The Taxman’s Going to Get You!

Even the most sophisticated fraudsters stumble when tax time rolls around.

When I'm conducting an investigation, I'm often amazed at the level of sophistication perpetrators of fraud employ. I’ve uncovered schemes that were so intricate that layer upon layer of bad data and creative accounting had to be peeled back in order to get at the truth.

While sophisticated, fraud is often a short-term play that fails to consider the long-term ramifications. Taxes are one of those ramifications.

Consider two distinct and very common cases: Asset misappropriation and income overstatement. Both cause tangible damage to the entity, can quickly rise to the level of criminal behavior, may mean substantial gains for the perpetrator— and have a tax “shoe” waiting to drop years after the fraud is committed.

Asset misappropriation most commonly involves the theft of cash. Of course, it also may involve anything from intellectual property being downloaded onto a portable storage device to inventory walking off a receiving dock. Regardless of the asset, let’s think about the accounting. For the sake of my example, we’ll only consider assets that are already entered into the accounting system rather than assets diverted prior to being recorded in the books. When assets are reduced, you’ll see a credit on the balance sheet. But what’s on the other side of the entry? A debit has to go somewhere, but where?

With the theft of cash, we commonly see a bogus expense involving an employee or vendor. In this case, a debit hits the income statement, reducing the entity’s profits. Only slightly less obvious is a cost-of-sales debit, with the same impact on profits. Have you ever talked to a business owner who knows they should be making more money but can’t figure out what’s wrong? Dollars are rolling off the balance sheet and draining the income statement, but why?

Less industrious fraudsters credit the misappropriated asset account and don’t have the brass to debit the income statement. Instead, they “re-class” the stolen asset and artificially inflate another asset account. This can go on for only so long before risking exposure. In some cases I’ve actually seen a reduction to cash and a reduction to payables. Talk about a short-term scheme.

Eventually, most asset thefts end up on the income statement as an understatement of income. The result is less income to distribute and a lower tax obligation. The entity fails to pay tax on actual profit because of the employee theft (an actual loss). Correcting this with the IRS typically doesn’t involve a big hit to the entity.

Far more impactful is the case of income overstatement, often committed to deceive stakeholders. At the turn of the millennium, we witnessed mass income overstatement among publicly traded entities, with the goal of meeting and exceeding Wall Street expectations, which in turn kept stock values and market capitalization artificially inflated. Enron, WorldCom/MCI and HealthSouth all aggressively sought tax credits and refunds when their respective frauds came to light, arguing with varying degrees of success that the entity overpaid taxes on artificial income, using shareholder dollars. They contended that, since this income wasn’t real, the tax obligation didn’t exist and shareholder dollars should be returned to the entity for distribution back to the shareholders.

Many of us recall those days back in 2003 and 2004 with a mix of amusement and disdain. These leviathans created massive amounts of artificial wealth for their shareholders and now wanted more dollars for shareholders as the “victims” of fraud.

More common is the case of overstating income in order to deceive creditors. In this scenario, an entity cooks the books, receives funding it’s not qualified to receive and, predictably, goes into default. The bad guys may think they’re smart, but often don’t consider the tax consequences when the lender actually writes off the bad debt and issues a debt cancellation. Now the fraudster may face both civil and criminal liability, as well as material tax obligations.

Ambitious fraudsters who juice the income statement and secure numerous loans are particularly at risk when this double whammy comes back to bite them down the road. Of course, this is all predicated on the fraud being uncovered and the bad guys being caught.

The basic accounting for income overstatements is a false credit to revenue or to cost of sales. But where do you hide the debit? Putting it on the income statement offsets the credit and defeats the purpose of the fraud. The balance sheet, then, is the logical place; and, in fact, contra-asset accounts are a favorite hiding place. Intercompany accounts also are frequently used as a landing place for the other side of a bogus entry into the general ledger. In an asset-based lending scenario, inflating income and the asset base is a “win-win” for the bad guys and terrible news for the lending institution. Simple audit procedures, such as counts, confirmations and ratio analytics, ultimately can expose massive income overstatements. If you’re a business owner with concerns about your profits, try these basic audit procedures.

If you’re a fraudster looking to prolong your fraud, think twice about the unforeseen tax consequences of your acts. You may pay far more than you think!