Written by Tracy L. Coenen, CPA, CFF
ABA Section of Family Law eNewsletter
One of the chief concerns in a divorce or child custody case is identifying the true income of one or both of the parties. It is not unusual for such a case to include allegations of hidden income or assets. It is common for a closely held business to suspiciously encounter declining sales and profits following the filing of a family law case.
In each of these instances, properly determining the income of the party is critical to getting a fair and equitable settlement, maintenance award, or child support award. Until you have the correct numbers, the attorney may find it very difficult to decide what is fair or in the best interest of the client.
How can a spouse or parent with little to no direct access to the other party’s financial records prove that there is undisclosed income? What happens if the financial records obtained during discovery appear woefully incomplete? A forensic accountant is the logical choice to help reconstruct financial records, estimate earnings, and analyze fine details of financial documents to prove or disprove income claims.
A forensic accountant may also be needed when there are few financial records available with which to analyze income. It is not uncommon for records to be discarded or destroyed. Lack of documentation is also an issue when one party works in all cash business. In these situations, an analysis of the person’s lifestyle becomes critical.
The most common method of proving an individual’s income is the “lifestyle analysis.” This analysis is not only used family law cases. It is also used by government agencies and defense counsel in tax cases or other prosecutions which involve income issues. It is also called the “expenditures method,” signifying the analysis of a person’s spending patterns relative to known sources of funds.
The concept of a lifestyle analysis is simple, but the execution is not. The analysis attempts to quantify someone’s living expenses and compare those expenses to known sources of income. If there are differences between the living expenses and the known income, they can be attributed to concealed income. The goal is to compute the cost of the lifestyle of the target and determine whether the reported income is sufficient to fund this lifestyle.
With enough information, this analysis can be fairly precise. Estimates are required when there are gaps in information, with the forensic accountant looking for outside pieces of information that can support estimates and assumptions.
In a simple lifestyle analysis, we would add the known expenses such as groceries, mortgage, auto lease, insurance, credit card payments, income taxes, and the like. The key is to include all the ways the subject may be spending money. The total spending is then compared to known sources of funds, such as wages, bonuses, dividends, gifts received, and loan proceeds. Again it is important to include all possible sources of income.
If the spending during the period under analysis exceeds the known funding sources, then it is likely that there is another source of income. The logic is simple: The money has to come from somewhere. The forensic accountant must continue to search for other sources of income that could explain the difference. Any remaining unexplained difference likely represents unreported income.
A lifestyle analysis begins with documentation of known income and expenses such as bank statements, investment account statements, mortgage statements, income tax returns, credit card statements, auto purchase documents, home sale or purchase documents, invoices for home repairs, and the like. Hundreds of items could contribute to this analysis, but these are some of the most common. One-time expenses should be noted as such, and vacation and recreational activities should be examined over a period of time to understand normal patterns. It is typical to look at two to five years’ worth of data to get a good baseline of spending patterns.
After available documentation has been analyzed, the search is on for undocumented spending, which may be evidence of concealed income. Additional spending is often found based on tips from insiders or circumstantial evidence. People in-the-know might be able to point the forensic accountant to vacations taken, vehicles purchased, or other business and recreational interests that cost money. Basic personal finance knowledge can help the forensic accountant make reasonable estimates of other spending. For example, gasoline and groceries are two common personal expenditures that occur on a regular basis. If documentation shows unusually low figures for these amounts, it may be necessary to try to estimate a reasonable figure.
To estimate the spending on gasoline, the forensic accountant may take into account the person’s commute to work, the number of car drivers in the household, and personal activities that require driving. From this, mileage can be estimated, and along with historical prices of gas, an estimate of spending on this item can be made. Grocery expenses can be estimated based on the size of a household, age of the children, and frequency of dining out.
Using known facts and common sense assumptions, estimates of other spending can be made as well. When estimating expenditures, it is important to consider the historical spending of the person and household. Significant changes in spending patterns should be carefully analyzed to determine if there is a reasonable explanation for the change, or if the change is reflective of hidden income. When a lifestyle analysis finds a difference between known sources of income and known and estimated spending, the forensic accountant will rule out additional sources and uses of funds. Legitimate sources of funds could make up the difference between income and spending. However, there may still be spending that exceeds known sources of funds, and this result is important in the litigation.
Situational factors can affect the reliability of a lifestyle analysis. The receipt of gifts or loans from third parties could constitute legitimate sources of funds, but it may not be possible to factor them into the analysis if they are undisclosed.
It may also be difficult to account for personal expenses or other benefits, such as a vehicle, paid by a business. These items ultimately are income to the individual, but lack of documentation makes them difficult to consider.
These difficulties should not deter a litigant from doing a lifestyle analysis. The calculation is done when there are suspicions or allegations of undocumented or unreported sources of funds and/or to document the parties’ standard of living over time. It is only natural that there may be some unanswered questions or imprecisions in the calculation. However, when done properly, the lifestyle analysis can yield some very valuable information.
Tracy L. Coenen, CPA, CFF, is a forensic accountant and fraud investigator with Sequence Inc. She specializes in cases of embezzlement, financial statement fraud, white collar crime, securities fraud, and family law. She can be reached at 312.498.3661 or [email protected].