Accountants’ Handbook Special Industries and Special Topics 10th Edition_19

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Nội dung Text: Accountants’ Handbook Special Industries and Special Topics 10th Edition_19

44 CHAPTER FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES Dennis S. Neier, CPA American Express Tax and Business Services, Inc. Margaret R. Kolb, CPA American Express Tax and Business Services, Inc. 44.1 INTRODUCTION 44.4 PROFESSIONAL STANDARDS 2 RELEVENT TO LITIGATION CONSULTING 7 44.2 THE LEGAL CONTEXT 3 (a) AICPA Code of Professional (a) The Adversarial Process 3 Conduct 8 (b) Stages in a Civil Suit 3 (i) Rule 101: Independence 8 (i) Pleadings 3 (ii) Rule 102: Integrity and (ii) Pretrial Discovery 3 Objectivity 8 (iii) Trial 3 (iii) Conﬂicts of Interest 8 (iv) Settlement 4 (iv) Rule 201: General Standards 9 (c) Alternative Dispute Resolution 4 (v) Rule 202: Compliance with (d) Required Proofs 4 Standards 9 (i) Liability 4 (vi) Rule 203: Accounting (ii) Causation 4 Principles 9 (iii) Damages 4 (vii) Rule 301: Conﬁdential Client Information 9 44.3 THE ACCOUNTANT’S ROLE (b) Statement on Standards for IN THE LITIGATION Consulting Services 9 PROCESS 5 (i) General Standards 10 (ii) Consulting Standards 10 (a) The Testifying Expert 5 (c) AICPA Consulting Services (b) Nontestifying Consultant 5 Practice Aids 11 (c) Comparing Litigation Consulting Services to 44.5 FEDERAL RULES OF EVIDENCE 11 Attest Services 5 (d) Case Analysis and Planning 6 (a) Federal Rule of Evidence (e) Discovery 6 Rule 702 11 (f) Settlement Analysis 7 (b) Effect of Daubert v. Merrell Dow (g) Pretrial 7 Pharmaceuticals 11 (h) Trial 7 (c) Federal Rule of Civil Procedure 26 12 The authors would like to thank the following PricewaterhouseCoopers partners for their contribution by having authored the predecessor chapter on forensic accounting and litigation consulting services: Jeffrey H. Kinrich, CPA, M. Freddie Reiss, CPA, and Elo R. Kabe, CPA. 44 1 •
44 2 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • (c) Mitigation 20 44.6 TYPES OF CASES 12 (d) Interest on Damage (a) General Role of Accountant 12 Awards 20 (b) Business-Oriented Cases 13 (e) Present Value and (i) Breach of Contract 13 Inﬂation 21 (ii) Business Interruption 13 (f) Income Taxes 21 (iii) Intellectual Property 13 (iv) Antitrust 13 (v) White Collar Crime and 44.8 SUPPORT FOR OPINIONS 22 Fraud 14 (a) Sources of Information 22 (vi) Securities Act Violations 15 (b) Reliance on Others 22 (vii) Bankruptcy and Bankruptcy (c) Documentation 22 Frauds 15 (d) Engagement Letters 22 (viii) Lender Liability 17 (ix) Employment Litigation 17 (x) Accountant’s Liability 17 44.9 TESTIMONY 23 (xi) Contractual Purchases (a) Giving Deposition Litigation 18 Testimony 23 (xii) Breach of Fiduciary Duty 18 (b) Giving Trial Testimony 24 (c) Nonbusiness Cases 18 (i) District Testimony 24 (i) Marital Dissolution 18 (ii) Cross-Examination 24 (ii) Partnership Dissolution 19 (iii) Redirect (iii) Personal Injury 19 Examination 25 44.7 CALCULATING DAMAGES 19 44.10 SOURCES AND SUGGESTED (a) General Concepts 19 REFERENCES 25 (b) Measuring Damages 20 44.1 INTRODUCTION Forensic accounting can broadly be deﬁned as the application of accounting principles, theories, and discipline to facts and hypotheses at issue in a legal context. This legal context is generally litigation, but any dispute resolution proceeding (e.g., arbitration or mediation) is a candidate for the applica- tion of forensic accounting. Litigation consulting services involve any professional assistance nonlawyers provide to lawyers in the litigation process in connection with pending or potential formal legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between two or more parties. A trier of fact is a court, regulatory body, or government authority; their agents; a grand jury; or an arbitrator of a dispute. Litigation consulting services include the application of specialized disciplines to the issues involved in a matter in order to express an expert opinion that would help the trier of fact reach an informed conclusion. Forensic accounting and litigation consulting services apply to both civil and criminal litigation. The principal focus of this chapter will be civil litigation because it is by far the most frequent dis- pute resolution proceeding in which the professional accountant will be involved. The terms “forensic accounting,” “dispute analysis,” “litigation support,” or “litigation consult- ing” are sometimes used as synonyms. For purposes of this chapter, “forensic accounting” and “liti- gation consulting services” include all ﬁnancial and accounting analysis performed by a professional accountant to assist counsel in connection with its investigation, assessment, and proof of issues in a dispute resolution proceeding. This chapter provides a brief description of the litigation process and a discussion of the ac- countant’s role in, and contribution to, that process. In this chapter, the terms “accountant,” “prac- titioner,” “CPA,” and “litigation consultant” are used interchangeably to describe an accountant who is providing litigation consulting services. It includes a description of the types of cases in
44.2 THE LEGAL CONTEXT 44 3 • which professional accountants typically get involved, the types of services accountants usually provide, and a discussion of the professional standards relevant to litigation consulting services. The last section of this chapter, “Testimony,” provides suggestions as to how to prepare and de- liver deposition and trial testimony. 44.2 THE LEGAL CONTEXT (a) THE ADVERSARIAL PROCESS. In civil disputes, it is generally up to the parties (the plaintiff and defendant), not the court, to initiate and prosecute litigation, to investigate the pertinent facts, and to present proof and legal argument to the adjudicative body. The court’s function, in general, is limited to adjudicating the issues that the parties submit to it, based on the proofs presented by them. (b) STAGES IN A CIVIL SUIT. There are three basic phases or stages in a civil suit, barring ap- peal. These stages are the same for virtually all adversarial proceedings, whether in a federal, state, or administrative court. (i) Pleadings. A lawsuit is started by a complaint that is ﬁled with the clerk of the trial court and served on the defendants. The complaint lays out the facts and causes of action alleged by the plain- tiff. The defendants may ﬁle a motion to dismiss (arguing that the defendant is not legally liable even if the alleged facts are true) or an answer to the complaint. The answer may contain a denial of the allegations or an afﬁrmative defense (e.g., statute of limitations has expired). The defendant also may ﬁle a counterclaim which presents a claim by the defendant (counterplaintiff) against the plain- tiff (counterdefendant). (ii) Pretrial Discovery. The purpose of pretrial discovery is to narrow the issues that need to be decided at trial and to obtain evidence to support legal and factual arguments. It is essentially an information-gathering process. Evidence is obtained in advance to facilitate presentation of an or- ganized, concise case as well as to prevent any surprises at trial. This sharing of information often will result in the settlement of the case before trial. The ﬁrst step in discovery typically involves the use of interrogatories and document requests. In- terrogatories are sets of formal written questions directed by one party in the lawsuit to the other. They are usually broad in nature and are used to ﬁll in and amplify the fact situation set out in the pleadings. Interrogatories are also used to identify individuals who may possess unique knowledge or information about the issues in the case. Requests for production of documents identify speciﬁc documents and records that the request- ing party believes are relevant to its case and that are in the possession of and controlled by the op- posing party. The opposing party is only required to produce the speciﬁc documents requested. Accordingly, when drafting these requests, care must be taken to be as broad as possible so as to in- clude all relevant documents but narrow enough to be descriptive. It is not unusual for more than one set of interrogatories and document requests to be issued during the course of a lawsuit. The ac- countant is often involved in developing interrogatories and document requests on ﬁnancial and business issues. Depositions are the second step in the discovery process. They are the sworn testimony of a witness recorded by a court reporter. During the deposition, the witness may be asked questions by the attorneys for each party to the suit. The questions and answers are transcribed, sworn to, and signed. The testimony will allow the party taking the deposition to better understand the facts of the case and may be used as evidence in the trial. The accountant expert witness may be heavily involved at this stage, both in being deposed and in developing questions for the deposition of op- posing witnesses. (iii) Trial. The third stage of the litigation/adversarial process is the trial. It is the judicial exami- nation and determination of issues between the parties to the action. In a jury trial, the trial begins
44 4 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • with the selection of a jury. The attorneys for each party then make opening statements concerning the facts they expect to prove during the trial. Then the plaintiff puts forth its case, calling all of the witnesses it believes are required to prove its case. Each witness will be subject to direct examination and then cross-examination by the opposing party’s attorney. After the plaintiff has called all of its witnesses and presented all of its evidence, the defendant will then present its case in the same man- ner. The plaintiff then has an opportunity to present additional evidence to refute the defendant’s case in a rebuttal. The defendant can respond in a surrebuttal. Finally, each party has the opportunity to make a closing statement before the court. (iv) Settlement. At any time in the litigation process, the parties can attempt to settle the dispute without the intervention of the court. This can be accomplished by participating in settlement discus- sions or by using alternative methods of dispute resolution. (c) ALTERNATIVE DISPUTE RESOLUTION. Alternative dispute resolution encompasses mediation, arbitration, facilitation, and other ways of resolving disputes focused on effective communication and negotiation, rather than using adversarial processes such as the courtroom. Two basic types of alternative dispute resolution exist. There are nonbinding methods, such as mediation, negotiation, or facilitation, which assist in reaching, but do not impose a resolution of the dispute. There are also more binding methods, such as arbitration or adjudication, in which a neutral decision maker rules on the issues presented. Combinations of these methods also exist. Alternative dispute resolution is often used because it is the vehicle prescribed in an agreement or contract for the resolution of a dispute. The U.S. Constitution and most state constitutions provide for the right of trial by jury in most cases. This right does not have to be exercised, and many cases are tried without a jury (i.e., a bench trial where the judge is the trier of fact). In most states and in federal courts, one of the par- ties must request a jury or the right is presumed to be waived. (d) REQUIRED PROOFS. In order for a plaintiff to succeed in a claim for damages, it must sat- isfy three different but related proofs: liability, causation, and amount of damages if applicable. If the burden of proof is not met on any one of these, the claim will fail. (i) Liability. The plaintiff must prove that one of its legal rights has been transgressed by the de- fendant. It will present evidence attempting to prove that the actions of the defendant were in viola- tion of the plaintiff’s legal rights. Similarly, the defendant will present evidence in an effort to prove that the plaintiff’s rights were not violated, or at least were not violated by the defendant. (ii) Causation. If the plaintiff proves that the defendant has violated one of its legal rights, it must be shown that this violation resulted in some harm to the plaintiff. Here, attorneys for the plaintiff and defendant will try to prove or disprove the nexus between the defendant’s actions and some harm to the plaintiff. (iii) Damages. After presenting the evidence relating to the liability and causation issues, the par- ties’ next step in most cases is to prove damages. Damages are one of a number of remedies that may be available to a prevailing plaintiff. Other types of remedies include speciﬁc performance (performance of the act that was promised), injunc- tions (an order by the court forbidding or restraining a party from doing an act), and restitution (the return of goods, property, or money previously conveyed). Damages are the only type of remedy dis- cussed in this chapter. The general principle in awarding damages is to put the plaintiff in the same position it would have been in if its legal rights had not been transgressed. There are three main categories of dam- ages: compensatory, consequential, and punitive. Compensatory damages compensate the injured party only for injuries or losses actually sustained and proved to have arisen directly from the vio- lation of the plaintiff’s rights. Consequential damages are foreseeable damages that are caused by
44.3 THE ACCOUNTANT’S ROLE IN THE LITIGATION PROCESS 44 5 • special circumstances beyond the action itself. They ﬂow only from the consequences or results of an action. Punitive damages are intended to penalize the guilty party and to make an example of the party to deter similar conduct in the future. They are awarded only in certain types of cases (e.g., fraud). The quantiﬁcation of damages is primarily a question of fact. The burden of proving the damage amount normally falls on the plaintiff. Although accountants can be used in cases in which damages are not an issue, accountants are most frequently used in cases in which damages are an issue. 44.3 THE ACCOUNTANT’S ROLE IN THE LITIGATION PROCESS Typically the accountant is hired by attorneys representing either the plaintiff or the defendant. In some cases, however, an accountant may be engaged directly by one of the parties to the action. No matter who engages the accountant, a number of possible roles might be played. A litigation con- sulting practitioner can work as a testifying expert, a consultant, a trier of fact (e.g., an arbitra- tor), a special master (working for the court), or a court-appointed neutral party (an expert, not for the parties to the dispute, but to the court as a neutral party). A detailed discussion of the role of the testifying expert and the consultant follows. (a) THE TESTIFYING EXPERT. Frequently, the accountant’s purpose in the case will be to de- velop and render an opinion regarding ﬁnancial or accounting issues. Ordinarily, only facts and ﬁrst- hand knowledge can be presented by witnesses at trial. The only exception to this rule is the testimony of experts, which can include an expression of the expert’s opinions as discussed in detail in Section 44.3(a). According to the courts and the law, experts are those who are qualiﬁed to testify authoritatively because of their education, special training, and experience. Clearly, a professional accountant can qualify as an expert in issues relating to accounting and ﬁnancial data. As discussed in Subsections 44.4(a–c) and 44.5(a–c), the accountant as expert may be asked to develop and present evidence in support of any or all of the required proofs. For example, the ac- countant can review and offer an opinion as to the adequacy of the work performed by another ac- countant in a professional liability suit (proof of liability). Or the accountant might review the ﬁnancial records and the business environment of a company to determine whether a bank’s with- drawal of credit caused the company to go out of business (proof of causation). Most commonly, the accountant will be asked to provide an opinion regarding the economic loss suffered by the plaintiff in the case or to rebut the damages alleged by the plaintiff on behalf of the defendant (proof of damages). (b) NONTESTIFYING CONSULTANT. In certain situations, the accountant will be asked to be a consultant rather than a testifying expert. The accountant will take on more of an advisory role and will not provide testimony. The work the accountant performs for the attorney as a consultant is gen- erally protected by the attorney’s work product privilege and as such is not discoverable by the op- posing party. For this reason, accountants are often engaged initially as consultants. This enables the attorney to explore avenues and conduct analyses from which he might want to shield his testifying expert. However, once the accountant has been designated as an expert, all work products may be subject to discovery. (c) COMPARING LITIGATION CONSULTING SERVICES TO ATTEST SERVICES. The role of the practitioner in a litigation consulting engagement is different from that in an attestation en- gagement, where the CPA expresses a conclusion about the reliability of a written assertion of an- other party. In a litigation consulting engagement, the practitioner is the asserter and must support and defend any conclusions reached against challenge. In an attestation engagement, the audience is composed of all persons relying on the ac- countant’s report, whereas in a litigation consulting engagement, the audience for the litigation
44 6 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • consulting practitioner’s opinion and work product is generally limited to the trier of fact and the parties to the dispute who have the opportunity to evaluate and question the practitioner’s conclusions, working papers, documents, and methodology. The standards for attestation engagements do not envision the practitioner as the asserter and were established to provide assurance to third parties about the assertion of another party. Litigation consulting engagements and attestations engagements differ in the purpose in en- gaging the practitioner and in the use of the practitioner’s conclusions. Also, unlike an attes- tation engagement, there are usually no uninformed third parties in a litigation consulting engagement because all the parties (if the practitioner is an expert) generally have access to the working papers of, and other documents relied on by, the practitioner and can question the conclusions. (d) CASE ANALYSIS AND PLANNING. Whether in the role as testifying expert or nontesti- fying consultant, the litigation consulting practitioner can provide valuable assistance through- out the litigation process. In many circumstances, the accountant can be of use to the attorney before the complaint is even ﬁled. The accountant can help the attorney understand the accounting, ﬁnancial, and economic issues involved in the case and can also assess the potential value of the claim by providing an estimate of the amount of damages. In certain cases, the accountant may actually help to identify causes of ac- tion to be included in the complaint. Once a case has been filed, the accountant can help the attorney understand and evaluate critical accounting, financial, and economic issues and assist with the formulation of an ap- propriate strategy. Strategy formulation is a continual process; as new information is received and additional issues uncovered, the overall strategy is revised. During the planning phase, the accountant will evaluate alternative approaches and determine the most reasonable ap- proach to take based on all available information. At the same time, the accountant will assess the strengths and weaknesses of the opponent’s case. The accountant’s involvement in this phase will help the attorney to focus on those issues that have the greatest impact on proving the case. (e) DISCOVERY. Discovery is the information-gathering stage of the litigation process. During discovery, each party attempts to identify and obtain all the information and docu- ments necessary to prove its case. The accountant’s initial assistance may be in formulating specific accounting and financially oriented questions to be included in interrogatories. The accountant will also assist in drafting document requests by identifying in a very specific manner the types of documents (particularly accounting records and reports) that would be of interest and that the opposing party is likely to have retained. The more specific the requests are, the more likely the response will be useful. The accountant will also be able to assist the attorney with the preparation of responses to the opposing party’s interrogatories and docu- ment requests. A significant role that the litigation consulting practitioner can play during the discovery phase is in the review and analysis of the documents. During this review, the litigation con- sulting practitioner identifies key documents that are helpful or harmful to the parties that have retained him. It is also during this phase that the litigation consulting practitioner iden- tifies documents requiring further explanation that can be provided during deposition. De- pending on the legal forum in which the case is being tried, expert reports are usually drafted, issued, and exchanged with the opposing party during or just after the discovery phase. Depositions provide each side with an opportunity to elicit relevant facts and to identify weaknesses in an opponent’s argument. The accountant can be helpful in this area by assisting the attorney in identifying subjects to be explored and in developing speciﬁc deposition ques- tions, especially when ﬁnancial executives or experts are being deposed. Frequently, an attor- ney will request the accounting expert to be present at these key depositions. Here the
44.4 PROFESSIONAL STANDARDS RELEVANT TO LITIGATION CONSULTING 44 7 • accountant can help the attorney understand and interpret the deponent’s responses and formu- late follow-up questions to probe more deeply into the subject area. Having the accountant pre- sent at the deposition will enable the attorney to completely understand and consider the ﬁnancial issues. The accountant who will be a testifying expert may be subject to deposition by the opposing attor- ney. The opposition will attempt to gain a thorough understanding of the accountant’s analysis and con- clusions and, when possible, identify weaknesses and lay the groundwork for attack at trial. Section 44.9 presents a description of the deposition process and some pointers for giving deposition testimony. (f) SETTLEMENT ANALYSIS. Settlement negotiations can occur at any point during the litiga- tion process. They can be greatly facilitated by the use of an accounting expert. The accountant can be instrumental in evaluating existing alternatives and terms as well as in proposing other strategic approaches. The accountant’s evaluation may involve (1) the determination of economic value and feasibility of various strategies or (2) an analysis of the strengths and weaknesses of the two sides’ positions. When determining value and evaluating feasibility, the accountant can estimate damages under various scenarios and help to assess the probability of occurrence for each, thereby giving the attor- ney a better understanding of the risks involved. Just as importantly, the accountant can evaluate the true economic value of various settlement alternatives and determine possible tax effects of each. This will enable the attorney and client to make a more informed decision regarding settlement op- tions and perhaps offer alternatives that beneﬁt both parties. The accountant also can provide an evaluation of the relative strengths and weaknesses of both the plaintiff’s and the defendant’s positions, thereby helping the attorney strengthen his bargaining position and anticipate potential problems. (g) PRETRIAL. When preparing for trial, the accountant can assist the attorney by: (1) prepar- ing courtroom graphics, presentations, and exhibits; (2) preparing witnesses for trial testimony; (3) preparing for the cross examination of opposing witnesses; and (4) ﬁne-tuning the overall case strategy. (h) TRIAL. If the case does not settle, the ﬁnal role of the accountant will be to assist during the trial itself. The accountant’s testimony in court is a key part of this role. In testimony, the accountant presents the opinions developed as a result of his information gathering, review, and analysis. This role is clearly the most important one the accountant will play in the process. It is imperative that the accountant present opinions in a straightforward, cogent, and concise manner. The last section of this chapter describes the course of direct testimony and suggests ways to enhance the effectiveness of the testimony. Although opinion testimony is of paramount importance at the trial stage, the accountant can play other valuable roles. For example, the accountant can be of tremendous value to attorneys during the cross-examination of opposing experts and ﬁnancial witnesses. The accountant can work with the at- torney to prepare cross-examination questions in an effort to undermine the testimony or the credi- bility of the witness. The accountant will be important in this phase because of his ability to formulate accounting and ﬁnancially oriented questions that will be difﬁcult for the witness to evade or deﬂect. More importantly, the accountant will be able to assess the responses and provide follow- up questions to “close the loop” on important issues. 44.4 PROFESSIONAL STANDARDS RELEVANT TO LITIGATION CONSULTING Throughout the litigation process, the accountant will be asked to provide input, conduct analy- ses, and offer advice or opinions regarding facts at issue in the case. Clearly, the attorney-client will expect that appropriate standards of care are followed by the accountant during the course of
44 8 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • the engagement. However, although the litigation process itself is a formal, structured process with many rules and procedures that must be followed, the nature of the accountant’s work is typically very unstructured and loosely deﬁned. However, the accountant should recognize that there is a hierarchy of standards that apply to litigation consulting services as follows: • AICPA Code of Professional Conduct • AICPA Statement on Standards for Consulting Services • AICPA Consulting Services Practice Aids (a) AICPA CODE OF PROFESSIONAL CONDUCT. The AICPA Code of Professional Conduct applies to all professional services rendered by AICPA members. Certain sections of the Code of Pro- fessional Conduct have particular applicability to litigation consulting services; they are the guiding principles of this practice area. A greater understanding and appreciation of the importance of the ex- isting standards contained in the Code will assist practitioners in their efforts to provide opinions that are relevant and reliable and that assist the trier of fact. (i) Rule 101: Independence. When performing a litigation service engagement, independence is not required. However, the practitioner should be sensitive to the appearance of independence so that the trier of fact will accept conclusions and judgments as objective and impartial. (ii) Rule 102: Integrity and Objectivity. Although independence is not required in a litigation consulting engagement, the accountant is required to comply with Rule 102 of the AICPA Code of Professional Conduct. Rule 102 requires that members shall, in the performance of any profes- sional service, maintain objectivity and integrity, shall be free of conﬂicts of interest, and shall not knowingly misrepresent facts or subordinate their judgment to others. The accountant should be aware of situations that would cause the trier of fact to question his integrity and objectivity; for example, current, prior, or possible future relationships with either the attorneys or the parties to the dispute, the rendering of contradictory opinions on the same subject matter at issue in the liti- gation, or having knowledge of facts obtained outside the normal discovery process could impair integrity and objectivity. The accountant must also recognize how the roles and responsibilities of attorneys differ from those of CPAs in the litigation process. The litigating attorney is the client’s advocate. “The litigation process demands that the attorney take every available advantage for the client, put the client’s case in the best possible light, not offer evidence that is harmful to the client (with some exceptions) and challenge everything possible in the opponent’s case.”1 The accountant as an expert witness has a role that differs from that of an attorney. The ac- countant-expert does not serve as an advocate but rather is presented to the trier of fact as some- one with specialized knowledge, training, and experience in a particular area and presents positions with objectivity. The function of the accountant as an expert witness is to assist the trier of fact in understanding complex or unfamiliar concepts. The accountant-expert is not ex- pected to single-mindedly and one-sidedly offer only evidence and opinions that help the client. The accountant expert is expected to offer an objective opinion, based on knowledge and expe- rience, of how the issues at hand should be interpreted by the trier of fact.2 When acting as a consultant, the accountant can provide assistance that is more like that of an advocate. (iii) Conﬂicts of Interest. In a litigation services engagement, a conﬂict of interest exists when a litigation consulting practitioner’s ability to objectively evaluate and present an issue for a client will 1 AICPA Consulting Services Special Report No. 93–2, Conﬂicts of Interest in Litigation Services Engage- ments, ¶ 2/105.16, AICPA, 1993. 2 AICPA Consulting Services Special Report No. 93-2, Conﬂicts of Interest in Litigation Services Engage- ments, ¶ 2/105.21.
44.4 PROFESSIONAL STANDARDS RELEVANT TO LITIGATION CONSULTING 44 9 • be impaired by current, prior, or possible future relationships with parties to the litigation. The crite- rion for evaluating whether a conﬂict of interest is involved in a litigation services engagement is the ability of the accountant to maintain integrity and objectivity. A conﬂict of interest is based in fact, rather than appearance. However, the accountant should be mindful of and deal with appearances of conﬂicts before accepting the engagement. Unlike the legal profession, the accounting profession has developed little formal guidance on conﬂicts of interest. An attorney has a well-deﬁned and documented concept of what consti- tutes a conﬂict in the legal profession. Consequently, this concept may be applied inappropri- ately to the accountant. The standards of the legal profession concerning conﬂicts of interest should not be applied to the accounting profession because the roles of the attorney and the ac- countant in litigation are entirely different. If a conﬂict of interest does not exist in fact, the accountant must decide if a conﬂict in ap- pearance exists of if business issues would prevent acceptance of the engagement. For example, the accountant may decline to perform services because the position required by the prospective client conﬂicts with the business interests of an existing client. These determinations are based on the accountant’s judgment. Before accepting a litigation services engagement, the accountant should perform procedures that will enable him to determine if a conﬂict exists with any parties to the litigation. All conﬂicts and po- tential conﬂicts must be disclosed to the retaining attorney for his evaluation. Interpretation 102.2 of the AICPA Code of Professional Conduct provides that if a conﬂict exists and is disclosed to the client and other appropriate parties, the accountant can accept the engagement with the consent of all parties. The accountant should be aware that new federal regulations prohibit the performance of lit- igation consulting services for any audit client that is an SEC Registrant. For more information re- garding conﬂicts of interest refer to AICPA Consulting Services Special Report No. 93-2, Conﬂicts of Interest in Litigation Services Engagements. (iv) Rule 201: General Standards. The four general standards, professional competence, due professional care, planning and supervision, and sufﬁcient relevant data, under Rule 201 of the Code of Professional Conduct apply to litigation consulting services. In fact, these four standards are in- cluded in Statement on Standards for Consulting Services No. 1 (SSCS No. 1) and are discussed in more detail below. (v) Rule 202: Compliance with Standards. Pursuant to Rule 202 of the Code of Professional Conduct, the accountant must comply with the standards promulgated by the Consulting Services Executive Committee. (vi) Rule 203: Accounting Principles. Rule 203 requires the accountant to demonstrate an un- derstanding of generally accepted accounting principles. To the extent that GAAP is applicable, the accountant shall apply the appropriate accounting principles. (vii) Rule 301: Conﬁdential Client Information. Pursuant to Rule 301, the CPA in public prac- tice may not disclose conﬁdential client information without the client’s consent. In litigation con- sulting services engagements, conﬁdential client information obtained in prior engagements must be protected. Thus, the accountant has the dual responsibility to be both truthful and honest while pre- serving past and present client conﬁdences. Before the accountant relies on speciﬁc information ob- tained in an unrelated prior engagement and uses that information as the basis for his opinion, he must either obtain the consent of the prior client to reveal its conﬁdences or abandon any effort to use such information as the basis of his opinion. (b) STATEMENT ON STANDARDS FOR CONSULTING SERVICES. Litigation consulting services are consulting services as deﬁned in SSCS No. 1. SSCS No. 1 sets standards that must be followed for all consulting engagements.
44 10 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • (i) General Standards. The general standards deﬁned in Rule 201 of the AICPA Code of Profes- sional Conduct are applicable to litigation consulting engagements. • Professional competence. The practitioner should accept only those engagements he or the CPA ﬁrm can reasonably expect to complete with professional competence. The practitioner must have adequate knowledge, skills, training, and experience so that duties can be performed in accordance with appropriate professional standards. Litigation consulting services involve many diverse issues. As a result, the practitioner may need to rely on the assistance of other in- dividuals with the required education and experience in order to comply with this standard. For example, a practitioner may have the required expertise to develop a model for computing damages to a restaurant chain in a breach of contract litigation. However, he may need the as- sistance of someone in the restaurant industry to provide key components that will be used in the model, for example, the gross proﬁt margin that is typical in the industry. • Due professional care. The practitioner should make a conscientious effort in his perfor- mance of the engagement by obtaining sufﬁcient relevant data and applying reliable princi- ples and methods to the facts of the dispute before reaching conclusions and ﬁndings and should be able to present his conclusions and ﬁndings to the trier of fact in a concise, clear, and correct manner. • Planning and supervision. Planning and supervision have different implications for the litiga- tion consulting practitioner than for many of the other services a CPA may be engaged to pro- vide. A litigation consulting services engagement is usually far more dynamic than other engagements. The facts and circumstances of each litigation consulting engagement are unique. Planning is essential in a litigation consulting engagement to control costs and focus the practitioner’s work product on the engagement requirements. Plans continually change in a litigation engagement and are usually not written because of the dynamic nature of the litiga- tion process. Supervision ensures the quality of the engagement performance. Since the testifying expert must express the opinions and conclusions reached as his own, the testifying expert should closely supervise the ongoing work that is performed by others. • Sufficient relevant data. The practitioner needs to base his conclusions and judgments on sufficient relevant data. It is not only the practitioner’s opinion that is evaluated by the trier of fact, but also the relevancy, sufficiency, and verifiability of the underlying evidence supporting the opinion. The practitioner can generally rely on documents that have been authenticated by the parties to the proceeding or that are acceptable to the court under the various rules of evidence. It is important to communicate to the attorney what evidence is necessary to properly support the practitioner’s conclusions and judg- ments, and it is incumbent upon the practitioner to advise the attorney of possible miss- ing or questionable documents and the lack of relevant data upon which to reach an opinion. Generally, the practitioner may look to the guidance of generally accepted auditing and other attestation standards with respect to the sufﬁciency, relevancy, and reliability or evidential matter. (ii) Consulting Standards. In addition to the general standards, SSCS No. 1 also establishes spe- ciﬁc consulting standards for consulting services. • Client interest. The accountant should serve the interests of the client while maintaining objec- tivity and integrity. In addition, when acting as an expert, the accountant also has a duty to the trier of fact. • Understanding with the client. The accountant should establish a written understanding with the client about the responsibilities of the parties and the nature, scope, and limitation of the services to be provided.
44.5 FEDERAL RULES OF EVIDENCE 44 11 • • Communication with client. The client should be informed about: • Conﬂicts of interest • Signiﬁcant reservations concerning the scope or beneﬁts of the engagement • Signiﬁcant engagement ﬁndings or events When acting as an expert, the accountant should be aware that all of his communications with the client, written or oral, are subject to discovery and must be provided upon request by the opposing party. All of the accountant’s work product, including draft reports and schedules, notes, supporting schedules, and correspondence, can be requested as part of the discovery process. (c) AICPA CONSULTING SERVICES PRACTICE AIDS. The AICPA has published nonauthori- tative educational guidance for practitioners, including Consulting Services Special Report No. 93- 1, “Application of AICPA Professional Standards in the Performance of Litigation Services,” Report 93-2, “Conﬂicts of Interest in Litigation Services Engagements,” Report 93-3, “Comparing Attest and Consulting Services: A Guide for the Practitioner,” Report 93-4, “Providing Litigation Services,” Consulting Services Practice Aid 95-2, “Communicating Understandings in Litigation Services: Engagement Letters,” Consulting Services Practice Aid 96-3, “Communicating in Litiga- tion Services: Reports,” Consulting Services Practice Aid 97-1, “Fraud Investigations in Litiga- tion and Dispute Resolution Services,” Consulting Services Practice Aid 98-1, “Providing Bankruptcy and Reorganization Services,” Consulting Services Practice Aid 98-2, “Calculation of Damages from Personal Injury, Wrongful Death, and Employment Discrimination,” Consult- ing Services Practice Aid 99-1, “Alternative Dispute Resolution Services,” Consulting Services Practice Aid 99-2, “Valuing Intellectual Property and Calculating Infringement Damages,” and Consulting Services Practice Aid 02-01, “Business Valuation in Bankruptcy.” 44.5 FEDERAL RULES OF EVIDENCE (a) FEDERAL RULE OF EVIDENCE 702. Most witnesses who testify in a litigation are fact wit- nesses. A fact witness can provide testimony based on what he has seen, heard, or otherwise ob- served. A fact witness may not offer opinions. By contrast, an expert witness by reason of education or specialized experience possesses superior knowledge about a subject and as such may offer opin- ions at trial. An accountant may testify as an expert witness if his opinion will assist the trier of fact in understanding the evidence or determining the issues in a case. Federal Rule of Evidence 702 governs the admissibility of expert opinion testimony. Rule 702 states that “if scientiﬁc, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualiﬁed as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opin- ion or otherwise.” (b) EFFECT OF DAUBERT V. MERRELL DOW PHARMACEUTICALS. In Daubert v. Mer- rell Dow Pharmaceuticals, 113 S. Ct. 2796 (1993), the Supreme Court addressed the rules per- taining to the admission of expert testimony. Since 1923, based on Frye v. United States, 293 F.1013 (D.C. Cir 1923), the federal courts applied a test (the general acceptance test) by which scientiﬁc expert opinions should be admit- ted into evidence. Under this standard, an opinion was admitted only if it was based on gener- ally accepted methodology within the industry. In the Daubert decision, the Supreme Court determined that in order for expert witness opin- ions to be admitted under 702, they did not have to meet the Frye general acceptance test and clariﬁed that Rule 702 does not establish general acceptance as a criteria for admissibility. The Daubert decision clariﬁed the trial court’s role in determining the admissibility of expert testi- mony. In doing so, the court need not determine whether the methodology meets the general ac-
44 12 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • ceptance test but must assess the validity of the methodology used and the applicability of that methodology to the speciﬁc facts of the case. (c) FEDERAL RULE OF CIVIL PROCEDURE 26. If the accountant has been engaged to serve as a testifying expert witness, he must become aware of the effect of Rule 26 of the Federal Rules of Civil Procedure, which deals with the procedure for written disclosure of expert testimony. Pursuant to Rule 26, the identity of one side’s potential testifying experts, as well as infor- mation about the expected testimony, must be voluntarily disclosed at the outset of a case, with- out receipt of a formal discovery request. In addition, Rule 26 provides that the expert prepare and sign a written report. This report must be disclosed to the other parties before the expert will be allowed to testify at trial. Unless the date by which disclosure of the written report must be made is decided by the trial judge, rules of the local court, or by agreement of the parties, the report must be disclosed at least 90 days before the date of trial. If an expert is retained solely to rebut the testimony of an opposing expert, the report of the re- buttal witness must be disclosed within 30 days of the disclosure of the other expert’s report. Generally, the expert witness will not be permitted to testify at trial to his opinions unless the opinions are contained in the expert witness’s written report. Therefore, the content of the ex- pert’s report should contain all of his opinions and the bases for the opinions. In addition, once the expert’s report is disclosed to the other side, any changes to the report must be disclosed be- fore the commencement of trial. Rule 26 requires that the expert’s report contain: • A complete statement of the opinion to be expressed and the bases and reasons therefore • The data or other information the witness considered in forming the opinions • Any exhibits to be used as a summary of or as support for the opinions • Qualiﬁcations of the witness, including a list of publications the witness authored within the preceding 10 years • The compensation to be paid to the witness for the study and testimony • A list of all other cases in which the witness has testiﬁed as an expert at trial or in deposition within the preceding four years • Signature of the expert Pursuant to Rule 26, once the expert’s written report required by Rule 26 has been disclosed, the opposing side has the right to take the deposition of any person who has been identiﬁed as an expert whose opinions may be presented at trial. The accountant who is engaged as an expert witness in a matter to be tried in a federal court should ascertain the current status of Rule 26 in the applicable federal district and discuss com- pliance with Rule 26 with the counsel retaining him. It is important to point out that the Federal Rules of Civil Procedure give local courts the option of not complying with certain provisions, including the provisions of Rule 26 discussed above. The accountant should consult with the retaining attorney to ascertain whether the case is to be tried in federal or local court and the local rules that apply to the case. 44.6 TYPES OF CASES (a) GENERAL ROLE OF ACCOUNTANT. An accountant may provide services in almost any case where there are accounting, ﬁnancial, bankruptcy, or fraud issues. Since most civil lawsuits involve one or more of these issues, an accountant may be involved in almost any type of litigation. Accountants are also used as experts in cases that require a knowledge of business records and trans- actions. However, there are certain types of cases in which accountants more likely to be involved.
44.6 TYPES OF CASES 44 13 • A lawsuit typically requires proof of liability, causation, and damages. An accountant may be involved in any or all of these areas. Cases requiring an accountant’s testimony on liability typically revolve around professional liability (e.g., was the audit performed properly?) or in- vestigatory accounting (e.g., can the accountant determine what really happened?). Cases in- volving an accountant’s testimony on damages usually involve the computation of lost economic value, including lost proﬁts, lost royalties, or loss of asset value. This chapter dis- cusses the types of cases that typically involve accountants and the roles that the accountant typically plays in those cases. (b) BUSINESS-ORIENTED CASES. The accountant’s work often involves business disputes. This section presents a summary of common types of cases and the accountant’s role. (i) Breach of Contract. Typically, the plaintiff has a contract with the defendant that the defen- dant is accused of breaching. For example, the contract may call for the defendant to buy a certain quantity of product for a certain price. The defendant, however, fails to make the required pur- chases. Or the defendant may be accused of breaching a warranty on its goods or services. The ac- countant may be asked to quantify the damages suffered by the plaintiff as a result of the breach. Usually, the damages are measured by lost proﬁts, that is, the additional proﬁts the plaintiff would have earned but for the defendant’s breach. Among the issues the accountant may address are lost revenues, avoided costs, available capacity, and possible mitigating actions, including sale of the product to others. (ii) Business Interruption. A business interruption claim may arise from an accident, ﬁre, ﬂood, strike, or other unexpected event. It may even arise from a contract or warranty claim where the defendant’s breach has caused the plaintiff to suspend operations. Typically, these claims are ﬁled by a business against its insurance carrier, though a claim against the entity causing the event is possible. In a business interruption case, the plaintiff claims the event caused the business to suffer losses. Often, the accountant is asked to quantify the loss. Elements to be considered may include lost proﬁts, loss of tangible assets, loss of intangible assets (including goodwill), loss of an entire business or business line, cost to repair or reestablish the business, cost of down- time, or cost of wasted effort (time spent ﬁxing the problem instead of generating operating proﬁts). (iii) Intellectual Property. Intellectual property disputes involve the rights to use patents, copy- rights, and trademarks. The plaintiff claims that the defendant infringed on the plaintiff’s intellectual property by illegally using the patent, copyright, or trademark. For patents, damages are deﬁned by law to be plaintiff’s lost proﬁts (if reasonably provable), but not less than a reasonable royalty. Dam- ages in a copyright case are the market value of the infringed work, the proﬁts that the owner lost or will lose as a result of the infringement, or the defendant’s proﬁt. In a trademark case, where the mark has been registered with the Patent and Trademark Ofﬁce, the owner may recover actual dam- ages and also the infringer’s proﬁts. Often computations are made separately for lost proﬁts and for reasonable royalties. Sometimes the accountant can perform both analyses. Other times the accountant’s opinion on reasonable roy- alty may be supplemented by another expert with experience in negotiating royalties in the particu- lar industry. (iv) Antitrust. The plaintiff in antitrust litigation may be either the government or a private party. The government usually brings suit to oppose a merger or to break up a monopolist. Gov- ernment suits are usually not for monetary damages. Experts in these suits, particularly in liability issues involving monopolistic practices, relevant market share, and the like, are often economists, not accountants.
44 14 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • In a private suit, the plaintiff accuses the defendant of violating antitrust laws, resulting in injury to competition, including (or especially) injury to the plaintiff. The accountant’s role again may be the computation of lost proﬁts. A company may be accused of violating antitrust laws by selling the same goods at different prices to different parties in the same channel of distribution. This ostensibly discriminatory pric- ing may be refuted if the defendant can show that the price differences are justiﬁed by differences in cost of production, service, freight, and so on. An accountant may conduct these cost justiﬁca- tion studies. Accusations of predatory pricing also fall under the antitrust laws. The defendant in a predatory pricing case is accused of pricing so low that competitors lose money and are driven out of business. Once the competition is eliminated, the defendant presumably raises prices and enjoys monopoly proﬁts. One legal standard for predatory pricing is pricing below cost of production. Depending on the law, the standard may be either incremental costs or fully allocated costs. An accountant may help establish or refute this claim by studying product pricing and production costs and measuring the resulting proﬁt margins. (v) White-Collar Crime and Fraud. This is a growing ﬁeld within the area of litigation consult- ing and covers a wide range of cases. Examples of fraud and white-collar crime cases are schemes by executives, employees, and customers to siphon funds from ﬁnancial institutions for their per- sonal use, check kiting, lapping, computer fraud, embezzlement, defense procurement fraud, cost- ing fraud, schemes involving kickbacks, income tax frauds, charity and religious frauds, money laundering, insider trading cases, and fraudulent bankruptcy actions. Additional examples include investigations of “boiler room” operations that solicit funds from investors based on promises of high investment return and Ponzi arrangements (i.e., arrangements in which there are no real prof- its; instead, funds from new investors are used to pay investment returns to existing investors, giv- ing the impression of proﬁts). The accountant’s work in this area centers on investigating what happened and establishing liability. After the investigation is completed, the accountant may be asked to quantify the amount of the loss attributable to the fraud or crime. The accountant will typically review and analyze many types of data, including correspon- dence, e-mail, journal entries, ﬁnancial statements, and ﬁnancial schedules. Many times, the ac- countant commences his investigation with little to no detail as to the extent of the situation and must put the pieces of a puzzle together. This involves developing and testing hypotheses throughout the investigation. Therefore, when reviewing documents and other data, it is impor- tant to keep an open mind and not dismiss any reasonable possibilities. Very often, an investiga- tion in one area will lead to other problem areas. Although most litigation takes place in an unfriendly environment, this is especially true in cases involving white-collar crime or fraud. The accountant may conduct or assist the attorney in conducting interviews of relevant parties. Often, the accountant or attorney is attempting to obtain information from the persons who are the subject of the investigation and are attempting to conceal their activities. As such, the accountant should maintain the highest level of profes- sional skepticism throughout the investigation. Since the accountant’s investigation, work product, and conclusions may form the basis of evidence in the case, it is critical to understand the importance of obtaining and preserving evi- dence and seek guidance from the retaining attorney about such matters whenever necessary. In addition, the accountant may have to coordinate efforts with other areas of law enforcement that may have an interest in the matter. The circumstances of each engagement are unique. Depending on the circumstances, the ac- countant or retaining attorney may need to engage other specialists or experts. Computer spe- cialists are frequently used in these types of cases to extract data that have been removed from computer drives or to search the contents of computer disks using key word searches. Private in- vestigators can also be of great assistance in performing detailed background checks or surveil- lance of potential suspects.
44.6 TYPES OF CASES 44 15 • The following are speciﬁc examples of tasks that the accountant might perform in different types of white-collar crime cases. In white-collar crime cases where Ponzi schemes are suspected, the accountant will want to doc- ument how the enterprise was structured and to develop organizational charts and ﬂow charts. Trac- ing transactions from the receipt of investor funds to their ultimate investment or disposition will be required. Analyses that illustrate the lack of any positive cash ﬂow other than by raising additional investor funds will be useful to the attorney in proving liability. Documenting the ﬂow of all cash transactions or custodial arrangements is all within the accountant’s scope. The accountant should also analyze cash disbursements to see whether any patterns indicating self-dealing emerge or to identify possible related entities or personal use or beneﬁt of company as- sets. Unusual expenses should be vouched, and particular attention should be devoted to traditionally sensitive areas, such as travel and entertainment expenses. Some suspicious transactions are easily detected. Many illegal activities involve disguised transactions, but it is just as likely that the paid bills and supporting evidence will be fairly explanatory. In the case of a penny stock fraud scheme, the accountant may shift greater attention to the ﬁnan- cial results and reports to shareholders, press releases, and the like to determine if evidence exists that such data were incorrect or inaccurate. Income recognition abuses or improper capitalization of expenses are typical categories of abuses used by penny stock promoters to misstate the operating re- sults and mislead investors. In addition, the accountant should analyze key contracts, employment agreements, and other consulting arrangements. A time-line analysis that reﬂects all key “publicized events” should be developed and used to determine if such events did occur. From the time line it can be determined whether, in the same time frame, all acquisitions or dispositions of assets and other ﬁ- nancial transactions were accounted for properly. (vi) Securities Act Violations. Lawsuits in this area usually involve alleged violations of the fed- eral acts, speciﬁcally Sections 11 and 12(2) of the Securities Act of 1933 and Section 10(b) of the Se- curities and Exchange Act of 1934. These sections concern making false or misleading public statements about a company or omitting a material fact (either in a prospectus or in public state- ments, including ﬁnancial statements), resulting in an alleged overvaluing of the company’s stock. Typically, when the correct information becomes public, the value of the stock drops. Plaintiffs claim that, but for the misleading statements, they would not have bought the stock or they would have bought at a lower price. These lawsuits are often brought against ofﬁcers, directors, investment bankers, lawyers, accountants, and others who may have been party to misstatements. Accountants may be involved in the liability, causation, and damages portions of securities cases. Involvement with liability issues is most common when an auditor has been accused of violating Section 10(b)5 by failing to perform a generally accepted auditing standards (GAAS) audit and/or by giving a clean opinion to non-GAAP ﬁnancial statements. The accountant will review the auditor’s work papers and other relevant materials to reach a conclusion as to the adequacy of the audit of the ﬁnancial statements. The causation and damages phases of securities cases are closely linked. They consist of deter- mining whether the information had any impact on the stock price and quantifying the losses suf- fered by the plaintiff investors as a result. Typically, this involves determining what the stock price would have been if the proper information had been released at the proper time. The methods for doing this are beyond the scope of this chapter; see de Silva et al. for a treatment of this subject.3 (vii) Bankruptcy and Bankruptcy Frauds. Bankruptcy matters may require an accountant’s ser- vices for many different tasks. The role of the accountant and scope of services to be performed are inﬂuenced by the size of the company and by whether the accountant is working for the trustee, debtor in possession, secured creditors, or the creditors’ committee(s). 3 Harinda de Silva, Nancy N. Low, and Tara N. Nells, “Securities Act Violations: Estimation of Damages,” in Litigation Services Handbook: The Role of the Accountant as Expert, ed. Romal L. Weil, Michael J. Wag- ner, and Peter B. Frank (John Wiley & Sons, New York, 1995).
44 16 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • Accountants for the debtor in possession may be asked to prepare analyses supporting the sol- vency or insolvency of the debtor, which may affect creditors’ claims, recoveries, or security in- terests. Such accountants also may be involved in preparing prospective ﬁnancial information ﬁled with the U.S. Trustee’s Ofﬁce or used in negotiating plans of reorganization with the parties of interest. Another important role may require making analyses to support a debtor’s use of cash collateral and analyses showing that adequate protection is available to the secured creditor. An accountant for the creditors’ committee, in addition to reviewing any analyses prepared for the debtor, will have additional responsibilities. The accountant may initially be asked to determine the cause for the business failure and may need to determine quickly whether the debtor’s operation may be further depleting the assets available for creditors. The creditors’ accountants also may need to investigate the conduct of the debtor. The scope and depth may vary signiﬁcantly based on the re- lationship and conﬁdence the creditors have with existing management. At a minimum, a review to determine possible preferential payments, fraudulent conveyances, and insider transactions is usu- ally performed. The roles, deﬁnitions, and exceptions to preferences and fraudulent conveyances are detailed in the Bankruptcy Code as well as in Newton.4 The work required to establish liability in bankruptcy cases is similar to that discussed in the subsection on white-collar crime. One difference is that liability issues in bankruptcy have the beneﬁt of explicit rules in the Bankruptcy Code (Title 11 USC, more speciﬁcally, Subsections 543–549). These sections of the Bankruptcy Code detail the powers of a trustee to avoid transfers that defraud, hinder, or delay creditors, give preferential treatment to certain creditors, or do not give the bankrupt person or entity fair value for the transfer. Since these Code sections deﬁne the scope of the trustee’s power, an accountant engaged by the trustee should ﬁrst read and under- stand the relevant provisions before planning the work. In addition, an accountant must obtain an understanding of certain sections of the Uniform Commercial Code and in particular the Uniform Fraudulent Transfer Act of the state where the business is situated. The location of the business may inﬂuence the scope of the work since the time period under the bankruptcy statute only al- lows for recovery one year prior to the bankruptcy, whereas state laws vary from 3 to 10 years. Once the appropriate time period and scope have been determined, the accountant needs to review all material transactions to gain an understanding as to the economic beneﬁt of the exchange to the bankrupt, including all monetary and nonmonetary exchanges. In addition, the accountant needs to de- termine the timing and explanation for any liens or other security interest granted or recorded during the time period. This review should include any asset sales, purchases, foreclosures, and tax assessments. Transactions between related entities or commonly controlled entities or their afﬁliates must be re- viewed. In a bankruptcy case, the accountant is trying to develop any evidence that might show fraud or fraudulent intent. A preferential payment analysis covers a review of transactions within 90 days (one year for in- siders) prior to bankruptcy wherein a creditor is paid for an antecedent debt at a time the debtor is in- solvent and such payment is not in the ordinary course of business. The deﬁnition of insolvency for this purpose is the fair value of assets compared with the fair value of liabilities—a balance sheet ap- proach. “Ordinary course of business” is not deﬁned except by reference to case precedents. For ex- ample, if creditors are routinely paid in 90 days but certain creditors get paid just before bankruptcy within 30 days, such payments are probably not in the ordinary course of business. Certain leveraged buyouts (LBOs) have encountered ﬁnancial difﬁculty shortly after consumma- tion, and some creditors have used various security law and bankruptcy law theories to unwind these transactions and seek recoveries from selling shareholders, secured creditors, and others. The accountant’s work in establishing or defending liability is critical. Analyses that show the cash ﬂow of the entity before and after the LBO help establish whether sufﬁcient capital or working capital was available to the company. Changes in a company’s borrowing, especially where a signif- icant amount of assets have been recently pledged, also illustrate the potential damage to unsecured creditors. The accountant’s ability to distinguish operating losses caused by the form and structure of 4 Grant W. Newton, Bankruptcy and Insolvency Accounting, 5th ed. (John Wiley & Sons: New York, 1994).
44.6 TYPES OF CASES 44 17 • the buyout from losses due to the economy or other competing companies will also assist counsel in determining whether the LBO can be attacked as a fraudulent transfer. (viii) Lender Liability. Common law verdicts in numerous states have established a duty requir- ing banks to act in good faith and to provide a reasonable time period for a customer to arrange al- ternative ﬁnancing should the bank no longer wish to continue the relationship. Other cases involve inaccurate or incomplete responses from banks to inquiries by third parties or failure to honor ﬁ- nancing commitments. In some situations the bank’s activity, either as a member of the business’s board of directors, or in selecting those members, or the bank’s insistence on designating workout consultants, places them in a position of being too close to operating the business; and they may ﬁnd themselves accountable for its losses or ultimate bankruptcy. The accountant’s role is to assist with liability, causation, and damage issues. With respect to liability issues, the accountant may develop ﬁnancial data to determine whether the borrower was in compliance with various loan covenants at various intervals during the banking relationship, including at its commencement. A review of debt and equity items in the ﬁnancial statements could identify differences in deﬁnitions or inconsistencies between GAAP and the bank loan doc- ument terminology. Accounting consultants working with defendants to lender liability actions may provide useful in- formation to show the bank was acting prudently in calling a loan or in refusing to extend it based on the results of a ﬁnancial analysis of the debtor. On the causation issue, the accountant can determine whether the bank’s actions caused the business failure or whether other circumstances were involved. The accountant’s role in damages is important for both the plaintiff and defendant. Damage theo- ries may include both the actual cost of the termination of the credit relationship and more complex damages, including punitive and racketeer inﬂuenced corrupt organizations (RICO) claims where business failure occurs. (ix) Employment Litigation. Employment litigation typically involves claims of employment discrimination (including discrimination on the basis of age, race, or gender) or wrongful discharge. Claims may involve discrimination in hiring, promotion, or wages. The accountant may be involved in both liability and damages phases of employment claims. For liability, the accountant may compile hiring rates, promotion rates, salary levels, or similar historical information to prove or refute a claim of differential treatment. This liability work often may be per- formed in conjunction with a statistician. On damages, the accountant may determine what the plaintiff’s income would have been had the alleged discrimination not occurred. The accountant will consider the proper level of earnings, the likely duration of the earnings, and any offset from amounts actually earned. The issues are very sim- ilar to loss of earnings claims in personal injury cases. Although speciﬁc approaches are not dis- cussed in this chapter, the methods are logically similar to lost proﬁts claims. (x) Accountant’s Liability. Most litigated claims against accountants have arisen from audit work. Recently, signiﬁcant litigation has come from compilation, review, and prospective ﬁnancial statement engagements. Litigation over audited ﬁnancial statements generally involves allegations that GAAP was not ap- plied or that the audit was not conducted in accordance with GAAS, or both. In class action securi- ties litigation, noncompliance with SEC Regulations S-X and S-K as well as Financial Reporting Releases may also be alleged. During the discovery process, the accountant has the opportunity to explore the underlying docu- ments and associate the facts with the accounting pronouncements. The accountant will refer to a company’s general accounting records and documents as well as to the work papers of the indepen- dent auditor. Such a review process requires the expert either to be an auditor or to have some audit- ing background. Issues related to the auditing ﬁrm’s consideration of GAAP, their consultation with parties in their ﬁrm who provide technical expertise, and the extent to which they have researched a speciﬁc area of accounting should be documented in the auditor’s work papers.
44 18 FORENSIC ACCOUNTING AND LITIGATION CONSULTING SERVICES • The accountant may review and assess potential violations of GAAS or other applicable profes- sional standards. Such violations may range from the failure of the defendant auditing ﬁrm to ade- quately observe the physical inventory, to not conﬁrming sufﬁcient accounts receivable, to not performing an adequate subsequent events review. Liability issues related to a failure to perform an audit in accordance with GAAS are usually not unearthed until a review of the auditing ﬁrm’s work papers has taken place. In order to adequately address GAAP and GAAS issues, the accountant must stay current with ac- counting and auditing literature issued by the FASB, the AICPA, and the SEC. With these types of cases, it often becomes necessary to consult with an accountant with relevant industry expertise. (xi) Contractual Purchases Litigation. Litigation often results from the purchase of a company. With such purchases, the audited ﬁnancial statements are used as the basis for the purchase or con- dition of the sale. The issues often center on the valuation of assets or the quantiﬁcation and disclo- sure of liabilities in those ﬁnancial statements. Asset values in dispute may include such issues as proper use of LIFO or FIFO, inventory write-downs, unrecorded liabilities, accounting for impaired assets, amortization of goodwill, replacement cost versus book value, and realizable value of ac- counts receivable. Many purchase and sale agreements contain a “postclosing adjustment” provision. This pro- vision allows for the purchase price to be adjusted based on events that occur or become known after the closing. The accountant can serve as the expert for the buyer or seller with respect to the arguments as to why the purchase price should or should not be adjusted. The accountant can also serve as the arbitrator or mediator on such cases. The expert in these cases is usually called on to review the working papers of the indepen- dent auditor of the ﬁnancial statements. From these working papers and the notes to the ﬁnancial statements, the expert can determine what accounting methods were employed and whether they are in conformity with GAAP and common industry practice. Liabilities are of critical importance since the buyer needs to be alerted to all potential and contingent debts and encumbrances. The accountant would determine whether there was ade- quate disclosure of the liabilities in the ﬁnancial statements that were either issued or relied on by the buyer. The accountant may also need to evaluate whether subsequent events were reason- ably foreseeable. Contracts for the purchase and sale of a company sometimes include a provision regarding a material adverse change in the business. In these cases, an accountant may be asked to review the ﬁnancial records of the company to search for any adverse changes in the business. (xii) Breach of Fiduciary Duty. These cases involve the issue of whether a trustee, executor, of- ﬁcer, director, or other ﬁduciary has breached his ﬁduciary duties, thus causing damages to the trust estate or corporation. The accountant can play a vital role in proving or rebutting liability on the part of the ﬁduciary by demonstrating that the ﬁduciary acted correctly or incorrectly with respect to ac- counting, ﬁnancial, or economic issues or transaction. (c) NONBUSINESS CASES. Important nonbusiness issues include marital dissolution, partner- ship dissolution, and personal injury matters. (i) Marital Dissolution. In many states, the ﬁnancial aspects of a marital dissolution are governed by family law statutes that establish rules for sharing of income and the division of property. The tax laws have also greatly inﬂuenced the allocation of income and assets during and after a marital dis- solution. Most states divide assets “equitably”; a few states are governed by community property rules. Awareness of the local rules and practices is of critical importance to accountants in their ﬁ- nancial analyses. In cases governed by community property laws, the accountant’s role is often to trace assets, re- ceipts, and disbursements to determine which assets are community property. In cases governed by
44.7 CALCULATING DAMAGES 44 19 • equitable distribution law, the accountant may be asked to analyze the assets in order to determine which assets are subject to equitable distribution. He may also be asked to help an equitable distrib- ution of marital assets. The “liability” role of the accountant is to identify all assets and liabilities of the parties so that a fair and equitable distribution of assets results. Most family law courts are equity ori- ented, so the substance of transactions should carefully be considered when analyzing ﬁnancial data. The forensic accountant has to examine ﬁnancial data with concern for diversion of assets, improper cash transactions, and padded payroll and other fringe beneﬁts and perks that may de- prive the nonworking spouse of a fair share of the business’s net worth as well as a share of spousal support. If ﬁnancial statements do not exist for closely held companies, such ﬁnancial statements may need to be prepared. The accountant must be familiar with the local state family law. The ac- countant must also be familiar with tax implications of various asset transfers or split-ups so that neither spouse later ﬁnds unexpected tax consequences. The accountant should be aware of the proper handling of pension plan assets, individual retirement accounts, 401(k) plans, and the like, so that each party receives a fair share of assets and so that income tax or excise taxes are not triggered unnecessarily. In community property states, the existence of separate property and the impact of prenuptial agreements may also require analysis. Signiﬁcant tracing of funds may become necessary if a total segregation of separate property assets has not been maintained. The marital community may have rights to a contribution for increased value of separate property that arises from ser- vices provided by the community after marriage. Lastly, the community may have some interest in separate property if joint tax returns have been ﬁled and no separate tax cost was allocated to each category of assets. Accountants often are asked to determine the value of the assets owned by the litigants as well as the income sources from which spousal and child support can be calculated. The valuation of assets often includes business valuation and, in the case of professionals, the value of their shareholdings, partnership interest, or professional licenses. Issues such as professional goodwill or celebrity good- will are important and contested often in marital dissolution litigation. (ii) Partnership Dissolution. Partnerships sometimes break up in a manner similar to a divorce. The accountant’s work is also similar, focusing on tracing, valuation, and fair appor- tionment of assets and liabilities, usually pursuant to the terms of the partnership agreement, if one exists. (iii) Personal Injury. Personal injury cases stem from automobile accidents, slip-and-falls, and the like. Typically, damage components include medical expenses, pain and suffering, lost earnings, and loss of consortium to the injured party’s spouse. The accountant is usually involved in the calcu- lation of lost earnings and in calculations regarding the interest components of the judgment. For identiﬁcation of the issues involved, see Subsection 44.4(b)(ix). 44.7 CALCULATING DAMAGES (a) GENERAL CONCEPTS. In proving liability, the plaintiff must demonstrate that the de- fendant’s actions were in violation of the plaintiff’s legal rights. In moving from liability to cau- sation, the plaintiff must demonstrate that the illegal actions caused injury to the defendant. Only then can damages be calculated. In discussing damages, we rely on the concept of the “but-for” world. The but-for world is the economic and physical environment that would have existed “but for” the actions of the defendant. In other words, it is the “undamaged” world, in contrast to the “actual,” damaged world that did occur and in which the defendant performed the alleged illegal acts.