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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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The power of walk throughs in investigations

As a former auditor, I performed walk throughs of certain key account processes or cycles to gain a complete understanding of a transaction from start to finish.  Sometimes it became quite cumbersome because certain processes were complex or lengthy.  However, after walking through a process I was able to gain a solid understanding of the areas of risk exposure and, most importantly, I could answer the question, “what could go wrong in this area.”  This informed me further in planning my audits and responding to risks.

As a basis for framing my post today, the PCAOB AU No. 5 at ¶ 37, describes a walkthrough as follows:

In performing a walkthrough, the auditor follows a transaction from origination through the company’s processes, including information systems, until it is reflected in the company’s financial records, using the same documents and information technology that company personnel use. Walkthrough procedures usually include a combination of inquiry, observation, inspection of relevant documentation, and re-performance of controls.

Although this guidance is intended to apply to audits of internal controls over financial reporting, implemented by an entity in preparing its financial statements, the principles gathered from walk throughs can be applied to a variety of circumstances.

As basic as they may seem, walk throughs I believe are the bedrock to understanding the flow of transactions in accounts, particularly complex ones.  Following are some powerful things that can be gathered from a walk through:

  • Build rapport with the interviewee through conversation that can be transitioned from “formal” (early on in the walk through) to “informal” or more “relaxed” (once enough questions have been discussed and the anxiety of meeting someone for the first time can be overcome)
  • Identify “types” of documentation not previously known
  • Assess the competency of an account owner/interviewee
  • Assess the body language of the interviewee and gather relevant information therefrom
  • Identify improper segregation of duties (custody, record keeping, and authorization/verification)
  • Identify exposures to fraud and/or error

To do effective walk throughs, it’s critical that the person conducting the meeting have sufficient experience to understand what types of questions to ask and, maybe more importantly, if answers are satisfactory or if probing is necessary.  Depending on the risks/allegations, a walk through may encompass a portion of or an entire process, including: initiation, authorization, recording, processing, and reporting.

I’ve found the following types of questions to be helpful in a walk through (of course, adapting the questions to the relevant facts/allegations and circumstances is critical to an effective discussion):

  • Please describe your role in this process.
  • Who else is involved in this process (preparers, reviewers, approvers, etc.)?
  • What happens when a transaction is not approved?
  • What systems (internal or external) do you use or rely upon to perform your duties?  This type of questioning can assist in identifying the areas of manual intervention, which often times are the areas of highest exposure to fraud and/or error.
  • Where do you understand the areas of judgment or estimate to be?
  • Have you or anyone you know been asked to override any controls?
  • If there were a questionable transaction or request, who would you go to for guidance or advice?

Depending on the situation, I recommend two interviewers in attendance.  For example, in an investigative scenario, it may be appropriate to have two persons in attendance, one to ask the questions and interact with the interviewee and another to take notes, but also to stand as a “witness” should allegations come back against the interviewer.

Sometimes a walk through may not be possible because access to the person(s) may be restricted.  In these scenarios, the best available information should be considered and, using an experienced professional’s understanding of the flow of similar business transactions, one should formulate an “expectation” for how transactions are processed and then refine that “expectation” as new information becomes available.

As a reiterative point, having an experienced professional involved in the process greatly increases the odds of a successful outcome (“successful” of course being a relative term) and is critical in sorting through what is relevant, what is not, and what may be an intentional diversion.

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