Forensic Accounting

Tom Kavanagh

Contents

1. What is Forensic Accounting?2. Audit/Due Diligence -v- Forensic Accounting3. Acceptable Earnings Management4. Fraud – the chilling reality

• Risk to Businesses• Fraud in Business Cycles• Building your Fraud Case• Strategy to Succeed

5. Commercial Disputes & Litigation6. Insurance Claims7. Employment Issues

Forensic Accounting defined

Forensic Accounting is the analysis and presentation of financial information that is suitable for use in a Court or a Tribunal

– Commercial litigation and disputes– Fraud and corporate investigations– Financial due diligence– Insurance claims– Business valuation– Regulatory compliance

Audit/Due Diligence -v- Forensic Accounting

Opinion on financialstatements

Investigate specificissues

Rely on management Investigate suspicions

Review largequantities of data

Work from Summaries

Tell a story, uncoverfacts

Financial statementfocus

Audit/Due Diligence -v- Forensic Accounting

Work to GAAPIntuitive process

applied

Verification of pastRecreate past, predict

future

Focus on events andstransactions

Focus on patterns andexceptions

Reactive basisActive basis (annual)

Where were the Auditors?

“The media has reported on a number of alleged spectacular earnings management cases. Articles have included headlines such as ‘Pick A Number, Any Number’, ‘Abracadabra’ and ‘10 Reasons Numbers Lie.’ In these articles, the question has been raised ‘where were the auditors?’”

Lynn Turner, Chief Accountant, SEC

Acceptable Earnings Management

Examples of legitimate earnings management efforts include…

– postponing an acquisition or a disposal – accelerating expenses when earnings are high and

postponing expenses when earnings are low– not replenishing inventories– selling investments for a gain or loss during a period of

high or low earnings– careful timing of capital gains and losses

Aggressive or Abusive?

“Managers that always promise to ‘make up the numbers’ will at some point be tempted to make up the numbers”

Warren Buffett

Targets for Abuse

•Revenue recognition including…– fraudulent reporting of fictitious sales– inaccurate timing of revenue– improper valuation of revenue

•Expense recognition including…– improper capitalization or deferral of expenses– off balance sheet finance

•Using reserves to inflate earnings in years with falling revenues

Early Warning Signs

• Cash flows that are not correlated with earnings

• Debtors that are not correlated with revenues

• Provision for bad debts that is not correlated with receivables

• Reserves that are not correlated with balance sheet items

• Questionable acquisition strategy and accounting

• Earnings that consistently and precisely meet analysts’ expectations.

Fraud - the chilling reality…

Ernst & Young research:• Most fraud is perpetrated by those we trust• Most fraud is committed by the victim company’s own

employees• 75% of companies admit that directors and senior

management have the scope to override internal controls

• Most companies feel that their directors have a limited understanding of computers and treasury

• 2 out of 5 companies are defrauded annually• 50% of all fraud is discovered by chance

Fraud – what is the motivator?

•Greed / Personal Gain•Undervalued Senior Manager•Personal financial problems

Fraud - Risks to Business

• Autocratic management leaves the door wide open

• Poor internal controls / complex structures

• Ineffective recruitment procedures

• No code of business ethics

• Lack of adequate supervision at remote locations

Internal Fraud in Sales

• Back-handers for extra discounts• Free goods for back-handers• False sales to boost commission• Leaking sensitive information e.g. tenders• Abuse of invoice discounting (draw downs by list)• Credit Term manipulation:

–new customer–small orders–prompt payments–large order–disappears before paying

Fraud in Purchases

• Internal Fraud in Purchases:–Disclosing tender information–Accepting gifts

• External Fraud in Purchases:–Invoicing for work not completed–Offering volume discounts then customer returns stock

• Be weary of photocopied invoices

Fraud in Inventory

• Internal Inventory Fraud:–staff theft disguised as shop-lifting–theft of returned goods

• External Inventory Fraud:–claiming goods were damaged before delivery

when in fact they arrived in perfect condition and were damaged in stores

–claiming non-delivery

Building a Fraud Case

•Suspicion•Commence preliminary discreet investigation•Collate basic evidence•Establish if there is a prima facie case of fraud

What you’re looking for

•Proof of Pre-meditation/ Wrongdoing•“Hand in the till”•Original documentation•Digital backup•Books & records•Asset transfer at undervalue, both tangible and

intangible •Misappropriation of assets•Debtors paid cash – not recorded•Secret bank accounts

What you’re looking for

•Hand Pick Team to Collate the Evidence•Be Careful about disclosing to managers/directors

under suspicion or people close to them, any evidence gleaned

•Co-operation from key personnel–Directors, company secretary, senior

management, and any key personnel should be interviewed

–Careful memos of all interviews–If communication is in writing, all correspondence

to be carefully recorded

What you’re looking for

•Co-operation from 3rd parties, for example–Returned paid cheques–Leads/information–Documentation from 3rd parties i.e. Creditors–Company advisors such as auditors, solicitors, banks

•Meet managers/directors under suspicion with all the evidence and put forward case in professional manner and obtain other side of the story

•Allow managers/directors access to books and records and give them plenty of time to deal with allegations (ensure you have full back up of digital data)

What you’re looking for

•Consider Injunction if circumstances are appropriate•Legal advice:

–Get opinion from top SC–Don’t proceed unless opinion is very strong–Is there sufficient evidence?–If depending on oral evidence from witnesses

ensure they are committed to your cause•Issue letter to relevant parties setting out all findings

and allegations of fraud, and any other allegations

What you’re looking for

•Request thorough written explanation within 21 days, or failing that the stated legal proceedings will commence without further notice

•Are there real assets to be recovered and/or are suspect Managers/Directors a ‘Mark’?

Case Study – Sales Fraud

CASE STUDY

Doherty Advertising Ltd

Background

•One of the oldest Irish owned advertising agencies located in Dublin

•Turnover of approx €18m in 2002•Large Client base which included Health Boards,

Holiday Companies, Banks & Car marques•Receiver appointed by the Bank on foot of

charge/Invoice discounting agreement over the debtors’ ledger of the Company

Mechanics & Results of Investigation

•False/Bogus invoices being presented to the Bank for payment

•Over €500k of invoices had no narrative

•Over €700k of invoices had services charged that were never agreed/accepted by the debtor

•Debtors assumed these invoices were issued in error

•Over €320K of invoices were raised in advance of the work being carried out, a breach of contract in the invoice discounting agreement

Mechanics & Results of Investigation

•Large amount of ‘Personal Expenditure’ •Directors’ drawings in excess of €290k•Direct debits to personal credit cards in excess of

€225k•Approx €100k paid to Directors in the form of

‘creditor’ payments•Over €220k of personal expenditure on Company

credit cards. E.g. Family holidays, School fees, chauffer driven cars, etc

•Personal legal expenses discharged by the Company

Mechanics & Results of Investigation

•Directors’ spouses receiving salaries for ‘ghost’ jobs in the Company ‘secret’ bank account

•Preference payments to Creditors•€3.7m of debtors reported collectable by Directors –

approx. €800k actually collected•Directors benefited to the tune of €1.47m in just over

2 years

Litigation

•Section 297A (Reckless Trading) and Section 139 of the Companies’ Acts 1963 & Section 150 of the Companies’ Acts 1990 were considered

•A detailed letter was issued to Directors alleging Reckless Trading

•Proceedings commenced in the Commercial Court

•The Bank registered Judgment Mortgages against the family homes of the Directors on foot of personal guarantees

Litigation

•During 2004, sworn statements of assets and liabilities were prepared by the Directors•In the latter part of 2004, the Bank reached a

settlement with the Directors•In December 2004, Section 297A and Section

150 Orders were accepted by Directors and granted by the Commercial Court•Turnaround in this case of approx 12mths

CASE STUDY

Manufacturing Company

(Purchases Fraud)

Fraud on Customer

•Purchasing Manager in a large, compliant entity was being blackmailed by the Director of one of it’s suppliers.

•This Purchasing Manager was blackmailed into signing goods received notes for approximately €500K worth of goods which were never in fact delivered.

•This matter was reported to the Gardaí and there was a fraud conviction.

•No recoveries, as stocks didn’t exist and perpetrator was not a mark.

Commercial Disputes & Litigation

Commercial Disputes & Litigation

•Shareholder / partnership disputes•Breach of Contract•Trademark infringements•Product liability claims•Non-competition agreements

Business Valuation

Business Separation / Valuation

•Business separation - two business partners splitting up and ask for an independent valuation of the business.

•Can be amicable or result of a dispute.

•In SME's - owners generally value their business higher than it is actually worth and can be disappointed when a valuation is carried out.

•If splitting up / dispute - can lead to litigation and each side appointing a forensic accountant to provide a business valuation.

Basic Rules of Values

•BASIC RULE = Future Maintainable Profits X Appropriate Multiple

•Calculation of "future maintainable profits"•Review last audited financial statements for past 3 years•Review up to date management accounts •Review profit trend over past 3 years - consistent / volatile •Check for any material "once off" items of income/expenditure (need

to be removed!) •Any major events since date of last set of accounts? •Calculate average profits over past 3 years

–Can use "weighted average" approach to attach more weight to recent periods

Basic Rules of Values

•Apply the appropriate "multiple" to "future maintainable profits •Review P/E (price to earnings) ratio of PLC's or similar companies in

the industry •If "LTD" company - will need to discount P/E ratio due to the lack of

marketability of shares •Typical SME may have its "multiple" discounted by 50-60% compared

to PLC in same industry •Valuer's knowledge of industry and market sector is important -

needs to be aware of trends / news in that industry•"Rule of thumb" valuations for certain types of business can be

helpful and assist valuer

Basic Rules of Values

•Control •Minority shareholding may be discounted due to lack of

control•Example: Business is split 80%:20% between

shareholders - as a minority shareholder, 20% of shares may not mean that your shares are worth 20% of the business, the value of your shares should be discounted to reflect lack of control and ability to influence decisions

Basic Rules of Values

•Other Factors•Consider any known or foreseeable major factors that will

influence the continuity and/or profitability of the business for good/bad

•Review key personnel and their respective roles •Review shareholder agreements and any other

information relating to sale of an interest in business •True value ultimately set by the market•Unique characteristics of that industry are relevant•Limited market as founders are very important for future

success

Insurance Claims

Insurance Claims - Loss of Profits / Loss of Stock

•Fire and business interruption.•Forensic accountant prepares a report for the

Company on the loss of profits. •Will need to calculate loss of revenue resulting from

the fire–Future maintainable profits based on weighted average–Exceptional items distorting profits–Sale or purchase of major assets–Weighted average calculation of profit.

Insurance Claims - Loss of Profits / Loss of Stock

•With loss of stock, exact figures required in insurance claims – insurers will look closely at trends, goods inwards / goods outwards, etc.

•Insurer will do more than audit stock – they will seek originating documentation and reconstruct the stock figure.

Employment Issues(other issues apart from Internal Fraud)

Employee Issues

•Unfair Dismissal claims•Discrimination claims•Identity theft

Unfair Dismissal & Discrimination

•Research industry / market standards.•Quantify the actual loss, period of loss, and future loss, if any.•Quantify losses relating to

–Salary & Benefits

–Share options

–Pension

–Tax benefits.

•Calculate the consequence on the employment prospects of the individual.

•Ultimately, if litigation arises, damages may be awarded in respect of character defamation, such figures are determined by the Courts.

Identity Theft

•As an employer - are you putting your employees at risk of identity theft?

•Does your company have a policy for storing personal / sensitive material relating to staff or clients?

•What about destroying such material?•Do you train staff in this area?•In 2003 Experian concluded in a survey that out of 71

local authorities surveyed, 76% reported that bin raiding had occurred.

CASE STUDY

Sales Rep with large multi-national

•Employee had set sales territory & received commission on all sales

•Sales far exceeded expectations - enormous commission cheques earned by the employee

•Company positioned itself to ‘squeeze’ the Sales Rep out of some of his territories in order to avoid paying commission

•Company targeted customers directly•Contrary to employment contract•Employee suffered loss of earnings•Litigation instigated•Settlement reached

About Us

•Leading Specialist Forensic Accounting, Turnaround and Insolvency Practice

•3 Partners - Tom Kavanagh, Ken Fennell, David Van Dessel

•Team of 22 Professionals•Practical, commercial approach•Associated to Begbies Traynor (UK) and

Begbies Global Network