How Accurate are Corporate Earnings Reports?
Author: Tim McPoland
Researchers from Duke University and Emory University recently released surprising results of their study on the prevalence of corporate earnings “management.” As described in the report, “Earnings Quality: Evidence from the Field,” the researchers surveyed 169 CFOs of public companies and conducted in-depth interviews of 12 CFOs and two setters of accounting standards. Their report provides valuable insight into earnings manipulations that potentially could affect damages calculations and other legal matters.
Signs of quality
The report explains what constitutes high-quality earnings. According to the surveyed CFOs, a company’s earnings are “high quality” when they’re sustainable and backed by actual cash flows. Other, more-specific characteristics of quality include consistent reporting choices over time and avoidance of long-term estimates.
The study’s researchers indicate that this view of earnings quality is consistent with a valuation perspective because a company’s value is assessed by estimating and discounting the stream of future profits. Thus, current earnings should be considered high quality if they serve as a reliable guide to a company’s long-term profits.
What’s wrong with management?
For its part, earnings management is defined as manipulation that misrepresents performance but nonetheless falls within Generally Accepted Accounting Principles (GAAP). The CFOs estimated that, in any given period, roughly 20% of companies manage earnings, and that the typical misrepresentation was about 10% of reported earnings per share.
The study’s subjects believe that 60% of earnings management increases income, while 40% decreases income. While the latter figure may sound counterintuitive, the researchers attribute it to accounting practices such as “cookie jar reserves,” whereby, for example, a company records a discretionary expense in a period with high profits because it can afford to take the income hit.
“Big baths” is another accounting practice that could explain the 40% decrease. In that scenario, a company manipulates its income statement to make weak results appear even worse by, for example, shifting profits from a bad year forward to artificially enhance the following year’s earnings. Such manipulation produces a performance bonus.
Watch for red flags
Researchers asked the participants to list three red flags that would help detect earnings misrepresentations. The most commonly cited were:
- Earnings inconsistent with cash flows. More than 100 CFOs identified this or the similar “weak cash flows” and “earnings strength with deteriorating cash flows” as warning signs. The authors noted that the importance of the link between earnings and underlying cash flows was prominent throughout the study.
- Deviation from norms. Deviations from industry norms or experience registered 88 responses. Specific examples include disparity in financial statement items such as cash cycle, average profitability, revenue and investment growth, and asset impairments.
- Unusual accruals. Another red flag is “lots of accruals or unusual behavior in accruals,” including large jumps. The CFOs emphasized changes in accruals, as opposed to extreme levels of accruals.
With reported earnings playing a critical role in a variety of legal matters — from damages calculations to transaction prices — your clients can’t afford to take them at face value. A qualified financial expert can help detect managed earnings that misrepresent performance.
If you have any questions about reported earnings or any other forensic accounting issue, give us a call at 716.847.2651, or you may contact us here.
Court Allows Lost Profits Expert Testimony
Author: Tim McPoland
When an opposing party in a lawsuit challenges the admissibility of an expert’s testimony, the matter often comes down to one of two interpretations: whether the court believes the party’s arguments go to the admissibility of the evidence or to the weight of the evidence. The ruling in a federal district court case, BK Cypress Log Homes v. Auto-Owners Insurance Co., illustrates such determinations and highlights the need to present relevant expert testimony.
BK Cypress Log Homes sued Auto-Owners Insurance Company, alleging bad-faith conduct in the handling of a third-party claim. The defendant moved to exclude the plaintiff’s damages expert’s testimony on the grounds that his techniques weren’t generally accepted in the economic community. The expert used a two-part model, estimating lost profits with both the before-and-after and yardstick methods.
In his first calculation, he determined the plaintiff’s profit margins before and after the loss period. He attributed the difference to effects created by BK Cypress owner Jim Keeton’s participation in dispute-related activities that should have been handled by the defendant and that resulted in operational inefficiencies.
In the second calculation, the expert considered what the plaintiff’s sales would have been if the company had matched the industry average sales for the loss period. He used sales information from a log-home industry publication, as well as a “sample survey” of members of the Log Homes Council. Together, these sources yielded growth rate numbers for six companies.
Court rejects challenge
In the Florida court, the defendant asserted that the plaintiff’s before-and-after analysis wasn’t acceptable because it assumed that all loss in profitability was attributable to the defendant’s bad faith. In particular, Auto-Owners faulted the lack of data documenting:
- The amount of time Keeton spent attending to dispute-related matters, and
- The failure to account for time he would have expended on such matters even in the absence of bad faith.
The court concluded that the defendant’s criticisms should be raised through cross-examination of the expert and other witnesses regarding the assumptions underlying the damages calculation.
The defendant also argued that the yardstick analysis wasn’t acceptable because, among other things, the expert’s report didn’t establish that the businesses used to measure the losses were sufficiently similar to BK Cypress. The court denied the motion to exclude this part of the analysis — but without prejudice to the defendant’s right to exclude the testimony at trial if the plaintiff was unable to establish the survey data’s reliability through other evidence.
Rebuttable witness also rebuffed
Notably, the court also rejected the testimony of the defendant’s financial expert because he didn’t provide an estimate of damages. It characterized that expert’s testimony as a rebuttal opinion that failed to offer an alternative analysis methodology.
In the end, the court decided that the defendant’s expert’s testimony wouldn’t aid the jury in determining damages and would in fact be “redundant and unduly prejudicial.” Instead, the defendant was instructed to explore the criticisms in its expert’s report during cross-examination of the plaintiff’s expert and other witnesses.
If you have any questions about lost profits, testimony or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.
Court Confirms the “Gold Standard” of Valuation
Author: Tim McPoland
Business valuation arises in many legal contexts, including damages calculations in commercial litigation. In a recent case we have discussed, Malik v. Falcon Holdings, LLC, Seventh Circuit Court of Appeals Chief Judge Frank Easterbrook turned to what he called the “gold standard of valuation” to help determine damages for plaintiffs.
Aslam Khan held 40% of the common units in Falcon Holdings, a limited liability company that owned and operated 100 fast-food restaurants. Khan allegedly told Falcon’s managers that when he acquired full ownership of the company one day he would reward top managers with 50% of Falcon’s equity.
In 2005, Khan bought out Falcon’s other owners and became the company’s sole equity owner. When he failed to distribute common units to any of the managers, five of them took him to court.
The plaintiffs used the price Khan paid in the buyout to calculate that the company was worth about $48 million. They also determined that because 20 managers qualified for units under the terms of Khan’s offers, each plaintiff lost about $1.2 million ($48 million × 50%/20).
District court’s ruling
In summary judgment the district court found that Khan had promised the plaintiffs an equity stake in Falcon. But it held that the managers hadn’t adequately estimated their damages.
The court reasoned that the other owners didn’t own 100% of Falcon, making it impossible to derive the value of the whole firm from the amount Khan paid for their interests. Also, the amount the other owners were paid depended on how much Khan and Falcon could borrow — not on Falcon’s true value. Therefore, the plaintiffs’ approach was flawed.
Easterbrook questions analysis
On appeal, Judge Easterbrook rejected the district court’s analysis. That court’s two propositions ignore the fact that the “gold standard of valuation” is what a willing buyer will pay a willing seller in an arm’s-length transaction. Easterbrook concluded that the buyout of the other owners involved a willing buyer and a willing seller dealing at arm’s length, so the price they agreed on was the value of the asset.
But the judge also found fault with the plaintiffs’ damages estimate. The interest that plaintiffs valued and the interest Khan owned were different. The plaintiffs valued the entire company — or the sum of Falcon’s debt plus its equity. However, while Khan owned 100% of the equity, the bank held the debt interest. The judge found it unsound to assume that Khan’s equity interest in Falcon was worth 100% of the company’s total value.
Easterbrook also questioned the plaintiffs’ assumption that Khan would give each of the 20 managers 2.5% of Falcon’s equity units without attaching terms or conditions to them. He characterized this proposition as “a disaster not only for the ownership structure of a closely held firm but also from a tax perspective.”
Plaintiffs hold out hope
Easterbrook vacated the district court judgment and remanded the case for proceedings consistent with his opinion. The plaintiffs are still expected to receive something if they calculate damages according to the “gold standard,” but that amount will likely be less than the $1.2 million each manager had hoped for.
If you have any questions about the “gold standard” of valuation or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.
Financial Professionals Can Assess Severity and Risk
Author: Tim McPoland
Business bankruptcies are finally on the decline after several consecutive years of high and rising rates. According to the American Bankruptcy Institute, in the first nine months of 2012 U.S. commercial bankruptcies fell 22% over the same period in 2011.
Of course, favorable statistics don’t mean much to the thousands of companies still in financial peril. If you have clients facing bankruptcy, you want to help them make the best decisions. And to do so, you need financial experts on your team. Accounting, valuation, damages, and merger and acquisition (M&A) professionals can help assess the severity of the financial crisis, determine whether liquidation or reorganization makes sense, and provide guidance on everything from selling assets to shareholder disputes.
Cut losses or keep going?
The recovery process starts by identifying ways the troubled business might regain control of its cash flows. After working with the business to establish a daily cash budget to stop the immediate bleeding, a financial expert can determine which form of bankruptcy is more appropriate — Chapter 7 (liquidation) or Chapter 11 (reorganization). There might also be a third option: Take steps to avoid bankruptcy altogether.
The expert can develop financial projections for several reorganization options, including best-, probable- and worst-case scenarios. Using a Z-score formula, he or she begins to assess a struggling company’s financial strength and estimate the risk and probability of whether the business will go bankrupt.
Chapter(s) and verse
When a company’s liquidation value exceeds going concern value, most experts recommend that it consider filing for Chapter 7 bankruptcy protection. Liquidation value is often seen as a “floor” for a company’s value.
But sometimes businesses are actually insolvent, meaning they can’t pay their debts. In such cases, a financial expert might act as a court-appointed receiver and turnaround consultant who can facilitate the liquidation process — including winding down operations and paying out creditors in order of legal preference.
If, on the other hand, a Chapter 11 filing is deemed appropriate, a financial expert can help “sell” a reorganization strategy, such as debt forgiveness and restructuring, to lenders and other creditors. Due to the tight credit market and recent conservatism of lenders, many loans are over collateralized. By appraising assets (including inventory, equipment and receivables), a valuation expert can assist in renegotiating working capital covenants. As debt terms are eased, cash can be freed up.
Alternatively, a reorganization might call for divestitures of unprofitable segments, so the company’s owners can refocus on core operations. Or a distressed business might solicit offers to buy the company or its assets. An M&A expert can help your client find potential buyers and evaluate whether divestitures and offers appear reasonable.
When minority shareholders or creditors contest a divestiture or sale, distribution or other transaction, a valuation expert can write a fairness opinion to help demonstrate that management exercised good judgment in analyzing a transaction. Fairness opinions are especially important when transactions involve related parties or if the CFO’s compensation package includes a “golden parachute” clause.
End the squabbling
Another unfortunate side effect of financial distress is shareholder disputes. When management squabbles impair daily operations and decision-making, owners may decide to split the assets — or one owner may choose to buy another’s interest. In these cases, buyers tend to undervalue the business while sellers tend to overvalue it.
A valuation expert can help bridge the two sides by objectively estimating what the company and its underlying assets are worth. The expert also can help the parties identify assets that aren’t on the balance sheet — including contingent legal and tax liabilities, customer lists, brand names, and business goodwill — and explain the tax implications of buyout terms, such as installment sales and earnouts.
When so much has already gone wrong, financially distressed businesses just want to make the best possible decisions going forward. Whether that means an immediate Chapter 7 filing or an elaborate reorganization plan, the input of financial professionals is essential.
If you have any questions about business bankruptcies, give us a call at 716.847.2651, or you may contact us here.
An Enforceable Buy-Sell Agreement Should Provide for an Up-to-Date Appraisal
Author: Tim McPoland
Closely held businesses commonly rely on buy-sell agreements to facilitate liquidity and smooth ownership transitions. But the agreements also occasionally play a part in divorce proceedings. In one such case, Wood v. Wood, a Missouri appellate court rejected a buy-sell agreement’s valuation formula as the basis for valuing the business in the divorce settlement.
The husband was an employee and part owner of a closely held corporation. At their divorce trial, he and his wife both presented expert testimony on the value of his interest in the business.
The wife’s expert applied a valuation formula included in the buy-sell agreement that her husband and the two other shareholders entered into in 2007 when they purchased the business. The formula provided that the total shares’ value equaled the last appraised value of the company, plus or minus earnings or losses, and less dividends paid or declared by its board. Using this approach, the expert calculated the total value of the business to be approximately $3.5 million, with the value of the husband’s interest being about $1 million.
The husband’s expert conducted an actual appraisal of the business and presented an opinion on the fair market value (FMV) of his interest. The expert relied on traditional measures of valuing closely held businesses, including accounting for goodwill, minority ownership and the impact of the economic recession. He calculated the FMV of the husband’s interest to be $325,000.
Finding the testimony of the wife’s expert more persuasive and credible, the trial court relied on her valuation formula’s calculation. The husband appealed.
The appeals court noted that a closely held corporation’s share value is usually reached using the earning, liquidation (or underlying asset) or comparable sale approach. It also pointed out that, in a divorce proceeding, the objective of a business valuation is to determine FMV as of the date of trial.
However, the wife’s expert’s calculation didn’t seek FMV. Moreover, the expert didn’t use a current appraisal of the business as part of the calculation of present share value. Instead, the expert used the historical value of the company in 2007 as the starting point.
The appellate court acknowledged that a trial court generally can accept the opinion of one expert on value over another and can prefer one valuation method over others based on the particular facts of the case. But it explained that, when an expert’s testimony doesn’t attempt to determine FMV, a trial court simply can’t find it more persuasive and credible than another valuation. And it can’t rely on such testimony in valuing the shares.
The trial court, therefore, had misapplied the law. The appeals court reversed and remanded for a proper determination of the value of the business as of the date of the divorce.
Easier isn’t better
The main lesson in Wood is that it’s critical to ensure that a valuation is seeking the appropriate standard of value for the matter at hand. But the case provides a secondary lesson as well: Although the valuation formula in the husband’s buy-sell agreement didn’t harm him here, it could in other situations.
Say, for example, the husband was involved in a dispute over how much he was required to pay a co-owner who was exiting the company. Using a formula like that in the Wood case, he could end up paying the co-owner about three times as much as he would if FMV were determined under traditional methods.
It may seem easier and cheaper to include a valuation formulation in a buy-sell agreement than to provide for an independent appraisal. But it’s not advisable because formulas often are overly simplified. They may rely primarily on preset multiples of historical earnings or on current book value. Such formulas often exclude subjective, but important, factors such as the company’s risk premium and future growth rate, current economic conditions, and other key factors that involve professional judgment and analysis. A full valuation by an independent appraiser can account for all critical elements.
Drafting a solid agreement
Depending on the jurisdiction, an enforceable buy-sell agreement should provide for an up-to-date appraisal. A valuation expert can work with you and your client to draft a solid agreement, as well as provide a current appraisal when needed, whether for purposes of divorce, ownership changes or other reasons.
For any questions on buy-sell agreements or any other litigation support issue, contact us here or give us a call at 716.847.2651.
How “Speculative” Lost Profits Damages Can Crumble in Court
Author: Tim McPoland
Lost profits damages can be tricky to assess, particularly when valuators must base their calculations on a new business’s projected profits. A recent California case, Beijing Tong Ren Tang (USA) Corp. v. TRT USA Corp., illustrates how such claims can easily crumble upon examination.
A falling out
Beijing Tong Ren Tang USA (BTRTUSA) entered into an agreement with Advantage United Corporation, predecessor of TRT USA Corporation (TRT), to cooperatively sell traditional Chinese medicine products in the United States. According to the agreement, TRT would be the general exclusive agent distributing the main BTRTUSA products.
When the parties’ business relationship soured, BTRTUSA sued TRT and three of its officers and directors, alleging violations of the Lanham Act. TRT and its three officers and directors filed a counterclaim against BTRTUSA and Chuanli Zhou, BTRTUSA’s vice president, for fraud and breach of fiduciary duty.
A jury ruled in favor of TRT on the fraud claim against BTR and Zhou. As compensatory damages, it awarded $1.3 million in lost profits. The jury also ruled in TRT’s favor on the breach of fiduciary duty claim against Zhou, awarding an additional $741,450 in lost profits.
Evidentiary support is lacking
BTRTUSA and Zhou responded to the ruling by asking the district court for a judgment as a matter of law on the basis that the jury lacked sufficient evidence for its decisions. The district court determined that the fraud award was based on projected profits according to TRT’s business plan. BTRTUSA argued that, because the business plan projected profits for a new venture in an area where TRT had no track record, the lost profits damages were too speculative.
The court conceded that damages generally aren’t awarded for anticipated profits of a new business. However, that presumption can be overcome by concrete evidence that allows a fact finder to establish the amount of damages with reasonable certainty. TRT, the court decided, failed to provide such evidence. What’s more, evidentiary support for a lost profits claim was totally lacking. The lost profits projection was made on the basis of a “speculative, grandiose business plan” and, according to the court, made assumptions that were “totally unrealistic and unreasonably optimistic.”
Some damages allowed
In some circumstances, projected profits in a business plan may provide enough certainty regarding damages to overcome the absence of a proven track record. But the district court considered the profits projected by TRT’s business plan too speculative to meet the legal standard of reasonable certainty necessary to support lost profits damages.
However, the court allowed some lost profits damages. TRT’s damages expert had testified on an alternative way of computing fraud damages based on monies that TRT paid but wouldn’t have paid but for the wrongdoing by BTRTUSA and Zhou. This calculation included money paid for a product that wasn’t delivered or couldn’t be used; consulting and label design fees paid to Zhou; and a deposit paid on a canceled order.
These damages, according to TRT’s expert, totaled $141,168. The court found sufficient evidence to support the conclusion that they were caused by Zhou’s fraudulent representations.
Fiduciary duty damages fall
Part of the lost profits the court awarded for the breach of fiduciary duty claim was based on Zhou’s failure to ensure regulatory compliance and to provide exclusivity. The court held that those damages were too speculative.
Also ruled speculative was the part of the award related to distribution of Gummy Bear vitamins in China. TRT’s expert’s testimony on those lost profits was based entirely on a business plan by New York corporation IHI to sell the vitamins. Because TRT owned 50% of IHI, the expert assumed TRT would have received 50% of IHI’s profits. And because the business plan involved the distribution of 50 products, profits from the sale of the vitamins would represent one-fiftieth of overall profits.
The court, however, pointed out that IHI was an unestablished business. What’s more, it had never executed its plan to sell the vitamins in China. Further, TRT’s expert didn’t explain how projected profits in the plan were calculated or why the figures could be considered reliable estimates of anticipated profits. The court therefore found he wasn’t a credible witness.
Consequences of weak evidence
In the end, TRT saw its damages award slashed by more than 90%. Don’t let weak supporting evidence harm your clients’ claims. Credible experts who can prove lost profits to a reasonable certainty are essential in these types of cases.
For any questions relating to damage calculation or any litigation support issues, contact us here or call us at 716.847.2651.
Fraud Control Measures Necessary to Avoid Scams
Author: Tim McPolandWithout strong fraud control measures, companies can easily fall victim to fictitious vendor, kickback and other procurement schemes. Although prevention is the best policy, your clients also need to know how to root out existing fraud in their purchasing departments.
Where’s the money?
If a company finds it’s paying higher prices for lower quality products, there’s always a possibility that the culprit is marketplace fluctuations — or even employee incompetence. But it’s worth taking a closer look at procurement practices to determine if kickbacks might be involved.
Cash payments to employees generally are difficult to detect because they aren’t reflected in the company’s books. Kickbacks probably are, however, reflected in higher pricing. Even fraudulent vendors must cover their costs. If your client suspects fraud, it should look for red flags such as consistent shortages, informal communication (such as mobile phone calls or personal e-mails) between purchasing staff and suppliers, and poor record-keeping.
Businesses that accept contract bids for goods or services are at greater risk for kickback schemes. Vendors could be slipping cash to the employee who approves those contracts. Warning signs include fewer bids than expected, widely divergent bids on the same projects and unexplained deadline changes.
Suspicious companies also need to look for payments to vendors that may not actually exist. Employees may conduct fictitious vendor schemes alone or in collusion with individuals outside the organization. Malfeasance may be indicated when invoices are photocopied, sequentially numbered, from companies that have only post-office box addresses, and for amounts that consistently fall just below sums that require manager approval for payment.
Companies also need to scrutinize the relationships between procurement staff and suppliers. In many procurement fraud schemes, an employee is related to or otherwise linked with the owner or management of a supplier. If such a connection is found, the employee should be prohibited from making purchasing decisions that involve the vendor.
Put policies in place
As with any type of fraud, the best way to avoid procurement schemes is by developing policies and taking other preventive steps. For example, no one employee should be allowed to handle most or all of a company’s purchasing procedures. Specifically, the person who orders supplies and materials shouldn’t be allowed to check shipments or approve invoices.
Anonymous fraud hotlines are a time-tested method of preventing and detecting employee theft. The Sarbanes-Oxley Act requires public companies to offer one. But both public and privately owned businesses at risk may want to establish two hotlines: one for employees and a separate one for vendors to report suspicious or questionable activities. Giving vendors a separate line may make them more comfortable sharing concerns. Also, it allows them to ask questions about the business’s ethical practices.
Your clients also should state in writing how they expect their employees — and vendors — to conduct business. This code of ethics should be reviewed and updated annually, and employees and vendors should be required to sign it every year. Annual reminders reinforce the idea that the company takes ethical, professional business practices seriously.
Going the extra mile
Companies that are at higher risk for procurement fraud may want to perform background checks on new vendors. To weed out dubious vendors, such checks should cover:
- Financial standing,
- History of litigation, and
- Record of regulatory or legal violations or suspensions.
In addition, companies should periodically conduct random checks of vendors’ business records. Vendor address and telephone matches could indicate that two purportedly different companies are, in fact, the same or related.
Finally, it’s always a good idea to verify that supplies or services were delivered as ordered and that there are no billing and payment anomalies in amounts, invoice numbering or other red-flag areas.
Prevention and action
Preventive measures such as internal controls and ethics policies are critical to reducing the incidence of fraud — as well as financial losses. But if a client suspects that a scheme is already underway, engage the help of a forensic accountant immediately. Time is of the essence when it comes to finding fraud and its perpetrators and gathering evidence that will hold up in court.
For any questions relating to procurement fraud or any other forensic accounting issues, contact us here or give us a call at 716.847.2651.
Claims are Relative to a Company’s Existing Policy
Author: Tim McPoland
No matter how well a business documents evidence for business interruption claims, the payout on a claim is always governed by the coverage under a policy. Businesses can provide proof for physical damages that would stand up under the most detailed scrutiny, but if the policy only covers lost sales, there would be no payout. There are three major types of business interruption coverage, and it is essential businesses are aware of their needs and what type of policy they have.
One type of business interruption coverage centers on specific property. For example, a policy may cover loss due to damage or failure of factory equipment. Depending on the policy language, business interruption claims of this type may allow companies to be reimbursed for repair or replacement costs.
Contingent Business Interruption Coverage
This type of coverage reimburses the business for lost sales or revenue associated with damaged equipment, buildings or supplies. However, unlike the above policy, the coverage does not include the physical damage. Businesses would need to have another policy to cover repairs or replacement costs.
An extended interruption coverage policy covers losses over a certain amount of time. For example, an extended coverage policy may reimburse a business for lost sales due to call centers shutting down during a hurricane. These policies usually do not include any type of repair or replacement coverage.
Policy Understanding, Mediation and Court
Insurance policies for business interruption claims can be detailed and complex documents. Likewise, they usually require detailed and documented proof of any claims. Because many business interruption claims can appear subjective in nature, the business is required to provide proof of lost sales in the form of trend-backed data.
Even when an insurance policy covers certain expenses, the insurance company may not agree that a business has provided sufficient evidence. In these cases, it is essential to have experienced legal counsel and expert witnesses. If a case goes to court, a forensic accounting expert can provide detailed testimony regarding lost sales in an understandable manner that will enhance the business's case.
For any questions on business interruption claims, contact our experts here or give us a call at 716.847.2651.
Why You Need a Data-Driven Approach or Lose a Claim
Author: Tim McPoland
A business interruption claim can occur when physical damage or unforeseen events impact a company's bottom-line. In most cases, substantial proof linking the damage or interruption event to specific revenue and sales must be presented by the business. Many companies lose business interruption claims through incomplete evidence because it is difficult to prove something that did not occur.
This is where forensic accounting comes in. Forensic accounting experts use data trends from the business, logical assumptions regarding the business processes and accounting principles to construct proof for sales that did not occur. In order to do this, the expert works with in-house staff to develop a data-driven approach to business interruption claims. Basically, the work of developing a solid claim breaks down into the following procedure.
- Identify the damage.
- Calculate production lost to the damage.
- Use sales trends, data regarding distribution channels and order data to prove the company had the capacity to move items that would have been produced.
- Calculate loss of revenue on those items.
- Document company expenses associated with repairs, work-arounds, or expedited processing to meet orders that would otherwise have been met through standard business processes if the interruption event had not occurred.
The claim may include monetary compensation for lost revenue as well as reimbursement for abnormal business expenses and repairs. Not all business interruption policies cover physical damage or reimbursement for expenses, however. In addition to a forensic accounting specialist, companies should also have legal counsel who will interpret the coverage of any policy.
Comprehensive business interruption claims require a team approach. Legal counsel provides advice on policy issues and ensures a strong appearance in court, if necessary. A forensic accounting expert helps to document the strongest possible claim and can testify in court if needed. The business must also put forth in-house subject matter experts that can provide both the legal counsel and outside accounting firm with industry-specific knowledge regarding processes, sales and trending. Without all of these components, the business risks an incomplete claim that does not satisfy burden of proof and will not hold up in court.
For any questions on business interruption claims, contact our experts here or give us a call at 716.847.2651.
Missing! How Fraud Experts Prove Inventory Theft
Author: Tim McPoland
Sometimes employees lose or misplace inventory. But when theft is a real possibility, your clients need a professional to properly assemble evidence of fraud — and possibly present it in court. Inventory fraud is notoriously difficult to find and document. So when a company suspects an employee of stealing, it’s important to get a fraud expert involved as quickly as possible. Such experts can help find the perpetrator, assemble evidence, testify in court and work with the company to prevent inventory fraud from happening again.
Before assuming theft, a fraud expert determines whether the items were really stolen or were simply misplaced. If employees keep sloppy records or fail to follow proper procedures, “missing” inventory commonly is the result. If the expert can’t find an innocent explanation for missing inventory, he or she looks for signs that the work environment is conducive to fraud. A company with poor controls over purchasing, receiving and cash disbursement is at higher risk of inventory theft. For example, if one person performs multiple duties, that employee can easily steal goods and conceal the crime.
Once an expert believes inventory fraud is a possibility, he or she reviews the company’s records for clues. Anything that doesn’t follow established inventory procedures could be a red flag, such as:
- Odd journal entries posted to inventory,
- Large gross margin decreases, or
- Sudden problems with out-of-stock inventory.
Next, the expert works on establishing proof of fraud.
Follow the paper trail
Inventory fraud may leave a paper or electronic trail, so fraud experts typically review journal entries for unusual patterns. An entry recording a physical count adjustment made during a period when no count was taken obviously warrants investigation. The expert then traces unusual entries to supporting documents.
When inventory fraud is being committed, experts often find evidence in vendor lists. Such lists may show suspicious patterns, such as post office box addresses substituting for street addresses, vendors with multiple addresses, and names that closely resemble those of established vendors.
Even if they’ve found no evidence of nonexistent vendors, fraud investigators look at vendor invoices and purchase orders for anomalies. These include unusually large invoices or alleged purchases that don’t involve delivery of goods. Discrepancies between the amounts due per invoice, the purchase order and the amount actually paid also may suggest something fishy. Experts further familiarize themselves with the cost, timing and purpose of routine purchases and investigate any that deviate from the norm.
Let’s get physical
Physical inventory must be confirmed as well. An inventory count performed by employees could disrupt normal business routines. But it’s an effective way to learn exactly what merchandise may be missing — and could lead directly to the thief. On the other hand, a fraud expert might recommend hiring an outside inventory firm to perform the count and value the inventory.
Whether employees or inventory specialists perform the job, fraud investigators carefully observe warehouse activity once employees realize a count is imminent. Panicked thieves may try to shift inventory from another location to substitute for missing items they know will be discovered during the inventory count.
Because inventory at remote locations also can disappear, fraud experts often will confirm quantities with the storage facility or go with the client to inspect them personally. Whenever possible, it’s best to perform a count in person rather than risk delegating the job to someone who may not be trustworthy.
Expertise is essential
When companies fail to limit access to inventory, allow poor record-keeping, use haphazard counting methods or perform a complete inventory only once a year, they set themselves up for fraud. If your client already has become a victim, make sure the company stops investigating the possible fraud on its own and hands the investigation over to an experienced fraud expert.
If you have any questions regarding inventory fraud or are in need of litigation support, please contact our experts or call us at 716.847.2651.