David R. Evanson
Auditor’s Guide to Forensic Investigations, Fall, 2004
Other Dimensions of Forensic Accounting
Some believe that all forensic accountants perform financial crime investigations. This view is largely explained by the fact that in the post-Enron, post-WorldCom era, forensic accounting has for many become associated solely with fraud detection and investigation. In reality, forensic accountants offer a much wider range of services. Although this book is dominantly focused on the prevention, detection, investigation, and resolution of corporate fraud, it makes sense to offer here a chapter-length overview of the other dimensions of forensic accounting.
In their day-to-day practice, some forensic accountants focus on commercial disputes in specific industries or practice areas. In commercial disputes, forensic accountants typically play three roles: expert witness, consultant on technical accounting or financial issues, and arbiter of facts. As an arbiter or trier of facts, sometimes referred to as special master, forensic accountants are appointed by the court to act as judge and jury. In their consulting role, forensic accountants may provide discovery assistance, prove business facts, compute damages, and assist counsel in the development of strategy. One should not assume that a forensic accountant involved in commercial dispute projects is qualified to perform financial crime investigations. For an inventory of the skills to look for in selecting a forensic accounting investigator who focuses on financial crime investigation, see chapter 14. Close attention should be given to the individual’s qualifications including certifications and especially experience before deciding on the right forensic accountant for the task at hand. Assuming that all forensic accountants are interchangeably capable of executing all forensic accounting engagements would be analogous to assuming that all CPAs are qualified to prepare tax returns.
While fraud can be sensational and garner headlines, commercial disputes (as well as marital disputes among high net worth individuals) occur often, involve billions of dollars, and may involve complex issues requiring expert analysis. The majority of forensic accounting work actually occurs outside of investigations in a wide range of specific practice areas. A glimpse of these areas, suggesting why forensic accounting expertise may be helpful, is provided below.
“How does a capital project with a $100 million budget end up costing us $1 billion?” This question is heard all too often from municipal authorities as well as chief executives and board members of corporations, universities, and hospitals. Unfortunately, when the creation, development, and execution of a capital project is not the core activity of an organization, cost overruns, scheduling delays, and quality issues sometimes occur.
Good counsel during the planning stages and an active approach toward risk management of capital projects may head off many problems before they even start. Ultimately, however, disputes and litigation are a reasonable probability because capital projects often are fraught with change, and many changes may have implications for the cost, scheduling, and quality of the project. In many disputes, the contractor brings a construction claim against others involved in the project who are responsible for the added costs. The list of those against whom claims may be made often includes owners as well as other contactors involved in the project. These added costs may take many forms: additional work, forced delays, acceleration of time frames, disruption of workflow, unabsorbed overhead, and marginal cost of capital are among the possibilities, and there are others. Proving the sequence of events, facts, and circumstances that lead to these additional costs may require specialized forensic accounting that blends construction with accounting expertise.
Suppose that there are changes in the scope of a project during construction that affect the contractor, the construction manager, and several subcontractors. Further assume that each must now revise estimates regarding time, cost, and materials. Owing to the complexity of the work and the interdependency of relationships, the costs associated with unplanned changes may have multifaceted consequences or a cumulative effect that may wipe out all of the contractor’s anticipated profits for the project. Unfortunately, a simple tacking and tying of invoices may not help the contractor prove its case. Forensic analysis is often helpful in proving a logical connection between changes in the project and the resulting damages. Moreover, those damages should be calculated to the standard of “reasonable certainty,” which has been well established by legal precedent.
Given the complexity of the accounts and sequence of events, forensic accountants are often found on both sides of such cases. While one set of forensic accountants may calculate damages and provide expert testimony in court or at arbitration on behalf of the plaintiff, others may work for the defendants by analyzing plaintiff’s expert’s findings and possibly additional issues not considered by plaintiff’s expert, ultimately providing expert testimony intended to rebut damage claims with due force and persuasiveness. Defendant’s expert may also be asked to support a counterclaim with financial analysis and expert testimony.
The shock felt across the United States when the Cuyahoga River caught fire in 1969, or when the entire community alongside Love Canal was evacuated in 1977 because of hazardous chemicals buried there, has been converted into reasonably tough federal and state environmental legislation. The Comprehensive Environmental Response, Compensation & Recovery Act (the Superfund Act), the Resource Conservation & Recovery Act (the Hazardous Waste Act), and to a lesser extent the Clean Air and Clean Water Acts sometimes generate complex disputes in which forensic accounting expertise may be helpful.
Specifically, the “cradle to grave” provisions of the Hazardous Waste Act and the shared responsibility of successive owners in the Superfund Act mean that environmental costs and damages can occur quite suddenly and under the leadership of a management team that was not in place at the time of the event. As a result, companies seeking to limit, reduce, or eliminate the costs of clean-up may engage forensic accountants to help reconstruct and present the operations of the company during the period in question.
Suppose that the successive owner of a property that is now a Superfund site is sued for the clean-up of a certain chemical remaining there. By conducting a forensic investigation that demonstrates that it never bought, sold, made, or took possession of the chemical in question, the defendant in the litigation may be able to eliminate or significantly reduce its liability.
In the environmental arena, forensic accountants may be useful in helping to reduce fines levied by the Environmental Protection Agency under the so-called Economic Benefit Model. While the government looks at the economic benefits that have accrued to a company for being out of compliance, forensic accountants look at and present historical expenditures that were made to achieve compliance. Such expenditures may be used to offset portions of penalties ultimately payable.
In 1982, the value of intellectual assets constituted approximately 38 percent of the aggregate market capitalization of the S&P 500. By 1992, the figure had grown to 62 percent, and in 2002, the figured had climbed to over 80 percent. These figures demonstrate that intellectual property (IP)—consisting of patents, trademarks, copyrights, and trade secrets—represents a significant portion of corporate value. As IP grew in importance, so too did the patent and copyright activity designed to protect such assets. For many industries, patents and copyrights represent an important barrier to entry. Yet even as many companies move to protect their intellectual property, they increasingly engage in technology sharing agreements as well.
While all of these trends contributed materially to the quality of life and productivity gains, they sometimes create fertile ground for disputes, including litigation. Because intellectual property has unique characteristics, determining damages may require complex analysis. For instance, in an intellectual property infringement case, there may be claims of lost sales and profits. But infringement tends to have an impact on prices, competition, and quantities in the marketplace. Therefore, forensic accountants may often go beyond lost sales and find the additional losses associated with the effects of price erosion, reduced economies of scale, and the presence of competition, among other factors that might not have otherwise existed. In some disputes, forensic accountants may calculate what a reasonable royalty would have been, had such a royalty arrangement been in place. This calculation often considers the large number of terms and conditions that typically appear in complex royalty agreements—for example, exclusive versus nonexclusive—and their economic implications.
Many disputes arise out of licensing agreements. Licensors of intellectual property, disputing the ways in which licensees utilize their rights, may claim damages as well as lost profits. Forensic accountants may be consulted to help establish the damages sustained by the licensor, as well as the lost profits resulting from actions taken by the licensee.
Because of the value of IP assets, and the degree of difficulty associated with intellectual property disputes, forensic accountants are often retained by licensors to monitor licensing programs and ensure that licensees are in compliance in terms of usage and payments. Proactive auditing by the owners of intellectual property assets can be an important tool for avoiding future disputes.
In the area of patents, owners of intellectual property may seek protection not just for specific technologies but also for fundamental processes and algorithms. In 1991, Kodak paid $925 million to Polaroid over a patent rights dispute involving instant cameras and films. The figure that forensic accountants had to establish in this case was the amount of profit that Polaroid had lost. Meanwhile, forensic accountants for the defendant were tasked with rebutting the argument of lost profits.
Because of the increasing value of IP assets and the role they play in corporations, forensic accountants are increasingly called upon in merger and acquisition transactions where significant intellectual property is present. Specifically, forensic accountants help buyers and merger partners determine if the intellectual property assets, as well as rights that have been assigned or licensed, are consistent with the representations parties in the transaction.
The federal government is the largest customer in the world with unparalleled creditworthiness. Given the size of contract awards—frequently in the hundreds of millions and billions of dollars—disputes and litigation often arise in the course of government contracting that require complex financial analysis.
In some instances, the government litigates to recoup its costs. For instance, in one landmark case the termination of a contract for a Navy attack plane, the A-12, provoked a $2 billion demand from the government for the return of progress payments, which in turn resulted in several countersuits for wrongful termination. In disputes brought by the federal government, forensic accountants typically support counsel for the defense, since the government is supported by expertise from other governmental agencies such as the Defense Contract Audit Agency (DCAA), Office of the Inspector General (OIG), and Contracting Officerzzs Technical Representative (COTR).
The vast majority of suits, however, are actions brought against the government by contractors or disputes between parties who are government contractors. Claims in these suits often revolve around three primary issues: costs, performance, and scheduling. Cost disputes frequently center on allocation between direct and indirect costs and their allowability. When the government disallows costs, plaintiffs may obtain a forensic analysis to help determine the compliance of a cost with a contract or the connection of a cost to work requested . Performance-based disputes take several forms. For instance, if a government contractor is being terminated, questions may arise as to whether the termination is based on performance or simply for the convenience of the government. Forensic accountants are sometimes used to help demonstrate adequate performance or to help demonstrate that the contractor has made changes that result in acceptable performance as demonstrated by the contract. When forensic accountants can help plaintiffs establish that termination was for the convenience of the government, the plaintiff may receive better compensation than if allegations of inadequate performance had withstood scrutiny and trial. Finally, the change provisions in government contracts may have an impact on the contractor’s ability to meet deadlines established by the contract, sometimes causing termination and/or penalties. In such situations, contractors may seek to prove that changes by the government resulted in a constructive acceleration of the project.
Corporate forensic investigations can intersect with government contracting when a corporation detects fraudulent activity in the work it is doing for the government. Or fraudulent activity may be alleged, as in a Qui Tam case brought against a company by a relator and the government. In such cases, in addition to conducting an investigation to detect the possible existence and extent of the fraud, forensic accountants may assess the financial impact of the fraud so that adequate reparations can be made to the government in an effort to ward off litigation with attendant possible criminal sanctions.
Insurance and Business Interruption
Many insurance policies now include a professional fees endorsement. Many believe that the existence of these endorsements represents recognition on the part of insurers that the preparation of a claim in the event of a catastrophe, and the resulting interruption of business, is a complex matter that generates a risk for the policyholder. Companies often retain forensic accountants to help them prepare claims, establish damages and losses, and, in some circumstances, to rebut the arguments of the insurance company’s forensic accountants.
One of the primary challenges often facing the insured is putting accounting information into a format that reflects how insurance policies are written. Specifically, while corporate accounting calculates profit and loss within a production framework, losses from business interruption claims are structured quite differently. In the context of a business interruption claim, loss represents the difference between what happened to a company following a loss versus what would have happened had the loss not occurred. In other words, but for the loss, how would the company have performed? Calculating loss in this fashion is often a multifaceted challenge which, while utilizing accounting, also requires an understanding of such factors as the industry and company personnel. Forensic accountants are often able to reconstruct and estimate how a business might have performed, had the insured event not occurred. This is usually compared to post-event performance, recognizing the changes in revenues and expenses that occur as a result of the disaster. Changes in the revenue and expense components can be complex because the operations of the business—from what it sells, to where and how products and services are produced—can be fundamentally changed by the disaster that befell the company.
Forensic accountants may establish and calculate the company’s sustained loss, and also provide expert witness services to defend their findings. The challenge is compounded by the activities of similar expertise on the other side of the dispute. Given that reality, forensic accountants acting on behalf of the plaintiff may adopt the pragmatic goal of fighting for the best possible result rather than an overwhelming victory..
The incidence of divorce between spouses with substantial wealth often creates several challenges in setting entitlement awards as well as the valuation and division of marital property. For example, when there is a prenuptial agreement, such contracts often specify entitlements based on the living expenses of each spouse. Thus, in a marital dispute, the calculation of the entitlement may rely on estimating these expenses. A complication: the spending patterns established during the marriage often reflect joint expenditures. Forensic accountants may help analyze and separate historical spending to provide a basis for and defense of a proposed entitlement.
Apportionment of marital assets may present a number of challenges, compounded by whether or not the divorce is occurring in a community property state or equitable distribution state. Questions may arise as to the value of assets that were initially brought into the marriage (pre-marital assets), their current value, and the portion of the marital estate they now represent. The task of apportioning assets may lead to the work of tracing assets to determine who acquired them initially and how, and ensuring that all assets are taken into account during the apportionment process. The location of assets not disclosed by a spouse may materially weaken a proposed apportionment or give rise to dispute over a proposed settlement. Forensic accountants may be helpful in bringing important facts to light.
Forensic accountants may also address the value of professional goodwill in cases of marital dissolution in community property states. There is a wide range of valuation techniques for professional goodwill. Establishing a value for this asset, or determining whether it even exists, may have a material impact on the apportionment of marital assets.
Three federal securities acts create the framework on which interstate securities transactions are regulated. These are the Securities Act of 1933, The Securities Exchange Act of 1934, and the Securities Litigation Reform Act of 1995. Together these laws attempt to ensure that the investing public has sufficient information to enter knowledgeably into securities transactions. Although each law defines a different standard of recovery for investors, they share a common goal: to make the plaintiff whole through a reversal of inappropriate transactions or through monetary compensation of losses stemming from the violation or infraction of the law.
In general, the remedy of monetary compensation may require forensic analysis in order to estimate damages. There are several widely accepted techniques for estimating damages. One of the most widely employed is the so-called out-of-pocket measure, which is the difference between the price paid for a security and the actual value at the date of the sale.
While this approach is easily understood, its application is often complex. Forensic accountants can estimate the value of the security in question, absent the fraud or misrepresentation that provoked the action to begin with. The process often requires analyses that take into account macroeconomic information as well as industry and company-specific information. A more numerical, statistical approach to valuing securities uses linear regression analysis.
Shareholders sometimes file lawsuits against corporate officers and directors for violation of securities laws, in addition to a wide range of other alleged offenses including breach of fiduciary duty, personal appropriation of corporate opportunities, discrimination, self-dealing, oppression of minority shareholders, and violation of environmental laws. The majority of suits are brought against directors for the first alleged infraction in the preceding list: breach of fiduciary duty. In such suits, forensic accountants may be engaged to evaluate the causes of a business decline and assess the relationship of that decline to a board’s decisions and performance.
The concepts and principles of business valuation for litigation purposes are the same as those for business valuations pursuing other purposes such as a buyout, creation of an employee stock option plan, or an equity investment. Business valuation in litigation frequently may occur as a result of marital dissolutions, dissident shareholder disputes, corporate dissolution, or a taxable transaction that is subsequently challenged by the Internal Revenue Service or other taxing authorities.
Forensic accountants engaged to clarify such situations often perform intensive data gathering in the financial, contractual, legal, operational, and historical dimensions of the business under review. That information may be used to develop valuations under a number of generally accepted techniques, including market comparisons, discounted cashflow, net assets, comparable transactions, and comparable sales. Because disputes can arise with shareholders of different classes, the analysis often goes beyond the aggregate determination of value. In many instances, forensic accountants take into account the rights, privileges, and restrictions on various equity securities and assign values to each class.
Forensic accountants sometimes value preferred shares as well as pure equity securities. In such instances, the focus of analysis usually shifts toward a risk-based examination, in which they evaluate a company’s ability to make preferred share payouts based on the presence of other fixed payment obligations and other short- and long-term debt.
Some business combinations provoke disputes related to antitrust laws, while others may generate disputes because of clauses in merger and acquisition contracts and the effects they have on purchase prices. In the former arena, plaintiffs establish harm from anticompetitive effects of the defendant’s antitrust violations. Forensic accountants may be engaged to help plaintiffs prove, and defendants rebut, alleged damages stemming from restraint of trade. Restraint of trade can take numerous forms, including monopolization, exclusive dealing, price discrimination, and mergers that substantially lessen competition, among others. In many cases, success may rest on testimony and analyses of forensic accountants, who may be able to demonstrate lost profits based on a competitive impact analysis, market definition analyses by product and geography, and price elasticity in the marketplace.
Of course, not all business combinations provoke antitrust claims. But merger or acquisition contracts may generate disputes between buyers and the sellers—for example, disputes that arise from irregularities discovered after closing, the application of offsets, notices of objection immediately following closing, interpretations of materiality, and earnouts. Those are just a few of the possible grounds for dispute. Forensic accountants may assist one or both parties in formulating the dispute, discovery, analysis, and calculation of damages. In litigation connected to merger and acquisition activity, there can be a high degree of subjectivity because of the personal involvement by the principals in the transaction. Forensic accountants may be helpful in such situations: they have no emotional involvement in the transaction. By providing objective unbiased analysis, they may help move disputes toward resolution.
In the current environment, a security breach may more likely refer to the attack and penetration of a computer network than to a masked intruder on the premises after hours. When an electronic breach occurs, security specialists may be retained to determine the point of weakness in a corporation’s information systems and to implement remedies that will prevent a comparable breach from occurring in the future. Forensic technologists may be called upon to help determine what information or records were compromised and perhaps to look for telltale signs that could aid in identifying the attackers.
Often, however, an attack has consequences that go beyond the immediate need to repair a security breach. In such instances, forensic accountants may be called on to help quantify losses that may include costs to remedy, lost productivity, price erosion, reduction in barriers to entry, and still other factors. Quantifying these losses may also be required in support of criminal or civil litigation. During the course of litigation, forensic accountants may serve as expert witnesses to establish facts and fact patterns associated with a cybercrime. Forensic accountants may also assist in the filing of an insurance claim associated with losses from cybercrime.
When a cybercrime has occurred, forensic accountants may be asked to help support the settlement of claims between a company and its vendors. The existence of outsourced technology services often means that an attack and penetration results in liability for one or more companies providing technology services. Forensic accountants may be able to assist counsel in formulating claims specified by their technology outsourcing agreements. The formulation of such claims is often complicated by the interdependent relationships among technology vendors. As a result, counsel may desire detailed analysis to support claims they are making on vendors.