Why a Forensic Accountant? Using a forensic account is essential in developing a strategy to handle and defend the findings of a cash-based audit. However, before delving into how they can assist counsel and the client, it’s essential to define what a forensic accountant is.
Forensic accounting is a subset of the accounting profession. The Oxford Dictionary defines forensic accounting as “the use of accounting skills to investigate fraud or embezzlement and to analyze financial information for use in legal proceedings.”
In the context of a cash-based audit, an accountant or counsel may handle the actual audit and interface with the agent, and a forensic accountant (FA) may evaluate the books and records in advance of the audit or after the fact by reviewing the findings of the IRS. Their role will include accumulating appropriate evidence, critically assessing the assertions and calculations of the IRS, and identifying additional financial and nonfinancial information not considered or not given the right level of relevance in the conduct of the audit.
Depending on how a case develops, counsel can utilize forensic accountants in various capacities, including as a consulting expert who consults with the attorney but does not testify or as a testifying expert and fact witness.
It is typical for counsel to retain the FA under a Kovel letter. Under this form of representation, the accountant is considered part of the defense team, advising the attorney. As such, unless the expert will testify, their work product is not discoverable. This becomes even more critical in instances where additional non-tax related charges may be possible or if the audit may result in criminal charges.
The remainder of the article will address the forensic approach to a cash audit, including:
- Understanding the business and its operations
- Understanding cash controls and documentation
- Evaluation of the IRS findings
We will also address Form 8300-Cash Payment Report, consideration of digital transactions, and recalculation of the tax loss.
The Forensic Approach to a Cash Audit
There is no one-size-fits-all approach to a cash audit. Each engagement will have different issues that need to be addressed, and the FA’s role is not just to address the findings but to identify mitigating factors and alternatives that can be used to minimize the asserted tax loss or potential fraud claims.
In some cases, depending on the extent of the estimated tax loss, coupled with the investigating agent’s suspicions of fraudulent activities, a criminal referral may be made. In such cases, the taxpayer’s intent will become a key element in determining the trajectory of the audit and the case. Accordingly, forensic accountants must understand the taxpayer’s state of mind. This involves a meticulous examination of a company’s financial transactions and scrutinizing records to determine whether there was a deliberate attempt to underreport income or engage in fraudulent activities.
The taxpayer will no doubt be frustrated and at a heightened stress level as the agent goes through their interview and assessment processes. The taxpayer, typically a business and its owner(s), often find themselves on defense and asked to explain transactions that are multiple years old, with records that may not be perfect. Forensic accountants will navigate the company and its owners through this process, understanding the discomfort an in-depth examination of this type causes.
Understanding the Business and Its Operation
Critically important when evaluating findings, evaluating indicia of intent (more on that later), and reconstructing the business’s financial activity is understanding what they do, how they do it, and the capabilities of key personnel. In addition, understanding the industry and its competitors will provide valuable insight. Some of the areas of evaluation include:
- What’s standard in the industry
- Comparison to similar businesses
- Industry trends
- Financial history
- Banking history
- Relationships with customers and vendors
- Capabilities of management and finance personnel
Understanding of Cash Controls and Documentation
The focus on controls and supporting documentation cannot be understated. This will often go directly to intent in a criminal fraud matter. Documenting the systems and walking through the actual implementation of the controls will pay dividends in the investigation and reconstruction. It is also from these records that the financial history can be recreated and documented even after the fact. The FA will want to document the controls, including segregation of duties and documentation maintained for various areas. Including:
- Deposits and cash deposits
- Record keeping, oversight, and reconciliations
- Cash disbursements
- W-2’s 1099’s, particularly cash payroll
There is no formal definition of books and records. Not every business has full-time, educated financial staff and the tools to capture and report financial transactions. Understanding the informal accounting processes and their utilization can be vital to presenting the financial activity.
Evaluation of IRS Findings
The IRS agents who perform these audits of cash-intensive businesses tend to be highly skilled. The reality is that there is not much new in the means of business undertaken to disguise or divert cash. The IRS has published audit guides designed around specific industries. Certainly, before agreeing to a meeting with an agent, the audit guide should be reviewed to identify issues likely to come under review.
You can expect that before the agent ever steps into the conference room, they will have utilized the tools at the IRS’s disposal to investigate the company. They will review social media and potentially interview competitors, customers, and vendors. They will have banking information and undertake other financial discovery from available public and not-so-public sources. They will have a wealth of industry and comparative financial data and specific operating details. They will likely have visited the business and already understand how it operates. They will have reviewed the business’s and its owners’ tax returns. In short, you’re not talking your way past the auditor.
Should the books and records be insufficient, the agent will attempt to reconstruct the business’s revenue via an alternate means. We will discuss the specific methods in a follow-up article; however, know that there are five prevalent methodologies to prove unreported cash. Depending on the industry and the availability of information, the auditor will choose a method, including:
- Cash T
- Percent markup
- Net worth
- Source and application of funds
- Cash expenditure
The forensic accountant must evaluate what the IRS has calculated and the related conclusions. By design, all these methods are indirect and imperfect income measures. There may also be another methodology that will more accurately achieve the result and may need to be independently computed by the FA. By identifying flaws in the calculation, unsupported assumptions and conclusions, or errors in the information utilized, the FA can drive the tax loss lower. The key is to access information and records to document alternative positions to the IRS’s conclusions.
One area to review is the diligence undertaken in accumulating and categorizing the deposits to the entity’s bank accounts. There are numerous types of deposits that do not represent taxable income, in whole or part. Identification of these items through access to information can effectively negate the inclusion. Some of these items include:
- Tips to be paid to employees
- Loan proceeds
- Asset sale proceeds
- Sales tax
- Contribution to capital
One of the areas that should also be evaluated is the revenue reported on sales and excise tax returns versus the revenue reported on the income tax return and computed by the IRS. The FA must be aware that the analysis can open new issues to the State(s) for underreporting trust fund taxes.
Business entities that are cash-intensive also tend to use cash to pay vendors and staff. This can quickly become a problem if not documented, as the IRS will have arrived at a revised income number; they have no incentive to look at the other side of the ledger and identify expenditures paid with cash, which reduces taxable income. The result, of course, is inflated taxable income. Once again, the ability to document these expenditures is critical.
One concern is always compensation paid in cash to “contractors.” Not only is this extremely difficult to document to the IRS, but it comes with additional concerns of underreported employee withholding and employment taxes. What may assist is the review of 1099s if they have been issued. The issuance at least supports the proposition that the payments were made. We’ll leave the employee vs contractor argument for another day.
Contacting vendors to obtain purchase records and payment reconciliation can effectively support cash payments to vendors. We recommend contacting vendors early in the process and gauging their willingness to cooperate. Realize you will have alerted the IRS to the fact that they, too, have cash-based revenues.
Form 8300 – Cash Payments Report
Most people are familiar with the foreign bank reporting requirements and know that US banks will report deposits greater than $10,000 in cash on a suspicious activity report. Less known is Form 8300, which businesses are required to file with the IRS and FinCen for cash received over $10,000 within 15 days of the receipt of the money. In the context of a cash basis audit, supporting deposits with the 8300 filing will assist the forensic accountant in validating the revenue streams. Further, it demonstrates a level of diligence on the part of the business to report its cash income that will negate many of the negative connotations that can come with the auditor’s review.
Consideration of Digital Transactions
Business transactions have evolved from cash to credit cards to digital currency and peer-to-peer networks. What can quickly be lost in the review of cash-based transactions are companion transactions using nontraditional payment methods for both inbound and outbound transactions. Some of these transactions are well documented, and the details of the transactions are easily obtained, such as through PayPal. Other transactions are far less recorded, particularly if digital currencies enter the equation. Know that the use of these platforms may draw additional scrutiny. Accordingly, the time should be taken to document the transactions. Tracing digital currencies was once thought to be impossible; it is now well within the IRS’s wheelhouse and should not be taken lightly.
The use of check-cashing businesses will also insert a level of complexity into the documentation of the financial transactions of the business, as well as barter transactions. All of this will undoubtedly raise the auditor’s level of interest.
Recalculation of the Tax Loss
Unfortunately, in most cash audits, an assessment will be forthcoming. The forensic accountant needs to evaluate the agent’s findings to reduce the computed tax or tax loss. There will certainly be penalties and interest associated with the amount. In addition, there may be substantial underpayment penalties and civil fraud assessments. Through a critical evaluation of the methodologies and the transactions identified, the FA may be able to either reduce the assessment or at least create substantial doubt, which may become helpful in negotiations or on appeal.
Depending on the circumstances, the auditor may have decided to make a fraud referral. While in the past, most of these cases remained in the civil arena, agents are now given the training and the tools to refer the matter for possible criminal charges. While the number of criminal cases yearly remains small, the forensic accountant must be aware of the possibility.
For the IRS to prevail in a criminal proceeding, the key element they need to prove is intent. The standard is beyond simply sloppy bookkeeping or the result of untrained people managing the finances. The IRS will look for what are known as the badges of fraud. There is no one size fits all, and no one element will rule the day. Instead, it’s an accumulation of factors that will point to a taxpayer who intended to underreport their income and failed to pay the appropriate amount of tax. Some of the criteria, a more detailed listing that can be found in the Internal Revenue Manual, include:
- Fictitious payees
- Low margin, net loss
- Use of zappers
- Lack of adequate records
- Destruction of records
- Concealing assets
- A second set of books
- Failure to report
In conclusion, as explained above, the role of the forensic accountant, both in anticipation of the audit and after the fact, is multi-faceted. Understanding the business, documenting the processes and procedures, recreating the books and records, and evaluating the findings are all critical aspects of the procedures the IRS and the forensic accountant follow. Therefore, no cash-intensive business should take on an IRS cash audit without the proper representation utilizing legal, accounting, and forensic professionals.