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How forensic accountants can help fight discovery abuse

Not long ago I supported an expert witness in a civil dispute.  My team was hired by the defense.  Throughout the course of our engagement I saw first-hand some of the tactics that plaintiff’s counsel employed to portray the defendant in a manner that was inconsistent with the evidence my team reviewed.  Furthermore, I observed on numerous occasions the plaintiff counsel’s “abusive” tactics during the discovery phase.

Depending on one’s exposure to dispute matters, the spectrum of discovery abuse can range from “never seen it” to “seen it a lot.”  Due to the realities of discovery abuse and its implications for practitioners, today’s post will discuss some of the strategies that practitioners can assist counsel in responding to what I call “risk of discovery abuse,” or the risk that opposing counsel may employ abusive discovery tactics.

Establishing objectives

As a general matter, practitioners should quickly establish with counsel an agreed-upon objective for discovery.  Of course, the objectives may differ depending on the nature of the engagement (e.g., consultant vs. expert witness).  In any case, practitioners should obtain sufficient relevant data, including documents and other evidence already in the client’s possession.  On the surface this may seem straightforward, but in practice it can be difficult to do this, particularly in cases where the documents produced are voluminous or relevant documents may not yet have been produced.

Once sufficient relevant data is obtained, practitioners can then work with counsel to collect relevant information regarding opposing counsel’s work habits, style, and practices.  This step may or may not be cost-effective.  Recognizing this, at a minimum, it can inform both the practitioner and counsel of the risk of discovery abuse by opposing counsel.

Meaningful steps

There are a number of valuable resources on this topic, such as a 2013 publication by the Defense Research Institute and a December 2014 article published by Hopwood, Pacini & Young in the Journal of Forensic & Investigative Accounting entitled “Fighting Discovery Abuse in Litigation“, to name a few.  A condensed version of this 2014 article can be found in Essentials of Forensic Accounting, published by Crain, Hopwood, Pacini & Young, 2015.  This publication identifies number of ways in which practitioners and counsel may obtain relevant data to assess the likelihood and extent of potential risk of discovery abuse by opposing counsel.  Indeed, there are multiple ways to understand opposing counsel’s litigation techniques and practices.  Examples include:

  • Observation of opposing counsel performing direct and cross-examinations, lodging objections, and engaging in opening and closing arguments at trial.
  • Inquiry of lawyers who have litigated against opposing counsel.
  • Inspection of trial court files for cases handled by opposing counsel.

Based on findings from this research, both practitioners and counsel can gather answers to questions, such as:

  • What types of objections, if any, did counsel raise to various interrogatories?
  • Did counsel file any motions for a protective order?
  • Did counsel do a document dump or engage in otherwise abusive discovery practices?
  • Did counsel ever refuse to comply with a court order?
  • How did counsel respond to requests for admission?
  • Did counsel often have motions to compel filed against him or her?
  • Does counsel respond to discovery?
  • Has counsel been sanctioned for misconduct?

Answers to these and other questions can assist practitioners and counsel in obtaining valuable information to assess the risk of discovery abuse.

Using precision when appropriate

In the discovery phase, depending on the nature of the information being sought, requests for evidence should be tailored sufficiently accurately and precisely so as to provide the highest likelihood of obtaining the information requested.  For this purpose practitioners can provide counsel meaningful input in the preparation of discovery requests (such as financial-related or technical evidence).

When using precision, the legitimacy of opposing counsel’s objection can be diminished.  Furthermore, this puts pressure on opposing counsel to offer precise or specific objections if the objections are to withstand judicial scrutiny.  As one would expect, precision in discovery requests tends to have a higher likelihood of surviving a motion for a protective order from the opposing side.

Courses of action

There are, of course, various means of addressing the risk of discovery abuse.  These can include keeping detailed records of requests, motions, and status, insisting that the counter-party provide a privilege log, seeking a protective order from the court, thereby placing limitations and conditions for violations, and seeking sanctions under the Federal Rules of Civil Procedure, Rule 37 for failure to cooperate in discovery.

As the saying goes, “an ounce of prevention is worth a pound of cure.”  With this in mind, to the extent that practitioners and counsel believe, in consultation with the client, that the potential benefits of conducting such research on opposing counsel may exceed the costs, practitioners can offer valuable assistance to counsel and their clients to effectively address discovery-related abuses.

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Potentially costly accounting standards on the horizon

For a number of years we experienced a “lull” in significant accounting standards issued by the FASB.  However, just within the last two years, the FASB has issued two significant, complicated accounting standards that will have far-reaching implications for companies.

These two accounting standards affect how companies recognize revenues and recognize leases.  Based on my experience, I expect that just about every company whose financial reporting framework is U.S. GAAP will be affected by at least one, if not both, of these standards.  As such, today’s post will focus on what these two standards are and how they will affect companies.

Revenue recognition

In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606).  This standard is designed to achieve a number of goals.  First, the standard removes inconsistencies and weaknesses in revenue requirements and provides a more robust framework for addressing revenue issues.  Second, the standard improves comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets (particularly companies that have adopted IFRS).  Third, it provides more useful information to users of financial statements through improved disclosure requirements.  Finally, the standard simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The core principle of the guidance in Topic 606 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  With a move away from industry and more prescriptive guidance on recognizing revenue, this standard uses the following five-step model:

  1. Identify the contract(s) with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue when (or as) the entity satisfies a performance obligation

The desired goals of this standard seem nice on paper and I believe they are a significant step toward improved financial reporting.  However, what this means for companies is that they will need to apply a significant amount of resources and thought to achieving the objectives set forth in the standard.

ASU No. 2014-09 has been subsequently amended as follows:

Accounting for leases

Earlier this year the FASB issued ASU No. 2016-02, Leases (Topic 842).  The key change from the existing leasing accounting standard (Topic 840) is that, under the new standard, lessees will need to recognize lease assets and lease liabilities for leases classified as operating leases.  For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities.  If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.

This standard is effective for fiscal years beginning after December 15, 2018 for publicly traded companies.  Although 2019 seems like a long way into the future, many companies will need to make significant endeavors to effectively implement this accounting standard.

Internal coordination a must

It goes without saying that departmental decisions within a company tend to have an effect on accounting and financial reporting.  With this in mind, in implementing these new accounting standards companies will need to coordinate internally to ensure that all of the relevant facts and circumstances are gathered for accounting and financial reporting consideration.

In the spirit of coordinating between the accounting function and other departments to ensure that business operations are not adversely affected by adoption of these new accounting standards, following are things to consider:

  • Legal – In implementing the new lease standard, leases with terms greater than 12 months will be included in the balance sheet.  Companies will need to revisit their contractual terms, particularly with lenders, to ensure that the accounting changes on the balance sheet do not adversely affect compliance with debt covenants.  Further, companies will need to consider implications of adopting these two standards on securing financing.  Finally, companies may wish to revisit the terms and conditions, including pricing structure, in customer contracts and consider how adoption of the new revenue recognition standard may affect the timing of revenue recognition.
  • Financial planning and analysis – Companies will need to consider the timing of revenue recognition for internal budgeting and forecasts.
  • Information technology – Companies will need to revisit their accounting and operational systems and processes.  Specifically, systems and processes will likely need to be reconfigured and/or reports may need to be modified or created to obtain relevant data for appropriate accounting and more extensive accounting disclosures.
  • Human resources – Often times variable compensation is based on key financial metrics, such as revenues, earnings, and EBITDA.  With the adoption of the new accounting standards, because the timing of revenue recognition may change, companies will need to revisit their variable compensation arrangements with employees to ensure that targets are reasonable and achievable.  Moreover, companies will need to ensure there is adequate staffing with the right level of experience and technical skills to implement these standards.
  • Tax – With expected changes in the recognition of revenue, for example, companies will need to consider the impact on income taxes.
  • Investor relations – Companies will need to consider changes to guidance provided to the street on revenues, EPS, and non-GAAP measures (such as EBITDA) as these metrics will be affected by adoption of these new accounting standards.  Furthermore, companies will need to consider the nature and extent of communications with users of their financial statements regarding expected changes to business practices from adopting these standards.

As I indicated in a previous post, just like individuals, companies can procrastinate decision-making until it becomes costly.  Of particular concern in light of these two significant accounting standards is that companies may lack sufficient resources to effectively adopt them, either in terms of quantity or quality of headcount.

Likewise, companies may not provide adequate budgeting for additional resources needed to effectively adopt these standards.  Many companies, whether by choice or out of necessity, may find themselves hiring consultants carrying price tags higher than internal resources to accomplish the following two objectives.  First, they will need to meet the adoption requirements in the accounting standards.  Second, they will need to satisfy their external auditor of compliance with these accounting standards.

Potentially costly audits

In my line of business, hiring outside assistance to pass financial statement audits can become costly in a relatively short period of time.  With this in mind, in connection with an audit of financial statements, public companies should be mindful of the implications that the adoption of these standards will have on internal controls over financial reporting.

In essence, there are multiple “types” of internal controls:  IT general, application, automated, manual, and IT-dependent manual controls.  As is typical of significant changes in accounting and disclosure, the adoption of these new standards will likely require more manual-type controls to verify that financial reporting is reliable.

In light of this, companies will need to consider the increased risk of material misstatement that manual controls introduce to an audit.

Next steps

For these reasons companies should begin now planning for these scenarios.  In reality, these new accounting standards are a significant undertaking and companies should approach implementation of these standards with a high degree of determination.

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What others have said in the past and why it matters

In the past I’ve worked on a number of financial disputes dealing with improper accounting for liabilities, among other things.   In one such instance, the plaintiff alleged that the defendant understated certain liabilities and, as a result, the defendant’s historical financial statements were materially misstated.

To support his opinion, the plaintiff’s expert relied on certain documents produced in the litigation that my team believed were taken out of context.  What was somewhat comical about the situation was that the alleged understatement was so large that it left a number of us scratching our heads.  We wondered why would anyone have gone into that particular business at the time if they “knew” (using the plaintiff expert’s words) they had to record certain liabilities as large as what the plaintiff’s expert claimed.  Indeed, no company in the industry at the time was recording liabilities anywhere near the extent that the plaintiff’s expert alleged should have been recorded by the defendant.

As experienced forensic accounting practitioners and expert witnesses understand, hindsight provides a clear picture of what took place and whether or not it was reasonable.  On the other hand, hindsight can be difficult to justify its reliance.  In particular, if the facts and circumstances known to an entity at the time were the best available information, then they may be considered reliable and reasonable.

Contemporaneous understanding

This brings me to my topic for today, that of understanding what others were saying and doing at the time.  More specifically, to follow my story through I will discuss the importance of identifying (generally speaking, without disclosing confidential information) what the plaintiff in this case was saying at the time and why it matters in a dispute.

For privately-held businesses, obtaining contemporaneous information may prove to be a challenge.  This is because private companies tend to disclose less (or sometimes no) information to the public.  In contrast, publicly-traded companies are held to a higher standard of public disclosure through various means.  These public disclosures can prove to be a treasure chest of information.

Back to my story of the plaintiff, which happened to be a publicly-traded company and a user of the defendant’s financial statements.  The plaintiff’s expert claimed there were all sorts of red flags at the time that the defendant prepared its financial statements.  Further, the plaintiff’s expert alleged that the defendant “should have” noticed these red flags and incorporated them into its accounting decisions.

What I find intriguing is that during the time period in dispute the plaintiff publicly disclosed that it believed the market factors affecting these accounting liabilities were not of big concern.  This was important because the plaintiff’s public statements lent credence to the liability accounting decisions made by the defendant.  Were we able to find these public statements by the plaintiff in the plaintiff’s complaint?  Of course not.

When an entity is in the public light, it provides information to the public in multiple ways.  So, knowing where to look for these types of public statements made our job easier.

SEC resources

A fabulous resource for identifying public statements is the SEC’s website.  For those less familiar, the SEC’s website archives various public filings.  In my experience, the following resources are helpful in identifying historical public statements:

  • Form 10-K – This is probably the most commonly known SEC form.  SEC registrants are required to file this annual report with the SEC, including annual financial statements, related schedules and various textual information.  SEC registrants also include discussion and analysis of financial trends within a section called Management Discussion and Analysis (MD&A).
  • Form 10-Q – SEC registrants are required to file this quarterly report with the SEC, consisting primarily of the company’s quarterly financial statements.  These forms also include a section on MD&A.
  • Form 8-K – These SEC forms can contain a wealth of information.  SEC registrants are required to file these forms with the SEC when certain significant, reportable events occur.  Examples include: quarterly press releases, major acquisitions, material contracts, and legal proceedings.
  • Comment Letters – Generally, the SEC publishes comment letters that it sends to SEC registrants, which can be identified by filtering for “UPLOAD.”  Similarly, the SEC publishes letters it receives from registrants on the SEC’s website, which can be identified by filtering for “CORRESP.”  Because the SEC is a regulator with a heavy hand, what a company writes to the SEC matters greatly.  Therefore, practitioners should pay specific attention to letters between the SEC and registrants.

Other resources

I have found the following other resources to also be worthy of digging through in search of relevant information:

  • Company website – Companies issue press releases and post them on their website.  Practitioners should be aware that not all company press releases are filed with the SEC via Form 8-K.
  • Industry news and reports – Depending on in which industry a company operates, there may be industry publications from reputable sources.  Again, these sources can provide reliable information that was known or communicated at the time.
  • General media communications – Media outlets may overlook or de-emphasize some aspects of company press releases.  In order to attempt to have a degree of control of the narrative, companies often have relationships with major media outlets.  Running web searches of public statements made by company personnel can generate interesting results.

Relevance

As one can gather from my story, it certainly doesn’t help the plaintiff’s case when it was disclosing to the public a certain narrative at the time, but then it switched gears and makes contradictory allegations later in support of its lawsuit.  Therefore, when looking to the correct sources, experienced forensic accountants can find valuable information.  This information can help to obtain a more full, or correct, understanding of the facts and circumstances at the time to assist their clients in all types of dispute matters.

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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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