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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

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Anticipating Biases

Once I listened to a lecturer, who happens to be an expert in the field of jury persuasion, discuss various types of “bias” and how they may influence a juror.  I thought there were some great parallels to make in the context of the work that expert witnesses do.  Today’s post will discuss some key considerations regarding juror bias and how to anticipate and plan for issues before they arise.

Bias

Anticipating the following types of bias that jurors will likely have is critical to ensuring a bullet-proof expert testimony:

  • Availability bias – what one spends the most time on or emphasizes contributes to what information is perceived as most important.
  • Confirmation bias – one’s life experiences and prior knowledge shape one’s view/bias.
  • Belief perseverance bias – early impressions and early narratives are crucial to shaping one’s understanding of an issue.

To emphasize or not

I do want to expand more on the first type of bias.  You may already be able to connect the dots between availability bias and using good judgment in emphasizing facts, analyses, or opinions.  Key points that influence one’s opinion should be emphasized in a judicious manner, not taking up too much time in testimony or space on a report, but conveyed in such a manner that the trier of fact will pick up on the degree of importance that the expert witness intends to convey.  In the moment it can be really difficult to craft one’s delivery.  Therefore, expert witnesses should consider (in collaboration with counsel and, if appropriate, the client) how to deliver.

Applicability

If I am given only a few minutes to explain to a listener how an individual or entity fraudulently misrepresented its top-line revenues over a period of time to achieve certain results, how should I spend my time doing this, knowing that my desired outcome is to convince the listener that my opinion is the best answer?  Here are some considerations:

  • Should I assume the listener has a comprehensive understanding of the environment surrounding the matter (e.g., generally accepted accounting principles, financial statements, users of financial statements, responsibility of management vs. external auditors, etc.)?  How do I emphasize or de-emphasize?
  • Should I assume the listener understands what guidance or standard is applicable to the matter (e.g., revenue recognition)?  How do I emphasize or de-emphasize?
  • Should I spend more time talking about how things “should be” done (how revenue should be recognized), how things “were” done (how revenue was recognized), or keep it balanced?
  • Should I explain the details of what I did to arrive at my opinion or just keep it general?  What “material” facts should I emphasize?
  • Keep complex issues simple
  • Think about the logical steps to arrive at my conclusion.
  • How do I keep the listener’s interest and attention?
  • What do I want the listener to remember?
  • Teach, don’t just conclude.

Although this example is intended to be straightforward to get my point across, the principles can be applied to many scenarios.  Availability bias must be understood and planned for such that the message the expert witness conveys to the trier of fact is delivered concisely (without giving too much information to confuse or lose interest) and that it flows such that, to the extent complex issues must be explained, the steps taken are logical and progressive.

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The inter-connectedness of financial information

When I was a financial statement auditor, any exception that could potentially cause problems from the perspective of financial reporting reliability had to be investigated further to understand its magnitude and implications on other areas of the financial statements.  For example, a control failure with regard to compliance with applicable revenue recognition criteria at the time of sale could mean expansive controls testing, increased scrutiny of revenue transactions during the substantive audit testing phase, or a combination of both.  It could also mean increased scrutiny of the balance sheet (accounts receivables) to the extent that sales are typically made on credit.  The reason being that recording sales on credit impact more than one account — revenues and accounts receivable.  And finally, when sales are recorded, the cost of goods and services are recorded as well, resulting in changes to the balance sheet (inventory, reserves against specific inventory sold, etc.) as well as the P&L (cost of sales).  The same applies to any other accounting transaction or entry because journal entries in an entity’s books are double entry, meaning at least two accounts are impacted at the same time.

As a forensic accounting professional, it is critical to have a comprehensive understanding of financial statements and their inter-dependence.  In this context, today’s post will discuss fundamental attributes of financial statements and how financial information is so inter-connected.

Financial Statements

I think it’s important to begin by defining the most common financial statements:

  1. Balance Sheet (also referred to as statement of financial position or statement of financial condition).  This financial statement presents current and non-current (or long-term), assets and liabilities and owners’ equity.  Depending on who the owners of an entity are, the equity section may be labeled differently (e.g., stockholders, shareholders, members, etc.)
  2. Statement of Income (also referred to as profit and loss [P&L] statement, statement of operations, statement of financial performance, or statement of revenue and expenses).  This financial statement presents revenues and expenses from the entity’s core, or continuing operations, non-operating income and expense, and provision for income taxes.
  3. Statement of Cash Flows.  This financial statement presents the three areas of cash inflow or outflow for the period: (1) from operating activities, (2) from investing activities, and (3) from financing activities.
  4. Statement of Changes in Equity.  This financial statement reconciles the beginning of the period equity accounts with the end of the period equity accounts.  Auditors commonly refer to this type of presentation as a “roll-forward” because the account balances are presented in such a manner as to show the transactions or activities that caused the account balances to increase or decrease throughout the period.

These statements are commonly referred to as the “face of the financials” because they are placed prior to the accompanying notes and they represent the key information, in summarized or statement format, that are relied upon by financial statement users.  One thing I want to cover here is that both the SEC (Regulation S-X, Rule 1-01, paragraph (a)(3)(b)) and the AICPA (Statement on Auditing Standards No. 62, codified as AU 623, paragraph 2) have defined the term “financial statements” to also include the accompanying notes, or footnotes.

As a side note, this understanding of the term “financial statements” from the SEC and AICPA is critical in the context of a dispute absent any definition to the contrary.

Basis of Accounting

Now that we’ve defined the most common financial statements that entities, forensic accountants, or legal counsel deal with in disputes or investigations, I think it’s important to note that one’s understanding of the relationships within financial information is heavily affected by the basis of accounting that an entity has applied in preparing its financial statements.  There are a number of accounting bases to note:

  • Accrual or GAAP basis – revenues and expenses are recorded once earned/realized or incurred, respectively.  For example, revenues could be recorded prior to cash coming in (earned and realizable) or after cash comes in (earned and realized), depending on the nature of the arrangement and whether or not the performance obligations to the customer have been met.
  • Other comprehensive basis – this is sort of a “catch all” for any basis that doesn’t fit into the accrual basis.  AU 623, Special Reports, (paragraph 4) does a really good job of identifying what types of accounting bases are included in this category.  Here’s a list:
    • Basis to comply with the requirements or financial reporting provisions of a governmental regulatory agency to whose jurisdiction the entity is subject (e.g., rules of a state insurance commission).
    • Basis used to file its income tax return for the period covered by the financial statements
    • The cash receipts and disbursements basis of accounting (“cash basis” used by many smaller companies)
    • A definite set of criteria having substantial support that is applied to all material items appearing in financial statements, such as the price-level basis of accounting
  • Liquidation basis – the financial statements are prepared with the anticipation of an entity ceasing all of its activities.

By the way, the financial statements are required to disclose the basis of accounting used to prepare the financial statements.  A reader can find this information in a few different places.  First, the independent auditor’s report, or opinion, is required to disclose the basis of accounting as per AU 410, Adherence to Generally Accepted Accounting Principles (see paragraph 2 and footnote 1).  Second, FASB Accounting Standards Codification (ASC) 235, Notes to Financial Statements, requires that management of the entity disclose the basis of accounting used in preparing its financial statements (see 235-10-50-3).  This is generally disclosed within footnote 1 immediately following the face of the financials under a header such as “Basis of Presentation.”

Relationships, but not just within the financial statements

As I briefly mentioned in the beginning, revenue typically moves in line with accounts receivable (for sales made on credit), deferred or unearned revenues (for sales made where customers made pre-payment) and/or cash.  When revenue is recorded, the associated expenses to sell the good or service are recorded (cost of sales, cost of goods sold, etc.) and inventory is reduced.  Expenses typically move in line with accounts payable (for goods or services received), accrued liabilities (for goods or services received, but a corresponding vendor invoice has not been received), stock-based compensation, etc.  Property, plant, and equipment (PP&E) accounts typically move in line with accounts payable (for purchases made on credit) or cash.  These examples are relatively simple.  However, cash isn’t always moving at the same time that the entry is recorded (accrual basis vs cash basis).  Further, more complex or sophisticated transactions can raise difficult questions as to what corresponding account should be affected and for how much.  If fraud is suspected, the identification of corresponding accounts can prove to be very difficult.  Entities whose financial statements are required to be audited may also be required to be audited from an internal controls over financial reporting perspective.  Mixing internal controls implications with financial statement issues can also be challenging.

Relationships also exist between financial and non-financial data.  For example, when I was an auditor, I performed analytical procedures to prove out relationships among revenue accounts.  In one instance I obtained “click” data from operations personnel for a web-based lead generation provider and analyzed the data to understand whether or not the revenues recorded by the entity for the period were reasonable.  Benchmarking against other periods of time, other revenue streams, or industry peers (to the extent the information is available) is also effective.  In order to effectively perform these types of analyses, it’s important to understand the main drivers for accounts being analyzed.

Applicability

I worked on an investigation involving alleged fraudulent financial reporting with regard to sales transactions.  A whistleblower internal to the entity provided a tip with some details of the sales transactions in question.  My team conducted various interviews and reviewed multiple sales transactions to decide if the whistleblower’s allegations were factual.  What was not made clear until later in the engagement is that a high-level sales person had entered into an undisclosed side arrangement (that is, undisclosed to the accounting department and in the entity’s financial statements) with a key customer of the entity.  The nature of the side arrangement actually changed the terms of the sales agreement such that revenue was prematurely recognized by the entity in its financial statements.  This ultimately turned into the termination of the high-level sales person, a restatement of the entity’s financial statements, reputational issues for the entity, and whole host of other problems and costs.

So, I put forth a simple question:  based on this fact pattern, which financial statement accounts are misstated?  The obvious answer is revenue.  But, what is the offsetting account?  Accounts receivable, deferred revenue, or cash?  And, we cannot forget the associated direct costs to sell and inventory that were recorded.  What about the implications on the effectiveness of the entity’s internal controls over sales transactions?  If an individual of influence contributed to the fraud, what does this say about the potential that the individual could have influenced other aspects of the entity’s business, and, therefore, other aspects of the entity’s financial statements?

In the context of an investigation, understanding these types of relationships is critical to performing a thorough, robust investigation that will satisfy stakeholders, regulators, creditors, and any other parties of interest.

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