The following is an excerpt from “Income Reconstruction: A Guide to Discovering Unreported Income,” published by the American Institute of Certified Public Accountants. It provides insight into how a Forensic Accountant would trace nondisclosed income in one particular type of business.
Overview of Law Practices:
It is important to understand how law practices account for income and expenses to gain insight into how an attorney can possibly underreport his or her income. Most law practices’ books are maintained on the cash receipts and cash disbursements basis
of accounting for income tax reporting purposes. Occasionally, a second set of internal books using the accrual method or modified cash basis method of accounting is created. This separate set of books provides reliable assessment of the firm’s financial position and results of operations during any given interim period, and can provide a better evaluation of internal controls.
For cash deposits, law firms generally use one general bank account oftentimes together with one or more client trust accounts. They may also open separate payroll, savings and/ or money market accounts. Total deposits into accounts held in banks or in other quasi-banking institutions, when compared to gross receipts, will pinpoint probable diversion of income away from company coffers.
Size and makeup of firm play a significant role in assessing whether or not the firm reports all of its income. Additionally, the number of individuals in control can influence whether the practice reports only necessary business-related expenses or whether discretionary or personal expenses are paid through the practice. As with most other businesses and professional practices,
larger organizations usually have more stringent internal controls than smaller firms and are less likely to understate income. An indicator of an attorney’s degree of control over the books is the nature of his involvement with the company. Some attorneys are
employees. Others are self-employed, partners or shareholders in large law firms or closely held law practices. Attorneys who are employees have less power to manipulate the books and less control to self-allocate discretionary funds for personal expenses than do owners of law firms.
One other factor that defines the method with which law firms collect and report income is the type of law they practice. The type of legal practice usually determines the arrangement for client payments. A general law firm, practicing as many types of law as their expertise will allow, oftentimes charges an agreed upon fee for a particular legal engagement, which usually involves a pre-paid retainer. Commonly, this retainer is put into a client trust account and the attorney pays him or herself from the trust account as the case progresses. This is when the income is reported. Law firms specializing in personal injury cases may base their fees on a percentage of the settlement. This is referred to as a contingent fee. Most attorneys, practicing in such areas as family law, civil law, bankruptcy, estate-planning, corporate law, taxation, criminal law, environmental law and maritime law base their fees on the number of hours worked at their respective hourly rates plus fees and costs incurred on the particular case.