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Author: Stephen L. Ferraro

Stephen Ferraro, CPA is a Partner with Ferraro, Amodio & Zarecki CPAs (FAZ). FAZ is an experienced team of leading forensic CPAs, valuation experts, Certified Fraud Examiners (CFEs) and business advisors who seek to truly understand clients’ needs. Serving Albany, Boston, NYC, White Plains, Saratoga Springs and the surrounding areas, they leverage deep experience and a genuine, people-focused approach to provide best-in-class forensic accounting, business valuation and business advisory services. www.fazforensics.com

Creating a Successful Business Transition: Measuring and Managing Owner Dependence

Written by Stephen L. Ferraro on . Posted in Business Advisory.

Business owners who are thinking about the future will often wonder “who will own my business after me?”  Owners who consider this issue need to ask a very important question in preparation for a future transition, i.e. “Is My Company Transferable?”  In order to answer this question, it is recommended that you review your company to make a certain number of assessments as to whether or not your company is transferable.  One of the most significant assessments that can be made in this regard is how dependent your company is on your individual efforts.  Another way of putting this is “what is your owner dependence?”  This article is written to help privately held business owners begin the process of thinking through the future transferability of your business, starting with the replacement of your role(s) within the business and leading you down the path of Creating a Successful Business Transition.

Creating a Successful Business Transition

In order to begin thinking about what would make your business attractive to a new owner, one must first consider what it means to own and run a Transferable Business.  A transferable business is one that can be owned and run by someone other than you (and/or your partners) today.  Many privately held business owners do not have a transferable business because their individual efforts and contributions are indispensable to the successful running of the company.

So, a key to Creating a Successful Business Transition is measuring and managing your level of involvement in the running of your business. While the formula to calculate your total involvement in your business is a bit complex, there are a few simple items that you can review to determine how involved you are in running your own business.  Let’s first take a look at the risks of your company having a high owner dependence score.

The Risk of High Owner Dependence

When it comes time to transfer ownership of your business to someone else, your level of involvement in the company is going to become a major issue that needs to be discussed and navigated.  The primary issue should be obvious – if your company cannot run effectively without you, then you should not expect that a buyer of your business will simply take over the company without your active involvement into the future.  And, when owner dependency is high and the owner’s active involvement in the business is required for the business to operate, the riskiness of the business goes up and the overall value (including how and when an owner would get paid for the business transfer) tends to be reduced to account for this riskiness.  In short, a high owner dependency makes for a difficult business to transfer.

Creating, Selling & Delivering Products and Services.

While there are likely a great many important tasks that you perform in your company, one of the most significant is your involvement in the marketplace that you serve. Our experience shows that one of the most critical areas where owners provide leadership in their businesses in creation, distribution, and delivery in the company’s products and services.  One of the first sets of questions that an owner can ask themselves about how involved they are with their business includes the following items.

  1. How involved are you in the creation of new products and services for your company?
  2. How involved are you in the selling process for the existing and new products and services in your company?
  3. How involved are you in the process of your company’s delivery of its products and services?

If you are like most privately held business owners, you have a high level of involvement in at least one (1), if not all three (3) of these “market-facing” areas.  Company founders are often the most knowledgeable of their company’s products and also struggle with the transfer of this knowledge to others in the business.  The process of Creating a Successful Business Transition is dependent on addressing this key issue.

Other Areas of Owner Dependence

There is a secondary list of considerations that an owner can evaluate to further see how dependent their business is upon their efforts.  Additional areas that help to measure your direct involvement in the business include:

  • Are key decisions at the company made primarily by you?
  • Do you handle major accounts?
  • Do you have written detailed systems and procedures for your business and a process to assure that they are followed?
  • How often do you enter financial records into the system and/or run for office supplies?
  • Do you have daily meetings with key managers to review objectives?

The answers to this relatively small sample set of questions can assist you in starting to think through your overall involvement in your business.

Reducing Owner Dependence

It has been said that “you cannot manage that which you cannot measure’.  In order to reduce owner dependency, it is important that you first measure how much your company has.  Once that is complete, you can look to reduce that owner dependency and start down the path of Creating a Successful Business Transition.

Concluding Thoughts

While most privately held businesses are run by their founders, it is important when considering a future transfer of ownership of the business that you evaluate your company’s owner dependence.  By taking stock of these important considerations, you put yourself in a better position to reduce the “single-point-of-failure” risk within your business and you begin Creating a Successful Business Transition that you might be able to more easily cash in one day. We hope this article has generated some thinking around your involvement in your business and how you can begin to work today to reduce the overall dependence that your company has on you.

What’s your owner dependency index? Take our survey to find out.

 

A focused mentor is explaining project to mentees at the boardroom at enterprise.

Are You Working ON Your Business?

Written by Stephen L. Ferraro on . Posted in Business Advisory.

A focused mentor is explaining project to mentees at the boardroom at enterprise.

Business owners need an ongoing planning process and implementation of targeted strategies to grow and maximize the value of their business. Now more than ever, it’s just as important to work ON your business as it is to work IN your business…EXECUTION is key! The process should coordinate business valuation, growth planning and business transfer analysis with personal retirement planning. The ultimate goal…successfully operate, grow and transfer your business on your terms and timeframe, while maximizing and protecting your personal wealth.

Maximize Business Value

To determine how fast you can get to where you want to go, you need to know where you are now. That’s why business valuation is so important.  As part of the process, you should review the profits and cash flow generated by your business so you can understand the range of values the market will place on your business as it is today and in the future. You should assess your value drivers – those factors that enhance the inherent value of your business – and discuss strategies that allow you to maximize business value. The process should focus on key areas such as growth, recurring revenue, product differentiation, customer diversification, financial, sales and marketing, customer satisfaction, human resources and more. You should have a customized and evolving roadmap to maximize the value of your business.

Mental Readiness & Owner Dependence

When will you be ready to leave your business? Mental readiness for a transition is a critical factor for nearly every business owner who wants to continue with their business, but still protect their illiquid wealth. You need to know what the business really means to you – personally – and what you are going to do with your time after the transition. The key indicator of this mental readiness is usually how involved you are in the day-to-day operations of the business.  These are critical questions to answer so that you can think clearly through the transfer process and design a plan to meet your goals.  You need to focus on how ready you are to leave, as well as how dependent the business is on you…. what’s your Owner Dependency Index?

Personal Value Gap

In order to answer the question “can I afford to transfer my business?” you must know your personal financial situation.  In other words, is there enough money saved outside the business to provide financial freedom.  In the case of most owners the majority of your wealth is locked in your business. You need to understand the following:

  • What you currently have saved outside the business.
  • What other sources of income are available to you today and in the future.
  • What your lifestyle expenses are today and are expected to be in the future.
  • What the difference is between what you have for assets and income versus what you need for personal living expenses – this is called your Personal Value Gap.

The Personal Value Gap analysis provides an overview of your current financial situation as it relates to being financially free from your business. As part of this process you should discuss and review the following:

  • Your existing lifestyle and how much the business pays for personal expenses.
  • Your current savings, investments, and savings habits, as well as, your current and projected sources of income (such as real estate, social security, pension income, etc.).
  • Your comfort level with projecting certain estimates of return on investments and growth of your liquid assets to complete the Personal Value Gap calculation.
Transfer Options Analysis

As you move through the process you will continually explore when, as well as how you would like to transfer your business. This also leads towards identifying the transfer option(s) that are most likely suitable for you to begin to build your transfer strategy around. Each business owner can identify transfer alternatives available that fit your respective situation.  You should examine all the options available to determine which one is the best fit for helping you to achieve your overall goals. This may include one, or a combination of, the following transfer options:

  • Sale of the Business to an Outside Party/Strategic Buyer
  • Private Equity Group Recapitalization
  • Employee Stock Ownership Plan (ESOP)
  • Management Buyout (MBO)
  • Gifting Program

The various transfer options may have different business values associated with them.  In order to evaluate the outcome from each of the options, you should understand the “Range of Values” that exists for your business. The estimated range of values for the transfer of a business could include the following different values:

  • “Fair Market Value” through the establishment of an ESOP, MBO or gifting program
  • “Investment Value” an investor (such as private equity) may pay for your business
  • “Synergistic or Strategic Value” a competitor may pay for your business
Ongoing Process

Employing an ongoing business planning process of working ON the business will give you peace of mind in having known you have done the hard part, namely making the commitment to move ahead and invest in protecting your most valuable asset and being the best prepared to make the largest financial and emotional decision of your life.

Business Valuation image - going over paperwork

What’s Your Business Worth?

Written by Stephen L. Ferraro on . Posted in Business Advisory.

We perform business valuation services to support the successful transition of ownership in middle market businesses, provide business owners the timely information they need to make informed financial decisions, as well as support successful litigation efforts.

The personal wealth of over two-thirds (70%) of business owners is tied up in their business. For many of these individuals, the business becomes their personal retirement savings vehicle. These individuals, however, could be driving blind. Without knowing the value of the business, how will they know when they can stop working or the lifestyle to expect in retirement? Having the information needed to prepare adequately for retirement is just one of the many benefits to a business valuation.

Besides transition planning, privately held business owners, as well as the legal community can rely on our team of experts in valuation matters for assistance in the following areas:

  • Increase Business Value. What is measured improves, and valuation is no different than establishing and overseeing a sales quota. A comprehensive business valuation will provide owners with a clear explanation of the value of the business along with evidence to support the result. It can tell an owner if efforts need refocusing, or … even better … if the company is headed in the right direction. The data helps guide strategic decisions and business development plans and can even help an owner determine whether the right people are in place to support long-term goals.
  • Divorce. Business interests represent marital assets and could become part of an owner, partner, or shareholder’s divorce settlement. Both spouses may approach the settlement proceedings with independent business valuation reports, so historical valuations could provide valuable insights.
  • Dissolution of Partnership. When a business partnership goes bad or partners agree to part ways, the parties have to find a fair and equitable split of interests. Whether the weighting shares changes, one partner buys the other out, the partnership gets dissolved, or there’s a litigated shareholder divorce, a business valuation will facilitate the process.
  • Capital Infusion. Outside investors and lending institutions will evaluate the business plan, shareholders’ agreement, investment memorandum, and valuation before investing or loaning capital.
  • Mergers and Acquisitions. A business valuation facilitates a negotiation between entities entertaining a possible merger or acquisition.
  • Tax Strategies. A valuation report can lead to tax benefits an owner might not otherwise claim. A current valuation is also required for estate tax settlements, to calculate capital gains tax liabilities, and for income or property tax disputes.
  • Employee Incentive Programs. A company must disclose its value to employees to satisfy annual requirements for Employee Stock Ownership Plans.
  • Insurance Planning. Nearly three-quarters (70%) of businesses do not have adequate insurance coverage. When an owner doesn’t know the value of his/her business, it is challenging to determine how much insurance is needed. Also, if an owner is injured or wrongfully distracted from business, a historical valuation could help recover losses.
Conclusions / Opinions of Value

We have extensive experience with traditional and more formal business valuations, which are often necessary based on the intended use, such as litigation, annual ESOP engagements or estate and gift tax filings. These engagements result in a “Conclusion or Opinion of Value” and can be performed at various levels.

BV Level 1 – We perform all of the procedures required to present an Opinion or Conclusion of Value. Our findings are communicated in computational exhibits without a valuation report narrative. In addition to financial analysis, industry benchmarking and comparable transaction searches, Level 1 includes a self-assessment of owner dependency to help identify where the business may be vulnerable, or increase value, due to over reliance on key individuals.  It also involves a self-assessed value driver profile to evaluate how the company may be viewed from the standpoint of company specific risk and growth potential. The assessments of owner dependency and value drivers, particularly in transition planning engagements, can also be used as tools to help facilitate discussions around increasing the transferability and profitability of the business.

BV Level 2 – We provide everything in BV Level 1 and our valuation findings are communicated in a summary report narrative.

BV Level 3 – We provide everything in BV Level 1 and our findings are communicated in a detailed report narrative suitable to support testimony in deposition, arbitration, or litigation, and may be introduced as evidence before a trier of fact.

*Engagements can be conducted in 2 phases where Phase 1 includes BV Level 1 and Phase 2 includes the reporting from BV Level 2 or BV Level 3.

Consulting, Litigation Support and Related Valuation Services

Additional services will be billed at our standard hourly rates. Such services could include expanded due diligence, asset tracing, merger and acquisition planning, risk assessments, succession planning, exit planning, business growth and profitability planning, transactional tax planning, owner dependency or value driver consulting, transfer options analysis, proform a development, owner dispute resolution assistance, deposition assistance and expert testimony.

Calculations of Value

The real reason most business owners put off knowing the value of their business could be the result of an error in perception. Formal business valuations, while required or desirable under certain circumstances, typically involve a fairly extensive, more expensive and time-consuming process. Thanks to innovative technology, however, those barriers can be avoided in many situations. Our valuation experts can provide accurate “Calculations of Value” at a much more reasonable cost and quicker turnaround. Calculations of Value can be ideal for certain purposes, such as: strategic planning, transaction (purchase or sale) planning, transition planning or litigation or divorce proceedings, which are in the settlement stage.

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Breach of Fiduciary Duty and the Forensic CPA

Written by Stephen L. Ferraro on . Posted in Financial Investigations and Fraud Prevention, Forensic Accounting.

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Where a fiduciary does not act in the best interests of the beneficiary a forensic CPA can play a critical role in analyzing and quantifying economic damages, as well as determining the parties responsible for the breach.

Types of Fiduciary Duty

When one party has an obligation to act in the best interest of another party it is referred to as a fiduciary duty. If the party acts contrary to that duty, it is called a breach of fiduciary duty and can give rise to legal action in civil court. Examples of relationships involving fiduciary duty include:

  • Trustee/Beneficiary
  • Principal/Agent
  • Controlling Stockholder/Company
  • Guardian/Ward
  • Attorney/Client

Breach of fiduciary duty as a business tort (a cause of action for a civil lawsuit) is discussed below, including elements of the tort and common remedies.

An Overview of a Fiduciary Relationship

At its most basic level, a fiduciary relationship may exist when a party places confidence and trust in another party with that party’s full knowledge. The party who owes a duty to the other party in such a relationship is called a fiduciary. For instance, attorneys are the fiduciaries of their clients. But in order for this duty to be legally enforceable, the relationship must have been created either under the law (statutes, legal proceedings, or contracts) or through the factual circumstances of the relationship (often based on established case law).

Fiduciary duties governed by statute include, for example, those owed by a business partner to his or her other partners or the duty of board members to represent the interests of the shareholders. If the fiduciary relationship isn’t implied through statute, then it may be stated explicitly through a contract…along with the specific duties owed.

What Does it Mean to Breach One’s Fiduciary Duty?

There are several ways a fiduciary can breach his or her duty, but it basically comes down to the following factors:

  • A fiduciary relationship existed at the time of the dispute.
  • The scope of the relationship and duties of the fiduciary is defined.
  • The duties were breached within the defined scope of the relationship.

A breach could be actions that are contrary to the interests of a client, actions done out of the fiduciary’s own self-interest, or failure to disclose pertinent information (such as a conflict of interest). For example, a company’s CEO orchestrates a deal to acquire a struggling company owned by his best friend. Assuming the acquisition was not in the best interests of the acquirer and actually hurts its bottom line (and share price), the shareholders may pursue a breach of fiduciary duty lawsuit to recover losses.

Elements of a Breach of Fiduciary Duty Claim

In order to prevail in a claim for this tort, the Plaintiff must be able to prove the following elements:

  • Duty – The defendant had a duty or duties to the plaintiff, such as the duty of good faith and fair dealing, the duty of full disclosure, or the duty of loyalty (the exact nature of the duty or duties will depend on the facts of the particular case).
  • Breach – The defendant breached this duty in some way, such as by failing to disclose certain information, misappropriation of funds, misuse of influential position, neglect of responsibilities, or misrepresentation with regard to a statement of fact.
  • Damages – The plaintiff must have suffered damages, for which the breach was the proximate cause; a breach without damages is not actionable.
Remedies for Breach of Fiduciary Duty

A plaintiff who prevails in a breach of fiduciary duty lawsuit typically will recover the  actual damages incurred, but also may recover punitive damages if the breach can be proven to have been committed out of malice or fraud. But calculating the exact amount of damages caused by the breach…or even proving that a poorly executed business action was in fact a breach…can be quite difficult.

Role of the Forensic CPA

In a breach of fiduciary duty matter, the forensic CPA should first conduct a discovery phase. They typically will know what information to look for and the right people to interview to collect relevant and helpful data. Next, they will combine their accounting and investigative skills to analyze all information and create written reports of their findings…with supporting financial analyses. Within this step, they will trace assets by looking through financial statements and banking documents to determine if there was any asset misappropriation. Importantly, an experienced forensic CPA can effectively serve as an expert witness in support of their opinions during depositions or trial.

The reports and final analyses provided by the forensic CPA can play a key role in the outcome of breach of fiduciary duty action. Their ability to identify, investigate, analyze, test and interpret financial data is a significant value-add to parties involved in these cases. You should select a firm that is dedicated to the forensic accounting field, which provides for ample experience managing a diverse caseload of litigation matters requiring forensic investigation. They also can tap into best practices daily to ensure their clients receive efficient and quality service.

Types of Fraud

Genesis of a Fraud Investigation and Major Types of Fraud

Written by Stephen L. Ferraro on . Posted in Financial Investigations and Fraud Prevention, Forensic Accounting.

Types of Fraud
Detecting Fraud

Most fraud or forensic investigations begin with a suspicion of wrongdoing. The suspicion may be the result of a tip provided through a fraud reporting portal, an unexpected financial occurrence, a person internal to the Company (such as an owner, director or manager), or the result of an external audit. Steps will normally be taken to conduct a preliminary internal investigation. The purpose of the investigation is to determine whether there are fact patterns that indicate there may have been wrongdoing in the area(s) suspected, determine the possible method(s) employed, and attempt to quantify the questionable amounts involved.  It is shortly after the point of the preliminary internal investigation that we are typically called in for assistance. We are engaged to help prove a fraud for prosecutorial and recovery purposes, as well as to help defend an alleged fraud to eliminate or mitigate the monetary implications of any fraudulent activity.

Although many of the fact-finding steps performed are somewhat similar, it is important to differentiate the various types of frauds. The three major types of frauds, described below, are: (1) asset misappropriation, (2) financial statement misrepresentation, and (3) corruption or other illegal acts. Please keep in mind that one single fraud scheme may include all three major types of fraud.

Asset Misappropriation

Asset misappropriation refers to theft, embezzlement, or wrongful use of assets. Typically, it involves vendors and other third parties, as well as management and other employees entrusted to manage Company assets who abuse their position to steal through one or more fraudulent schemes.

In many cases, asset misappropriation is accounted for appropriately in the financial statements and does not result in financial statement misrepresentation. For example, inventory theft would likely be caught during variances identified during inventory counts. The inventory balance would be adjusted accordingly, and the financial statements would not be misstated. To the extent that the misappropriation becomes material, and remains unaccounted for in the accounting records, misappropriation may cause the financial statements not to be fairly presented in conformity with generally accepted accounting principles (GAAP).

Some of the more common types of fraud schemes involving asset misappropriation we have investigated include the following:

  • Embezzlement (skimming, larceny, vendor fraud, investor fraud, ghost employees, kickback arrangements, employee expense reimbursements)
  • Ponzi schemes
  • Corruption or bribery schemes
Financial Statement Misrepresentation

Another area in which we may provide forensic accounting services is in the investigation of alleged financial statement misrepresentations. Different from other fraud schemes in which assets are suspected to have been misappropriated, financial statement misrepresentations may not have resulted in the loss of company assets or the addition of company liabilities. The losses generally associated with financial statement misrepresentations are those that may be claimed by lenders, creditors, investors, or shareholders who placed assets or loans with a company based on misrepresentations in the financial statements (or disclosure omissions). Another common damage related to financial statement misrepresentations may be in the form of additional compensation (bonuses) paid to executives because of meeting certain performance metrics that are ultimately found not to have been met.

Most of financial statement misrepresentation matters involve companies with financial statements that had been audited by an external independent audit firm. Many involve public companies, whose financial statements are required to be filed with the U.S. Securities and Exchange Commission (SEC).  Many investigations regarding claimed financial statement misrepresentation are initiated through inquiries or investigations (or both) conducted by the SEC or Department of Justice. Regardless of the initiation of the investigation, we may be retained by one or more parties to assist with the fact finding, data gathering and investigative analysis. Frequently, the external auditors will deploy a group to participate in the investigation in a “shadow” role. The shadow role exists so that the audit team receives satisfactory information about the investigation process and results to enable reliance as part of audit evidence. The external auditor does not typically lead the investigation due to the potential impairment of independence.

Generally, the misrepresentations are claimed in one or more of the four areas described as follows, although they may affect multiple areas:

  • Income statement (misstated revenue, expenses, net income).
  • Balance sheet (asset valuation, misstated liabilities, fictitious assets).
  • Cash flow statement (misclassified finance versus operating cash flows).
  • Notes to the financial statements, contingent liabilities, pending litigation, variable-interest entities, related party transactions).
Corruption and Other Illegal Acts

Corruption and other illegal acts include all other violations of laws or governmental regulations not covered in asset misappropriation or financial statement misrepresentation. There has been a new focus on corporate governance and enforcement of enacted legislation including the Foreign Corrupt Practices Act (FCPA), the Dodd-Frank Act, and the UK Bribery Act to cite a few. As forensic accountants we may serve several roles related to the prevention, monitoring, or investigation of claims related to corruption and bribery.

Some illegal acts may have a direct and material effect on the determination of financial amounts, such as payments of bribes to foreign officials in violation of the FCPA. Such payments may be mischaracterized in a company’s books and records as “consulting fees” or “”commissions” to conceal their illegal nature. Companies may also improperly deduct bribe payments for tax purposes in violation of US or foreign tax laws, resulting in the understatement of tax provisions and overstatement of reported net income. Failure to disclose material effects of bribe payments on a company’s revenues and profits may also violate other securities laws. Other illegal acts may be far removed from the books and records supporting the financial statements, such as violations of antitrust law. Such illegal acts could result in enforcement proceedings that prevent an organization from doing business in a market, region or service line. Although this type of enforcement action is further removed from the financial statements, it may represent a serious threat to the continued profitability and projected result of the business.

Proving Fraud

Our work in a forensic engagement does not include making a legal conclusion as to the existence of fraud or determining the liability for fraud. While we understand the legal elements, our work is based on an objective evaluation of evidence gathered. That evidence is presented to the client, insurance company or a trier-of- fact who may make legal conclusions as to the existence of fraud.

In proving fraud, the following primary elements must exist:

  • Misrepresentation of a material fact,
  • Knowledge that a statement is false,
  • An act done with the intent to deceive,
  • Reliance was placed on the false representation, and
  • Damage was sustained as a result.
Preventing Fraud

There are many roles and services that we may provide in matters related to fraud prevention and corporate governance. Because of our specialized skills, experience, education, and training, we can provide valuable consulting services in this arena.  Corporate governance-related services include consulting related to the following:

  • Fraud risk assessments.
  • Fraud prevention through enhancements to the systems of internal controls.
  • Development of anti-fraud programs.
  • Monitoring and enhancing established compliance programs.
  • Implementation of fraud reporting portals and other reporting systems.
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Fraud, Economic Damages & Forensic Accounting

Written by Stephen L. Ferraro on . Posted in Economic Damage Analysis, Financial Investigations and Fraud Prevention, Forensic Accounting.

This article is the first in a series by FAZ Forensics intended to provide education on fraud prevention and detection, financial investigations,  critical aspects in the quantification of economic damages, as well as the effective use of forensic accounting methods and techniques.

Fraudulent activity and financial disputes are already widespread in our society and vastly increasing in their frequency. The Association of Certified Fraud Examiners (ACFE) produces an annual Report to the Nation about their global study related to occupational fraud. Occupational fraud includes cases of asset misappropriation, financial statement fraud and business corruption. The 2018 ACFE report cited 2,690 cases of occupational fraud worldwide that were reported and investigated between January 2016 and October 2017. In just the United States, during this period, the reported losses associated with occupational fraud totaled over $7 billion.

Elements of Fraud

Fraud represents a clear intersection between law and accounting…fraud is commonly understood as dishonesty calculated for advantage. A person who is dishonest may also be called a fraudster. In the US legal system, fraud is a specific offense with certain required features. Fraud must be proved by showing that the defendant’s actions involved five separate elements:

  • A false statement of a material fact.
  • Knowledge on the part of the defendant that the statement is untrue.
  • Intent on the part of the defendant to deceive the alleged victim.
  • Justifiable reliance by the alleged victim on the statement.
  • Injury to the alleged victim as a result.
Fraud Theory

Fraud is a crime that is costlier than most people realize. Certain factors must be present to allow most individuals to commit these crimes. There a several theories that explain the factors that lead to fraud and other unethical behavior. Following are two of the more common of those theories. Together, the theories say that an individual’s personality traits and capability have a direct impact on the probability of fraud.

The Fraud Triangle – Developed in the 1950’s by American criminologist Donald Cressey, the fraud triangle is a three-pronged theory of fraud, whereby three factors need to be present for fraud to occur; specifically, pressure (incentive), together with rationalization and opportunity:

  • Pressure (Incentive) – Usually a financial need, is often cited as the reason for committing a fraud. Depending on the context, pressures can be either personal or company based. Personal pressure may come from an individual spending beyond their means, a spouse losing a job, or gambling or drug issues. Personal pressures lead to the individual committing embezzlement or other asset misappropriation schemes. Company pressures may be the result of having to meet earnings expectations or the need for management to meet certain goals to receive compensation. These results could be achieved through financial statement fraud, such as improper revenue recognition, earnings management and other schemes.
  • Rationalization – To justify their actions, the person committing fraud will rationalize such actions. These rationalizations may include: “I only borrowed the money and was intending to pay it back” or “They are a big company and won’t miss the funds” or “I’m not being paid enough in my job.” Entity-based rationalization may include: “The company won’t survive if we miss earnings again” or “We won’t get the loan if our assets don’t exceed $X.
  • Opportunity – If internal controls are weak, the perpetrator may believe no one will notice if funds are taken. In many cases, the system may be tested with small amounts; and larger amounts as the expectation of getting caught becomes lower.

The Fraud Diamond – In the December 2004 New York State Society of CPA’s CPA Journal, David T. Wolfe and Dana R. Hermanson discussed the “fraud diamond.” The authors, added a fourth factor of capability to the Fraud Triangle, and discussed the fraudster’s thought process as follows:

  • Incentive – I want to, or have a need to, commit fraud.
  • Opportunity – There is a weakness in the system that the right person could exploit. Fraud is possible.
  • Rationalization – I have convinced myself that fraudulent behavior is worth the risks.
  • Capability – I have the necessary traits and abilities to be the right person to pull it off. I have recognized this fraud opportunity and can turn it into reality.
Areas of Fraud

In addition to the defense and examination of occupational fraud, forensic accountants are involved in cases pertaining to healthcare fraud, fiduciary fraud, the fraudulent activity of third party administrators, bankruptcy fraud, computer fraud, vendor fraud, procurement fraud, the Racketeer Influenced and Corrupt Organization Statute (RICO), bank fraud, tax fraud, financial fraud, and foreign corrupt practices.

In the healthcare fraud arena, many cases are triggered by the False Claims Act (FCA), the Stark Law, the Anti-Kickback Statute (AKS) and the Criminal health care fraud statute. Additionally, Sarbanes Oxley Corporate and Auditing Accountability and Responsibility Act (SOX) the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) are relevant pieces of legislation that cause forensic accountants to be involved to help defend and investigate financial fraud.

Economic Damages and the Forensic Accountant

Some forensic accountants quantify or value the financial impact a dispute or incident may have on a business and/or individual. They help insurance adjusters and representatives understand the true economic value of submitted claims.  In addition, law firms often engage forensic accountants to bring their expert knowledge to bear on difficult cases where economic damages are in dispute.

Forensic accountants work on contractual disputes, shareholder and partner disputes, intellectual property infringement matters, securities and antitrust cases, business interruption losses, subrogation actions, self-employed lost earnings calculations, and economic damages in wrongful death and personal injury, as well as wrongful termination.

In quantifying a disputed amount or a financial loss, a qualified forensic accountant will question the underlying assumptions, identify the relevant issues and thoroughly examine the detail. The measure of damages follows generally accepted methodologies. The skilled forensic accountant prepares recognized financial models to provide an estimate of the economic damages experienced resulting directly or indirectly from the wrongful act or incident. The depth and breadth of their industry knowledge and their financial acumen enable forensic accountants to really understand whether the numbers make sense and will stand up under the toughest scrutiny.

To prove economic damages in a litigation setting the experienced forensic accountant will successfully address and abide by the following legal principles:

  • Proximate Cause: The recovery of damages for lost profits is subject to the general principle that damages must be proximately caused by the wrongful act or incident. This requirement is expressed in numerous cases and governs the recovery of all compensatory damages.
  • Reasonable Certainty: A second requirement for the recovery of damages for lost profits is that the damages be proven with reasonable certainty. It requires that damages be capable of measurement based upon reliable factors without undue speculation. Again, this principle is expressed in many cases and is unquestionable.
  • Foreseeability: There is a key question presented by cases looking for recovery of damages for lost profits on contract claims. The question is whether those damages were reasonably foreseeable as the expected and likely result of a breach of the contract at the time the contract was made.

These governing legal principles, which have been well established and reinforced by case law, should be woven into the financial analysis by the forensic accountant in a manner that shows their applicability to the case at hand. Specific supporting case law and practical approaches to demonstrate the relevance to financial models will be addressed in a future article.

Engaging the Forensic Accountant

Whether you’re dealing with fraudulent activity or a financial dispute, the positive impact of an accomplished forensic accountant can be significant. Fraud investigations and dispute resolution will often benefit from the services and skills of an experienced forensic accountant, which include: accounting, tax, general business and financial consulting, strong analytical and research skills, as well as legal knowledge. Forensic accountants also bring intellectual curiosity, professional skepticism, the attention to detail, persistence and the ability to think creatively and communicate effectively.

In addition to having the required skill set to help defend and investigate fraud and quantify financial disputes, many forensic accounting firms have developed the requisite knowledge, systems and procedures to deal efficiently and effectively in the resolution of fraud investigations and financial disputes. This will be covered in detail in future articles and will include the following areas:

  • Effective Use of the Forensic Accountant
  • Prevention and Detection of Occupational Fraud
  • Asset Misappropriation Fraud Schemes
  • Financial Statement Fraud Schemes
  • Specifics and Benefits of Computer Forensics
  • Criteria for Selecting a Financial Damages Expert
  • Overview of Commercial Damages
  • Overview of Individual Damages
  • Legal Principles in Economic Damage Cases
  • Mitigation of Damages Doctrine
  • Anatomy of a Business Interruption Loss
  • Business Divorce: Basics in Shareholder and Partner Disputes
  • Fiduciary Duty and the Exposure for Fraudulent Activity
  • Forensic Engagements: Acceptance and Scope of Services
  • Forensic Accountant: Serving as a Consultant and/or Expert Witness
  • Framework of a Forensic Accounting Investigation
  • Art of the Forensic Accounting Interview Process
  • Forensic Analysis of Financial Transactions
  • Effective Use of Other Forensic Specialists
  • Proper Communication of Forensic Accounting Findings
  • Successful Expert Testimony at Deposition and Trial
  • Case Studies in Forensic Accounting
A brightly lit gas station at dusk with cars refueling and a convenience store in the background.

The Case of Lotto Fever!

Written by Stephen L. Ferraro on . Posted in Economic Damage Analysis, Financial Investigations and Fraud Prevention, Forensic Accounting, Insurance Claims Services.

Everyone knows that hitting the lottery can be an extremely positive and potentially life-altering experience. Well here is a story about “hitting the lottery” that didn’t have such a happy ending.

The Plaintiff in this case owned and operated a convenience store in the suburbs. While running the store, he had managed to earn a consistent, though modest, income for many years. One evening, upon his return home from the store, he received a phone call advising him that his business was on fire. He quickly returned to the scene, only to watch as he lost his livelihood went up in flames. Fortunately for him, he had insurance! That’s how we got involved.

The Fire

The Plaintiff claimed to have locked up the store and headed for home roughly 10 minutes before the blaze broke out. He was allegedly alone in the store when he closed. He claimed that everything appeared normal before he left. Interestingly, upon returning to the scene and seeing the fire, he reportedly proceeded straight to a bar across the street…he supposedly never spoke to any of the firemen at the scene.

An investigation quickly ensued and it was determined that arson was involved in this blaze. As in any such case, suspicion usually turns first to the business owner. Based on the insurance company’s preliminary review of the facts and circumstances, the claim was denied. The business owner sued the insurance company for damages. All the evidence seemed to point to the business owner being responsible for the fire. However, the insurance company and their attorneys had to prove that the owner was, in fact, responsible for causing this loss, or they would be forced to pay for the damages.

Bring on the Forensic Accountants

In every arson case, motive must be established. Typically, the motive is financial in nature. Once engaged, we set out to assess the financial condition of the owner prior to the loss to determine if he may have had a financial motive to burn his business.

We began with a review of his business operations. We learned that sales had been steadily declining in each of the four years prior to the fire. In fact, we discovered the business had been for sale for over a year, with no potential buyers in sight. Competition from the large chains that had moved into the area had become intense, contributing to declining sales. To continue his personal income level, the owner was forced to cut his payroll and expenses. This meant that the he had to spend many more hours at the store. Increasing competition, declining sales, longer hours with no end in sight…all these factors surely contributed to the business owner’s next move.

We then reviewed the owner’s personal financial situation. Not surprisingly, due to declining business sales, his personal income was also declining. Future growth of income was not likely…at least if he continued to rely solely on the convenience store for income. We determined his personal debts were mounting. He had virtually tapped every conceivable dollar of credit card and personal debt he could get his hands on.

Unfortunately, he decided to turn to gambling as the solution to his problems. Lotto would be the answer! Unlike most people, however, the business owner had access to his own lottery machines right in his convenience store. So, he began to play.

Every week for nearly four years prior to the fire, the store’s lottery ticket sales averaged about $2,500. On a rare occasion, sales would jump to $3,500 or maybe $4,000 in any one week, generally corresponding to a larger lottery jackpot. Suddenly, however, lottery sales began to escalate. They increased from about $2,500 per week to $9,000 per week! Then up to $16,000! Then $22,000! Then nearly $40,000 in one week! Then the FIRE!

Within a two-month period, weekly lottery sales had grown exponentially! A comparison of sales to jackpot values revealed no consistent or meaningful correlation. There was, however, a correlation between the fire and the State Lottery Office looking for its lottery sales proceeds!

Initially, the business owner did not win much money. In fact, just two months before the fire, he had to use about $20,000 of home equity loan proceeds to pay the Lottery what they were due. This bought the himself more time to hopefully strike it rich. About two weeks before the fire, he won a net of between a $8,000 and $10,000! He got more daring. He “acquired” nearly $40,000 worth of lottery tickets just days before the fire. Unfortunately for him, he collected only $20,000 of winnings, for a one-week net loss of $20,000! With no more financial sources to tap, all his equity fully depleted, and facing a payment to the State Lottery Commission of over $20,000, he apparently resorted to arson. (By the way, he claimed that the cash due the lottery was inadvertently left in a brown paper bag inside the store and was lost in the fire.)

All said, the evidence was overwhelming and financial motive was proven. The business owner lost his case; the attorneys and insurance company won theirs.

insurance

Calculating Lost Profits: Commercial Damages

Written by Stephen L. Ferraro on . Posted in Business Valuations for Litigation, Economic Damage Analysis, Financial Investigations and Fraud Prevention, Forensic Accounting, Insurance Claims Services.

Commercial damages can occur in breach of contract and business tort cases and result in claims for lost profits or diminished business value. Intellectual property infringement cases, securities fraud and antitrust cases also can involve such loss claims. Measure of damages in commercial cases follows basic and generally accepted methodologies. This article covers the basics of calculating lost profits in commercial damage cases from a forensic accounting perspective. There are variations in measurement in intellectual property and securities cases and these variations will be detailed in subsequent articles.

In general, lost profits are determined by first estimating the lost gross revenue (or lost sales) due to an event. The lost revenue is then reduced by the avoided (or saved) costs, which entails evaluating all the direct and other costs related to providing goods or services. This results in the lost profit that would have been enjoyed had the loss of sales not occurred.

Some experts like to use lost gross margin or profits as the of measure of damages. This usually isn’t the correct way to value damages. Gross margin only comprises revenue reduced by cost of goods sold. Such a calculation fails to consider other costs of a business that may be directly, or indirectly, related to providing a good or service and avoided.

Another important aspect of a damage calculation is correctly assessing the loss period. The loss period normally begins on the date the event occurred, which should be easy to determine. The ending date of the loss period may be more difficult to estimate. It will likely be based upon the date the business resumed to normal operating levels or the end of the term of a contract. The requirement for mitigation could also come into play in the determination of the loss period.

Lost Revenue

As mentioned, the first, and probably primary, element of a lost profits calculation is the determination of revenue lost due to the event or action. The method used for calculating lost revenue will vary depending upon the industry, the data available for the calculation, and the type of loss. There are few typical methods for calculating lost revenue. A brief description of each follows:

  • The “Before and After” Method: Under this approach, the expert compares the revenue of the business before and after the event. The underlying theory is that “but for” the event, the business would have experienced the same level of revenues and profits after the event as the business did before that event. Some consideration for other factors that could have affected the level of revenues is also warranted, such as the potential future impact of the trends in revenue in place prior to the event.
  • The “Yardstick” (or “Benchmark”) Method: Under this approach, the expert utilizes a “yardstick” to estimate what the revenues and profits of the affected business would have been. Examples of potential yardsticks that could be used include; comparing the revenue trends and results of the business to a similar business; comparing to other unharmed locations of the business; utilizing the actual experience versus budgeted results or industry averages.
  • Contract Terms: In some instances, the expert can reference a specific contract that may set forth terms which determine anticipated revenue levels. A model might be developed that calculates the revenues and profits anticipated under the terms of the contract.
  • Defendant’s Profits: In cases involving unfair competition or the intellectual property infringement an accounting of the profits realized by the defendant may be used as the measure of damages. The plaintiff is entitled to receive the value of unjust enrichment of the defendant through disgorgement. We will provide much more information related to this method and measure of damages in a subsequent article.
Direct Costs and Other Expenses

To arrive at an accurate lost profit amount, the forensic accounting expert must determine the direct costs and other expenses associated with generating revenue. For example, many businesses incur direct material costs, labor costs, utilities, supplies, and other costs and expenses to make and deploy their product and services. To the extent that the company lost sales, the company also did not incur the expenses associated with those sales. These avoided (or saved) costs need to be calculated and factored into the lost profits.

It’s important for the forensic expert to understand the company’s cost structure, but the degree of detail required in estimating costs will vary from business to business. It is necessary to understand how the company’s costs relate to the sales and what factors affect the costs. The accounting concepts involved in understanding and separating the cost structure are many, and require thoroughness on the part of the expert.

As with the calculation of lost revenues, it is always important for the expert to examine the calculated expenses for reasonableness. They must be satisfied that the numbers make sense considering the information available in the case.

Other Important Considerations

One critical part of the damage calculation process is the assessment of causation. If a company suffers a loss of sales compared to “expected” levels, the expert should consider all possible reasons for the reduction in sales. All, or part, of the reduction could be the result of something completely unrelated to the alleged event. While the sales loss may be related to the event, it is also possible that certain market or industry conditions may have impacted sales. It is important to examine how things such as economic conditions, competition, expiration or loss of a key contract, government regulations, weather patterns, company reputation, and the desires of the marketplace may have impacted a sales loss. Any reduction in sales related to these types of factors should be evaluated, and in most cases, excluded from the lost profits calculation.

The expert must also consider the potential for sales “make up” at other locations, or after the loss period, as well as, other ways to mitigate the damages in the matter at hand. If a company can find alternative ways to produce a product or locate a new supplier of raw materials, these types of things might reduce the damages. Since the plaintiff is required to mitigate, the expert must also evaluate whether mitigation was possible, even if the plaintiff did little or nothing to mitigate the damages.

While the mitigation efforts are required and could help the loss situation and may ultimately serve to preserve sales levels, they may come with additional costs that should also be evaluated by the expert. These costs could result from temporary operating locations, subcontracting expenses or expediting expenses incurred to receive or ship product.

Lost profits for new businesses are difficult to estimate because of the lack of operating history. In these cases, other sources of data must be sought to help calculate damages. Sometimes business plans or budgets are used, even though these may be regarded as somewhat speculative. The expert is often left to make many assumptions about the new business, but ought to seek as much support for those estimates as possible.

If statistics or other data are used to calculate damages, they should be derived from widely-respected and reliable sources. Experts often look for outside information to support assumptions made in the calculation of lost profits. This information should only come from sources that are known to provide generally accepted, reliable and accurate data.

Summary

The calculation of lost profits can be a very subjective, detailed and time-consuming process. It is necessary to be as thoughtful and accurate as possible when estimating lost sales and the related saved costs or expenses. Maybe most important, is the fact that this is not an exact process, and relies on significant estimates. A forensic accounting expert must calculate damages that are reasonable and that use reliable information and widely-accepted methodology.

Forensic Accounting and CPA

Effective Use of the Forensic CPA

Written by Stephen L. Ferraro on . Posted in Business Valuations for Litigation, Economic Damage Analysis, Financial Investigations and Fraud Prevention, Forensic Accounting, Insurance Claims Services.

During the course of your work, you may have called upon a Forensic CPA for assistance. It might have been for the assessment of commercial damages or to perform a fraud or financial investigation. You may have hired one to calculate future lost earnings related to personal injury or to prepare a business valuation for a shareholder dispute or estate matter. Perhaps you engaged a forensic CPA to determine financial motive in an arson case. As with most things in life, some attorney experiences with CPA Experts have probably been good and some…not so good. So how can you get the most out of your Forensic CPA relationships?

1. Call Early

One of the best ways to compromise the effectiveness of any expert is by delaying their involvement in the process. Some attorneys are hesitant to call in the hopes of controlling the cost of outside experts. Others only think of CPAs as expert witnesses at trial and, consequently, delay their involvement. There are also those who mistakenly think if they gather some financial information on their own it will make the process smoother. Whatever the reason, most delays in making that phone call will result in weakening the expert’s value to the process.

The initial phone call does not have to result in the start of a full-scale engagement. In fact, it may only be for assurance purposes, since sometimes there is no need for further involvement on the part of the expert. On the other hand, many times the immediate involvement by the Forensic CPA is required to effectively develop the document request, follow-up interrogatories, or important deposition questions. Having expert financial assistance to develop a well drawn document request and insightful deposition questions is the first step toward negotiation and, ultimately, a reasonable settlement. The bottom line is that it does not hurt and, in fact, can only help the situation by calling the Forensic CPA early in the process.

2. Communicate Throughout the Process

Advanced and regular communication is required to properly manage the work, and ultimately the bill, of the Forensic CPA. The attorney should be very specific in their instructions right from the start. This will serve to avoid unnecessary or duplicate work, as well as the omission of important procedures, on the part of the expert.

The attorney should discuss the overall strategy with the expert. Often an attorney may discuss what needs to be done, but omit the reason. CPAs dedicated to forensic accounting and expert witness services have a broad background and a great deal of experience in dealing with these types of financial matters. If the attorney discusses strategy with the expert, they may be able to suggest alternatives that the attorney had not even considered.

3. Determine Relevant Experience

Engaging a CPA with forensic accounting and litigation experience should be a must. Litigation support and expert testimony are very different from more traditional accounting, which typically involves tax return preparation and auditing for a client with whom they have had a cooperative relationship for many years. A Forensic CPA has to be much more creative and adaptable. They are often faced with many adversarial relationships that a more traditional CPA may be unprepared to deal with. These situations require the ability to be forthright, yet tactful. A Forensic CPA must also have a broad business background and be perceptive to differing methodologies, techniques and record keeping options. They must be able to delve into the situation in spite of disorganized or incomplete records.

Engaging an experienced CPA who has no expertise in forensic accounting and litigation support could result in the attorney paying for the CPA to get the proper training or experience. Even a very talented CPA who has no previous forensic accounting experience will have to spend some time getting up to speed in forensic techniques and methods and the litigation environment. The basic point is that hiring a CPA inexperienced in forensic accounting and litigation could easily produce substandard results, mishandling of the case, or unnecessarily high billings.

4. Evaluate Supporting Forensic Credentials

The CPA expert’s credentials are an important part of the decision making process. The attorney should look for an expert with relevant credentials governed by the American institute of Public Accountants (AICPA), the National Association of Certified Valuation Analysts (NACVA) and other relevant organizations. Some of the more pertinent credentials are the following: Master Analyst in Financial Forensics (MAFF), Certified Fraud Examiner (CFE), Certified Business Appraiser (CBA), Accredited in Business Valuation (ABV), Certified in Financial Forensics (CFF) and Certified Valuation Analyst (CVA). The CPA expert should also be an active participant in the organizations that monitor their relevant designations and continuing educational requirements.

5. Assess Expected Costs vs. Potential Benefits

During the initial telephone call the attorney should begin to evaluate the extent of involvement warranted by the Forensic CPA. If the issue is relatively small, the attorney may be able to proceed after only a short conversation with the expert. In this type of situation extensive work would probably be overkill and not considered cost effective. On the other hand, in more complex situations, the attorney may want more extensive involvement on the part of the expert to help develop effective document requests, interrogatories, deposition questions, and perhaps ultimately, expert testimony.

6. Review Previous Expert Testimony

Attorneys should look into previous cases to see the opinions and reports the CPA Expert has issued in the past for deposition or trial. Counsel should also find out whether an expert has been subject to Daubert challenges and/or has had their opinion excluded at trial. This is a critical part of the selection process.

7. Control the Costs Where Possible

One way to keep billings under control is to remember that attorneys should not always request a formal detailed written report. The CPA’s financial analysis can be made in financial schedules. A shorter, less formal report can serve well in many instances for effective negotiation and settlement proceedings. In many situations the attorney could make the most effective use of the expert’s time by hiring them for a meeting or teleconference to help explain the analysis and reach a mutually agreeable settlement. Formal detailed reports are more appropriate for cases definitely going to trial and with complicated fact patterns. If appeal is a factor, a formal detailed report will undoubtedly become a welcomed part of the attorney’s records.

Summary

In summary, if used effectively, a Forensic CPA can be an invaluable resource for an attorney in litigation matters. The relationship should begin early and there should be good ongoing communication between the expert and the attorney regarding the work to be performed and the related strategy. The attorney should weigh the cost of the CPA Expert against the benefit they hope to obtain and direct the expert work accordingly.

Read Our Reviews

FAZ Forensics is rated 4.95 out of 5.0 stars based on 21 review(s).

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FAZ Forensics did a full review and evaluation of my business and I was very happy with the level of detail and expertise.

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Christian has, along with his good nature and thoughtful regard, been exceedingly helpful with sorting out the complexities of our case. We could not be more pleased with our exchange. Thomas and Hema Easley

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Christian was patient and easy to understand. clear, concise and thorough. he spoke “plain” English and was respectful. he did not “rush” and he responded to every question i had, in a timely manner. no matter how “dumb” it may have seemed. for example, i received some paperwork by mail and i did not understand it. i emailed him about it and he cleared it up that day. thats great customer service!

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Really good, very knowledgeable and communicated with us every step of the way.

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FAZ has a great team doing terrific work for our clients.

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Exceptional work produced.

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Thanks!

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FAZ was very professional, knowledgeable and very fair priced. The work performed was prompt, accurate and reliable. I would absolutely hire them again if in need for additional accounting work.

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Awesome team! They were a pleasure to work with. I would definitely recommend.

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FAZ was extremely thorough and professional in doing our business valuation. We are very pleased with the results

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Steve and GeNet were great at the valuation we needed. Very satisfied. Thanks,Vince and Anne

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Perfect

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Gen'et and Paul were extremely responsive to our needs. They listened and responded to any concerns that we had. I would highly recommend them for any forensic engagement needs.

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Thank-you for asking. Our experience was excellent. The people at FAZ showed a depth of knowledge and experience that was very helpful with the undertaking before us. Well done.

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The CPAs and staff at FAZ are truly amazing. They explain their process very well and always answered my questions right away. I highly recommend them for all your forensic accounting and evaluation services.

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Excellent and responsible.

- Peter Lee

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Steve Ferraro did an excellent job and worked tirelessly as our expert forensic accountant witness. Based on Steve's hard work, the jury awarded every penny that Steve showed our client to be entitled to and completely rejected the conclusions of the opposing side's expert.

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Great firm!

- John Harwick

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The people at FAZ are amazing. They are true professionals. The staff is knowledgeable & kind. You feel like you matter. Anytime I have questions they take the time to go through everything in detail so I completely understand everything. I would definitely recommend FAZ.

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