Financial Fraud Investigations: Spotting the Red Flags and Stopping White-Collar Criminals

If you scatter a thousand $1 bills around the company breakroom and hang a sign asking employees not to steal, how long will it take before someone gives in to temptation? Perhaps an employee might start taking cash by rationalizing that no one would miss a few dollars. Or worse, they might take advantage of the lack of oversight and steal it all.

Dropping cash in the breakroom is not an experiment we recommend, but it’s worth considering whether your organization is making it easier for employees to commit financial fraud.

Ask yourself the following questions: Are you able to spot the warning signs that a potential fraudster may be at work; are your internal controls designed to deter fraud; if you do suspect theft, are you prepared to launch an effective financial fraud investigation that will catch employees who are stealing and prevent future theft?

Why Good Employees Become Fraudsters

Even employees who may seem the most honest might consider taking money under the right conditions. The key to preventing them from doing so is reducing the twin forces that drive financial fraud—temptation and opportunity.

The temptation to commit fraud usually begins in environments with lax internal controls. Pay particular attention to employees positioned to check their own work with little or no oversight, or who have unfettered access to money going in or out of the business.

Those factors alone do not mean an employee is on the path to wrongdoing—but they do increase the odds, especially when combined with external stresses the employee may be facing. Bad economic times, a divorce, an illness, a gambling habit or the failure of their own business may drive an employee to consider theft. They may even tell themselves, “I’ll only take a small amount, then return it later when I’m in a better situation.” Lenient or lax internal controls simply feed the temptation.

Habits of Typical Perpetrators

Remember the Where’s Waldo books? Each page asked readers to find the striped-shirted hero in a highly detailed scene. Finding workplace criminals is similar. You must pay close attention to the details and pick out anomalies in employee behavior to spot fraudulent activity.

Those behavioral anomalies often include employees showing consistent unhappiness with their jobs or habitually finding ways around established procedures to “beat the system,” They might demonstrate an extreme reluctance to relinquish control or share information with colleagues or management.

All of these actions should serve as red flags of potential fraud. They don’t always mean that an employee is guilty of something—the employee may really just be a curmudgeon or a control freak. However, if these signals are present, it is a good idea to take a closer look. And if a fraud is suspected or discovered, you must be prepared with an action plan to stop the plot before it causes irreparable damage to the company.

Appropriate Responses to Workplace Fraud

If you suspect employee fraud, taking the following steps can aid your financial fraud investigation team.

  • Secure any evidence. This includes computers, flash drives, cell phones and digital accounts. “Secure” is the operative word—don’t tamper with the evidence. An act as simple as attaching an external device to a computer can render the evidence useless. Instead, assemble a team of forensic experts to investigate as quickly as possible.
  • Don’t immediately fire the employee. Resist the temptation to terminate an employee accused of fraud. Employees have a duty to cooperate with employers during a lawful investigation. Consider keeping them on payroll until the evidence has been sufficiently developed by the financial fraud investigation team.
  • Restrict access. Once employees know they are the subjects of an internal investigation, restrict their access to their office and company information systems. This will prevent them from covering their tracks, encrypting programs, stealing confidential information and deleting incriminating evidence.
  • Contact your insurer. You should contact your insurer as early as possible. Many policies have a 30- or 60-day notification provision, beginning from the first day that you discover a loss may have occurred. Failing to notify insurance may void your coverage, making an already difficult loss even greater.

Preventative Measures to Take Now

Even if you do not currently suspect employee fraud in your workplace, taking precautionary measures now can deter fraudsters from committing financial crimes in your workplace.

Preventative measures include: segregating duties; placing daily and monthly limits on company credit cards; and monitoring electronic audit trails. Also, be sure to maintain strong employee recruiting controls to check the background of all potential new hires, thus helping to avoid hiring those with a questionable past.

Finally, if possible, try to rotate staff within critical financial areas, such as cash management, accounts receivable and purchasing. This ensures that no single employee can gain too much control over or become secretive about a segment of your business.

Discovering employee fraud in the workplace isn’t easy. Unlike the movies, criminals don’t wear black hats and aren’t accompanied by a sinister theme song when they enter a room. However, with the right tools, you can identify real-life criminals in your office, one red flag at a time.

To learn more about how FSS helps organizations combat and investigate employee fraud, contact us.

 

 

 

 

CATEGORIZED UNDER: News

Business Valuation in a Divorce: Analyzing Cash Flow v. Net Income – Don’t Expect (or Give Away) What Doesn’t Exist

When a couple is divorcing in an equitable distribution or community property jurisdiction and their assets include ownership in a closely held company, the value of the business typically must be determined.

Analyzing the company’s cashflow is imperative during such a valuation. This is true whether the couple tries to establish the value themselves—with or without the assistance of their divorce attorney—or if they hire a professional who is experienced in performing business valuations for divorce purposes.

We have seen many cases where litigants or their attorneys attempt to place a “value” on a business by:

  • using the equity value on a company’s historical cost-based balance sheet (which is equity at book value and not necessarily a reliable indication of fair market value).
  • capitalizing the operating income or net income of the company on the income statement (also called profit and loss statement).

These “quick and dirty” methods may, by mere coincidence, provide a reasonable estimation of the fair market value of the company. However, the uses and management of cash flow are crucial to a business, so the cash flow statement of the company should be examined in conjunction with the balance sheet and income statement.

CASH FLOW STATEMENTS

For companies using accrual accounting to report net income, revenues are recorded when earned—not necessarily when cash is received. Expenses are recorded when incurred-not necessarily when cash is paid, so profit may bear no relationship to increases in cash. A business must have cash to pay bills and make distributions to owners.

A statement of cash flows, which reconciles net income and cash, may be the most underutilized, yet most helpful, schedule in the financial statements of a company.

ANALYZING CASH FLOW AND NET INCOME

Is cash flow or accrual net income more relevant to a business valuation? Consider the following:

Cash Flow (CF) Accrual Net Income (NI)
CF to equity owners is calculated as net income adjusted by non-cash items and changes in working capital accounts on the balance sheet, less capital expenditures, investments, and acquisitions, plus proceeds from new debt less payments on debt. A business can have good cash flow and but not show a profit. NI is calculated as sales minus cost of goods sold, selling, general, and operating costs, depreciation, interest, taxes, and other expenses. A business can report a profit but not have adequate cash flow.
CF is the lifeblood of a business. It is needed to pay operational costs, suppliers, and bankers. If operating CF differs from NI, this indicates that further analysis is necessary. The amount by which revenue exceeds expenses is an indicator of company’s profitability, but not necessarily its cash flow.
CF can be more difficult to manipulate than NI. Calculation of operating cash flow can indicate if working capital was manipulated to boost or decrease NI. NI can be subject to manipulation through steps that impact cash flow, such as tightening/loosening credit policy to slow/boost sales, accelerating/slowing paying suppliers to decrease/increase cash, and others. There will be indications of these types of business decisions in the cash flow statements.

 

HOW EXPERTS CAN HELP

An astute business valuation expert will attempt to isolate any manipulations of net income by interviewing company management and the company’s outside CPA about accounting policies used, operational decisions made, and any changes during the analysis period.

While net income can be subject to manipulation, this is not necessarily an indication of fraud. If fraud is suspected and a financial investigation is determined to be necessary, we suggest our clients hire a certified fraud examiner or forensic accountant.

The analysis of both cash flow and net income are crucial to the valuation of a company. In our work preparing business valuations for divorce purposes , the discrepancy between the net income and cash flow of a company is a frequent reason for divergent expectations of company value between the owner and non-owner divorcing spouses.

A credible business appraiser will analyze the company’s:

  • Assets and liabilities on the balance sheets.
  • Profitability on the income statements.
  • Cash Flows on the cash flow statements.

Analysis of a company’s balance sheets and income statements in conjunction with the cash flow statements will give the most complete indication of a company’s financial performance and health, and provide the most complete suite of financial data to be used in the determination of company value.

To learn more about our business valuation services, contact us for a consultation.

 

 

 

 

 

Calculating Economic Damages: It’s About Far More than the Math

Economic damages are designed to give claimants a chance to recover their financial positions in the wake of injuries caused by another party. To calculate those damages, however, is no easy task. Experts are required to help counsel and claimants build a credible calculation that matches the facts and circumstances of a case and can help tell a story about the data that triers of fact will understand and embrace. 

Without this kind of careful review and analysis, risks can multiply. Speculative projections or cherry-picked numbers that are not rooted in evidence are likely to result in a poor outcome in front of a judge or jury. Further, an expert must clearly understand professional accounting standards, have the right qualifications, and possess excellent communications skills if they are to overcome challenges from opposing counsel.

Calculating economic damages is not a straightforward process.

Experts must consider all evidence in the record—and will be open to attack if they blindly assume a plaintiff’s lost profits are all attributable to the actions of a defendant. They must consider other reasons the plaintiff could have experienced losses.  Failure to consider the sufficient relevant data (a term of art in the CPA’s professional standards of conduct) is a significant reason expert testimony is excluded from cases.

An expert opinion that is illogical or inconsistent with the evidence will crumble under scrutiny and may be excluded by a trier of fact. To avoid this, it is critical for experts to rely upon independent data to confirm that economic damages calculations are reasonable and that they will reconcile with the information available in the case. Also helpful is a strong dose of common sense, as well as the knowledge that data can tell a clear story that can help an expert determine whether a damages calculation aligns with the evidence or relies solely on speculation. 

Economic damages must be computed with reasonable certainty.

An expert should be involved in the discovery process and request information necessary to complete calculations.  Attorneys can be helpful in identifying categories of documents available, but the expert must decide what is relevant for his or her analysis and opinion.  

Often, the specific information that we want to review is not obtainable. In these situations, experts need to determine if there is sufficient relevant data to determine damages to a reasonable degree of certainty.

Independent research can assist in forming the basis of expert opinions and should be used to test the reasonableness of the assumptions and data utilized in calculations. It is important to verify that opinions are logical and supported by sufficient, relevant data.  Reconciling opinions to the realities of the case is a critical element to ensure they will withstand cross examination.

Why could an expert’s opinion be excluded?

An expert must consider sufficient, relevant data in the record or readily available for review. Cherry-picking or ignoring pertinent information allows the possibility of challenges to opinions or the exclusion by the court.  As we have noted, the expert should consider all appropriate evidence in the matter and be sure the story he or she tells is consistent with the events in the record.

An expert must demonstrate that the methodology used is reasonable, generally accepted in the professional community, and/or has been tested by other professionals. Experts must also establish that they have the appropriate level of skill, knowledge, experience, education, and training to offer expert opinions in a court of law.  Failure to make evident any of the above may result in an expert opinion being excluded from evidence.

Takeaway: A damages calculation is no simple matter. 

Calculating economic damages based on a lost-profits methodology is not a straightforward affair. For claimants and their counsel, it is critical to find a professional who understands the relationship between economic damages calculations and the evidence in record.  Equally important is finding the expert who can clearly and effectively communicate that story to a judge, jury, or other trier of fact.

Contact us to learn more about our litigation services.

Financial Fraud Investigations: Why an Employee’s Vacation is a Great Time to Detect Fraud

Time off isn’t just a necessity to help employees recover and regroup, it’s also an opportunity for an organization to measure its efficiency and to uncover vulnerabilities it may face from fraud, waste, and abuse.

Here are just a few of the ways an organization can leverage its vacation and time-off policies to help detect fraudulent activity and prevent—or, if necessary, launch—a financial fraud investigation.

1) Don’t let an employee’s time off go to waste. The first rule of a successful fraud is that it must be hidden from view. Employees who engage in fraud are often adept at using their positions to cover their tracks.

When an employee is away from the office for more than a day or two, another employee should be asked to perform the position’s key functions. If the fill-in employee notices that something isn’t right — for example, the vacationing employee isn’t following company policy or has hidden away key information critical to performing the task — a deeper review is likely necessary.

This kind of check is particularly important for positions focused on accepting or disbursing cash, purchasing goods and services, or receiving or shipping goods. All of these areas are traditional breeding grounds for employee-related misconduct, such as embezzlement fraud.

2) An employee who never takes time off should raise red flags. In an age when tech startups lionize workers for putting in 80-hour weeks and July 5 has been named “National Workaholics Day,” managers might be forgiven for thinking its counterintuitive to suspect employees who refuse to take time off.

However, in financial fraud investigations, examiners routinely find that employees under suspicion go undetected because they have exerted control over the flow of information around their work. Those employees are often the first to arrive at the office and the last to go home, and they rarely—if ever—take time off.

Refusing to take vacation should be seen as a potential red flag. Dishonest employees know that they will be unable to hide their activities if they are gone for more than a couple of days. To fight back, companies can embed a simple solution in their employee handbooks: They can make vacations mandatory.

As we noted previously, during the mandatory vacation period, the company can assign another worker to an employee’s tasks to detect any potential wrongdoing. And the knowledge that a person’s job will be under scrutiny during time away may serve as a preventative measure as well. Employees may be less likely to engage in fraud if they have a reasonable fear of detection.

3) Don’t wait for vacations to rotate job duties. Though a vacation allows an employer the opportunity to perform a spot check to help detect fraud, an organization needn’t wait for time off to rotate job duties.

In areas of particular vulnerability for issues like embezzlement fraud (an accounting department, for instance), a regular rotation of job duties among employees can serve as a strong fraud deterrent. Again, when employees know they will have others picking up where they left off, they are much less likely to use their positions to perpetrate a fraud.

4) Don’t be afraid to go deeper. Simply having an employee take over another worker’s duties may not be enough if managers suspect that a fraud is underway. A forensic examination may be necessary. This may start with a more in-depth review of accounting records and may extend to a suspected employee’s digital and personal activities.

A forensic examination may uncover fictitious vendors, invoices or payments that are consistently just below approval limits, duplicate invoices, and unexpected changes to the volume and amounts of transactions, among other issues.

To learn more about the ways an organization can leverage an employee’s time off to detect and prevent fraud or to discuss a more in-depth forensic examination, contact us for a consultation.

 

 

 

 

 

 

 

In a Financial Fraud Investigation, It Pays to Follow the Digital Footprint

Fraudsters often believe they have covered their tracks so well that their activity is untraceable, but they are increasingly running into a significant obstacle when attempting to hide their crimes: Their digital footprint.

During the last decade, people have integrated digital tools into their personal and business lives at an astonishing rate. Since 2010, for instance, the portion of the global population actively using the web has increased from 27 percent to nearly 60 percent—and the number is climbing rapidly.

And for every text, email, card swipe, social media post, and web surfing session, those internet users are leaving digital breadcrumbs. In a financial fraud investigation, digital records can be crucial in proving fraudulent activity has occurred and can also help financial fraud investigators uncover the size and scope of a fraud and identify who is involved in a scheme.

A DIGITAL STANDARD

Clearly, analysis and interpretation of electronic evidence is now a standard part of a forensic investigation. During a forensic examination, modern fraud investigators understand that no physical evidential paper trail may exist and that fraudsters may be adept at covering up their activity in an organization’s electronic accounting system.

This means the investigator must cast a much broader net. As adept as an alleged fraudster may be at hiding a transaction in an accounting program, they may not know how—or even think—to permanently eliminate incriminating emails and documents from a hard drive or cloud storage system. A voice mail stored on a web-based telephone network or a recorded video call can give them away, as can the remnants of a text message chain.

In fact, a digital footprint is often far larger than a person may anticipate, and it is far more difficult  to cover up than a physical paper trail. Deleting or encrypting messages or documents are not safeguards, as they still provide evidence via the metadata they generate.

SOCIAL CLUES

In a  financial fraud investigation, it pays to look in every electronic corner—even those that, at first glance, may seem the least likely to produce viable evidence of financial misconduct.

This includes social media. A person’s Facebook, Instagram, Twitter and other feeds can actually become something of a goldmine for investigators. Through social media, fraud examiners have access to an abundance of metadata, including timestamps and geolocations. They can examine photos, and parse the content of postings for clues.

People are often so immersed in social media that they often share a wealth of information that can be immensely helpful in a forensic examination. They may, for example, discuss or display major purchases that do not align with their current compensation—and that can trigger a line of inquiry for investigators. They may post on a timeline their whereabouts at a particular moment that contradicts an alibi or that places them in the right location at the right time to commit a fraud.

In the end, the digital portion of a  financial fraud investigation can be critical in halting a fraud, provided one has the expertise to know where to look and how to extract information that may not be obvious to the naked eye. To learn more about how FSS helps organizations combat fraud via digital financial fraud investigations, contact us here.

 

 

 

 

 

 

Business Valuation Calculation Reports: Analyzing Assumptions in Cash Flow Forecast

During my over two decades of working in the valuation profession, I have valued several hundred entities and reviewed hundreds of valuation reports, including business valuation calculation reports, summary reports, and comprehensive valuation reports prepared by other experts.

While I have only infrequently seen valuation theory applied incorrectly, I routinely have seen business appraisers make assumptions in a valuation that could be considered illogical disconnects within the valuation at best—and outright errors at worst. 

Several of these assumptions may be found within the forecast of future cash flows used in the income approach.  Business appraisers must often deal with financial forecasts in their valuation of private companies.  In many cases, management of the company being valued will provide financial forecasts or projections to an appraiser to be used in a discounted or capitalized cash flow model. 

Appraisers preparing a calculation report, summary report, or comprehensive valuation report might:

  • accept these forecasts at face value because management prepared them
  • tweak the forecasts based on the appraiser’s judgement
  • come up with their own forecasts of the company’s cash flow

Regardless of which forecast an appraiser relies upon, there will be several assumptions within that forecast that must be adequately analyzed and supported, or the effect could be overvaluation or undervaluation of a company.  

While there are many assumptions used by an appraiser in a valuation, the assumptions I will focus on for this blog series are forecasts of:

  • capital expenditures, depreciation, and amortization
  • working capital to sales
  • short and long term growth rates
  • use of future debt

These ratios and assumptions are embedded in the forecasted cash flows an appraiser uses in capitalized cash flow or discounted cash flow model  A model of capitalized cash flow or discounted cash flow may be theoretically and mathematically correct, yet not provide a reasonable value due to unreasonable or unsustainable assumptions. 

This is the first in a series of blog posts on assumptions made in cash flow forecasts. In coming posts, I will point out several issues I have observed in my review of cash flow forecasts in business valuation calculation reports, summary reports, and comprehensive valuation reports and valuation models. 

In the meantime, if you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.

How Attorneys Can Effectively Utilize a CPA in a Breach of Contract Claim

Selecting the right expert to calculate economic damages in a breach of contract claim can be critical in the success of an attorney’s case. The expert must be able to calculate damages resulting from a breach of contract and convey the story to a trier of fact in a manner that will make the attorney’s job easier. As CPAs, we can provide independent, objective expert opinions and consult on various issues in a case on an undisclosed basis.

What CPAs do in litigation

CPAs analyze financial information and other relevant data to help clients determine the existence and extent of damages associated with a particular set of facts and circumstances. These analyses are used to develop conclusions about the issues and form the basis of independently calculated economic damage opinions that are defensible in a court of law or another forum.

We are hired to assist in a variety of breach of contract claims:

  • Employment disputes / Covenants not to compete
  • Sales contracts
  • Insurance losses
  • Business interruption
  • Franchise agreements
  • Leases
  • Construction contracts
  • Distributor agreements
  • Lending agreements

We provide additional services beyond the financial analyses expected of CPAs to assist with the breach of contract claim:

  • Assistance with document requests
  • Development of deposition questions
  • Support with responses to interrogatories
  • Review correspondence/non-financial information

FSS assists attorneys in anticipated litigation

Forensic Strategic Solutions provides the analyses that attorneys can use to settle a breach of contract claim prior to filing a lawsuit. Bringing FSS in early to assist, we can assess the facts of the case from a financial perspective to improve the efficiency of the damages calculation.  We determine if quantifiable damages are available for recovery and provide preliminary estimates of a reasonable range.  We also identify critical information required to form a more focused damage calculation.  Setting expectations early can benefit a breach of contract claim by improving chances for a reasonable settlement or determining that trial is the likely remedy.

FSS serves attorneys in litigation

We can be retained as a consulting expert or a testifying expert. As consulting experts, our role is usually never disclosed, so our work is generally not discoverable.  Attorneys can view us as trusted advisors to provide strategic advantages throughout all phases of litigation.

As testifying experts, we will be put forth as your expert witness in the ongoing litigation, and all of our work is usually discoverable.  In this role, we will advocate for our independent opinion and not for the attorney’s client.  Litigation work can be complex, involving high stakes, and the FSS team understands what it takes to provide attorneys with the highest level of professional service in that environment.

Reasons to hire FSS

  • Economic damages analyses and forensic investigations involve complex financial issues. FSS has professionals with the skill to explain these subjects in a clear and concise manner so a trier of fact can understand clearly as we present our opinions.
  • FSS has credentialed professionals with the knowledge, experience, education, and training to provide credible opinions and defend them under intense scrutiny.
  • Our professionals use some of the most advanced technology to develop our work product. This not only enables us to be highly efficient, but we are then able to use that technology to aid in telling the story to the trier of fact.

When should an attorney hire FSS?

The earlier we are brought into a case, the greater the likelihood that we will be able to proceed with the highest level of efficiency.  While cost is usually a consideration, early involvement reduces wasted time and the pursuit of fruitless theories, and generally results in lower fees to the client.  We are able to assist managing the process from the outset, as opposed to dashing to the finish line with a reduced ability to leverage.

FSS manages fees for the client by:

  • Implementing budgets and workplans
  • Performing work in phases, allowing the client to control spending
  • Billing on a regular basis to avoid any surprises

Learn more about how FSS can add value to a breach of contract claim or other litigation involving economic damages here.

 

 

 

 

 

 

 

Business Valuation in Divorce Cases in a COVID-19 World, Part I: An Overview of Active Passive Appreciation Analysis

The impact of COVID-19 on the value of private company interests is being actively explored and discussed nationwide by business valuation professionals, their professional trade associations, and users of business valuations (e.g. attorneys).

Because COVID-19 can materially impact the value of a private company, consideration must necessarily be given to the impact of COVID-19 on an active passive appreciation (APA) analysis in a divorce case. This post is the first in a series exploring and addressing the impact of COVID-19 on APA.  While divorce cases include consideration of both business and non-business assets and liabilities, the focus of these posts will be on the business valuation in divorce cases involving the interests in private companies.

Given that COVID-19 continues to have an active impact on the U.S. and global economies and is dramatically affecting operations for public and private companies in some industries, consider these posts a work in progress and subject to revision as more information becomes available.

APA: A General Overview

An APA analysis is performed when state divorce law requires a determination of whether, and under what circumstances, value changes in a non-marital or separate business, occurring during a marriage or between the end of the marriage and the divorce trial, might be recharacterized in whole or part as marital property.

The business appraiser performing an APA analysis looks to their engaging legal counsel to define and interpret state law in the particular jurisdiction pertaining to APA, including any state-specific definitions of key terms (“marital property”, “non-marital property”, “separate property”, “divisible property”, etc.).  Given the variety of APA-related terminology utilized in divorce statutes and case law of various jurisdictions, references in this and subsequent blog posts are intended to refer to general concepts typically found in an APA context, rather than try to cover all of the jurisdiction-specific definitions and nuances of terms.  In these posts, general definitions are provided where necessary for clarity.

In practice, the non-marital or separate business interests (henceforth “Separate”) that are the subject of APA analyses are typically businesses already owned by one spouse prior to the marriage, or gifted or bequeathed to one of the spouses during the marriage

Whether changes in value of Separate businesses identified in an APA analysis are reclassified as marital property (henceforth “Marital”) is jurisdiction-specific and can depend upon factors including, but not limited to:

  • The cause(s) of the value change; and,
  • The timing of the value change:
    • Whether any change in Separate business value occurred between the date of marriage (“DOM”) and the date of separation (“DOS” – in some jurisdictions called the Date of Filing); and,
    • Whether any change in separate business value occurred after the DOS but before the date of distribution (“DOD” – in some jurisdictions also called the Date of Trial or “DOT”).

APA Overview – Active vs. Passive

Commonly recurring requirements in some jurisdictions are that value changes in Separate businesses can be reclassified as Marital based in part upon the cause(s) of the value change along with the timing of the value change, as follows:

  • Separate business value changes between the DOM and DOS:
    • Typically become Marital property to the extent they were caused by marital efforts or marital funds (often called “Active Efforts”).
    • Typically remain Separate property to the extent they were caused by factors OTHER than marital efforts or marital funds (often called “Passive Factors”).
  • Separate business value changes between the DOS and DOD:
    • Typically remain Separate to the extent they were caused by Active Efforts.
    • Typically become Marital to the extent they were caused by Passive Factors.
  • Note that in such jurisdictions, a “flip” occurs depending upon whether the measurement period is between the DOM and DOS or between the DOS and DOD:
    • Separate business value changes between the DOM and DOS caused by Active Efforts can be reclassified to Marital property;
    • Separate business value changes caused by similar Active Efforts between the DOS and DOD often remain Separate property.
    • State statute and/or case law sometimes explain this “flip” by referring to the concept that the period between the DOM and DOS is a period of an economic partnership in addition to being a marital partnership, but that the economic partnership ceases when the marital partnership ends (the DOS).

APA Overview – Hypothetical Illustration

The following graph illustrates hypothetical changes in Separate business value between the DOM and DOD.

 

 

  • The total business value is reflected by adding the blue, gray and orange areas on the graph. In this graph, the DOM business value is approximately $17 million, which increased to approximately $28 million at the DOS and approximately $38 million by the DOD.
  • The blue area reflects the cumulative DOM value, which is unchanged during the period from the DOM through the DOD.
  • Hypothetically assuming that active efforts by the owner spouse caused 75% of the value increase for the entire period from the DOM to the DOD, and that factors OTHER than active efforts by the owner spouse caused 25% of the value increase for the entire period from the DOM to the DOD:
    • The gray area reflects the cumulative increase in the Separate business value that remains separate property.
    • The orange area as of the DOS reflects the cumulative increase in the Separate business value between the DOM and the DOS that can be reclassified as marital property. Some jurisdictions characterize this amount as the part of the Separate business value increase in which the non-owner spouse gains an “equitable” Marital interest.
  • The DOS is designated in the graph as the point at which the “flip” occurs:
    • The gray area of the graph grows more rapidly than the orange area post DOS, since all of the Separate business value increase caused by the active efforts of the owner spouse post-DOS is allocated to Separate property. Increases in Separate business value post DOS caused by active efforts of the owner spouse remain Separate property.
    • The orange area of the graph grows more slowly than the gray area post DOS, as only the allocated part of the post DOS business value increase caused by factors OTHER than active efforts is allocated to Marital property. Increases in business value post-DOS caused by efforts OTHER than the active efforts of the owner spouse can become Marital property.

 

Now that a foundation for APA analysis has been laid, our future blog posts will address incorporating the impact of COVID-19 in APA analyses.

If you are interested in more information regarding business valuation in divorce cases, how you can strengthen your case with a business valuation and active passive appreciation expert, or want to learn more about our services and our team, please contact us.

Unlocking the Potential of Electronically Stored Information to Determine Lost Profit Damages

At many small businesses, it’s not uncommon to still find a mass of paper records, yellowing with age and haphazardly tossed in boxes, as well as old-school computers and dot-matrix printers with tractor feeds and green bar paper.

Yet even the most unorganized and technologically unsophisticated small business may contain a trove of useful electronically stored information (ESI) that can prove crucial in determining economic damages in a case or in providing evidence in a financial fraud investigation. 

The first and most basic step is to determine whether such data exists at a business. If in doubt, consider this question: Does the business have documents that look as if they’ve been printed from a computer? If those documents have telltale headers and footers that indicate they are generated from a computer system, then the business likely uses computers regularly and probably possesses valuable ESI. 

KEY CHALLENGES

Many small business owners and employees, as well as their attorneys are unaware of the types of ESI available that could be the key to their case.  Persistence, creativity, and knowledge are necessary to unlock the potential of a small business’ electronically stored information.

Three primary challenges are often encountered with small business ESI:

  1. The information may be stored on archaic hardware and/or software.
  2. The business owner and employees lack technological savvy and may be unaware of the type and extent of data that is present on their system. They are often adamant that no useful ESI is available from their system because they have had difficulty or even failed in trying to extract information.  
  3. Small businesses generally have limited resources, and their personnel usually do not have the expertise to extract relevant useful data from an outdated system.

A FIGHT OVER GAS

Consider this example concerning identifying and obtaining forensic evidence from a small business to help determine economic damages. Green Fuel was a small gasoline distributor that provided fuel to local gas stations. The owner, a gentleman in his late 70s did not own a computer, and he had a limited office staff that included an accounting clerk and a manager. 

Green was a defendant in a state court case where numerous claims were made by Morris, a gas station owner. Morris alleged that Green overcharged him for fuel delivered to Morris’ two small-town gas stations during an eight-year period. Morris claimed that Green failed to transact business pursuant to their contract, and as result, Morris suffered economic damages of $1 million dollars arising from overcharges and a failure to share profits as specified by their contract.

At first glance, both parties appeared to have inadequate documentation of fuel deliveries and payments.  The only documentation maintained by the gas station owner, Morris, was a sparse set of paper receipts and logs regarding fuel delivery.  

Moreover, Morris’ stations used unsophisticated point-of-sale cash registers and did not utilize a computer system to maintain accounting records or other records of fuel deliveries.  Morris said in his deposition that he relied on Green to keep detailed records of fuel orders and deliveries and that this allowed Green to overcharge him.

Green’s documentation of fuel deliveries was only slightly better than those of Morris.  Although Green used an antiquated DOS-based computer system to maintain limited accounting records, Green’s management vehemently maintained that no electronic record existed of fuel delivery or receipt of payment.

HIDDEN ESI

The Green case epitomizes not only the challenges faced in extracting useful forensic evidence in small businesses, but also the need for persistence in seeking ESI.  Left with such sparse information to determine losses, the attorneys for both parties were highly doubtful that any meaningful analysis of the transactions could be conducted.

A deeper review of the parties’ sparse documents revealed Green electronically produced invoices for fuel sales to Morris. This was a telltale sign that Green more than likely did have ESI available despite its claims to the contrary.  

The issue became not only convincing Green that the information existed, but also helping Green and its attorneys understand how it could be retrieved. An ESI challenge like this is rarely accomplished through force or the use of highly technical jargon; rather, success comes through understanding and observing key personnel’s daily routines and processes.

Information-seeking interviews with personnel that regularly use the computer system—such as the accounting clerk or administrator in this case—are a good place to start.  Interview questions should seek to understand of the daily routine, including the functions regularly performed, and the tools used to accomplish those functions.

Observation of the performance of key functions will also aid in gaining an understanding of the computer system and the software programs used.

In the case of Green, the interview required a few hours with its accounting clerk to observe her daily routine, including the data processing of fuel deliveries, creation of computer-generated invoices and subsequent processing of payment receipts.

AN EXTRACTION PLAN

At the completion of the interview, a plan was developed to extract the data from Green’s archaic system, which required a multi-step process including the use of more advanced technology.

A detailed discussion of the process is beyond the scope of this blog post, but let’s just say that Green’s system was able to provide electronic records of the gallons of fuel delivered to Morris, the date, and the amount charged – for all eight years.

With the ESI extracted from Green’s database, Morris’ economic loss claims were analyzed using two methods:

  1. Contract Method.  The analysis of the ESI focused on the terms as specified by the contract. This analysis revealed Morris was not economically damaged, and that, in fact, he had underpaid Green in excess of $1 million.
  2. Actual Performance Method.  The analysis of the ESI focused on the way business was actually transacted revealed that Morris underpaid Green in excess of $700,000.

A LETHAL BLOW

The analysis of relevant ESI dealt a lethal blow to Morris’ claims.  Initially, Morris’ claims seemed somewhat feasible due to the lack of data, and Morris’ made a bet that Green would never be able to organize and analyze the data to disprove his claims.

Morris also had no way to prove his claims with reasonable certainty, but by using electronic data analysis, Green was able to disprove the claims — and actually determine that he was owed money. The end result: Morris dismissed his claims against Green just two weeks after the findings were revealed to his attorneys. 

It’s an example that, even in the most technologically backward of businesses, it pays to find the electronic record and dig into it as deeply as possible to prove or disprove economic damages or to aid a financial fraud investigation.

To learn more about ways we help businesses and their counsel extract critical ESI, contact us for consultation.