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The proliferation of forensic accounting

I had the pleasure of being a guest speaker last week at a university in Denver.  I presented to students enrolled in a forensic accounting course on the topic of litigation services and expert testimony.  The audience, consisting mostly of graduate students, was highly engaged during the presentation.

Certainly, I see a strong level of interest in the field of forensic accounting, not just within the professional world, but also within colleges and universities.  Contrast this with when I was in school.  Although it doesn’t feel like a long time, when I finished my university studies in 2005 there seemed to be less talk within the business school of forensic accounting careers.

Today, forensic accounting is a multi-billion dollar industry and its growth is expected to continue for the foreseeable future.

Where to begin

During my presentation, I could sense the eagerness of the students to find their career fit within forensic accounting.  At the completion of the discussion they asked me how I would recommend they tap into the field.  Of course, I was happy to respond because I was in their shoes at one point in my career and I’ve always appreciated meaningful career counsel.

First, I believe those interested in this field should find out what type of industry or practice-area they are most interested in.  It could be financial services, manufacturing, technology, communications, etc.  Next, I recommend they build a strong foundation in whatever industry or practice-area they choose by gaining at least a few years of diverse experience.

If they still desire to be a forensic accountant once they establish a strong foundation, then I recommended they search for the right fit with patience, relying as much as possible on their network of contacts.

Experience is critical

Unfortunately, too often I think college graduates do themselves a disservice when they seek to jump right into forensic accounting without any real-world experience.  Of course, this isn’t always the case, but I have worked with enough junior professionals within the industry to make this observation.

I make the following case to illustrate my point.  Auditors are trained to approach their work with “materiality” in mind.  Those in criminal justice approach their work with “beyond a reasonable doubt” in mind.  Statisticians often approach their work with “statistical significance” in mind.  Forensic accountants, on the other hand, may or may not approach their work with these concepts in mind.  Truly, the application of concepts or principles depends on the facts and circumstances of a case.

For this reason, I believe a forensic accountant should have sufficient experience so that he or she can appropriately apply professional judgment, no matter the circumstance.

With ever-changing regulations and increasing complexity of the world we live in, I believe the role we forensic accountants provide will become increasingly valuable.

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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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The FASB’s comment letter process and why we need to understand it

Today I’m writing about the Financial Accounting Standards Board’s (FASB) comment letter process.  Prior to issuing authoritative accounting and disclosure standards, the FASB interacts with its constituents in a variety of ways to gather information that it may not have already considered.  Having a strong understanding of this process can provide practitioners with meaningful context to assist companies in their application of the FASB’s standards.

To begin, the FASB is a private organization overseen by the SEC.  The FASB sets standards, which become a part of U.S. GAAP accounting standards serving the broad public interest.  To note is that since September 15, 2009 the U.S. GAAP accounting standards have been codified in what is known as the Accounting Standards Codification (ASC).  In connection with setting these standards, the FASB has adopted an open decision-making process that provides for interaction between the FASB and its constituents.  This interaction takes many forms, including comment letters.  The FASB explains:

Comment letters are received from constituents in response to Discussion Papers, Exposure Drafts, and other discussion documents that are released to the public for comment.  Comment letters, which become an important part of a project’s public record, are an important source of information regarding constituents’ views on and experiences related to issues raised in a discussion document.

Comment Letter Process

The following summarizes the FASB’s standard-setting process, which is governed by the FASB’s Rules of Procedures:

The part I want to focus on in the above graphic is step number five.  When the FASB seeks to issue new authoritative accounting guidance, it commences by issuing exposure documents to solicit input.  These exposure documents may include Exposure Drafts (ED), Discussion Papers, Preliminary Views, and Invitations to Comment.  Often times the FASB issues an ED, but in some cases it may issue a Discussion Paper to obtain input in the early stages of a project.

The FASB typically issues EDs with a designated timeframe for respondents to reply, often in the form of comment letters, but also via public roundtable discussion and other due process activities.  Depending on the nature and extent of the feedback it receives, the FASB may redeliberate the proposed provisions to accounting and disclosure standards.  This, according to the FASB, is done at one or more public meetings.

Once all key concerns and issues have been considered and addressed, the FASB nears completion of its standard-setting process by issuing a final standard, in the form of an Accounting Standards Update (ASU).  The ASU describes the amendments to the ASC.

Resources

When litigation cases or accounting consulting engagements involve the interpretation or application of accounting and disclosure standards, it is critical to understand the thought process surrounding the decisions that become part of a standard.  Having a strong understanding of the FASB’s standard-setting process and knowing where to locate relevant information is key to building a strong position.

Practitioners have at their fingertips access to a host of FASB resources that can assist them in preparing arguments, opinions, or positions on a variety of accounting and disclosure topics.  Some helpful resources include:

  • Exposure documents previously issued by the FASB for comment, but are now closed for comment, unless otherwise stated.  This link includes FASB documents issued after 2002.
  • Responses received by the FASB in connection with its online comment letter process.  One can read specific comment letters the FASB receives from constituents, including public accounting firms, SEC filers, and other organizations taking a keen interest in the FASB’s exposure documents.
  • Unsolicited online comment letters from constituents.  This link includes related documents dating from 2002.
  • Exposure documents currently open for comment.  I suggest these types of documents are less valuable to preparing arguments, opinions, or positions.  However, understanding current deliberations may be applicable in certain engagements.
  • ASU documents.  Perusing certain aspects of these ASC amendments is a good way to obtain color and context to them.  I have found the following ASU sections to be particularly helpful in obtaining the understanding I may be seeking:
    • Why Is the FASB Issuing This Accounting Standards Update?
    • Who Is Affected by the Amendments in This Update?
    • How Do the Main Provisions Differ from Current U.S. Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?
    • Background Information and Basis for Conclusions

Application

I once worked on an engagement with a Fortune 1000 company that had become the center of a wave of negative media attention.  In a move that was anticipated, the external auditor raised challenging questions about the company’s application of a particular ASU in light of the negative media attention the company had received.  As an engagement team, in order to effectively address the external auditor’s concerns, we decided it was important to understand the details behind the ASU, including reviewing the comment letters the FASB received prior to issuing the ASU.  This exercise shed meaningful light on the implementation issues that multiple constituents predicted would, and indeed had occurred with the company.  Because of our ability to quickly look to relevant sources for reliable information, my firm was able to assist our client in navigating this challenge effectively and provide credible, supportable arguments to the company’s external auditor.

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How to effectively identify a peer group

When writing expert reports I am often faced with the task of carefully benchmarking an entity against its peers. Disputes often deal with alleged accounting failures of an entity to recognize, disclose, or perform some other activity appropriately. Alternatively, financial statement preparers, users of financial statements, and/or auditors may wish to assess the reasonableness of management’s accounting recognition and disclosures against other entities.  For these reasons it is imperative that a careful benchmarking exercise be performed to assess the reasonableness of an entity’s accounting decisions in light of the decisions of peer entities. In this post I define peer entities as those entities that are most closely related to or aligned with the subject entity.

On the surface it may seem relatively straightforward to identify a peer group. However, when one peels back the onion the nuances begin to surface and, if not careful, practitioners may find themselves in a tough situation trying to defend their thought process in a rebuttal report, deposition or trial or trying to explain variances that prove to be irrelevant.  Today’s post will discuss some helpful tips to consider when selecting an appropriate peer group for benchmarking purposes.

To begin, a practitioner should have sufficient knowledge and understanding of the entity’s business and the industry in which it operates. Following are some items to consider to test ones knowledge and understanding of an entity’s business environment, not in any particular order:

  • What types of products or services does the entity offer?
  • Are any of these products or services different from other entities within its industry?
  • Does the entity operate in a regulated industry?
  • Is the entity publicly traded, or are the entity’s financial statements publicly available?
  • If so, what potential peer entities has the entity disclosed within its annual report (i.e., SEC Form 10-K) (more on this below)?
  • Can one easily identify the Standard Industrial Classification (“SIC”) code of the entity (more on this below)? Or, can one identify at least one potential peer entity that is similar to the entity, whose SIC code is readily available?
  • Do industry publications exist from a reputable source that may identify potential peer entities?

Screening considerations

Upon responding to the questions above, one focuses on a list of potential peer entities; however, it may still be necessary to screen the list further. I generally screen entities based on key financial metrics, which may include: assets, revenues, equity, net asset value, PP&E, headcount, or some other specific account or disclosure in the financial statements (depending on the nature of the research or litigation one is addressing).

Alternatively, one may look to segment disclosures in the financial statements, which often include disaggregated financial metrics based on geography, product line, or some other meaningful attribute. Furthermore, market capitalization may be meaningful; however, one should take caution with relying on this metric as it may be more volatile relative to other financial metrics.

In some cases, an entity may operate in a highly specialized industry. When this occurs and financial information of a direct competitor is not publicly available, one may consider selecting potential peer entities associated with the direct competitor that are upstream or downstream. In my view this is reasonable because upstream or downstream entities tend to have similar operations or business risks within the highly specialized industry.

Once a screening process is selected, one may also consider screening the same criteria for multiple periods to confirm that the selected screening criteria yield consistent results and, therefore, are reliable for benchmarking.

Annual Report Disclosures

SEC Regulation S-K Item 201(e) requires an SEC registrant to disclose a performance graph in its annual report (i.e., SEC Form 10-K filing).  This performance graph is relevant in the context of benchmarking because, depending on its business, an SEC registrant is required to construct a “peer group index,” which may identify potential peer entities of interest. The SEC guidance stipulates, “If the registrant uses a peer issuer(s) comparison or comparison with issuer(s) with similar market capitalizations, the identity of those issuers must be disclosed and the returns of each component issuer of the group must be weighted according to the respective issuer’s stock market capitalization at the beginning of each period for which a return is indicated.”

Care should be taken when relying on the SEC registrant’s selected peer group as the SEC guidance states, “If the registrant does not select its peer issuer(s) on an industry or line-of-business basis, the registrant shall disclose the basis for its selection.”  In the end, the judgments or assumptions applied by a practitioner in connection with a benchmarking exercise must be adequately considered and documented.

SIC Codes

The U.S. Bureau of Labor Statistics developed SIC codes to indicate an entity’s type of business.  SIC codes are categorized by major industry and sub-industry.  Public entities that file statements with the SEC include their SIC codes within their filings, which can be used for comparative analysis.

Application

The manner of execution of the benchmarking exercise can strengthen one’s position in a dispute.  Conversely, if left to inexperienced practitioners or lack of careful consideration, this exercise can create more problems than it was designed to solve. I’ve worked on a number of disputes wherein a robust benchmarking exercise was applied. In my experience well thought out benchmarking exercises have consistently played a critical role in persuasion of the arguments and opinions presented in the dispute.

In one such case a key allegation brought by an opposing expert dealt with inadequate accounting and disclosure of a particular FASB interpretation (“FIN”). My team carefully selected a peer group for comparison and we successfully demonstrated that diversity in practice existed with respect to peer entities complying with the disclosure requirements, which findings supported my client’s position.

In closing, I wish to reiterate that judgments or assumptions applied by a practitioner in connection with a benchmarking exercise must be adequately considered and documented for a successful outcome to occur.

Photo credit – Craig Jewell Photography