19 Aug

Lifestyle Analysis in Criminal Cases: Proving Income Without Full Documentation

Both civil and criminal cases often involve an element of proving or disproving income of an individual or business. It is not unusual for a divorce case to include allegations of hidden income or assets. In contract disputes alleging the loss of sales or profits, an accurate determination of income is critical.

In criminal cases, the issues surrounding the income of an individual or business have even higher stakes. These cases are quite often tax-related matters, but cases involving white collar crimes and drug trafficking usually include questions about income too.

What happens when the government is alleging a defendant earned a certain amount of income from a legal or illegal activity? Tax cases often include the government’s determination of the amount of income a taxpayer failed to report, and the defendant is left to prove how much income really was earned. In a similar fashion, a defendant in a white collar crime case may find it important to prove the level of income earned in order to refute allegations of hidden income or ill-gotten gains.

How would a person in this position prove their income, particularly if some of it was indeed from undocumented sources or if the allegations of undocumented or unreported income are completely false? In these cases, the help of a forensic accountant or fraud investigator can be invaluable. This type of professional is usually proficient in reconstructing books and records, making the task of proving income something that can be completed accurately.

But what happens when there aren’t books and records from which to reconstruct income? The records may have been destroyed or discarded. Even worse, the income alleged to have been earned by the defendant may be all cash, meaning that there is no paper trail. How then, can a defendant’s earnings be reconstructed?

Of course it is next to impossible to “prove a negative” in the case of cash proceeds from legal or illegal activity. Someone is alleging that your client had cash income that wasn’t reported or documented anywhere, and you’re left to prove that the money didn’t really exist. Where would you start?

Lifestyle Analysis
Probably the most commonly used method of proving income for an individual is the “lifestyle analysis.” It is used by both government agencies and defense counsel to prove (or disprove) income (legal and illegal, reported and unreported). It is also sometimes called the “expenditures method,” signifying the analysis of a person’s spending patterns in relation to their known sources of funds.

The idea behind this analysis is simple, although the execution of it usually is not. A lifestyle analysis attempts to quantify the living expenses of an individual and compare those expenses to known sources of income and other funds. Any differences can be attributed to concealed income. It is a matter of looking at the cost of living the lifestyle of the target, and determining whether the reported income is sufficient to do so.

With enough information, this type of analysis can be fairly precise. Gaps in information require estimates to be made, and the more estimates made, the less precise the analysis becomes. In these cases, a forensic accountant or fraud investigator is looking for outside pieces of information that may support estimates and assumptions.

A simplistic example of a lifestyle analysis would include adding up the known expenses of a person and his family: mortgage, groceries, auto lease or loan, groceries, insurance, credit card payments, and income taxes. Of course, there are many more items that may be included in such a list, and the forensic accountant has to be sure to include things like vacations, recreation, loans made to others, and a variety of ways that money could be spent.

The total spending is compared to known sources of income or funds: wages, bonuses, stocks sold, bank loan proceeds, gifts from family, and gambling winnings. As with the expenses, the forensic accountant should be careful to consider all possible sources of income in order to be as accurate as possible.

If the money spent during the period analyzed exceeds the known funding sources, it is quite possible that there is another source of income. The logic is simple: The money has to come from somewhere. It’s up to the forensic accountant to continue searching for proof of sources of income that could reduce the difference. Any remaining unexplained difference is likely representative of the elusive unreported earnings or proceeds of white collar crime.

Related Analysis Methods
The other methods used to search for unreported or unrecorded income are very similar, and are recognized by courts as valid methods of calculating income. The Internal Revenue Service frequently uses “indirect methods” of calculating income, including the bank deposits method and the net worth method.

If the majority of a person’s income is believed to be deposited to known bank accounts, the bank deposits method is a simple way to estimate income. Quite simply, all deposits to bank accounts are deemed to be income, unless they can be traced to another source, such as a bank loan, a transfer from another account, a gift, or other documented source.

The net worth method is very similar to the lifestyle analysis. Like the lifestyle or expenditures analysis, the net worth method requires the forensic accountant to analyze the sources of funds and how those funds are spent. In addition, the net worth of the individual must be established for the beginning of the period in question, as well as the end of the period.

Changes in a person’s assets or liabilities will affect the net worth, and any changes in net worth over the period in question are factored into the overall determination of sources and uses of funds.

The Nuts and Bolts of Lifestyle Analysis
The lifestyle analysis begins with the documentation that supports the known income and expenses of the party: bank statements, investment account statements, mortgage statements, income tax returns, credit card statements, auto or boat purchase and lease documents, home sale or purchase documents, invoices related to home repairs or remodeling, and the like. There are literally hundreds of items that could contribute to this part of the analysis, but these are the most common.

These documents help establish the ordinary spending of the party, and they also document the known sources of income and funds. It’s often helpful to look at three years of records to get a good feel for the spending patterns of the individual.

There can be one-time expenses that should be noted as such, and recreational activities should be examined over a period of time to best understand the usual pattern. This method can be used effectively when a person or business hasn’t kept adequate records or the records have been destroyed by a fire or flood.

After all of the available documentation has been analyzed, the search is on for spending that occurred outside the documented accounts. If that spending can be pinpointed or estimated, this may be evidence of unreported income.

Additional spending is often found based on tips for insiders or circumstantial evidence. People who are 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 knowledge of personal finance issues can lead the forensic accountant to estimate other items of spending. For example, fuel for an auto and groceries are two common items that a person needs to buy on a regular basis. If all the documentation suggests an unusually low level of spending on these types of items, the forensic account should try to create a reasonable estimate.

In the case of fuel, the investigator will probably take into account the person’s commute to work, the number of people in the household who may have access to the car, and personal activities that require driving. An estimate of mileage driven will be the result of this analysis, and in conjunction with historical prices of gas, a monthly estimate of spending on this item can be made.

Other items can be estimated in a similar fashion. Grocery expenses can be estimated based upon the size of a household, age of the children, and frequency of dining out.  When estimating various expenditures, it will be important to consider the historical spending of person and household. Any 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 and spending.

When the lifestyle analysis results in a difference between known sources of income and known and estimated spending, it’s important for the forensic accountant to rule out additional sources and uses of funds. In cases like this, the spending often exceeds the known sources of funding, which is precisely why someone (the government or a third party) is alleging there is hidden income.

It is necessary to continue to search for other legitimate sources of funds that might make up for the difference between income and spending. This often involves thorough questioning of the client, in addition to careful analysis of documentation that might signal other sources or accounts. The forensic accountant must exhaust all possibilities, hopefully with the assistance of the client.

But in the end, there may still be spending that exceeds known sources of funding, and that result will be important in the litigation. If the result differs significantly from allegations by the government or other parties, the forensic accountant will be left to prove that sound methodology was used and that her or his results can be relied upon.

Problems with Analysis
Certain situational factors can affect the reliability of a lifestyle analysis, many of them legitimate. One such situation is the receipt of gifts or loans from third parties (especially if done in cash), for which the target of the analysis will not provide information or confirmation. Clearly, such sources of funds could be legitimate, but it’s not possible to factor them into an analysis if the recipient will not disclose them. Of course, this type of analysis is often done because of the fact that information remains undisclosed, so this isn’t so unusual after all.

It is also difficult to do a complete analysis when the person in question owns a business that provides some of the funds for the lifestyle. Items like paychecks or bonus distributions from the business are easy enough to track. But what about a company that pays for the person’s vehicle or contributes to the cost of a vacation? There are many items for which the business might provide funds, but for which the forensic accountant may have no data.

You can see that the difficulty arises with sources of income or funds that are outside the usual sources like paychecks, bank loans, and the like. Again, the reason why a lifestyle analysis is done is because of allegations of undocumented or unreported sources of income or funding, so this isn’t unexpected. It is, however, important to understand that there are legitimate sources of money that can factor into an analysis such as this, and the forensic accountant or fraud investigator must take these things into account.

Because an analysis like this will often include many estimates, it’s important for the forensic account to consider applying ranges to certain expenditures. There are lots of resources available to help estimate “normal” spending for a person or family, but every situation isn’t the same and averages won’t apply across the board. Offering a range of estimated expenses may help the user of the analysis put the situation in proper perspective.

Another option when calculating lifestyle and expenditures is doing a “worst case scenario.” In addition to estimating and calculating the most reasonable and supportable numbers, the forensic accountant might also calculate the figures that would represent the worst possible result for the client.

For example, suppose an executive of a public company is accused of embezzling $10 million from the company. The government has done an analysis which supports the accusations and documents an estimated $10 million of spending above the known sources of income.

The defendant hires a forensic accountant to do a complete analysis, which results in a determination that $3 million is the correct figure for spending above known sources of funding. This figure was calculated using the documentation available in conjunction with the most fair and reasonable estimates the forensic accountant could come up with.

In addition to this calculation, the forensic account may do a second calculation that uses estimates that are all detrimental to the defendant. For example, suppose that the forensic accountant determined that the executive spent $1,000 to $3,000 per month on entertainment expenses, paid for with cash. A middle figure of $2,000 was used in the initial calculations.

In the “worst case scenario” calculation, the figure of $3,000 is used and the same thing is done for all other items that were estimated. Using all of the worst possible figures for each line item, the forensic accountant determines that there may be $6.5 million of expenditures in excess of the executive’s known sources of income .

This type of calculation may not end up in the forensic accountant’s final report, but the information can be very helpful to defense counsel when developing a defense or working on a plea agreement. It is critical for defense counsel to have the worst possible results quantified in order to make informed decisions about the defense.

Results of the Analysis
What you’re left with in the end is a situation in which the level of income (legal or illegal) being alleged by a third party such as the government or a civil case opponent, is either confirmed or refuted based on the facts surrounding the lifestyle of the target.

One risk that always exists is the allegation of a secret bank account or investment account domestically or abroad, which holds all the alleged funds. The analysis of the forensic accountant might tend to disprove the government’s theory that there was an unreported source of income, but if there’s money hidden away, the government may still be right.

Of course, that is always possible in any case. However, if a thorough and accurate lifestyle analysis has been done, that allegation is probably much weaker. A successful lifestyle analysis will account for all the income and spending, and there will be no evidence of funds secretly stashed anywhere.

This is not to say that the fraud investigator or forensic accountant assisting with this analysis sets out to prove or disprove the allegations. The examination of the finances should be as objective as possible, and the forensic accountant should be independent enough to do a fair and reasonable calculation.

2 thoughts on “Lifestyle Analysis in Criminal Cases: Proving Income Without Full Documentation

  1. Pingback: Defending Tax Fraud Cases -Expert Financial Analysis Required « Due Diligence

  2. Pingback: Fraud Files Forensic Accounting Blog » Kwame Kilpatrick: Lifestyle Analysis in Criminal Cases

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