How can income be calculated in a divorce case when a spouse refuses to produce documentation or is suspected of concealing sources of income? One way is through the Net Worth Method of Proof, which is used to analyze income and assets when detailed documentation is not available, either because the opposing spouse is obstructing efforts to get data and documents, or because data and documents are legitimately not available.
This method of determining income is used by the federal government in criminal income tax cases. Because it is accepted in federal criminal cases, family courts often will accept this as a reliable method for calculating income.
A detailed analysis of expenditures is performed using any documentation available. Each expenditure for the period under review is captured from bank, brokerage, and credit card statements, and each item is categorized so that totals can be accumulated for the period under analysis.
For example, expenses could be categorized as mortgage payment, automobile lease, utilities, groceries, clothing, or similar categories. Expenses are best classified using the categories that are identified by your state. States assign their financial disclosure forms different names, and the forms include different categories. These categories should guide the lifestyle analysis and be the main categories that are used to classify expenses. When documentation related to known expenses is not available, the financial expert must estimate those items and include them in the analysis.
The change in net worth is then evaluated in conjunction with expenditures during the period. The net worth of the parties is determined by subtracting known liabilities from known assets. If the parties are earning more money than they are spending in a period, the net worth should increase during that period. Conversely, if the parties are spending more than they are making (usually by incurring debt), then the net worth will decrease during the period.
This type of analysis is completed as follows:
- Beginning net worth is calculated by identifying assets and liabilities. Liabilities are subtracted from assets to arrive at net worth.
- Ending net worth is calculated by identifying the assets and liabilities at the end of the period under analysis. Liabilities are again subtracted from assets to arrive at net worth.
- Beginning net worth is subtracted from ending net worth to arrive at the change in net worth. A positive number indicates the net worth has increased. A negative number indicates the net worth has decreased.
- Expenditures during the period are analyzed. These include all living expenses, asset purchases, asset sales, additional debts incurred, debts paid down, or other inflows or outflows of funds.
- Outflows of funds are added to the change in net worth calculated in number three above.
- Inflows of funds are subtracted from the change in net worth calculated in number three above.
- The resulting figure is the calculated gross income.
- The calculated gross income is compared to the reported gross income. Any difference may represent unreported income or expenditures.
Key points in completing a thorough and accurate net worth analysis include:
- When hard data is available, actual figures should be used.
- Reasonable estimates should be made when hard data is not available. The estimates should be carefully considered and should be made conservatively.
- All living expenses should be included. Items like housing, groceries, fuel, utilities, education are important. Other less frequent expenditures must also be considered. This may include vacations, furniture, weddings, or artwork.
- The impact of loans, gifts, and inheritances must be considered.
- The possibility that a party is hoarding cash or other valuable assets must be recognized.
- The financial analyst must be careful not to double count items. It is especially important that increases in assets or reductions in debts not be duplicated in the tabulation of living expenses.
While the Net Worth Method is typically recognized by courts as an accurate and valid method for calculating the income of a party, there are negatives to using this method. First, it can be difficult to understand for someone without an accounting background. It is hoped that the financial expert can effectively explain the technique to non-accountants, but there is always a risk that the court may not understand. Second, opposing counsel will likely argue that the method is unreliable because it uses estimates rather than documented, exact figures.
However, the forensic accountant can (and should) point out that this method was necessitated by the lack of data and documents, and was the best alternative. It should be further demonstrated that all estimates were made carefully, and when documentation was available, exact figures were used.
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]