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Financial Forensic Evidence: Reconstructing Business Income

18/07/2017


​​This was previously published in Montreal Lawyer and is reproduced with permission.

by Richard M. Wise, Partner, and Andrew Yas, Consultant MNP SENCRL, srl LLP

​​Part one of a two-part series. 

In valuing a closely-held business, there may be cases in which the reported income (on the financial statement) of the business might not reflect its real income. Unlike publicly-traded companies, the privately owned business is less focused on reporting large profits on its financial statements; rather, it often tends to (legally) minimize its net income and, hence, taxes within a reasonable threshold. There are cases, however, where the records of a business are incomplete, missing or otherwise lacking.

Suppressed business income can have a material and direct impact on a conclusion as to the value of an enterprise and dramatically affect shareholders, lenders, investors, taxation authorities, divorcing spouses, and other stakeholders who rely on the meaningfulness and integrity of the financial statements of the enterprise.

This article outlines a number of considerations with respect to the reconstruction of a business’ operating profits for financial valuation purposes, particularly in those situations where “the books are cooked” in order to suppress income. It also refers to authoritative sources that the forensic accountant or business valuator might use to support the analytical techniques applied in financial litigation involving shareholder, matrimonial and taxation disputes. For example, in the United States, Treasury Regulation 1.446 authorizes the Internal Revenue Service (IRS) to compute income in accordance with whatever method clearly reflects income in cases where the taxpayer maintains no records, or the financial records are inadequate and unreliable. The percentage or unit volume method has been considered an acceptable method of proving income in the United States Tax Court. Also, the U.S. Tax Court has allowed the use of third-party supplier records in ascertaining the cost of goods and the gross profit resulting from business activities where the records are inadequate.

Both the IRS and the Canada Revenue Agency believe that indirect methods should be considered when, inter alia:

• Gross profit percentages change significantly from one to another or are unusual or low for that business.

• The taxpayer does not make regular deposits of income, but uses cash instead.

Determining, or verifying, the gross receipts of a business can sometimes be performed by multiplying the number of units sold by the selling price per unit. If this can be done with reasonable accuracy, the gross profit margin can then be applied to determine the gross profit of the business before overhead expenses. Determining the number of units sold is generally geared to some performance function, e.g., gallons consumed, garments made, etc.

A restaurant business can provide a particularly good example of the types of procedures that the forensic analyst can apply in order to prepare his or her expert report.

In its Audit Technique Guide, the U.S. Internal Revenue Service states: “One fact that is consistent is that all restaurants have numerous sales transactions with small dollar amounts, taking place in a short time frame, such as during lunch or dinner. Many restaurants, especially smaller or closely held ones, are cash intensive and employees and/ or owners handle large volumes of cash transactions every day.”

Some observations culled from various commentaries by forensic experts include: “Industry associations can also provide a source of industry operating standards. Business appraisers often experience difficulty in determining exactly what an expense item should be, due to the questionable nature of the financial statement reporting of the subject company. Industry operating standards are very useful in deciding what a “normal” operating level of a company should be. ... “Another way in which industry standards can be useful is in determining if accounts are being “padded”. If most companies in an industry have gross profit margins of 45 percent, and the subject firm has varying amounts, all under 45 percent, a close examination of the cost of goods sold category is warranted. Other accounts where businesses tend to bury items are travel and entertainment, bad debt, and promotional expenses. Industry averages are very helpful in determining what appropriate levels should be.”1

In an article2 , Unreported Income and Hidden Assets, the author states: “Look at the industry There are statistics available for many businesses, and the statistics of the subject business should be compared with others similar to it. In particular, the gross profit margins should be compared, and the overall profitability should be compared. If in the industry, it costs fifty cents for each dollar of sales, and in the subject business, it costs sixty five cents for every dollar of sales, then one should examine the expenses to see if they are inflated by personal or unusual expenses. It may be that there is a logical explanation for the variance of the subject business from the industry norm, but the variance itself is an indication that something is unusual, and deserving of special analysis.” (Emphasis added.)

In a case study on restaurants published by the American Institute of Certified Public Accountants, the authors comment as follows:3

Case Study I — Restaurant

“[The wife’s attorney] astutely noted the husband’s lifestyle, his incredible ability to live lavishly out of the humble restaurant profits and meagre salary of $500 per week. The husband’s other investments did not account for his style of living, either.

“Once [the wife’s business valuator] received the tax returns, he quickly noted that food costs were averaging 55 percent of sales. This figure was in the line with what the husband was professing all along; however, it seemed extremely high for [the valuator’s] comfort. [He] decided to dig deeper into the numbers.

“According to [his] own experience and several industry sources, restaurant food costs typically fall between 28 percent and 40 percent of sales, depending on the style of restaurant. ... Given this knowledge, [he] questioned why the costs were so far out of line with industry norms. There were four scenarios likely to cause such a significant discrepancy:

“1. Low prices ...

“2. Large or excessive food portions ...

“3. Employee theft ...

“4. Unreported sales ... .” (Emphasis added.)

The IRS provides guidance to its income tax auditors in various publications it releases. The IRS Internal Revenue Manual states that indirect methods of determining income involve the development of circumstantial proof of income through the use of bank deposits, source and application of funds, net worth or other methodologies.4

“Irregularities in a taxpayer’s books, inconsistencies between reported income and personal living expenses, increases to net worth not supported by reported income, or cash [‘T’ accounts] that cannot be balanced are not unusual. These inconsistencies may lead examiners to conclude that the taxpayer’s tax return and supporting books and records do not accurately reflect the total taxable income received. These conclusions may be confirmed by using an indirect method to reconstruct income.” (Emphasis added.)

For a bar operation, for example, forensic analyst would obtain copies of purchase invoices from the liquor board and, based on the establishment’s posted prices for the drinks and estimated volume consumed, a sales figure could be reconstructed.
Interestingly, some of the methods used to reconstruct a defendant’s business income can be very similar to those applied in determining damages for lost profits.5

In Maltese v. Commissioner6 the United States Tax Court ruled in favour of the Internal Revenue Service, where the taxpayer failed to keep adequate records for a pizza restaurant’s sales, cost of sales and expenses.

Not all of the restaurant’s receipts were deposited and some of the expenses were paid in cash. The court found for the IRS, which had used supplier information to reconstruct the income. The Service determined corrected gross receipts from the estimated number of pizzas that could be made from the amount of flour purchases during the years in question. However, because the IRS failed to compare the pizzas sold by the taxpayer with those sold by retail chains, which provided the information on which the reconstruction was based, it was criticized by the court. The IRS Pizza Restaurant Audit Technique Guide accordingly instructs its agents to support the application of the method by carefully documenting the quantity of flour the taxpayer would need to produce a given number of pizzas.

The level of “actual” revenues may be imputed by dividing certain profit- or expense-related line items appearing on the firm’s income statements by an appropriate “industry norm” profit margin or percent of sales statistic (such as total salary and benefit expense, operating profit margin, gross profit margin, etc.). The reported revenues may then be deducted from the imputed actual revenues, with any positive balance representing the amount of indicated understated revenues.

Another method often used for purposes of marking income-statement adjustments is to consult publicly available statistical reference sources providing industry “norms” or benchmarks with which a subject firm may be compared.

In the final analysis, a judge may have to weigh the expert evidence of each of the parties. Part 2 of this article will use the business of a delicatessen to provide an example of how income can be reconstructed.

Contract Richard Wise, ​FCPA, FCA, CA-IFA, FCBV, FASA, FRICS, MCBA, CFF, CVA, CFE, C.Arb,​​ at [email protected] or Andrew Yas, CPA, CA, CBV, CFF, at 514.228.7727 or [email protected]

1 S.F. Stone, “Analyzing and Adjusting Financial Statements”, Valuation Strategies, Third Edition (Ed. R.D. Feder), John Wiley & Sons (New York: 1993), pp. 8 and 9. 2 Posted at www.divorcesource.com. 3 Income Reconstruction: A Guide to Discovering Unreported Income, American Institute of Certified Public Accountants (New York: 1999). 4 U.S. Internal Revenue Service, Department of the Treasury, Internal Revenue Manual, Part 4, Chapter 10, Section 4, “Examination of Income”, Section 4.1.10.4.6, “Indirect Methods of Determining Income — Overview”. 5 See, for example, Richard M. Wise, “Quantification of Economic Damages”, The Journal of Business Valuation, Proceedings of the Fourth Joint Business Valuation Conference of The Canadian Institute of Chartered Business Valuators and the American Society of Appraisers, Montreal, 1998, pp. 361-412. 6 TC Memo 1988-322.