Mixing Forensic Acctg And Valuation In Litigation

Presented by:

W. James Lloyd, CPA/ABV/CFF, CFE, ASA

AICPA National Business Valuation Conference November 15-17, 2009

Mixing Forensic Accounting and Valuation

in a Litigation Engagement

AICPA National Business Valuation Conference November 15 – 17, 2009 Page 2

Presentation Objectives

• CPA’s role in litigation/dispute resolution matters

• Overview of fraud/forensic accounting

• Fraud statistics – how and how much

• When to do it – assertions and/or suspicions

• What to look for – red flags

• How to find it – tools and techniques

• What to do with it – documentation and using the results


CPA’s Role in Litigation

• CPA’s are often engaged as experts in connection with litigation matters for purposes such as:

– Determining the value of a business or business interest

– Measuring damages such as lost profits or diminished value

– Investigating fraudulent or other inappropriate activity

• Generally engaged as either: testifying expert or consulting expert


Applicability

• Litigation engagements where forensic accounting procedures may be necessary:

– Marital disputes where one spouse has control of the business

– Shareholder disputes (minority oppression matters)

– Post M&A transactions

– Lost profits/diminished value claims

– Bankruptcies

– Lender fraud


Fraud Defined

• Fraud is defined in Black’s Law Dictionary as:

– A knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment. A misrepresentation made recklessly without belief in its truth to induce another person to act. A tort arising from a knowing misrepresentation made to induce another to act to his or her detriment.

– Could also be defined as – the improper conversion of another’s assets to one’s own benefit.


Essential Elements of Fraud

• Intentional material false statements or willful omission of a material fact

• Knowledge by the perpetrator that the statements or omissions are false and misleading

• Intent for the misrepresentation to be acted upon

• Reliance by the victim

• Damages to the victim


Fraud Determination

• The ultimate conclusion as to whether fraud has been committed is a matter for the trier of fact

• Involves “state of mind” issues for both the perpetrator and the victim (e.g., intent and reliance)

• Our job as forensic/valuation experts is to determine the facts – i.e. what actually happened?.... and what’s the result?


Fraud Triangle

Management or other employees have an incentive or are under

pressure

Circumstances exist – ineffective or absent control, or management ability to override controls – that

provide opportunity

Culture or environment enables management or other employees to rationalize committing fraud

Rationalize Opportunity

Incentive


General Categories of Occupational Fraud

• The general categories of fraud involving businesses include:

– Asset misappropriations

– Corruption

– Fraudulent financial statements


Asset Misappropriations

• Defined as “any scheme that involves the theft or misuse of an organization’s assets”

• Asset misappropriations generally involve either incoming receipts or outgoing disbursements


Common Asset Misappropriation Schemes

• Schemes involving incoming receipts:

– Skimming (before the cash is recorded)

– Cash larceny (after the cash is recorded)

• Schemes involving outgoing disbursements:

– Billing schemes

– Expense reimbursements

– Check tampering


Corruption

• Defined as: “any scheme in which a person uses

his/her influence in a business transaction to

obtain an unauthorized benefit that is contrary to

that person’s duty to his/her employer”


Common Types of Corruption Fraud

• Conflicts of InterestExample: employee owns an undisclosed interest in a supplier and negotiates a contract his employer and the supplier

• BriberyExample: employee accepts a payment from a vendor for confidential information about a competitor’s bid on a project

• Illegal GratuitiesExample: employee accepts a free vacation from a vendor after negotiating a contract for his employer


Financial Statement Fraud

• Generally committed by upper management to make the company’s earnings and/or financial condition appear better (or worse) than actual

• Typical reasons include:

– Lure investors or creditors

– Receive performance based compensation

– Keep stock price high for acquisitions

– Debt covenants

– Divorce (business is a marital asset)


Forensic Accounting

• Forensic accounting services generally involve:

– The application of special skills in accounting, auditing, finance, quantitative methods, certain areas of the law and research, and

– Investigative skills to collect, analyze, and evaluate evidential matter and to interpret and communicate findings, and

– May involve either an attest or consulting engagement.

Above definition adopted by the AICPA Business Valuation/Forensic and Litigation Services Executive Committee: January 2006


Primary Purpose

• The primary purpose of a forensic accounting engagement is to:

– Determine whether the suspicions or allegations of fraud have merit

– Quantify the estimated losses/damages

– Gather information that will assist the trier of fact with resolving the matter


Fraud Stats - ACFE’s 2008 Report to the Nation

• Approximately 7% of revenue is lost each year due to fraud

• Median loss was $175,000

• Median loss for companies with less than 100 employees was $200,000

• 25% of the cases had losses of at least $1M

• Typical length of time between the date the fraud started and detected was 2 years

ACFE’s 2008 Report to the Nation (Continued)

Initial Detection of Occupational Frauds

46%

19%

20%

23%

9%3%

Employee Tip

Internal Audit

Accident

Internal Controls

External Audit

Notified by Police

Respondents were asked how the frauds they investigated were initially discovered.

•

The sum of the percentages exceeds 100% because some cases involve more than one type of fraudThe sum of the percentages exceeds 100% because some cases involve more than one type of fraud

Perpetrator’s Profile

• Higher income and education = greater loss

• Highest median losses related to employees with 6-10 years of tenure: ($261,000 for 6-10 years vs. $50,000 for <1 year)

• Median loss for males was $250,000 vs. $110,000 for females

• More education means higher losses: ($550,000 for postgraduate vs. $100,000 for high school)

• Ages 51-60 represented the highest median loss ($500,000 for 51-60 vs. $25,000 for <26)


Small Organizations Suffered Disproportionately Large Losses

$200,000

$176,000

$116,000

$147,000

$- $50,000 $100,000 $150,000

Median Loss

<100

100-999

1,000-9,999

10,000+

Nu

mb

er o

f E

mp

loye

es

Median Loss Based on Size of Victim Organization

2008

Source: Association of Certified Fraud Examiners 2008 Report to the Nation


ACFE’s 2008 Report to the Nation on Occupational Fraud & Abuse

$- $400 $800 $1,200 $1,600 $2,000

Median Loss (in thousands)

AssetMisappropriation

Corruption

FraudulentStatements

Cat

egor

y

All Occupational Frauds

Fraudulent Statements

Corruption

AssetMisappropriation

Source: Association of Certified Fraud Examiner’s 2008 Report to the Nation


When To Do It

• Valuing a business/business interest in connection with litigation/dispute; or measuring economic damages such as lost profits or diminished value; and:

– Specific allegations of fraud have been asserted; or

– Fraud is suspected


Divorce Engagements

• Managing spouse suspected of using the business to secretly acquire personal assets

• Managing spouse suspected of receiving excessive perks or undisclosed income from the business – such amounts must be considered in determining true income for support purposes

• Value of the ownership interest should be determined based on normalized cash flows


Word of Caution

• Before undertaking a forensic accounting assignment that may result in someone being accused of fraud, the CPA should consider obtaining statements or other documentation from the client regarding the suspected or alleged fraud

• Such statements are considered the predication or basis for the investigation and will help protect against unwarranted lawsuits

• The engagement letter will probably suffice if it adequately describes the suspected or alleged fraud


Pre-Engagement Considerations

• Prior to accepting a forensic accounting engagement, consider the following:

– Confirm competence and experience as required by AICPA Code of Professional Conduct, Rule 201

– Check for potential conflicts of interest

– Fee constraints vs. time requirements

– Staffing and resources

– Generally high risk engagements


What To Look For

Will generally depend on the type of dispute.

For example:

• Divorce, Shareholder Disputes, and Bankruptcy cases will generally be concerned about understated assets and revenue and/or overstated liabilities and expenses; whereas

• M&A transactions/lender fraud - will generally be concerned about overstated assets and revenue and/or understated liabilities and expenses


What To Look For –Red Flags

• Large checks written to cash (or large number of smaller checks)

• Unusual cash transfers

• Transactions not consistent with the entity’s business

• Unusual related party transactions

• Bank accounts not reconciled timely

• Out of balance subsidiary ledgers


What To Look For – Red Flags

• Pressure from investors or lenders to achieve a certain level of profitability and/or financial condition

• Standard of living is unusual relative to known financial resources

• Disorganized operations

• Poor internal controls – easy for management to override

• Unusual and/or unsupported journal entries


What To Look For – Red Flags

• High dependence on a relatively small number of customers or suppliers

• Impressive financial results in a poor economy and/or with poor industry performance

• Unusually consistent financial performance and growth

• Disconnect between cash and profitability

• Growing days in AR – higher than industry average

What To Look For – Healthcare Entities

• For healthcare providers (entities that bill insurance companies, Medicare, Medicaid, etc) - watch out for over billing and up-coding practices

– Could substantially overstate revenues

– Result in penalties and sanctions

• Revenues should be reasonable relative to other similar providers



What To Look For – Financial Statement Fraud

• Financial statement related frauds generally have the most impact on valuation and lost profits calculations

• Normally involves one or more of the following:

– Overstated revenues

– Concealed liabilities and expenses

– Improper asset valuations

– Improper disclosures

– Mismatching of revenues and expenses

Common Methods Used to Overstate Revenues

• Fictitious revenues – did not actually occur

• Premature revenue recognition – sale not yet complete

• Channel stuffing – customer agrees to accept more product than needed in exchange for substantial discounts or on consignment

• Vender rebates – recognizing incentive rebate income prior to meeting the required terms



Concealed Liabilitiesand Expenses

• Understating liabilities and expenses is one of the most common ways companies manipulate their financial statements

• It is generally easier to omit recording an expense than to falsify revenues

• Concealed liabilities and expenses can be difficult to detect because there is generally no audit trail to follow

• Examples:

– Omitting legitimate accounts payable

– Capitalizing inappropriate expenses

– Failure to disclose warranty costs and liabilities


Timing Differences

• Recording revenue and/or expenses in improper periods

• Red Flags:

– Unusual growth in the number of days’ sales in receivables

– Unusual decline in the number of days’ purchases in accounts payable


How To Find It

• A key objective of the investigation is to gather sufficient relevant data to assist the trier of fact with making a determination regarding the suspected or alleged fraud

• Therefore, the investigation/procedures should be planned based on the individual facts and circumstances (i.e. based on the allegations or suspicions)


Basic Preliminary Steps

• Determine that proper predication has been established by the client

• Obtain an understanding of the specific fraud suspicions or allegations by discussing the case with the client/attorneys and review any work already performed

• Start gathering and analyzing data


Gathering and Analyzing Data

• Relevant data is generally gathered from a combination of methods such as:

– Obtaining and reviewing documents - from client and/or other sources

– Personal interviews

– Observations

– Background investigations

– Public record inquiries


Reviewing Documents –Caution

• Data should be gathered/analyzed with a high degree of skepticism

• Perpetrators may use false documents, often in collusion with others, in an effort to conceal their fraud

• Proper chain of records custody may become an issue especially if documents have been altered or falsified

– Responsibility should be established with client/attorneys at beginning of the investigation


Interviews

• The purpose of interviews are to gather additional information from individuals who may have knowledge of the fraud scheme.

• Types of information generally solicited include:

– Background information on the individual

– Any direct knowledge of the fraud suspicions/allegations

– Names of others who may have useful knowledge

– Documents supporting the interviewee’s responses

– Any other information that may be helpful


Interviews (continued)

• Open ended questions are generally more productive than closed (“yes or no”) questions – get the interviewee engaged in the conversation

• Start with individuals believed to have only peripheral knowledge of the fraud and progress to those believed to have more knowledge – the primary suspects should generally be interviewed last


Analytical Procedures

• Analytical procedures can be useful in finding potential problem areas

• Look for unusual or unexplained trends:

– Vertical analysis – percentage change from year to year

– Horizontal analysis – compare to prior years and benchmark data

– Ratio analysis – balance sheet

– Benchmark analysis – financial and operational data if available


Statistical Sampling

• Statistical sampling techniques can be used to help establish upper and lower limits of the estimated damages

• More beneficial for “on-book” as opposed to “off-book” frauds

• Sometimes difficult to convince a jury of its accuracy/reliability

• Less expensive than a complete analysis of every potential fraudulent transaction


Data Mining

• Data mining can be an effective and efficient way to find potential fraudulent activity

• Queries can be made to identify unusual/abnormal activity such as:

– Recurring cash disbursements of the same dollar amount

– Vendors and employees with the same address

– Transaction activity occurring at odd times (i.e. weekends or holidays)

Link Analysis

• Link Analysis is the process of finding and documenting the common relationships between objects – such as people, companies, transactions, etc

• Key is to find common relationships between important objects and link them together to test/support fraud hypothesis

• Need: mapping or similar software with timeline capabilities

• Drawback: time consuming



Cash is Still King

• Profitable companies generate positive net cash flow; whereas companies with low profits should not be generating large amounts of cash for the owners

– There should be a direct relationship between income and cash

– Analyze bank activity and compare to income being reported

• Follow the money – tracing funds generally provides a wealth of useful information, especially for small/medium sized businesses


What To Do I With It-Documentation

• SSCS No. 1 requires communication with the client but does not require a written report

• However, if litigation is involved, some type of written report will generally be needed to document the work performed and findings

– Consult with counsel regarding the particular report requirements/disclosures

• The report should avoid any conclusions or opinions regarding whether fraud was or was not committed


Using the Results

• Depending upon the circumstances, the forensic accounting results should be incorporated into the valuation or damages analysis as appropriate.

• Such incorporation may involve:

– Normalization adjustments to the existing financial statements

– Reconstructing the financial statements all together

– Determining the potential negative implications that the fraud will have on the business (i.e. loss of reputation, employees, etc)

Using the Results (continued)

Query #1:

• Should the discount rate be adjusted to reflect additional risk for companies that have recently been associated with fraud or believed to have been involved in fraudulent activity?

• Even if we think our forensic accounting procedures identified and quantified the problems and the financial statements have been normalized?



Query #2

• Can market comps (guideline public companies and/or M&A transaction data) be relied upon as proxies for companies that have recently been associated with fraud?



Query #3

• Are companies (or interests in companies) that have been recently associated with fraud as marketable as other companies?

• Most likely there will be a stigma that may make them more difficult to sell



Tools and Resources

• Data Mining software

– IDEA: Caseware International (www.caseware.com)

– ACL: ACL Services, Ltd. (www.acl.com)

• Electronic files

– Caseware Working Papers (document management software)

• Case analysis/management software

– CaseMap/TimeMap by LexisNexis (www.lexisnexis.com)

Tools and Resources

• Mapping software – such as MindManager by Mind Jet (i.e. www.mindjet.com)

• AICPA’s Certified in Financial Forensics (CFF) credential (http://fvs.aicpa.org)



Professional Standards

• Statement on Standards for Consulting Services (SSCS) No. 1

• Rule 201 of the AICPA Code of Professional Conduct

– Professional competence

– Due professional care

– Planning and supervision

– Understanding with the client

– Communication with the client


Professional Standards

• Statement on Standards for Valuation Services (SSVS) No. 1

• Ethics Interpretation No. 101-3, Performance of non-attest services under Rule 101, Independence


References

• Consulting Services Practice Aid 96-3, Communicating in Litigation Services: Reports

• Consulting Services Special Report 03-1, Litigation Services and Applicable Professional Standards

• Business Valuation and Forensic and Litigation Services Practice Aid 04-1, Engagement Letters for Litigation Services


References

• Business Valuation and Forensic & Litigation Services Section Special Report 06-5, Forensic Procedures and Specialists: Useful Tools and Techniques

• Business Valuation and Forensic & Litigation Services Section Practice Aid 07-1, Forensic Accounting – Fraud Investigations

• Forensic & Valuation Services Section Special Report 08-1, Independence and Objectivity in Performing Forensic and Valuation Services

References

• FVS Section Special Report 09-1, Introduction to Civil Litigation Services



Questions?

W. James Lloyd, CPA/ABV/CFF, CFE, ASA

[email protected]

(865) 673-0844

www.pyapc.com

Mixing Forensic Acctg And Valuation In Litigation

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