DETERMINING AND DIVIDING MARITAL ASSETS

A.        Use of Financial Statements

            B.        Interpretation and Use of Tax Returns

            C.        Cash Flow:  Bank Records vs. Financial Records

            D.        Pension and Retirement Plans

For the purposes of this presentation, Mr. Monroe will focus on closely held businesses or partnerships, as many, if not all, of the principles discussed here would apply to similar marital financial situations, as well. 

            In order to understand and apply the principles which are used in forensic accounting, it is necessary to have a working knowledge of some basic accounting terms:

            A Balance Sheet is an itemized statement that lists the total assets and the total liabilities of a given business (or person) to portray its net worth at a given moment in time.  The amounts shown on a Balance Sheet are generally the historic cost of items and not their current values.

            A Statement of Operations is often called a Profit and Loss Statement.  This statement shows revenue and expenses for a specific period of time.  The difference between total revenue and the total expense is net income.  A key element of this statement, and one that distinguishes it from a Balance Sheet, is that the amounts shown on the statement represent transactions over a period of time, while the items represented on a Balance Sheet show information as of a specific date or point in time. 

            In analyzing a Balance Sheet, there are several different types of adjustments which must be considered in order to have an accurate financial picture of the enterprise or person.  Balance Sheet changes are either to adjust items existing on the Balance Sheet or to add unrecorded items onto the Balance Sheet.  Existing items might include correcting the amount of accounts receivable or the reserve for bad debts; perhaps increasing or decreasing the fixed assets; or adjusting inventory to its correct amount (or something believed to be closer to the correct amount).  Adding previously unrecorded items might include some of what was just described (i.e. adding receivables which were previously unrecorded); perhaps picking up inventory or similar type items not previously reflected on the Balance Sheet (for instance, a walk through of a business revealing that there is inventory or large amounts of supplies when the Balance Sheet showed none of that); or perhaps even picking up a bank account which was not previously reflected. 

            Two types of modifications to a Profit and Loss Statement can be either benefits or perquisites run through (expensed on) the company=s books; or unreported income outside of the company=s books.  These corrections can be made by going through the books of the corporation or going outside of the books.  Needless to say, discovery of monies outside of the books is much more difficult to determine and prove. 

            Tracing the flow of money or the use and disposition of funds within a family unit is pretty much the same as that of a business.  Finding adjustments to the Balance Sheet (often no formal one has been developed, but part of a careful analysis requires that we, in effect, create one, for that couple or family) Bank accounts may be found that one party did not know about, stocks or bonds hidden, or assets of understated value.  It may also be determined that there were bonuses paid to one of the parties from his or her employer which were not known to the other spouse.  How these funds were handled - where they were deposited, how they were spent, or why this family unit which had a reported income of $300,000.00 per year and a modest lifestyle, did not save any money in ten years B is very important. 

            Needless to say, as trial attorneys, we need to be familiar with this process.  However, it is no substitute, in the appropriate case, for the hiring of a forensic accountant or Certified Fraud Examiner (CFE) who is far more familiar with these issues by training and experience than the average lawyer. 

            TOOLS OF THE TRADE:       There are certain tangible tools which are required to analyze marital assets.  These include the books and records of the business or family.  Typically, this includes financial statements, tax returns, bank statements and cancelled checks, disbursement and receipt journals, general ledgers, paid bills, sales invoices, and insurance policies.  Intangible tools are also extremely valuable.  If it is possible to do an Ain person@ inspection of the place of business, many important pieces of information can be gained.   If the opposing party will not consent or agree to an inspection, a motion pursuant to Rule 34 of the Tennessee Rules of Civil Procedure may produce the desired result.  If the spouse you represent is an officer, director or shareholder of the business, it can become far easier to convince a court that you should be permitted, along with your expert witness, to perform an inspection of the place of business.  This is particularly true if the represented spouse has actively worked at the business in the recent past. 

            In the family context, a visit to the home can often times be productive.  Many spouses are unaware of exactly what types of documents are important or needed for marital asset evaluation and division purposes.  While a good paralegal or associate can conduct this interview, the person who will actually be trying the case should consider making the visit, as well.

            THE BALANCE SHEET:        Whether it be unreported income, withdrawals from the business used personally, or expenses that are not appropriate, in most situations, in one fashion or another, the problems and the adjustments impact cash.  In order to properly analyze this area, we must understand the income flow of the business.  Where does the money originate and where does it go?  We must understand what the business sells, how it is sold and what the market is.  Does it sell many small items for a few dollars or does it sell large items for thousands of dollars?  Does it have one location or many?  Is the selling function controlled or run by the business owner (spouse) and to what extent are sales of the entity paid for in Agreen cash@?  Are collections done by mail or in person?  And, perhaps most importantly, when money comes in, who touches it?  The concept is always the same.  When someone has a significant degree of control over a business= operations and paper flow, we need to know everything we can about the flow of funds between that person (spouse) and the business, regardless of the direction of the flow.

            Oftentimes, disbursements of a business can be a source of unreported income for a spouse.  Was the disbursement by check?  Was it cashed or was it deposited into a bank account?  What do the endorsements show? 

            An off Balance Sheet benefit (pun intended) of looking at endorsements, can be the revelation of unreported assets as well.  Suppose that a number of checks were payable to the spouse, which had endorsements from a local coin or gun dealer.  In that situation, we may have a clue to substantial assets that are easily traded, sold, or secreted.  Likewise, the absence of cash deposits on bank deposit slips may not, by itself, be proof positive of unreported income.  However, it certainly constitutes one important element of establishing that fact.  This is particularly true in some professional practices.  A dentist, for example, may be closely identified by his patients as being the recipients of income of Smiles R Us Dental Clinic.  It is not uncommon for a patient to say that they wish to make payment by check out to the doctor.  This is a difficult situation which can be far worse by the fact that many professionals= books are not kept according to generally accepted accounting principles, to say the least. 

            ACCOUNTS RECEIVABLES AND BAD DEBT RESERVES:          A review of accounts receivable will enable you to determine the nature of the spouse=s business and who their major customers are.  While this can be obtained from reviewing sales records, looking at the accounts receivable area tends to put this in a more compact setting.  When this is done in conjunction with a review of the allowance for bad debts, many times it will raise red flags.  Some types of bad debt write-offs are of particular concern. 

            The timing of bad debt write-offs can reveal important information about the spouse=s business.  During a good year, many businesses try to write off everything and anything possible to reduce reported income B whether it be for tax purposes or divorce planning.  Therefore, if there are unreasonable or accelerated bad debt write-offs, these need to be added back to the Balance Sheet.  Also, by reviewing subsequent collections, it may be determined that a bad debt was written off at the end of a fiscal year, only to be collected in the first few days or weeks of the next fiscal year. 

            It is far more difficult to determine unreported income from an analysis of receivables or bad debt.  For instance, a customer pays in cash which gets pocketed and the receivable written off (perhaps at that time, perhaps a year or more later) as uncollectable.  Red flags in this area include letting this type of transaction occur far too often, especially with customers who continue to trade in volume and for time frames well after the write-off is being presented as a bad debt.  It is illogical to believe that a customer for whom you write off a large bad debt is one with whom you continue to do large volumes of business, unless it is some sort of accommodation to the customer. 

            INVENTORIES:          Adjusting the inventory up or down not only impacts upon the Balance Sheet, but also upon the income and expenses of the business.  If inventory has been understated and is increased, then the previously reported Balance Sheet of the entity will have its assets increase, as well.  When analyzing inventory, there are a multitude of accounting conventions which can be used to test the accuracy of the recorded inventory.  One approach is the cost of goods sold.  Another approach is to consider how much insurance the business is carrying on its inventory.  The production of insurance records should reveal this and sometimes insurance companies require some form of detail each year to justify the existence and the amount of the insurance coverage. 

            FIXED ASSETS:         The most common adjustment in this area involves a redetermination of the appropriate amount of depreciation and, therefore, the appropriate value, as contrasted with book value, of the subject assets.  In theory, if by the book accounting procedures were used, the book value of the assets would reasonably approximate their economic value.  However, the reality is that this is often not the case, particularly for small to medium size businesses.  Depreciation is often determined by tax motivation and little or no effort is made to distinguish between book and tax depreciation.  This tends, with the exception of automobiles, to overstate the depreciation and, thereby, understate the economic value of various assets. 

            Another type of adjustment which occurs in the analysis of fixed assets is where we find non-business type assets on the company books.  This may be furniture for the household or perhaps vehicles for sundry family, friends or lovers. 

            CUSTOMER DEPOSITS:       This item is the functional equivalent of deferred income.  That is, customers have made payments, or income has been recorded, but treated as not yet earned and, therefore, deferred awaiting on the delivery of a sale or service.  For example, if a client comes to an attorney for a divorce and pays a $5,000.00 retainer to be billed at $500.00 per hour, those funds remain in the escrow account of the attorney until earned and billed.  Absent the death of the attorney or being fired by the client (which occurs with some frequency), this is nothing more than a savings account for the service provider.  This is an area of analysis which must not be overlooked.

            ANALYZING INCOME AND EXPENSES, SALES AND COSTS OF GOODS SOLD:     If unreported income is a concern, an analysis of sales and costs of goods sold is almost always essential.  A benchmark to this analysis must be a clear understanding of the way the business operates.  Does the business have clearance sales during the year- and if so, how steeply discounted are prices?  If the concern is deferral of sales (and the concept of how we approach this is quite similar if we are instead concerned about the acceleration of sales into a year), then a careful review of sales invoices for several days or even several weeks after year end, or the period end, in order to determine whether or not sales have been properly recorded from the time standpoint.

            For instance a rather simple deferral technique is to simply post various invoices in the month following year end.  By that simple stroke of the keyboard, sales and potential profits have been deferred outside of a relevant period of inquiry.  It is also not unusual in these situations to find significantly reduced deposits at the end of one year and then dramatically increased deposits immediately thereafter. 

            It can be helpful to analyze the records of the business in a search for unreported income in conjunction with the foregoing.  An analyses of an appointment book or route sheet can identify customers for whom goods or services have been provided, but for which no payment has been made or which have been declared bad debts and written off.  Also, one can examine sales invoices looking for a break in numerical sequence.

            Costs of goods sold can also reveal unreported income.  The flip side of costs of goods sold is the gross profit margin.  If the costs of goods sold on a $100.00 widget is $58.00, then the gross profit margin is forty-two percent.  What that means is that every $100.00 of sales is represented by $58.00 of costs or a $42.00 gross profit.  Assuming that one looks at a broad enough sample, in the example above, if the business was showing a thirty-five percent gross profit, then on the order of seven percent of sales (and potentially profit) is going unreported.  The following is a listing of various types of businesses which may reveal a brief idea of how sales can be determined and income recalculated, based on using the costs of goods sold or some other aspect of the company=s operations which has a direct relationship to sales:

            1.         Bar or Tavern B Determine how many drinks can be sold from a bottle, with an allowance for spillage and complimentary drinks.  Determine the price for items sold by the bottle, whether beer or otherwise, as compared to their costs.  Observe the number of people who work at the establishment and the number of hours that they work for the likely determination of unrecorded payroll.  Don=t forget gaming machines and cigarettes. 

            2.         Beauty Salon B This is a very difficult type of business because there is usually very little one can do to create a relationship between a tangible item and sales.  The best way to approach this is to have group or individual appointment books produced, but only after an investigator has been sent in on a given day (or days) to covertly count the number of patrons (if possible, determining their names) by a given beauty operator or the salon as a whole. 

            3.         Convenience Food Store B It is important to trace products to their purchases to determine the appropriate gross profit margins.  Make an unannounced visit to the store to see if there is a second or third (an extra) cash register in operation.  If the sale of sandwiches is a major item,  actually purchase a couple of sandwiches and then analyze the contents.  It sounds funny, but you can use a postage scale to weigh the meat and cheese, and compare that to the price or cost of those contents in order to determine the cost of making each of those sandwiches.

            4.         Gas Station B Observe the posted prices and compare to current purchase invoices to determine the typical profit margin.  You must take into account price wars or discount days that may throw off the normal margins.  Subpoena the delivery invoices from the gasoline company to determine the number of gallons purchased, thereby determining the number of gallons sold.  If the station also repairs cars, do the normal type of analysis of repair bills and parts to determine the typical gross profit margin.  Analyze payroll to determine if it makes sense based on the number of hours the gas station operates. 

            5.         Supply and Stationary Store B These stores typically have both walk in-trade at full price and discounted commercial customers.  Determine the percentage of each and analyze the profit margins for both types of sales.  Remember that a number of items are prepriced by the manufacturer, which is almost always the price charged to the walk-in trade. 

            6.         Landscaper B Determine the number of labor hours worked by employees.  Many are often paid off the books.  Factor in the typical charge for labor versus what that labor costs the employer, and compare that to what the employer actual charges his customers per labor hour.  Also, do not forget to determine mark up on products which are generally purchased in bulk by the landscaper and sold for profit to the end user.

            7.         Restaurants B Use the purchases of food as a barometer, since you can normally determine what food should consist of as a percentage of sales.  This is known as food cost.  Also, do not forget to measure the use of consumables, such as disposable napkins, paper plates or paper cups.  This will also give you a clue to the volume of the restaurant.  If reusable napkins are used by the restaurant, you can compare the outside laundry service charges from one period to the next in order to determine the volume of the business. 

OFFICER OR OWNER COMPENSATION

            OTHER PAYROLL:    This is often an area of amusement for all of us who practice in this area.  Items that are interesting to look for and even more interesting to find include no-show jobs, paramours on the books, children on the books, and even fictitious employees.  Especially in a smaller business, it is not that difficult to determine various job functions and whether or not there are simply too many employees on the payroll.  When this is discovered, not only should the payroll be added back to the income of the business, but do not forget the payroll taxes and insurance expenses, as well.  Additionally, even though someone may be working for the company, do not forget that they may be being paid at an obscenely high wage, presumably for services rendered both in and out of the office.  Two ways to determine this are worker=s compensation payroll audits and income records submitted to health, disability or life insurers.

            EMPLOYEE RENT:    Sometimes this is as blatant as rent for a business owner=s apartment or paramour=s home being run through as a business expenses.  The basis for the rent can be even more revealing.  Is the rent paid to a related party or is the amount of the rent for a place of business, i.e., a dental practice, inflated such that it is not consistent with what one would expect for business rentals of that type. 

            INSURANCE:               Not only can the records of property casualty insurers reveal personal items which are having their premiums paid for by the business, i.e., jewelry, cars, boats, airplanes, etc., but one should also look at prepaid insurance expenses.  That is to say, many Balance Sheets are impacted once there is an adjustment for prepaid insurance.  Sometimes such prepaid insurance can be for excessively long periods or may be for things that are not included within the property casualty realm.  For example, annuities or universal life policies, or other growth funds types of insurance policies may be paid for by the company when, in fact, they benefit only the owner of the policy. 

            DEPRECIATION:       It is important to remember that the tax code for depreciation at a certain rate is usually irrelevant to its actual economic depreciation.  The theory behind tax depreciation is that a prudent business person will save enough money each year into a special depreciation account to replace a given item at the end of its usable life.  This occurs with such a vanishingly small percentage of businesses that it would be ridiculous to say that it has any meaningful impact upon business practices.  Rather, most businesses synchronize their book depreciation with their tax depreciation.  While this is not in conformity with Generally Accepted Accounting Principles, very few businesses make any real effort to comply.

            A forensic accountant can be helpful in many areas, however, for evidentiary purposes, as well as accuracy purposes, the use of an equipment appraiser may be far more helpful.  Additionally, one must also look at first year bonus depreciation (Internal Revenue Code ' 179) for relatively new items.  This first year bonus depreciation is very much like the one experienced with a new automobile.  A brand new BMW may be worth $40,000.00 until you drive it off the lot.  In that one instant, it may suddenly be worth $30,000.00 or a first year bonus depreciation of $10,000.00.  Subsequent year depreciation in the real economic sense may be far less. 

            PERSONAL FINANCIAL ANALYSIS:         One of the most fertile areas of discovery in analyzing the value of a family unit=s assets is if they have resorted to the use of a certified financial planner or investment counselor.  The information given to these professionals is usually far more accurate than that which is given to us in response to Interrogatories or Requests for Production of Documents, or for that matter, to one=s banker.  Do not neglect to inquire as to whether or not the family has done any on-line investment analysis or received any on-line advice in that regard.

            PERSONAL CHECKING ACCOUNT:         Aside from the obvious benefits of expenditures which are questionable in nature, trends can also be determined by a simple analysis of a personal checking account.  To do this, put the expenses on a spreadsheet with a column for each type of expense (including checks payable to the individual or to cash) and each expenditure listed on a separate line.  The lines would be separated by month with a clear separation between each month.  This is so that you can read across the spreadsheet and very easily see expenditures by month without having the expenses in one category from one month run into the lines with expenses of another category from another month.

            This type of analysis will make clear what is and what is not paid through the personal checking account.  For instance, are there no telephone and utility bills?  If so, it strongly suggests that the business is paying those expenses.

            Part of this analysis also involves understanding what gets deposited into the checking account.  It is nothing short of amazing how often people with unreported income simply deposit part of their paychecks into their checking accounts, so that they can pay their bills.  Do the frequency, amount and type of deposits ring true and consistent with known sources of income? 

            TAX RETURN ANALYSIS:           Tax returns need to be carefully reviewed for both the individual and any businesses in which they are involved.  Schedule A may reveal real estate taxes being paid on previously unknown assets.  Schedule B lists interest bearing banking relationships as well as dividend sources.  Having a list of banks, even if only those with interest bearing accounts, flags the situation so we are certain of the need for review.  Even if the amount of interest is small, the account still bears reviewing since significant cash flow might go through the account, even if it does not stay in it very long.  Dividend income indicates some form of stock investments, as well as likely activity with a broker or financial planner.  Similarly, Schedule D would indicate that the individual has some level of activity with one or more stock brokers.  Of course, Schedule C may reveal inflated expenses or suppressed income for a person who is self-employed.       

            As a final cautionary note, do not forget to examine the tax returns and any bank accounts of the parties= children.

            PENSION AND RETIREMENT PLANS:      Tennessee Code Annotated ' 36-4-121(b)(1)(B) includes in the definition of marital property Athe value of vested pension, retirement or other fringe benefit rights accrued during the period of the marriage@.  Vested rights are often divided by the courts as any other asset.  Typically, they are equitably divided when they are distributed.  However, as we will see in this section, they can be ?? divided based on their present value, by the courts, as well. 

                        The litigant is not necessarily entitled to a share of each item of marital property.  Brown v. Brown, 915 S.W.2d 163 (Tenn. App. 1994).  Rather the law requires only that the overall division of all marital property be equitable to both parties.  Furthermore, the goal is an equitable division, not necessarily an equal one.  Ward v. Ward, 937 S.W.2d 931 (Tenn. App. 1996). 

            The issue of military retirement and benefits was recently dealt with by the Supreme Court.  Justice Holder, writing for the Court, offered the opinion, in Johnson v. Johnson, 37 S.W.3d 892 (Feb. 23, 2001), that any attempt to reduce or modify military retirement benefits after the Marital Dissolution Agreement is ineffective.  The parties= Marital Dissolution Agreement divided Mr. Johnson=s military retirement benefits to provide one-half of those benefits to Mrs. Johnson.  After the Final Decree was entered, Mr. Johnson unilaterally waived a portion of his benefits.  The Court held that when a Marital Dissolution Agreement divides military retirement benefits, the non-military spouse obtains a vested interest in his or her portion of those benefits, as of the date of Court=s decree.  Any act of the military spouse that unilaterally decreases the non-military spouse=s vested interest is an impermissible modification of a division of marital property and a violation of the Final Decree of Divorce incorporating the Marital Dissolution Agreement.

            E.         New Law Update

            There are a variety of new and different issues that are coming to the fore in this area of the law.  However, one of the most interesting cases of recent days is the case of Hurst v. Hurst, 2001 Tenn. App. Lexis 310.  In that case, the Appellant, the former wife, and the Appellee, the former husband, divorced.  Upon doing so, they executed a Marital Dissolution Agreement stating that the Wife would receive certain property.  The property that the Wife was supposed to receive was never actually distributed to her.  Less than a year after the first divorce decree was entered, the parties remarried.  They remained remarried for another five years.  When they divorced again, they executed a second Marital Dissolution Agreement.  The second Agreement stated that the parties had previously divided all of their personal property, furniture and furnishings, and that each party had received all items in their respective possession. 

            The question before the Court is since the Wife was never actually in receipt of the personal property from the first Marital Dissolution Agreement, was it=s proposed distribution in the second divorce proceeding under the principles of separate property or marital property.

            The Court said that equity regarded having been done that which ought to have been done, and thus the property was deemed to be in the Wife=s possession for the purposes of property distribution in the second divorce.