Valuation & Forensic StrategiesForensic Accounting Techniques In BV Engagements

A forensic analysis is often performed in an attempt to reconstruct one or more aspects of the historical financial results. It often employs methodologies similar to those used by auditors, such as reviewing bank statements and invoices, or performing tests of accounting records. However, an auditor's role is to ensure that the financial statements fairly represent the true operations of the business, whereas a forensic analysis is designed to investigate and substantiate the actual amounts reported. Often, the most common need for a forensic analysis is to reconstruct unreported income.

There are a number of techniques that one can employ to perform a forensic analysis. The two methods commonly employed are the Direct Method and the Indirect Method.

The Direct Method, also known as the Transaction Method, is similar to traditional auditing procedures. This method commonly includes an examination and analysis of the following:

  • Cancelled checks and invoices
  • Contracts and agreements
  • Public records and notices
  • Interview management and staff (multi levels)

The Indirect Method is commonly employed when the conventional Direct Method is not productive. The most widely used techniques under the Indirect Method are the:

  • Cash T Method
  • Source and Application of Funds Method
  • Net Worth Method
  • Bank Deposit Method

The following is a condensed summary of these methodologies:

Cash T Method

  • Simplest indirect method
  • Used to determine understated income
  • Compares all cash received to all cash spent
  • If cash spent exceeds cash received from taxable and nontaxable sources then excess may represent unreported income
  • Requires adjustment for loan proceeds and use of savings
  • Frequently used to analyze Retail/Wholesale and its owners

Source and Application of Funds Method

  • Employed when large sums are spent on lifestyle instead of purchasing assets or investments
  • Similar technique to Cash "T" Method
  • Used often because of ease of presentation
  • People (including Judges and Jury) understand cash coming in and out
Net Worth Method
  • Balance Sheet approach to estimating income
  • Net worth calculated at beginning and end of period
  • Difference in beginning and ending net worth compared to reported income
  • Include nontaxable income and other reconciling items
  • Un-reconciled differences represent underreported income

Bank Deposit Method

  • Analyzes funds deposited during the year by reconstructing gross taxable receipts
  • An appropriate method when income is deposited in banks and most of expenses are paid in cash
The application of these and other methods are frequently determined by industry. In fact, a useful resource for industry-specific methods is the Market Segment Specialization Program, published by the Internal Revenue Service.

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