CPAs as Forensic Accountants in Divorce Engagements

By Ron Marden and Tige Darner

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Marriage: The Leading Cause of Divorce? Out of the more than 2 million marriages performed last year, 60% were the first marriage for both bride and groom. Unfortunately, for those first marriages that do end in divorce, the average length of a first marriage is only about eight years. The median duration of second marriages that end in divorce is only about seven years.

Most newlyweds probably don’t think of their wedding day as the beginning of a personal business partnership: making money, budgeting, accumulating assets, and investing for the future. Nevertheless, couples should still plan how to divide this property at the blissful beginning, not the bitter end. This planning could take the form of a premarital agreement, which may not be a perfect document, but is generally enforceable in all 50 states. This is why both spouses must understand their household’s finances. It is not a good idea to allow one spouse to run all the finances while the other spouse knows nothing about it. After all, the person you plan to spend the rest of your life with would never try to hide something from you … or would they?

Locating Hidden Assets

Most marital assets are not hidden at all; it’s simply a matter of knowing where to look. This is what Ron, a hypothetical CPA and forensic accountant, told Mary, who has recently filed for divorce from John, her husband of the past nine years. Mary hired Ron as a CPA in her divorce engagement because she knows nothing about the family finances and no longer trusts John. Mary’s request to hire Ron is not unusual. CPAs who are hired to perform forensic accounting are often hired to represent the spouse who doesn’t have knowledge about or access to the family financial information and normally is not the breadwinner. The other spouse often has the higher earnings and thus the opportunity and motive to either hide assets or defer income. The reason is simply greed. Some spouses believe that the income they earned is theirs and theirs alone, especially in situations where there is either generational family income or one spouse earns a majority of the family income. John thought that, by hiding assets or deferring income, he could reduce any child support or alimony settlements Mary may be entitled to.

Forensic accounting in divorce engagements is a fairly new discipline, and the process of locating hidden assets or deferred income can be difficult. Many times the other spouse will go to extreme lengths in order to hide the assets not only from their spouse but from the IRS.

The critical first step in Ron’s investigation was to meet with Mary and her attorney and to obtain the following information:

• A complete education and employment history of John;
• A list of all banks, brokerage firms, and other financial institutions with which John has ever had a relationship, including each account number and type;
• All sources of income, whether earned or passive, including pending litigation and insurance settlements, estate proceeds, asset sales, and loans;
• Lifestyle and expense levels for items such as entertainment, travel, child care, interest, and property taxes; and
• Detailed information on personal and business relationships, such as the names of children, parents, any ex-spouses, Mary’s maiden name, and the names of all current and former business entities and partners.

This checklist should familiarize Ron with John’s dealings and provide a foundation for his investigation. Once Ron has finished the interview process, he has several common methods at his disposal to determine if John may be hiding assets (Exhibit 1).

The expenditure method is used by CPAs to prove the existence of hidden assets and income by comparing total personal expenditures to reported income. Reported income will often come from tax returns, financial statements prepared for bank loans, or financial statements prepared for the courts. By analyzing this data, Ron can determine if the level of reported income is sufficient to support the family, based upon their spending habits. This will often lead to more-detailed analysis and is a good first step to gauge whether assets and income have been hidden. Another method is the net worth method, in which CPAs compare net worth at the beginning of the year (or period) to net worth at the end of the period. The increase or decrease in net worth is then reconciled to the reported income for the period, to help determine the likelihood of hidden assets. A final method is the bank deposit method, in which CPAs examine bank and investment deposit activities. The bank deposit method is often used when there are large amounts of deposits and very little money is actually dispersed.

An important item Ron can also look for is a premarital agreement, if one exists. A properly executed premarital agreement should be very detailed as to what assets existed before the marriage. In this case, Ron focused on tracing the assets that were listed on the premarital agreement to see if they led to acquisitions of other, undisclosed assets.

The initial interview with Mary and her attorney, the methods for detecting hidden assets, and the review of the premarital agreement should help Ron establish whether assets are being hidden. The actual search for hidden assets will usually require, as a first step, a public-records search. Public-records searches are used to help identify unknown businesses and real estate investments. When reviewing the public records, Ron will also look out for any associates he learned about from the interview process. A review of “frequent flyer statements” may show a pattern of travel to a particular city. Phone bills will be analyzed for toll charges to unusual locations, and credit card statements will be similarly examined for unusual expenditures, purchase locations, and hotel, air travel, and rental car charges. This information would lead to a search in any particular location that suggests an unusual spending pattern.

Separate Property Versus Marital Property

CPAs are often asked in divorce proceedings to determine what property may be considered separate property from marital property and to identify “transmuted” property (i.e., separate property that has subsequently been converted into marital property). Property owned by either spouse upon divorce is deemed to be marital property unless it can be proven otherwise. Ron will either substantiate John’s and Mary’s separate property from their marital property or disprove that certain property is separate property, often by tracing the ownership of the property of either spouse back to the date it was received, in order to clearly show that the property continued to qualify as separate property until the divorce. Tracing premarital property will involve reviewing documents that existed at the time of the marriage, including a premarital agreement. If a claim is made by one spouse that property was received by gift or inheritance, then a review of gift and estate tax returns for family members will often be required.

The discussion of separate and marital property often centers on transmuted property. The easiest way to think of transmuted property would be to assume that one spouse had received a gift of stock. The fact that the gift occurred during the marriage would be irrelevant, as the stock would most likely qualify as separate property. Now assume that the spouse sells that stock and uses the proceeds to purchase appliances for their marital home. In such a case, a CPA would have to determine whether the separate property has been transmuted into marital property.

Forensic accountants have at their disposal several different methods to determine proper ownership of property (Exhibit 2). In the first method, the specific identification method, expenses that are tied to a specific item of separate or marital property are thus characterized according to that property.

The second method, the family expense doctrine method, has been variously applied by courts in divorce proceedings. One application is that funds withdrawn from a commingled account in order to pay living expenses of the family are deemed to be marital funds and thus marital property. The other application that some courts have used is when family expenses exceed family income during the marriage. In this case, any funds withdrawn from the account are deemed to be separate funds and thus separate property.

A method used when the first two cannot be is the marital-property-out-first method. If separate and marital funds have been commingled into one account, then all withdrawals from that account are assumed to come first from marital property. For example, assume Mary deposits $10,000 into a joint account with John. Mary received the money as a gift and it is thus separate property. Mary and John’s joint account already had $4,000 in the account. If the spouses chose to withdraw $5,000 from the account, under the marital-property-out-first method, then the first $4,000 will be deemed to have been withdrawn from the joint account and $1,000 will be deemed to have been withdrawn from Mary’s separate property. The remaining $9,000 will still be considered separate property for Mary.

The fourth method, the minimum balance method, is similar to the marital-property-out-first method. Consider the previous example: If the joint account never falls below $10,000, then Ron could infer, by using the minimum balance method, that the $10,000 remaining is separate property.

The fifth method is the identical sum inference method. If one spouse deposits separate funds into a commingled account and shortly thereafter withdraws the same amount as was deposited, then the withdrawal is considered to be separate funds.

The sixth and final method is the pro rata method. Withdrawals from a commingled account are allocated between separate and marital funds based on the balance in the account at the time of the withdrawal. Based on the joint account above, if $5,000 was removed from that account, then 71.43% ($10,000/$14,000) of the $5,000 would be considered separate property and 28.57% ($4,000/$14,000) of the $5,000 would be considered marital property.

Because some courts have a precedence of allowing only certain methods to be used in separate, marital, and transmuted property determination, a forensic accountant must know what the courts in the jurisdiction will permit.

Closely Held Businesses

In evaluating John and Mary’s dissolved marriage, Ron would look at the level of suspicion and animosity in the relationship. The more distrust and hostility exist, the more likely that one spouse is or will be trying to hide assets. Often the easiest way for a controlling spouse to hide assets or income is in a closely held business, somewhere the other spouse has no knowledge of. Because Mary had little or no involvement in the business, the task of hiding assets would be easy for John.

The basic purpose of a forensic examination of a closely held business is to analyze four important items (Exhibit 3). The first item Ron needs to analyze is whether John has used business funds to acquire personal assets. The second is to determine if business funds were used for John’s personal expenses. The third is to uncover or identify unreported business income. The fourth and final item is the gathering of information necessary in order to determine the value of John’s ownership interest.

The first two items, use of business funds for personal assets and for personal expenses, go hand in hand. Ron focused on a business fixed-asset schedule to determine if “company” assets are actually John’s personal assets. Such assets typically include cars, real estate, boats, and collectibles. As far as personal expenses, closely held businesses often pay common personal expenses such as utility bills, cellular phone bills, insurance, home taxes, recreational club dues, and vehicle expenses. These personal expenses reduce the amount of John’s income and thus the “family” income. This can have a direct effect on Mary’s eventual divorce settlement and potential child support and alimony payments.

Another critical focal point in a divorce engagement that includes a closely held business is the third item: evaluating and searching for unreported income. This may be the most difficult job for a forensic accountant, considering that this income is often hidden from outside services, particularly the IRS. Ron must consider what type of business John has, because certain businesses—such as those with high volumes of cash sales, like restaurants, gas stations, or convenience stores—lend themselves more easily to hiding and underreporting income.

Finding Hidden Income

Internal controls. The first step for a forensic accountant is to review a business’s internal controls. The bigger the business, the more likely that internal controls will be present, especially if the business is a publicly traded company. However, many businesses, like John’s, are small businesses without the resources or personnel to fully implement good internal controls. As in John’s case, the person who is receiving deposits or cash is the same person who is recording the deposit. Given that John will have the ability to override any internal control functions, Ron must carefully review the internal controls for weaknesses and evaluate whether it is possible that John could divert cash and underreport income.

Business markup and profitability. After analyzing internal controls, a forensic accountant will focus on two reviews. The first review is the typical markup and profitability of the business. By understanding the normal markup of a business, either through historical comparison or industry standards, one can infer the possibility that income has been unreported. For example, if the average markup on cost is 50% for John’s retail clothing store, and the cost of clothing sold for the year is $1 million, then sales should be around $1,500,000. If, on Ron’s review of the books, the related sales are only $1,100,000, then a review of the inventory records and turnover should indicate that sales are underreported.

The normal level of expenses. The second review involves analyzing the normal level of expenses. Many times certain businesses have expenses that have a direct relationship to income. If a CPA can determine and understand the normal level of expenses associated with the business, then she should be able to estimate sales.

If either review gives Ron the impression that sales are unreported and thus cash has been diverted, then he has several methods to confirm this. Ron would first look at the amount and frequency of John’s deposits. Any inconsistencies in the deposits should be evaluated and reviewed. If possible, a comparison of deposits (or sales) from the same time period in prior years should help in this review.

Additional methods. Several other methods can be used to detect unreported income and cash. One method would be to compare the journal entries to the receivables accounts. Any journal entries showing significant write-offs should be reviewed for efforts to collect, such as letters or correspondence. If no documentation exists, it is possible that John pocketed the cash and subsequently wrote off the account. Another method is to have spotters and surveillance. The surveillance would be conducted by Ron, who would watch, from a distance, cash transactions at the business while a spotter would act as a normal customer. This would give Ron the ability to see the business in action and determine if any “skimming” is occurring.

Determining the Value of the Business

A forensic accountant must determine if a spouse is purposely trying to minimize the value of a closely held business. This would impact the value of the marital assets and thus affect the ultimate settlement the other spouse is entitled to.

John may try to transfer assets or income to other businesses, especially one Mary is not aware of. Ron may be able to find out information on the concealed company through corporate filings. Correlating this information with data retrieved from personal checkbooks, other public records, and tax returns often can reveal where assets are being hidden. John may also purposely try to reduce the profitability of the company through discounted or inflated transactions with related parties. Related parties typically include other family members or personal friends. If Ron believes that John is purposely reducing income, then he should investigate any unexplained changes in revenue and expenses, investigate customers and vendors for any related parties, evaluate any related-party transactions, and review accounts payable and receivables for unusual patterns. The two or three years prior to a divorce filing is a critical time period when a spouse may conspire with related parties.

Seek Assistance

Mary was wise to hire Ron as her CPA; she could never have done this type of forensic investigation on her own. While there’s an old saying that “everyone loses in a divorce,” sadly, this is not always the case. It can be a complicated matter of who gets the house versus the retirement assets, or both. Quite often, the spouse who is not the primary breadwinner will likely need to be particularly aggressive in a divorce proceeding, and this is where a CPA can help. CPAs can provide a valuable service that builds on their existing expertise in tax, audit, and accounting services.