useless by the obliteration of much of the significant information. With regard to the Laboratory Services Group, we were advised by Dr. Healing that she has no interest in same, and, therefore, there would be no records for us to review. Our presence in her office, and our review of the records of the partnership Healing & Dealing, indicated to us that we were not told the truth and that information that should have been available to us was intentionally withheld. Conversation among the staff in Dr. Healing’s office included reference to the Lab Group, and the Laboratory’s telephone number was being answered in the Doctor’s office. Most convincing however, was the finding of two checks, payable to the Laboratory from the partnership, apparently to set up a checking account for the Laboratory. Since the partnership is one-third owned by Dr. Healing, it is obvious that, contrary to what we were advised, she did have an interest in the Lab Group. There was a significant problem in getting a reasonable degree of cooperation, and we were still denied access to much information and records documentation. As an indication of the extent of the problems, we were shown two inadequate

Introductory Comments.

EXPENSES Other salaries — Note 3 Consulting fees — Note 4 Medical supplies — Note 5 Rent Utilities — Note 6 Office maintenance — Note 7 Office supplies — Note 8 Office expense — Note 9 Collection expense Telephone — Note 6 Automobile — Note 10 Insurance — Note 11 Health and welfare — Note 12 Medical licenses and dues Medical books and journals 63,045 — 15,769 7,694 2,286 1,088 2,078 4,940 — 3,838 1,550 14,757 434 1,665 16

102,620 12,739 31,537 20,553 4,184 2,741 6,078 17,251 — 8,322 6,633 29,514 969 2,531 627

$172,633

Less 6 Months Ended 3/31/88

535 866 611

1,653 4,000 12,311 — 4,484 5,083 14,757

39,575 12,739 15,768 12,859 1,898

$203,271

6 Months Ended 9/30/88

1,482 2,650 729

4,086 5,488 14,910 3,117 6,103 4,563 35,638

82,880 9,000 17,596 23,146 3,133

$349,371


2,017 3,516 1,340

5,739 9,488 27,221 3,117 10,587 9,646 50,395

122,455 21,739 33,364 36,005 5,031

$552,642


(300) — —

— (2,553) (7,737) — — (3,985) (4,531)

— (12,739) (576) — —

$000,310


(847) — —

(1,240) (874) (12,518) — (984) (3,388) (2,605)

(1,400) (9,000) (2,288) — (443)

$000,891


Adjustments

(1,147) — —

(1,240) (3,427) (20,255) — (984) (7,373) (7,136)

(1,400) (21,739) (2,864) — (443)

$001,201


870 3,516 1,340

4,499 6,061 6,966 3,117 9,603 2,273 43,259

121,055 — 30,500 36,005 4,588

$553,843


696 2,813 1,072

3,599 4,849 5,573 2,494 7,682 1,818 34,607

96,844 — 24,400 28,804 3,670

$443,074

Annualized Adjusted

Adjusted

1:26 PM

$375,904

Per Form 1120 Year Ended 9/30/88

Per Books and Records

The Healing Group, P.A. Reconstructed Statement of Income for 15 Months Ended June 30, 1989 (Note 1)

10/22/01

INCOME FROM FEES — Note 2

EXHIBIT C–63

Barson App.C (339-512) Page 419

419

420 5,191 1,141 3,953 602

821 5,863 000,222

10,043 3,396 7,905 602

1,643 11,727 000,444 289,896

$ 86,008

TOTAL EXPENSES

NET INCOME AND DR. HEALING’S SALARY $ 31,680

$ 54,328

148,943

000,222

822 5,864

4,852 2,255 3,952 —

61 2,526 1,250


$ 94,551

254,820

000,695

— 8,482

11,434 3,614 10,168 178

4,228 750 750


$148,879

403,763

000,917

822 14,346

16,286 5,869 14,120 178

4,289 3,276 2,000


$ 42,625

(42,315)

(66)

(822) (1,873)

(3,480) — (965) —

— (2,500) (188)


$ 52,056

(51,165)

—

— (399)

(9,947) — (3,049) —

(2,071) — (112)


Adjustments

$ 94,681

(93,480)

(66)

(822) (2,272)

(13,427) — (4,014) —

(2,071) (2,500) (300)


$243,560

310,283

000,851

— 12,074

2,859 5,869 10,106 178

2,218 776 1,700


$194,849

248,225

000,681

— 9,659

2,287 4,695 8,805 142

1,774 621 1,360

Annualized Adjusted

Adjusted

1:26 PM

140,953

400 1,600 2,000

Less 6 Months Ended 3/31/88

461 4,126 3,250

Per Form 1120 Year Ended 9/30/88

Per Books and Records

The Healing Group, P.A. Reconstructed Statement of Income for 15 Months Ended June 30, 1989 (Note 1) (continued)

10/22/01

Medical conventions and seminars — Note 13 Legal — Note 14 Accounting — Note 14 Entertainment and gifts — Note 15 Interest Payroll taxes — Note 16 Other taxes Loss due to abandonment of leasehold improvements — Note 17 Depreciation — Note 18 Amortization of leasehold improvements

EXHIBIT C–63



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421

“bills” to support payments to “Parve Industries” (see Notes 8 and 9). While these “bills” could not prove the business relationship of the expense, it should be noted that the correct name is “Parve Meats.” It appears that a conscious effort was made to avoid having this item highlighted in the disbursements journal by misrepresenting the name. Notes to Reconstructed Statement of Income for the 15 Months Ended June 30, 1989 Note 1. The income statement for the six months ended September 30, 1988, was reconstructed by reviewing the summaries of cash receipts and disbursements of the practice. Where it was not practical to determine a reasonably precise allocation between periods, it was assumed that 50 percent of the expenses occurred in each six-month period.

We reclassified nine checks recorded as patient reimbursements. The check stubs indicated four were for personal dental bills, one was for glasses, one was to a psychologist, and three were to a lawn service. Note 2: Income from Fees.

This adjustment represents eight checks for $175 made out to Dr. Healing’s minor children and classified as payroll. These checks had no taxes withheld from them and appear to have been for personal expenses. Note 3: Other Salaries.

We removed payments to Dr. Naomi Holistic, who was employed by The Healing Group until February 1988. We were not permitted to review her employment agreement. It appears that these payments were in the nature of a nondeductible buyout, rather than deductible compensation.

Note 4: Consulting Fees.

Note 5: Medical Supplies. We reclassified the five checks as shown in Exhibit C–64:

EXHIBIT C–64

Reclassified Checks

Payee

Description

Amount

Hands-On Equipment Co.

P-T equipment (capitalized)

$1,000

The Electronic Supply House

Video cassette (capitalized)

788

Melissa’s

No bill

500

All City

Auto insurance

286

CYA Insurance Co.

Building insurance

TOTAL

0,290 $2,864 2.864

Dr. Healing ceased paying her home telephone and utility bills through her personal account in September 1988. At that time, she moved into a new residence and The Healing Group began paying two telephone and utility bills. We were given access to only one of the monthly bills — the practice’s.

Note 6: Utilities and Telephone.


422

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SAMPLE REPORTS

We adjusted 11 items recorded as office maintenance; seven of these were marked oil. They all occurred after September 1988. No bills were made available to us, and it appears that these were the personal heating bills for Dr. Healing. The four remaining items included a $200 check to her son and three small checks for lawn maintenance.

Note 7: Office Maintenance.

We reclassified 16 items: three checks to Williams University for Dr. Healing’s son; an unexplained $150 check to her (new) husband; a check to cash for $350; a check to Parve Industries for meat; $450 to Melissa’s, marked as personal on the stub; $209 to the Rack, marked clothes; $1,455 to Caterer’s Delight for a party; and various smaller checks.

Note 8: Office Supplies.

Note 9: Office Expense.

Over 100 checks, covering the items in Exhibit C–65,

were reclassified:

EXHIBIT C–65

Reclassified Checks

Payee Marmaduke Healing Anna Healing Maureen Jones Hunk Healing Laura Healing Cash Mark Stones Cash Marina del Doc Parve Industries Various capitalized items All-Star Sports Camp Maintenance Co. EAB Miscellaneous TOTAL

Description Doctor’s son Doctor’s daughter Doctor’s daughter’s friend Doctor’s (new) husband Doctor’s daughter Other Appraisal of diamonds Other Repair daughter’s boat Doctor’s meat market Office furniture

Number of Checks

Total Amount

14 10

$01,047 420

12 8 2 2 3 7 4 12

305 1,287 108 1,678 1,225 2,298 345 777

12

5,928

1 1 1 34

95 416 658 03,668

For Laura Landscaping Architect Many checks

$20,255 20.255

The doctor owns and drives a Mercedes. It is three years old and has 63,000 miles on it. The doctor advised us that she averages four trips to the local hospital each day. Each round-trip is less than one mile. She also goes, one day per week, to Our Lady of Speedy Healing Hospital, a distance of 44 miles. On 75 percent of Saturday mornings, she drives to seminars, averaging 64 miles per round-trip. Note 10: Automobile.


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EXHIBIT C–66

423

Gas Bills

Description

Total

To local hospital: 4 trips @ 1 mile @ 5 days per week

20

To OLSHH: 1 trip @ 44 miles

00044

To Seminars: 3/4 trips @ 64

00,048

Total business mileage per week

112

Number of weeks

00,050

Total business miles per year

05,600

Divide by total annual mileage of

21,000

Percent of business use

0026.7%

Some of the gas bills were signed by the doctor’s husband, some bills were missing, and we did not have access to many others. The doctor is paid $2,500, plus all gas and repairs for the use of her car. We subtracted the bills that were not for the doctor’s car, and multiplied the remainder by 73.3 percent to arrive at the personal portion of the automobile expenses. (See Exhibit C–66.) We reclassified 20 checks totaling $7,136 as personal. In most cases, neither the policies nor the bills were available to us. Instead, we were obliged to use a brief schedule of policies. The items reclassified included the doctor’s homeowner policy, life insurance, automobile insurance, and a $500 check to Melissa’s for a party. Note 11: Insurance.

Note 12: Health and Welfare.

We reclassified six checks for personal medical

expenses of Dr. Healing. Note 13: Medical Conventions and Seminars. The following two checks were reclas-

sified as shown in Exhibit C–67:

EXHIBIT C–67 Payee

Reclassified Checks Description

Travel Agent Inc.

Super Bowl

Roadside Motel

No explanation

TOTAL

Amount $1,467 0,604 $2,071 2.071

We were advised that no bills are submitted by the attorneys or the accountants. This highly unusual procedure hampered our review. However, we were able to determine the personal nature of the following items in Exhibit C–68.

Note 14: Legal and Accounting.


424

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SAMPLE REPORTS

EXHIBIT C–68 Payee Advocacy Plus EAB

Two Items of Personal Nature Description

Amount

Divorce counsel Architect

$1,500 0,1,300

TOTAL

$2,800 2.071

Note 15: Entertainment and Gifts. No bills were made available to us for American Express and other credit cards. Furthermore, we were advised that the Doctor did not keep a diary. We reclassified as personal the items in Exhibit C–69.

EXHIBIT C–69

Entertainment and Gifts of Personal Nature

Payee American Express Bate & Takkel Quarry-side Local Hospital Cafeteria and Coffee Shop Dr. Healing Shanna’s Eatery Aristotle’s Retreat Dr. Emily Lasagne Burning Bush Last State Bank Bank Center Vista Minnow & Line Hunk Healing Various smaller checks

Description No supporting documents Fishing trip The dock for daughter’s boat Dr. Healing’s lunches and dinners No description Dr. Healing’s lunches No description No description Cigars and gifts Mastercharge No description No description Fishing trips Doctor’s (new) husband

TOTAL

Number of Checks

Total

15 1 1

$05,625 350 82

12 1 6 1 2 2 5 1 1 4 1

1,208 297 61 650 379 231 1,531 100 244 1,280 175 01,214 $13,427 13.427

A check to the Internal Revenue Service, dated January 17, 1983, for $1,622, was in payment of Dr. Healing’s individual income taxes, yet was included in the payroll tax expense. In addition, part of Dr. Healing’s FICA taxes were not withheld from her wages during the 15-month period examined. The “Company” paid and deducted $2,392 of personal FICA withholding tax on behalf of Dr. Healing.

Note 16: Payroll Taxes.

This item was disregarded as being nonrecurring and, therefore, not indicative of the ongoing medical practice. Note 17: Loss on Abandonment.

Note 18: Depreciation. We adjusted depreciation to correct the improper depre-

ciation method used by the medical practice. We also included depreciation on the expensed items that we capitalized.


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C.23 AN APPLE A DAY IS NOT ENOUGH 䊳

425

C.23 AN APPLE A DAY IS NOT ENOUGH

Dr. Leo Morales established his radiation therapy practice in 1979 in Butte, Montana. In 1981, Our Lady of Perpetual Misery Hospital in Southern New Jersey offered Dr. Morales a position as head of radiation therapy, which he accepted and has held ever since. Dr. Morales has an office one block from the hospital in a well-maintained middle-class neighborhood. His office is comfortable without being luxurious. Other than the rent for this office, inasmuch as all equipment and virtually all space needs are provided by the hospital, there is little else to the physical existence of Dr. Morales’s practice. In many ways, Dr. Morales is a very highly compensated employee of the hospital. In reviewing the books, records, and supporting documentation of his practice (see Exhibits C–70 and C–71), we noted that there was an extraordinary amount of personal expenses paid for by the business, the details of which we have enumerated in this report. In addition, we were advised by Mrs. Morales that there were significant financial dealings involving other medical practices and potential investment situations, and that these dealings required Dr. Morales’s attorney, Courtney Goldfarb, to render considerable services. Our analysis of the practice’s expenses indicated legal fees of substantial magnitude. When we attempted to review the legal bills in support of these expenses, initially we were faced with no bills being made available to us. After repeated and persistent efforts on our behalf to obtain these bills, we were supplied with same by Ms. Goldfarb. These bills do coincide, as to amounts, with the payments made by the practice. However, we would note that all such bills indicate merely legal services — with no details and no supporting information. When we inquired of Ms. Goldfarb as to what we viewed to be a rather unorthodox method of billing a client for such substantial amounts, she advised us that the bills she supplied to us were complete as they were and that they were the extent of how her firm billed this client. Even in the absence of such detail, it was obvious, based on the magnitude of the fees, that (even if not personal) they clearly were not normal recurring expenses for a medical practice. Unfortunately, we were unable to use these bills as a source for verifying various claims of Mrs. Morales. Introduction and Observations.

EXHIBIT C–70

Morales v. Morales Leo Morales, M.D., P.A. Comparative Statements of Operations for the Years Ended December 31

GROSS REVENUES EXPENSES Compensation of officer Other salaries Repairs Taxes Depreciation Pension expense Professional assistance

1994

1993

1992

1991

1990

$1,422,549

$1,178,069

$0,790,060

$0,612,435

$0,462,654

770,100 249,099 — 7,866 5,855 36,693 60,880

765,737 122,917 — 10,875 8,472 26,461 2,260

451,500 38,000 — 5,251 12,119 43,519 32,929

390,000 28,167 12,220 6,812 8,309 52,653 10,865

278,000 26,000 940 8,301 5,164 50,500 10,330


426

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SAMPLE REPORTS

EXHIBIT C–70

Morales v. Morales Leo Morales, M.D., P.A. Comparative Statements of Operations for the Years Ended December 31 (continued) 1994

1993

1992

1991

1990

Management services 64,569 Travel and entertainment 14,220 Books, dues, and publications 9,245 Meetings and seminars 13,158 Office expenses 33,724 Telephone and advertising 642 Insurance 48,267 Professional fees 58,361 Auto expense 12,535 Typing fees and filing 4,310 Employee benefits 15,319 Supplies 5,787 Miscellaneous 0,003,411

45,168 15,066

25,661 19,342

19,825 14,697

17,034 11,255

10,164 15,107 27,748 — 49,043 52,042 14,081 4,700 — — 0,001,652

8,593 15,435 30,663 — 37,218 18,696 9,764 — — — —

3,607 17,313 11,896 10,906 13,258 8,200 — — — — —

3,345 7,134 12,739 11,424 15,932 4,783 — — — — —

TOTAL EXPENSES

1,414,041

1,171,493

0,748,690

0,608,728

0,462,881

NET OPERATING INCOME

$1,118,508

$1,116,576

$,1141,370

$1,113,707

EXHIBIT C–71

$

,11(227)

Morales v. Morales Leo Morales M.D., P.A. Adjusted Profit from Operations for the Years Ended December 31 1994

Net operating income $0,008,508 Officer compensation 770,100 Other salaries — Note 1 — Repairs — Note 2 — Depreciation — Note 3 2,279 Pension expense — Note 4 36,693 Travel and entertainment — Note 5 10,665 Meetings and seminars — Note 6 9,869 Office expense — Note 7 8,431 Insurance — Note 8 16,089 Professional fees — Note 9 44,361 Auto expense — Note 10 11,281 Employee benefits — Note 11 0,010,000

1993

1992

1991

1990

$0,006,576 765,737 — — 4,679 26,461

$0,041,370 451,500 13,000 — 8,286 43,519

$0,003,707 390,000 28,167 10,000 5,400 52,653

$0,000(227) 278,000 26,000 — 3,600 50,500

11,300

14,506

11,023

8,441

11,330 6,937 16,348 40,042 12,673

11,576 7,666 12,406 8,696 8,788

12,985 5,948 4,419 — —

5,350 6,370 5,311 — —

l00,000—

l00,000—

l00,000—

l00,000—


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C.23 AN APPLE A DAY IS NOT ENOUGH

EXHIBIT C–71

427

Morales v. Morales Leo Morales M.D., P.A. Adjusted Profit from Operations for the Years Ended December 31 (continued)

ADJUSTED COMPENSATION AND PROFIT PAID OR AVAILABLE TO DR. MORALES Incremental change in accounts receivable ADJUSTED NET INCOME

1994

1993

1992

1991

1990

928,276

902,083

621,313

524,302

383,345

99,000

153,634

37,654

91,328

108,142

$1,027,276

$1,055,717

$1,658,967

$1,615,630

$1,491,487

Notes to Adjusted Profit from Operations Note 1: Other Salaries. This entry is to add back the payroll paid to Mrs. Melissa Morales as being a nonoperational expenditure.

The repairs expense for 1991 was far in excess of normal expectations and inconsistent with customary expenses of this type of practice. Note 2: Repairs.

Substantially all this expense relates to Dr. Morales’s automobile, and represents a personal rather than business expense. As with our auto expense adjustment, we have added back 90 percent of such depreciation. In addition, in 1992, $3,607 of depreciation was taken via an accelerated tax method, having no economic reality. We “allowed” 20 percent of this amount for that year and similar amounts for each succeeding year. Note 3: Depreciation.

This expense represents the deferral of compensation for the benefit of Dr. Morales via the use of a qualified pension plan. The issue is not the legitimacy of the deductibility of the pension payments, but rather the economic benefit derived by the Doctor and his practice by having a pension that is effectively at Dr. Morales’s option.

Note 4: Pension.

This account had frequent payments to charge accounts such as Visa, American Express, and the like. There were also frequent checks made payable to Dr. Morales and to various local restaurants. In addition, in September 1992, there was a check to Macy’s in the amount of $2,500 and to Bloomingdales in the amount of $1,500 — both of the checks labeled (in the books of the practice) as Arbor Day gifts. Further, in January 1992, there was a check for $504 to Vicki’s Luxury Rentals (apparently a limousine service) and $597 to the Metropolitan Opera. Documentation for these expenses — in the form of supportable evidence that these expenditures were business-related—was virtually nonexistent. Therefore, it is our conclusion that approximately 75 percent of the travel and entertainment expenses are personal in nature. Note 5: Travel and Entertainment.

Expenditures in this category included disbursements for Visa/Mastercard types of bills, to Fun & Sun Travel, to Dr. Morales, to

Note 6: Meetings and Seminars.


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JoAnna’s Village Deli, and to American Express. As was the case with the travel and entertainment expenses, documentation was substantially nonexistent. As a consequence, it is our conclusion that approximately 75 percent of these expenses were personal and nonoperational in nature. Note 7: Office Expenses. Similarly, many of the office expenses were paid to charge

account vendors and/or to Dr. Morales personally. There were regular (virtually weekly) checks to Jillie Belvoir, whom we understand is/was the housemaid. In addition, to illustrate some of the expenditures that were treated as if they were business expenses, there was a check in May 1991 to Michelle’s Service Co. in the amount of $883.39 for pool maintenance; to Pipes R Us in July 1991 for $536 for plumbing and heating; to Carmellita Morales (Dr. and Mrs. Morales’s daughter) in August 1991 for $900 and again in December for $400; to Carla in October 1991 for $344.65 (the endorsement on the check reads “Carla Sheet Metal, Inc.”). Again, documentation was nearly nonexistent. Therefore, it is our conclusion that approximately 50 percent of this expense category was personal in nature. Although it is clear that some portion of the insurance expense is appropriate for the practice (for example, malpractice insurance expense), we were not permitted to inspect various insurance policies and, therefore, were unable to determine the propriety of various insurance bills as business expenses. Based on what we were able to review, and by inference from what remained, it is our estimate that approximately 33 percent of insurance payments were nonbusiness in nature.

Note 8: Insurance.

The practice has consistently incurred legal expenses of an extraordinarily high magnitude. A review of the legal bills was substantially nonrevealing. Commonly, the legal bills referred to services for various corporate and tax matters — and were silent, or uninformative because of their lack of specificity, and as a consequence were inadequate for revealing the business connection of those expenses to the medical practice. In addition, in the past couple of years, it is our understanding and belief that a significant amount of the legal bills related to the ongoing divorce action — again, not a recurring type of legal fee that an operational medical practice would anticipate or one properly chargeable as a practice expense. Note 9: Professional Fees.

Note 10: Auto Expenses. Considering the nature of the practice, there is an unreasonable level of auto expenses. There were frequent (nearly monthly) checks for auto leasing, various gas credit card bills, and checks payable to Dr. Morales personally for alleged expense reimbursements. Substantially all (approximately 90 percent) of these expenses were personal in nature.

Notwithstanding the issue of whether or not it is legitimately deductible by the corporation, this expense represents personal economic benefit to Dr. and Mrs. Morales and is not an operational expense necessary for the functioning of Dr. Morales’s medical practice. Note 11: Employee Benefits.

䊳

C.24 THE POOR OFFICE SUPPLY STORE. Sometimes, when trying to determine the correct income in a business that is either all or substantially all cash in nature, we discover that the business has good paper trails, whether for part of the business or across the board. Even so, a significant volume of the paper may need to


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C.24 THE POOR OFFICE SUPPLY STORE

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be analyzed to obtain any usable and reliable data. We faced such a situation with an office supply store, a business that was reporting a gross profit significantly below industry expectations. There were no apparent reasons for this, except for allegations by the business owners that they could not realize the standard markup, that there was heavy competition, that they had to give significant discounts to their commercial clients, and that they had poor collection experience. We performed many of the usual and customary procedures in our investigation of the store. For instance, we visited the store unannounced and did a casual walk-through to get a visual idea of the environment and what was being sold. We also obtained a good idea not only about what was being sold but also about the prices being charged. The inspection indicated that, by and large, everything was being sold at standard retail prices. Nevertheless, we gained no insight into the amount of activity conducted with commercial/industrial sources or into the extent of discounts that were given to them. The visual investigation also did not tell us anything about the company’s collection history and the nature of its receivables, which were, as indicated to us by the business owners, a serious issue with respect to the business’s profitability. To satisfy ourselves about the reasonableness of the reported gross profit, we took two months of sales invoices and thoroughly analyzed them. Keep in mind that sales invoices were only available to us when actual receipts were written or otherwise produced, and that would typically mean when the store had dealt with commercial customers. Walk-in business got nothing more than a sales register receipt (if anything) — and those receipts were not saved. Even if they had been kept, they would not be in any meaningful or usable form. Therefore, the cash retail price phase of the business was not represented by this detailed sampling. If anything, our analysis would tend to overstate the cost of goods sold as a percentage of sales and understate the gross profit. It would also, as a consequence, tend to understate the sales, if this was a methodology for determining sales and unreported cash income. Using a computer, we keyed in those two months of sales invoices to create a database that would specify the category of product, the particular type of item, the quantity of product sold, the price at which it was sold, and the discount against that price as indicated on the invoice. By using the computer’s compiling capability, we were then able to get a representative picture of the amount of discount realized against the retail price of products. Our database indicated that, with regard to the commercial business, the typical discount realized was 10 percent, occasionally going to 20 percent; sometimes there was no discount at all. Our sample averaged a 12 percent discount, in direct contrast to the owner’s allegations of much greater typical discounts. Additionally, we had to determine the approximate amount of sales subject to the discount and compare it with sales from the walk-in retail business. For that we used the company’s own accounts receivable schedule. It indicated that approximately half of the sales (by dollar volume) were on account and, therefore, by inference, the balance comprised walk-in cash-on-delivery sales, sold only at full retail. Therefore, approximately half the sales were made at 12 percent off list prices, and approximately half were made at list — for an average discount of 6 percent. In addition, a review of the accounts receivable schedule indicated that a relatively modest amount of sales on account were outstanding at the end of the year and most of those were current. Therefore, we found, again in contra-


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diction to what was being professed to us as the company’s miserable condition, that the store’s collection track record was really quite good. We also did a detailed analysis of purchase invoices from the key suppliers, using that to get a thorough understanding of the costs of the products so that we could compare those costs to the sales prices listed on the invoices. Also, as is common in this type of industry, in most situations the purchase invoices indicated not only the cost of the products to the store but also the suggested retail price for the objects. In most cases, it was those suggested retail prices that the store used as its own prices. We went one additional step. Besides looking at the detailed sampling of the business’s own actual practices, we also went to published sources to learn what the trade typically did. Those sources gave us great comfort that our sampling made sense: despite the fact that reported numbers were significantly below industry norms, our sampling and the conclusion from it suggested that the company did just slightly better than the industry norm. In a business where purchase invoices go so far as to indicate suggested retail price, there is a strong built-in bias toward maintaining those prices. That is especially true when the nature of the store operation is such that it is more akin to a neighborhood/retail operation, though with a significant portion of its business coming from local businesses. An overview of numerous purchase invoices indicated that the typical suggested retail markup over cost ranged from a low of about 67 percent to a high in excess of 200 percent on selected products. The typical range of markup for list over cost was between 85 and 100 percent. No better financial data was available directly from the company. As a consequence, there was the need for us to reconstruct the true gross profit in the above manner. It was our conclusion from our overview of the purchase invoices that the typical product sold by The Poor Office Supply Store had a markup over cost of approximately 90 percent. Therefore, if we were to take the hypothetical average product costing the company $1.00, mark it up to its average retail price of $1.90 (90 percent markup over the $1.00 cost), and then discount that by our calculated average discount of 6 percent against list, the hypothetical average product would sell for $1.79 (90 percent markup over cost, bringing it to a $1.90 list, less 6 percent discount against that $1.90, bringing it to a $1.79 average realizable sale). Inasmuch as this average hypothetical product costing $1.00 was selling for $1.79, the company should be reflecting a typical gross profit of $.79 on a $1.79 sale — or an average gross profit of 44.1 percent. For conservatism, we discounted that by 10 percent, reducing the 44.1 percent calculated gross profit by 4.4 percent to bring the average gross profit to 39.7 percent. We further reduced that to 38.6 percent so as not to exceed the highest gross profit reflected by outside sources as the industry norm. Also compared to industry norms was the average inventory turn. Inventory turn is a measurement of the total cost of goods sold, divided by the average inventory. Using the tax returns, the inventory turn was indicated to be between 12 and 18 times per year — an extraordinarily high rate. The national averages are typically between 4 and 5 times per year. An inference from this comparison is that the inventory of the company is substantially understated, resulting in the use of a lower denominator in that fraction and the resultant higher inventory turn figure. Our conclusion, as illustrated in Exhibits C–72 to C–74, was that there was unreported income in excess of $100,000 per year.

The Poor Office Supply Store Comparative Reconstruction of Sales

Unreported Sales

$0,142,125

37.8% 62.2% 884,352 0,742,227

Average gross profit % (per above) Cost of Goods Sold Reconstructed Sales (cost of goods sold ÷ CGS%) Reported Sales (per tax returns)

*

*

$0,119,546

38.2% 61.8% 945,960 0,826,414

*

0,584,603

000(5,905)

000(5,556) 0,550,067

Adjusted Cost of Goods Sold

590,508

555,623

$0,598,772 000(8,264)

37.8% 38.6% — 38.2%

1987

$0,109,111

37.75% 62.25% 1,024,487 0,915,376

0,637,743

000(6,442)

644,185

$0,653,339 000(9,154)

38.0% 37.5% — 37.75%

1988

$0,108,877

37.75% 62.25% 1,140,980 1,032,103

0,710,260

000(7,174)

717,434

$0,727,755 00(10,321)

37.0% 38.5% — 37.75%

1989

$0,123,087

37.8% 62.2% 1,141,450 1,018,363

0,709,982

000(7,172)

717,154

$0,727,338 00(10,184)

— 37.0% 38.6% 37.8%

1990

1:26 PM

Purchases Available for Sale Less: estimated additional increase in inventory— 1% of above

$0,563,045 000(7,422)

38.0% 37.6% — 37.8%

1986

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Reported Cost of Goods Sold (per tax returns) Less: personal use

Gross Profit % per National Business Products Society Gross Profit % per Office Supplies Associates Gross Profit % per November 1990 Reconstruction Average gross profit %

EXHIBIT C–72


431


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EXHIBIT C–73

Comparison of Operating Statistics to Industry Norms

GROSS PROFIT Poor Store — per tax returns Poor Store — per sales and purchases tabulation National Business Products Society— Dealer Operating Results Office Supplies Associates — Annual Report INVENTORY TURN Poor Store National Business Products Society Office Supplies Associates

EXHIBIT C–74

1986

1987

1988

1989

1990

24.1%

27.5%

28.6%

29.5%

28.6%

—

—

—

—

44.1%

38.0%

37.8%

38.0%

37.0%

—

37.6%

38.6%

37.5%

38.5%

37.0%

11.8

12.9

15.5

18.0

16.9

4.5 4.2

4.4 4.5

4.5 4.4

49 4.5

— 4.7

Comparative Reconstruction of Income

Net Income Before Income Taxes Officer Compensation — Per Tax Returns Unreported Sales Personal Use of Purchases — Note 1 Inventory Understatement — Note 2 Depreciation — Note 3 Employee Benefits — Note 4 Insurance — Note 5 Auto and Lease Expenses — Note 6 Interest — Note 7 Reconstructed Income Before Compensation to Officers

1986

1987

1988

1989

1990

$008,885

$017,105

$027,610

$043,695

$028,588

57,000 142,125

85,000 119,546

90,000 109,111

100,000 108,877

97,120 123,087

7,422

8,264

9,154

10,321

10,184

5,556 — 2,448 938

5,905 4,257 3,976 4,750

6,442 7,721 7,660 4,960

7,174 6,259 6,664 10,246

7,172 8,244 6,609 11,924

10,650 —

9,780 001,315

8,720 001,861

12,441 006,368

7,187 002,669

$235,024

$259,898

$273,239

$312,045

$302,784

Notes to Reconstruction of Sales and of Income

Based on our discussions with Mrs. Jennifer Poor, and our understanding of the operations of The Poor Office Supply Store, we estimated the personal use of the cost of goods sold to amount to 1 percent of the reported sales of the business. In our reconstruction of sales, we subtracted this from the base used for cost of goods sold. This tends to have a mitigating Note 1: Personal Use of Purchase.


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effect on the calculation of unreported sales when that calculation is done by backing into the correct amount of sales by the use of the cost of goods sold. Note 2: Inventory Understatement. As with the personal use of company purchases, we also concluded that part of the approximate 10 percent disparity in the cost of goods sold for The Poor Office Supply Store as compared to the industry norm is attributable to the consistent understatement of the inventory. We have estimated this understatement to amount to 1 percent of the purchases available for sale on an annual basis. This, of course, has a cumulative effect on the extent of inventory carried by the business at any point in time.

We adjusted the reported depreciation for each of the years under investigation to correct the improper utilization of 100 percent of the company’s cars as a legitimate business expense. In considering the nature of the business — a mostly retail office supply establishment — it is clear that the use of a personal vehicle (such as a Mercedes) is unnecessary and unrelated to the nature of the business. As a consequence, we considered 90 percent of the depreciation of such a vehicle to be personal in nature. Further, the van that is used by the business, which we accept as a business vehicle, has been depreciated under a method of depreciation that far exceeds its true economic depreciation. We have added back 50 percent of such depreciation as being excessive from an economic point of view. Note 3: Depreciation.

Note 4: Employee Benefits. We added back to income as a personal expense, not

properly attributable to the operations of the business, a substantial amount of life insurance premiums paid on behalf of the officers. Much personal insurance is paid through the business. This includes personal liability umbrellas, homeowners’ insurance, and insurance on various personal cars (more than just those carried on the business). As a consequence, we estimated the personal portion of the insurance expense to be 20 percent in 1986, 50 percent in 1987 and 1988, and 60 percent in 1989 and 1990. Note 5: Insurance.

The company incurs unusually high auto and lease expenses for a retail operation. This is because of the substantial personal nature and utilization of company vehicles. The company’s accountants each year removed a modest amount of such expenses from the operations, charging them to the officers personally. It is our conclusion that such addbacks were far too modest, and we have adjusted them accordingly. We have accepted only 50 percent of the total auto expenses as legitimately business in nature (most of it for the van and a minimal acceptable amount for the personal vehicles). Also, considering that the company for a good part of this period of time leased two cars besides carrying the Mercedes, and inasmuch as there are only two operating officers in the business, it is clear that the third car was totally personal. Therefore, we have adjusted the expenses to reflect that 50 percent of the auto lease expense is totally personal and that of the remaining 50 percent, 90 percent of that is personal. To the extent that the company’s accountants did not so reflect these in any particular year, we made the necessary adjustments. Note 6: Auto and Lease Expenses.

Adjustment for interest expense was similar to the adjustment for depreciation on the vehicles. When the interest expense related to vehicles, we treated 90 percent of such interest expenses as personal in nature.

Note 7: Interest.


434 䊳

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C.25 THE UNSAINTLY TAINTED PAINT STORE. What could be more mundane than a paint and accessories store dealing with the general buying public, builders, and contractors? We had to investigate the financial operations of just such a store (see Exhibits C–75 to C–76) and were given the opportunity to uncover a number of fine nuggets. Complications included the differing interpretations between husband and wife with regard to what the store originally cost them only a few years ago, both agreeing that whatever it was, a significant portion of the purchase price was unstated — paid under the table. Mrs. Margo Wall ran the operation. She increased the product lines, automated the sales and accounting functions, and in general brought the store into a modernized phase to the extent that sales were recorded on point-of-sale registers with scanner guns that facilitated inventory control. Despite that, we were advised by Ms. Wall that the computerized system could not generate a sales and purchase report by product. Needless to say, we found that rather unusual considering that information was gathered at the point of sale. This, of course, forced us to approach the issue of the reconstruction of sales by alternative means. Also interestingly, inventory was not maintained in any standard accounting form, such as first-in–first-out, last-in–first-out, historical average, or cost basis. Rather, the computer system apparently updated all inventories at the last cost entered. This in effect caused a slight built-in profit every time there was a tick up in the cost of any item, or a loss if an item decreased in price. That didn’t really cause the company any problems since it habits were to significantly understate the inventory anyway. In fact, year-end inventories as reflected on the tax returns were determined by a crude application of the gross profit percentage method — using a gross profit percentage that was significantly below actuality.

EXHIBIT C–75

Wall v. Wall T/A Saint’s Paint and Decorating Statements of Income (As per Tax Returns) Years Ended September 30, 1994 1993

Net Sales Cost of Goods Sold Beginning inventory Purchases Cost of goods available for sale Ending inventory Cost of Goods Sold Gross Profit Operating Expenses Officer’s compensation Salaries Rent Taxes Interest Depreciation

$ 408,481

$ 322,211

95,746 0259,619

109,612 0208,115

355,365 0067,103

317,727 0095,746

0288,262

0221,981

0120,219

0100,230

12,000 17,745 27,600 5,310 11,403 7,312

— 16,725 27,600 6,845 14,148 3,199


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C.25 THE UNSAINTLY TAINTED PAINT STORE

EXHIBIT C–75

435

Wall v. Wall T/A Saint’s Paint and Decorating Statements of Income (As per Tax Returns) (continued) Years Ended September 30, 1994 1993

Advertising Office Telephone Credit card fees Utilities Professional fees Insurance Bank charges Miscellaneous Amortization expense Total Operating Expenses Income Before Taxes and Adjustments

EXHIBIT C–76

3,800 2,125 3,918 1,313 4,370 1,230 5,668 1,216 2,046 0005,294

2,674 700 3,022 690 3,393 1,080 4,350 — 1,634 0005,294

0112,350

0091,354

$

7,869

$

8,876

Wall v. Wall T/A Saint’s Paint and Decorating Adjustments to Statements of Income Years Ended September 30, 1994 1993

Income Before Taxes and Adjustments Salaries — Note 1 Amortization — Note 2 Costs of goods sold — Note 3 Unreported income — Note 4 Interest — Note 5 Depreciation — Note 6 Officer’s compensation Adjusted Operational Income Before Officer’s Compensation

$007,869 (5,200) 5,294 35,000 33,000 11,403 (4,000) 12,000 $ 95,366

$008,876 (5,200) 5,294 20,000 29,000 14,148 (2,000) — $ 70,118

Explanation of Adjustments to Statements of Income Adjustment No. 1: Salaries. Ms. Wall advised us that besides herself, she has one full-time employee (Srikala Smith) and one part-time employee. Based on our review of payroll, Ms. Smith is paid $300 a week and the part-timer is paid approximately $5.00 to $5.50 per hour. Ms. Wall also advised us that the full-time employee has significant responsibilities and works between 50 and 60 hours per week. The tax returns of the company show that total payroll (other than Ms. Wall) approximated $17,000 to $18,000 for each of the previous two fiscal years.


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While those figures are consistent with her representations to us, it is our belief that it is implausible that a full-time employee with significant responsibilities, working between 50 and 60 hours per week, would be receiving a pay that essentially is the same on an hourly basis as a part-time employee. In addition, if an overtime premium were factored in, it would place that full-time employee below the minimum wage scale. It is therefore our conclusion that the full-time employee is receiving at least $100 per week off the books — in cash. We would note this payroll issue is further support for our conclusion that unreported income exists. Amortization expense represents the annual write-off of the covenant not to compete acquired with the purchase of the business. This expense relates to the acquisition of the company — it is not an operational expense. Adjustment No. 2: Amortization.

The largest of the adjustments made to the reported figures involves our determination that there was a significant understatement of inventory, and, as a consequence, a similar overstatement of the costs of goods sold, resulting in a like understatement of gross profit and net profit. We noted that, as part of the acquisition of this business from its former owner, the inventory at the time of the acquisition was calculated at approximately $125,000. As of the end of the first full fiscal year under the ownership and management of Ms. Wall, as of September 30, 1993, that inventory was reflected on the company’s tax return as having declined to $95,746. The following year, the company’s tax return, as of September 30, 1994, indicated a further decline to $67,103. It is our belief that the reported inventory figures are inconsistent with reality. We base this conclusion on the following factors: Adjustment No. 3: Costs of Goods Sold.

1. Although Ms. Wall advised us that she did not have a printout of the inventory as of the tax return dates, she did supply us with two runs of inventory as of April 1995 and May 1995. These reflected inventory carried at $148,202 and $145,303, respectively. 2. During discussions with Ms. Wall and her accountant, with regard to the basis for the stated inventory on the tax returns, we were advised that the inventory is determined based upon what is necessary to reflect an estimate of what is considered a “reasonable” gross profit margin. This concept of backing into an inventory based on the profit desired to be reflected generally is an indication of a pattern of inventory understatement. 3. The normal gross profit based on industry sources approximates 40 percent, whereas the gross profit percentages reflected on the tax returns of Saint’s Paint were 31.1 percent and 29.4 percent for the years ended September 30, 1993, and September 30, 1994, respectively. We believe this to be another indication of the understatement of the inventory, causing an understatement of the gross and net profit. Adjustment No. 4: Unreported Income. Based on our observations, it would appear that the majority of the sales of Saint’s Paint are properly recorded. However, our tests suggest that there is a level of unreported income — typically, cash sales retained by Ms. Wall rather than deposited in the company’s bank account.


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C.26 RUPERT FLOWTHRU’S PERSONAL CHECKING ACCOUNTS

437

As part of our investigative procedures, keeping in mind that Saint’s Paint has what we understand to be a fairly sophisticated computer system, we asked Ms. Wall for a printout of sales and purchases by product. This type of information would typically be very desirable for management for control purposes as well as for projecting future sales and needs. In addition, it is the type of information one would expect from the computerization that was evident. It would also be very helpful in that it provides detail as to the nature of what is being sold, which in turn provides valuable insight into what costs need to have been to generate those specific sales. Ms. Wall advised us that no such computer runs exist. Therefore, we proceeded with less satisfactory methods of verifying reported gross profit. We compared industry norms for gross profit (40 percent) to the reported gross profit (around 30 percent). A 10 percent variation is substantial and demands explanation. Secondly, we selected a number of sales invoices, noted what was sold on these invoices, traced the items sold to purchase invoices so as to determine their costs, and compared those costs to the sales amounts listed on the chosen sales invoices. Our tests illustrated varying profit margins that, when averaged in an approximation of a weighted sales mix, suggested that rather than the reported 30 percent gross profit, the actual gross profit was closer to 45 percent. As a result, it is our conclusion that the reported gross profit was understated. The above conclusion as to the gross profit is consistent with our conclusions relevant to the determination of an understatement of inventory. In fact, these two items are closely linked. Since it was our conclusion, as detailed above, that there was an inventory understatement, to the extent we concluded an understatement of gross profit, part of same is represented by the understatement of the inventory, with the balance being unreported sales (cash income). Our adjustment to interest expense is not a reflection that anything is improper or that this expense does not exist. Rather, it is not an operational expense. It relates to the acquisition of the company from its former owner, and thus constitutes acquisition indebtedness. Adjustment No. 5: Interest.

Adjustment No. 6: Depreciation. The figures reflected were taken from the tax returns. Since the Company is an S Corporation, the Section 179 first-year depreciation is not reflected as an operating expense but rather as an adjustment on the Form K-1. However, this extra depreciation is a tax fiction allowed by the IRS rather than a true reflection of the costs of depreciation. Therefore, we have “allowed” a reasonable depreciation of $2,000 on the $10,000 written off for the first of the two years as well as $2,000 of that again in the second year and $2,000 of the nearly $3,000 written off in the second year. 䊳

C.26 ANALYSIS OF RUPERT FLOWTHRU’S PERSONAL CHECKING ACCOUNTS, 1987 THROUGH 1992

There were frequent and recurring checks, ranging up to several hundred dollars, drawn to cash. This by itself is not unusual. However, there were recurring patterns of the endorsements on the back of these checks that are noteworthy. Exhibit C–77 is a brief analysis of the magnitude of checks payable to cash that were endorsed by Miss Matic, a known coin dealer:

Checks Payable to Cash.


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EXHIBIT C–77

Analysis of the Magnitude of Checks Payable to Cash

1987 1988 1989 1990 1991 1992

14 checks 12 23 20 16 11

$ 11,675 13,255 26,549 24,629 14,525 010,575

Total of the above

96 checks

$101,208

The magnitude and frequency of the cash checks endorsed by Miss Matic suggests that they were used to buy coins. During testimony, the issue of the personal auto expenses of Mr. Flowthru was raised. He indicated that he had two gas credit cards, and that he used them for his personal gas expenditures. Exhibit C–78 is an analysis of payments to gas companies for the years covered:

Checks Payable to Gas Companies for Gas Credit Cards.

EXHIBIT C–78

Analysis of Payments to Gas Companies

1987 1988 1989

1 check 1 check 2 checks

1990

3 checks

1991 1992

1 check No checks

Six-year total

8 checks 8 checks

$ 10.00 11.50 $ 80.65 01.04 81.69 13.40 12.30 20.50 46.20 20.00 000-0$169.39 169.39

A negligible amount of gasoline expense was paid by Mr. Flowthru personally over a six-year period. For the six-year period, the following is an analysis of the checks paid to auto dealers or repair shops on behalf of auto maintenance: Auto Maintenance.

• 1987: • 1988: • 1989:

none none 2 checks: one each in September and November; for $23.00 and $7.95, respectively; for a total of $30.95.


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439

• 1990:

6 checks: one each in February, May, August, September, November, and December; for $339.96, $21.10, $200.00, $157.16, $50.00, and $53.00, respectively; for a total of $821.22. • 1991: 4 checks: one each in February, June, July, and August; for $90.39, $25.52, $28.87, and $68.37, respectively; for a total of $213.15. • 1992: 2 checks: one each in August and September; for $10.07 and $249.98, respectively; for a total of $260.05. • The six-year total: $1,325.37. Exhibit C–79 is an analysis of water, telephone, electric/gas, and heating oil bills paid through the personal checking accounts of Mr. Flowthru from 1988 through 1992. Utility Bills.

EXHIBIT C–79

Analysis of Water, Telephone, Electric/Gas, and Oil Bills

Water

Electric/Gas

Oil

$

Avg/ Mo

$

Avg/ Mo

$

Avg/ Mo

$

Avg/ Mo

$ 78 63 138 160 165

$ 7 5 12 13 14

$2,600 1,221 367 339 384

$217 102 31 28 32

$1,263 1,571 1,423 1,261 1,536

$105 131 119 105 128

$1,816 1,659 2,302 -0-0-

$151 138 184 -0-0-

Year 1988 1989 1990 1991 1992

Telephone

The exhibit illustrates the modest amount for utility bills paid personally by Mr. Flowthru. We had been advised that he has extremely high oil bills because of his large house. In fact, we found that for 1991 and 1992 he paid no oil bills through his personal accounts. However, we do know that Flowthru Products Company paid a significant number of fuel oil bills. Exhibit C–80 is a detailing of the legal bills paid by Mr. Flowthru through his personal checking accounts.

Legal Bills.

EXHIBIT C–80 Month/Year October 1988 January 1989 March 1989 June 1989 December 1989 December 1989 1990 1991 1992 FIVE-YEAR TOTAL

Legal Bills Paid by Mr. Flowthru Payee

Amount

Underling Overling Ling-Ling Hop Skip Jump

$ ,200.00 1,333.87 500.00 308.80 192.00 20.00 -0-00,000- 0 $2,554.67 2.554.67


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The exhibit indicates that in the five-year period 1988 through 1992, Mr. Flowthru personally paid a total of $2,554.67 in legal bills. This was during a period when there were significant legal proceedings in matrimonial and other areas affecting Mr. Flowthru. Flowthru Products Company paid the vast bulk of his legal expenses. Internal Revenue Service. In addition to the preceding, on July 4, 1990, Mr. Flowthru drew a check for $10,000, from his Hidden Bank account, payable to the IRS. This check cannot be accounted for from his known/supplied tax returns. Similarly, an August 1989 check for $14,786.33, payable to the IRS, cannot be accounted for from his tax returns. Matters Relevant to the Bank Accounts of Rupert Flowthru. We repeatedly requested copies of all the bank statements (checking and savings) and other indicia of savings of Mr. Flowthru. We were supplied with records relevant to just two checking accounts: the joint checking account of Rupert and Lizz Flowthru at First Regional Bank, #02-0070000; and the checking account of Rupert Flowthru at First Infidelity National Bank, #007-0069. Despite the existence of savings and/or certificate of deposit interest income on the tax returns of Mr. Flowthru, no records relevant to such were produced. Furthermore, investigation of the endorsements on the back of various joint account checks indicated the existence of at least two other accounts: #0812345 at First Regional Bank in the name of Rupert Flowthru; and #123456 at Hidden Valley Bank. Exhibit C–81 is a listing of checks drawn by Mr. Flowthru against the joint account, the disposition or use of which we have been unable to ascertain based on records made available date.

EXHIBIT C–81 #519 544 532 547 546 548 550 551 553 554 555

Checks Drawn by Mr. Flowthru

10/24/88 10/01/90 12/21/90 03/14/91 04/11/91 05/06/91 06/27/91 10/01/91 12/22/91 03/12/92 04/06/92

R.F. Cash Cash Cash Cash Cash Cash Cash Cash Cash Cash

$

5,000 16,800 33,600 48,325 100,000 16,800 25,200 25,200 33,600 200,000 70,000

The exhibit represents $574,525 of checks drawn by Rupert Flowthru out of funds owned jointly with Lizz Flowthru, all but $5,000 payable to “cash,” the use of which has not be explained. It should be further explained that the above-referenced joint account was in the sole possession of Mr. Flowthru, and from 1988 through 1992, the only transactions therein were the depositing of joint distribution checks by Mr. Flowthru and the simultaneous withdrawal of same by Mr. Flowthru — by checks payable either to himself or to cash.


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441

Exhibit C–82 is a listing of deposits, of $10,000 or more, to Mr. Flowthru’s account #007-0069 at First Infidelity, the sources of which we have been unable to deduce: EXHIBIT C–82 01/09/89 03/14/89 04/03/89 06/30/89 04/16/90 07/24/90 05/01/92

Listing of Deposits > $10,000 $ 22,500 93,769 10,000 20,100 108,145 12,000 253,138

Exhibit C–83 is an incomplete listing, derived from the incomplete copies of statements of Mr. Flowthru’s account #007-0069 at First Infidelity, of checks of $10,000 or more, drawn on that account, the use of which we have been unable to deduce:

EXHIBIT C–83 04/27/88 03/16/90 05/04/90 07/27/90 08/08/90 03/18/92 05/01/92

Incomplete Listing of Account $ 10,002 130,000 95,941 10,000 10,800 18,850 86,554

Tax Returns of Rupert Flowthru, 1988 Through 1992. Months after we requested, we were supplied with alleged copies of Mr. Flowthru’s tax returns for 1988 through 1992. We found that these returns raised a number of issues compelling enough to request authenticated, certified copies directly from the Internal Revenue Service. We have not yet been granted authorization to so obtain these returns. The issues raised include the following:

1. In a few instances, for the federal and state returns, a copy of the check in payment of the tax balance was attached. These attached checks have a number of apparent or potential defects as follows: A. They are unnumbered. B. There are no cancellation marks from the bank. C. We cannot find any of the checks on the partially submitted bank statements of Rupert Flowthru. 2. Despite his salary of over $100,000 a year and total income ranging from $300,000 to over $500,000 a year in each of the years 1988 through 1992, his


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income from sources other than Flowthru Products never exceeds $1,000 and, in fact, in 1991 there was no other income. 3. The returns were missing certain key schedules that were indicated on the return as being attached, yet not submitted to us. 4. The returns submitted reflected various inconsistencies in typing and reproduction quality; the 1991 return was handwritten whereas the returns for other years were typed; there are some (minor) arithmetic errors on the returns; we cannot reconcile the deduction for state and local income taxes to known information; the typing on the 1989 Form Schedule A is different than the typing on the rest of the return. Notes to Reconstruction of Income and Expenditures of Rupert Flowthru SUMMATION: The schedule in Exhibit C–84 suggests possible irregularities or

unknowns. It would appear that Mr. Flowthru has other sources of funds not revealed to us. EXHIBIT C–84

Flowthru v. Flowthru Reconstruction of Income and Expenditures of Rupert Flowthru 1988 through 1992

INCOME — PER TAX RETURNS Salary— Flowthru Products Interest income Distributions from Flowthru Products Less: distribution received following year Add: previous year’s distribution received Miscellaneous TOTAL KNOWN/ ADMITTED INCOME RECONSTRUCTION OF EXPENDITURES Stock purchase — Flowthru Products Personal (pocket money) — Note 1 Food — Note 2 Home and lawn maintenance — Note 2

1988

1989

1990

1991

1992

$100,710 937

$122,736 450

$119,360 342

$140,853 -0-

$114,168 3,000

197,934

244,770

245,568

441,439

-0-

(113,089)

(148,970)

(161,569)

(349,089)

(- 0 -)

56,152 -0-

113,089 006,800

148,970 001,875

161,569 003,600

349,089 0,00038

242,644

338,875

354,546

398,372

466,295

-0-

23,920

-0-

-0-

-0-

6,387 5,142

7,514 6,049

8,840 7,117

10,400 8,373

11,960 9,850

5,377

6,325

7,422

8,755

10,300


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C.26 RUPERT FLOWTHRU’S PERSONAL CHECKING ACCOUNTS,

EXHIBIT C–84

443

Flowthru v. Flowthru Reconstruction of Income and Expenditures of Rupert Flowthru 1988 through 1992 (continued) 1988

1989

Utilities (electric, gas, and oil) — Note 2 3,320 Telephone — Note 2 656 Sundries — Note 1 2,211 Auto expense — Note 3 -0Clothes — Note 2 7,873 Gifts and entertainment — Note 3 -0Contributions — Note 4 5,805 Federal and state taxes — Note 4 135,560 Less taxes paid following year — Note 4 (88,080) Add previous year’s tax paid — Note 4 83,452 Real estate taxes — Note 4 1,745 Mortgage interest — Note 4 2,097 Vacations — Note 2 5,249 Tangible personal property acquisitions — Note 5 132,471 Child care expenses — Note 4 1,037 Other interest — Note 4 6,562 Miscellaneous deductions — Note 4 7,639 Payments to acquire Proctology Associates 33,333 Mortgage principal payments — Note 6 4,779 Insurance — Note 2 004,461

1990

1991

1992

3,906 729 2,601 -08,748

4,595 810 3,060 -09,720

5,406 900 3,600 -010,800

6,360 1,000 4,140 -012,000

-06,162

-07,590

-08,647

-04,167

164,402

177,061

358,171

54,038

(108,880)

(112,297)

(286,554)

88,080 1,856 2,097 5,832

108,880 1,739 2,494 6,480

112,297 1,851 3,809 7,200

286,554 2,104 2,889 8,000

186,649

307,825

234,508

168,906

2,300 7,073

-06,881

-04,556

-03,977

17,024

16,723

1,265

1,667

33,333

33,333

33,333

33,333

4,779 004,957

4,382 005,508

3,067 006,120

3,683 006,800

-0-

TOTAL EXPENDITURES

367,076

475,456

608,183

536,504

631,728

INCOME (DEFICIENCY)

($124,432)

($136,581)

($253,637)

($138,132)

($165,433)

SUMMARY FOR 1988 THROUGH 1992: Total Income Total Expenditures Income (Deficiency)

Note 1: Personal and Sundries.

$1,800,732 2,618,947 $ (818,215)

These items were estimated.

Note 2: Food, Home and Lawn Maintenance, Utilities, Telephone, Clothes, Vacation, and Insurance. These items for 1992 were taken directly from Rupert Flowthru’s


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expense budget statement, submitted in this present action, and reduced successively by 15 percent per year (for food, home and lawn maintenance, and utilities) and by 10 percent per year (for telephone, clothes, vacations, and insurance) for the years 1991 through 1988. These items were not on Mr. Flowthru’s budget and, therefore, were treated as being paid in total by the Company. Note 3: Auto, Gifts, and Entertainment.

Note 4: Contributions, Taxes, Interest, Child Care, and Miscellaneous Deductions.

These items were taken directly from Mr. Flowthru’s tax returns. This item was calculated based on purchase invoices made available to us from sundry sources.

Note 5: Tangible Property.

This item was based on Mr. Flowthru’s budget, after reduction of real estate taxes and mortgage interest as per his tax returns. Note 6: Mortgage Principal.

䊳

C.27 ON THE VERGE PSYCHOTHERAPY CENTER

The practice know as On the Verge Psychotherapy Center was founded by Dr. George Verge in 1984 and is located in a small suite of offices in a modern office building in Suburban, New Jersey. The offices are modestly appointed and reasonably well maintained. There are a few conference/ meeting rooms utilized by Dr. Verge as well as various associates/tenants. Under the umbrella of On the Verge Psychotherapy Center, using a fee-sharing/rentaltype arrangement, Dr. Verge has permitted other psychotherapists to operate from the offices. We encountered a number of significant problems and obstacles in attempting to fully and timely analyze and review the books and records of the practice (see Exhibit C–85). Among the problems we faced were the following: Background and Commentary.

• • • • • • • • • • • •

Customary bookkeeping/accounting records were almost completely absent. Formal cash receipts journals did not exist. Formal cash disbursements journals did not exist. Check registers were incomplete and did not account for all checks written. Various canceled checks were missing. Bank statements were not accompanied by their respective canceled checks. Checks were not always written or used in numerical sequence. Deposit slips were not available. Financial records were poorly organized. Various transfers between bank accounts were not documented. There were no accountant’s worksheets to support and/or tie into tax returns. The lack of a normal insurance billing system further complicated the tracing of income. • There was no apparent accounts receivable system. Dr. Verge’s only admitted business checking account is Second Fidelity Regional Bank account #333-222-1. Per Dr. Verge, deposits are made once a week


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445

and consist primarily of checks received from insurance companies and patients. Since most of his patients have insurance, the majority of deposits are insurance monies. Dr. Verge accumulates session fees and submits bills to insurance companies about every three to four months. Inasmuch as Dr. Verge allegedly discards all deposit slips upon verification of bank statements and credits, it was not possible for us to review any deposit slips. Therefore, it was not possible for us to ascertain whether or not Dr. Verge (as per his advice to us) customarily settled for only the insurance proceeds and virtually never pressed patients for the difference (and whether or not any cash was deposited). Our reconstruction of Dr. Verge’s fee income based on his own appointment books and insurance records prove the existence of substantial unreported income. Inasmuch as the reported (and deposited) funds have been utilized to maintain his standard of living or have been otherwise withdrawn, it is our conclusion that a significant cash hoard must exist — that Dr. George Verge has, or controls, or has access to, a significant pool of cash or other assets that he has not as yet acknowledged. Such a cash hoard logically has accumulated at the rate of at least $50,000 per year over the last several years. We estimate such hoard to approximate $300,000 to $500,000. EXHIBIT C–85

Letter re: Verge v. Verge

Rebecca D. Artsy, Esq. 380 Foothill Road Bridgewater, NJ 08807 Re: Verge v. Verge Dear Ms. Artsy: At your request, on behalf of Gillian Verge, we have prepared this report to assist in the above matter as to the determination of the income derived from the On the Verge Psychotherapy Center by Dr. George Verge. It is our conclusion that Dr. George Verge’s annual income derived from the On the Verge Psychotherapy Center approximates $250,000 to $300,000. We have further concluded that a cash hoard exists, and that it approximates $300,000 to $500,000. This report should not be considered as an audit in accordance with generally accepted auditing standards but rather as an investigatory valuation prepared for the purposes of determination of income as stated above. Very truly yours, Kalman A. Barson, CPA Member of the Firm KAB/dcl cc: Gillian Verge


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Inasmuch as the nature of On the Verge Psychotherapy Center is an unincorporated sole proprietorship reflected on Dr. George Verge’s tax return as a Schedule “C,” there is no requirement on the tax return to reflect a balance sheet. Furthermore, as indicated earlier in this report, the nature of the record keeping is such that no formal balance sheet is maintained. Therefore, in order to understand not only the goodwill of the practice, but also the various assets and liabilities, certain calculations and estimates are necessary (see Exhibit C–86). On the Verge Psychotherapy Center Reconstructed Book Value.

Dr. Verge advised us, and our review of his records tend to support, that he submits bills to insurance companies approximately every three to four months. Therefore, accounts receivable billed to insurance companies (based on payments within 60 to 90 days) would approximate three to four months of gross revenues. For this purpose, we are using only the reported revenues — believing that the unreported revenues are cash income that, for the most part, do not constitute receivables at any time (that is, the funds are collected as the services are rendered). It is certainly possible, however, that some part of this unreported income (see Exhibit C–87) would represent accounts receivable, which would tend to make these figures even larger. Since the reported revenues approximate $15,000 per month, we estimate that the accounts receivable approximate $50,000. Accounts Receivable.

This element constitutes, in effect, the unbilled accounts receivable. That is, during the time frame between rendering services and billing the insurance companies, there is an additional build-up of services rendered for which bills have not been submitted to the insurance companies. In other words, if every three months bills are submitted to the insurance companies for reimbursement, and if the insurance companies take 60 days to reimburse, then by the end of that 60-day period, there is outstanding not only the receivables from the insurance companies but also two additional months of services not yet billed — therefore constituting the equivalent of work in progress or, in effect, unbilled receivables. We have assumed that this approximates typically one month’s revenues — or $15,000. Depending on the cutoff time frame (that is, whether we are dealing with receivables and work in progress near the end of a billing submission cycle or near the beginning), the receivables to work-in-progress relationship might reverse. However, in general, the aggregate should be approximately constant. The sum of the above receivables of $50,000 and the work in progress of $15,000 amounts to $65,000. Inasmuch as this represents anticipated near-term receipt of income, which upon receipt is fully taxable, it would be appropriate to apply a tax burden against that income. During the most recent years, the effective tax bracket for the Verges was 30 percent. Therefore, these receivables and work in progress are considered at their net value of $45,500. Work in Progress.

Accounts Payable. Just as it is necessary to reflect the extent of receivables and unbilled services as an asset, it is important to reflect the extent of accounts payable as a liability. Our review of disbursements subsequent to the complaint date indicate no unpaid or accruable liabilities existed.


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EXHIBIT C–86

447

Verge v. Verge On the Verge Psychotherapy Center Comparative Statements of Operations as Reported

Gross professional fees

1990

1989

1988

1987

$201,858

$187,604

$154,233

$157,121

Other income

065,280

022,049

027,469

056,796

Gross Revenue

267,138

209,653

181,702

213,917 6,961

Expenses Automobile Depreciation and amortization

0

0

4,189

2,705

2,705

2,705

0

0

1,903

1,038

1,049

13,491

0

0

28,423

Insurance Commissions/fee sharing Legal and professional fees

0

5,591

850

0

5,327

596

1,552

1,867

26,065

25,057

10,553

12,323

4,650

2,546

1,461

1,710

0

3,717

1,948

0

17,902

13,619

6,575

8,859

000,238

004,607

006,858

007,005

Total Expenses

070,378

060,341

037,729

068,197

Net Income as Reported

$196,760

$149,312

$143,973

$145,720

Office expense and sundries Office rent Taxes Travel and entertainment Utilities and telephone Office cleaning

EXHIBIT C–87

Verge v. Verge On the Verge Psychotherapy Center Adjustments to Statements of Operations 1990

1989

1988

1987

$196,760

$149,312

$143,973

$145,720

Unreported income

80,562

81,154

82,935

78,751

Rent income

10,000

10,000

0

0

Automobile

(1,200)

(1,200)

2,989

5,761

Net Income — as reported Adjustments:

Legal and professional fees

0

5,591

Utilities and telephone

005,000

005,000

850

Total Adjustments

094,362

100,545

085,274

084,512

ADJUSTED NET INCOME

(1,500)

0 000,000

291,122

249,857

229,247

230,232

Remove other income

(65,280)

(22,049)

(27,469)

(56,796)

Remove commissions/fee sharing

013,491

000,000

000,000

028,423

$239,333

$227,808

$201,778

$201,859

ADJUSTED NET INCOME FROM SERVICES


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SAMPLE REPORTS

Notes to Reconstruction of Income

As per our detailed review of Dr. George Verge’s patient appointment books, days worked for 1987 through 1990 were as shown in Exhibit C–88: Note 1.

EXHIBIT C–88

Days Worked, 1987 to 1990 Total Days Worked

Weekdays

Saturdays

1987

297

249

48

1988

300

249

51

1989

300

253

47

1990

274

249

25

Calendar Year

Note 2. As per Dr. Verge, sessions average 45 minutes. Morning appointments may be scheduled on the hour; however, afternoons are busier, and patients are often scheduled back to back. This results in very efficient time utilization. We counted patient names entered on various days of the appointment book and determined an average number of patient visits per day. Our analysis indicated Dr. Verge typically has 12 to 15 patients per weekday and 6 to 7 on Saturdays. We used 12 and 6, respectively, for conservatism. Fifteen sessions per day at .75 hour for 5 days, plus 7 sessions on Saturday at .75 hour totals 82 sessions per week — or 61.5 hours. Our use of 12 sessions per day and 6 on Saturday totals 66 per week — or 50 hours. Per Dr. Verge, his weekday hours range between 9:30 and 10:30 A.M. until 10:00 or 11:00 P.M. (12 to 13hour days), and on Saturdays he is in the office from 11:00 A.M. to 4:00 P.M. (5-hour days). Therefore, as per Dr. Verge, his typical workweek is 65 to 70 hours. Our reconstruction shown in Exhibit C–89 implicitly and amply allows for missed appointments and unscheduled time (neither of which seems to be the case, based on his appointment books and his advice to us), as well as administrative time (which appears to be minimal). Note 3. Dr. Verge provided us with annual income summaries of patient receipts, by patient name, which he represents as his total Schedule C fee income and which is provided to his accountant for tax preparation purposes. Any commissions, rents, or collections Dr. Verge received from his associates working out of and utilizing his office space are treated separately.

We reviewed a representative sample of Dr. Verge’s patient files. Information obtained from such files (to the extent so recorded) included patients’ history of confirmed appointment dates, payments received, insurance company remittances, and annual income reported by year for the timespan patients were receiving counseling. Note 4.

Examination of patient files referred to in Note 4 revealed documentary evidence, either from insurance claims filed or from collections noted for sessions, as to the session rates charged during the period. We noted several group

Note 5.

448

12

2,988

2. Average daily appointments — Note 2

3. Estimated annual appointments (line ⫻ 2 line 2)

157,121

46,555

8. Gross patient fee income reviewed (patient files line 5)

30.8

6. Percentage of patient files reviewed (line 5 divided by 4)

7. Gross patient fee income per detailed Schedule C gross income sheet referred to on line 4

33

107

3,276

Total

5. Number of patient files reviewed — Note 4

288

6

48

Sat.

2,988

12

249

Weekdays

306

6

51

Sat.

1988

67,330

154,233

34.8

39

112

3,294

Total

3,036

12

253

Weekdays

282

6

47

Sat.

1989

104,834

187,604

42.3

63

149

3,318

Total

2,988

12

249

Weekdays

150

6

25

Sat.

1990

106,945

201,858

53.6

90

168

3,138

Total

1:26 PM

4. Number of patient entries listed on detailed Schedule C gross income sheet — Note 3

249

Weekdays

1987

Verge v. Verge On the Verge Psychotherapy Center Reconstruction of Income

10/22/01

1. Working days — Note 1

EXHIBIT C–89


449

450 $235,872

$078,751

12. Annual appointments ⫻ average discounted rate (line 3 ⫻ line 11)

13. Excess of actual revenues over reported gross income — unreported income (line 12 less line 7)

$72

11. Discounted/Adjusted session rate — Note 6

29.6

Total

Weekdays Sat.

$082,935

$237,168

$72

$80

43.7

Total

Weekdays Sat.

1989

$081,154

$268,758

$81

$90

55.9

Total

Weekdays

Sat.

1990

$080,562

$282,420

$90

$100

53.0

Total

1:26 PM

$80

Sat.

1988

10/22/01

10. Average session rate — Note 5

Weekdays

1987

Verge v. Verge On the Verge Psychotherapy Center Reconstruction of Income (continued)

9. Percentage of gross fee income reviewed to total Schedule C reported income (line 8 divided by 7)

EXHIBIT C–89



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C.28 WOULD YOU BUY A USED CAR FROM THIS MAN?

451

and family sessions for which one session yielded a multiple of the usual single counseling session fee. Such data would have distorted our conclusions and have not been included herein. This represents another conservatism factor in our calculations. Rates varied from patient to patient, year to year, as well as within a year due to fee increases and, per Dr. Verge, a patient’s ability to pay. Insurance companies often paid 80 percent of total fees charged until a level was met, at which time 100 percent collection was realized from insurance proceeds. We reviewed our sample data and have discounted the standard fee per session by a 10 percent factor to allow for rate variations and alleged discounted rates to various patients. Note 6.

䊳

C.28 WOULD YOU BUY A USED CAR FROM THIS MAN? Among those areas that are most notorious for bad jokes, and where accusations of questionable tactics fly left and right, is the used car sales operation. We faced such a situation not long ago in our investigation of an individual whose business was the buying and selling of used cars. To begin with, the accounting/financial records were in poor condition. Various requested items were missing, and little reliance could be given to the numbers that were supplied. In addition, it was obvious, based on the tax returns (financial statements were not an issue in that there simply were none), that the gross profit margin as indicated on the returns was significantly at odds with (less than) the typical gross profit percentage that one would expect in a used car operation. Fortunately, this type of business usually maintains a form of a job cost system. That is, each item being sold is a very determinable and discernible item — a singular product. Even in this case, even as bad as the records were, we did have, for some of the months within a few-year period, the inventory records by car — maintained on a perpetual inventory card system. These cards were used to, in effect, keep a running inventory on the cost of each of the items being sold — a job cost concept. A car would be purchased from a wholesaler or an individual, a card would be established for that car, and any additional expenses (such as an engine overhaul, body repairs, and the like) would be entered on this card so that, at a glance, you could tell immediately what the hard costs of that asset were and, therefore, what you would need it to be sold for to get a fair return. Also entered on those cards, when the car was sold, was the actual sales price. Therefore, we had in one available source a significant amount of usable financial data as to the company’s products. Best of all, this source was independent of the company’s reported cash flow. We did a detailed analysis of three months of sales (the cards for the cars were filed by month of sale), scheduling the details of each car that was sold, the costs of that car, and the sales price. By using this approach, we were able to determine a representative gross profit margin. We then compared that to what was reported and determined that there was a significant amount of unreported income. Our analysis showed that for February 1989, the wholesale gross profit was 8.13 percent; for April 1989, 10.46 percent; and for May 1989, 9.18 percent — a straight average for the three months of 9.26 percent; a weighted (in proportion to sales volume) average of 9.07 percent. This contrasted sharply with representations to us that the wholesale operation barely broken even. Furthermore, the


452

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entire (wholesale and retail) year’s operations reportedly (per tax returns) averaged a 6.1 percent gross profit. Cards for cars sold at retail were not available. In addition, our analysis of the sales journals, as available (the detail described below was not available for more than the periods that we have indicated), highlighted the following: For the fiscal year July 1988 through June 1989, wholesale sales represented approximately 63 percent of total sales (we indicate approximately, since there were some relatively minor discrepancies between the total analyses per the sales journal as versus the tax returns) with the retail sales, therefore, being approximately 37 percent of total sales. This percentage relationship was fairly constant in each half of the fiscal year. For the period July 1989 through December 1989, the first half of the 1989– 1990 fiscal year, in a year when total sales increased 42.3 percent over the prior year, the proportion of wholesale sales to total sales decreased from 63 percent to approximately 53 percent, with retail sales increasing from 37 percent to approximately 47 percent. Therefore, taking into account that retail sales had a greater (than wholesale) profit margin, it was clear that the reported profit was understated. To augment our statistical data, we also obtained gross profit data from three other sources: Robert Morris Associates Annual Statement Studies: gross profit typically 18.5 to 20.5 percent. Controller at a car-leasing company: gross profit typically 20 percent. Another CPA (an auto industry expert): gross profit typically 20 percent. To reconstruct the actual (or more likely) gross profit, we did the following calculation: Based on our test sample, wholesale gross profit was 9 percent. Based on our outside sources, retail gross profit was 20 percent. 63% of sales that were wholesale ⫻ 9% gross profit ⫽ 37% of sales that were retail ⫻ 20% gross profit ⫽ Reconstructed Gross Profit

5.7% 07.4% 13.1%

Therefore, it was our conclusion that the true gross profit was 13 percent, from which we allowed a 10 percent (of 13 percent) reduction for conservatism and the possibility of a poorer than average realization, resulting in a determined gross profit of 11.7 percent, or conversely, a cost of goods sold of 88.3 percent. Under the assumption that the costs were fully reflected, with reported cost of goods of $1,856,578, at 88.3 percent, sales would have had to have been $2,102,580. Since


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reported sales were $1,976,375, it was our conclusion that sales (income) were understated by $126,205 for that year. 䊳

C.29 PLEASANT VALLEY ANIMAL HOSPITAL. Another type of business in which our work resulted in numerous adjustments involved a veterinary practice (see Exhibit C–90).

EXHIBIT C–90

Harmony v. Harmony Pleasant Valley Animal Hospital Statement of Operations For the Years Ended December 31, 1991

1990

$320,309

$293,033

64,970 61,825 4,568 9,868 3,548 5,332 24,180 000,967

49,677 49,486 5,277 6,992 4,868 2,853 26,382 005,251

175,258

150,786

GROSS PROFIT FROM OPERATIONS

145,051

142,247

OPERATING EXPENSES Auto expense Dues and subscriptions Insurance Office supplies and expense Professional fees Miscellaneous expense Telephone Advertising and promotion Interest expense Office cleaning Ground maintenance Cremations

6,891 3,347 6,125 7,036 5,508 1,831 5,038 1,685 29,001 4,609 3,866 003,251

5,218 3,200 9,119 4,321 1,750 1,638 1,996 586 32,470 4,065 2,046 00,00—

078,188

066,409

$ 66,863

$ 75,838

FEES COLLECTED COST OF REVENUES Drugs and other medical supplies Salaries and wages Repairs and maintenance Utilities Lab fees Payroll taxes Depreciation Outside labor COST OF REVENUES

TOTAL OPERATING EXPENSES OPERATING INCOME


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EXHIBIT C–91

Harmony v. Harmony Pleasant Valley Animal Hospital Adjustment to Reported Net Income For the Years Ended December 31, 1991

OPERATING INCOME

$ 66,863

ADJUSTMENTS: Car and truck expense — Note 1 Depreciation —vehicles — Note 2 Dues and publications — Note 3 Insurance — Note 4 Legal and professional fees — Note 5 Office expense — Note 6 Supplies and drugs — Note 7 Utilities and telephone — Note 8 Lab fees — Note 9 Interest to Dr. Alyssa — Note 10 Depreciation — building — Note 11 Rent — Note 12 Salaries and casual wages — Note 13 Interest on vehicles — Note 14 Change in accounts payable ADJUSTED NET INCOME

2,756 4,667 673 — 4,508 350 3,976 3,379 799 23,315 11,667 (17,475) — 1,271 9,110 $115,859

1990 $ 75,838 3,261 7,094 300 3,062 700 198 1,496 1,100 — 23,643 11,667 (16,130) 4,500 1,547 (9,110) $109,166

Notes to Adjustments Note 1: Car and Truck Expense. For each of the years we reviewed (see Exhibit C–91), between 50 and 60 percent of gasoline charges were for out-of-state travel. In addition, we noted gasoline and repair charges for vehicles other than for Dr. Emma Harmony’s 1989 Suburban (which is recorded as the business auto). For 1990 and 1991, 20 percent and 50 percent, respectively, of car and truck expenses were charged to Dr. Harmony’s drawings. Taking into account the above two factors, and also considering Dr. Harmony’s normal commutation between home and her practice, personal use is at least 70 percent. We have therefore adjusted income to reflect 30 percent business use as shown in Exhibit C–92.

EXHIBIT C–92

Adjusted Income

Total car and truck expenditures before personal use allocation Business use percentage Amounts charged to expense Adjustment to income

1991

1990

$13,782 30%

$ 6,523 30%

4,135 06,891

1,957 05,218

$ 2,756

$ 3,261


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We have added back 70 percent of depreciation on the business auto for the reasons discussed in Note 1 above. In addition, in 1990 we added back $2,300 for a horse trailer deducted under § 179 of the Internal Revenue Code. It is our understanding that this trailer serves no business function and is used for personal purposes.

Note 2: Depreciation.

Note 3: Dues and Subscriptions. Based upon our review, we noted the inclusion of personal expenses, such as payments to a gymnastic school, health and racquet club fees, and sewing club dues, which amounted to $300 for 1990 and $673 for 1991. We have accordingly added these amounts back to income.

Based upon our review of insurance expense for each year, we noted that various life insurance policies, homeowners’ insurance, and auto and motorcycle insurance on nonbusiness automobiles were being paid by the company. For 1991, these amounts were charged to Dr. Harmony’s drawings account and thus no adjustment is necessary. However, these premiums were deducted as business expenses in 1990. Therefore, we have added them back to income. Note 4: Insurance.

Included in professional fees for 1991 were payments to Danielle & Benjamin—totaling $2,408—for representing Mr. Harmony in a personal lawsuit. In addition, $1,500 paid to Cohen & Shah for their representation of Dr. Harmony in the complaint at hand, $12 paid for personal financial planning, and $588 paid for personal medical care were expensed. These are clearly personal expenses. In 1990, there were similar, though considerably lesser, payments requiring adjustment. Note 5: Legal and Professional Fees.

Expenses of a personal nature, including clothing and dry-cleaning bills, were noted in our review of this expense category.

Note 6: Office Expense.

In our review of expenses for supplies and drugs for 1991, we noted $3,479 included therein for personal medical bills, mainly payments to the Amanda Rehabilitation Center for Mr. Harmony. The figure also included dental fees as well as $160 in personal utility bills and $337 to Sam’s Apothecary. Upon examination of the Apothecary invoices, it was noted that the merchandise purchased was clearly personal in nature, for example, shampoo, deodorant, and condoms (extra large size). For 1990, we examined three months of activity and noted basically similar payments to Sam’s Apothecary totaling $309 and doctor’s bills totaling $640. To estimate the total personal expense to be added back for the year, we annualized the results of our analysis. Note 7: Supplies and Drugs.

Based upon our review, we noted $2,179 in telephone and utility bills for the Harmonys’ personal residence paid by the business in 1991. No such expenses were noted for 1990. In addition, the business paid all the fuel oil bills — including those for the marital residence, estimated to be $1,200 in 1991 and $1,100 in 1990.

Note 8: Utilities and Telephone.

Note 9: Lab Fees. We noted personal medical and dental expenses totaling $799 in our review for 1991, which we have added back to income. No such personal expenses were found to be included in 1990.


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Treated as business deductions were interest expenses of $23,315 in 1991 and $23,643 in 1990 paid to Dr. Alyssa (Dr. Harmony’s predecessor and former partner). This interest was for the purchase of the practice and the real estate on and in which it is located. Thus, these are not business operational expenses but rather either costs of acquiring the business (personal investmenttype expense of Dr. Harmony) or a landlord’s costs of carrying real estate. Therefore, we have added these expenses back to income. Note 10: Interest.

Note 11: Depreciation on Building. Similarly to the interest (Note 10) on the real estate, the depreciation on the building (though not on medical equipment or fixtures) has been added back to income. It is a tax cost of building ownership, not a practice operational expense.

The practice has not been charged rent because the premises on which it operates are owned by Dr. Harmony. However, it has been charged with the costs of real estate ownership — interest and depreciation (Notes 10 and 11) — which we have added back. The practice should be charged with a fair rental expense, which we have determined in accordance with that paid to Dr. Alyssa in 1989, presumably an arms-length fair rent. We increased that by 20 percent for 1990 and by 30 percent for 1991. In addition, the practice pays the real estate taxes.

Note 12: Rent.

In 1990, a year-end journal entry charged the practice $4,500 (as wages and casual labor) for services allegedly rendered by Ruth Harmony (Dr. Harmony’s daughter) ($2,000) and by Mr. Harmony ($2,500). These are not legitimate business expenses.

Note 13: Salaries and Wages.

We have added back to income, as personal, nonbusiness expenses, 70 percent of the interest on a GMAC loan and 70 percent of one-fifth of the interest on a loan from First Loyalty Bank. As to the latter, onefifth of the total loan proceeds were used for the purchase of the company vehicle. Note 14: Interest on Vehicles.

䊳

C.30 BUSH V. BUSH, POLLEN HEAVEN, INC., COMPANY HISTORY. The Company was incorporated in 1947 in the State of Bliss and was initially owned by four investors, which included Burning Bush. Three of their sons, Rose, Thorn, and Gar, became active in the business during the 1970s with the three brothers eventually coming to own the entire Company. The ownership of the Company is currently comprised as follows:

Brow Beaten Hubby (Rose Bush) Brother of Brow Beaten Hubby (Thorn Bush) Other Brother of Brow Beaten Hubby (Gar Bush)

47.5% 47.5% 5.0%

The Company is in the wholesale flower and related supplies business. Originally located in Moscow, the Company moved its facilities and all activities to Brazil in September 1987. The Company leases its warehouse and office space from a related party, Realty R U Associates. The Company’s customer base consists primarily of local retail florists with fresh-cut flowers representing approximately 70 percent of sales and related supplies the remainder. Targeted gross


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profit margins are 20 percent and 35 percent on the fresh-cut flowers and related supplies, respectively. The Company’s sales (see Exhibit C–93) are very much seasonal since it is dependent on major holidays such as Valentine’s Day, Mother’s Day, Fast of the Sacred Snapdragon, Easter, and Christmas for the majority of its sales. In addition, the local weather can be of concern due to its effect on fresh-cut flowers, which are highly perishable. Market share of the Company is very small, with the overall market for freshcut flowers very fragmented but stable. The Company relies on telemarketing and distributes its products by means of its own fleet of delivery trucks. The Company is not reliant on any one major customer and finds its clientele to be very price sensitive, with price being the selling feature. Pricing policies are set based on cost plus a industry determined mark up. Marketing activities are done in-house and activities include special day promotions, some mailings, and Internet advertising. Competition in the industry is strong and drives prices. The Company’s major competitors are mainly other Brazilian flower wholesalers. Most of these wholesalers are of equivalent size or larger. Key personnel consist of Rose Bush, 49 years old, president, with BA in communications, who concentrates activities in purchasing and office management, and Thorn Bush, 45 years old, secretary, with a BA in History, who concentrates activities in sales and distribution. EXHIBIT C–93

Bush v. Bush Pollen Heaven, Inc. Statements of Income (Unadjusted) Years Ended December 31

Net Sales Cost of Sales Inventory beginning Purchases — materials Freight Store expenses Utilities Less: ending inventory Total Cost of Sales Gross Profit General and Administrative Expenses Officers’ compensation Salaries and wages Repairs Rents Taxes Interest Depreciation Advertising Commissions Bank charges Dues and subscriptions

1999

1998

1997

$6,805,197

$6,396,967

$6,211,930

$1,155,568 $4,461,180 $1,235,939 $1,127,751 $1,130,391 $1,(214,318)

$1,151,768 $4,109,042 $1,245,514 $11,22,761 $11,34,539 $1,(155,568)

$1,141,367 $3,981,081 $1,281,020 $1,124,232 $1,130,578 $1,(150,768)

$4,696,511

$4,407,056

$4,307,510

$2,108,686

$1,989,911

$1,904,420

$1,360,187 $1,829,442 $1,111,491 $1,120,000 $1,137,337 $1,118,849 $1,177,809 $1,125,653 $1,1111— $1,118,013 $1,111,454

$1,334,467 $1,750,243 $1,111,109 $1,120,000 $1,115,261 $1,115,974 $1,164,948 $1,136,211 $1,1111— $1,114,927 $1,111,054

$1,295,268 $1,755,276 $1,121,272 $1,120,000 $1,116,889 $1,118,812 $1,137,847 $1,134,720 $1,1111— $1,114,264 $1,111,184


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EXHIBIT C–93

Bush v. Bush Pollen Heaven, Inc. Statements of Income (Unadjusted) Years Ended December 31 (continued) 1999

1998

1997

$1,111,176 $1,1111— $1,183,376 $1,116,101 $1,111,450 $1,121,426 $1,163,795 $1,128,506 $1,113,775 $1,150,650 $1,116,410 $1,117,034 $1,1111— $1,121,288 $1,116,670

$1,113,769 $1,112,138 $1,105,865 $1,198,848 $1,$1,1547 $1,120,225 $1,197,841 $1,116,772 $1,119,786 $1,153,065 $1,119,026 $1,113,612 $1,1111— $1,1111— $1,1111—

$1,113,162 $1,115,082 $1,171,804 $1,183,400 $1,111,455 $1,118,980 $1,204,861 $1,120,084 $1,118,398 $1,158,467 $1,116,600 $1,112,090 $1,1111— $1,1111— $1,1111—

$12,11,892

$1,995,688

$1,908,915

Operating Profit (Loss) Interest and Other Income

$1,11(3,206) $1,116,163

$1,11(5,777) $1,114,294

$1,11(4,495) $1,111,338

Income (Loss) Before Taxes and Adjustments

$$1,12,957

$$1,18,517

$$1,16,843

Employment expense Flower designer Group insurance Insurance Miscellaneous expense Office expense Delivery and freight Professional Promoflor expense Telephone Travel Meals and entertainment Sales promotion Computer expense Pension Total General and Administrative Expenses

EXHIBIT C–94

Bush v. Bush Pollen Heaven, Inc. Adjustments to Net Income Years Ended December 31 Adjustment

Pretax Operating Profit (Loss) Additions Officers’ salaries Interest Discretionary expenses Rent Total Reductions Reasonable officers’ compensation Compensation adjustment for underpaid family members Earnings Before Interest and Taxes Depreciation EBITDA*

1999

1998

1997

$11(3,206)

$11(5,777)

$11(4,495)

$360,187 $118,849 $150,000 $133,000

$334,467 $115,974 $149,020 $133,000

$295,268 $118,812 $148,058 $133,000

1448,830

$416,684

$380,643

1

$(238,182)

$(223,894)

$(217,418)

5

$1(22,000)

$1(34,000)

$1(33,010)

4

$188,648 $177,809

$158,790 $164,948

$130,215 $137,847

$266,457

$223,738

$168,062

1 4 2 3

*Earnings before interest, taxes, depreciation, and amortization.


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BUSH V. BUSH, POLLEN HEAVEN, INC.: EXPLANATION OF ADJUSTMENTS TO NET INCOME

When valuing a closely held corporation, it must be recognized that the stated officers’ (or owner’s) compensation does not necessarily have any relationship to what that person would receive were he or she to work for a company that he or she did not own. That is, the incidence of ownership permits one to receive a compensation package that is not necessarily the same as would be paid to an unrelated third party. To the extent that the company has profits and cash flow to support those profits (or to the extent that the officer/also-owner has the ability to cause the company to borrow funds), the company can pay almost any figure. Common practice in the valuation of a closely held business is to “permit” as an operating and normal expense for the business only a fair compensation for the owners. This adjustment (see Exhibit C–94) first adds back the original officers’ salaries and then subtracts reasonable market compensation. We used the Green Thumb Associates Annuals to determine reasonable compensation. Exhibit C–95 shows the statistics for 1997 to 1999: Adjustments No. 1: Determination of Reasonable Compensation.

EXHIBIT C–95

Statistics for 1997 to 1999 1999

1998

1997

Sales

$6,805%

$6,397%

$6,212%

Assets

1,372%

1,431%

1,294%

4.60% 4.60% 2.40%

4.20% 4.10% 3.50%

4.10% 4.00% 3.50%

As Percent of Sales: Officers’ compensation based on assets 500–2MM Officers’ compensation based on sales 3–5MM Officers’ compensation based on sales 5–10MM

Based on these figures, we used 3.5 percent of revenues for reasonable compensation for the three officers — Rose Bush, Thorn Bush, and Gar Bush. We first added back those people who were considered officers on the financial statements/ tax returns — Rose, Gar, Belle, and Thorn Bush. We then applied the 3.5 percent rate as compensation for Rose, Thorn, and Gar Bush. For Belle and Hillary Bush’s salary, see Adjustment No. 5. Adjustment No. 2: Discretionary Expenses. This amount represents a discretionary

use allocation of the Company’s auto lease, cellular phone, and auto insurance expense by the corporate officers’ and related parties. For the year ended December 31, 1999, such costs totaled $64,381, as shown in Exhibit C–96: EXHIBIT C–96

Discretionary Expenses

Auto Leases Cellular Phones Auto Insurance

$36,268 17,509 10,604

Total

$64,381


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Based on our analysis, it is our estimate that $50,000 of these expenses in 1999 should be deemed excess and not directly necessary for Company operations. This amount (as adjusted for inflation) was also applied to the other years as well. Utilizing information obtained from an appraisal done for the current corporate premises, an adjustment of $33,000 was made to the $120,00 annual rent charged by a related party to arrive at a fair market rent.

Adjustment No. 3: Rent.

Adjustment No. 4: Interest and Depreciation. Since we are using a debt-free approach to value, we added back interest and depreciation expenses.

Belle Bush performs an order fulfillment and credit and collection function for the Company. For 1997 and 1998 she was only paid approximately $8,000, and in 1999 $20,000. Hillary Bush (wife of Thorn) has also been paid a modest $8,000 a year since the Flood; her functions include accounting and bookkeeping duties. We have deemed $50,000 as reasonable compensation for both Hillary and Belle Bush combined. We have adjusted their respective salaries accordingly for 1999 and for prior years with an inflation adjustment.

Adjustment No. 5: Compensation Adjustment for Underpaid Family Members.

䊳

C.31 NO CASH? NO PROBLEM, KON V. KON, KON GRASS CO. Everything we understood based on discussions with our client suggested that there was significantly more income than being shown. The problem was that this business, Kon Grass Co., was making point of sale displays, and all of its customers were large reputable companies that would never pay in cash. Furthermore, the company had a trade name, all the invoices were issued in the trade name, and it was extremely unlikely that checks would be made payable to the business owner. With that in mind, where could there be unreported income? What we found was that the business owner was manufacturing phony invoices — and fortunately was doing it in such a crude and unsophisticated way that our trained eyes jumped all over it. Those invoices were suspicious. They weren’t uniform, the handwriting was a problem, the numerical sequence was inconsistent, and so on. Doing this work well requires the use of experienced people who are willing to think outside of that proverbial box. Frankly, we were amazed by the extent of the concocted invoices, to say nothing of the double dipping (having expenses paid by charge as well as claiming they were paid in cash out of his own pocket) as well as various other procedures, as detailed herein. Without any truly unreported income, this was a massive tax fraud. On our first review of the Kon Grass’s records (see Exhibit C–97), we came across a number of invoices marked “Paid in Cash.” Not only were there a large number of invoices allegedly paid by cash, but many of the invoices were substantial in amount. In 1997, suppliers and vendors were allegedly paid $69,694 in cash. When we questioned our client regarding these cash payments, she was very surprised as she said her husband never carried around significant amounts of cash. The accountant for the Company prepared an entry based on a summary, prepared by the husband, detailing the amount of cash he paid for various expenses. That entry deducted the expenses and gave the husband credit in his capital account.


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From examining these invoices, we determined that many were manufactured to create deductions. For example, in our review of invoices of Demo Co., we found two invoices, with the same invoice number, the same dollar amount, and the same description of services. The only difference was the date, where it could be seen that the “2” had been whited out and an “11” handwritten in. Further, the correct spelling of “Summerville” is “Somerville,” and the town’s area code is 908, not 973. We also observed other Demo invoices having different letterheads, type, and references to job numbers (which were inconsistent with other invoices). It is our belief that the only plausible explanation is that these invoices were created by Mr. Kon. For Repub Co., again we found several different versions of invoices. On the typed invoices there was a thin line that ran across the page. It appears that Mr. Kon copied the top of the letterhead onto a piece of paper and filled in the bottom himself. The “invoice” and the invoice number were not in the same type as the rest of the top of the letterhead. The word “invoice” was inconsistent. On many of the invoices the invoice date was inconsistent with when the models were picked up. Some bills were invoiced before the displays were picked up. Another example involved Cratlic Co., where we reviewed various versions of invoices. Among the problems we found were different invoices with the same invoice number and different dollar amounts. For example, on May 13, 1998, there were two invoices with the number 0513, one for $630 and one for $210. On June 12, 1998, there were two invoices with the number 0612, one for $1,200 and one for $400. On our first visit, we were presented with invoices that had whitedout dates and invoice numbers. They were no longer present when we returned. Even cab fares were not exempt from this fraudulent invoice tampering. On our initial visit we made copies of four cab receipts. Mr. Kon had filled in three of them. Apparently, the cab company had given him blank receipts, and he took the liberty of filling them out himself. There is one receipt partially filled in by someone else, but even here, he filled in the dollar amount. This is obvious based on there being the same handwriting on several cab receipts. It is highly improbable that Mr. Kon always had the same cab driver whose handwriting was remarkably similar to his. In addition, his diary repeatedly claimed parking expenses allegedly paid for in cash, for the same locations and on the same days and in the same amounts that his credit card statement (fully paid and deducted by his company) reflected such. In his attempt to document travel and entertainment, Mr. Kon supplied us with two diaries. One seems to have been his original diary, and the second was prepared in response to our request for justification of the travel and entertainment. In comparing the two diaries, there were inconsistencies between the two books as to his itinerary. During our first visit we found many blank restaurant tabs (the perforated bottom of the restaurant bill that can be torn off to be used as evidence of the bill) in folders of alleged out-of-pocket expenses. When we returned, all of those tabs had been filled in. Fortunately, at our first visit we made copies of various of these blank (but often numbered) tabs, which now had been filled in. Our review of travel and entertainment expenses revealed that there were at least monthly checks made payable to Mr. Kon. When we asked for support for those checks, the accountant provided a detailed analysis of invoices for materials and subcontractors that he claimed were paid by cashing those checks and


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then paying the vendors in cash. When we reviewed those checks, we found they were not cashed but rather deposited into Mr. Kon’s personal account. We did not find any cash removed from his account so as to be available to fund payments to pay the vendors. Finally, in reviewing the travel and entertainment expenses, we found that the Company was paying 100 percent of Mr. Kon’s credit card bills. The bills included a large amount of personal expenses paid by Kon Grass. We found numerous expenses for vacations, clothing, and housewares. To illustrate the magnitude and brazenness of the problem, consider the Visa bill from August/September of 1997. There were eight purchases in August for Delta Air tickets and six purchases in September for American Air tickets — in each case, all posted on the same day. We asked Mrs. Kon about these tickets, and she advised that her husband would purchase the tickets for himself and his friends to fly down to Georgia to go golfing. His friends would pay him back in cash. We found further support of this occurring on the letter to his friends dated September 10, 1997, where he detailed their golf agenda. Mr. Kon identified his friends by name in his letter. Mrs. Kon advised us that these were all personal friends from their swim club and that he did not do business with any of them. EXHIBIT C–97

Kon v. Kon Kon Grass Co. Statements of Income For the Years Ended December 31, 1997 1996 1995

Net Sales Subcontractors Materials and supplies Freight Photography and art work Design and model costs Total Cost of Sales Gross Profit Car and truck expenses Insurance Interest Legal and professional services Office expense Equipment/lease Supplies Travel Meals and entertainment Utilities and telephone Wages and secretarial service Dues and subscriptions Miscellaneous Postage Total Expenses Income Before Taxes and Adjustments

$1,889,292

$1,631,498

$1,487,859

595,714 739,240 19,512 58,388 70,935 1,483,789 405,503

736,451 468,046 16,364 14,564 15,262 1,250,687 380,811

575,447 423,236 22,177 25,705 31,800 1,078,365 409,494

12,876 7,807 32,837 11,323 6,072 11,048 11,632 5,300 56,595 14,673 5,397 94 602 838

24,455 4,989 35,870 898 11,847 — 10,049 653 70,880 11,404 3,441 599 1,302 800

14,876 8,519 43,861 5,978 32,163 — — 3,259 50,902 11,545 2,465 1,014 1,972 1,156

177,094

177,187

177,710

$1,228,409

$1,203,624

$1,231,784


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EXHIBIT C–98

463

Kon v. Kon Kon Grass Co. Adjustment to Income Adjustment No.

Income Before Taxes and Adjustments Adjustments Expenses paid in cash Design and model costs Auto leases Gas Auto insurance Computer leases Telephone Other insurance Office expense/travel Meals and entertainment Reasonable rent Interest

1 2 3 4 5 6 7 8 9 10 11 12

Total Adjustments Adjusted Net Income

1997

1996

1995

$(228,409)

$(203,624)

$(231,784)

38,060) 45,970) 2,259) 978) 3,879) 1,740) 2,323) 3,475) 1,500) 50,283) (10,000) 32,387)

27,643) 4,392) 12,416) 809) 4,148) 1,680) 953) 3,690) 4,721) 42,948) (9,600) 35,870)

16,208) 9,776) 6,639) 862) 4,083) 806) —) 2,888) 18,369) 40,157) (9,216) 43,861)

172,854)

129,670)

134,433)

$ 401,263)

$ 333,294)

$ 366,217)

Adjustments

As detailed in the “Commentary” section of our report, Mr. Kon prepared a summary of expenses he allegedly paid by cash and personal checks. From reviewing the “cash paid” invoices, we found evidence of invoice tampering and manufacturing. We have determined that all alleged cash invoices were phony (see adjustments in Exhibit C–98). Adjustment No. 1 : Expenses Paid in Cash.

Also detailed in the “Commentary” section of our report, we described the reclassification from meals and entertainment of cash invoices. The first deduction occurred as a result of a summary Mr. Kon prepared for his alleged out-of-pocket/cash expenses and the second to correct design and model costs originally booked to meals and entertainment. These were checks payable to Mr. Kon, which he claimed he cashed and then used the cash to pay the vendors (but were erroneously classified as meals and entertainment). We found that the checks were not cashed but deposited into his checking account. Nor do we find cash being withdrawn to pay these vendors.

Adjustment No. 2 : Design and Model Costs.

Adjustment No. 3: Auto Leases. In addition to the Company paying for Mr. Kon’s auto, it was also paying and deducting auto payments for his father, mother, and wife. We have added these back as they are not a proper expense of the business. We allowed Mr. Kon 100 percent on his auto-related expenses.


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Not only was the Company paying Mr. Kon’s gas bills, but also Mrs. Kon’s. We were not able to review the original bills to determine how much was business versus personal. We allowed 67 percent of the total as business.

Adjustment No. 4 : Gas.

The Company was paying for four autos — for Mr. and Mrs. Kon and for his parents. We were able to review the 1996 bills and allowed 100 percent of Mr. Kon’s auto insurance. The balance of the expense was added back to income.

Adjustment No. 5 : Auto Insurance.

Adjustment No. 6 : Computer Lease. From reviewing the general ledger, we found two computer leases being deducted through the business. Mrs. Kon confirmed that one was for their personal use and one was for business. We allowed the more expensive computer to be for the business.

We found many of Mrs. Kon’s cellular phone bills being paid through the business. These were identified and added back to income. Adjustment No. 7 : Telephone.

The business was deducting Mr. and Mrs. Kon’s personal homeowners’ and boat insurance premiums. These were added back to income. Adjustment No. 8 : Other Insurance.

We found a number of personal home improvements being deducted as office expenses. We also found a trip taken by a Fifi Lovey deducted through the business. Adjustment No. 9 : Office Expense/Travel.

The meals and entertainment expenses consisted mostly of two types of disbursements — checks payable to Mr. Kon and payments to credit card companies, most commonly Visa. As discussed in Adjustment No. 2, Mr. Kon claimed he wrote checks payable to himself, cashed the checks, and then paid the vendors in cash. However, we found the checks were not cashed but deposited into his checking account. Regarding credit card payments, we reviewed the monthly statements from Visa and found a significant amount of personal expenses paid by the Company. Again, as discussed in the “Commentary” section of our report, we found many expenses to be improperly expensed by the Company. Adjustment No. 10 : Meals and Entertainment.

Adjustment No. 11 : Reasonable Rent. The Company was using the basement of the marital home as its one location. We have determined that a reasonable commercial rent for a similar space would be approximately $20 per square foot. We estimated that the square footage needed to operate this business would be about 500 square feet, for a total rent expense of $10,000 for 1997. We deflated that 4 percent per year for prior years.

A business such as Kon Grass should have little, if any, interest expense. The magnitude of such here was startling. Our investigation revealed that all of the marital home mortgage interest was being deducted. Notably, in combination with a home equity line, it was also being deducted on the Schedule A (itemized deductions) of the Kons’ personal tax returns. Adjustment No. 12 : Interest.


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C.32 ABY SENT V. ONS ITE, CASH COW ENTERPRISES 䊳

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C.32 ABY SENT V. ONS ITE, CASH COW ENTERPRISES. You have probably heard this many times before, but this case was really somewhat different. This one involved a commercial divorce—partners in a piece of real estate (a strip mall) where one of them was active and hands on and the other was an absentee owner. We got to work for the good guys — the absentee owner (Aby Sent) who was ripped off by her fellow shareholder (Ons Ite). The business involved here, as indicated, was a strip mall. It was a fairly small situation, there being one strip mall, and that having only several tenants. This was reflected within one company. The company was owned 50 percent by each of two parties. Our client was the absentee shareholder, not involved in the operations, and very trusting of her fellow shareholder who ran the business. Actually, there was not much to run — other than collecting the rents and some general property upkeep, there was very little to do. There were only about five tenants, most of the leases were long term, and since the tenants were commercial/business tenants, most of the maintenance was taken care of by them. The result was that for the most part, all the shareholders had to do was sit back, collect the rents, and pay themselves every once in a while. That clearly was not good enough for Ons Ite. He obviously figured that since Aby Sent had long ago relinquished any serious involvement (unfortunately, she did not even press for solid information on a regular basis), he was certainly in a position (or perhaps in his mind even entitled) to take advantage of what the business offered. As a result, we found such an egregious situation as two cars on the books (both for the active shareholder and his wife — keep in mind that this business did not even need one car), large loans interest free, management fees out of proportion to that which he was entitled (and there was no agreement permitting management fees anyway), and, in general, quite a bit of additional abuse of the financial resources of this business. Our assignment was to help quantify the damages incurred by our client.

We were contacted by the attorney for Aby Sent, who advised us his client (a 50 percent shareholder in Cash Cow Enterprises — CCE) was concerned that the other shareholder was misusing corporate funds. Our services took the form of the following procedures: Introduction and Background.

Conferences and discussions with Slim Porpoise, Esq. Telephone discussions with Ms. Aby Sent Conferences with Brute Chark, Esq. — attorney for CCE Conference with Lone Scribe — accountant for CCE A conference with Ons Ite Review of relevant deposition transcripts Before detailing our specific findings, it is relevant to briefly detail some of the questionable and/or inappropriate record keeping and other practices that we noted. These improprieties include the following: • Loan to a shareholder or related parties without any documentation in support of same, without collateral, and without interest • Management fees paid to a related party without any apparent authorization or support for same


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• A disparity in the type and expense of vehicles maintained for the two shareholders • The providing (or at least access to use) of another vehicle by a related party • The discarding of various bills (for example, telephone bills) so as to make the review of same impossible • Numerous expenditures, many to cash or Ons Ite, unsupported and without any apparent business justification Summary of Financial Improprieties. The following summarizes the financial damages inflicted upon CCE through December 31, 1998 by or on behalf of Ons Ite. Because of the nature of this type of analysis, some of the figures presented in Exhibit C–99 are estimates.

EXHIBIT C–99 Description

Summary of Financial Damages Page #

Loans taken by Ons Ite Loans taken by Gesund Ite Management fees paid to Ons Ite Vehicle leases Insurance Repairs and maintenance expenditures Miscellaneous items — year ended June 30, 1994 June 30, 1995 June 30, 1996 June 30, 1997 June 30, 1998 Half year December 31, 1998 Checks to Cash TOTALS

Amount of Impropriety

Interest Thereon

Totals

$137,458 —

$95,369 7,920

$232,827 7,920

79,050 47,685 29,278

18,614 10,770 4,488

97,664 58,455 33,766

22,352

7,512

29,864

15,083 10,530 8,595 11,841 4,422 1,211 10,950

7,500 4,200 2,410 2,370 400 50 2,769

22,583 14,730 11,005 14,211 4,822 1,261 13,719

$378,455

$164,372

$542,827

Since at least 1993, Ons Ite has had a substantial (and generally increasing) “loan” account with CCE. However, to the best of our knowledge, there are no loan documents or corporate resolutions authorizing and documenting such loans. In addition, no interest has been paid on these loans, nor has any been accrued on the Company books. Exhibit C–100 serves as a brief summarized chart to illustrate the extent and changes in his loan account as well as to provide an approximated calculation of the interest that should have been paid to CCE, using a 9 percent rate (the approximate cost of borrowing incurred by CCE). Since, for the most part, changes to his loan account during any one fiscal year occurred throughout the year, except where specifically noted because of unusual activity, for ease of presentation we have averaged the changes as if occurring at midyear.

Officer Shareholder Loan to Ons Ite.


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C.32 ABY SENT V. ONS ITE, CASH COW ENTERPRISES

EXHIBIT C–100

467

Extent and Changes in Loan Account

Date June 30, 1993 balance Increase during the year June 30, 1994 balance Increase during the year June 30, 1995 balance Increase during the year June 30, 1996 balance Increase during the year June 30, 1997 balance November 1997 payment Balance of changes during the year June 30, 1998 balance December 31, 1998 balance

Amount of Loan

Interest for Fiscal Year

Interest on Unpaid Interest (to December 31, 1998)

$107,847) $120,834) $128,681) $118,044) $146,725) $149,819) $196,544) $121,914) $218,458) $(46,000)

$111—) $11938) $19,706) $11812) $11,581) $12,242) $13,205) $1,1986) $17,689) $(2,415)

$111—) $11446) $14,612) $1,1287) $14,092) $11,542) $13,190) $11,137) $12,460) $1,(227)

$(35,000) $137,458) $137,458)

$(1,575) $19,661) $16,186)

$11,1(71) $11,885) $111—)

$79,016)

$16,353)

Totals

Exhibit C–100 indicates that, through December 31, 1998, Ons Ite owes to CCE the following: Balance on loan Unpaid interest Interest on unpaid interest

$137,458 $179,016 $116,353

Total Owed

$232,827

Gesund Ite is not a shareholder in CCE. Approximately January 1993, Gesund Ite apparently took over the role previously filled by Ons Ite (his father) as to maintaining corporate records and managing the property. Although not to the magnitude and degree of Ons Ite, he too benefited from a loan account with the Company, which was, as was for Ons Ite, undocumented, unsupported by corporate resolutions, and maintained without interest.

Officer Shareholder Loan Gesund Ite.

EXHIBIT C–101

Officer Shareholder Loan

Date May 1995 June 30, 1995 balance Increase in first three quarters of fiscal year April 1996

Amount of Loan


Interest on Unpaid Interest

$(13,000) (113,000)

$(1 1—) (111—)

$111—) (111—)

(114,950) (172,500)

(11,841) (11,631)

(11,203) (11,394)


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EXHIBIT C–101

Officer Shareholder Loan (continued)

Date June 30, 1996 balance September 1996 Remainder of the year June 30, 1997 balance Activity during the year June 30, 1998 balance December 31, 1998 balance

Amount of Loan


Interest on Unpaid Interest

(190,450) (1(73,000) (116,721) (124,171) (1(24,171) (1111—) (1111—)

(11270) ((5,475) (11302) (18,141) ((1,088) (12,175) (111—)

(11,165) (1,(762) (11,142) (11,132) (11,(49) (111,98) (111—)

$(6,797)

$(1,123)

Totals

Exhibit C–101 indicates that, through December 31, 1998, Gesund Ite owes to CCE the following: Balance on loan Unpaid interest Interest on unpaid interest

$1,1— $6,797 $1,123

Total Owed

$7,920

The books and records of CCE reflect that Gesund Ite was paid a management fee from approximately January 1994 in the amount of $1,000 per month (increasing to $1,500 per month in late 1995). Such was not authorized nor approved by Aby Sent. Furthermore, these payments did not reduce the payments that were made to his father, Ons Ite, thereby equalizing the payments between the two shareholders (Ms. Sent and Mr. Ite). We question whether these payments should have been made at all and whether they were appropriate under the circumstances. Exhibit C–102 provides a summary analysis of these payments and the interest calculations applicable thereto.

Management Fees.

EXHIBIT C–102

Summary of Analysis of Payments

Fiscal Year Ended June 30, 1994 June 30, 1995 June 30, 1996 June 30, 1997 June 30, 1998 Six Months December 31, 1998

Management Fee Payments

Interest Thereon Through 12/31/98

$16,000 $13,050 $16,500 $18,000 $18,000 $17,500

$13,050 $15,405 $14,908 $13,426 $11,656 $11,169

$79,050

$18,614

While not apparently a problem at this time, and while we are not aware of this being threatened as an issue, we must recognize the potential for the IRS and the


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State of New Jersey to argue that the payments to Gesund Ite should have been treated as employee compensation — and thereby subject to social security and unemployment taxes as well as withholding taxes. Were the IRS and the State of New Jersey to take these positions, while we have not specifically calculated the magnitude of the Company’s exposure (for payroll taxes as well as penalties and interest thereon), such exposure would undoubtedly exceed $30,000. Vehicle Leases and Insurance. Based on our review of the records of CCE, it appears

that going back to 1993, the Company maintained two vehicles (both Volvos), one for each of the principal officers/shareholders — specifically, Ms. Sent and Mr. Ite. These vehicles appear to have cost the same, and the Company was thereby incurring similar (if not exactly the same) vehicle expenses on behalf of each of the two shareholders. Starting in about January 1995, this level of equality apparently changed dramatically — without corporate authorization for such a change. In January 1995 CCE entered into a lease for a 1995 Bugatti. This was a 98-month lease at $368 per month. Gesund Ite advised that the vehicle was used in the management of CCE’s activities and was also available to repairmen for miscellaneous repair work. During a subsequent discussion with us, Mr. Ite also acknowledged that the vehicle was primarily for his use. We consider this another flagrant example of the misuse of corporate funds. It seems illogical that for a single piece of property with several commercial tenants and relatively little activity called for by management, there could be the slightest justification for leasing a car for Mr. Ite. In addition, there was no authorization or approval of same by Ms. Sent. In July 1995 the Company entered into a 130-month lease for a 1995 Stutz with SMAC Leasing Company, at $678.50 per month, that car being for the benefit of Ons Ite. There is nothing in the Company’s records to suggest that Ms. Sent received any consideration for same, or the quid pro quo of a similar car. In June 1997 Ons Ite committed CCE to a 248-month lease for a 1997 Nash Rambler, at $1,286.96 per month. To compound the issue, the Company continued to pay the remaining months of payments on the lease for the 1995 Stutz. The use of same is unknown to us. Taking into account the narrative above, and contrasting the vehicles leased by or on behalf of Ons Ite or Gesund Ite, and comparing same to the vehicle benefit equivalent received by Aby Sent, it is our conclusion that the entire amount of all such lease payments were an abuse of corporate assets and to the detriment of the corporation in general and Ms. Sent in particular. We have estimated such damages based on the total lease payments made and have calculated interest thereon from a midpoint of each year through December 31, 1998 (or as otherwise appropriate where the lease payments did not encompass an entire fiscal year). Our calculation is shown in Exhibit C–103: EXHIBIT C–103

Fiscal Year Ended June 30, 1995 June 30, 1996 June 30, 1997

Calculated Interest on Lease Payments

1995 Stutz $

— 8,950 8,142

1995 Bugatti

1997 Nash Rambler

Total Lease Expenditures


$ 2,791 4,416 4,416

$ — — 1,840

$ 2,791 13,366 14,398

$ 1,071 5,536 2,740


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EXHIBIT C–103

Calculated Interest on Lease Payments (continued)

Fiscal Year Ended June 30, 1998

1995 Stutz 4,071

4,416

—

2,208

Six months ended December 31, 1998 Totals

1995 Bugatti

$21,163

$18,247


1997 Nash Rambler

Total Lease Expenditures

6,435

14,922

1,373

2,208

50

$47,685

$10,770

— $8,275

Effective December 1997 the lease payments on the Nash Rambler were charged to Ons Ite personally via his loan account. Directly related to the matter of these leased vehicles is the issue of insurance thereon, paid by CCE. Based on the documents provided by the insurance agency, in addition to the aforementioned vehicles, it was discovered that CCE also paid for a 1995 Fairlane, believed to be the personal vehicle of Gesund Ite. Using said documents, we have determined that the magnitude of such insurance expense paid by CCE was as shown in Exhibit C–104:

EXHIBIT C–104

Insurance Expense Paid by CCE

Fiscal Year Ended June 30, 1995

Insurance Payments 577

$ 237

June 30, 1996

6,525

1,925

June 30, 1997

6,873

1,293

June 30, 1998

10,202

918

5,101

115

$29,278

$4,488

Six Months ended December 31, 1998* Totals

$


*Estimated at 1/2 expense of fiscal June 30, 1998.

Repairs and Maintenance. Throughout the years reviewed, there were frequent and substantial payments to various parties classified as repairs and maintenance and in some instances as improvements. The extent of these transactions were so numerous as to justify, in Exhibits C–105 and C–106, a separate detailing and schedule herein. In some cases, even in the absence of adequate documentation, because of either what appears to be a surface legitimacy of same or a rather minor magnitude of the amount, we have accepted same without challenge.


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EXHIBIT C–105

Fiscal Year Ended

Amount

Interest Through 12/31/98

June 30, 1994 June 30, 1995 June 30, 1996 June 30, 1997 June 30, 1998

$ 3,571 3,622 12,230 2,314 ,615

$1,923 1,491 3,608 ,435 ,55

$22,352

$7,512

EXHIBIT C–106 I.

Repair and Maintenance Transactions, Overview 1994 –1998

Repair and Maintenance Transactions, Detail 1994 –1998

Year Ended June 30, 1994 Date October 2, 1993 January 11, 1994 May 23, 1994 October 1, 1993

Payee ABC Distributors Quarry ABC Total

$ 1,200 ,700 , 171 1,500* $ 3,571

*Posted to leasehold improvements.

II.

Year Ended June 30, 1995 Date February 6, 1995 February 23, 1995 May 27, 1995 June 12, 1995 June 30, 1995

Payee Cash Plumbing Bag Co. Nursery Transfer from Petty Cash Total

$ , 500 ,75* ,737 ,310 2,000† $ 3,622

*Notation on bill: “Service call for smell in living room.” †Original source represents checks to “cash” and/or to Ons Ite.

III. Year Ended June 30, 1996 Date June 18, 1995 (bill date) July 21, 1995 July 21, 1995 July 28, 1995 September 3, 1995 September 11, 1995

Payee Quarry Fairlane Service Quarry ABC Quarry Quarry

$

,108* 4,955† ,168* 1,000 ,209 , 90*

471


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EXHIBIT C–106

Repair and Maintenance Transactions, Detail 1994 –1998 (continued)

III. Year Ended June 30, 1996 Date September 12, 1995 October 18, 1995 November 23, 1995 December 24, 1995 April 7, 1996

Payee ABC Cash ABC Cash ABC

1,000 ,200 ,500 1,500 2,500

Total

$12,230

*This check was accompanied by a notation “Bury it.” †Admitted to Gesund Ite in deposition as being personal.

IV. Year Ended June 30, 1997 Date August 5, 1996 December, 1996

V.

Payee Electric Cash

$ 2,014 ,300

Total

$ 2,314

Year Ended June 30, 1998 Date January 1998

Payee ABC

$

,615

Miscellaneous Questionable Entries and Transactions, Fiscal Year Ended June 30, 1994

On June 30, 1994, via a journal entry, the Company was charged $1,622 for the benefit of Ons Ite (see Exhibit C–107). The entry indicated that this was (allegedly) reimbursement for expenses he paid personally for the years ended June 30, 1988, 1989, 1990, 1991, and 1992. Besides being unorthodox, no support was provided for this entry. Using an average cost of money for CCE of 9 percent, and the four and a half years from June 30, 1994, through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $800 — bringing the total due to $2,422.

Entertainment.

Interest and Penalties. CCE has consistently paid its real estate taxes late and as a result has incurred penalties and interest. We have estimated the extent of same to be $2,000 per year (except in fiscal June 1995 when it was $3,000). Using an average cost of money for CCE of 9 percent, and the four and a half years from June 1994 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $900 — bringing the total due to $2,953.


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Similar to the preceding item, on June 30, 1994, the Company was charged $1,822 for the benefit of Ons Ite. Again, the explanation was for reimbursement for expenses that he allegedly paid personally for the years ended June 30, 1988, 1989, 1990, 1991, and 1992. Again, no support was provided for this unorthodox entry. In addition, on November 21, 1993, Ons Ite was paid $350 for office expenses — but with no support or documentation available to support this payment. These two total $2,172. Using an average cost of money for CCE of 9 percent, and the four and a half years from June 30, 1994, through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $1,100 — bringing the total due to $3,272.

Office Expenses.

Utilities. Similar to the discussion above as to entertainment and office expenses, at June 30, 1994, the Company, for the benefit of Ons Ite, was charged $3,556 as reimbursement for expenses he allegedly paid personally for the years ended June 30, 1988, 1989, 1990, 1991, and 1992. Again, no documentation was provided. Using an average cost of money for CCE of 9 percent, and the four and a half years from June 30, 1994, through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $1,800 — bringing the total due to $5,356.

During the fiscal year ended June 30, 1994, there were several checks totaling $2,450 , payable either to Ons Ite or to Cash, posted as vehicle expense, for which no supporting data was provided. We would also note, though this is not necessarily determinative of wrongdoing, that all of these were in round amounts. Using an average cost of money for CCE of 9 percent, and the five years from December 1993 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $1,300 — bringing the total due to $3,750. Vehicle Expense (Other Than Leasing).

In addition to the preceding, at June 30, 1994 there was an accountant’s journal entry charging the Company $3,000 (for the benefit of Ons Ite), with a description that it was for reimbursement of expenses paid personally. This is another situation involving a year-end journal entry without any support, crediting Ons Ite for expenses allegedly paid by him. Using an average cost of money for CCE of 9 percent, and the four and a half years from June 30, 1994 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $1,500 — bringing the total due to $4,500.

Additional Vehicle Expense (Other Than Leasing).

The preceding $3,000 amount was the fourth in a series of year-end journal entries crediting Ons Ite and charging the Company for expenses allegedly paid by him personally — and further, with the exception Commentary and Observations.


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of this last item, they were all for items allegedly expended over a several-year period first recognized and being reimbursed at the current time. Further, none of these was supported by documentation evidencing these payments. It is perhaps most interesting to note, in support of the outrageous manner in which Corporate funds were abused (using this series of transactions as a specific flagrant example), that were one to add these four figures together ($1,622, $1,822, $3,556, and $3,000), their cumulative total is exactly $10,000. We believe it is no mere coincidence that these alleged expenses conveniently total such a round figure. It is our belief that these figures were totally fictitious and that the allocation of the $10,000 to four different accounts was arbitrary and probably done in an effort to at least in part disguise the actual nature of this transaction. There were other situations of expenditures unsupported by documentation. However, they were generally of lesser consequence, and not clear as to whether inappropriate or improper or not. Therefore, we have chosen not to consider such transactions as questionable for purposes herein. In March 1994 there was a check for $230 payable to the Gift Warehouse. We saw no documentation in support of this expense, and it appears to be personal. Using an average cost of money for CCE of 9 percent, and the four and a half years from June 30, 1994 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $100 — bringing the total due to $300. Advertising.

EXHIBIT C–107

Summary

Entertainment Interest and penalties Office expenses Utilities Vehicle expense Additional vehicle expense Advertising Total

Expenditure or Benefit

Interest

Total

$ 1,622 , 2,053 2,172 , 3,556 , 2,450 , 3,000 , 3,230

$, 800 , 900 $1,100 $1,800 $1,300 $1,500 $ 100

$,2,422 , 2,953 , 3,272 , 5,356 , 3,750 , 4,500 , 330

$15,083

$7,500

$22,583


There were four contributions of significant note during this fiscal year, totaling $2,200. These are clearly not in the normal course of business; and further there was no authorization of same by Aby Sent. However, we are not including same in the calculation of damages.

Contributions.

There is a check in December 1994 in the amount of $150 payable to cash, with no supporting invoice. In addition, in January 1998 there was a Advertising.


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check for $300, payable to St. Abraham’s College — with indication that it was a donation on behalf of Ons Ite’s nephew. These two questionable items total $450, as shown in Exhibit C–108. Using an average cost of money for CCE of 9 percent, and the four years from December 1994 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $180 — bringing the total due to $630. Office Expense. In June 1995 there was a check in the amount of $400 payable to cash posted to office expense. No supporting invoice or documentation was available for this item. Using an average cost of money for CCE of 9 percent, and the three and a half years from June 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $140 — bringing the total due to $540.

At June 30, 1995, as part of the year-end closing entries, the accountant made an entry transferring out of petty cash $440 and charging same to the utilities expense account. The original source of this charge originated with checks that were payable to either cash or to Ons Ite. Again, no support was provided for these alleged expenses. Using an average cost of money for CCE of 9 percent, and the four years from December 1994 to December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $180 — bringing the total due to $620. Utilities.

There were four payments, totaling $399, for automobile maintenance. Using an average cost of money for CCE of 9 percent, and the four years from December 1994 to December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $160 — bringing the total due to $559. Automobile.

In June 1995, like what has been described above, there was a journal entry transferring payments from petty cash into (in this case) entertainment expense. The source of these disbursements were originally checks payable to either cash or Ons Ite. This entry was in the amount of $560. Using an average cost of money for CCE of 9 percent, and the four years from December 1994 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $240 — bringing the total due to $800.

Entertainment.

In March 1995, there was a payment in the amount of $1,500 to cover charges on Gesund Ite’s American Express bill, said charges Computer Equipment.


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amounting to slightly in excess of $1,500, with most of it being for lodging at the Five Seasons Hotel in New York City. Documentation as to the business purpose is sorely lacking, and Gesund Ite’s explanation as to the justification for charging lodging expenses to the Company was that he was visiting his attorney to discuss CCE leases. We consider this to be extremely inappropriate. Even if it was corporate business, considering the modest distance to New York City, there is no justification for lodging expenses; and further, even if there was a justification for lodging expenses, there can be no justification for charging CCE in excess of $1,000. Using an average cost of money for CCE of 9 percent, and the over three and a half years from March 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $500 — bringing the total due to $2,000. CCE has consistently paid its real estate taxes late and as a result has incurred penalties and interest. In fiscal June 1995 this amounted to $6,781. Using an average cost of money for CCE of 9 percent, and the four years from December 1994 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $2,800 — bringing the total due to $9,581. Interest and Penalties.

EXHIBIT C–108

CCE Summary Expenditure or Benefit

Advertising Office expense Utilities Automobile Entertainment Computer equipment Interest and penalties Total

$, , , , ,

Interest

Total

450 400 440 399 560 1,500 6,781

$, 180 , 140 , 180 , 160 , 240 , 500 2,800

$, , , , ,

630 540 620 559 800 2,000 9,581

$10,530

$4,200

$14,730


Throughout the year, there were a number of payments posted as advertising expenses for which no supporting documentation was provided and, in certain cases, which appeared suspect on their face. This included three checks payable to cash totaling $2,029; a check to Alps in the amount of $535 (that appeared to be some form of gifts); and two checks to Pera Nees totaling $1,040 which, at least in one case, appears to be related to the purchase of purses. Particularly as to the payments for cash, we must consider these questionable. In addition, the absence of documentation supporting the business purpose Advertising.


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477

of same, especially when taken into combination with the pattern established for CCE, reinforces that these payments are suspect. They total $3,604, as shown in Exhibit C–109. Using an average cost of money for CCE of 9 percent, and the three years from December 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $1,100 — bringing the total due to $4,704. Contributions. As previously discussed, although contributions (totaling $1,600) are arguably not business expenses, no add-back is proposed.

There were two payments, totaling $1,090, posted to entertainment that we considered to be questionable and for which no support was provided. These involve a $550 payment in August 1995 to Andes and a $540 payment in January 1996 that was unidentified. Using an average cost of money for CCE of 9 percent, and the three years from December 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $310 — bringing the total due to $1,400.

Entertainment.

Fuel Oil. A September 10, 1995, payment of $364 to Appa Latian Oil was acknowl-

edged by Gesund Ite as having been personal. Using an average cost of money for CCE of 9 percent, and the three years from December 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $100 — bringing the total due to $464. Outside Services/Management Fees. During this fiscal year, Rachel Offzyt (daughter of Ons Ite) was paid $2,000, said payment being classified as a management fee. We are unaware of any services rendered by Ms. Offzyt that would justify a $2,000 payment, nor was said payment authorized and approved by Ms. Sent. Using an average cost of money for CCE of 9 percent, and the two and a half years from June 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $500 — bringing the total due to $2,500.

In October and November 1995, there were three questionable checks, totaling $1,003, for automobile expenses — to Repo Pontiac for $203, to Ms. Offzyt for $500, and to cash for $300. Using an average cost of money for CCE of 9 percent, and the three years from December 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $300 — bringing the total due to $1,303. Automobile.


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Interest and Penalties. CCE has consistently paid its real estate taxes late and as a result has incurred penalties and interest. This fiscal year it amounted to $534 (paid late in the fiscal year). Using an average cost of money for CCE of 9 percent, and the three years from December 1995 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $100 — bringing the total due to $634.

EXHIBIT C–109

Summary of Interest Due December 1995 to December 1998

Advertising Entertainment Fuel oil Outside services Automobile Interest and penalties Total


Interest

Total

$3,604 1,090 , 364 2,000 1,003 , 534

$1,100 , 310 , 100 , 500 , 300 , 100

$ 4,704 1,400 , 464 2,500 1,303 , 634

$8,595

$2,410

$11,005

Miscellaneous Questionable Entries and Transactions, Fiscal Year Ended June 30, 1997 Contributions.

Similarly as previously discussed, no addback is proposed.

There were a number of payments posted as advertising expense that were clearly questionable and for which documentation was either lacking or inadequate. These included two payments to Ig Neas in the amount of $500 and $300, a payment to Sedi Mentry for $357, a payment to Shale’s in the amount of $400, and a payment labeled Gran Ite in the amount of $907 (this one referenced as being for gifts). In total these amounted to $2,464 (see Exhibit C–110). Using an average cost of money for CCE of 9 percent, and the two years from December 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $500 — bringing the total due to $2,964. Advertising.

There were four payments to cash, ranging between $250 and $423, posted as for office expenses. No support was provided for these expenses, which totaled $1,319. Using an average cost of money for CCE of 9 percent, and the two years from December 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $250 — bringing the total due to $1,569.

Office Expenses.


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479

Commissions. In December 1996, CCE paid the Paris Ite Agency $5,000—allegedly

as a commission on Towmayne’s Restaurant. We are unaware of any authorization from Ms. Sent approving of this arrangement, and, especially considering that such a payment was made to an entity with the name Ite, we must consider this to be a questionable item. Using an average cost of money for CCE of 9 percent, and the two years from December 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $1,000 — bringing the total due to $6,000. On March 6, 1997, there were two checks payable to cash, for $100 and $400 — totaling $500 — posted as utilities expense. To say the least, the legitimacy of these expenditures is in doubt. Using an average cost of money for CCE of 9 percent, and the nearly two years from March 1997 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $90 — bringing the total due to $590. Utilities.

Effective December 1, 1996, CCE entered into a lease with Bottcha Lizm Caterers, Inc. which called for a security deposit payment of $1,000. A review of the cash receipts journal for the fiscal year ended June 30, 1997, did not indicate a receipt of this security deposit. Subject to clarification, we are not at this time treating this as being taken or misapplied, and no calculation or addback for same is being made.

Security Deposits.

In August 1996, there was a check to Lovem and Leasem for $121, and in January 1997, for $47. We do not believe that these expenses, totaling $168, were properly chargeable to the Company. Using an average cost of money for CCE of 9 percent, and the two years from December 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $30 — bringing the total due to $198. Automobile.

Telephone. Telephone expense for fiscal June 1997 was $1,998. When we attempted

to review a sample of the telephone bills, we were advised (by Gesund Ite) that he throws out the telephone bills. We do not believe it is reasonable for CCE to be paying telephone bills averaging between $100 and $200 per month. We have treated 50 percent of telephone expense as nonbusiness — $999. Using an average cost of money for CCE of 9 percent, and the two years from December 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $200 — bringing the total due to $1,199. Interest and Penalties. CCE has consistently paid its real estate taxes late and as a

result has incurred penalties and interest. This amounted to $1,391 in fiscal June 1997.


480

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Using an average cost of money for CCE of 9 percent, and the two years from December 1996 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $300 — bringing the total due to $1,691. EXHIBIT C–110

Summary of Interest Due, December 1996 to December 1998

Advertising Office expense Commissions Utilities Automobile Telephone Interest and penalties Total


Interest

Total

$ 2,464 1,319 5,000 , 500 , 168 , 999 1,391

$, 500 , 250 1,000 , 90 , 30 , 200 , 300

$2,964 1,569 6,000 , 590 , 198 1,199 1,691

$11,841

$2,370

$14,211


In July 1997, a check payable to cash for $250 was posted to office expense (see Exhibit C–111). As with other situations, we consider such payment improper. Using an average cost of money for CCE of 9 percent, and the nearly one and a half years from July 1997 through December 1998, and rounding upward to allow for interest on unpaid interest, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $30 — bringing the total due to $280. Office.

Telephone. Telephone expense for fiscal June 1998 was $1,593. When we attempted

to review a sample of the telephone bills, we were advised (by Gesund Ite) that he throws out the telephone bills. We do not believe it is reasonable for CCE to be paying telephone bills averaging between $100 and $200 per month. We have treated 50 percent of telephone expense as nonbusiness — $796. It is noteworthy that on a Bell Atlantic work invoice, for an installation at the Ite home, the work performed description reads “Inst RJ11C in Bedroom.” Using an average cost of money for CCE of 9 percent, and the one year from December 1997 through December 1998, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $70 — bringing the total due to $866. Interest and Penalties. During fiscal June 1998, CCE paid $3,376 of penalties and interest on the late payment of real estate taxes. That this occurred is irresponsible and wasteful of corporate assets. Using an average cost of money for CCE of 9 percent, and the one year from December 1997 through December 1998, it is our estimate that the interest due


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481

and owing to the Company as a result of this transaction is approximately $300 — bringing the total due to $3,676. EXHIBIT C–111

Summary of Interest Due, December 1997 to December 1998

Office expense Telephone Interest and penalties Total


Interest

Total

$ ,250 , 796 3,376

$ 30 70 300

$, 280 , 866 3,676

$4,422

$400

$4,822

Miscellaneous Questionable Entries and Transactions, Six Months Ended December 31, 1998

In July 1998, Jim’s Car Wash and All Around Auto Service was paid $1,211 for repairs to the Bugatti. Since this is Gesund Ite’s personal vehicle, it is not an appropriate charge to CCE. Using an average cost of money for CCE of 9 percent, it is our estimate that the interest due and owing to the Company as a result of this transaction is approximately $50 — bringing the total due to $1,261. Automobile.

Checks to Cash. In his deposition, Gesund Ite acknowledged the lack of documentation in support of numerous cash checks drawn against CCE. It would appear, therefore, that such disbursements were for his personal benefit. Those listed in Exhibit C–112 are in addition to those classified elsewhere.

EXHIBIT C–112

Cash Checks Drawn Against CCE

Check #

Date

Amount

Annual Totals


1020

12/21/93

$1,400

$1, 400

$1,215

1142 1147 1240 1245 1266 1281 1299 1302 1306 1327 1329 1388 1392

07/05/94 07/20/94 11/16/94 11/23/94 12/30/94 01/30/95 02/24/95 02/27/95 03/09/95 03/27/95 03/28/95 06/13/95 06/26/95

1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 1, 1,

3,250

1,338

50 500 200 150 500 100 200 300 100 250 500 200 200


482

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SAMPLE REPORTS

EXHIBIT C–112

Cash Checks Drawn Against CCE (continued)

Annual Totals


Check #

Date

Amount

128 151 212 245 273

09/25/95 11/01/95 01/16/96 02/26/96 04/05/96

1, 250 1, 500 1, 300 1,000 1, 150

2,200

1, 649

449 531 531

03/02/97 06/17/97 06/17/97

1, 100 1, 500 1, 500

1,100

1, 207

1105 1151 1161

12/30/97 03/31/98 04/04/98

2,000 1,000 1,000

4,000

1, 360

$10,950

2,769

Totals

䊳

Page 482

C.33 THE GOOD, THE BAD, AND THE RESTAURANT. In a quintessential cash business situation, we were engaged on behalf of an absentee minority shareholder in a restaurant to help him recover that to which he was entitled. This is another example of a commercial divorce — which, in almost all ways regarding investigation and valuation (with perhaps the exception of a typical lack of access to personal financial records), is essentially the same type of work that we do in a domestic divorce case. One way or another, it is people getting a divorce. This case involved a restaurant — and, therefore, an upfront assumption that there might be a cash — unreported income — problem. Not that it is a guarantee, but, let’s face it, it is a cash business. And when a quick review of the tax returns suggested that the gross profit percentages looked too low and the payroll looked too low, we could be pretty sure there was an issue as to the veracity of the reported income. Then when we got a chance to actually look at some of the payroll records, we found that on the books the chef was getting paid less than the dishwasher. It does not take a 30-year veteran of financial investigations to figure out that all is not pristine, despite a clean bill of health from the local health inspector. Our client owned a minority position in this restaurant and had a contract for him to get paid his percentage (30 percent) of the profits each year. In addition, he was also to receive a salary — even though he was not working. This was perhaps (it was not clear) a long-term buyout of what was at one time a larger percentage interest in the business. Need any of us be told, it’s tantamount to malpractice for an attorney to draft a contract providing his client with a percentage of profits of a business without clearly defining profits. This contract did not define profits or what was our guy going to get. Of course, he got nothing. The business never showed a profit — not surprising or difficult if you are trying to avoid paying a minority shareholder (or for avoiding taxes in general), and certainly no real effort in a cash business like a restaurant. A quick review of the restaurant’s tax returns immediately suggested that there were problems — based both on the gross profits margins (they were


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C.33 THE GOOD, THE BAD, AND THE RESTAURANT

483

too low) and the amount of payroll (it too was too low, and the officers listed on the tax returns were getting paid ridiculously low salaries). In addition, not that this was proof of anything, but our client had told us to expect a certain sales volume — and the tax returns reflected a much lower sales volume. Our initial steps were classic forensic accounting type of work. We went to the restaurant a couple of times and observed that it was very busy — high turnover, and the seats were kept full. Also, it was a full-service, lunch and dinner (no breakfast) restaurant, it served liquor (the bar was pretty busy) and it catered to a middle-age middle-class clientele. The meals were full, not elaborate, and moderately priced. The restaurant also accepted a popular discount card, and there was an upstairs to handle overflow or, more typically, cater parties. There was a lot of staff (it was needed), including many waiters, busboys, a manager, bartenders — and presumably (I was not able to get into the kitchen) a few chefs. I also observed (and this was later to prove to be a very important aspect of the restaurant’s operations) that, befitting a restaurant trying to be a somewhat upscale middle-age budget restaurant, it of course used linens (as contrasted with paper napkins). Thus, all diners had full-size linen napkins, besides of course the tables being covered with linen tablecloths. Other procedures employed included getting a copy of a menu and noting (as part of what we ordered) pricing, the size of the portions, the accoutrements of what accompanied the meals — a house salad, garnishment on the side, a potato, and the like—what was included for the price with which type of meal. Of course, while we asked for the past few years of sales slips/receipts, we knew that there was no way they were going to be available. And in fact, that is exactly what happened — we were advised that they were not retained. We were able to examine a book reflecting daily collections (of course, only to the extent they were reported) broken out by food, liquor, and sales tax. That did prove of help in terms of making certain allocations/ratios. In addition, we got on a goingforward basis (to a limited degree) daily cash register printouts, which eventually proved of some help in determining/verifying average sales prices. A complicating factor was that, as we were advised by our client, the management of the restaurant had a habit of purchasing some of its food with cash. In addition, it was obvious from a review of the payroll records that a portion of payroll was being paid in cash. Therefore, any attempt at a gross profit margin analysis (that is, comparing how much food was purchased to how much was sold) would be incorrect and understate the true extent of sales. We needed a better, more honest count of volume. Without question, the critical item in support of our income calculations turned out to be laundry bills—how many napkins were laundered? Fortunately, this restaurant used an outside linen service — which, twice a week, all the time like clockwork, picked up the tablecloths and napkins, replaced them with clean ones, and then repeated the cycle. The bills from the laundry service were quite detailed, listing the number of napkins, the number of tablecloths (of varying sizes), even listing them by color. We did an exhaustive analysis of those laundry bills and decided to focus on the number of dark green napkins (we had determined that those were the napkins used by restaurant patrons with their meals) laundered during several months of a few different years that we sampled. The result of this analysis was a determination of the number of napkins that were used, extrapolated to a full year. Combining that with the calculations we


484

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SAMPLE REPORTS

had done determining what the average meal sold for, and also allowing that some of the napkins were probably not used for salable meals (that is, some were used for extra clean-up, perhaps some for courtesy meals for the employees or whatever), we arrived at what was a very supportable and sound determination of the correct of gross revenues. The results were mind-boggling. We had concluded (and were later able to prove by other methods that will be left unstated) that the extent of the unreported revenues actually reached 50 percent of the total sales of the restaurant. We illustrate in Exhibits C–113 to C–118 the process we employed in our conclusions. Note that our presentation is purely to illustrate the extent of the unreported revenues. We knew, and forensics made it obvious, that there was a fair amount of unreported payroll. In addition, our client made us aware that there were unreported purchases. These, of course, even though improperly handled, are legitimate business expenses. For this purpose we made no attempt to illustrate or determine the approximate amount of these cash expenditures. We had no solid basis for concluding how much they were, and our major purpose was to prove unreported revenues — leaving it to the other side to respond with and address the matter of the unreported expenses. Procedures Used to Reconstruct Income for the Kashkow Restaurant

Copies of lunch and dinner menus, in use during 1997, were used for one method of estimating the price of the average meal. Using the prices listed on the menus, various dining scenarios were developed in order to estimate the price of the average lunch and dinner, as illustrated in Exhibit C–113. Estimated Average Meal Price.

EXHIBIT C–113

Average Estimated Meal per Menu

Lunch Menu

ITEM/MENU Appetizers Soups Entrées: (A) Salads (B) Eggs & Omelets (C) Sandwiches (D) Seafood (E) Non-Seafood

ITEM Entrée Beverage Soups Appetizer

Scenario 1

Total Cost

No. of Items

Avg Cost Per Item

$ 51.10 3.45

9 2

$ 5.68 1.73

51.65 25.70 99.40 189.90 82.60

7 6 20 22 8

7.38 4.28 4.97 8.63 10.33

Scenario 2

Scenario 3

Scenario 4

Scenario 5

Scenario 6

$7.38

$7.38 1.48

$ 7.38 1.82 1.73

$ 7.38 2.61 5.68

$ 7.38 2.96 1.73 5.68

$15.67

$17.75

1.14 5.68 $6.82

AVERAGE LUNCH

$7.38

$11.24

$8.86

$10.93

TOTAL

$67.41


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Page 485


EXHIBIT C–113

485

Average Estimated Meal per Menu (continued)

Dinner Menu

ITEM/MENU

ITEM Entrée

Total Cost

No. of Items

Avg Cost Per Item

$ ,138.25

18

$ 7.68

(A)

Appetizers

(B)

Soups

,

16.35

7

2.34

(C)

All Entrée Items

1,041.90

62

16.80

(D)

Early Bird Specials (includes soup)

91.50

10

9.15

,

Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario Scenario 1 2 3 4 5 6 7 8 9 Early Early Early Early Bird Bird Bird Bird TOTAL $9.15

Beverage

$ 9.15

$ 9.15

$ 9.15

1.83

2.43

3.37

$16.80

$16.80

$16.80

$16.80

$16.80

3.36

3.83

4.90

5.50

Soups

2.34

Appetizer

7.68

Dessert

7.68

3.00 $9.15

$10.98

$14.58

7.68 3.00

$20.20

AVERAGE DINNER

$19.69

AVERAGE MEAL

$16.87

$16.80

$20.16

$22.97

$29.38

$32.98 $177.20

In Exhibit C–113, beverage price was computed using 20 percent of total food price, which was based on the ratio of “bar sales” to “food sales,” as listed in the Kashkow’s “Daily Sales Log.” The average meal price of $16.87 was computed by averaging the lunch and dinner prices, assuming that two dinners are served for every lunch. This average meal price will be used in the reconstruction of income for the fiscal years ended 1996 and 1997. The second method for estimating average price per meal employed the use of waitress/waiter check chits, which were made available only during the latter portion of the investigation. The check chits used for two complete days were analyzed and summarized in order to obtain a more recent estimate of an average price. May 8, 1999, a Saturday, was chosen because it represented a day with a greater amount of volume, during a time of year with typically greater volume of business. Wednesday, November 11, 1998, was chosen due to the lower amount of volume for this day of the week and it being a slower period of the year. Exhibit C–114 shows this analysis.


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EXHIBIT C–114

Daily Check Chits 5/8/99 Saturday 11/11/98 Wednesday Discounted Meal Features: Early Bird Special Entertainment Coupon

Day

# Guests

Dinner

Beverage

Sales Tax

Total

Total Disc Meal

Disc Meal Exclude Tax

Reduction Of Meal For Discount

—) —) —) —) —) —) —) —) —) —) —) —) —) —) 46.27) —) —) —) —) —) —) —) —) 42.26) —) 56.84) —) —) —) —) 24.95) —) —) —) —) —) 56.93) —) —) 46.70)

—) —) —) —) —) —) —) —) —) —) —) —) —) —) (11.43) —) —) —) —) —) —) —) —) (14.14) —) (30.91) —) —) —) —) (15.95) —) —) —) —) —) (13.92) —) —) (35.85)

Saturday 5/8/99 58897 58898 58899 58900 58905 58906 58907 58908 58909 58910 58911 58912 58914 58915 58917 58918 58918 58919 58920 58921 58922 58923 58925 58926 58927 58928 58928 58929 58930 58931 58932 58933 58934 58935 58936 58937 58939 58940 58941 58942

3 1 3 2 3 2 2 18 3 5 4 2 7 2 5 2 1 2 4 3 2 2 5 2 2 4 2 5 2 2 2 3 2 3 3 5 3 4 2 4

22.85 7.95 43.30 16.90 36.15 17.90 20.90 238.75 25.45 65.10 63.25 13.90 123.50 31.90 57.70 45.90 15.45 21.90 86.75 47.80 45.90 26.90 153.65 44.90 23.90 75.75 18.90 29.85 57.90 17.90 33.90 44.85 30.90 47.85 31.90 103.75 45.85 43.70 17.90 65.80

1.50

8.00 98.50 1.50 7.50 3.00 52.00 13.00 4.25 1.50 1.30 4.50 6.00 16.00 11.50 11.50 7.00 12.00 3.50 9.50 8.00 7.00 — 10.00 8.50 17.00 4.50 25.00 9.50 16.75

1.40 0.60 2.60 1.11 2.17 1.60 1.54 20.25 1.60 4.20 3.80 1.10 10.55 2.70 2.50 3.00 1.05 5.45 3.25 3.70 2.30 9.22 3.30 1.90 5.30 2.00 2.35 3.95 1.10 2.60 2.70 2.40 2.40 2.95 6.50 4.50 3.20 1.07 4.95

24.25 10.05 45.90 18.01 38.32 27.50 22.44 357.50 28.55 76.80 67.05 18.00 186.05 47.60 60.20 53.15 18.00 23.20 96.70 57.05 65.60 40.70 162.87 59.70 32.80 93.05 24.40 41.70 69.85 19.00 43.50 47.55 43.30 58.75 51.85 114.75 75.35 56.40 18.97 87.50

49.05

44.80 60.25

26.45

60.35

49.50


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EXHIBIT C–114

487

Daily Check Chits 5/8/99 Saturday 11/11/98 Wednesday (continued) Discounted Meal Features: Early Bird Special Entertainment Coupon

Day 58943 58943 58944 58945 58946 58947 58947 58948 58949 58950 58951 58952 58953 58954 58955 58956 58956 58957 58958 58959 58960 58961 58961 58962 58963 58964 58965 58966 58967 58968 58969 58970 58971 58972 58973 58974 58975 58976 58977 58978 58979 58980

# Guests 2 6 2 4 3 7 7 2 8 5 2 3 3 2 4 2 6 15 5 2 2 2 2 2 2 5 2 2 2 6 2 3 2 9 4 2 2 4 2 4 2 2

Dinner 25.10 83.75 18.90 39.80 26.85 110.65 110.65 39.90 79.60 62.20 32.85 33.80 39.35 36.90 72.05 42.85 128.70 233.50 101.70 44.85 32.90 57.90 57.90 39.90 51.85 40.90 43.90 78.80 34.90 120.15 72.80 55.85 42.90 131.65 76.75 56.90 33.90 106.95 55.90 81.05 57.90 34.80

Beverage 12.00 3.00 11.25 1.50 5.00 21.00 11.25 1.50 5.00 12.50 4.50 22.50 51.50 11.25 6.50 24.25 3.00 6.00 11.50 6.00 4.80 6.00 22.00 3.00 43.50 20.00 9.50 7.50 28.00 57.50 9.00 15.00

Sales Tax

Total

1.50 5.75 1.35 2.40 2.40 6.64 6.75 2.70 6.05 4.40 2.10 2.05 2.65 2.25 5.05 2.85 9.00 17.10 6.80 3.60 1.95 4.95 3.47 2.60 3.50 3.25 3.00 83.60 2.45 7.20 5.70 3.50 2.55 9.20 5.80 3.95 2.50 8.05 3.35 8.50 4.00 3.00

26.60 101.50 23.25 42.20 40.50 117.29 118.90 47.60 106.65 77.85 36.45 35.85 47.00 39.15 89.60 50.20 160.20 302.10 119.75 54.95 34.85 87.10 61.37 45.50 61.35 55.65 52.90 48.90 43.35 127.35 100.50 62.35 45.45 184.35 102.55 70.35 43.90 143.00 59.25 147.05 70.90 52.80

Total Disc Meal 57.10

89.50 32.70

22.35

128.50 252.30 98.40 38.60 19.00 69.05

34.96 46.13

47.85 152.95

111.10



—) 53.87) —) —) —) —) 84.43) 30.85) —) —) —) —) —) 21.08) —) —) 121.23) 238.02) 92.83) 36.42) 17.92) 65.14) —) —) —) —) 32.98) (32.67) —) —) —) 45.14) —) 144.29) —) —) —) 104.81) —) —) —) —)

—) (41.88) —) —) —) —) (27.72) (14.05) —) —) —) —) —) (15.82) —) —) (29.97) (46.98) (20.12) (14.93) (14.98) (17.01) —) —) —) —) (16.92) —) —) —) (13.71) —) (30.86) —) —) —) (30.14) —) —) —) —)


488

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SAMPLE REPORTS

EXHIBIT C–114


Day 58981 58982 58983 58984 58985 58986 58987 58988 58989 58990 58991 58992 58993 58994 58995 58996 58997 58997 58998 58999 59000 59001 59002 59002 59004 59005 59006 59007 59008 59009 59010 59011 59012 59013 59014 59016 59017 59019 59020 59021 59022 59023

# Guests 2 4 4 3 5 3 2 4 4 4 2 4 2 2 3 6 2 2 5 3 2 2 4 4 3 3 4 9 6 6 4 2 2 4 2 2 3 3 2 4 4 2

Dinner 39.90 59.80 91.70 74.70 110.60 71.70 42.30 65.80 65.80 79.75 33.90 93.75 41.90 55.85 80.85 94.65 29.90 29.90 80.30 56.30 43.80 41.85 113.75 71.75 67.80 65.85 62.80 181.45 148.15 108.70 84.30 65.85 60.40 105.80 44.90 67.40 64.75 57.90 35.85 96.25 68.80 41.90

Beverage 13.25 — 9.00 13.25 26.00 16.50 6.00 15.00 14.00 18.00 1.50 24.00 11.00 23.50 3.00 22.50 3.00 17.75 10.50 7.50 8.00 3.00 14.00 17.00 11.00 41.50 34.50 23.00 5.50 4.50 16.00 13.25 3.00 13.00 3.00 9.00 31.00 32.00 14.00

Sales Tax

Total

3.20 3.60 6.05 5.30 6.30 4.40 2.90 4.85 4.80 5.95 2.15 5.05 3.20 4.75 5.05 7.05 2.00 2.00 5.60 4.05 3.10 3.00 7.00 5.15 5.05 4.60 3.77 13.40 10.95 6.55 6.45 4.30 3.90 7.30 3.50 4.25 4.65 3.80 2.70 6.40 6.05 3.55

56.35 63.40 106.75 93.25 142.90 92.60 51.20 85.65 84.60 103.70 37.55 122.80 56.10 84.10 88.90 124.20 34.90 31.90 103.65 70.85 54.40 52.85 123.75 90.90 89.85 81.45 66.57 236.35 193.60 115.25 113.75 75.65 68.80 129.10 61.65 74.65 82.40 64.70 47.55 133.65 106.85 59.45

Total Disc Meal 31.70 89.90 111.00 77.65

52.90 86.70 19.75 89.90 45.00

36.90 96.90

65.50

142.85 83.55 96.85 57.65 50.80 93.10 44.75

46.55 35.95 114.65 92.05



—) 29.91) 84.81) —) 104.72) 73.25) —) —) 49.91) 81.79) 18.63) 84.81) 42.45) —) —) —) —) —) —) —) —) 34.81) 91.42) —) —) 61.79) —) —) 134.76) 78.82) 91.37) 54.39) 47.92) 87.83) 42.22) —) —) 43.92) 33.92) 108.16) 86.84) —)

—) (29.89) (15.89) —) (31.88) (14.95) —) —) (29.89) (15.96) (16.77) (32.94) (10.45) —) —) —) —) —) —) —) —) (15.04) (25.33) —) —) (15.06) —) —) (47.89) (29.88) (15.93) (16.96) (16.98) (33.97) (15.93) —) —) (16.98) (10.93) (19.09) (13.96) —)


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EXHIBIT C–114

489


Day 59024 59025 59026 59027 59029 59030 59031 59032 59033 59034 59035 59036 59037 59038 59039 59040 ?58942? 589?? 589?? 597?? various bar & food

# Guests 2 5 2 5 2 2 2 22 4 4 2 2 2 2 1 2 4 9 6 5

Dinner

Beverage

28.95 161.15 41.90 119.45 30.90 41.85 44.80 31.90 100.25 72.80 35.40 35.90 51.85 49.90 15.95 29.90 77.25 105.60 87.40 115.70

6.50 28.75 4.50 23.00 6.50 6.50 19.00 4.25 22.00 12.00 3.00 4.10 17.00 — 3.00 26.75 39.00 33.50 15.00

Sales Tax

Total

2.10 11.40 2.85 8.55 2.25 2.90 3.85 2.15 7.30 5.10 2.45 2.35 68.35 4.05

37.55 201.30 49.25 151.00 39.65 51.25 67.65 38.30 129.55 89.90 37.85 41.25 124.30 70.95

2.00 6.25 8.70 7.20 7.85

34.90 110.25 153.30 128.10 138.55

394.72 518



—) —) —) —) —) —) —) 20.19) 91.46) 53.02) —) 23.96) —) —) —) 19.95) —) —) —) —)

—) —) —) —) —) —) —) (15.96) (30.79) (31.78) —) (14.94) —) —) —) (12.95) —) —) —) —)

21.40 96.95 56.20 25.40

21.15

394.72

8,991.70 1,657.65

Average price per customer

Total Disc Meal

695.94 11,724.06

(1,088.91)

8,991.7 ⫹ 1,657.65 ⫺ 1,088.91/518 ⫽ $18.46

Wednesday 11/11/98 48809 48819 48792 48792 48790 48789

12 2 3 3 2 2

356.20 48.8 26.85 27.85 18.90 19.90

100.25 15

27.40

10.25 11 1.5

2.3 1.8 1.9

483.85 63.80 26.85 40.40 31.70 23.30

To go 48791 48788 48787 48785 48786 48784 48779

3 3 2 3 2 2 1

18.85 28.85 17.90 25.35 15.40 21.90 11.45

3.5

1.3 1.75 1.7 1.7 1.2 1.75 1

23.65 30.60 29.60 30.05 21.1 30.65 19.45

10 3 4.5 7 7

420.25

25.6

396.46) —) —) —) —) —)

(59.99) —) —) —) —) —)

—) —) 24.15) —) —) —) —)

—) —) (3.75) —) —) —) —)


490

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Page 490

SAMPLE REPORTS

EXHIBIT C–114


Day 48783 48781 48782 48780 48718 48801 48797 48808 48817 48816 48814 48815 48805 48813 48806 48810 48804 48811 48802 48803 48800 48799 48798 48796 48795 various bar & food

# Guests

Dinner

Beverage

2 2 2 2 4 2 2 2 4 2 2 3 2 5 2 2 2 2 4 2 2 1 4 2 2

14.90 27.10 15.90 24.40 38.90 16.95 18.90 33.90 123.70 54.90 51.85 72.85 85.20 62.20 59.10 38.90 27.90 18.95 51.80 35.90 44.90 8.95 39.80 17.90 23.90

101

1,647.85

3

3.5 4.25 3 1.5 1.25 4.7 26.5 12.25 12.25 10 21.25 10

14 7 3 6

Sales Tax 1.1 1.6 0.95 1.65 2.6 1 1.75 2.1 8.4 3.7 4.7 5.1 5.4 4.37 4.8 2.9 1.7 1.15 4 2.4 2.7 0.6 2.5 1.1 1.5

19 28.7 16.85 29.55 45.75 17.95 23.65 37.5 133.35 63.3 83.05 90.2 102.85 6.5 85.15 51.8 29.6 20.1 69.8 45.33 47.6 12.55 48.3 19 25.4

113.50

2,077.80

278.70

Average price per customer

Total

Total Disc Meal

72.2

72.45 15.85 59.2 8.1 38.05



—) —) —) —) —) —) —) —) —) —) —) 68.11) —) —) 68.35) —) 14.95) —) 55.85) 35.94) 35.90) —) —) —) —)

—) —) —) —) —) —) —) —) —) —) —) (16.99) —) —) (12.00) —) (12.95) —) (9.95) (6.96) (9.00) —) —) —) —)

278.7 316.45

741.70

(131.58)

1,647.85 ⫹ 316.45 ⫺ 131.58/101 ⫽ $18.18

The “various bar & food” checks included in the exhibit were excluded in the calculation of the average meal per customer as these checks did not show the number of guests. The above method yielded an average meal price of $18.46 for May 8, 1999, and $18.18 for November 11, 1998. These prices support the meal price computed in Exhibit C–113 and reflect what we consider a reasonable inflationary increase in the price of meals served. In addition to and excluding the check chits included in Exhibit C–114, a random selection of 19 check chits from November 8, 1998, through November 14, 1998, as well as 16 check chits from May 2, 1999, through May 8, 1999, was chosen


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491

for similar analysis. The testing of the check chits in November 1998 yielded an average price per meal, including discounted meals, of $18.19. The testing of the 19 May check chits yielded an average price per meal of $20.95, which also included discounted meals. The amounts arrived at, which represent the averaging of 657 check chits, will be used in the calculation of the average price per meal served for the fiscal years ended 1999 and 1998 as follows. Fiscal year ended November 1999: $18.46 $20.95 $18.18 $18.19

5/8/99 — Exhibit C–113 16 check chits from May 1999 11/11/98 — Exhibit C–113 19 check chits from November 1998

$75.78/4 ⫽ $18.95 estimated average price per meal for the year ended November 1999 Fiscal year ended November 1998: $16.87 $18.18 $18.19

estimated average price per meal for 1996 & 1997 11/11/98 — Exhibit C–113 19 check chits from November 1998

$53.24/3 ⫽ $17.75 estimated average price per meal for the year ended November 1998 The Kashkow uses a cleaning service for laundering the linens used. The service picks up and delivers the laundry on Wednesdays and Fridays and was paid in cash during 1996, 1997, and 1998. An analysis of the number of napkins included on the laundry service invoices was performed in order to approximate the amount of meals served. All laundry invoices were accumulated for 25 months during 1996 through 1999. The cash payments of the invoices were compared and agreed to the entries in the “Daily Cash Logs” for 1996 through 1998, to ensure that all invoices for the months were included in the analysis. The amount of dark green napkins shown as laundered on each invoice was added up and divided by the number of days in the month in order to arrive at an average of napkins laundered per day in each month. The results are summarized by fiscal year ended November 30, in Exhibit C–115.

Estimated Number of Meals Served.

EXHIBIT C–115 Month April 96 June 96 August 96

Number Napkins Laundered Per Day 220 217 287

Average per day for fiscal November 1996 ⳱ 241


492

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SAMPLE REPORTS

EXHIBIT C–115

Number Napkins Laundered (continued)

Month December 96 February 97 April 97 June 97 July 97 October 97

Per Day 194 207 272 255 256 252

Average per day for fiscal November 1997 ⳱ 239 January 98 February 98 March 98 June 98 July 98 August 98 September 98 November 98

200 195 215 287 344 256 295 193

Average per day for fiscal November 1998 ⳱ 248 January 99 February 99 March 99 April 99 June 99 July 99 August 99 September 99

156 227 202 207 290 277 300 268

Average per day for fiscal November 1999 ⳱ 241

The Kashkow’s volume of customers is typically higher in the summer months. The selection of months used for testing was done so as to include months with higher and lower volume so as to ascertain a reasonable and accurate approximation of the number of meals served. The selection of months used for analysis for fiscal November 1996 was limited due to the destruction of invoices caused by an irate customer. The average of 241 may be somewhat high as the months available for testing typically show a higher volume of customers. In order to be conservative, the average of 241 will be lowered to 230 for the purpose of reconstructing income. The average of 241 for fiscal November 1999 appears too low, especially for January. As was stated earlier, laundry bills were paid by check as opposed to cash in 1999. We were unable to ascertain whether all laundry bills were included in the calculation as we were unable to reconcile bills to cash payments in the “Daily Cash Log.” However, in order to be conservative, the average of 241 will be used for fiscal November 1999 for further calculations. The average number of napkins computed above will be used to estimate the average number of meals served. Together with the average price per meal, the income will be reconstructed as shown in Exhibit C–116.


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Page 493


EXHIBIT C–116

493

Reconstruction of Gross Income

Item Description

11/30/96

Average number of napkins laundered per day ⫻ Estimated average meal price ⫻ Days per year

11/30/97

,

,230

$,

16.87

,

,363

,, $

11/30/98

239

, 16.87

248

,,241

, 17.75

$

, 18.95

363

,,363

⳱ $1,408,476

$1,463,591

$1,597,926

$1,657,803

, 42,254

, 43,908

,47,938

49,734

Adjusted gross revenues

1,366,222

1,419,683

1,549,988

1,608,069

Gross sales as reported on corporate tax return

$ ,624,624

$ ,695,097

$1,054,804

$1,379,381

Unreported gross income

$ ,741,598

$ ,724,586

$ ,495,184

$ ,228,688

Estimated gross income Less 3 percent

,,

,, $

11/30/99

,,

363

In Exhibit C–116, the average number of napkins laundered per day is reduced by 3 percent in order to arrive at the estimated number of meals served per day. This reduction is used to provide for a measure of conservatism, allowing for the use of napkins other than for meals, such as for cleaning up of spills or for courtesy meal usage by employees. Industry operations reports may also be used to estimate the amount of gross income using industry percentages. The following amounts and percentages were derived from the National Restaurant Association 1999 “Restaurant Industry Operations Report,” which used 1,278 restaurant operator surveys of the operating results of restaurants in 1998 as a basis for this report. The amounts in Exhibit C–117 are in the median quartile for full-service restaurants with an average check per person of $10 and over. Columns do not total when medians are involved because each line item is analyzed separately.

EXHIBIT C–117

Median Quartile Amounts for Full-Serve Restaurants with an Average Check per Person of $10 or More Amount per Seat

Ratio to Total Sales

Sales Food Beverage (alcoholic) Total Sales

$

,4,696

76.9%

,

1,416

23.1%

,

6,468

100.0%

Cost of Sales Food

,

1,714

35.0%

,415

29.8%

,

2,197

33.8%

$,

4,172

66.2%

Beverage (alcoholic) Total Cost of Sales Gross Profit

,


494

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SAMPLE REPORTS

EXHIBIT C–117

Median Quartile Amounts for Full-Serve Restaurants with an Average Check per Person of $10 or More (continued)

By applying the percentages above to the Kashkow’s fiscal November 1998 cost of goods sold amount per the Company’s tax return, total gross receipts can be estimated as follows:

$ , 579,745

Cost of sales per the year ended 11/30/98 tax return

Divided by the cost of 33.8 % sales percentage above ⫽ $1,715,222

Total estimated gross sales

This calculation supports the estimated gross revenue computed previously of $1,549,988 and in fact makes the previous computation appear conservative. However, the information presented in Exhibit C–118 is derived from a nationwide survey, where the results may differ from those derived from information specifically about the Kashkow Restaurant (see Exhibit C–119). Thus, we will rely on the analyses of the Kashkow rather than on national surveys. Determination of Damages

EXHIBIT C–118

Damages 11/30/99

Income (loss) before taxes and adjustments per corporate tax returns Unreported sales* Adjusted income (rounded) Client’s share — 30% (rounded)

11/30/98

11/30/97

11/30/96

11/30/95

11/30/94

$ 9,450 $ (9,292) $ (28,341) $ (1,629) $ 79,937) $ 29,187) 229,000 495,000) 725,000 742,000 667,000 721,000 238,000

486,000

697,000

740,000

747,000

750,000

$ 71,000 $146,000) $209,000) $222,000) $224,000) $225,000)

*All amounts rounded. Refer to narrative in report. Amounts for fiscal November 1994 and 1995 assumed to be in proportion to those for fiscal November 1996 (based on reported sales).

EXHIBIT C –119 Fiscal Fiscal Fiscal Fiscal Fiscal Fiscal

Client’s Share of Adjusted Income

November 30, 1994 November 30, 1995 November 30, 1996 November 30, 1997 November 30, 1998 September 30, 1999 Totals

$1,225,000 $1,224,000 $1,222,000 $1,209,000 $1,146,000 $11,71,000 $1,097,000


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C.34 IZOR V. IZOR, VISUAL REALITY 䊳

495

C.34 IZOR V. IZOR, VISUAL REALITY. I guess of all the different types of businesses that we get called upon to investigate and value in our divorce practice, the type of business that occurs most often, hands down, is a medical practice. Not a year goes by that we are not handling several doctors’ divorces. Whatever the reason for doctors’ seemingly high rates of divorce, investigating a medical practice has become an absolute standard. Frankly, most of the time the real serious work in these cases is investigating the practice to determine the income of the doctor; the valuation itself usually isn’t all that exciting. In one interesting case not too long ago, an ophthalmologist, was actually making pretty good money and had a very nice practice. However, the income just didn’t seem to be where it should be. This time, however, the practice had a little bit (and in some cases more than a little bit) of everything. We had unreported income from cash paid by patients, we had unreported income from the sale of product, we had some of the usual perquisites, and more. The investigation of this practice began in much of the usual fashion, but as we progressed, we kept on finding more and more interesting things and found ourselves going in various directions. We were able to get three years of printouts of patient collections and charges from the doctor’s computer system. The really interesting thing was that the revenues indicated thereon as being collected (we were very careful to deal with collections, not billings) each and every year were significantly in excess of that reported on his tax return. And the collections were typically between 50 and 70 percent of the billings — so there was no question in our minds that we had a genuine problem here. Even more interesting, none of those collections reflected the sale of contact lenses. However, the doctor acknowledged that he sold contact lenses. Thus, there had to be even more unreported income than the computer printouts showed. The icing on the cake for the unreported income was that the doctor and his accountant showed us the forms 1099 for one of the years (it seems they didn’t have all of the 1099s for two of the years that we investigated). They pointed out how the 1099s virtually exactly tied into the reported revenues on the doctor’s tax return for that year. For those of us with more than a week’s experience in accounting, that just proved our point. What about the co-pays? The insurance company 1099s do not reflect co-pays. Considering that this doctor had several thousand patient visits per year, we were talking real serious money here. The doctor acknowledged that he had contracts/arrangements with about 70 insurance carriers — but the 1099s were only from 40 of them. What happened to the other 30? Did he not get 1099s because they were under the threshold, did the 1099s fall through the cracks? Also, what about the sale of product? The doctor had acknowledged that he sold product, but those don’t show up on 1099s. In other words, the doctor’s own records (see Exhibit C–120) proved without any doubt that there was significant unreported income.


496

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Page 496

SAMPLE REPORTS

EXHIBIT C–120

Izor v. Izor Visual Reality Comparative Statements of Income As Per Tax Returns For the Years Ended December 31, 1997

1998

1999

Revenues

$647,849

$696,160

$621,449

Expenses Advertising Car expenses Depreciation Insurance Mortgage interest Other interest Professional fees Office expense Pension plan Rent —vehicles and equipment Rent — office Repairs and maintenance Supplies Meals and entertainment Utilities Wages, taxes, and licenses Bank charges Dues and subscriptions Continuing education Miscellaneous Postage Office upkeep Referrals

,689 1,594 31,127 37,397 29,833 3,281 8,968 30,358 1,363 24,450 65,513 3,093 33,410 1,985 16,870 127,125 , 665 10,028 , 6,00 — 4,200 — 4,795

, ,

,

Total Expenses Profit Before Compensation to Dr. Izor

305 595 26,841 32,863 25,664 6,835 10,136 23,630 4,328 19,296 65,396 8,202 43,945 3,648 18,288 193,064 3,574 9,818 36,758 3,538 3,400 — —

200 4,407 23,497 33,617 27,281 — 5,996 21,126 2,223 24,327 65,396 15,950 31,007 3,226 24,831 243,646 3,066 10,316 8,088 2,584 2,028 — 6,973

442,747

510,124

559,785

$205,102

$186,036

$ 61,664

That of course wasn’t enough. We had a lot of fun with perquisites — including parents who were getting paid unbelievable amounts of money and rent being paid on the premises. The problem was the doctor’s parents owned the premises, and the rent was in excess of the fair market level. There were, of course, some of the usual perquisites — such as a car on the books, certain personal expenses being paid, meals and entertainment and the like — but the real magnitude of distortion came about through the payroll and the rent expense. The doctor had both his mother and his father on the books. The mother was actually a fairly accomplished individual and operated as his office manager. We weren’t challenging that — everyone agreed (including our client) that the mother was indeed the office manager. However, $80,000 per year was a tad high for that position. In addition, the doctor’s father was on the books. Now, his pay was much more modest — only at about $40,000 per year. However, his role was probably best described as “some kind of a few hours per week gopher.” For the work that his


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C.34 IZOR V. IZOR, VISUAL REALITY

497

father did, something closer to $5,000 per year probably would have been more reasonable. And then of course we had the matter of the rent. The parents owned the building (let’s put aside the source of funds for them to buy the building were funds from the doctor diverted from the marital estate) — and the practice was paying rent of over $60,000 per year. Considering that it was office space of 1,500 square foot, that worked out to somewhat over $40 per foot — in a market where the going rate was approximately $15 per foot. EXHIBIT C–121

Izor v. Izor Visual Reality Reconstructed Balance Sheet As of December 31, 1999

Assets Cash in bank Accounts Receivable — Note 1 Fixed assets Less: Accumulated Depreciation Total Assets

$

(6,414) 450,013 226,587 (181,435) 488,751

Liabilities and Capital Accounts payable — Note 2 Income tax payable — Note 3

31,911 146,336

Total Liabilities

178,247

Capital

310,504

Total Liabilities and Capital

$(488,751)

Explanation of Adjustments to the Balance Sheet

The December 31, 1999, aged accounts receivable reflects total receivables of $534,407 (see Exhibit C–121). It would be inappropriate to assume that all such receivables are collectible. Based on discussions with other ophthalmologists, we have provided for an allowance for uncollectibility as shown in Exhibit C–122. Note 1: Accounts Receivable.

EXHIBIT C–122

Accounts Receivable

Aging

Amount

% Collectible

Amount Collectible

Current 31–60 days 61–90 days 91–120 days 121–⫹ days

$375,399 16,582 18,523 8,453 115,450

95% 90% 80% 70% 50%

$356,629 14,924 14,818 5,917 57,725

$534,407

$450,013


498

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SAMPLE REPORTS

A schedule or detailing of accounts payable is not maintained by the Practice (not an unusual situation for a cash basis medical practice). We estimated same as shown in Exhibit C–123. Note 2: Accounts Payable.

EXHIBIT C–123

Accounts Payable

Total Expenses 1999 (per tax return) Less: Depreciation Mortgage Interest Pension Plan Rents Wages Temporary Help

$509,785 $ 23,497 27,281 2,223 39,723 218,620 6,973

318,317

Approximate Expenses Subject to Payment Terms

$191,468

We estimated that outstanding payables would approximate 60 days — one-sixth of such expenses — $31,911.

When recognizing receivables and payables on the balance sheet of a cash basis business, it is normally appropriate to also reflect the tax cost that accompanies same. We calculated said tax as shown in Exhibit C–124.

Note 3: Income Taxes Payable.

EXHIBIT C–124

EXHIBIT C–125

Income Taxes Payable

Accounts Receivable Less: Accounts Payable Net Increase to Balance Sheet

$450,013 31,911 418,102

Tax Burden at 35%

$146,336

Izor v. Izor Visual Reality Adjusted Statements of Income For the Years Ended December 31,

Net Profit per Tax Returns Additions Unreported income (Note 1) Advertising (Note 2) Depreciation (Note 3) Insurance (Note 4) Mortgage (Note 5) Office expense (Note 6) Office supplies (Note 7)

1997

1998

1999

$205,102)

$186,036)

$ 61,664)

107,701 ,500 6,387 11,381 29,833 6,658 3,157

216,073 — (3,562) 14,245 25,664 8,142 —

286,443 — ,(882) 11,358 27,281 1,509 —


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Page 499

C.34 IZOR V. IZOR, VISUAL REALITY

EXHIBIT C–125

499

Izor v. Izor Visual Reality Adjusted Statements of Income (continued) For the Years Ended December 31, 1997

1998

43,013 21,135 6,236 41,000 (3,700) — —

42,896 16,677 10,122 46,000 (3,300) 1,400 —

42,896 21,609 6,201 74,000 (2,600) , 600 4,227

$478,403)

$560,393)

$534,306)

Rent — office space (Note 5) Rent —vehicles and equipment (note 8) Supplies (Note 9) Wages (Note 10) Taxes and license (Note 10) Postage (Note 11) Repairs and maintenance (Note 12) Adjusted Net Income Before Owner’s Compensation

1999

Notes to Adjusted Net Profit from Operations

We added back unreported patient revenues (see Exhibit C–125) based on practice activity reports obtained from the practice. Note 1: Unreported Income.

1997

1998

1999

Revenue per Practice Activity Report Revenue reported per tax return

$755,550 647,849

$912,233 696,160

$907,892 621,449

Unreported Income

$107,701

$216,073

$286,443

Note 2: Advertising.

We reclassified a $500 payment for liquor.

Depreciation was adjusted after calculating the correct depreciation expense for all capitalizable assets and removing the cost of the land and building. Note 3: Depreciation.

Note 4: Insurance. We removed payments for life and disability insurances on Dr. Izor, which are for the personal benefit of the doctor and are not operational expenses. Building insurance was likewise added back. Note 5: Mortgage. The land and building where the medical practice operates are

jointly owned by the doctor and his father. We removed all mortgage payments and insurance as well as the asset and accumulated depreciation charged and assumed reasonable rent of $15.00 per square foot (1,500 square feet of office space). Note 6: Office Expense. Sixteen checks in 1997 and five in 1999, all payable to cash, allegedly for purchase of stamps and office supplies, were without documentation and were reclassified. In Charge Systems payments are related to the practice’s computer system and are considered to be capitalizable and therefore added back, and regular depreciation calculated.


500

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Page 500

SAMPLE REPORTS

Total payments to In Charge Systems of $3,157 were capitalized as related to the computer system. See note 6. Note 7: Office Supplies.

All payments related to equipment lease were capitalized as these are classified as equipment purchase, which the practice pays in installments.

Note 8: Vehicle and Equipment Rent.

One check dated 2/19/98 (check #3620) for $1,200 payable to cash and check #3677 dated 3/14/98 also payable to cash, both unsupported, were treated as personal expenses.

Note 9: Supplies.

Note 10: Wages and Taxes. Both of Dr. Izor’s parents are carried as employees of his medical practice. In 1997 Mrs. Iris Izor’s gross pay was $46,000; in 1998 it was $54,000, and in 1999 it was $78,000. It is our belief and understanding that Mrs. Izor acts in a clerical/administrative function, and as such is overpaid. In addition, Mr. Retna Izor is also on the books of Dr. Izor’s medical practice. In 1997 his gross pay was $40,000; in 1998 it was $37,000; and in 1999 it was $41,000. It is our understanding that Mr. Izor effectively works for the medical practice only a few hours a week, and for the most part for odds and ends errands. As such, he is also overpaid. We estimated the extent of such overpayment. We added back estimated payroll taxes paid by the practice on the excess payroll above and subtracted imputed payroll taxes on Dr. Izor’s compensation. Note 11: Postage.

Checks payable to cash with no documentation were added

back. Expenses to overhaul Dr. Izor’s classic automobile were personal and/or nonrecurring, and thus added back. Note 12: Repairs and Maintenance.

䊳

C.35 ISADORE V. ISADORE, IZZY’S PASTA. Since the early 1800s Izzy’s (the Company) has been manufacturing and selling fresh homemade pasta from its retail location on W. 145th Street in New York City. The Company was incorporated in 1951 and was 100 percent owned by Leroy Isadore until 1980, when all of the stock was gifted to Leroy’s two sons — Achmed and Wilhelm. Under their leadership, the Company has grown significantly. In addition to the retail store, the Company sells a variety of pasta products to 11 restaurants in New York City and several hundred in North Dakota. The product lines consist of Izzy’s manufactured pastas, purchased dry pastas, cheeses, and imported specialties. The majority of the Company’s revenues are derived from restaurant sales. The Company has two vans, three rickshaws, and a bicycle used for deliveries to its various commercial accounts. The retail store is still in its original location on 145th Street. The Company’s tax return (see Exhibit C–126) is on a cash basis, thus not reflecting any accounts receivable or accounts payable. The Company’s reported cash activity is summarized by its accountant, Schmooie Esposito, who prepares a nondetailed cash receipts and detailed cash disbursements journal. The Company allegedly kept no detailed sales journals prior to 1998, so we used alternative procedures (for example, the conversion of reported purchases to sales) to test the accuracy of the reported sales. Our tests revealed significant unreported income — at least in part acknowledged by the Isadore brothers.


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C.35 ISADORE V. ISADORE, IZZY’S PASTA

501

While visiting the Company’s facilities, Achmed Isadore showed us a separate journal with the “actual” amounts paid to employees in 1998. The journal reflected an estimated $150,000 of unreported payroll. He also revealed to us that a close family friend is paid $36,000 rent on the retail facility in cash. Achmed and Wilhelm also admitted to $50,000 of additional payments to themselves. This reflects an admission of over $230,000 of unreported expenses paid for by unreported sales. Our tests revealed that the amounts of unreported revenues were approximately $400,000 per year.

EXHIBIT C–126

Isadore v. Isadore Izzy’s Pasta Statements of Income Years Ended December 31, Unadjusted as Per Tax Returns 1998

1997

Net Sales

$2,070,980)

$1,826,151)

100.0%

Inventory Beginning Purchases — materials

$1,114,788 $1,285,820

0.7 62.1

$1,112,591 $1,431,047

0.6 67.4

$1,112,008 $1,038,664

0.7 56.9

Packaging and other materials Less: ending inventory

$1,113,771 (32,938)

5.5 (1.6)

$1,189,582 $1, (14,788)

4.2 (0.7)

$1,195,860 $1, (12,591)

5.2 (0.7)

1,381,441

66.7

$1,518,432

71.5

$1,133,941

62.1

33.3)%

$1,604,019

28.5)%

$1,692,210

37.9)%

Total Cost of Materials Gross Profit on Materials

,

General and Administrative Expenses Officers compensation Salaries and wages Repairs Rents Taxes Interest Depreciation Lease expense Employee welfare Insurance Office expense Professional Telephone Utilities Other expenses

$1,137,800 $1,213,424 $1,117,705 $1,138,300 $1,132,953 $1,116,110 $1,169,331 $1,131,153 $1,11,1375 $1,150,148 $1,114,712 $1,111,750 $1,111,044 $1,133,417 $1,137,672

Total Operating Income

689,539

100.0)%

$2,122,451)

1996

$1,137,800 $1,232,842 $1,113,903 $1,123,400 $1,144,855 $1,111,533 $1,139,697 $1,113,315 $1,116,064 $1,133,357 $1,113,503 $1,111,450 $1,113,912 $1,130,945 $1,117,010

100.0)%

$1,137,800 $1,205,492 $1,120,411 $1,136,200 $1,168,355 $1,114,854 $1,147,188 $1,117,437 $1,11,1655 $1,131,314 $1,112,569 $1,114,424 $1,110,020 $1,123,809 $1,116,263

$1,685,894

$ 592,586

$1,626,791

$$1,13,645

$1,111,433

$1,165,419

Determination of Unreported Income. At first, Achmed and Wilhelm Isadore advised us that there were no daily sales journals for 1997 and 1998 for us to test. It was later revealed to us that a 1998 sales journal did exist. The journal recorded daily and cumulative sales to commercial customers and a cumulative total. The 1998 journal reflected a total of approximately $1,850,000 in commercial sales.


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Based on our tests, we have concluded this to be an understatement. Even then, much of the cash sales in this journal were not deposited. We were also given a schedule of alleged actual retail sales register tapes for the period December 5 through December 20, 1999 (12 business days). The average retail sales per day totaled approximately $1,800. Using a 262-day retail business year, this equates to approximately $470,000 in retail sales — agreed to by the Isadores. Thus, the Isadores own records acknowledge that there was approximately $2,320,000 in sales in 1998. The reported sales were $2,070,000. Therefore, unreported revenue in 1998 begins at no less than $250,000. We also tested 20 (chosen at random) days of sales slips. The test revealed that, on average, the ratio of commercial (nonretail) sales of manufactured products versus wholesale products was 3:1. This was consistent with our initial interviews with the Isadore brothers. This ratio was a key factor in determining the amount of unreported income. The starting point for testing for unreported income was the Company’s records of food purchases for the years 1996 through 1998. We asked Achmed and Wilhelm to advise which of three categories each vendor fell into: Raw Materials, Wholesale Goods, or items sold at the Retail facility. After adjusting for items paid for in one year belonging to a prior year (accounts payable), the results were as shown in Exhibit C–127:

EXHIBIT C–127

1996

Food Purchases

Raw Materials

Wholesale Goods

Retail Goods

Total Purchases

$415,027

$545,941

$143,600

$1,104,568

1997

468,966

840,354

143,978

1,453,298

1998

447,348

638,355

106,535

1,192,238

Next we determined the profit margin on each category. For retail and wholesale goods, the tests were straightforward. But for manufactured items, there were extreme inconsistencies with what the Isadores represented to us in our first interview versus in later interviews. In our initial interview, we were provided with the recipes for egg pasta, spinach pasta, and spinach ravioli. We concluded that spinach and egg pasta yielded a 75 percent materials profit margin, or had a 25 percent cost of materials. The spinach ravioli, which we were initially advised was produced in batches yielding 17,000 ravioli, had a 68.5 percent profit margin. It was our initial conclusion that overall the manufactured products yielded a 72 percent profit margin, or a 28 percent material cost. Based on same, unreported revenue would be between $550,000 and $650,000 per year. We were concerned about the magnitude of this preliminary conclusion, and we asked the Isadores to interview with us again. In our second interview, they told us that the specialty pastas yielded a lower profit margin, that the spinach ravioli recipe yielded only 14,000, and that there was wastage for which we did not account. However, in our initial interview, they made it a point to state that there was very little wastage in the manufacturing


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503

process. We also went through other recipes with them. The representations were as shown in Exhibit C–128: EXHIBIT C–128

Profit Margins Materials Profit Margin

Seafood ravioli Matzoh tortellini Mushroom tortellini LoMein pasta

47% 50% 44% 60%

Coupling these representations with our initial tests, we concluded there was a weighted material cost of 40 percent based on our two-day sales test. In addition, the Isadores advised that $300,000 of commercial sales are to larger customers where they offer 10 to 20 percent discounts off the normal price. This would add an additional 2 percent cost factor, making their representation of manufacturing cost on materials at 42 percent. Our tests of retail and wholesale goods profit margins reflected 30 percent and 22 percent profit margins, respectively. As shown in Exhibit C–129, applying their second interview representations suggests: EXHIBIT C–129

Reported Sales

1996 1996 adjusted purchases Relative markup* Adjusted sales Assumed raw material sales sold at retail location† Adjusted sales per Isadore brothers Sales per tax return

Raw Materials

Wholesale Goods

Retail Goods

$1,415,027) 2.38

$1,545,941 1,1.29

$143,600 1, 1.41

704,264

202,476

987,764 1,(270,000)

—

270,000

$1,717,764)

$1,704,264

$472,476

Underreported sales 1996

Total

$1,894,504) 1,826,151) $1,,68,353)

* For instance, 42 percent cost equals a relative markup of 2.38. † Assumed manufactured pasta sold at retail store to bring store revenues to approximately $470,000.

Raw Materials

Wholesale Goods

Retail Goods

$1,468,966) 2.38

$1,840,354 1.29

$143,978 1.41

Adjusted sales Assumed raw material sales sold at retail location

1,116,139

1,084,057

203,009

(270,000)

—

270,000

Adjusted sales per Isadore brothers Sales per tax return

$1,846,139)

$1,084,057

$473,009

1997 1997 adjusted purchases Relative markup


Total

$2,403,205) 2,122,451) $1,280,754)


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EXHIBIT C–129

Reported Sales (continued) Raw Materials

Wholesale Goods

Retail Goods

$1,447,348) 2.38

$1,638,355 1.29

$106,535 1.41

Adjusted sales Assumed raw material sales sold at retail location

1,064,688

1, 823,478

150,214

(320,000)

—

320,000

Adjusted sales per Isadore brothers Sales per tax return

$1,744,688)

$1,823,478

$470,214

1998 1998 adjusted purchases Relative markup

Overreported sales 1998

Total

$2,038,380) 2,070,980) $ 1,(32,600)

Except for the anomaly that 1997 underreported sales are close to the Isadores’ representations, the result of these tests (calculated using the Isadores’ most recent representations) present problems and inconsistencies. One key problem is the ratio of commercial manufactured goods sales to wholesale goods sales. In all cases, wholesale sales of manufactured pastas are greater than commercial manufactured goods sales. We are comfortable in agreeing, based on our interviews with the Isadores and our tests of sales, that the ratio of these sales should have approximated between 2:1 to 3:1. If we assume that the wholesale revenues in 1998 are accurate, then commercial manufacturing sales should be $2.1 million at 2.5:1 and is short in the above calculation by $1.5 million. The 1996 and 1998 reported revenues are close to the calculated amounts above. Even by the Isadores’ own admission, this cannot be true. In 1997 there were almost $200,000 of additional purchases from a pasta company called Pam’s Partially Prepared Pasta (PPPP). There were large quantities of Kasha brand dry pasta purchased from this company at a lower price than their competitor. These purchases, according to Achmed Isadore, circumvented the manufacturers’ agreement which allowed the Company to purchase Kasha pasta only from a supplier called Meorelse. Despite the assumed increase in sales this would have caused in 1997, 1998 purchases of Kasha pasta from Meorelse did not increase, leaving us to question whether there were off-the-books purchases of this pasta in 1998. As a result of the above inconsistencies, we have calculated (in Exhibit C–130) the sales of manufactured pastas based on a 30 percent cost factor — which is consistent with the representations made by the Isadore brothers at our initial interview, allowing for a wastage factor of an additional 10 percent. EXHIBIT C –130 1996 Adjusted purchases Relative markup Adjusted sales

Reported Sales Raw Materials

Wholesale Goods

Retail Goods

$1,415,027) 3.30

$1,545,941 1,1.29

$143,600 1, 1.41

1,369,589

704,264

202,476

Total


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Page 505


EXHIBIT C –130

505

Reported Sales (continued)

1996

Raw Materials

Reclassification to retail sales

1,(270,000)

—

270,000

$1,099,589)

$1,704,264

$472,476

Adjusted sales

Wholesale Goods

Retail Goods

Sales per tax return

Adjusted purchases

$1,450,178)

Raw Materials

Wholesale Goods

Retail Goods

$1 ,468,966)

$1,840,354

$143,978

Adjust for PPPP

—

(200,000)

—

Inventory adjustment

—

(35,000)

—

Adjusted purchases Relative markup Total sales Reclassification to retail sales Adjusted sales Add PPPP purchases w/1.20 markup Adjusted sales

468,966

1,605,354

143,978

3.30

1.29

1.41

1,547,588

780,907

203,009

(270,000)

—

270,000

1,277,588)

1,780,907

473,009

1,258,000

—

$1,038,907

$473,009

— $1,277,588)

Sales as reported

Adjusted purchases Relative markup Adjusted sales Reclassification to retail sales Adjusted sales

Total

$2,789,504) 2,122,451)


1998

$2,276,329) 1,826,151)


1997

Total

$1,667,053)

Raw Materials

Wholesale Goods

Retail Goods

$1, 447,348)

$1,638,355

$106,535

3.30

1.29

1.41

1,476,248

1, 823,478

150,214

(320,000)

—

320,000

$1,156,248)

$1,823,478

$470,214

Sales as reported

Total

$2,449,940) 2,070,980)


$1,378,960)

Average unreported sales 1996 to 1998

$1,498,000)

Amount used to adjust financial statements 1996 to 1998.*

$1,400,000)

*Since the majority of our testing involved 1998, we rounded down our conclusion as to unreported income to $400,000 (which approximates 1998).


506

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EXHIBIT C–131

Isadore v. Isadore Izzy’s Pasta Reconstructed Income 1998

Operating Income

$

1997

1996

3,645

$ 11,433

$ 65,419

400,000 137,800 35,212 (22,251) 39,697 — 9,477

400,000 137,800 — (65,904) 47,188 15,000 30,132

Additions: Additional income Officers salaries Inventory Purchases Depreciation Repairs Income taxes

2 2 3 4 5

400,000 137,800 (35,212) 93,582 69,331 — —

Reductions: Unreported payroll Reasonable rent Lease expense adjustment

6 7 8

(150,000) (44,700) —

(142,857) (59,600) (20,000)

(136,054) (46,800) —

$474,446

$388,911

$446,781

1

Adjusted Income Before Officers Compensation

Explanation of Adjustments.

The following adjustments are shown in Exhibit

C–131. Adjustment No. 1: Additional Income.

Refer to analysis provided previously.

The 1996 to 1998 purchases have been analyzed and adjusted to the amounts previously presented in this report. The majority of adjustments relate to accounts payable (which are not reported on the Company tax returns) and misposted items that do not belong in purchases. Adjustment No. 2: Purchases.

The Company purchased significant amounts of equipment between 1996 and 1998. Achmed and Wilhelm Isadore advised us that much of the equipment was contracted to be built and was not utilized because it wasn’t built properly. Adjustment No. 3: Depreciation.

Adjustment No. 4: Repairs. There were extensive repairs done as a result of moving the manufacturing facility from 145th Street to 144th Street in 1996. These repairs were deemed nonrecurring in the normal course of business and thus added back to income.

Items related to income taxes are removed from the income statement to arrive at income before taxes. Adjustment No. 5: Income Taxes.

Adjustment No. 6: Payroll. The Isadores acknowledged there was approximately $150,000 of unreported cash payroll paid to various individuals in 1998. When reviewing with Achmed Isadore the various people paid in cash, he would not reveal cash paid to his mother, father, himself, or Wilhelm Isadore. When we came to these names on the payroll list, his response was “I can’t give you that.” This was


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C.36 CHOCOLATE V. CHOCOLATE, JACKIN BOX MANUFACTURING CO., INC.

507

already after he and Wilhelm acknowledged $50,000 between them and $36,000 of rent to a close family friend. We believe this constitutes additional support that there is more unreported income than they wish to admit. To the agreed $150,000 of unreported payroll for 1998, we subtracted 5 percent per year for inflation. Adjustment No. 7: Reasonable Rent. From 1989 to 1992, the Company rented most of its space from related parties. However, when it started expanding in 1992 and 1993, additional space was leased near the store on 145th Street. Factory space was rented at $36 a square foot from an unrelated party. Storage space at approximately $20 a square foot was also rented. Once the factory and warehouse space were moved in 1993, all rents were to related parties. The factory contains factory, storage, office, and conference room space. We have estimated a fair total rental for 1997 and 1998 at $83,000 determined as follows:

Store 800 sq. ft. @ $36 Factory, storage and office (per real estate appraiser)

$28,800 54,500 $83,300

Rounded

$83,000

Adjustment No. 8: Lease Expense. In 1997, truck lease payments of approximately $20,000 were misposted to a liability account. We subtracted same from income. 䊳


Jackin Box Manufacturing Co., Inc. ( JBM), whose income statements are shown in Exhibit C–132, is located in an industrial building in Scenic, New Jersey. JBM prints specialty packaging boxes on paperboard. Common examples of its products are video jackets and film boxes. The Company does not manufacture the boxes — it purchases the box material and prints to its customers’ specifications. The Company specializes in small runs (which many larger printers would not accept) or larger printer overflows. JBM has some of its own customers, with Pfizer being its largest, representing approximately 10 percent of total sales. However, most sales are not repeat business, but rather either introduced by brokers who place the business for the client, or through larger printers’ special needs. Therefore, JBM’s competition can, at times, be its own customers. Although price is critical in getting jobs, equally as important is the time factor of being able to complete the job within near-term deadlines. The Company does not have a sales force but rather relies on word of mouth and brokers. The competition in this market is intense, with approximately eight competing companies within a 10-mile radius of Scenic. JBM does, however, have a website and advertises in a regional printing journal. The Company’s website claims JBM is full service, able to do all of its work under one roof. JBM offers printing, die cutting, finishing, gluing, lamination, design, and even contract packaging. JBM employs about 12 people. Besides Rip Chocolate, who handles all aspects of the business, the other key employees are Mel Strawberry, who operates the printing press, and George Paschio, who operates the die cutter. They have been with JBM over 15 years each.


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EXHIBIT C–132

Chocolate v. Chocolate Jackin Box Manufacturing Co., Inc. Income Statements (Unadjusted) Years Ending August 31 2000

1999

1998

Net Sales

$4,228,001

$3,701,380

$3,103,546

Cost of Goods Sold Beginning inventory Purchases Direct labor Subcontractors Other expenses Ending inventory Cost of Goods Sold Gross Profit

$0,027,265 $0,026,059 $0,26,734 $0,940,410 1,008,643 $1,087,072 $0,394,160 $0,351,944 $0,336,674 $0,477,272 — — $0,013,485 — — $0,0(30,924) (27,265) (26,059) $1,821,668 $1,359,381 1,424,421 $2,406,333 2,341,999 $1,679,125

Operating Expenses Officers’ salaries $0,798,549 Officers’ life insurance $0,058,423 Other salaries $0,051,329 Real estate taxes $0,025,355 Rent $0,099,185 Equipment lease $0,01,1253 Interest expense $0,029,565 Advertising and promotional expense $0,027,137 Bad debt expense $0,010,185 Vehicle expense $0,019,093 Insurance expense $0,042,827 Commissions $0,114,308 Travel $0,013,906 Entertainment expense $0,017,194 Utilities $0,036,712 Supplies $0,016,311 Office/Postage expense $0,014,342 Professional fees $0,034,004 Telephone $0,019,159 Repairs and maintenance$0,021,086 Employee medical $0,040,336 Miscellaneous $0,016,038 Depreciation expense $0,214,566 Payroll taxes $0,048,428 Bank charges — Retirement plan — Total Operating Expenses

1997

1996

$2,647,906 $2,704,844 $0,025,979 $0,761,172 $0,258,086 — — (26,734) $1,018,503 $1,629,403

$0,023,030 $0,687,710 $0,285,767 $0,098,120 $0,023,915 (25,979) $1,092,563 $1,612,281

$0,719,519 $0,046,256 $0,044,270 $0,023,426 $0,090,000 — $0,043,026

$0,598,032 $0,035,177 $0,041,635 $0,022,806 $0,090,000 $0,014,780 $0,044,423

$0,560,600 $0,019,101 $0,038,707 $0,021,635 $0,094,000 $0,016,602 $0,061,532

$0,426,000 — $0,038,354 $0,017,363 $0,084,000 $0,016,662 $0,042,925

$0,038,754 — $0,014,814 $0,031,509 $0,070,392 $0,012,087 $0,012,140 $0,037,045 $0,014,533 $0,011,822 $0,012,307 $0,016,846 $0,041,811 $0,048,724 $0,016,717 $0,228,582 $0,088,655 $0,015,457 —

$0,014,978 $0,014,259 $0,010,574 $0,036,206 $0,074,870 $0,010,807 $0,016,338 $0,035,926 $0,013,264 $0,018,073 $0,011,569 $0,015,564 $0,025,196 $0,032,399 $0,019,377 , 224,153 $0,044,151 $0,01,1157 —

$0,018,367 — $0,016,553 $0,071,317 $0,058,499 $0,011,550 $0,015,532 $0,030,541 $0,015,693 $0,014,259 $0,014,799 $0,014,394 $0,017,396 $0,036,685 $0,018,457 $0,217,280 $0,047,154 $0,012,912 —

$0,022,531 $0,037,209 $0,011,027 $0,064,488 $0,081,040 — $0,019,371 $0,030,752 — $0,018,737 $0,010,600 $0,015,096 $0,026,062 — $0,013,691 , 197,019 $0,039,376 — $0,093,719

$1,332,565

1,246,022

$1,728,291

1,628,692

1,394,714

Operating Profit Interest and Other Income

$0,678,042 $0,085,086

$0,713,307 $0,063,612

$0,284,411 $0,038,239

$0,296,838 $0,366,259 $0,025,572 $0,023,324

Income Before Taxes and Adjustment

$0,763,128

$1,776,919

$1,322,650

$1,322,410 $1,389,583


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Page 509


509

Explanation of Adjustments to Net Income

When valuing a closely held corporation, it must be recognized that the stated officer’s (or owner’s) compensation does not necessarily have any relationship to what that person would receive were he or she to work for a company that he or she did not own. That is, the incidence of ownership permits one to receive a compensation package that is not necessarily the same as would be paid to an unrelated third party. To the extent that the company has profits and cash flow to support those profits (or to the extent that the officer/also-owner has the ability to cause the company to borrow funds), the company can pay almost any figure. Common practice in the valuation of a closely held business is to “permit” as an operating and normal expense for the business only a fair compensation for the owners. This adjustment first adds back the original officers’ salaries and then subtracts reasonable market compensation. We used the National Crime Institute’s Capo Salary Survey to determine reasonable compensation (see Exhibit C–133). The 2000 NCI Capo Salary Survey indicated that the median total compensation for a CEO/president for a manufacturing company with sales between $2.5 and $4.99 million was $101,000. A manufacturing and operations officer total compensation in the same category was $65,000. This totals $166,000. It is our understanding that Rip Chocolate fills both roles. As a result, providing for an ample margin of error, using $200,000 as a base for officers’ compensation is reasonable for 1999, and we have adjusted this amount up by 4 percent for 2000 and down 4 percent for each year prior to 1999. We also added back any Medicare taxes paid on compensation in excess of the above fair salary. Adjustment No. 1: Determination of Reasonable Compensation.

From conversations with Rip Chocolate, he explained that there is very little traveling or entertaining involved with his job. From reviewing the credit card bills that were expensed through the business as travel and entertainment, it appeared to be mostly personal in nature. Therefore, we added back one-half of those expenses, treating 50 percent of the total as being reasonable. Since the expense in 1997 was relatively modest, we made no such adjustment for that year. Adjustment No. 2: Travel and Entertainment.

Adjustment No. 3: Officer’s Life Insurance. Included in officer’s life insurance are three life insurance policies. Two policies had Rip Chocolate as the beneficiary, and one had the Company as the beneficiary. These expenses are added back as not ordinary and necessary.

We added back professional fees related to the divorce proceedings and estate planning. Adjustment No. 4: Professional Fees.

Included in this category were expenses that were not entirely business related, such as country club expenses, florists, and limousines. These were clearly not all promotion, and as with the travel and entertainment expenses, we added back one-half.

Adjustment No. 5: Promotion.

510

*Earnings before interest, taxes, depreciation, and amortization.

Adjusted EBITDA*

Other Adjustments Interest Depreciation 12 12

1 1 11

Reductions Reasonable officers’ compensation Less payroll tax adjustment Other income

29,565 214,566

1,857,175

(210,000) 12,700 (85,086)

798,549 15,550 58,423 21,472 11,629 425,000 — 7,000 38,810 —

$2,101,306

, ,

,

, ,

, , , , , ,

43,026 228,582

1,396,342

(200,000) 12,200 (63,612)

719,519 12,114 46,256 — 19,021 — 38,000 6,300 29,625 —

$1,667,950

, ,

,

, , ,

,

, , ,

$, 776,919

1999

44,423 224,153

788,284

(192,308) 11,700 (38,239)

598,032 13,573 35,177 — 2,404 — — 5,670 29,625 —

$1,056,860

, ,

,

,

, ,

,

, , ,

$, 322,650

1998

61,532 217,280

734,478

(184,911) 11,200 (25,572)

560,600 — 9,101 — 2,922 — — 5,103 33,625 —

$1,013,290

, ,

,

,

, ,

,

,

,

$, 322,410

1997

$992,434

42,925 197,019

752,490

(177,799) 11,000 (23,324)

426,000 9,686 ,— ,— ,— ,— ,— ,— 23,625 93,719

$389,583

1996

1:26 PM

Adjusted Operating Income Before Taxes

1 2 3 4 5 6 7 8 9 10

$ ,763,128

2000

10/22/01

Additions Officers’ salaries Travel/entertainment Officers’ life insurance Professional fees Promotion Subcontractor Payroll taxes Auto insurance Fair rent Retirement plan

ADJ#

Chocolate v. Chocolate Jackin Box Manufacturing Co., Inc. Adjustments to Net Income Years Ending August 31

Income Before Taxes (as reported)

EXHIBIT C–133



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Page 511


511

In 2000, there was a one-time accrual to the subcontractor expense account for $425,000. When we questioned the Company’s accountant, we were told that this was not a subcontractor expense, rather a personal investment for a new company called Flavors, LLC, that Rip Chocolate had set up with himself as 90 percent owner and his children owning 10 percent. We received a closing statement for property Flavors purchased on January 25, 2001, at 48 Fudge Street in Scenic, New Jersey for $650,000. It should be noted that, aside from the issues addressed in this report, this $425,000 represents a marital asset. Adjustment No. 6: Subcontractor.

Adjustment No. 7: Payroll Taxes. Payroll taxes for 1999 were approximately $38,000

overstated based on comparisons with prior and subsequent years. Adjustment No. 8: Auto Insurance. We have allowed 100 percent of the auto insurance for Rip Chocolate’s auto usage. We added back the approximate cost of nonworking family members, insurance.

Rip Chocolate owns 100 percent of the building where the Company is located at 471/2 Fudge Street, in Scenic, New Jersey. Since the Company pays rent to a related party, we reviewed the rent that the Company paid, as contrasted to what a fair rent would be if the Company had to pay rent to a nonrelated third party. The Company paid approximately $8.50 per square foot. (We were told the total square footage is 10,500 square feet.) We called several commercial Realtors in the Scenic area who were familiar with industrial/warehouse space. We were quoted a range of $5 to $6.50 per square foot. We took the average, $5.75, as a fair rental price or $60,375 per year for 1996 to 2000 and added back the differential. Adjustment No. 9: Fair Rent.

In 1997, the Company stopped contributing to a retirement plan. For comparative valuation purposes, we have eliminated the 1996 contribution from the income statement. Adjustment No. 10: Retirement Plan.

Adjustment No. 11: Other Income. Other income is a result of either nonrecurring income or earnings from nonoperating assets, such as investments. Nonoperating assets are added back to capitalized income value. As a result we subtracted this type of income from reported income to properly conclude on adjusted operating income.

Since we are using an adjusted debt-free cash flow as a basis for income capitalization, we have added back to income depreciation and interest expenses. Adjustment No. 12: Interest and Depreciation.

NOTE Portions adapted from FAIR$HARE: The Matrimonial Law Monthly, published by Prentice Hall Law & Business, now assigned to Aspen Law & Business, a division of Aspen Publishers, Inc. 1995.


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Page 512

Barson Index (513-536)

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1:25 PM

Page 513

INDEX

A ABANDONED SPOUSE RULE Tax returns 11.18, 11.19, 11.21 ABANDONMENT OF ASSETS Economic issues, impact on inquiry 4.1 ABANDONMENT OF MARITAL RESIDENCE Marital residence sale, tax-free rollover of profit 11.41 ACCELERATION OF DEFERRED GAIN Taxes, installment sales 11.36 ACCESSIBILITY Personal financial investigation 9.1 ACCOUNTANTS Accountant-client relationships, types 1.1 Company’s regular accountant, dealing with 5.2 Opposing CPA, working with 12.2 ACCOUNTANTS’ FEES Operating expenses 8.12 ACCOUNTING PRACTICES Income information 7.3 Work in progress on balance sheet 6.6 ACCOUNTS PAYABLE Balance sheet 6.11 ACCOUNTS RECEIVABLE Balance sheet 6.4 Operating expenses, bad debts 8.18 Work in progress on balance sheet 6.6

ACCRUAL-BASIS BUSINESSES Accounts receivable on balance sheet 6.4 Prepaid expenses on balance sheet 6.7 ACCRUED EXPENSES Balance sheet 6.12 ACQUISITIONS Equity on balance sheet 6.18 ADD-BACKS Disability insurance, operating expenses 8.15 Insurance, operating expenses 8.8 Operating expenses, travel, entertainment, and promotion 8.9 ADJUSTED GROSS INCOME Taxes, alimony and support 11.8 ADJUSTMENTS Target company, IRS examination of company’s books 5.3 ADVANCES AGAINST SALARY Loans to officers, owners and shareholders on balance sheet 6.14 AGING Accounts payable on balance sheet 6.11 Accounts receivable on balance sheet 6.4 Accrued expenses on balance sheet 6.12 Work in progress on balance sheet 6.6 ALIEN SPOUSE Taxes, property distributions 11.29 513


514

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Page 514

INDEX

ALIMONY Negotiation for settlement 12.5 Taxes. See TAXES ALIMONY TRUSTS Generally 11.45 ALLOCATIONS TO OWNER Retirement plan, operating expenses 8.6 ANCILLARY SOURCES OF INCOME Income information, professional practices 7.3 ANNUITIES Taxes, property distributions 11.34 ANNULMENTS Taxes, property distributions 11.30 ANTIFRONTLOADING RULES Alimony and support 11.6 APPRAISERS Business appraisers, use of 1.3 Fixed assets on balance sheet, equipment valuation 6.8 Opposition’s expert, working with 12.2 Valuing closely held business 10.1 APPRECIATED PROPERTY Taxes, property distributions 11.33 ARM’S-LENGTH TRANSACTIONS Accounts payable on balance sheet 6.11 Multiple companies, target company dealings 5.8 Notes receivable on balance sheet 6.9 Valuing closely held business, recent sales 10.9 ARREARAGES Legal fee tax deductibiity 11.20 ASSET DIMINUTION Valuation date, impact on inquiry 4.3 ASSETS Accounts receivable on balance sheet 6.4 Copyrights, intangibles on balance sheet 6.10 Goodwill, intangibles on balance sheet 6.10 Inventory on balance sheets 6.5

Loans to officers, owners and shareholders on balance sheet 6.14 Prepaid expenses on balance sheet 6.7 Work in progress 6.6 ATTORNEYS Initial discussions with 1.2 Negotiations 12.5 Stipulation v. court appointment 1.7 ATTORNEYS’ FEES Alimony, deductibility of fees 11.20 Operating expenses 8.12 AUTOMOBILES Operating expenses. See OPERATING EXPENSES Repairs, gross profits and cost of goods sold 7.5 B BAD DEBTS Accounts payable on balance sheet 6.11 Accounts receivable on balance sheet 6.4 Loans and notes payable on balance sheet 6.15 Operating expenses 8.18 BALANCE SHEET Generally 6.1 Accounts payable 6.11 Accounts receivable 6.4 Accrued expenses 6.12 Cash balance 6.2 Documentation, preliminary disclosure 3.1 Equity 6.18 Fixed assets 6.8 Intangibles 6.10 Inventory 6.5 Loans – Cash payments to owner 6.2 – Exchanges and loans 6.13 – Notes payable 6.15 – Officers, owners, and shareholders, loans to 6.14


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Page 515

INDEX

Notes receivable 6.9 Payroll taxes withheld 6.16 Petty cash 6.3 Prepaid expenses 6.7 Property, plant and equipment 6.8 Sales taxes payable 6.17 Valuing closely held business 10.4 Work in progress 6.6 BANK ACCOUNTS Operating expenses, travel, entertainment, and promotion 8.9 BANK RECORDS Income information, professional practices, safe deposit boxes 7.4 BANK STATEMENTS Client interviews 2.2 BANKRUPTCY Alimony and support surviving 11.1 BARTER Accounts receivable on balance sheet 6.4 BASIS Property distributions, transfer of basis, nonspousal gift rules 11.39 Taxes, property distributions, liabilities exceeding basis 11.37 BIAS Stipulation v. court appointment 1.7 BOETTIGER v. COMMISSIONER Abandoned spouse rule 11.18 BOGUS PURCHASES Loans and notes payable on balance sheet 6.15 BOOK VALUE Balance sheets and disclosure statements 6.1 BROKERAGE ACCOUNTS Personal financial investigation 9.4 BUSINESS APPRAISERS Use of 1.3 BUSINESS SPOUSE Client interviews 2.3 Sales and income information sources 7.1

515

BUSINESS TAX RETURNS Documentation, preliminary disclosure 3.1 BUSINESS WALK-THROUGH Income information, gross profits and cost of goods sold 7.5 Report to client 12.3 BUY-OUTS Economic issues, impact on inquiry 4.1 Taxability and deductibility of interest on interspousal buyouts 11.40 BUY-SELL AGREEMENT Closely held business 10.2, 10.12 C C CORPORATIONS Corporate stock redemption and transfer 11.42 Form of business, impact on inquiry 4.2 CANCELED CHECKS Client interviews 2.2 CAPITAL Equity on balance sheet 6.18 CAPITAL ACCOUNT RECONCILIATION Documentation, preliminary disclosure 3.1 CAPITALIZATION OF INCOME Valuing closely held business, methods 10.10 CAPITALIZATION RATE Valuing closely held business, Revenue Ruling 68-609 10.6 CAPITALIZING Repairs and maintenance, operating expenses 8.7 CARRYING FORWARD Accrued expenses on balance sheet 6.12 CARRYOVERS Passive activity loss carryovers 11.43 CASH Alimony qualification rules for tax purposes 11.10


516

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Page 516

INDEX

CASH (continued ) Cash balance on balance sheet 6.2 Personal financial investigation, standard of living 9.2 CASH-BASIS BUSINESSES Accounts receivable on balance sheet 6.4 Income information, professional practices 7.4 Prepaid expenses on balance sheet 6.7 Sales and income information sources 7.1 CASH FLOW Loans to officers, owners and shareholders on balance sheet 6.14 Personal financial investigation 9.3 Target company dealings 5.7 Valuing closely held business, discounted cash flow 10.11 CASH SURRENDER VALUE Operating expenses, life insurance 8.8 CASUALTY LOSS Tax return analysis, personal financial investigation 9.8 CERTIFICATES OF DEPOSIT Cash on balance sheet 6.2 CHECKING ACCOUNTS Cash on balance sheet 6.2 CHILD CARE CREDIT Taxes, child support 11.21 CHILD SUPPORT Negotiation for settlement 12.5 Support trusts 11.44 Taxes. See TAXES Valuing closely held business 10.1 CHILD TAX CREDIT Taxes, child support 11.23 CHILDREN Operating expenses, automobiles 8.10 Personal financial investigation, children’s accounts 9.1, 9.10 Support. See CHILD SUPPORT CLIENT INTERVIEWS Generally 2.1

Business-owner/spouse interview checklist 2.8, 5.1 Business spouse 2.3 Initial disclosure statement review 2.5 Nonbusiness spouse interview 2.2 – Generally 2.2 – Checklist 2.7 –Tax issues 2.6 Nonclient business owner interview 2.4 CLOSELY HELD BUSINESSES Cash on balance sheet 6.2 Client interviews. See CLIENT INTERVIEWS Deferred taxes’ effect on equitable distribution 11.46 Equity on balance sheet 6.18 Impact on inquiry 4.6 Operating expenses, retirement plans 8.6 Personal financial investigation 9.1 Valuing. See VALUING CLOSELY HELD BUSINESS COHABITATION Alimony qualification rules for tax purposes 11.10 COLLATERAL Negotiation for settlement 12.5 COLLECTIBILITY Accounts receivable on balance sheet 6.4 Work in progress on balance sheet 6.6 COLLECTION OF DEBTS Accounts receivable on balance sheet, estimating 6.4 Operating expenses, bad debts 8.18 Sales and income information 7.1 COLLECTIONS OF OBJECTS Personal financial investigation 9.7 COLLUSION Planning for divorce, reflection in business dealings 5.10 COMMINGLING OF FUNDS Form of business, impact on inquiry 4.2


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Page 517

INDEX

COMMON OWNERSHIP Accounts payable on balance sheet 6.11 COMMON STOCK Equity on balance sheet 6.18 COMMUNITY PROPERTY Loans to officers, owners and shareholders on balance sheet 6.14 COMPANY PERQUISITES Personal financial investigation, standard of living 9.2 COMPENSATION See also SALARIES Loans to officers, owners and shareholders on balance sheet 6.14 Operating expenses, owner and officer payroll 8.2 Valuing closely held business, reasonable compensation, Revenue Ruling 68-609 10.6 COMPLAINT DATE Valuation date, impact on inquiry 4.3 CONCEALMENT OF ASSETS Documentation, comparing records 3.2 Personal financial investigation 9.4 CONSULTING Scope of accountant’s involvement 1.2 CONSULTING CONTRACTS Valuing closely held business, recent sales 10.9 CONSULTING FEES Operating expenses 8.2, 8.12 CONSUMER GOODS Personal financial investigation, standard of living 9.2 CONTACTS Access to opposition’s information 5.1 CONTINGENCY PAYMENTS Alimony qualification rules for tax purposes 11.10 Child support, tax treatment 11.13

517

CONTRIBUTIONS Tax return analysis, personal financial investigation 9.8 CONTROLLING INTEREST Valuing closely held business, premium 10.16 CONVENTIONS Operating expenses 8.9, 8.20 COPYRIGHTS Intangibles on balance sheet 6.10 CORPORATE STOCK Taxes, transfers and redemption 11.42 CORPORATION AS LIABILITY Personal financial investigation 9.6 COST OF GOODS SOLD Sales and income 7.5 Unreported income, allegations of 7.8 COURT-APPOINTED ACCOUNTANT Accountant-client relationships 1.1 Stipulation v. court appointment 1.7 COURT DECREE Alimony qualification rules for tax purposes 11.10 COURT TESTIMONY Final stages 12.5 CREDIBILITY Accountant-client relationships 1.1 CREDIT CARDS Operating expenses 8.9, 8.10 CURRENT COUNT Inventory on balance sheets, determining 6.5 CUSTODIAL PARENT Dependency exemptions 11.14 Taxes, child support 11.15 CUSTOMERS Accounts receivable on balance sheet 6.4 Sales and income information sources 7.1 D DATE OF VALUATION Impact on inquiry 4.3


518

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1:25 PM

Page 518

INDEX

DAY SHEETS Cash on balance sheet 6.2 DEATH Alimony qualification rules for tax purposes 11.10 Antifrontloading rules, alimony and support 11.6 Front loading rule exceptions 11.11 Taxes, cessation of alimony and support at death 11.4 Valuing closely held business, buysell agreement 10.12 DEFERRED TAXES Equitable distribution, effect upon 11.46 DEFINED BENEFIT PENSION PLAN Operating expenses 8.6 DEFINITIONS See WORDS AND PHRASES DEPENDENCY EXEMPTIONS Adjusted gross income 11.8 Child care tax credit 11.21 Head of household tax return filing status 11.19 Taxes, child support 11.14 DEPENDENTS Tax return analysis, personal financial investigation 9.8 DEPRECIATED PROPERTY Taxes, property distributions 11.33 DEPRECIATION Automobile expenses 8.5 Balance sheets and disclosure statements 6.1 Fixed assets on balance sheet 6.8 Operating expenses 8.4, 8.5 DISABILITY INSURANCE Operating expenses 8.8, 8.15 DISBURSEMENTS Collections, valuation 9.7 DISBURSEMENTS JOURNAL Cash on balance sheet 6.2 Documentation, review of books and journals 3.3 DISCLOSURE Documentation, preliminary disclosure 3.1 Initial disclosure statements review 2.5

Statements, obtaining 1.4 Tax fraud, impact on inquiry 4.5 DISCOUNTED FUTURE EARNINGS Valuing closely held business, methods 10.11 DISCOUNTS Notes receivable on balance sheet 6.9 Sales and income information 7.1 Valuing closely held business 10.11, 10.15 DISPOSITION OF FUNDS Nonbusiness assets, impact on inquiry 4.6 DIVIDENDS Equity on balance sheet 6.18 DOCUMENTATION Client interviews 2.2 Comparing records 3.2 Equity on balance sheet, mergers and acquisitions 6.18 Goodwill, intangibles on balance sheet 6.10 Income information, professional practices, safe deposit boxes 7.4 Inventory on balance sheets 6.5 On-site work 5.4 Operating expenses, travel, entertainment, and promotion 8.9 Petty cash on balance sheet 6.3 Preliminary disclosure 3.1 Report to client 12.3 Requests for 1.5 Review of books and journals 3.3 Unreported income, allegations of 7.8 DOCUMENTS Access to opposition’s information 5.1 DOUBLE DIP Closely held business, valuation of 10.18 Goodwill, intangibles on balance sheet 6.10 DOUBLE ENTRY ACCOUNTING SYSTEMS Loans and notes payable on balance sheet 6.15


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Page 519

INDEX

DRAW Equity on balance sheet 6.18 DUES Operating expenses 8.20 DUPLICATE INVOICES Inventory on balance sheets, determining 6.5 DUPLICATIVE RENT Operating expenses 8.4 DURESS Innocent spouse exclusion from joint tax liability 11.26 E EARNED INCOME CREDIT Taxes, alimony 11.22 EFFECTIVE DATES Taxes, property distributions 11.31 ELECTING OUT OF ALIMONY Generally 11.5 EMPLOYEE BENEFITS Operating expenses 8.15 EMPLOYEES On-site work 5.4 END-OF-YEAR PURCHASES Inventory on balance sheets, determining 6.5 ENHANCED EARNINGS POWER Valuing closely held business 10.17 ENTERTAINMENT Operating expenses 8.9 EQUIPMENT Depreciation, operating expenses 8.5 Fixed assets on balance sheet 6.8 Repairs and maintenance, operating expenses 8.7 EQUITABLE DISTRIBUTION Loans to officers, owners and shareholders on balance sheet 6.14 Property distributions 11.44 –11.46 EQUITABLE RELIEF Innocent spouse 11.26 EQUITY Balance sheet 6.18 EQUIVALENTS TO CASH

519

Alimony qualification rules for tax purposes 11.10 ESTATE PLANNING Postdivorce services, return preparation 13.4 ESTIMATED TAXES Accounts receivable on balance sheet 6.4 Allocating tax refunds between spouses 11.25 Personal financial investigation 9.4, 9.8 EXCESS PAYMENTS Alimony qualification rules, recapture 11.10 Front loading rule exceptions 11.11 EXCESS PERSONAL LIABILITY INSURANCE Operating expenses 8.8 EXCESSIVE RENT Operating expenses 8.4 EXPENSES Accrued expenses on balance sheet 6.12 Unreported income, allegations of 7.8 EXPERT WITNESSES Testimony preparation 12.6 EXPERTS Inventory on balance sheets, business walk-through 6.5 F FACILITY Balance sheet, fixed assets 6.8 FAIR MARKET VALUE Closely held business 10.2 FAIR VALUE Closely held business 10.2 FAMILY LOANS Personal financial investigation 9.4 FAMILY MEMBERS See RELATED PERSONS FEES Stipulation v. court appointment 1.7 FICA TAXES Operating expenses 8.13


520

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Page 520

INDEX

FIFO Inventory on balance sheets, determining 6.5 FILING AS UNMARRIED Taxes, alimony 11.19 FILING STATUS Taxes, alimony 11.17 FINAL STAGES OF INVESTIGATION Generally 12.1 Court testimony 12.5 Negotiations 12.4 Opposing CPA, working with 12.2 Opposition’s report 12.4 Report to client 12.3 FINANCIAL MANAGEMENT Postdivorce services 13.3 FINANCIAL STATEMENTS Client interviews 2.2, 2.3, 2.5 Depreciation, operating expenses 8.5 Documentation, preliminary disclosure 3.1 Loans and notes payable on balance sheet 6.15 Valuing closely held business 10.1 FINANCIAL SUICIDE Recognition of 1.8 FINANCING APPLICATIONS Personal financial investigation 9.4 FINES Operating expenses 8.17 Valuing closely held business, discounts for unreported income liability 10.15 FIXED ASSETS Balance sheet 6.8 Depreciation, operating expenses 8.5 FIXED-RATE LOANS Operating expenses, interest expense 8.16 FLOOR SPACE Inventory on balance sheets, determining 6.5 FLUCTUATION IN SALES Sales and income information 7.2 FOOD STORES Income information, gross profits and cost of goods sold 7.5

FORM OF BUSINESS Impact on inquiry 4.2 FRANCHISE BUSINESSES Valuing closely held business 10.13 FRAUD Documentation, preliminary disclosure 3.1 Tax fraud, impact on inquiry 4.5 FRONT LOADING Taxes, alimony 11.6, 11.11 FURNITURE Depreciation, operating expenses 8.5 Fixed assets on balance sheet 6.8 Operating expenses, office expenses 8.19 FURS Personal financial investigation, standard of living 9.2 FUTURE EARNINGS Valuing closely held business 10.10, 10.11 G GENERAL JOURNAL ENTRIES Inventory on balance sheets, determining 6.5 GENERAL LEDGER Documentation, review of books and journals 3.3 GENERAL MARKETABILITY DISCOUNT Valuing closely held business, industry comparisons 10.7 GIFTS Jointly owned residences 11.35 Nonmarital asset valuation date, impact on inquiry 4.4 Passive activity loss carryovers 11.43 Personal financial investigation, standard of living 9.2 Property distributions, transfer of basis, nonspousal gift rules 11.39 Transfer of basis 11.42 GOING CONCERN VALUE Valuing closely held business 10.13


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Page 521

INDEX

GOODS Income information, professional practices 7.3 GOODWILL Balance sheets 6.1 Intangibles on balance sheet 6.10 Rules 59-60, 68-609 10.5, 10.6 Valuing closely held business 10.9, 10.13 GOVERNMENT REPORTS Documentation, comparing records 3.2 GROSS PROFIT Documentation, preliminary disclosure 3.1 Sales and income 7.5 H HEAD OF HOUSEHOLD Tax return filing status 11.19 HISTORICAL SPREAD OF OPERATIONS Documentation, preliminary disclosure 3.1 HOBBIES Personal financial investigation 9.7 HOLDER, VALUE TO Closely held business 10.2 HOME EQUITY LOANS Personal financial investigation 9.4 HOMEOWNERS INSURANCE Operating expenses 8.8 HOUSING COSTS Alimony qualification rules for tax purposes 11.10 I ILLEGALLY OBTAINED ASSETS Tax fraud, impact on inquiry 4.5 IN-PLACE VALUE Valuing closely held business, methods 10.13 INCOME Alimony, designating as income 11.7 Alimony as adjusted gross income 11.8

521

Capitalization of income, valuing closely held business 10.10 Child support 11.12 Pre- or post-tax income, valuing closely held business 10.1 INCOME AND LOSS STATEMENT Balance sheet. See BALANCE SHEET INCOME RECAPTURE Tax shelter issues 9.5 INCOME SHIFTING Alimony and support 11.3 Taxes, alimony and support 11.7 INDUSTRY NORMS Accounts receivable on balance sheet 6.4 Income information, gross profits and cost of goods sold 7.5 Inventory on balance sheets, determining 6.5 Patents and copyrights, intangibles on balance sheet 6.10 Unreported income, allegations of 7.8 INFLATION Closely held business, valuation of 10.19 INFORMATION Taxes, property distributions, supplying information to transferee 11.38 INHERITANCE Nonmarital asset valuation date, impact on inquiry 4.4 INITIAL DISCLOSURE STATEMENTS Review 2.5 INNOCENT SPOUSE Alimony, tax issues 11.26 Tax fraud, impact on inquiry 4.5 INSTALLMENT OBLIGATIONS Taxes, property distributions 11.36 Transfer of basis, nonspousal gift rules 11.38 INSURANCE Alimony qualification rules for tax purposes, insurance premiums 11.10 Fixed assets on balance sheet, equipment valuation 6.8


522

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Page 522

INDEX

INSURANCE (continued) Life insurance. See LIFE INSURANCE Operating expenses 8.8 Prepaid expenses on balance sheet 6.7 INTANGIBLES Balance sheet 6.10 INTEREST Income, accounts payable on balance sheet 6.11 Interspousal buyouts 11.40 Loans and notes payable on balance sheet 6.15 Negotiation for settlement 12.5 Operating expenses 8.16 Payroll taxes withheld on balance sheet 6.16 Tax return analysis, personal financial investigation 9.8 INTERIM FINANCIAL STATEMENTS Documentation, comparing records 3.2 INTERNAL WORK FLOW Target company dealings 5.7 INTERROGATORIES Statements, obtaining 1.4 INTERVIEWS Accountant-client relationships 1.1 Report to client 12.3 Sales and income information sources 7.1 INTRINSIC VALUE Closely held business 10.2 INVENTORY Balance sheets 6.1, 6.5 Documentation, comparing records 3.2 Operating expenses, insurance 8.8 Unreported income, allegations of 7.8 Valuing closely held business, liquidation 10.14 INVESTMENT ADVISING Postdivorce services 13.3 INVESTMENT INTEREST Tax return analysis, personal financial investigation 9.8

INVESTMENT TAX CREDITS Taxes, supplying information to transferee-spouse 11.38 INVESTMENT VALUE Closely held business 10.2 INVOICES Inventory on balance sheets, determining 6.5 Repairs and maintenance, operating expenses 8.7 Unreported income, allegations of 7.8 IRAS Equitable distribution and retirement plans 11.44 Personal financial investigation 9.4 Tax return analysis, personal financial investigation 9.8 IRS Form 1040, tax return analysis 9.8, 9.10 Tax fraud, impact on inquiry 4.5 J JOINT OWNERSHIP Negotiation for settlement 12.5 JOINT TAX LIABILITY Allocating taxes between spouses 11.25 Innocent spouse exclusion 11.26 JOINT TAX RETURNS Alimony qualification rules for tax purposes 11.10 Allocating tax and refunds between spouses 11.25 Postdivorce services, return preparation 13.4 Tax fraud, impact on inquiry 4.5 Taxes, alimony 11.18 JOINTLY OWNED RESIDENCE Marital residence sale, joint title after divorce 11.41 Taxes, property distributions 11.35 K K-1 FLOW-THROUGHS Tax return analysis, personal financial investigation 9.8


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Page 523

INDEX

KEOGHS Tax return analysis, personal financial investigation 9.8 L LACK OF CONTROL DISCOUNT Valuing closely held business 10.15 LAND VALUES Balance sheets and disclosure statements 6.1 LAW PRACTICES Cash on balance sheet, trust accounts 6.2 Income information 7.3 Valuing closely held business, industry comparisons 10.8 Work in progress on balance sheet 6.6 LEDGER Documentation, review of books and journals 3.3 LEGAL FEES Alimony, deductibility of fees 11.20 LIABILITIES Accounts payable on balance sheet 6.11 Accounts receivable on balance sheet, bad debts 6.4 Operating expenses, interest expense 8.16 Personal financial investigation, corporation as liability 9.6 Taxes, property distributions, liabilities exceeding basis 11.37 LIFE INSURANCE Deferred taxes’ effect on equitable distribution 11.46 Operating expenses 8.8, 8.14 LIFO Inventory on balance sheets, determining 6.5 LIMITED LIABILITY Corporation as liability 9.6 LIMITED PARTNERSHIPS Passive activity loss carryovers 11.43

523

LIQUIDATION VALUE Closely held business 10.2 Valuing closely held business, methods 10.14 LIQUIDITY Negotiation for settlement 12.5 LOANS Balance sheet. See BALANCE SHEET Multiple companies, target company dealings 5.8 Notes payable 6.15 Officers, loans to 6.14 Operating expenses, interest expense 8.16 Owners, loans –Interest as operating expense 8.16 – Loans to 6.14, 9.1 Personal financial investigation 9.1, 9.4 Retirement plan, operating expenses 8.6 Shareholders, loans to 6.14 LOCAL INCOME TAX Tax return analysis, personal financial investigation 9.8 LONG DISTANCE CHARGES Operating expenses, telephone 8.11 LOSS CARRYFORWARDS Documentation, preliminary disclosure 3.1 LOSSES Passive activity loss carryovers 11.43 M MAGAZINE SUBSCRIPTIONS Operating expenses 8.21 MAINTENANCE Alimony. See ALIMONY Contracts as prepaid expenses on balance sheet 6.7 Operating expenses 8.7 MAJORITY INTEREST Closely held business 10.2 MALPRACTICE INSURANCE Prepaid expenses on balance sheet 6.7


524

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Page 524

INDEX

MANUFACTURING OPERATIONS Valuing closely held business, industry comparisons 10.8 MARITAL RESIDENCE Alimony qualification rules for tax purposes 11.10 Negotiation for settlement 12.5 Taxes, property distributions 11.41 MARITAL STATUS Marital residence sale 11.41 MARKETABILITY DISCOUNT Valuing closely held business 10.15 MEDICAL BENEFITS Operating expenses 8.15 MEDICAL EXPENSES Tax return analysis, personal financial investigation 9.8 Taxes, child support 11.24 MEDICAL PRACTICES Income information 7.3 Valuing closely held business, industry comparisons 10.8 Work in progress on balance sheet 6.6 MEETING MINUTES BOOK Equity on balance sheet 6.18 MEETINGS Operating expenses, memberships and dues 8.20 MEMBERSHIPS Operating expenses 8.20 Prepaid expenses on balance sheet 6.7 MERGERS Equity on balance sheet 6.18 METHODS OF VALUATION Closely held business. See VALUING CLOSELY HELD BUSINESS MID-YEAR VALUATIONS Seasonality in sales and income information 7.2 MILEAGE Operating expenses, automobiles 8.10 MINORITY INTEREST Closely held business 10.2

MINORITY INTEREST DISCOUNT Valuing closely held business 10.15 MINORITY SHAREHOLDER Valuing closely held business, buysell agreement 10.12 MINUTES BOOK Equity on balance sheet 6.18 MISCELLANEOUS ACCOUNT Operating expenses 8.23 MISCELLANEOUS INCOME Tax return analysis, personal financial investigation 9.8 MONEY MARKET ACCOUNTS Cash on balance sheet 6.2 MONEY PURCHASE PENSION PLAN Operating expenses 8.6 MORTGAGE Operating expenses 8.4 MORTGAGE APPLICATIONS Personal financial investigation 9.4 MORTGAGE INTEREST Tax return analysis, personal financial investigation 9.8 MORTGAGE PAYMENTS Alimony qualification rules for tax purposes 11.10 Personal financial investigation, standard of living 9.2 MOVING Operating expenses 8.4 MOVING AVERAGE METHOD Inventory on balance sheets, determining 6.5 MULTIPLE BANK ACCOUNTS Cash on balance sheet 6.2 MULTIPLE COMPANIES Target company dealings 5.8 MULTIPLE LOCATIONS Income information, professional practices 7.3 Operating expenses, insurance 8.8 MULTIPLE OWNERS Loans to officers, owners and shareholders on balance sheet 6.14 MULTIPLE SUPPORT AGREEMENTS Dependency exemption 11.14 Taxes, child support 11.16


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Page 525

INDEX

525

N

O

NEGOTIATIONS Final stages 12.2, 12.4 NET OPERATING LOSSES Allocating tax refunds between spouses 11.25 NET WORTH Personal financial investigation, changes in worth 9.3 NONBUSINESS SPOUSE Client interviews 2.2, 2.6, 2.7 Corporate stock redemption and transfer 11.42 Goodwill, intangibles on balance sheet 6.10 Personal financial investigation, standard of living 9.2 Postdivorce services 13.2 Sales and income information sources 7.1 NONCASH FLOW INCOME Loans and exchanges on balance sheet 6.13 NONCLIENT BUSINESS OWNER INTERVIEW Client interviews 2.4 NONCUSTODIAL PARENT Dependency exemptions 11.14 Taxes, child support 11.15 NONFRANCHISE BUSINESSES Valuing closely held business 10.13 NONMARITAL ASSETS Valuation date, impact on inquiry 4.4 NONRECOGNITION RULE Property distributions, nonresident alien spouses 11.29 NONRESIDENT ALIEN SPOUSE Taxes, property distributions 11.29 NONSPOUSAL GIFT RULES Property distributions, transfer of basis 11.39 NONTAXABLE EVENT Property distributions 11.27, 11.28 NOTES PAYABLE Balance sheet 6.9, 6.15

OBJECTIVITY Accountant-client relationships 1.1 OFFICE EXPENSES Operating expenses 8.19 OFFICE SUPPLIES Operating expenses 8.19 Prepaid expenses on balance sheet 6.7 OFFICERS Life insurance as operating expense 8.14 Loans to officers on balance sheet 6.14 Operating expenses, owner payroll 8.2 OFFSET OF FUTURE INCOME Tax shelter issues 9.5 ON-SITE WORK Target company dealings 5.4 OPERATING EXPENSES Generally 8.1 Automobiles – Depreciation 8.5 – Expenses 8.10 – Insurance 8.8 – Interest expense 8.16 Bad debts 8.18 Depreciation 8.5 Employee benefits 8.15 Fines and penalties 8.17 Insurance – Generally 8.8 – Life insurance, officer’s 8.14 Interest expense 8.16 Life insurance, officer’s 8.14 Maintenance 8.7 Memberships and dues 8.20 Miscellaneous account 8.23 Office expenses and supplies 8.19 Officer’s life insurance 8.14 Payroll – Other payroll 8.3 – Owner and officer payroll 8.1 –Taxes 8.13 Professional fees 8.12 Rent 8.4 Repairs 8.7


526

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Page 526

INDEX

OPERATING EXPENSES (continued) Retirement plans 8.6 Social Security numbers 8.24 Subscriptions 8.21 Taxes 8.13 Telephone 8.11 Travel, entertainment, and promotion 8.9 Utilities 8.22 OVERFUNDING Defined benefit pension plan as operating expenses 8.6 OVERPAYMENT OF TAXES Allocating tax refunds between spouses 11.25 Prepaid expenses on balance sheet 6.7 OVERSTATED INVENTORY Balance sheets 6.5 OWNERS Loans to owners on balance sheet 6.14 Multiple companies, target company dealings 5.8 Operating expenses, owner payroll 8.2 OWNERSHIP INTERESTS Documentation, comparing records 3.2 Equity on balance sheet, stock register 6.18 Loans to officers, owners and shareholders on balance sheet 6.14 P PAID IN SURPLUS Equity on balance sheet 6.18 PAINTING Repairs and maintenance, operating expenses 8.7 PARTNERSHIPS Form of business, impact on inquiry 4.2 Partner’s capital contribution, equity on balance sheet 6.18 Tax return analysis, personal financial investigation 9.8

Valuing closely held business 10.3 PASSIVE ACTIVITY LOSS CARRYOVERS Tax shelter issues 9.5 Taxes, property distributions 11.43 PAST COMPENSATION Loans to officers, owners and shareholders on balance sheet 6.14 PAST DUE ACCOUNTS See also BAD DEBTS Accounts payable on balance sheet 6.11 PATENTS Intangibles on balance sheet 6.10 PATIENT RECORDS Income information, professional practices 7.3 PAYCHECKS Cash on balance sheet 6.2 PAYMENTS Notes receivable on balance sheet 6.9 To owner, cash on balance sheet 6.2 PAYROLL Gross profits and cost of goods sold, income information 7.5 Operating expenses. See OPERATING EXPENSES Professional practices, income information 7.3 PAYROLL TAXES Balance sheet 6.16 Operating expenses 8.13 PENALTIES Defined benefit pension, overfunding 8.6 Equitable distribution and retirement plans 11.44 Operating expenses 8.17 Payroll taxes withheld on balance sheet 6.16 Valuing closely held business, discounts for unreported income liability 10.15 PENSION PLANS See RETIREMENT PLANS


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PERQUISITES Operating expenses, owner and officer payroll 8.2 PERSONAL BANK RECORDS OF OWNER Cash on balance sheet 6.2 PERSONAL BUDGETING Postdivorce services 13.2 PERSONAL FINANCIAL INVESTIGATION Generally 9.1 Children’s tax returns 9.1, 9.10 Corporation as liability 9.6 Hobbies and collections 9.7 Net worth changes 9.3 Personal financial statements 9.4 Scope of accountant’s involvement 1.2 Standard of living 9.2 State tax returns 9.9 Tax return analysis 9.8 Tax shelters 9.5 PERSONAL FINANCIAL STATEMENTS Personal financial investigation 9.4 PERSONAL LIABILITY Loans to officers, owners and shareholders on balance sheet 6.14 PERSONAL MARITAL ASSETS Valuation date, impact on inquiry 4.3 PERSONAL PROPERTY TAXES Operating expenses 8.13 Tax return analysis, personal financial investigation 9.8 PERSONAL TAX RETURNS Documentation, preliminary disclosure 3.1 Operating expenses, owner and officer payroll 8.2 PERSONAL UMBRELLA INSURANCE Operating expenses 8.8 PETTY CASH Balance sheet 6.3 PLANNING FOR DIVORCE Target company, reflection in business dealings 5.10

527

POST-TAX INCOME Valuing closely held business 10.1, 10.6 POSTDIVORCE SERVICES Generally 13.1 Financial management 13.3 Personal budgeting 13.2 Remarriage 13.5 Tax assistance and preparation 13.4 PRE-TAX INCOME Revenue Ruling 68-609 10.6 Valuing closely held business 10.1 PREFERRED STOCK Equity on balance sheet 6.18 PREMIUMS Valuing closely held business 10.7, 10.16 PRENUPTIAL AGREEMENTS Postdivorce services 13.5 PREPAID EXPENSES Balance sheet 6.7 PREPAID INSURANCE Operating expenses 8.8 PREPAID TAXES Prepaid expenses on balance sheet 6.7 PRICE-TO-EARNINGS RATIO Valuing closely held business, methods 10.7 PRINCIPAL PLACE OF ABODE Tax return filing status 11.19 PRIVACY On-site work 5.5 PRODUCT LIABILITY INSURANCE Prepaid expenses on balance sheet 6.7 PRODUCTS Target company, multiple products 5.9 PROFESSIONAL FEES Operating expenses 8.12 Patents and copyrights, intangibles on balance sheet 6.10 PROFESSIONAL PRACTICES Cash on balance sheet, trust accounts 6.2 Sales and income 7.3 Work in progress on balance sheet 6.6


528

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Page 528

INDEX

PROFIT Marital residence sale, tax-free rollover of profit 11.41 PROFIT AND LOSS STATEMENT Balance sheet. See BALANCE SHEET PROFIT MARGINS Income information, gross profits and cost of goods sold 7.5 PROFIT-SHARING PLAN Operating expenses, retirement plans 8.6 PROPERTY Balance sheet, fixed assets 6.8 Taxes, distributions of appreciated or depreciated property 11.33 PROPERTY SETTLEMENT Interest on interspousal buyout, taxability and deductibility of 11.40 Negotiation for settlement 12.5 PROPERTY TRANSFERS Taxes and divorce 11.1 PUBLIC RECORDS Documentation, comparing records 3.2 PUBLICLY TRADED COMPANIES Valuing closely held business, industry comparisons 10.7 Q QDROS Alimony and support 11.1 Equitable distribution and retirement plans 11.44 QUALIFICATION Taxes, alimony qualification rules 11.10 QUALIFIED DOMESTIC RELATIONS ORDERS See QDROS R REAL PROPERTY Personal financial investigation, standard of living 9.1, 9.2 Residence. See RESIDENCE

REASONABLE COMPENSATION Valuing closely held business, Revenue Ruling 68-609 10.6 REASONABLENESS Operating expenses 8.1 RECAPTURE Alimony qualification rules for tax purposes 11.10 Antifrontloading rules, alimony and support 11.6 Legal fee tax deductibiity 11.20 RECEIPTS Petty cash on balance sheet 6.3 RECEIVABLES Loans to officers, owners and shareholders on balance sheet 6.14 RECENT SALES Valuing closely held business, methods 10.9 RECORD ACCESS Accountant-client relationships 1.1 Attorney, initial discussions with 1.2 Client interviews 2.1 On-site work 5.4 Requests for 1.5 Sample letter request 1.6 REDEMPTION Taxes, redemption of corporate stock 11.42 REDUCTION OF PAYMENTS Child support, tax treatment 11.13 REDUCTIONS Operating expenses, owner and officer payroll 8.2 REFINANCING Negotiation for settlement 12.5 REFUNDS See TAX REFUNDS REGISTRATION TAXES Operating expenses 8.13 REGULATORY AGENCY REPORTS Documentation, comparing records 3.2 RELATED BUSINESS ENTITIES Documentation, comparing records 3.2


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INDEX

RELATED PERSONS Accounts payable on balance sheet 6.11 Notes receivable on balance sheet 6.9 Personal financial investigation 9.4 Rent, operating expenses 8.4 Valuing closely held business, recent sales 10.9 REMARRIAGE Alimony qualification rules for tax purposes 11.10 Antifrontloading rules, alimony and support 11.6 Front loading rule exceptions 11.11 Postdivorce services 13.5 RENT Economic issues, impact on inquiry 4.1 Operating expenses 8.4 RENTAL PROPERTIES Deferred taxes’ effect on equitable distribution 11.46 Income, personal financial investigation 9.2 Passive activity loss carryovers 11.43 Tax return analysis, personal financial investigation 9.8 REPAIRS Operating expenses 8.7 REPORTING DATES Inventory on balance sheets, determining 6.5 RESIDENCE Marital residence, taxes 11.41 Property distribution of jointly owned residence, taxes 11.35 RESTAURANT MEALS Operating expenses, travel, entertainment, and promotion 8.9 RETAIL BUSINESSES Valuing closely held business, industry comparisons 10.8 RETAIL METHOD Inventory on balance sheets, determining 6.5

529

RETAINED EARNINGS Equity on balance sheet 6.18 RETIREMENT EQUITY ACT OF 1984 Equitable distribution and retirement plans 11.44 RETIREMENT PLAN DISTRIBUTIONS Tax return analysis, personal financial investigation 9.8 RETIREMENT PLANS Deferred taxes’ effect on equitable distribution 11.46 Operating expenses 8.6 Personal financial investigation 9.4 Taxes, property distributions 11.44 RETURN ON INVESTMENT Valuing closely held business, Revenue Ruling 68-609 10.6 REVENUE RULING 59-60 Valuing closely held business 10.5 REVENUE RULING 68-609 Valuing closely held business 10.6 REVENUE RULING 69-608, 1969-2 C.B. 43 Corporate stock redemption and transfer 11.42 REVENUE RULING 72-545, 1972-1 C.B. 179 Legal fee tax deductibiity 11.20 REVENUE RULING 74-611, 1974-2 C.B. 399 Allocating tax refunds between spouses 11.25 REVENUE RULING 80-7, 1980-1 C.B. 296 Allocating tax refunds between spouses 11.25 REVENUE RULING 86-57, 1986-1 C.B. 362 Allocating tax refunds between spouses 11.25 RISK RATE Valuing closely held business, future earnings 10.10, 10.11 ROLLOVERS Equitable distribution and retirement plans 11.44 Marital residence sale 11.41


530

10/22/01

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Page 530

INDEX

ROOFING Repairs and maintenance, operating expenses 8.7 S S CORPORATIONS Form of business, impact on inquiry 4.2 Tax return analysis, personal financial investigation 9.8 SAFE DEPOSIT BOXES Collections, valuation 9.7 Sales and income 7.4 SALE OF INTEREST Documentation, preliminary disclosure 3.1 SALES AND INCOME Accounts receivable on balance sheet, estimating 6.4 Asset sales, negotiation for settlement 12.5 Gross profit and costs of goods sold 7.5 Information sources 7.1 Professional practices 7.3 Safe deposit boxes 7.4 Seasonality 7.2 Unreported income, allegations of 7.6 Valuing closely held business, methods 10.9 SALES TAXES Balance sheet 6.17 SAVINGS ACCOUNTS Cash on balance sheet 6.2 SCHEDULES A-E Tax return analysis, personal financial investigation 9.8 SCHOOLS Income information, gross profits and cost of goods sold 7.5 SEASONALITY Flea market, income information 7.5 Greenhouses, gross profits and cost of goods sold 7.5 Sales and income 7.2 SECOND HOMES Deferred taxes’ effect on equitable distribution 11.46

SECOND LOCATIONS See MULTIPLE LOCATIONS SECURITIES Deferred taxes’ effect on equitable distribution 11.46 SEP IRAS Tax return analysis, personal financial investigation 9.8 SEPARATE MAINTENANCE DECREE Alimony. See ALIMONY Joint tax returns 11.18 SEPARATION Marital residence sale 11.41 SEPARATION AGREEMENTS Alimony qualification rules for tax purposes 11.10 SERVICE BUSINESSES Valuing closely held business, industry comparisons 10.8 SHAREHOLDERS Loans to shareholders on balance sheet 6.14 SHAREHOLDER’S AGREEMENT Valuing closely held business 10.12 SHIPMENTS Inventory on balance sheets, determining 6.5 SHRINKAGE Unreported income, allegations of 7.8 SIGNATURES Innocent spouse exclusion from joint tax liability 11.26 Operating expenses, payroll checks 8.3 SITE VISIT See WALK-THROUGH SMELL TEST Unreported income, allegations of 7.8 SOCIAL SECURITY NUMBERS Operating expenses 8.3, 8.24 Tax return analysis, personal financial investigation 9.8 SOLE PROPRIETORSHIPS Form of business, impact on inquiry 4.2 Valuing closely held business 10.3


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INDEX

SOURCES OF INCOME Patents and copyrights, intangibles on balance sheet 6.10 SPOUSES Operating expenses, automobiles 8.10 STALE TRANSACTIONS Equity on balance sheet, treasury stock 6.18 STANDARD OF LIVING Cash on balance sheet 6.2 Personal financial investigation 9.2 Taxes and divorce 11.1 Unreported income, allegations of 7.8 STATE TAXES Alimony and support 11.9 Income tax return analysis, personal financial investigation 9.8 Returns, personal financial investigation 9.9 STATEMENT OF OPERATIONS Balance sheet. See BALANCE SHEET STEP-UP BASIS UPON DEATH Tax shelter issues 9.5 STIPULATIONS Accountant-client relationships, stipulation to by both parties 1.1 Court appointment v. stipulation 1.7 STOCK Taxes, transfers and redemption of corporate stock 11.42 STOCK OPTIONS Personal financial investigation 9.4 STOCK REGISTER Equity on balance sheet 6.18 STOCKHOLDER’S EQUITY Equity on balance sheet 6.18 STOCKS AND BONDS Valuing closely held business, Revenue Ruling 59-60 10.5, 10.20 Valuing closely held business, Revenue Ruling 68-609 10.6, 10.21

531

SUBSCRIPTIONS Operating expenses 8.21 SUBSEQUENT SHIPMENTS Inventory on balance sheets, determining 6.5 SUNDRIES Operating expenses 8.23 SUPPLIERS Accounts payable on balance sheet 6.11 SUPPLIES Prepaid expenses on balance sheet 6.7 SUPPORT TRUSTS Taxes, property distributions 11.45 SUSPENDED PASSIVE ACTIVITY LOSS CARRYOVERS Between spouses or ex-spouses 11.43 T TARGET COMPANY Access to opposition’s information 5.1 Accountant, company’s regular 5.2 Internal work flow 5.7 IRS examination of company’s books 5.3 Multiple companies 5.8 Multiple departments, locations, or products 5.9 On-site work 5.4 Planning for divorce, reflection in business dealings 5.10 Privacy issues 5.5 Reluctance to allow assess to books 5.3 Walk-through of business – Checklist 5.11 – Need for 5.6 TAX BALANCE DUE Tax return analysis, personal financial investigation 9.8 TAX CREDITS Tax return analysis, personal financial investigation 9.8 TAX FRAUD Impact on inquiry 4.5


532

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Page 532

INDEX

TAX-FREE ROLLOVER OF PROFIT Marital residence sale 11.41 TAX ISSUES Impact on inquiry 4.1 Target company, IRS examination of company’s books 5.3 TAX LIABILITY Valuing closely held business, discounts for unreported income liability 10.15 TAX REFORM ACT 1984 Alimony and support 11.3, 11.4, 11.6, 11.9, 11.31 TAX REFORM ACT 1986 Alimony and support 11.3, 11.4, 11.6 TAX REFUNDS Allocating refund between spouses 11.25 Personal financial investigation 9.4 TAX RETURNS Client interviews 2.2, 2.3 Depreciation, operating expenses 8.5 Documentation, preliminary disclosure 3.1 Personal financial investigation 9.8 Postdivorce services, return preparation 13.4 Valuing closely held business 10.1 TAX SHELTERS Personal financial investigation 9.5 TAXABLE EVENT Property distributions 11.27, 11.28 TAXES Generally 11.1, 11.2, 11.47 Accounts receivable on balance sheet, estimated taxes 6.4 Alimony – Generally 11.3 – Adjusted gross income 11.8 – Allocating tax and refund between spouses 11.25 – Cessation at death 11.4 – Child support, excess amount as alimony 11.12 – Earned income credit 11.22 – Electing out of alimony 11.5 – Equitable relief 11.26

– Filing as unmarried 11.19 – Filing status 11.17 – Front loading 11.6 – Front loading rule exceptions 11.11 – Income-shifting planning 11.7 – Innocent spouse 11.26 – Joint returns 11.18 – Judicial review 11.26 – Legal fee deductibility 11.20 – Property distributions 11.45 – QDROs 11.44 – Qualification rules 11.10 – State tax law 11.9 Child support – Generally 11.12 – Changes related to a child 11.13 – Child care credit 11.21 – Child tax credit 11.23 – Custodial v. noncustodial parent 11.15 – Dependency exempions 11.14 – Legal fee deductibility 11.20 – Medical deductions 11.24 – Multiple support agreements 11.16 – QDROs 11.44 Child support, tax issues 2.6 Earned income credit 11.22 Operating expenses 8.13 Payroll taxes withheld on balance sheet 6.16 Personal financial investigation 9.4 Postdivorce services 13.4 Prepaid expenses on balance sheet 6.7 Property distributions – Generally 11.27 – Alimony and support trusts 11.45 – Annuities 11.34 – Annulments 11.30 –Appreciated or depreciated property 11.33 – Deferred taxes, effect upon equitable distribution 11.46 – Definitions 11.28 – Effective dates of legislation and distributions 11.31


10/22/01

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Page 533

INDEX

– Installment sales 11.36 – Interspousal buyout, taxability and deductibility of interest on 11.40 – Jointly owned residence 11.35 – Liabilities exceeding basis 11.37 – Marital residence 11.41 – Nonresident alien spouse 11.29 – Passive activity loss carryovers 11.43 – Retirement plans 11.44 – Supplying information to transferee 11.38 –Transfer of basis under § 1041 v. nonspousal gift rules 11.39 –Transferees basis 11.32 –Transfers and redemption of corporate stock 11.42 Sales taxes payable on balance sheet 6.17 TAXPAYERS OVER 55 Marital residence sale 11.41 TECHNICAL REVIEW Report to client 12.3 TELEPHONE Operating expenses 8.11 TEMPORARY ALIMONY PAYMENTS Front loading rule exceptions 11.11 TERM PAYOUT Negotiation for settlement 12.5 TESTIMONY Final stages 12.5 THIRD-PARTY PAYMENT Tax deductions for medical expenses 11.24 TITLE Marital residence sale, title transfer to one spouse 11.41 TRACING DISBURSEMENTS Operating expenses, owner and officer payroll 8.2 TRACING FLOW OF FUNDS Cash on balance sheet 6.2 TRADE RECEIVABLES Notes receivable on balance sheet, conversion to 6.9 TRADE SOURCES Sales and income information sources 7.1

533

TRANSFER OF BASIS Property distributions, nonspousal gift rules 11.39 TRANSFEREE Taxes, property distributions, supplying information to transferee 11.38 TRANSFEREE’S BASIS Taxes, property distributions 11.32 TRANSFERS Dependency exemption 11.14 Taxes, transfers of corporate stock 11.42 TRAVEL Operating expenses 8.9 TREASURY STOCK Equity on balance sheet 6.18 TRIAL DATE Valuation date, impact on inquiry 4.3 TRUST ACCOUNTS Cash on balance sheet 6.2 TRUSTS Support trusts, taxes 11.45 Tax return analysis, personal financial investigation 9.8 TURNOVER RATIO Inventory on balance sheets, determining 6.5 U UNBILLED SALES Work in progress on balance sheet 6.6 UNDERFUNDING Defined benefit pension plan as operating expenses 8.6 UNDERPAID TAXES Valuing closely held business, discounts for unreported income liability 10.15 UNDERSTATEMENT Inventory on balance sheets, longterm effects 6.5 UNMARRIED STATUS Tax return filing status 11.19 UNREPORTED ASSETS Inventory on balance sheets 6.5


534

10/22/01

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Page 534

INDEX

UNREPORTED ASSETS (continued) On-site work 5.4 UNREPORTED DISTRIBUTIONS Retirement plan, operating expenses 8.6 UNREPORTED EXPENSES Unreported income, allegations of 7.8 UNREPORTED INCOME Access to opposition’s information 5.1, 5.2 Cash on balance sheet 6.2 Challenges to allegations of 7.6 Client interviews 2.2, 2.3 Documentation, review of books and journals 3.3 Income information, gross profits and cost of goods sold 7.5 Income information, professional practices 7.3 Inventory on balance sheets, long-term effects 6.5 Operating expenses, owner and officer payroll 8.2 Personal financial investigation 9.1, 9.3 Sales and income information sources 7.1 Seasonality in sales and income information 7.2 Target company dealings 5.7 Tax fraud, impact on inquiry 4.5 Valuing closely held business 10.1, 10.15 Walk-through of target company 5.6 UNREPORTED SALES Sales taxes payable on balance sheet 6.17 UTILITIES Operating expenses 8.22 V VACATIONS Personal financial investigation, standard of living 9.1, 9.2 VALUATION Collections 9.7

Copyrights, intangibles on balance sheet 6.10 Walk-through of target company 5.6 VALUATION DATE Impact on inquiry 4.3 VALUATION OF EQUIPMENT Fixed assets on balance sheet 6.8 VALUING CLOSELY HELD BUSINESS Generally 10.1 Buy-sell agreements 10.2 Definition of value 10.2 Discounts 10.15 Double dip 10.18 Enhanced earnings power 10.17 Entire business entity 10.2 Fair market value 10.2 Fair value 10.2 Future earnings 10.10, 10.11 Holder, value to 10.2 Industry business is in 10.4 Inflation, role of 10.19 Intrinsic value 10.2 Investment value 10.2 Liquidation value 10.2 Majority interest 10.2 Methods of valuation – Buy-sell agreement 10.12 – Capitalization of income 10.10 – Discounted future earnings 10.11 – Discounted future earnings or cash flow 10.11 – In-place value 10.13 – Liquidation value 10.14 – Price-to-earnings ratio, industry comparison 10.7 – Recent sales 10.9 – Revenue Ruling 59-60 10.5 – Revenue Ruling 68-609 10.6 – Rules of thumb 10.8, 10.15 Minority interest 10.2 Premiums 10.16 Revenue Ruling 59-60 10.5, 10.20 Revenue Ruling 68-609 10.6, 10.21 Stocks and bonds valuation, Revenue Ruling 59-60 10.5, 10.20


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Page 535

INDEX

Stocks and bonds valuation, Revenue Ruling 68-609 10.6, 10.21 Structure of business 10.3 VARIABLE PAYMENTS Alimony qualification rules for tax purposes 11.10 Child support 11.12 Front loading rule exceptions 11.11 VEHICLES See also AUTOMOBILES Fixed assets on balance sheet 6.8 VESTING Retirement plan, operating expenses 8.6 VETERINARY PRACTICES Income information 7.3 VOLUNTARY PAYMENTS Alimony qualification rules for tax purposes 11.10 W W-2 Operating expenses, payroll 8.3 W-3 Operating expenses, payroll 8.3 WAGES See also PAYROLL; COMPENSATION Tax return analysis, personal financial investigation 9.8 WALK-THROUGH OF BUSINESS Fixed assets on balance sheet 6.8 Inventory on balance sheets 6.5 Seasonality in sales and income information 7.2 Target company dealings 5.6 WASTAGE Unreported income, allegations of 7.8

535

WITHHOLDING TAXES Balance sheet 6.16 Operating expenses 8.13 Tax return analysis, personal financial investigation 9.8 WORDS AND PHRASES Taxes, property distributions 11.28 WORK IN PROGRESS Balance sheet 6.6 WORK PAPERS Company’s regular accountant, dealing with 5.2 On-site work 5.5 WORK PROGRAMS Described 1.6 WORKERS’ COMPENSATION REPORTS Income information, gross profits and cost of goods sold 7.5 WORKSHEETS Documentation, review of books and journals 3.3 Unreported income, allegations of 7.8 WRITEOFFS Accounts receivable on balance sheet 6.4 Bad debts. See BAD DEBTS Depreciation, operating expenses 8.5 Y YEAR-END BALANCE Cash on balance sheet 6.2 YEAR-END SALES DEFERRALS Planning for divorce, reflection in business dealings 5.10

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