Cash tracing, a forensic accounting technique, is used to uncover the ownership and fate of funds within financial accounts. In a world where transactions weave intricate webs, tracing demystifies how funds are spent, converted, or transferred, and serves as an indispensable tool in government forfeiture cases, trust accounting, and investigating fraud, such as Ponzi schemes.

Once funds enter a financial account, they blend into a seamless whole, which presents a unique challenge. Forensic accountants are able to employ sophisticated methodologies to trace the origin and understand the flow of commingled funds. These methodologies —last-in, first-out (LIFO), first-in, first-out (FIFO), the pro rata rule, and the lowest intermediate balance rule (LIBR) — offer different lenses to view and analyze financial transactions.

Understanding LIFO and FIFO timelines

Imagine a scenario where Peter and Lisa, each unaware of the other's actions, deposit $100 into a shared account on consecutive days. Should the account holder withdraw $100 the following day, a question arises. Whose money was spent? LIFO suggests that Lisa's deposit, being the last in, was the first out, leaving Peter's contribution untouched. Conversely, FIFO posits a chronological order to the withdrawals, deeming Peter's deposit the first to be spent. These methodologies, akin to the rules governing the flow of inventory, shed light on transactions by emphasizing the timing of deposits and withdrawals.

Using the pro rata rule as a proportional approach to cash tracing

Beyond the linear narratives of LIFO and FIFO, the pro rata rule introduces a principle of proportionality. When funds are extracted from an account with contributions from multiple parties, this rule dictates that each withdrawal affects all parties' balances in proportion to their share. This approach ensures a balanced allocation of both the joys of investment growth and the pains of financial withdrawals, mirroring the democratic ethos of shared ownership.

Pro rata example:

Imagine an investment club consisting of three members: Alex, Casey, and Jordan. Each member contributes to the club's collective investment account but in differing amounts. Alex adds $5,000, Casey contributes $3,000, and Jordan invests $2,000, bringing the total pool to $10,000. This diversity in contributions sets the stage for applying the pro rata rule should the club decide to make a withdrawal.

A few months into their investment journey, the club agrees to withdraw $1,000 to cover a shared opportunity. According to the pro rata rule, this withdrawal does not arbitrarily subtract from just one member’s contribution. Instead, it is distributed proportionally based on each member's share in the total pool.

Here is how it breaks down:

• Alex's share is 50% of the pool ($5,000 out of $10,000)
• Casey's share is 30% of the pool ($3,000 out of $10,000)
• Jordan's share is 20% of the pool ($2,000 out of $10,000)

Therefore, of the $1,000 withdrawal, $500 would be considered to have come from Alex's contribution, $300 from Casey's, and $200 from Jordan's.

Implementing LIBR to protect depositors’ funds

LIBR prioritizes protecting all participants' interests in an account. It ensures that the account holder's funds are depleted first before any commingled funds are used. This method safeguards depositors' contributions until the account holder's resources are fully expended. If the balance dips to zero or below, it is assumed that all prior deposits have been utilized.

LIBR example:

Consider a scenario involving a family trust where Emma, the trustee, oversees an account holding both her personal investment and contributions from family members, Max and Lily. Initially, Emma invests $10,000 of her own money into the account. Subsequently, Max and Lily each add $5,000, bringing the total pool to $20,000.

As time progresses, trust-related expenses arise, necessitating withdrawals from the account. Emma makes a series of withdrawals totaling $12,000 for various personal expenses. Here, the LIBR method provides a framework to determine how these withdrawals impact the contributions from each party.

Applying LIBR for cash tracing:

1. Initial account balance: $10,000 of Emma's personal funds
2. Additional deposits: $5,000 from Max and $5,000 from Lily, increasing the total to $20,000
3. Withdrawals: Emma withdraws $12,000 for trust-related expenses.
4. Remaining balance post-withdrawal: According to the LIBR principle, Emma's own funds are used first for her withdrawal. This means the first $10,000 of the $12,000 withdrawn by Emma is attributed to her initial contribution, exhausting her balance. The remaining $2,000 of the withdrawal then starts to tap into the commingled funds from Max and Lily. Given their equal contributions, we can infer that $1,000 would be deducted from Max's contribution and another $1,000 from Lily's, leaving them each with $4,000 in the account.

How Citrin Cooperman can help

At the cutting edge of forensic accounting, Citrin Cooperman is not just participating in the industry's evolution; we are driving it. By integrating advanced software into our practice, we have revolutionized the analysis process, eliminating the need for manual data entry. Our software transforms PDF bank statements and supporting documents (checks, deposit slips, wires, etc.) into Excel formats with unmatched speed and efficiency, making the meticulous examination of financial documents for cash tracing both faster and more accurate. This innovation enables our team to examine complex financial landscapes with an unprecedented level of detail, turning vast data sets into clear, actionable insights, even in large-scale investigations.

Citrin Cooperman can help you navigate financial intricacies, bring clarity to complexity, and ensure that you are informed, empowered, and ahead of the curve. To learn more about our Forensic and Litigation Advisory Services Practice, please contact your Citrin Cooperman advisor or Mark Parisi at mparisi@citrincooperman.com.