Eight Tips for Detecting Fraud in Accounts Payable

According to the Association of Certified Fraud Examiners 2018 Report to the Nations, fraudulent disbursement schemes remain the costliest form of asset misappropriation fraud to threaten small businesses. Although this risk can seem overwhelming, it may be avoidable through taking proactive steps against fraud within your company.

Here are eight tips to help you expose this popular employee fraud scheme:

Rotate Accounts Payable Employees

A fresh set of eyes is a great way to expose unusual patterns in vendor invoices. If your company has more than one accounts payable clerk, each one is likely responsible for the processing of a set group of vendors. Consider rotating these employees across vendor groups to keep their perspective fresh.

Require Mandatory Vacation for Employees

Concealment is the modus operandi of fraud. Requiring employees to take vacation helps remove the opportunity for concealment and exposes unexpected patterns and irregularities. Remember: an employee who is hesitant or unwilling to leave the office may have something to hide. Don’t ignore this important red flag.

Vendor Review

You can expose fictitious vendors and conflicts of interest by analyzing employee information alongside the information of approved vendors:

  • Compare employee addresses to vendor addresses to identify payments directed to an employee’s home.
  • Compare vendor tax identification numbers to employee social security numbers.
  • Fuzzy matching can identify vendors and employees that have the same street and city.

Approval Limits

Vendor invoices or payments just below a pre-set approval limit is a common method to circumvent approval controls. The analysis of payments or vendor invoices just below the limit can expose transactions that require additional examination. If, for example, your company requires management approval for purchases over $2500, vendor invoices of $2499 should sound an alarm.

Duplicates

When searching for fraud, duplicates are anything but twice as nice. Duplicate invoice numbers and invoice amounts from a single vendor can be an indicator of a disbursement scheme. This can also occur by utilizing duplicate invoice amounts submitted on the same date but under different invoice numbers. Using a data mining software, run a twist on a duplicate test by searching for “Same, Same, Different.” For example: same vendor number, same invoice amount, same invoice date, different invoice number. And don’t forget to search for duplicate vendors and duplicate payments to vendors!

Gaps

Beware of gaps in pre-numbered business records that should be sequential. Checks written for the payment of vendor invoices are a perfect example. If you identify missing checks, review your accounting system’s audit log and bank statements to ensure the missing checks haven’t cleared the bank.

Irregular or Unusual Transaction Dates

Most business offices operate during a traditional Monday through Friday 9-to-5 schedule. A search that reveals transactions processed on nights, weekends, and holidays deserves an extra look, as an employee could be conducting nefarious activities during non-business hours. Be sure to run a similar search on invoice dates and check dates.

Unusual Activity

Unexpected changes to the dollar amount and frequency of transactions with a vendor or within a department of your business can be a warning signal for fraudulent activity. Search for and analyze rapid or unusual changes on a monthly and annual basis. This continual evaluation will not only uncover possible fraud, but also alert potential fraudsters that you are vigilant about detecting unusual activity. Additionally, analyzing activity by budget cycle may expose additional patterns.

When combined with the review of supporting documentation, these eight tips can go a long way in uncovering fraud in accounts payable. Remember: fraud detection is best conducted through early and proactive efforts. By putting these tips into action now, you may protect your company from devastating financial and reputational damage in the future.

Brilliance v. Ethics – Which One Wins?

Originally published by ACFE Insights.

Smart people commit fraud every day. A recent case gives us a prime example.

A federal judge asked Donald Watkins, Sr. to step away from the jury box as Watkins, Sr. made an impassioned plea in his closing argument. Watkins, Sr. was in the personal space of front-row jurors, who were clearly agitated and restless as they leaned, twisted back and forth and from side to side to move away from the attorney. Watkins, Sr. was pointing his finger at the jurors and leaning directly into them.

In their March 2019 fraud trial, Donald Watkins, Sr. and Donald Watkins, Jr. were both convicted of defrauding investors of more than $10 million. An FBI agent described both as “financial predators who truly represent pure greed.”

Condoleezza Rice, the Rev. Martin Luther King III and former Birmingham mayor Richard Arrington, Jr. testified for the prosecution at the trial. Former NBA star Charles Barkley also testified, as he is a former friend of Watkins. In over a decade, Barkley invested more than $6.1 million and “never got a dime back.” Other professional athletes also invested with Watkins and have not been repaid. According to prosecutors the investors were given “materially false and fraudulent pretenses, representations, and promises.”

The guilty verdict was delivered in the same Birmingham, Alabama, courthouse with the same federal judge as the infamous Richard Scrushy case. On June 29, 2005, Scrushy, founder and CEO of the $2.7 billion fraud-ridden HealthSouth Corporation, walked out of Federal Judge Karen Bowdre’s courtroom a free man — represented by Waktins, Sr. Scrushy was the first CEO indicted and tried under Sarbanes Oxley.

How did Scrushy make it out of the courtroom unscathed? Prior to the trial, Scrushy bought a local public television station, from which he and his wife produced a religious evangelism program. Soon, Scrushy became a lay minister, preaching at local churches and reportedly making large contributions to the congregations. This trial strategy, a strategy of positive image and strong community outreach, worked in securing an acquittal.

Unfortunately, Scrushy did not fare as well when, four months after his acquittal, he was indicted in a political corruption scandal with the governor of Alabama. Both Scrushy and former governor Don Siegelman were convicted of a political conspiracy in a federal criminal court in Montgomery, Alabama. Both were sentenced to over five years in federal prison.

Scrushy also received a bitter defeat in a later civil case. While incarcerated in 2009, a state court judge ruled “Scrushy was the C.E.O. of the fraud” at HealthSouth. The judge awarded a $2.8 billion judgement to the stockholders of HealthSouth against Scrushy.

By all accounts, Richard Scrushy was regarded as brilliant. He built a Fortune 500 company from scratch (albeit, by fraudulent means) and grew his self-proclaimed net worth to more than $600 million. But, after his criminal conviction and civil judgment, he lost his wealth and his freedom. Clearly, in this battle of flawed ethics vs. brilliance, Scrushy’s flawed personal ethics emerged victorious.

Donald Watkins, Sr. orchestrated his own defense in his fraud trial. The indicted 70-year-old attorney represented himself and testified as a defense witness. He would ask himself questions, then answer those questions. Unsurprisingly, this proceeding was exceedingly strange — the prosecutor even objected that Watkins was asking leading questions!

Watkins, Sr., who had developed a national reputation by representing Scrushy and the City of Birmingham’s then-mayor, Richard Arrington, Jr., was reported by several news sources to be a billionaire. According to Watkins, Sr., he was “certified by Goldman Saks” as being qualified to make a bid for the St. Louis Rams football team. Like Scrushy, however, Watkins’ alleged wealth and intellect met a test of brilliance v. flawed ethics.

The November 2018 indictment against Watkins and his son was filed after a 2016 SEC civil suit claiming Watkins duped investors into paying millions of dollars to a bank account controlled by Watkins, Sr. Rather than being used to finance the growth of two international companies, the funds were used to finance an elaborate personal lifestyle, paying for personal expenses such as American Express bills, private jet expenses, taxes, alimony, clothing and personal loans.

On March 8, 2019, the federal jury in Birmingham, Alabama returned a verdict of guilty on all 10 counts of the indictment against Watkins, Sr., along with a guilty verdict on two counts against Watkins, Jr. Sentencing for both men is set for July 16, 2019. In this battle between personal ethics and brilliance, flawed personal ethics again emerged the winner.

At FSS, we are a team of certified fraud examiners, certified public accountants, investigators and forensic technology experts – learn more about our work here.

Auditors Who Stole the Exam Are Convicted of Fraud

This failure of duty matters – it violates public trust and costs innocent people their jobs, their pensions and above all – faith in a system.

The Wall Street Journal reported on March 11, 2019 that David Middendorf, the former national managing partner for audit quality and professional practice at KPMG, and co-defendant, Jeffrey Wada, former employee of the Public Company Accounting Oversight Board (PCAOB), were convicted in a Manhattan federal court. The federal prosecutors termed their actions a “Steal the Exam” conspiracy.

In a previous blog about the trial, I described why this violation of trust matters, and why auditors must design audits to detect fraud.

We’ve all heard stories about students stealing exams. Years ago, when I was a young auditor, a student who had passed the CPA exam was discovered taking the exam for other candidates. In response, the controls to monitor the exam were changed.

That CPA was expelled by the state board, but on appeal, was surprisingly allowed to keep his CPA certificate. He then got a degree to practice law. Perhaps I was naïve in thinking this was an anomaly and would not happen again. Now, we have the case of the auditor and the regulator who oversees the auditor both being convicted of fraud.

Auditors have received a lot of publicity about their failures to detect fraud. Just a year ago in March 2018, Federal judge Barbara Rothstein ruled that Big 4 accounting firm PwC failed to design their audit to detect fraud at Colonial Bank, resulting in the bank’s failure. She entered a judgment of $625 million against the firm.

When auditors don’t design an audit to detect fraud, unfortunate circumstances may result – the failure at Colonial Bank cost thousands of employees their jobs; stakeholders lost their entire investment; all lost their retirement savings, and some lost a fortune in Colonial stock.

When the KPMG auditors stole the exam and knew which audits would be reviewed by the regulator, they took actions to cover their failures. KPMG wanted to improve their performance on inspections because they had performed poorly in past reviews.  For example, they were under close scrutiny by the SEC for their failure to detect problems at GE and Wells Fargo.

Rather than focus efforts on improvements such as performing their work at an acceptable level of care and committing to higher-quality work, the defendant at KPMG took an easier approach – he illegally obtained knowledge of which audits the inspectors would review, and made poor work appear better than it actually was.

We now see a fraud scheme where we didn’t expect to ever see one – among the group whose duty it is to detect it. And this is a question of ethics – both personal ethics and business ethics. I don’t see how you separate the two. How does this happen? As a fraud examiner, I was taught the Fraud Triangle. One of the three legs of the triangle is rationalization – the mindset of a person who rationalizes their fraudulent action. However, I will never understand how fraudsters rationalize these actions!

Auditors must be taught how to recognize fraud – and we have a mandate to teach them. Unlike a cat who attempts to cover its tracks, cover-ups and stealing the exam are unacceptable. It is simply fraud.

For information about our accounting malpractice work, contact us today.

Cash Flow and Fraud Go Hand-in-Hand

Imagine working at a company for a period of time, checking your bank account and realizing that no paycheck had been deposited in exchange for your work. This scenario would undoubtedly raise red flags. Similarly, cash flow analysis performed by lenders and auditors that reveals stagnant or negative cash flow can also serve as a warning sign that something is awry – and it could be fraud.

Cash flow is a significant indicator of a company’s overall health and operations. It allows investors, lenders and auditors to gauge the relative stability of a company by assessing its ability to avoid excessive borrowing, grow its business and endure hard times. Merger and acquisition professionals, business appraisers and lenders are keenly interested in the free cash flow of an organization. Auditors should be particularly aware of free cash flow and its ramifications, especially in designing an audit to look for fraud.

It is imperative to note how cash flow increases as sales increase, since both should be moving at a relatively consistent rate. This analysis can be conducted using a ratio of net operating cash flow to net sales, which shows how many dollars of cash are produced by each dollar of sales. Remember: the higher the percentage, the better.

2010 2011 2012 2013
Operating Activities:
Net Income (loss) (76,604) (64,815) 4,385 52
Adjustments to reconcile net income (loss) to net cash from operating activities:
Depreciation of property & equipment 41,501 37,235 36,535 38,085
Loss on Sales of Equipment 10,895
Decrease (Increase)
Inventories (107,265) (2,809) (88,442) (97,986)
Accounts receivable, net and other 164,231 (810,465) 376,837 (198,482)
Deferred Income Tax Benefit 202,360 (15,666) 48,710 10,620
Other Assets 16,502 (13,333) (22,318) 13,860
(Decrease) Increase in:
Accounts payable 207,525 523,501 (367,398) 42,004
Accrued expenses and other (62,082) 33,047 (22,746) (5,185)
Deferred Income Taxes Payable (8,673)
Franchise Tax Payable 3,277
Deposits on Hand (205,000)
Prepaid Deposits (16,255) 174,005
Net cash provided by (used in) operating activities 172,495 (310,028) (39,797) (23,027)
Total Net Sales 1,106,112  1,156,410  1,299,210  1,946,820
Operating Cash to Sales Ratio 16% -27% -3% -1%

 

In the table above, the operating cash to sales ratio is low, and cash is decreasing despite sales increasing. Cash that is stagnant or decreasing when sales are increasing should set off alarm bells for anyone, especially an auditor. Fraud and cash go hand in hand. When there is a cash flow pattern such as this, it is probable that there may be fraud lurking under the surface.

Companies often have an asset-based revolving line of credit in which the company receives loan advances based on a set percentage of asset balances such as accounts receivable. The gross receivables are typically reduced by receivables 90 days and over to calculate the eligible receivables balance as the borrowing base. This balance is then multiplied by the agreed advance rate (usually between 75 and 85 percent) to arrive at the available loan advance amount.

A common fraud scheme related to this type of lending arrangement occurs when a company inflates accounts receivable to increase their borrowing capacity. While this can be executed in a variety of ways, the cash flow analysis shown above would reveal that something is amiss. For example, assume a company generates fake receivables to increase its borrowing base. After the fake receivable goes over 90 days old, the receivable is written off and the borrowing base is decreased – the company now must pay down its loan. Typically, to continue the fraud scheme, the company will then create a new receivable to replace the old fake receivable in order to maintain a level borrowing base. Once the company finds that this scheme works, it will then create more false receivables and begin a cycle which generates cash flow through fraudulent bank loans. Thus, a negative or lower cash balance will exist because receivables should have generated cash, but did not.

Auditors should always follow the cash when evaluating a company. External auditors are required to plan an audit to detect fraud. Internal auditors and regulators should also include this procedure cash flow analysis in their audits as a “best practice.” Cash decreasing despite an increase in sales could be an indication that fraudulent activity is occurring – and prudent auditors will find this procedure invaluable on their path to determine the source of the cash flow problem.

For more information on cash flow, visit our blog center. Learn more about our work here.

Big 4 CPA Firm Knew in Advance Which Audits Would Be Inspected by Government Watchdogs

This is violation of trust, and it matters!

Auditors must design their audits to look for fraud, and failure to do so may cause massive losses for stakeholders, investors, creditors and retirees. Neglecting to detect fraud can be truly life-altering — especially for retirees.

While teaching a business ethics class in Jackson, Mississippi, I was approached by an employee of the former fraud-ridden company Worldcom. “Emily Simmons” (an alias) and her husband, “Jim”, both of retirement age, had worked at Worldcom and its predecessor companies for over 30 years. Their combined retirement plans (all in Worldcom stock) previously had a value of $3 million. After the fraud was discovered, the plans were worthless.

With tears running down her face, Emily said to me, “Jim and I cannot retire. I was looking forward to a comfortable retirement and helping my daughter raise my grandchildren. Now I can only visit them twice a year. I hope that one day I’ll have some sort of retirement – although I am not optimistic – where we can spend a little time together before Jim and I die.”

Time Magazine’s 2002 “Woman of the Year” Cynthia Cooper and her team of internal auditors at Worldcom blew the whistle on Worldcom CFO Scott Sullivan and CEO Bernie Ebbers. The fraud unraveled, the perpetrators went to jail and Worldcom – along with its value – ceased to exist. Because of the Worldcom fraud, Section 404 of the Sarbanes Oxley Law was written, requiring companies to have much stronger internal controls and for those controls to be tested by auditors. But these requirements did not help Emily and Jim.

The Sarbanes Oxley Law (SoX) was enacted in 2002 by Congress in response to the massive fraud schemes that occurred at Worldcom, Enron and HealthSouth, among others. In SoX, Congress established the Public Company Accounting Oversight Board (PCAOB) as the government watchdog to oversee and regulate public accounting firms who audit and report on publicly traded companies. Previously, these firms were self-regulated. The leadership of PCAOB consists of a five-member board, appointed by the Securities and Exchange Commission, whose duty is to oversee audits of public companies with yearly exams to protect investors and the public interest.

A recent case has brought into question the integrity of both auditor (KPMG) and government watchdog (PCAOB). KPMG has been under intense scrutiny for years for failing to find problems at audit clients such as General Electric and Wells Fargo. When the PCAOB recently issued long-awaited reports on examinations of KPMG, it was disclosed that almost half of the audits had serious deficiencies. Two previous PCAOB inspections of KPMG were compromised by the firm’s advance access to the information. When the PCAOB replaced some KPMG audits it previously reviewed with new ones, the new audits had a much higher rate of problems. This illustrates the extent to which the advance access helped KPMG.

So, does it matter that “Big Four” accounting firm, KPMG, knew in advance which of its audits would be inspected by the PCAOB? You bet it does, because SoX was enacted to regulate a former self-regulated industry when it comes to publicly traded companies. Now the watchdog has been compromised.

KPMG fired David Middendorf and other KPMG partners accused of being involved when the PCAOB information leak was revealed in 2017. Middendorf was directly responsible for dealing with the PCAOB. He is now a defendant in a federal criminal trial that started February 11, 2019, in Manhattan. He faces charges of wire fraud and conspiracy. Former inspections leader at PCAOB, Jeffrey Wada, is a second defendant in the trial.

Three other defendants have pled guilty and are expected to testify against Middendorf and Wada. One of the now-convicted felons is a former KPMG partner who helped oversee audit quality at the firm and another partner who formerly worked at PCAOB before joining KPMG.

This story is important because the individuals who are supposed to be guardians of innocent people like Emily, Jim and thousands more have been let down. Auditors are supposed to ferret out frauds and protect stakeholders, creditors, investors and retirees. Unfortunately, we are now left to question those who have a duty to protect – both the auditor and the watchdog.

Last week, it was gratifying to read a post on LinkedIn by Richard Chambers, CEO of the Institute of Internal Auditors. Richard reminded internal auditors of the important role they play, and reminded them that, “I am respected and admired, because I am a guardian of trust!”

I heartily commend Richard Chambers for imparting this message to auditors, and I suggest that all auditors adopt this moniker. “Guardians of Trust” instills a sense of pride, because all business and individuals in the private and public sectors want assets safeguarded, and to know that someone is watching over the operation to see that those assets are protected. Sometimes, unfortunately, unscrupulous individuals and firms will be tempted to put their hand in the cookie jar – we call them thieves and fraudsters.

The story of the criminal trial involving the KPMG partner and PCAOB inspector is extremely relevant to those in our industry. This is a high-profile scandal which may have helped a “Big Four” accounting firm look better to its regulator — and hurt average people like Emily and Jim. It is up to the rest of us to do better, and take up the mantel of “guardians of trust.” If we fail to do this, the vicious cycle of fraud will undoubtedly continue on for years to come.

Capital Expenditures, Depreciation and Amortization in a Cash Flow Forecast and the Impact of the New Tax Law

The US Tax Cuts and Jobs Act (“TCJA”) passed by Congress on December 20, 2017, will impact forecasts of a company’s cash flow and thereby will likely impact the valuation of a company. One of the forecast elements impacted is the forecast of capital expenditures, depreciation and amortization.

The lowering of the C Corporation income tax rate from 35 percent to 21 percent will have a positive effect on the cash flow of affected corporations, all else held constant. With less cash going to pay taxes, more cash will be available for other uses, including capital expenditures (“capex”). This necessitates an increased scrutiny of a capex forecast, as recent historical expenditures may no longer be relevant as an indication of expected future expenditures.

The TCJA also allows for a first-year bonus depreciation of 100 percent — it was 50 percent prior to the TCJA — for certain qualified tangible property placed in service between September 28, 2017, and December 31, 2022, that has a depreciable life of up to 20 years. Generally, this bonus depreciation then declines in subsequent calendar years (exceptions for certain property):

2023 80%
2024 60%
2025 40%
2026 20%

The impact of these tax law changes will not be reflected in book basis depreciation calculations that appear in US GAAP financial statements; therefore, it is necessary for projections to be on a tax basis if they are being used for an income approach in a valuation of a business.

Business valuation analysts must be aware that the TCJA will cause the relationship between capex and depreciation to have an irregular pattern, and it will affect a much longer projection period than both company management and the valuator may be accustomed to preparing and analyzing. A longer forecast period is necessary due to the impact of timing differences on the present value of forecasted cash flows.

The always-important issue of normalizing capex and depreciation for the terminal period in a discounted cash flow model is further complicated by the depreciation provisions in the TCJA. A valuation analyst may address the issue by using a multi-stage model and capturing the depreciation provisions of the period 2018-2022 in the first stage, 2023-2027 in the second stage, and the length of the third stage being a function of the lives of the company’s assets. A valuator may also normalize the capex/depreciation for the terminal period in the year following the end of the projection period, and then separately adjust for the present value of the remaining TCJA induced capex/depreciation differences. The tax benefit of the amount not captured in the projection period would be calculated and then present valued over its remaining life at the terminal year. This amount would be added to the value of the company obtained from the discounted cash flow model. A valuator may use other multi-stage models customized for the type and lives of a company’s assets.

Overall considerations when forecasting capex/depreciation/amortization are as follows:

  • Normalized future capex would typically be greater than depreciation in a projection for a growing company, to allow for inflationary growth in the replacement cost of fixed assets.
  • Amortization has a limited life and should not be projected into perpetuity. The tax benefits of amortization subsequent to a projection period should be valued separately from the terminal value and added to the enterprise value.
  • The tax benefit of the depreciation on long-lived assets subsequent to a projection period would be treated and calculated similarly as amortization.
  • Due to the effects of provisions of the TCJA, valuation analysts must consider:
    • Obtaining or preparing longer-term schedules of capex/depreciation forecasts;
    • Building multi-stage models that account for the present value of changes in cash flow based on the depreciation provisions; and,
    • Reviewing all management-supplied information for reasonableness and internal consistency, as other changes in the TCJA could also impact forecasted cash flows.

If you are interested in learning more about how you can strengthen your case with a business valuation expert or want more information about our services and team, please contact us.

The Power (and Variety) of Data in Forensic Investigations

Time and time again, we trumpet the incredible value of advanced data analytics in forensic investigations – often, it is the key to finding the needle in the haystack. Fortunately, our firm remains at the forefront of utilizing data to identify unexpected patterns when investigating financial fraud – that red flag that tells us something isn’t as it should be – whether for a qui tam case involving kickback schemes or a case of underreported revenue. While we’ve discussed the importance of data analytics in a past blog, it’s also important to understand the variety of data that’s available and why you should enlist an expert to help translate the immense amount of information.

There are two general categories of data: structured data and unstructured data. While there are critical differences between the two, it’s crucial to understand how their distinctions work in concert to help us put the pieces of the puzzle together.

Structured Data

Structured data includes information that is highly organized and transactional in nature, like accounting system data and bank account data. By its nature, structured data is readily searchable.

Without data analytics, anomalies in structured financial data can be difficult to detect – but with the right tools and a little knowledge, implementing analytical techniques can bring forward the evidence needed. Here’s a key example: FSS worked with a school district that had a control in place that limited funds that could be transferred without board approval to $50,000. Knowing this, we searched for transactions of exactly $49,999. We found that one of our persons of interest had transferred this exact amount 48 times within 60 days.

Thanks to the structured data and an understanding of the organization’s policies and procedures, we easily honed in on this anomaly among millions of transactions – something that couldn’t have been accomplished without the use of data analytics.

But what if there is more to the story — what if more questions need answers?

Unstructured Data

While structured data is, well, structured – unstructured data is essentially the opposite. Structured data plays a key role in data analytics, however, we continue to see the rise of unstructured data to bring context to our cases. The analysis of this “nontraditional” data can help investigators follow the electronic trail often left behind by wrongdoers. Unstructured data includes:

  • Email
  • Text messages
  • Social media
  • Public records
  • Word documents
  • PDF’s
  • Presentations

As time goes on, forensic investigators will be forced to branch out beyond traditional analytics. The use of advanced data analytics with the combination of structured and unstructured data can give investigators a broader understanding of their subject and can help uncover a wealth of evidence that may go undetected when only considering traditional data sets. Advanced data analytics can be particularly useful when faced with incongruent information systems or spotty evidence.

Validating & Comparing Varied Data

Recently, FSS was hired to investigate whistleblower allegations that a company violated the Anti-Kickback Statue and submitted false claims to the government.

This qui tam case involved a company that worked alongside a third-party organization that provided goods to customers in exchange for referrals. Allegedly, the company paid the third-party organization a percentage of the compensation they received from the federal government as a result of the referrals. As part of this investigation, FSS requested and analyzed the following data:

  • Transaction details used to submit claims to the government from two disparate billing systems (structured data)
  • Word documents and PDF records of purchases from vendors of goods provided to their customers (unstructured data)
  • Emails between the company and their customers requesting and acknowledging receipt of the goods (unstructured data)

Through the testing and analysis of this disparate data, FSS was able to identify evidence that customers were incentivized to do business – and that the third-party company was paid kickbacks. The structured data was used to establish that the claims were submitted to the government. The unstructured data was then used to compare against the structured data – allowing us to draw the connection among the incentivized referral (goods provided to the customer), claim submission to and payment received from the government, and commission payment to the third-party organization.

Without access to the varied types of data and the use of advanced data analytics, it would have been much more difficult to develop the evidence and reach our conclusion.

The Power of Advanced Data Analytics

The combination of structured and unstructured data in forensic investigations is a game-changer, particularly when used in conjunction with other techniques, such as interviews. Data analytics allows investigations to move faster and cost less, all while allowing our examiners to synthesize unlimited amounts of quantitative and qualitative data to identify trends, relationships, unexpected patterns, inconsistencies and irregularities – and helping them find the proverbial needle in the haystack.

How Attorneys Can Effectively Utilize a CPA in Litigation

The right expert selected to compute economic damages is a critical ingredient to help an attorney’s case involving economic damages. As CPAs, we are asked to provide independent, objective opinions and/or consult on issues in a case.

What CPAs do in litigation:

CPAs analyze financial information and other relevant data. These analyses are used to develop conclusions about the issues and form the basis to independently calculate economic damages that are defensible in a court of law or other forum.

We are hired in a variety of disputes and investigations:

  • Breach of contract
  • Breach of representation
  • Shareholder dispute
  • Insurance loss claims, especially those involving business profits
  • Franchise and distributor disputes
  • Intellectual property disputes (including patent, trademark and trade secrets)
  • Lender liability
  • Bankruptcy dispute and court appointed investigators
  • Trust and estate disputes
  • Marital dissolutions
  • Employee dishonesty or fraudulent financial statements
  • Accountants failure to detect fraud
  • Employment disputes

We perform a variety of tasks, including ones not solely related to the analysis of financial statements:

  • Developing deposition questions
  • Reviewing correspondence/non-financial information
  • Assisting with document requests/interrogatory responses

FSS helps attorneys in many ways in anticipated litigation:

We provide the analyses that attorneys use in settlement discussions even prior to a lawsuit being filed. During an initial phase of litigation, we can assess facts and provide a preliminary estimate of damages, if they exist.

FSS serves attorneys in litigation:

We serve as an expert witness or a consultant. As an expert witness, we are an advocate for our opinion, not the attorney’s client. There are nuances to litigation services work, which is why it is critical to enlist the FSS team, comprised of individuals who understand the litigation process.

When FSS serves as a consultant, our role is usually never disclosed, so our work is not generally discoverable. A consultant’s role is similar to an attorney’s advisor.

Reasons FSS is hired as expert witnesses by attorneys:

  1. Credentialed professionals bring credibility to important cases.
  2. Economic damages analyses and forensic investigations involve complex financial issues, which FSS can explain in clear, understandable terms. With the aid of the most advanced technology, FSS can show a trier the facts of what happened and the cost of what happened.
  3. Employees of a party to the litigation are not independent. Also, they are likely not trained to testify nor know how to calculate damages to a reasonable degree of certainty.

When an attorney should hire FSS as an expert witness: 

As early as possible.

While cost is always a consideration, cost can be managed by taking the appropriate steps in close communication with our client, the attorney. FSS can manage fees through the following:

  • Budgets and workplans
  • Work performed in phases
  • Regular billing to avoid any surprises

Whether serving as expert witness or consultant, FSS adds great value to attorneys. Learn more about FSS litigation services here.

 

Lost Profits Damage Measures: More than just a Mathematical Calculation

The methodology of a lost profits calculation of damages in a breach of contract claim or intellectual property claim attempts to restore the injured party to their prior financial position. To prepare a calculation that is not viewed as speculative, evidence of loss must match the facts of the case and cannot be cherry-picked.

The calculation of lost profits is not straightforward.

An expert must consider all evidence in the record. An expert who blindly assumes all lost sales are attributable to the plaintiff, without considering other reasons the defendant could have made those sales (especially if evidence exists), is open to attack. Failure to consider sufficient relevant data (a term of art in the CPA’s standard of care) is a major reason why experts’ testimonies get excluded from cases.

We rely on the numbers and the story the numbers tell. We must use common sense and consider whether the damage methodology and assumptions align with the facts of the case. Critical questions to answer when computing lost profits damages include:

  • Is there reasonable basis for the assumptions made?
  • Has the expert considered all independent data and reconciled it with other evidence in the record?

Damages must be computed with reasonable certainty. The following steps are helpful.

  1. Determine what evidence is in the record and what is relevant for determining damages.

    The expert needs to be involved in the discovery process and ask for information needed. An attorney is helpful in identifying categories of documents. However, the expert must decide what is relevant for his or her analysis.

    There will be times when specific information is not available. In that case, the expert should determine if there is sufficient relevant data to determine damages with reasonable certainty.

  2. Use third-party, independent research to form the basis of opinions.

    This information can also be used to test the reasonableness of assumptions and data used.

  3. Step back and ask the questions:
  • Does this make sense?
  • Is this calculation logical?
  • Do I have sufficient, relevant data to support my opinions?
  • Have I considered other reasons that would cause the assumptions to fail; if so, have I reconciled it to the data?

Why could an expert’s opinion be excluded?

  1. The expert has failed to consider sufficient, relevant data in the record, or readily available.

    An expert witness who cherry picks data and ignores other data is open to challenges and likely to have the opinion excluded by the court. The expert witness should investigate and consider the evidence within the totality of the record.

  2. The expert has utilized methodology which is not accepted.

    The expert must demonstrate their methodology is reasonable and generally accepted in the professional community, and/or has been tested by other professionals.

Takeaway: No case is simple.

The calculation of damages based on a lost profits damage methodology is not straightforward. It is critical to find a professional who understands the pairing of the damage calculations with the evidence in the record and, more importantly, can tell the story.

Learn more about our litigation services here.

 

Detecting Deception: Gathering Evidence and Seeking Admission

OPEN is a key word to remember when detecting deception. Open body language – and an open mind – are your best friends when looking for the truth.

An open mind is going to help keep you in the “information-gathering” mode, which usually proves to be more effective than the gruff interrogation techniques you’ve seen in the movies.

USING OPEN-ENDED QUESTIONS

Ask open-ended questions – and lots of them. The more questions you ask, the more information you gather – and the wiser you become.  Focus your questions on How, Who, What, When, Where and Why.

While there is place for yes-no questions, open-ended questions will allow you to gather as much data and facts (or lies) as you can:

  • The more information you gather, the more places you’ll be able to drill into when you identify a hotspot.
  • The more they talk, the more nonverbal cues you can gather.
  • The more words you hear, the more you can glean from statement analysis.

INFORMATION GATHERING

The interview process generally moves from general to specific, and information gathering is  more conversational and less threatening. Information gathering can help you understand process and procedure. It also leaves you open to other explanations that you may not have previously considered.

SEEKING ADMISSION

The secret to information gathering is to continue asking questions until you have what you need. Take your time and be patient. When it’s time to seek admission, your questions – many of which you will already know the answer to –  should become more specific.

Moving from general to specific questioning may look something like this:

  • Step One: Prime them for the truth

“I know you are an honest person…”

  • Step Two: Gather information

How does the deposit process work?”

  • Step Three: Drill a little deeper

“The front desk prepares the daily deposit – then explain to me again why you occasionally prepare the daily deposit?”

  • Step Four: “Maybe I’m wrong here…”

This step is where the baseline comes in – you are looking for those deviations when your subject becomes slightly uncomfortable. When you spot a deviation say something like, “Well, maybe I’m wrong here, but your explanation doesn’t make sense.”

  • Step Five: WAIT

WAIT stands for “Why Am I Talking?”

Silence is pure gold in an interview – no one likes awkward silence – but if you are patient and quiet, your subject will do almost anything to fill the silence.

  • Step Six: Confirm your hypothesis

Ask a question that confirms what you already suspect: “So, every time I see  ‘see detail’ written on the deposit slip, that means you prepared the deposit and took it to the bank?”

  • Step Seven: Move in with the strategic use of evidence

In this step, reveal some of the evidence and ask them to explain the contradiction. The television detective, Columbo, was the master of asking questions he already knew the answer to and strategically using evidence to find the truth:

“Explain: This deposit slip with ‘see deposit’ tells me that you prepared the deposit – why wasn’t the cash  deposited?”

WAIT

When they feed you a line, close in with a little more evidence:

“Really? That’s interesting, because every time there is a deposit with ’see deposit’ written on it, the cash wasn’t deposited. Why is that?

BINGO.

All of these techniques are helpful when questioning a suspected fraudster. Employing the right interview techniques can make the difference in leading you to the truth in a forensic investigation.

Detecting Deception: Body Language

Now that we’ve peeked behind the curtain of speech and facial expressions, it’s time to move on to body language. But before we focus on our subject’s nonverbal cues, let’s shine the light on our own body language.

Remember: when detecting deception, we aren’t looking for the lie – we are looking for the truth. One of your best chances to get to the truth is through trust. Open and honest body language is one tool to help you achieve trust.

As the interviewer, when you use open, honest, natural body language, your subject is likely to follow suit. When using open and honest body language, the honest person will tend to:

  • Turn their body and point their feet toward you
  • Lean forward with casual interest
  • Shift posture fluently without nervous tics

Continuing the analogy of the tightrope walker – when your questions probe into unwanted territory, your subject’s nonverbal cues will likely stray far from open and honest:

THE EQUIVOCATOR

Discrepancies indicating deception leak from the equivocator as obvious physical discomfort or gestures that are incongruous with what they are saying:

  • Ill-timed shoulder shrugs: Shoulder shrugs indicate uncertainty, so when a shrug shows up with a definitive statement it could indicate deception. For example, when a question like, “Have you stolen from your employer?” is answered with a resounding “No!” and partnered with a shoulder shrug, you may have landed on a hotspot. Beware –  these shrugs are usually quite subtle, and one shrug does not a fraudster make!
  • Involuntary bodily functions: The fight or flight response to stress can cause unintended physiological changes that can leak with the heightened stress the equivocator is experiencing.  Watch for clues like jittery hands, a growling stomach or a sweaty brow.

THE MAXIMIZER

Forever fighting to convince you of the truth, the maximizer’s body language is often anxious and laced with arrogance:

  • Timing of gestures: For the honest person, a hand gesture comes a beat before the words. An anxious liar’s gestures will follow the words.
  • Palm-down gestures: Palm-down gestures during an interview are often an attempt to control and keep a tight rein on the conversation. Used in a standing position, these gestures are often an attempt to get you to back off.
  • Steepling: For a liar, steepling is the non-verbal equivalent of “don’t even try me.”
  • The crotch display: Watch out for this one – it’s the ultimate attempt to communicate dominance, arrogance and defiance.

THE MINIMIZER

This behavior is among the easiest to spot. While the maximizer is busy puffing up, the minimizer is desperate to disappear.

Think about a time when you’ve embarrassed yourself in front of a group – didn’t you shrink just a little?

Watch for similar behaviors during an interview. If your subject’s open stance suddenly changes and they shrink, cross their ankles, or cover their face, they are minimizing – a perfect time to dig a bit deeper.

Minimizers will opt to have a table, a book, a purse – anything – in front of them. Keep this in mind and set your interview room so that nothing blocks your subject.

When the minimizer lacks physical blockers, they will likely resort to body-blocking behaviors, e.g., hands in front of the mouth, neck, throat or any other vulnerable area. Eye-blocking is another favorite – often accomplished by covering the eyes or squinting.

THE PACIFIER

Self-touch is often an unconscious way to relieve tension. Nail biting and hair twirling are examples of pacifiers in action.

Again, as with any nonverbal cues, be cautious – one cue or gesture does not necessarily mean you have found a fraudster.

SHARPEN YOUR SKILLS

Refining deception-detecting skills takes practice. People watching can be a great way to hone your skills. Deliberate observance of human interaction can provide invaluable instruction – watch for ill-timed gestures, changes in posture or other nonverbal cues.

Learn how we have used fraud examination techniques to catch fraudsters in the act.

Detecting Deception: Facial Expressions

THE FACIAL FAUX PAS

Now that you have gathered your intel – you have your subject’s baseline squared away and you’ve peeked behind their words – it’s time to focus on the facial faux pas. There are many facial signs that are likely indicators of deceptive hot spots.

When your subject’s expressions and gestures don’t match their words, pay attention. Spotting emotional “leakage” in the face, combined with other verbal and non-verbal cues, speaks volumes about the message your subject is trying to share… and that it may not be the truth.

As with any hints of deception, facial faux pas won’t give you all the information you’re looking for, but spotting them gives you potential areas to probe.

DETECTING FACIAL FAUX PAS

  1. Preparation: Our expressions affect each other dramatically – as interviewers, we need to continually be aware of the effect our own nonverbal communication has on our subject. Remember: how you approach any situation impacts the outcome. If you approach this step calmly, you will keep your subject at ease as well.
  2. Scale back on mirroring: Mirroring is important to establish rapport, but once rapport has been established you want to scale back, as it might interfere with your ability to detect deception.
  3. Remember the baseline: Without it, there is little relevance to non-verbal and verbal cues.
  4. Exposing hotspots: Remember, liars are like tightrope walkers whose goal is to stay upright while threading their web of deceit. You’ll see the same three categories of signals when looking for facial faux pas as you did when assessing verbal cues of deception in your subject:
  • The Equivocator’s Face
    • There are seven universal emotions that are hard-wired, no matter the person: happiness, sadness, disgust, fear, surprise, anger and contempt. Each of these emotions registers with very distinct patterns that are almost impossible to fake.
    • Micro-expressions of these emotions may leak out for only one-fifteenth of a second. They are a challenge to spot, but learning to spot these fleeting emotions is incredibly helpful.
    • With practice, learning to spot micro-expressions can significantly increase your ability to detect deception.
  • The Maximizer’s Face
    • Remember: the maximizer’s goal to bully their way through the interview. Classic facial faux pas for the maximizer include:
      • Changes in eye contact
      • Tight lips
      • Changes in blink rate
  • The Minimizer’s Face
    • The minimizer’s face is one of escape. Watch for these clues:
      • Facial blocking
      • Hiding in their hair
      • Lip sucking
      • Face wiping

Now that you know what facial expressions to look for in a liar, learn more about body language cues that can help you detect deception.

Detecting Deception: Speech and Voice as a Lie Detector

Once we’ve established the baseline, it’s time to drill down to expose the meaning behind the words. While body language has long been the focus of detecting deception, research has shown that the analysis of a person’s speech may be much more accurate than merely observing non-verbal behavior.

No matter the lie, there will always be verbal indicators of deception lurking in the tone and speech a liar uses.

THE VOICE AS A LIE DETECTOR

The tone of a person’s voice has an amazing effect on us. Singing a request versus shouting it in an exasperated voice can have a direct effect on trust.

Think about it: how many times have you gotten what you wanted when you used a buttery voice? You will almost never get what you want with an angry voice, unless you are trying to strike fear in someone.

Vocal tone is a powerful indicator of emotion – research has shown that a person’s vocal tone will waver from the baseline in up to 95 percent of all deceptive statements. It’s one of the most reliable indicators of deception, and whether it goes up or down depends on the emotions involved.

  • Vocal tone rises when we are angry or excited. You might see this when your subject is trying to convince you of something. Be careful, though – a truthful person will also get angry when wrongfully accused. The difference? The liar’s anger subsides more quickly.
  • Vocal tone lowers with sadness and shame. When your subject’s voice gets lower, pay close attention.

THE STORY BEHIND THE WORDS – STATEMENT ANALYSIS

Mastering the art of detecting deceptive speech is best learned through Statement Analysis – a system of analyzing the grammar and logic of words that come out of our mouths. Often the inconsistencies of a story can be picked up almost entirely from shifts in tense or word choice.

Picture this:

A liar is like a tightrope walker whose goal is to get across the canyon of your doubt and skepticism to freedom when they have convinced you of their tale. Their challenge is to remain upright and make steady progress throughout the interview. As the interviewer, your job is to watch for their imbalance or leaks of deception along their journey.

The extra baggage of deceit can be burdensome. This baggage includes:

  • The truth: the facts as they really happened
  • The “facts” in their own lie
  • What they’ve told you in previous conversations
  • The new “facts” they are feeding you
  • The fear of the unknown: what you know but haven’t disclosed
  • Your reaction to their tale

The extra baggage of deceit is likely to throw the liar off balance, triggering their fight or flight instincts.  Pay close attention, as this baggage creates three different categories of signals that can reveal your subject’s stress response and suggest there’s more to the story:

1. The Equivocator: the main balancing act. Consider the gymnast on the balance beam who might suddenly throw a leg out to one side to compensate for weight shift on the other. You will hear this same kind of equivocation when people are lying. Their speech wavers, deviating from its normal pattern and shifting in odd, uncharacteristic ways.

The equivocator will leak inconsistencies in many of their statements or try to make everything seem like sunshine and roses – liars don’t like to talk in the negative. If their answers don’t relate      to the question, or if their language is garbled or deviates from the baseline, it is cause for an amplifying question.

     Mixed-up tenses – When your subject recounts a story, pay close attention to the tenses they use – sometimes they will switch tenses in the middle of the story.

     Double-talk – Remember that it’s human nature to tell the truth. Because our brain is wired to tell the truth, when we lie, we may often say things in a strange way.

     Entering the Twilight Zone – This involves a variation on “one thing led to another,” using opaque language.

     Frequent pausing – When there is a dramatic pause at an inappropriate moment, your subject may be thinking of the word they want to say and then gathering another word instead.

     Start-Stop sentences –  Start-stop sentences occur when your subject realizes they’re about to tell you something they don’t want to tell you.

2. The Maximizer – the classic “fighter”.  The maximizer will try to overwhelm you with brute force language or nonsensical details. Honest people convey information, while liars try to convince.

3. The Minimizer – the classic “flighter”. The minimizer is reticent and subconsciously disappears into themselves in an attempt to avoid the truth and retreat from the conversation.

In forensic investigations, we look for deviations from normal behavior to catch a fraudster in the act. While speech and voice can help with deception detection, when combined with fleeting non-verbal cues like micro-expressions – the smallest and quickest of facial expressions – they can create a hotspot for a deeper dive.

Detecting Deception: Calculating the Baseline

In my previous blog post, I noted that when assessing whether someone is lying, you must first consider the person’s baseline – their typical behavior.

A LIAR IS CAUGHT… OR IS HE?

Body language helps us identify a person’s stress signals of deception. The key word here is “helps” – body language is far from foolproof. In fact, it can be quite misleading.

To begin with, not everyone feels stress about lying, and if they do, what does stress look like for them? It varies by individual.

A more effective approach to detecting deception is identifying “leakage,” or unintentional communication across multiple communication channels. These include:

  1. Facial expressions
  2. Gestures and body language
  3. Voice
  4. Communication style
  5. Verbal statements

Identifying leakage is only the beginning. Combined with your ability to identify the deviations from a person’s baseline behavior, you can create a powerful lie detector.

STEP ONE: GATHERING INTELLIGENCE

In fraud examination and other areas of lie detection, establishing a baseline of behavior, tone of voice and word choice can be challenging. Observing and noting nonverbal and verbal signals that are part of your subject’s general demeanor and social norms usually must be accomplished in a matter of a couple minutes.

Everyone has a “norm” – a basic pattern of behavior exhibited under normal amounts of stress – from how often or quick they blink to the words they tend to use.

Just as they have a norm, a person also has a “tic,” or a signal they are uncomfortable. You’ve seen these in your family and friends – the little smirk or quick scowl that washes over them when you have said something they disagree with.

However, even if you see a “tic,” keep looking – you won’t know what the person is “telling” you until you learn how to ask powerful questions.

Establishing the baseline will help you determine three key elements:

  1. Normal speech and gestures
  2. How does this change under stress?
  3. When and where are the most dramatic differences?

STEP TWO: ESTABLISH RAPPORT

Establishing the baseline requires getting an unguarded assessment of your subject. Your best chance is to develop rapport with them. Being in rapport with someone – having them feel warm and trusting toward you – increases the likelihood they will be honest with you.

People tell more lies when they feel uncomfortable or less connected with others. Conversely, building rapport helps people to believe that you are trustworthy and makes them want to help you.

Below are a few ways to establish rapport:

     1. Set your intention to build rapport and your body language will follow suit.

  • Your body language should be open and welcoming.
  • Aim for steady, but not oppressive, eye contact.
  • Lean slightly forward toward them in a relaxed manner.

     2. Lead with empathy.

  • Thinking in someone else’s shoes without judgment is critical to detecting deception.

     3. Listen to their stories.

  • Having patience with an unguarded story goes a long way toward establishing rapport and the baseline.

     4. Mirror their movements – subtly.

  • Matched rhythms and movement helps put you in sync with one another.

     5. Use transparency to create trust.

     6. Ask open-ended questions to get them talking.

  • One or two simple and disarming open-ended questions go a long way. The key to crafting these questions is to share a bit about yourself. Then, pose an open-ended question about seemingly irrelevant personal information that they are likely to answer truthfully, as it is unrelated to the current situation.

Next, conduct a baseline checklist:

STEP THREE: BASELINE CHECKLIST

With limited time to establish a baseline, this 5-part mental baseline checklist can work wonders.  Keep in mind in that your observance of what you don’t see or hear can be as important as what you do see or hear.

Start with the top and work your way down the person:

     1. First check the face

  • How do they hold their head?
  • Do they touch their face? How often?
  • What about eye movement and eye contact?

     2. Then notice the voice 

  • Tone: are they a soft, medium or loud talker?
  • Pitch: low, medium, or high?
  • How fast or slow to they talk?

     3. Listen to the words

  • Do they use verbal fillers? How often?
  • Do they use full sentences?
  • How is their grammar?

     4. Notice their posture

  • How much space to they take up? Wide, average, or disappearing?

     5. Fidget factor

  • What do they do in a relaxed position?
  • Are they calm, slightly fidgety, or constantly moving?

Remember to keep your attention steady, your communication simple and your body language open, and you will be successful at getting an unguarded assessment in no time.

To learn more about our fraud examination work, contact us today.

Detecting Deception: Common Myths

THE MASTER OF DECEPTION

Bernie Madoff infamously stole $65 billion reflecting 4,900 client accounts in a Ponzi scheme. All told, his investors lost approximately $20 billion of real principal.

How was he able to look hundreds of people in the eye without arousing suspicion, all the while knowing he was robbing them blind? This man was able to stuff his pockets and walk away whistling, without ever seeming to feel the first twinge of guilt.

THE HARD TRUTH

This brings me to a hard truth that must be acknowledged: we all lie. Our deceptive ways begin as early as infancy and escalate as we age. Sometimes we lie to spare feelings. Sometimes we lie solely to protect ourselves. When we lie for the second reason, we don’t feel very good about it. In turn, our feelings give us away. As for Madoff and other high-powered liars, they don’t feel bad like the rest of us – which explains why Madoff was so good at it.

Another reality is that most of us aren’t skilled in detecting deception. We tend to rely on a false sense of what we believe are obvious signs of deception – unfortunately those “obvious” signs may not be signs at all.

TOP MYTHS ABOUT DECEPTION

Myth 1:  The eyes are the window to deception

Many believe the eyes are a dead giveaway to deception. Let’s say you notice your daughter avoiding eye contact when you ask her a rather pointed question about her sleepover with her best friend last night. As she avoids your gaze when you ask her about her evening, you’re sure you’ve caught her in a lie.

Not so fast. There is little evidence to support your eye contact theory. The critical behavior to look for in a person’s eye movement is a deviation from normal behavior. Be sure to consider your daughter’s natural tendencies before you ground her.

Myth 2:  The itchy nose theory

Often thought to be a foolproof sign of deception, the itchy nose may reflect nothing more than a “fight or flight” reaction to stress.

In a threatening situation – like the way an employee feels when you unexpectedly ask them to step into your office – their blood will rush to their extremities, giving their arms and legs the needed energy to run or fight. When they do neither and instead take a seat in your office, the blood will rush to their head and make their nose itch like crazy.

Myth 3:  Liars wiggle and jiggle

We all know someone who is in constant motion – bouncing their foot, biting their fingernails or flipping their hair. For them, it’s completely normal. Take note, however, if these actions are a deviation from their norm, or if the wiggles suddenly appear after you ask a probing question.  You might just be on to something.

Myth 4:  Liars use absolutes

This is where gathering baseline information becomes crucial. If a particular phrase isn’t part of the person’s normal vernacular, pay attention when it comes out of their mouth during times of stress. Liars often use absolute statements (e.g., “I swear to God!”) to try and convince you of their innocence, while an honest person does not need to work so hard to convey their message.

Myth 5:  Liars drop words

If your colleague is typically tight-lipped or a person of few words, there may be nothing unusual when he drops words or pronouns when describing how a business process is supposed to work. Liars, on the other hand, will drop pronouns as a mechanism to distance themselves from the fib they are telling.

However, if your colleague is usually enthusiastic and full of details, then you may have an issue. Just the same, tread lightly here – in today’s world of text messaging and online chat, incomplete sentences and missing words have become commonplace.

THE MORAL OF THE STORY

Determining truth from deception is far from straightforward. These myths cloud our judgment and prevent us from finding the truth. When we can see through the errors in our judgment, we strengthen our ability to detect deception. In our fraud examination work at FSS, we do this every day.

To learn more about detecting actual signs of deception, be sure to read more on our blog.

Active Passive Appreciation – Active Efforts of Individuals

As discussed previously, once it has been determined that a separate business interest appreciated in value during a marriage, learned treatises and case law often delineate the active passive analysis into the following elements:

  • Identifying and quantifying market forces that caused the separate property appreciation.
  • Identifying and quantifying the separate property appreciation caused by the active efforts of third party managers, employees or owners (other than the divorcing parties).
  • Identifying and quantifying the separate property appreciation caused by the active efforts of the divorcing parties (typically including efforts of either the business owner spouse or the non-owner spouse).

Learned treatises and case law in equitable distribution jurisdictions typically first determine the part of the separate property appreciation during the marriage that was due to market forces, and remove this appreciation from consideration as it is typically not divisible. Any remaining separate property appreciation during the marriage is then carefully analyzed to allocate the remaining appreciation between the active efforts of third parties and the active efforts of the divorcing spouses. From a conceptual standpoint, some equitable jurisdictions have characterized separate property appreciation during the marriage caused by the active efforts of third parties as being essentially the same as appreciation from market forces, and is therefore typically not divisible.

The allocation of separate property appreciation during the marriage between the active efforts of third parties and the active efforts of the divorcing spouses is a fact specific process that requires researching and investigating factors including but not limited to the following:

  • Obtaining or developing organizational charts of the subject company during the relevant time period.
  • Interviewing managers, employees and owners who have knowledge of the operations of the subject company and the roles of the third parties and the divorcing parties during the relevant time period.
  • Interviewing managers, employees and owners who were present at the Company during the relevant time period and have knowledge of the roles of the third parties and the divorcing parties. Locating these individuals can be difficult if substantial time has passed between the relevant time period and the current active passive analysis date.
  • Locating and reviewing any relevant subject company documents that were prepared during or near the relevant time period.

The above information is then used by the business appraiser to develop a reasonable method to allocate separate company interest appreciation between third parties and divorcing parties. Reviews of learned treatises and case law reveals that, depending upon case facts and the particular jurisdiction, weight can be given to factors including but not limited to the following:

  • The relative control available and exercised by various individuals over the subject company and/or its operations, through ownership and/or management role.
  • The relative positions of authority and/or influence available and exercised by various individuals at the subject company.
  • Relative levels of compensation or levels of company-owned key person life insurance.
  • Specific metrics of the relative share of company performance, such as relative sales or profits of particular business units or lines, that are attributable to specific individuals.

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.

Active Passive Appreciation – Market Forces

As discussed previously, once it has been determined that a separate business interest appreciated in value during a marriage, learned treatises and case law often delineate the active passive analysis into the following elements:

  • Identifying and quantifying market forces that caused the separate property appreciation.
  • Identifying and quantifying the separate property appreciation caused by the active efforts of third party managers, employees or owners (other than the divorcing parties).
  • Identifying and quantifying the separate property appreciation caused by the active efforts of the divorcing parties (typically including efforts of either the business owner or the non-owner spouse).

A market force can be defined in general as a measurable economic factor that affects the price, demand, or availability of a product or service. These economic factors can include basic economic factors such as interest rates, population growth, inflation rates, commodity prices or foreign currency exchange rates. In the context of an active passive analysis of a business interest, a market force is more specifically defined, but can include a broad array of factors beyond basic economic factors. For example, a favorable government regulatory change can also be a market force. A market force in an active passive analysis context can be defined as a factor that reflects the following attributes:

  • It is a measurable factor that caused appreciation in a separate business interest either during a marriage or between the date of separate (sometimes called the date of filing) and the date of distribution.
  • It is a factor that is outside the control of subject company managers, employees or owners.
  • It can be analyzed distinctly from appreciation caused by the efforts of individual managers, employees or owners of the business (who might be either third parties or one of the divorcing parties).

For a factor to be a market force in an active passive analysis, there necessarily must be an identification of the relevant “market” on which the factor is a “force”. In the context of an active passive analysis of a business interest, the “market” is typically defined to include a sample of comparison companies exposed to a reasonably similar business environment as the subject company. A study of the impact of the factor on the performance and value of comparison companies helps to identify whether the factor has been a market force during the relevant time period. The business appraiser can then compare the increase in value of the subject company interest to the increase that would reasonably be expected based upon the market force impact on the value of the comparison companies

If the value of the subject company interest increased during the relevant period at a rate that was at or below the value increase of the comparison companies related to the market force, then much or all the subject company value appreciation was likely caused by the market force. On the other hand, if the value of the subject company interest increased at a greater rate than what would be expected from the market force, then the part of the increase over the expected impact of the market force is often attributed to the active efforts of one or more individual managers, employees or owners of the business. To the extent that one or both divorcing parties are among the individuals whose active efforts caused part or all the appreciation during the marriage in excess of the increase expected to be caused by market forces, then that part of the increase is often included in divisible assets.

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.

Active Passive Appreciation – Causation

The business appraiser performing an active passive appreciation analysis looks to their engaging legal counsel to define and interpret state law in the particular jurisdiction. An active passive analysis is performed when state divorce law requires a determination of whether, and under what circumstances, appreciation in otherwise separate property is classified as a divisible marital asset. A commonly recurring requirement in such jurisdictions is that separate property appreciation during the marriage is divisible marital property to the extent it was caused by marital efforts.

There can be many different types of property in a divorce case (e.g. real property, furnishings, retirement plans), but this discussion focuses on property consisting of business interests.

A jurisdiction requiring the isolation of separate business interest appreciation caused by marital efforts necessarily requires the business appraiser to also identify and quantify appreciation caused by factors other than marital efforts. Separate property appreciation during the marriage caused by marital efforts is called active appreciation and is typically included in divisible property. Separate property appreciation during the marriage caused by other factors is known as passive appreciation, and typically remains separate property.

Once it has been determined that a separate business interest appreciated in value during a marriage, learned treatises and case law often delineate the active passive analysis into the following elements:

  • Identifying and quantifying market forces that caused the separate property appreciation.
  • Identifying and quantifying the separate property appreciation caused by the active efforts of third party managers, employees or owners (other than the divorcing parties).
  • Identifying and quantifying the separate property appreciation caused by the active efforts of the divorcing parties (typically including efforts of either the business owner spouse or the non-owner spouse).

From an overall perspective, while case law differs on the market forces and efforts of individuals given weight based upon case facts and the particular jurisdiction, almost uniformly learned treatises and case law have required causation. There must be a reasonable connection or relationship such that market forces and/or the efforts of individuals caused separate property appreciation. In many jurisdictions, for example, merely because a party was active in a business going to work and laboring daily does not mean that that labor reasonably caused some or all the separate property appreciation.  In practice, in most equitable distribution jurisdictions, causation is determined not by a single mathematical formula, but rather by a more flexible facts and circumstances analysis.

While there is near uniformity among equitable distribution jurisdictions to require a reasonable causal link, differences in classification can arise when appreciation in a separate business interest has been caused both by market forces and by efforts of individuals during the same time period. The range of case outcomes varies by specific case facts and jurisdiction, but often the outcome reflects an allocation among the various factors.

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.

Working Capital Changes in a Free Cash Flow Forecast– Part III

Part II of my working capital blog identified methods often used by business appraisers when forecasting working capital. In this installment, I will present some additional thoughts regarding this topic.

Depending on the facts and circumstances, it is typically appropriate to consider the company’s historical working capital ratios and industry working capital metrics at the composite level (e.g. total working capital), as well as each separate component of working capital (e.g. accounts receivable, inventory, accounts payable, etc.). If the company’s metrics exhibit a large variance from the industry, the comparability of the companies in the industry group to the operations of the company being valued should be analyzed. If the subject company is not comparable, its historical ratios are more relevant for valuation purposes (this is often the case for very small companies, particularly depending upon how they choose to capitalize themselves). For larger companies that appear to be comparable to those included in the measurement of industry data, further analysis may still be necessary. For example, if the analysis of the company’s financial ratios show that the company’s speed of collections is slowing in relation to its historical collection ratio or in comparison to the industry, the individual components of the working capital change may need to be looked at separately.

Other items that may be implicit in a company’s working capital forecast and require a conversation with company management include:

  1. Payment strategy – As a source of cash flow, a company may negotiate longer payment periods with suppliers (typically a positive) or delay payments to suppliers (can be a negative, indicating questionable liquidity). Reducing the payment period has the opposite effect and reduces cash flow.
  2. Collection strategy – A company may tighten the terms of payments offered to credit customers or become more aggressive in its collection policies, which reduces accounts receivable and increases cash flow. However, tighter credit policies may cause loss of customers. Loosening credit terms and/or less aggressive collection policies increases accounts receivable and reduces cash flow, but may gain additional customers who desire longer payment terms.
  3. Inventory management strategy – A company may increase its inventory levels to improve fulfillment rates (which initially decreases cash flow, all else held constant) or may reduce inventory levels to reduce holding costs (which initially increases cash flow, all else held constant). However, reducing inventory levels beyond a certain point may increase stockouts, which can lead longer-term to declining sales and/or a reduced sales growth rate.
  4. Purchasing strategy – A company may negotiate discounts for paying more quickly, or it may receive reduced prices for purchasing larger volumes, both of which initially lower cash flow, all else held constant.

Overall, in the context of cash flow forecasting for business valuation purposes (as opposed to forecasting for capital or operating budgeting purposes), estimating a change in overall working capital is definitely simpler to do, as it avoids the detailed analysis necessary to forecast a number of inputs and may be reasonably accurate. However, the assumptions imbedded in each working capital component that comprise the overall change in working capital still often need to be considered.

The level of working capital has a direct influence on the value of a company. Tying up cash in excess working capital may cause cash flow and profits to suffer. Insufficient working capital reduces a company’s liquidity, potentially increasing a company’s risk and the cost of obtaining capital, thereby potentially reducing its value.

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.

Working Capital Changes in a Free Cash Flow Forecast– Part II

Part I of my working capital related blog addressed the impact on free cash flow of changes in current assets and changes in current liabilities, which are the two components that comprise working capital (calculated as current assets minus current liabilities). The combined impact of changes in current assets and changes in current liabilities equals the impact of changes in working capital on free cash flow. Part II of this blog identifies methods often used by business appraisers when forecasting working capital.

At the core, working capital changes are analyzed and projected to ensure changes in cash are correctly forecast. Merely because a company produces a net profit of $100,000 does not mean the company has $100,000 in cash available to distribute to its owners.

The ratio of sales method is commonly used to forecast the impact of working capital changes on free cash flow in a business valuation where the subject company utilizes the accrual basis of accounting.  This method is readily understandable and can reflect these variations:

  • Use the change (in currency) in working capital from the two years before the valuation date and grow working capital at the expected sales growth rate.
  • Use the ratio of working capital to sales reflected in the year prior to the valuation date to forecast working capital levels needed to support forecast sales levels.
  • Use the ratio of working capital to sales based on a historical multi-year period using a simple average, a weighted average or a median. While this method can smooth out year-to-year changes and allow a complete business cycle to be included, it may not be appropriate for companies exhibiting a consistent downward or upward trend in working capital in the years preceding the valuation date.
  • Forecast working capital using industry average ratios of working capital to sales. This method may be useful when a company has volatile historical working capital and/or is a start-up or in high-growth mode, for example, and the analyst is not comfortable making a forecast based on the company’s historical working capital levels.

Two key caveats are in order. Under the first three methods, the inherent assumption in applying historical average working capital levels is that the historical levels reflect expected future working capital levels. Since a business valuation should reflect expected future cash flows, expected variations between historical and future working capital levels must be considered. Second, if a non-controlling interest is being appraised, the assumption that the company’s working capital levels will be changed to industry averages might not be reasonable if the company rarely reflects industry-average working capital levels and the interest being appraised does not have the unilateral power to compel changes at the company.

Other considerations include:

  • The company’s historical working capital ratios and industry working capital metrics
  • Historical and industry normal metrics of the individual components of working capital (e.g., accounts receivable, inventory, accounts payable, etc.)
  • Comparability of companies in the industry group to the operations of the subject company when the subject’s metrics exhibit a large variance from the industry
    • In the case of very small companies, historical ratios may be more relevant
    • For larger companies that appear to be comparable, further analysis may still be necessary

My next blog will present additional thoughts on forecasting working capital.

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.