Plaintiff and Defense attorneys are guilty! Guilty of waiting until the last minute to address areas of damages. MDD is very often retained in litigation engagements when the measurement of damages takes a back seat to liability and causation. Although attorneys often rely upon experts in the areas of damages, it is very important that the damages receive the same due diligence as liability etc. This is true for both plaintiff and defense positions. Due diligence means assuring that the expert obtains all the information available to support the expert opinion. Unfortunately, it is often the case that the expert must testify with limited information because damages were not focused on until too late in the litigation process [i.e. discovery closed, or very short deadline for expert reports etc.]. It is prudent to involve your financial expert/consultant as early as possible so they can be fully prepared.
What is a Forensic Accountant?
A forensic accountant assists counsel by looking behind the numbers – the how’s and why’s of column after column of figures. You may have heard of forensic accountants, but have no idea how a forensic accountant is any different from the CPA who prepares your tax return – and how he can help you in the courtroom. Enron, Tyco, WorldCom and others were clearly cases for forensic accountants, but what about the case you’re working on right now?
Similar to attorneys, there are many types of accountants – tax accountants, audit accountants, cost accountants, bookkeepers, certified public accountants. Sufficient to say, just as all attorneys are not trial lawyers, not all accountants are forensic accountants.
Simply based on its root words, the basic definition of a forensic accountant is fairly obvious: “Forensic“, means specializing in the application of scientific knowledge to legal matters; and the word “accountant”, refers to a trained individual whose work is to inspect, keep, or adjust accounts.
True to its definition, the forensic accountant is distinguishable from others in the accounting field because he possesses a valuable combination in the courtroom: The technical accounting background necessary to determine and analyze the relevant accounting records blended with a familiarity of the litigation process such as discovery, deposition, expert reports, interrogatories, Daubert/Tokimo and federal rules of civil procedure.
A forensic accountant can help identify and locate the information you need to build or bolster your case. Forensic accountants understand that during the course of litigation, as well as during the time period prior to filing suit, each step must be carefully calculated and strategized so that counsel can control and develop the litigation process and, ultimately, the outcome of the case. A forensic accountant readily interprets financial data, understanding its significance to each particular case.
A qualified forensic accountant is also prepared to deal with the intricate legal system, aware of the differences between an expert and consultant, familiar with appropriate file maintenance, the distinction between deposition testimony vs. trial testimony, and is prepared to meet time-sensitive deadlines.
Many attorneys and lay people have a rudimentary knowledge and/or understanding of financial records. However, when handling matters involving questions of financial relevance, more than a rudimentary understanding is required. To best serve the client, and to properly develop the case, a detailed analysis of relevant financial data is required. In fact, identifying the records to be reviewed and analyzed is paramount to proper preparation of the case.
Financial statements can appear to be relatively innocuous and straightforward. It is important to realize that financial statements are summaries of financial data usually, but not necessarily, presented in accordance with generally accepting accounting principles (GAAP). What many do not understand is that there are various levels of detail in support of the summary documents. GAAP is learned knowledge establishing the requirements for entering financial information on financial documents. A forensic accountant knows how to interpret the data and unveil the story behind the records. For example:
- On the books is a piece of equipment recorded at $40,000. Most lay people believe the equipment is worth $40,000. But in actuality, GAAP requires that such items be recorded at historical cost, which is the price that the company originally paid for the item. A trained accountant will highlight this and point you to the detailed fixed asset register to determine the date of purchase and its purchase price, including all the associated costs for installation, etc.
- A company provides stock options to employees. Are the options expenses to the company? Are they income to the employee? What is the cost of an option? Currently, stock options are not recorded on financial statements, and are not income to recipients until they are executed. This can be a substantial hidden asset in determining an individual’s worth and/or his ability to pay. Because of their “hidden nature”, stock options are currently under scrutiny in the corporate financial world.
- Patents and copyrights are also recorded as an asset. Again, a forensic accountant will identify the parameters used in recording this asset on the books. Also, certain forensic accountants may also have the ability to value the intangible asset.
- Inventories on the books can be valued based on last-in-first out [LIFO] or first in first out [FIFO]. This is not clear to the layperson. However, during a period of rising or declining prices the method selected can misstate the current value of the inventory and profits of the company. Also, switching methods makes a comparison of yearly results inconclusive
- A furniture store makes a sale today and takes a deposit. If the product is ordered and delivered in two months, when does the company “book the sale”?
- A costume jewellery manufacturer sells to a large retailer at $5 per unit. Is this the actual selling price? Maybe not, since most large retailers “charge back” the customer if the product does not attain the planned sell-through at the suggested list price to end consumers.
There are many other areas of financial records that a forensic accountant that is trained to look behind the numbers can provide clarity to.
How can the Forensic Accountant Assist in Case Management?
Often counsel is faced with the difficult task of investigating the merits of a case, while the client is sensitive to cost. A forensic accountant can quickly digest the facts of complicated financial cases, and work with counsel to design scope for testing the assumptions or suspicions. For this reason, it is critical to retain the forensic accountant during the discovery process – not after all the documents have been identified. The forensic accountant knows the key accounting documents that will allow an efficient review. Further, he knows the strengths and weaknesses inherent in certain accounting documents. The forensic accountant assures that the appropriate documents are obtained during discovery as he is familiar with the case and the accounting records and can provide the appropriate terminology to assure the necessary documents are requested during discovery.
As the discovery process moves forward it is often the case that counsel is inundated with volumes of disorganized records. A forensic accountant can ascertain the relevant documents in a timely efficient manner as well as determine any missing documents. The accountant that is already versed in the case will utilize the “bulls-eye” approach to review the documents. This approach allows the forensic accountant to analyze top-level summary reports. Feedback is provided, and then counsel and the accountant can determine if the next level of review is warranted. Ultimately, very detailed “bulls-eye” information is reviewed if the facts of the case warrant such. The advantage of this technique is that counsel is obtaining periodic feedback and counsel and the client can make timely decisions based on the cost/benefit to the case.
Prior to the deposition, counsel should have the forensic accountant brainstorm and provide a list of questions for additional follow-up. Obviously, different cases and different attorneys warrant different strategies at deposition. The forensic accountant will merely provide a list of inquiries and counsel will determine if the inquiries are appropriate for the deposition.
The forensic accountant also should be included in the depositions of other experts and fact witnesses to help identify opportunities to obtain important clarifications of relevant financial data that would assist him in his conclusions. If the forensic accountant is not present during these events, there may be missed opportunities to inquire as the availability of documents that were not provided in discovery. Finally, it is critical for the forensic accountant to attend the deposition so that during breaks he can provide feedback to counsel. A trained forensic accountant is aware that he is not an active part of the deposition, and should only interact with his counsel.
A good forensic accountant can also quickly analyze the damages and identify inherent weaknesses in the damage measurement that might not have been apparent to his or her client. If early settlement is the objective, such information will assist the attorney in settlement strategies and may save time and money.
Let’s now take a look at how real issues were resolved using a forensic accountant:
- You just spent the last two years in discovery, deposition, and settlement discussions, including a multi-day mediation, and finally, you have your day in court. After a very arduous trial, a jury awards your client $2m. However, the celebration is short-lived as the defendant company declares they do not have the ability to pay the award, and will be filing bankruptcy. Now what? The forensic accountant you retained assisted in discovery and requested the accounting source documents that demonstrated that defendant had utilized various means of siphoning off cash to create illiquidity. He discovered bonuses paid to family member executives. He discovered gratuitous payments to other corporations that had common owners. He discovered the change from FIFO to LIFO inventory, the impact was to show less profit on the books vs. prior years.
- Your client is a shareholder of a family-operated business. Her brother is also a shareholder and became CEO after the father died three years ago. Your client feels her brother is living the “high life” while her semi-annual dividend check has been dramatically reduced. The CEO brother has indicated that the business is not doing well. Your client thinks her brother is lying or cooking the books. Now what? Counsel did not contact a forensic accountant until after the discovery was closed. Counsel assumed he could handle the discovery and requested everything that might be applicable. Unfortunately, counsel received everything that was requested, and a conference room full of banker boxes was provided. Counsel retained a forensic accountant to review the information but the client was concerned with fees. Therefore, a bulls-eye approach was utilized by the forensic accountant. The accountant reviewed top-level statements and determined that the business had become less profitable. However, the accountant recommended further analysis in attempt of ascertaining the cause of the reduction in profitability. It was determined that certain large customers were no longer conducting business with the subject company. This fact was pursued in the CEO’s deposition. He indicated the customers had gone to a competitor. When the name of the competitor was researched it was determined that it was owned by the brother. Lastly, the accountant discovered substantial disbursement to a computer consultant. The amounts were out of line with previous years and excess for the size of the business. The accountant researched the consultant and discovered the company address was the brother’s home. The accountant testified to all of these facts in state court clearly demonstrating that the brother was rerouting business to his solely owned business.
- You are defending a client being sued when an individual hurt himself in the store. The individual has presented copies of his W-2’s demonstrating the loss of earnings. But it is your understanding that he is self-employed and should not have W-2’s? Now what? The forensic accountant you contacted educated you as to how a “self-employed” individual may still receive a W-2 if the entity is a C or S corporation. The accountant then recommended that the individual be questioned in his deposition/trial as to if he was still working [he was], and who determined the W-2 salary [he did]. The accountant testified that there was no loss because the reduction in W-2 wages resulted in an increase in profit for the company owned by the claimant and that the reduction in W-2 wages was a manipulation by the plaintiff.
Enron, Tyco, WorldCom and other recent scandals have illustrated the need to look behind the numbers of financial statements. These cases have provided some sex appeal [believe it or not!] to the Forensic Accounting field. However, it is important to realize that there myriads of smaller less high-profile cases that require forensic accountants. Forensic accountants may be called upon when litigation involves financial statements because there are stories within the financial statements that may not be clear to lay people.
In summary, the challenges of proving a case involving sophisticated financial analysis can be greatly alleviated with the assistance of an effective forensic accounting expert. Such an expert can serve as a consultant, providing invaluable preliminary insight and advice, or if needed, an expert witness whose opinions are presented convincingly to an opponent.
By Kevin Flaherty.