Over the previous three issues of Forensic Accounting Today, I have provided an overview of how law practices account for revenue and expenses, and introduced the background of an actual case study concerning income reporting. In this issue, I am providing the continuation of the case study, focusing on calculation of unreported income. If you would like to review part one, two or three of this article, please visit our blog (https://anfusocpa.com/blog/) and click on the link Forensic Accounting Today Newsletter Archive.
Calculation of Unreported Income
Many attorneys calculate their gross fees based on the money transferred from the client trust account(s) into the general account(s). At times, we have encountered attorneys who deposit fees into personal accounts, thereby bypassing the general accounts all together. In this particular case, we examined client ledger cards and discovered that cash receipts posted to the ledger cards were not accounted for in the cash receipts journal or the general ledger. Upon analyzing the bank reconciliations, we determined that these receipts were not deposited into the firm’s bank accounts and therefore not included in the gross fees reported by the law practice. Apparently, Mr. Smith and his partners were cashing client checks and, in some instances, depositing them into personal bank accounts. These checks represented approximately 13 percent of the gross income of the corporation, or $1.3 million.
Additionally, after inspection, we found checks from the trust account representing expense reimbursements that were endorsed directly to the attorneys. These reimbursements, for the most part, were for personal expenses. We determine which expenses are business versus personal on an expense-by-expense basis. For example, some expenses, such as psychiatric fees, are inherently personal. Others we need to inquire about with the client.
For life insurance, for example, we ask about the beneficiary. If the beneficiary is the firm (which is sometimes the case when the policyholder is a key member of the firm), then it is a legitimate business expense. If the beneficiary is the spouse or children,however, it becomes a personal expense. For automobile expenses claimed, we ask such questions as what the distance is between home and business because those commuting miles are not considered business miles according to the IRS. We also inquire about business use of the automobiles. Our goal is to determine the actual business mileage incurred and deduct that from the total miles claimed to determine the personal automobile mileage and therefore personal expenses.
We inspect credit card receipts used for travel and ask about purpose of travel. If the client doesn’t provide us with information, we make estimates regarding how much of the expenses are personal based on our professional experience. For example, 50 percent of meal and entertainment expenses are not deductible per IRS code and are commonly considered personal expenses. Depending on the financial information used (i.e., tax returns versus financial statements), we estimate the amount of personal expenses deducted for net income purposes.
Following are the personal expenses for Mr. Smith that we culled out of the business expense ledger, with our determination supported by actual analysis and estimates based on personal experience:
These personal expenses totaled $ 337,971. Based upon our conversations with Mr. Smith, the other two shareholders enjoyed similar personal benefits paid for by the corporation.