The Tale of the Cash-Skimming Husbandby
Accounting horrors can exist where you least expect to find them, as you will see in this next chilling case of a business valuation that uncovered some grisly fraud!
Sometimes the service clients ask you to provide is not what they need, like the case where forensic accounting was needed instead of a business valuation.
Clients I will call “Andrew and Kathy” had came to me asking for a business valuation. They were, at the time, in the midst of a contentious divorce and what Kathy really wanted (and needed) was a forensic accounting engagement.
Andrew’s and Kathy’s divorce attorneys engaged us to perform a business valuation for the family business, which I’ll call “A & K Auto Services.” A & K was a relic of a past generation: a gas station with an attached auto repair shop. Back when I was growing up, that was the norm. Now they’re a rarity, as small one- or two-bay auto repair businesses have given way to larger shops that leverage economies of scale.
Andrew also sold cars on the side: cars he had either bought at auction or which had been abandoned by customers who couldn’t afford the repairs. Kathy sometimes worked the cash register in the tiny convenience store, and sometimes worked part-time as an administrative assistant. She also kept the books for A & K, which meant that since the time of the couple’s separation over a year ago they weren’t really up to date.
On a site visit, Andrew told me that he’d been capturing the sales in QuickBooks from the POS system, but he hadn’t been able to keep the expense side completely updated. So, he gave me a sheaf of receipts from the local Costco, where he purchased the sodas, candy, chips and other items he sold in the convenience store.
He also used the company checkbook to pay monthly rent and other expenses for his elderly parents, who lived nearby. He also had several credit cards that he sometimes used for the business, and sometimes for personal expenses. So, he also gave me several months’ worth of bank statements and credit card statements so I could compile a complete and accurate list of the business expenses.
I spent several weeks compiling data and performing the calculations and analysis that are part of any normal business valuation. Because there are very few gas stations with attached repair shops in existence, and even fewer that are sold, I couldn’t use the market approach. So I used a discounted cash flows approach, with the company’s tax returns and my calculations as a foundation.
All the numbers looked reasonable. Sales of gasoline showed the typical razor-thin margins I’d seen in other gas stations. The convenience store spun off a small profit and the sales of cars added a bit to the household’s overall cash flow.
Shortly before I completed all of my calculations, I got an interesting call from Kathy, asking if I had noticed anything odd about the sales ratios. I didn’t, but then she told me how the business really operated.
According to her, Andrew had developed an elaborate scheme, which involved pocketing cash receipts and using some of that to occasionally pay for loads of gas. He had a system so that his sales and cost of goods sold stayed in balance. Checks were also involved in through a convoluted path that she didn’t understand completely.
Over the years, A & K had generated enough extra cash to pay for luxury items, including several pieces of solid gold jewelry for Kathy costing $10,000. They had taken family trips every summer, all paid for with cash. And the extra cash meant a fancier house and nicer cars than they could have afforded otherwise.
Kathy also told me that Andrew had used a company credit card to pay for their daughter’s wedding and had run all of those expenses through the business. On Andrew’s orders, she had recorded those in the books as expenses for attending a seminar for gas station owners.
Andrew had also reportedly taken some $50,000 in cash with him several times on trips to visit relatives overseas. And the figures I had for sales of cars were also bogus and wildly understated.
According to Kathy, none of this extra income had been reported on the tax returns for more than a decade. Kathy wanted to make sure that her portion of the divorce settlement reflected what the business really brought in, not just what was reported on the tax returns.
I explained to her that a business valuation was not designed to detect or quantify fraud and if she wanted to pursue it, we would need to perform a forensic accounting engagement. The cost for that would all be on her because it was highly unlikely that Andrew would agree to split the cost with her.
I also pointed out that this might get the attention of the IRS and state tax authorities, who would then ask for back taxes on unreported income. Since she had signed tax returns that she knew were fraudulent, and because she had knowingly benefited from the fruits of that fraud, she would not be able to raise the innocent spouse defense and would be jointly liable.
None of the above had occurred to Kathy, so she reluctantly backed off. I discussed this with the partner who would be signing the valuation report. We didn’t have any concrete data to verify Kathy’s claims.
We then added a sentence to the report that stated that we had used as a basis for our report the documents provided to us, and that it was possible that other evidence existed that could lead to a different opinion of value.
As a courtesy, I called the CPA who had prepared the original tax returns and told him of Kathy’s allegations. He thanked me, but since he was in the process of selling his firm, he probably figured that Andrew and Kathy would soon be someone else’s problem.
Kathy’s complicity in the fraud meant that her share of the marital settlement was smaller than it perhaps should have been. It’s possible that their CPA, who had worked with them for years, might have noticed something was fishy when their standard of living seemed out of whack with their stated income.
It is also possible that their CPA didn’t have the kind of relationship with the couple that could have aroused his suspicions. The moral of this tale is that it’s wise to have more than a superficial knowledge of your clients’ lives, financial or otherwise.
Liz Farr, CPA, spent 15 years in tax and accounting at small firms in Albuquerque, NM. Besides tax returns of all flavors, she worked on audits of governmental entities and not-for-profits, business valuations, and litigation support. Now she's a full-time freelance writer specializing in content marketing for accountants and bookkeepers around...