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Takeaways from a recent study on Daubert challenges

Financial experts must constantly be aware of threats to their work.  Similarly, financial experts engaged in disputes understand there are risks associated with the Daubert challenge.  With this in mind, studies on this subject matter can provide meaningful information to inform practitioners on areas of increased sensitivity.  This is where PwC’s annual study on Daubert challenges comes into the conversation.  PwC, a Big 4 CPA firm, released a few months ago its 2016 edition of its study, which spans written court opinions from the last 16 years.

History

To put the study into context, there are two notable court cases addressing the standard for admitting expert testimony in U.S. federal courts.  These cases expanded the role of the trial judge as a gatekeeper for expert testimony:

  • Daubert v. Merrell Dow Pharmaceuticals Inc., 509 U.S. 579 (1993)
  • Kumho Tire Co. vs. Carmichael, 526 U.S. 137, 119 S.Ct. 1167, 1179 (1999)

In essence, the court found in the Daubert v. Merrell Dow Pharmaceuticals Inc. case that trial judges are to ensure expert witness testimony is based on a reliable foundation and is relevant to the task at hand.  Furthermore, this court ruling may be dissected into two parts:

  • Is the expertise and testimony of the expert witness relevant to matters at issue in the trial?
  • Is the testimony of the expert witness reliable because the theory or technique used by the expert?

The second question on expert testimony reliability might be further analyzed as follows:

  • Can and has been tested?
  • Has been subjected to peer review and publication?
  • Identifies the known or potential error rate?
  • Is standardized and generally accepted within the relevant peer community?

A few years later, in the Kumho Tire Co. v. Carmichael case, the court ruling expanded the gatekeeping function of the trial judge under Daubert v. Merrell Dow Pharmaceuticals Inc. to all (not just scientific) expert testimony based on scientific, technical, or other specialized knowledge, including experience-based technical testimony.

Study background

In connection with its study, PwC identified written court opinions issued between 2000 and 2015 that cited the Kumho Tire case and that related to financial experts.  The resulting pool of cases totaled 2,014 Daubert challenges for further analysis in the study.

Study observations

Of course, there are multiple aspects of the study, some of which I do not intend to cover in today’s post.  Nevertheless, the study identified the following trends in the last 16 years:

  • Often, rather than excluding financial expert testimony, judges prefer that flaws in the testimony be exposed through cross-examination at trial.  The study observed, on average, that approximately 53% of financial experts admitted by courts after being challenged.
  • The use and misuse of data is a common stumbling block for financial experts and the most common reason for financial expert exclusion.  The study observed that financial experts are excluded for various reasons, including not providing sufficient support for calculations and not performing due diligence on data received from clients.
  • Rule 702 of the Federal Rules of Evidence states that experts may testify if they are qualified based on their knowledge, skill, experience, education, or training. However, the interpretation of what that requisite knowledge, experience, and skill is can vary widely.
  • In 2011 the Federal Circuit made a landmark decision in Uniloc USA, Inc. v. Microsoft Corp., Nos. 2010-1035, 2010-1055 (Fed. Cir. Jan. 4, 2011).  The court described the royalty rate rule of thumb in intellectual property cases as a “fundamentally flawed tool” that fails to tie the royalty rate to the specific facts and circumstances of the case.  The PwC study identified other instances in 2015 where expert testimony was excluded due to the use of rules of thumb and generalizations that did not relate to the specific facts of the case.
  • In the past few years, the study observed several instances where the court allowed the expert to remedy challengeable issues in his or her original report by submitting a revised report.  While a Daubert exclusion typically means “game over” for an expert’s involvement in a case, the study has recently observed that courts provide financial experts a chance to revise or update their testimony before providing a final decision on the expert’s admissibility.
  • Financial expert testimony is often excluded if the court considers it a legal conclusion.  Such legal conclusions are typically the domain of the trier of fact.  The study notes that this can often happen when financial experts opine on contractual obligations or conclude on the interpretation of disputed contracts in the context of their financial testimony.

Some of the above observations may seem self-explanatory and straight-forward, yet they continue to surface as reasons for Daubert challenges and exclusions.

The study identified lack of reliability (as opposed to relevance or qualification) as the number one cause of financial expert exclusion in the last 16 years.  Moreover, the study calculated that approximately 44% of financial experts have been excluded over the same time frame.  Another statistic of relevance is that plaintiff-side financial experts experienced almost twice as many challenges as defendant-side experts, but only had a slightly higher exclusion rate of 47%.

More information

The study includes additional statistics not covered in this post which may be of interest to practitioners.  Those interested in learning more can find the study here.

Additionally, the Daubert Tracker database is a valuable resource for checking “gatekeeping history” of experts, which is a benefit to AICPA Forensic and Valuation Services (FVS) members.

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New going concern auditing standard proposed…so what?

Last week the AICPA’s Auditing Standards Board (ASB) released its exposure draft entitled “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.”  This proposed standard is designed to supersede SAS No. 126 (AU-C 570).  So, what should we learn from it?

To begin, the ASB made it clear that it wants to achieve three main goals with the exposure draft.  First, the ASB wishes to provide interpretative guidance on key aspects of the going concern assumption.  This interpretative guidance is, in part, designed to incorporate into the auditing standards the FASB’s ASU No. 2014-15 on going concern issued in 2014.  Second, the ASB wishes to converge the U.S. GAAS auditing standard on going concern (currently SAS No. 126) with International Standard on Auditing (ISA) No. 570 (revised).  And third, the ASB has designed this exposure draft to apply to different financial accounting standards, thereby necessitating a going concern standard written in a neutral accounting framework manner.

While the implications of this exposure draft may be varied depending on the circumstances in which it may be applied, I wish to focus today’s post on one aspect of this exposure draft–that of the definition of “substantial doubt.”

Substantial doubt

Paragraph A4 to this exposure draft reads:

A4. The FASB standards define substantial doubt about an entity’s ability to continue as a going concern as follows:

Substantial doubt about an entity’s ability to continue as a going concern exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). The term probable is used consistently with its use in topic 450 on contingencies.

Other applicable financial reporting frameworks may use different terms that are similar to substantial doubt. For example, International Financial Reporting Standards (IFRS) use the terms material uncertainty and significant doubt. Also, other applicable financial reporting frameworks may not use probable as their threshold. For example, IFRS uses “may cast significant doubt on the entity’s ability to continue as a going concern.” This SAS uses the terminology of the FASB standards and GASB statements; if an audit is performed under another financial reporting framework, the requirements and application guidance may need to be adapted as necessary. (emphasis added)

Clarification

Since the issuance of ASU No. 2014-15 there has been a disconnect in terms of the above definition of “substantial doubt” between U.S. accounting standards and U.S. auditing standards, which I discussed in a previous post.  In fact, this disconnect became a hot topic in one of my former consulting engagements of a Fortune 1000 company.  However, with the expectation that this definition will find its way in a new auditing standard on going concern, we should see agreement between these two sets of standards.  If adopted, the exposure draft will be effective for audits of financial statements for periods ending on or after December 15, 2017.

I find this a big step in the right direction to clarify auditing standards on this point.  Should practitioners take interest in this topic and wish to provide feedback to the ASB, comments are due on September 5, 2016.

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Effective interviewing techniques

Recently I attended a training by my local Association of Certified Fraud Examiners (ACFE) chapter addressing the topic of conducting interviews.  I thought the topic was interesting and certainly applicable in my line of business.  For this reason I’m writing today’s post on this topic.

To begin, television shows and movies too often seem to portray interviewing techniques that are wholly ineffective in most circumstances.  For example, in the movie L.A. Confidential the good cop-bad cop scene shows essentially every signal of aggression.  As expected, the bad cop plays really tough with the subject, who eventually submits to his wishes.  In reality, when faced with such drastic circumstances, an interviewee may say whatever the interviewer wishes, even giving a false or unreliable admission.  Experience dictates that this is not truly effective interviewing.

Rapport

Effective interviewing requires rapport building with the interviewee.  Indeed, there are various techniques to do this.  Examples include listening, asking follow-up questions, understanding the interviewee psychologically, saying “I want you to relax,” and asking the interviewee “tell me about your life/yourself.”

Of course, not having a checklist mentality is very important as well.  This is because a checklist mentality does not sufficiently accommodate for changes in plan or approach that often times are necessary on the fly.  I discuss the practice of check listing in another post.

Another key aspect of building rapport is deciding the best approach to take.  Appealing to reason or logic, rather than fear, is more likely to create an effective bond with the interviewee.  Moreover, the interviewer generally shouldn’t dominate the conversation, but rather seek to make the power neutral between the interviewer and the interviewee.

Interviewers should also think about what type of support network the interviewee may have.  For example, one might ask if there are other perpetrators or victims that may not already be identified.

What’s going on in the interviewee’s mind?

As a means of trying to anticipate potential issues or identify appropriate questioning techniques during an interview, interviewers should understand what is going on in the interviewee’s mind.  There are at least three things that an interviewee is thinking through, whether consciously or sub-consciously.  These include an interviewer assessment, a subject assessment, and asking him or herself “what about me” questions.

The interviewer assessment

  1. Do I like the interviewer?
  2. Do I trust the interviewer?
  3. Is the interviewer judging me?

The subject assessment

  1. Why is the interviewer talking to me?  The interviewer has responsibility to explain this up front.
  2. Do I have the information that the interviewer seeks?
  3. How much does the interviewer know?
  4. How much can the interviewer find out from other sources?

“What about me” questions

  1. What happens if I disclose the information?
  2. What happens if I do not disclose the information (fired, jail, fine, etc.?)
  3. Am I comfortable?

Voluntary disclosure

Of course we want the interviewee to voluntarily disclose information.  As such, an interviewer should take an approach that encourages the interviewee to do this.  Think of the art of persuasion, using the sales pitch to appeal by being genuine, compelling, and using logic and reason.

Awareness

Equally important to effective interviewing is situational awareness.  Sun Tzu, a 6th century BC Chinese military strategist, identified three attributes of awareness that are relevant to this topic and the ACFE training adapted these attributes to effective interviewing as follows:

Know yourself as an interviewer

As an interviewer, I need to identify my strengths and weaknesses, mold my techniques to my strengths, and create my style of interviewing.

Know your “enemy”

As an interviewer, I need to understand the interviewee’s motivations, strengths, and weaknesses.  Furthermore, I need to try to answer the 10 questions (listed above) on behalf of the interviewee beforehand.  Finally, I should acknowledge that every interviewee is different and that my approach should be fluid and flexible to accommodate changes in plan.

Know the terrain

As an interviewer, I need to understand the laws applicable to the facts and circumstances (e.g., employment law, criminal law).  In addition, I need to understand company policy and procedures as well as the corporate culture.  Ultimately, I need to understand the BIG picture in focus.

Application

When one gets into the details of effective interviewing, today’s post identified a number of factors to consider.  For some, thinking through each factor can be overwhelming.  With this in mind, consistent practice is what I believe makes an interviewer more effective.

I received permission from the authors of the training (Travis Boyd, CPA, Johnnie Bejarano, DBA, CPA, CFE, and Doug Laufer, PhD, CPA, CFE) to share the slide deck here.

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