ith a sixth-grade education, legendary gangster Al Capone thought he was smart enough. By the time he was 26, “Scarface” had 1,000 employees and a weekly payroll of $300,000. In the 1930s, when the average American worker made about $2,400 annually, Capone was raking in more than a hundred million dollars a year. The mobster, thought to be responsible for more than 300 gangland executions, was chauffeured around the mean streets of Chicago in a seven-ton limousine with 18 bodyguards. He had everything money could buy. But Alphonse Capone wasn’t so smart after all. He’d thought of protecting himself from all but his worst enemy: the Internal Revenue Service. Capone never bothered to declare his income and pay tax on it. So Elliot Ness and the IRS asked a simple but powerful question: How could someone live so well on nothing? A federal jury in the Northern District of Illinois came to the only obvious conclusion—Capone had evaded his tax obligations. On October 7, 1931, the legendary gangster’s career came to an abrupt stop when he was sentenced to 11 years in prison. | Capone wasn’t the first or the last to try to escape the cold logic of simple arithmetic—if you spend more than you legitimately bring in, the difference could come from illegal sources. Another Elliott—that is Elliott Leary, CPA, of KPMG in Washington, D.C.—says, “Financial investigators know the credo by heart: Follow the money.” In this article we will explore the most effective ways that fraud examiners and prosecutors prove that funds were derived from criminal activity. CPAs specializing in forensic accounting or litigation support regularly employ the same methods, because they can help uncover embezzlements, bribes, drug money and other illegal income. | Quote:
“The income tax law is a lot of bunk.
The government can’t collect legal
taxes from illegal money.”
—Attributed to Al Capone Al Capone was convicted on felony income tax evasion for the years 1925–1929 and misdemeanor failure to file income tax returns for 1928–1929. He was acquitted on conspiracy to violate probation laws from 1922–1931. For more on Capone’s trial, go to www.chicagohs.org/history/capone.html | | COMPILE A FINANCIAL PROFILE
To begin, the CPA develops a financial profile of the subject under suspicion. “The most important and difficult part of a net worth investigation is gathering enough evidence to prepare a financial profile,” Leary said. The goals are to obtain sufficient data to document the suspect’s changes in net worth or income and to determine his or her typical spending habits. According to Leary, “If financial records are not readily available, they often can be developed from alternative sources, such as interviews with the suspect, acquaintances and business associates and from public documents, including real estate and business filings and court records.” | Once you determine the comparative financial statements are complete, you can confirm their validity by addressing the following questions. Assets
When and from whom were they acquired?
How much did they cost?
What was the manner of payment? (Currency, check or cashier’s check, for example.)
Where did the suspect get the funds to purchase them?
What documentation exists for the transactions? | | Exhibit 1 : Asset Method | | | Assets | | – | Liabilities | | = | Net worth | | – | Prior-year net worth | | = | Net worth increase | | + | Living expenses | | = | Income (or expenditures) | | – | Funds from known sources | | = | Funds from unknown sources | | | | Liabilities
What were the original amounts of the liabilities?
What are the current balances?
When were the liabilities incurred?
What was the purpose of the loans or debts?
What security or collateral, if any, was given?
Who was the creditor or lender?
Were any of the debts written off?
From what sources were the liabilities paid?
What documentation exists? Sources of funds
What were the total amounts of funds or income during the questioned periods?
From what sources were the funds received?
How, when and where were the funds deposited?
What documentation exists?
| Exhibit 2 : Schedule of Increases (Decreases)
in Net Worth |  | | Note that in the example the target’s net worth rose by $54,925 during year two. To determine the source of such increase, the fraud examiner finds the suspect’s known income during year two and subtracts known expenses for year two. | | | | Expenditures or applications of funds
What were the total amounts spent?
What was the manner of payment?
From what sources were the expenditures made?
What were the expenditures for?
What documentation exists? Money from any source—lawful or not—can be disbursed in only four ways: It can be spent, saved, used to acquire assets or to pay debts. “The choice of method used to prove illegal income is largely determined by how most of the money was spent. All are variations of funds statements that CPAs use regularly in accounting for the inflows and outflows of a company’s money,” says Leary. | | Exhibit 3 : Increases (Decreases) in Net Worth From Known Sources |  | | THE ASSET METHOD
Investigators use this technique (see exhibit 1 , above) to prove the target’s net worth materially increased during the time of the suspect illegal activity. CPAs begin by comparing the beginning and ending net worth, then adjust for known income and expenditures. The result is income from unknown sources. They follow these rules when using this method. Note that items 2 and 3 give the benefit of the doubt to the subject under scrutiny.
They value assets at original cost, ignoring appreciation or depreciation.
They overestimate funds available to the subject from legitimate sources.
They underestimate expenditures on legitimate items—especially hard-to-document living costs, such as food and entertainment. | For an example of a computation using the asset method, see exhibit 2 , above. The difference between the target’s income and expenses equals the increase (or decrease) in net worth from year one to year two which can be attributed to known sources. In exhibit 3 , above, it is $13,985. When you subtract the increase in net worth from known sources from the total increase in net worth, you determine the amount from unknown sources. | | Exhibit 4 : Funds From Unknown Sources—Asset Method |  | | The results reflect that nearly $41,000 might be attributed to illegal income (see exhibit 4 , above). In some situations, the suspect will attempt to explain away this mysterious wealth as coming from legitimate sources. Later in this article, we will discuss ways CPAs can rebut these defenses. THE EXPENDITURES METHOD
The formula (see exhibit 5 , at right) for this analysis is the essence of simplicity. “The expenditures method is easy for jurors to comprehend,” says Leary, who has testified as an expert accounting witness in a number of court trials. “For a given period, you simply take the subject’s total expenditures and deduct the known sources of funds. The difference is funds from unknown sources.” | | Exhibit 5 : Expenditures Method | | | Expenditures | | – | Known source of funds | | = | Funds from unknown sources | | | In one of Leary’s cases, the defendants bought items such as $2,200 alligator shoes, $300 bottles of cologne and a dozen automobiles. “They were known for their shopping sprees on Rodeo Drive in Hollywood,” Leary said. “But they could not identify a legitimate source for their lavish spending. Because of the strength of the accounting evidence, the subjects were convicted on money laundering charges.” | Funds include money received from all sources—loans, salary, inheritance, gifts and cash on hand at the beginning of the period. See exhibit 6 , at right, for an example of the same computation using the expenditures method. THE BANK DEPOSITS METHOD
This formula (see exhibit 7 , below) operates on the assumption that only two things can be done with money: It can be deposited or spent. Leary says, “The bank deposits method should be used when the CPA can substantiate that the illegal income has been deposited in financial institutions.” See an example in exhibit 8 , below. | Exhibit 7 : Bank Deposits Method | | | Total deposits to all accounts | | – | Transfer and redeposits | | = | Net deposits to all accounts | | + | Cash expenditures | | = | Total receipts from all sources | | – | Funds from known sources | | = | Funds from unknown or illegal sources | | | | Exhibit 6 : Funds From Unknown Sources—Expenditures Method |  | | REBUTTING DEFENSES TO NET WORTH ANALYSES
It is common for a subject to attempt explaining away income from unknown sources. Some of the usual defenses are the money came from
Cash hordes.
Gifts from friends and relatives.
Private loans.
Spouse’s funds.
Gambling winnings. In each of these cases, the CPA must be prepared to negate the specific defense. A CPA can rebut the cash hordes explanation by showing the subject borrowed money, lived penuriously, made large installment purchases, was delinquent on debts, had a poor credit rating or filed for bankruptcy. Gambling winnings often can be negated by proving the subject did not list them on income tax returns. CPAs typically can debunk the excuse of gifts or loans from friends, relatives and spouses by proving the alleged providers were financially incapable of generating such funds. In one of Leary’s cases, a defendant claimed she had received substantial income from a relative. Leary was able to prove otherwise. “This person hardly existed in a financial sense. He had no job, no bank account, no credit cards and no tax returns,” he said. Another way a CPA can rebut the defense that money was received from acquaintances is to show the lack of documentation reflecting the transaction (for example, the absence of bank withdrawals by the alleged provider). | | Exhibit 8 : Funds From Unknown Sources—Bank Deposits Method |  | |
I’m frequently asked about the best method to hide illegal loot and get away with it. My answer? Secretly bury the cash in the middle of the desert in the dark of night. Tell no one. Wait until the statute of limitations expires before you dig it up and spend it. Although I suspect that is what a smart criminal would do, I’ve never encountered one; Elliott Leary says he hasn’t either. But as long as dumb criminals like Al Capone and others spend their ill-gotten booty, they can eventually be caught—if CPAs follow the greenback road.
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Resources | Books
CPA’s Handbook of Fraud and Commercial Crime Prevention (# 056504) Financial Reporting Fraud: A Practical Guide to Detection and Internal Control (# 029879) CPE
Introduction to Fraud Examination and Criminal Behavior (# 730275) Identifying Fraudulent Financial Transactions (# 730244) Finding the Truth: Effective Techniques for Interview and Communication (# 730164) To order, go to www.cpa2biz.com . | AICPA’s Antifraud Initiatives
Antifraud and Corporate Responsibility Resource Center, http://antifraud.aicpa.org/ . 
SAS no. 99 information.
Management Antifraud Programs and Controls (SAS no. 99 exhibit).
Fraud Specialist Competency Model.
Free corporate fraud prevention training and CPE.
Academia outreach and assistance.
Other antifraud activities. | JOSEPH T. WELLS, CPA, CFE, is founder and chairman of the Association of Certified Fraud Examiners and professor of fraud examination at the University of Texas at Austin. Mr. Wells won the Lawler Award for the best JofA article in 2000 and 2002 and has been inducted into the Journal of Accountancy Hall of Fame. His e-mail address is joe@cfenet.com . |
