Identification of Money and Assets for Recovery

The first step to successfully recover money and other assets is to identify them during the examination process. To prove fraud, the investigator needs to provide evidence that the perpetrator was involved in the act (money or other assets are missing), the concealment (there was an attempt to hide the act and possibly the assets), and the conversion (benefits accrued to the perpetrator). Inherently, the examination process requires that the fraud examiner or forensic accountant is able to show that the perpetrator was the recipient of assets and what, if anything, the perpetrator did with those assets.

As noted in prior chapters, this requires access and evaluation of banking, public, business, and personal records—financial and nonfinancial. The identification of money, assets, and other items of value obtained directly or indirectly as a result of fraud is one of the important goals of the examination. Such evidence not only facilitates the legal process but also helps to ensure the maximum recoverable amounts for the victim or plaintiff. One aspect of a civil action is that the jury will often be required by the presiding judge to consider the defendant’s ability to pay. If the defendant loses the civil issue in question, will they be able to pay the full amount of the award of damages or some lesser amount?

Generally, in order to be in a position to recover money from a civil suit, the injured party must prove two points:

1. Liability: the defendant was responsible for all or part of the damages claimed.
2. Losses or damages: the claimant suffered damages as a result of the actions or inactions of the offending party.

The types of losses available for recovery include (a) compensatory damages and restitution of losses such as value, cash, and other assets; (b) economic losses (e.g., wages, incremental expenses, or profits); (c) reliance, intended to restore the claimants back to where they would have been but for the actions of the defendant; and (d) punitive damages, to punish the defendant.

In a civil framework, the plaintiff must demonstrate three attributes:

1. That the defendant was the proximate cause of any damages, meaning that the plaintiff caused or contributed to the lost amounts as a direct result of the conduct at issue
2. Reasonable certainty as to the amounts (damages) claimed
3. That the defendant could reasonably foresee that his or her actions, or lack thereof, were likely to result in damages to the plaintiff

“Following” versus “Tracing” the Money

“Following the money” and “tracing the money” are slightly different activities and may have legal ramifications on amounts available for recovery. Following the money assumes an ability to directly track funds from the victim to the alleged perpetrator and involves specificity, whereby the investigator can track the exact assets in question from the plaintiff or victim to the defendant. When an investigator can follow the money with specificity, the ability of a victim or plaintiff to lay claim to the ill-gotten gains may determine the likelihood of asset recovery. Cash or other assets can only be followed if those assets remain in their original, identifiable form as they flow from place to place or person to person. Following provides for no exchanges or substitutions. Note that some cryptocurrencies, Bitcoin, for example, permit following the money with specificity due to their underlying technology—blockchain.

In many cases, defendants will convert their ill-gotten gains into another type of asset. The whole purpose behind money laundering is to take money derived from some illegal activity and “clean” it to make it appear to have come from a legitimate source. Once illegal money has been combined with money from legitimate sources, typically, one can no longer follow the money; rather, the money can be traced.

In contrast to following the money, tracing the money is a process of identifying both its present location and its current form of value relevant to the claim brought by the plaintiff or victim. In such cases, the legal issues can become challenging. For example, what if illegal money has been combined in a bank account with the legitimate salary dollars of a spouse? To further complicate the matter, let’s assume that the couple has children, and one of the items paid out of the bank account is the mortgage on their primary home where the children reside. Notwithstanding the legal issues involved, tracing is the process of determining what has happened to the money or property, who handled it, and where it is now. This helps to justify a claim against the property in its current form.

In theory, complex financial crimes, fraud, organized crime, drug trafficking, money laundering, and terrorism financing can be prosecuted by following the money. But to prevent investigators from following the money, perpetrators attempt to disguise its sources to make it difficult to connect them with their ill-gotten gains. Such efforts also act to limit the ability of investigators to lay claim to money that otherwise appears to be derived from legitimate sources.

A complicating factor is that “money” is no longer cash and coin; it can be anything of value that can be traded, transferred, or sold, such as cash, coin, certificates of deposit, stocks, bonds, money orders, cashier’s checks, cybercurrencies, airline tickets, gift certificates, gift cards, prepaid credit and debit cards, diamonds, jewels, minerals, mineral rights, or deeds. Often times, money, such as Second Life’s Linden dollars, is nothing more than a digital series of 0s and 1s, electronic off and on switches that another person or entity is willing to accept as value.

Once illegal money has been combined with money from legitimate sources, one can no longer follow the money; the money must be traced. Even mixing money in a bank account creates the need to subsequently trace the money. Modern laws have addressed this issue to a certain extent by allowing claims to be made in situations in which illegal gains can only be traced. This requires additional work on the part of the investigator to identify the sources of assets that have been commingled and to make various assumptions to demonstrate how the conversion process was completed.

Other issues related to tracing involve what happens to the incremental value of assets for those assets that have increased in worth. For example, what if the perpetrator purchased a vacation home and the value increased by 20% annually? Generally, the courts have held that the perpetrator was acting to make an investment on behalf of the victim or plaintiff and any increases accrue to the victim or plaintiff; however, that may not always be the case in every jurisdiction. This “investment” approach means that, although rare, it may be possible for a plaintiff or victim to recover more than what was originally lost.

Legal Methods for Recovery of Assets

Depending on the jurisdiction, plaintiffs and victims have a number of possible legal mechanisms available to recover assets either through the civil or criminal justice system.

The Character and Flavor of Being an Expert Witness

Les Heitger is the BKD Distinguished Professor of Forensic Accounting at Missouri State University. Prior to that, he was a professor in the Kelley School of Business at Indiana University. Dr. Heitger has served as an expert witness and as a litigation consultant in many cases in state courts, federal courts, federal tax court, and in mediations and arbitrations. He has coauthored numerous textbooks including one in the area of Forensic and Investigative Accounting. He is the immediate past president of the Forensic Accounting Section of the American Accounting Association. In the following passage, Dr. Heitger offers some pearls of wisdom based on his more than 30 years as a forensic accountant.

From Dr. Heitger…

Although the field of accounting, in general, does not seem to garner endless streams of comments about how interesting and exciting it is, just the opposite is true of forensic accounting. Just the term forensic accounting seems to elicit thoughts of detective work, finding fraud and those who commit it, court cases, and other non-traditional accounting activities. And much of that image is very true. Seasoned veterans of the world of forensic accounting often talk about how no two cases in their career were ever alike. In forensic accounting, routine is the exception, not the rule. This suggests that forensic accountants possess knowledge, skills sets, and characteristics that are essential to succeed.

For those who have never served as an expert witness or those who have only a passing knowledge of accounting/financial information, it is hard to understand the need or purpose of accounting expert witnesses. Such people may think, “The numbers don’t lie” or something similar. The implication being, “why is there controversy about the financial data? It is, what it is.”

Perhaps numbers don’t lie, but people do. Often financial information is slanted, carefully selected, or just plain wrong when those numbers are used for evaluating some situation that is in question. The trier-of-fact (Judge and / or Jury) seldom has much, if any, knowledge of accounting, financial information, or non-financial data that interacts with financial performance and condition, relevant to the resolution of the conflict. Because virtually all conflicts that are litigated are primarily about the financial consequences of the events that gave rise to the litigation, it is crucial that the judge and / or jury understand, as best they can, what those issues are. Often that is not possible without the guidance of an accounting, forensic accounting, or anti-fraud expert witnesses.

Successful forensic accountants must possess some important traits. For starters they must be very good with numbers. There is no such thing as a great forensic accountant who does not have a solid accounting foundation, in general. Good forensic accountants are also:

• tenacious
• look at all of the possibilities
• are able to see through illogical or unusual financial information
• are able to stay focused while operating in an adversarial environment
• thrive on doing problem-solving detective work.

Additionally, they understand that they must be able to present their opinion to a typically unsophisticated audience, but do so in an understandable and persuasive manner that is consistent with the facts, circumstances and evidence.

One of my first big cases was a federal antitrust case in which my client was a defendant. One of my major goals was to convince the court that my client had not engaged in “predatory pricing’” (selling products below their average variable costs). I prepared sophisticated cost behavior analyses using regression-correlation analysis and other techniques, and gave my direct testimony to a mock jury in preparation for the actual trial. After I proudly finished my practice testimony, the very wise attorney with whom I was working took me aside and said, “That was really great, you convinced me! Now what you need to do is say what you just said, only in terms of buying a loaf of bread and a gallon of milk.” The message was clear, “I am sure you are correct, but nobody—the judge or the jury—is going to understand you.” This exchange brought home a clear message—that it is not good enough to be correct, you also have to be understandable and persuasive.

But good forensic accountants do more than just present and interpret accounting, financial, and numerical data for the court. Frequently attorneys and clients need to understand the nature and character of the financial information that has been presented as proof of liability and damage amounts in a lawsuit. As an example, I was hired by attorneys for the defendant in a case that had been pending for several years. I was asked to serve as an expert to examine the alleged damages in the case. The plaintiff alleged that the defendant hired some of the plaintiff’s professional staff away from the plaintiff, and that this had caused the plaintiff organization significant economic harm. In an effort to support its allegations, and to measure the damages suffered, the plaintiff hired a business valuation firm to compute the alleged lost value of the plaintiff organization due to the actions of the defendant.

After reviewing the report of the plaintiff’s expert and doing a lot of additional analysis of the plaintiff’s financial data, it appeared to me that there was no liability by the defendant in this case, and that many of the assumptions made by the plaintiff’s expert had no basis in fact. In my expert report and during my deposition testimony, I carefully identified that (1) the time periods used in the business valuations were arbitrary and had no relationship to the alleged acts in the case, (2) the two methods of valuation used by the plaintiff’s expert were illogical, and had no basic in economic reality, (3) there were numerous other more logical, business-related explanations for why the plaintiff’s value had declined, and (4) various trend analyses of the plaintiff’s financial information showed that the entity had questionable management policies and actions before and after the time periods covered by the allegations in the case.

The case was settled when the plaintiff agreed to seek no damages at all. The defendant in the case was very pleased, because prior to the time when it hired an expert, the defendant was considering settling with the plaintiff for a significant amount of money.

In general, accountants are in the business of developing, reporting, and disseminating information. Perhaps more than any other business discipline, accountants are called upon to communicate accounting, financial, and numerical information to countless others with whom they interact.

The challenges of effective communication are even greater for forensic accountants. First the information that must be communicated is often less structured and more complex than is true for more traditional accounting communications (e.g., balance sheet and income statements). Further, forensic accountants often are communicating accounting information to individuals who have little or no knowledge of accounting or financial issues. Sometimes this requires forensic accountants to be more creative and careful in explaining the information. More importantly, at least some forensic accounting communications occur in an adversarial environment. Therefore, forensic accountants need to excel at communicating in challenging environments.

Hopefully, these tidbits of information from my experience will contribute positively to your career as a forensic accountant and anti-fraud professional.

Fact Witness versus Expert Witness

Most foundation testimony in a case is provided by fact or lay witnesses. These individuals testify to various facts that they put in perspective by talking about events, activities, and state of mind at the time the issues in question arose. Generally, fact witnesses must testify to firsthand facts and knowledge. They are not permitted to offer opinions unless those views are based on specialized knowledge required as part of their normal responsibilities. For example, mine supervisors with twenty years of experience can provide opinions on mining conditions because they make those same assessments as part of their jobs. Further, the lay opinion rule allows a fact witness to offer “everyday” opinions under three conditions¹:

1. The opinion must be based on the witness’s personal perceptions (as opposed to hearsay).
2. The opinion must be helpful to the trier-of-fact.
3. The opinion must be the product of reasoning processes familiar to the average person in everyday life.

In contrast to a fact or lay witness, an expert witness is one who, by virtue of education, profession, publication, or experience, is believed to have special knowledge of his or her subject beyond that of the average person, sufficient that others may officially (and legally) rely upon the opinion.

Generally, the role of the fraud examiner or forensic accountant when working with attorneys and other persons related to legal matters is to do the following:

• Educate counsel.
• Reconstruct cash flows and performance from records.
• Guide additional investigation and discovery.
• Make connections, draw conclusions, and offer observations.
• Determine whether evidence supports theories of case.
• Provide objective evaluations of the information, data, and evidence.
• Draft reports and exhibits.
• Offer deposition and trial testimony.

An expert’s opinion is subject to two types of challenges:

1. With the Daubert Rule, the basis of foundation for the opinion may not be based on “junk science.” Just because a person qualifies as an expert, that person cannot offer any opinion unless that opinion is reasonably grounded in scientific fact.
2. The Frye Rule makes an opinion admissible only if that opinion has general acceptance in the scientific community.

In either case, the expert must provide the basis for his or her opinions as well as the facts, data, and other information relied upon. Not surprisingly, determining the amount of losses is both an art and a science. The science aspect requires the fraud examiner and forensic accountant to understand and use methods appropriate for their field such as generally accepted accounting principles and proper examination tools and techniques. The artistic aspect is understanding the judgment inherent in accounting, accounting estimates, the ability to connect the dots, the need to use creative thinking, and the proper consideration of alternative theories of the case, to name a few.

Assuming that legal counsel initiated the examination, the professional should complete the following steps:

1. Obtain a written engagement letter with the terms and conditions of the engagement clearly spelled out. The antifraud professional or forensic accountant should ensure that the terms are clear and ethical. For example, the engagement letter should not state what the professional is expected to find as a result of his or her examination nor the topics on which the expert is expected to testify. Such language may suggest bias, may limit the examination, and may provide grounds for opposing counsel to attack the professional’s objectivity, integrity, and credibility.
2. Conduct an initial consultation to obtain an overview of the issues in question, determine the required areas in which expertise is required, and acquire initial direction and other information, facts, and data.
3. Complete the required investigative work. This requires fraud examiners and forensic accounting professionals to apply their judgment, develop insights, interpret the facts and data, draw conclusions, provide advice and counsel to the lawyers, and solicit additional data as needed. Typically, periodic consultations with the attorneys and others will be necessary to develop a complete picture of the issues in question, discuss preliminary findings and interpretations, and determine the next steps.
4. Wrap up the examination, draw conclusions, and write the report.
5. Prepare for depositions, hearings, and courtroom testimony and appear in court as needed.

Naturally, the investigative process involves the evaluation and interpretation of information, facts, and data. Nonetheless, much of what attorneys rely on from experts is determining what data are needed and what appears to be missing. In some cases, it’s not so much what you see, but what you don’t see, that needs to be identified. That requires the antifraud professional and forensic accountant to constantly apply their critical thinking skills, analytical reasoning, and brainstorming techniques to challenge their interpretations and preliminary conclusions. Once the expert has identified the needed data, the prosecutor or civil attorney can pursue obtaining those data through the legal system.

One of the continuing challenges faced by antifraud and forensic accounting professionals is “staying in their sandbox”—their area of expertise. As long as the professional remains within his or her field of expertise and develops conclusions grounded in the financial and nonfinancial evidence relevant to the issue at hand and within their domain, he or she has a safe haven. Determining what you can say as an expert is a challenge. For example, where are the boundaries of your expertise? When does accounting cross too far into finance, economics, marketing, management, and other business disciplines? Generally, when you have identified that you are relying on facts or another’s expertise, you need to acknowledge that reliance. You need to evaluate the importance of that evidence and be cognizant that the evidence needs to withstand the scrutiny of cross-examination. One technique is for the fraud examiner or forensic accountant to continually evaluate what happens to his or her own opinions and conclusions if or when a piece of evidence is eliminated for any reason.

Further, fraud and forensic accounting professionals should not get into a position in which they are defending the opinions and conclusions of others. Such defense is beyond their expertise. At the same time, the fraud examiner is likely to be working in an industry or business with which they do not have complete familiarity. Although professionals need to develop comfort with their knowledge base in order to understand the attributes of a successful business model, fraud examiners or forensic accountants need to expect some level of discomfort with not being experts in all subject areas; their opinions, to some extent, usually rely on facts and opinions of others where their own understanding is limited. In those situations, tread lightly with opinions or risk being criticized for drawing conclusions and expressing opinions beyond your area of expertise.

Supporting the Investigation

The fraud examiner or forensic accountant needs to recognize that although what they do during an examination may be second nature to them, others will not have the same knowledge or comfort level. For example, most law enforcement officers do not have training in following the money through checking accounts, books, and records. Many attorneys will miss basic accounting issues. This is not to suggest that the attorneys are not capable; in contrast, it is a result of their own training and specialization being directed toward other areas. That is why they rely on the expertise of the forensic accounting and fraud examination professional.

Thus, even though the forensic accountant and fraud examiner may work easily through books and records and recognize issues quickly, attorneys and nonfinancial investigative individuals may need a specialist to take the time to educate them, explain the issues, and show them the books, records, and other evidence. Optimally, the forensic accounting professional will explain the technical issues in such a manner that those orchestrating the broader legal activities can understand the underlying concepts and make strategic decisions regarding how to pursue the case. As such, although attorneys will direct the work of the forensic accountant or fraud examiner, the professional must take the initiative to look into issues that require further examination beyond those flagged by counsel.

In a pure litigation support effort, the attorney will have the case first. At the inception of the forensic engagement, the attorney should be giving the professional copies of court pleadings, interrogatories, whatever financial evidence has been accumulated thus far (e.g., selected depositions or portions of depositions that may impact the antifraud or forensic accounting professional’s work), and opposing expert testimony and reports. After an initial review of this material, the fraud examiner or forensic accountant will have more questions than answers, and it’s time to communicate with the attorney. Let the attorney know what’s missing, what is confusing, what doesn’t seem to make sense, and, perhaps most importantly, what data, information and evidence is needed. The documentary evidence will usually be less than one would like to have; that is just a fact of the profession. Some evidence will be lost; some may be destroyed; some may go too far back in time. Nevertheless, the forensic accountant needs to keep digging, keep thinking, and keep asking questions of the attorneys and themselves.

At all times, the fraud examiner or forensic accountant is an independent, objective professional who works to evaluate evidence from every angle. This means that forensic accountants need to examine every piece of paper that comes across their desks and consider its implications in the case, if any. Data may need to be obtained independently; for example, industry data can be collected from the SEC’s Edgar or other data sources. Consider a claim that unfair business practices forced a small enterprise to underperform—at least that was the allegation. Yet after “Googling” information about the business’s area of industry, a relatively unknown trade association was discovered. A brief phone call to the trade association found that it tracked key performance metrics for the United States and broke down those metrics into eight regions. The annual reports had a cost of $40 per year, and the reports revealed that although the business climate where the plaintiff operated was challenging, the plaintiff operated at or above the industry averages for all periods except for a partial startup year. This type of information was greatly appreciated by the attorneys, and invaluable when developing conclusions and opinions.

As noted above, one of the major challenges is identifying any missing data. This challenge is ongoing. As long as the expert requested the data—even if it wasn’t provided—he or she has minimized the risk of criticism for not being thorough. When the opposing attorney confronts the antifraud and forensic accounting professional with insinuations that he or she did not evaluate all the data needed, the response is twofold: (1) we asked for that data and it wasn’t provided, and (2) if you will provide me with that data now, I’d be happy to reconsider my conclusions and opinions in light of any new information. This response provides an excellent safe haven. It communicates the professional’s willingness to keep an open mind. Thus, the fraud examiner or forensic accountant’s opinions and conclusions are based on the evidence provided to date and are subject to change based upon new evidence. One should always reserve the right to modify or supplement analyses and other work as necessary, should additional information become available, facts become known, or additional inquiry arise.

While working with law enforcement, attorneys, and other professionals, your critical thinking, analytical reasoning, and brainstorming skills are some of your greatest strengths. The fraud examiner or forensic accountant should keep asking questions:

• Where does the information lead?
• Are things as they appear?
• Has this scenario been seen before (experience has no substitute)?
• Is data “mysteriously” missing?
• How are various items or facts connected?

Keep asking who, what, where, when, why, and how.

View from the Trenches: Obtaining the Necessary Evidence

Jim DiGabriele, CPA, PhD, CVA, is the author of Forensic Accounting in Matrimonial Divorce and has extensive experience in a wide range of litigation and forensic accounting assignments. His major areas of expertise include business valuation, economic damages, matrimonial disputes, partner/shareholder disputes, tax fraud, and commercial damages.

From Dr. DiGabriele…

Over more than 30 years, I have observed forensic accounting experts attempt to navigate the uncertainties, pitfalls and perils that are inherent in expert testimony. From my perspective, the primary purpose of deposition testimony is for future use by opposing counsel. A savvy opposing attorney will attempt to impeach the testimony of a forensic accounting expert witness at trial based on the answers given during the deposition.

Example: during a deposition, the forensic accounting expert was asked, “Was this tax return relied upon in the preparation of your report on lost profits?”

During the deposition, the expert answered, “no.”

During court testimony on direct examination, the expert was asked the same question but, responded “yes.”

Opposing counsel could hardly wait! During cross-examination, the opposing attorney showed the jury using a huge video screen the expert’s deposition transcript - illustrating “no,” a different answer. The expert’s credibility was impaired.

Lesson Learned: It is essential to read your deposition transcript before trial testimony and remember the details.

Example: In a tax fraud case, a forensic accounting expert had a convincing direct examination regarding the ordinary and necessary business expenses deducted by the defendant.

On cross-examination, the opposing attorney went through each business expense that the forensic accounting expert testified to, under oath, as a legitimate tax deduction.

As each “business” expense was presented to the expert, the cross-examining attorney showed the jury a stipulation provided by the expert’s client, where the taxpayer stated that each of these was personal—not a business expense. (The forensic accounting expert had not been provided the stipulations before the trial.)

The final question by opposing counsel to the forensic accounting expert, “does your opinion change regarding the deductibility of these expenses?” Answer: “yes.”

Lesson Learned: It’s critical to keep asking for all relevant facts, circumstances, documents, necessary to maintain credibility in the eyes of the judge and jury.

Evaluation of the Evidence

When evaluating the evidence, the fraud examiner or forensic accountant is expected to be independent. The professional should ensure that all conclusions and opinions are grounded in the evidence, supportable, and defensible. This leaves open the possibility that others may interpret the evidence differently; however, your conclusions and opinions are defensible because they are reasonable based on the entirety of the evidence evaluated.

The professional should identify key assumptions behind their conclusions and opinions. As noted in the earlier chapters of this book, the danger is not in dealing with identified assumptions but in assumptions made subconsciously. A conclusion that may seem obvious to one person may not be as apparent to another; the major difference is in the basic assumptions that the two have made.

To the extent possible, the antifraud professional should identify any research literature, theories, or other resources used as a basis for the work performed and conclusions and opinions reached. Examinations may be challenged by the opposition based on missing data or other limitations. Antifraud and forensic professionals should be aware of potential weaknesses and vulnerabilities in the examination. Once the evaluation is complete, the fraud examiner or forensic accountant needs to write a written report, if it is requested. After the report is written, the examination is not necessarily complete. One should continue to follow up, as necessary, if additional information becomes available, facts become known, or other inquiries arise.

Report Writing

During the examination, the antifraud professional or forensic accountant has likely developed a number of analyses and graphics. Some of these presentation tools may include the following:

• Link charts
• Events and activities charts
• Timelines
• Commodity and flow diagrams
• Direct and indirect financial analyses
• The evidence/hypothesis matrix

These analyses will address the central issues of the examination:

• The Elements of Fraud: the act, concealment, and conversion
• The Fraud Triangle: pressure, opportunity, and rationalization to the extent grounded in the evidence
• M.I.C.E. (money, ideology, coercion, and ego) to the extent grounded in the evidence

The analyses and central issues should be presented in a coherent storyline—clear, accurate, precise, and relevant to the issues under consideration; presented in reasonable depth to establish credibility; and logical. Most importantly, the storyline needs to be grounded in the evidence. The fraud examiner or forensic accountant could have vulnerability where the storyline is supported by weak evidence or the logical leap is rather large. All facts should be reported without bias or commentary and all relevant information should be included in the report, regardless of which side it favors or what it appears to prove or disprove.

Normally, the fraud examiner or forensic accountant will orally report preliminary findings prior to submitting a formal written report. This gives the entire examination team a chance to learn what has been found and to put the findings in context, identify next steps, and develop a plan for moving forward.

Although each fraud examiner or forensic accountant has his or her own style, the report generally can be divided into several sections. First, the executive summary provides an overview of the case, the major issues considered, all opinions and conclusions, and the primary basis and reasons therefore. This can be challenging at first. As an examiner, accountant, or investigator, we have usually built the case from symptoms and red flags until we have conclusions and opinions that we feel are reasonable and grounded in the evidence. In contrast, rather than building the case in the report, the report starts with the ending: the conclusions and opinions. Then, the report dives into an introduction, an optional section that provides further information about the background of the case: where it came from, the major issues under consideration, and other investigative aspects that were considered. From there, the details of the case examination and findings are presented in the case material section. This is the body of the report, develops an in-depth basis for all conclusions and opinions, and is where all of the presentation tools are reviewed and discussed. Finally, a concluding section summarizes the major points of the report.

Conclusions and opinions, though related, are distinct. Conclusions are positions grounded in the evidence, whereas opinions are based on the fraud examiner or forensic accountant’s interpretation of the facts. Opinions require the professional to connect the dots. Normally, the conclusions are self-evident, but it is likely that opposing counsel will try to interpret the facts in such a way as to draw different opinions. Fraud examiners and forensic accountants should avoid opinions regarding the guilt or innocence of any person or party. This is the responsibility of the judge or the jury based on the entirety of the case in which the fraud or forensic accounting professional is only one player among many. As the writing progresses, you should remember that your report will be carefully scrutinized and that you will have to defend it. Some of the places where that defense occurs include the following:

• Deposition testimony
• Trial testimony
• Questioning by client’s attorney
• Questioning by opposing attorney
• Preparation for trial testimony
• Rebuttal testimony (the other expert)

In addition, it is highly likely that the fraud examiner or forensic accountant will be asked to examine the expert report for the opposing side. Whether an alternative expert report is presented is dependent on the judgment of opposing counsel. One thing is for certain, you can expect to be rigorously examined over your work. Thus, your ethics and professionalism will come into play. A professional should do the best job possible for the client, but the way to do that is by being independent, objective, maintaining confidentiality, avoiding conflicts of interest, and not accepting any contingency fees based on the outcome of the case. An open, honest assessment of the facts and circumstances is the best approach to high-quality client service.

While not applicable to all engagements, the following report writing checklist may help guide the process.

The following sample reports are attached as Appendices to this chapter:

• Appendix A: Fraud and financial crimes report
• Appendix B: Commercial damages or lost profits report
• Appendix C: Valuation report
• Appendix D: Forensic economics (personal injury) report

For Appendices B–D, the case facts, analyses, and calculations were examined in the previous chapter. As noted on each sample report, it is not necessarily inclusive of all necessary report elements. Further, each report should reflect relevant case attributes and examination outcomes. Finally, professional standards may dictate various required report elements and professional standards should be consulted, as needed.

Credibility

Throughout this chapter, the issue of credibility has been implicitly examined. For the fraud examiner or forensic accountant, credibility is essential—in substance and in appearance. It is earned as the professional performs his or her role as a teacher, investigatory guide, and advisor. It is a function of plain language—making complicated matters seem simple—and ensuring that the “audience,” such as lawyers, opposing counsel, the judge, and jury can follow the work through each step so that conclusions and opinions developed will seem reasonable and logical. The short of it is: that credible information, presented credibly, is more likely to be believed and accepted. Furthermore, credibility is protected by being independent, honest, objective, and ethical.

If only one side’s opinions were offered, credibility would be easier. But the essence of criminal and civil litigation is controlled confrontation—both sides get the opportunity to present the facts and circumstances from their opposing perspectives. Thus, the fraud examiner or forensic accountant, especially in civil litigation, is likely to face a situation of “dueling experts,” in which each side takes roughly the same facts and circumstances and comes to different conclusions and opinions. How does one navigate through these troubled waters?

The answer lies in the professional’s underlying theories, interpretation of evidence, and attention to detail. These issues are paramount. Without a solid underlying methodology to the examination and evidence-based conclusions and opinions, the expert will lose not only the case but his or her credibility. The weaker side usually has a weaker methodological approach or ignores key facts and figures during their work to draw conclusions and opinions. It is only with attention to detail that the professional can identify the facts and information omitted.

Who ultimately decides on the issue of credibility? The judge and jury do. But importantly, as the counsel you are working for and the opposing counsel approach the negotiating table, one of the items that determine their position is your work and the outcomes of your examination—your conclusions and opinions.

When considering credibility, it is important to understand how listeners evaluate your work.² First, they will set up a baseline by listening to the background information. This is the responsibility of both attorneys during their opening arguments. Once the judge and jury have a basic storyline, they will add and incorporate new information into their pre-existing notions. The essence of this act is that people try to make decisions quickly based on their first impressions and are subsequently reluctant to revise prior beliefs.

It is also important to consider that this decision-making occurs almost instantly after opinions are offered. Therefore, you should be clear and concise and get to the most important points first. Then, you, as the expert, can drill down into the details that further solidify your credibility in the eyes and minds of the judge and jury. As new facts and information are presented, the judge and jury will interpret that information for consistency within their pre-existing beliefs. Typically by the time the expert testifies, the jury may have already “made up their minds.” If an expert is trying to change those pre-existing beliefs, he or she needs to clearly, concisely, and quickly explain the conclusions and the main reasons why the opposing expert’s testimony is in error. Otherwise, the decision-makers may reject your new information because it is inconsistent with their current beliefs.

Because most testimonies have gaps, the jury and judge will likely fill in the gaps as needed and make their own connections, inherently drawing their own conclusions and opinions. How does the dueling expert deal with this issue of pre-existing beliefs? Story-framing. One of the best techniques for getting a person to believe your version over an alternative account is to present a better narrative, one grounded in the evidence and one that is complete with regard to attention to detail. Of course, the expert witness has a challenge—to provide enough detail to establish credibility without overcomplicating the issues and boring the listeners. The expert witness should work with counsel and pay attention to the jury’s reaction to his or her testimony.

Rapport is another key attribute of the credible expert witness. The person needs to be likeable, interesting, interested, and lively. At the same time, each person has his or her own persona and personality; be natural but leverage your personal strengths and minimize your weaknesses to strike a chord with the jury.

Other attributes that help are to avoid bias in reporting, presentation, choice of methods, and use of facts. Fluency of communication also adds to your credibility. Professional accomplishments such as education, training, experience, familiarity with research in the field, professional organization affiliations, publications, and prior testimony experience all provide a foundation for credibility but are not sufficient by themselves.

Presenting a positive appearance can bolster credibility. Aspects of a positive appearance include the following:

• Body language, including attentiveness and sitting up straight
• Eye contact
• Business attire
• Concise organization
• Conversational language
• Varied formats throughout the presentation
• Illustrations and analogies
• Confidence
• Knowledge

In contrast, the expert witness can also present a negative impression through:

• Abrupt or argumentative responses
• Rambling answers
• Hesitation when answering questions, especially from opposing counsel
• Constant self-references
• Anger or aggression
• Arrogance or condescension
• Shifting posture
• Folded arms
• Opinions without substance

Deposition Testimony

A deposition is a pretrial process during which the parties to a civil litigation are allowed to examine the other side’s fact and expert witnesses. Generally, depositions do not occur in criminal litigation; although many of the witnesses may have been interviewed, those interviews are typically not under oath. Essentially, based on discovery in civil litigation (including depositions), each side knows the other side’s theory of the case and what the witnesses are expected to say. As such, the civil trial becomes, to some extent, an act of presentation and choreography. The function of a deposition is to do the following:

• Gather testimonial and documentary evidence from witnesses
• Limit the scope of what witnesses may say when the actual trial occurs
• Test or confirm theories and hypotheses
• Develop a record under oath and thereby “freeze” a witness’s testimony
• Evaluate the credibility and persuasiveness of witnesses as well as their work, conclusions, and opinions
• Move the case toward settlement or trial
• Compare the deposition testimony to prior statements and statements made by other witnesses
• Test the expert witness’s report

In preparation for a deposition, expert witnesses should thoroughly review their report and the underlying data. Additionally, in a pre-deposition meeting, the fraud examiner or forensic accountant should meet with counsel to review the report and answer questions. Counsel will normally have one of two strategic goals for the expert with regard to the deposition: (1) show the strength of their hand and (2) limit the areas of inquiry to those examined by opposing counsel. Assuming that the attorney you are working with believes in the strength of the case and the opposing side understands the depth and import of your work, they will more than likely move to settle. Retained counsel will want their experts to be clear, be concise, and expound on their opinions. Of course, there is risk in this approach.

If the case does not settle, opposing counsel will have a thorough understanding of your conclusions and opinions and be in the best position to attempt to undermine your work. In other cases, counsel will recognize that the case is going to trial and will be heard by a jury and judge. In that situation, as an expert witness, you must be clear and accurate in your testimony. Interestingly, opposing counsel may not explore every aspect of your work; your attorney may prefer that you only respond to those areas in which opposing counsel asks questions. Of course, if opposing counsel asks the blanket question, “Are those all of the conclusions and opinions that you plan to offer at trial?”, the expert will need to articulate areas not already explored.

The format of a deposition is more akin to cross-examination by opposing counsel. Though the attorney who retained you may ask some “clean up” questions near the end, it is common for only opposing counsel to ask questions. Although the deposition typically takes place in an attorney’s conference room or some other mutually agreed upon place, many aspects are similar to a trial. First, the testimony is recorded under oath by a stenographer. It will be prepared in transcript form and may be reviewed prior to finalization to ensure that the record is accurate. Further, opposing experts may observe the testimony of the fraud examiner or forensic accountant. When subpoenaed, the expert witness may receive a subpoena duces tecum, which requires that he or she arrive with his or her report and all documents that he or she reviewed, evaluated, and/or relied upon to develop his or her conclusions and opinions.

Direct Examination

Direct examination is the intersection of credibility and preparation.³ It is the heart of the case for the attorney and a chance to frame the issues and the evidence from his or her perspective for the jury and judge. The presentation of direct testimony is in the form of question and answer; the attorney who retained the expert witness will frame the question and the expert witness must answer that specific question. Thus, the attorney must navigate through the goals and objectives of the direct testimony by carefully asking questions that elicit the topical information needed. The expert witness must be careful to listen to and then answer the questions presented. Even though the form is question and answer, the goal is to present the narrative logically and carefully.

The expert witness may use analogies and metaphors to make difficult and technical testimony more understandable for the jury. Such tools should be developed carefully in advance so that the explanations are sound and do not allow opposing counsel to reframe the analogy or metaphor to its advantage. Examples that make the testimony more accessible and understandable for the jury and judge may be used. For example, if you state that the company spent $2.5 million for an airplane, hanger, fuel, and maintenance over a seven-year period, you could then explain that this breaks down to approximately $350,000 a year or almost $1,000 per day. Noting that a round-trip airline ticket from Pittsburgh to Atlanta costs about $350, this company with four executives, two hundred employees, and one location would have had to send three people to and from Atlanta almost every day for seven years to justify this expense. It’s easy now for the jury to understand what an expense of $2.5 million for an airplane may mean for a relatively small entity, their financial performance, and financial condition, and it’s easy to see that the expense may be unnecessary for the few flights the company might require annually.

Other key points related to direct examination:

• Listen
• Watch the jury and judge to ensure that they seem to understand
• Use summaries of testimony and exhibits
• Enumerate points (1, 2, 3, etc.)
• Demonstrate “open-mindedness” without compromising the integrity of your conclusions and opinions
• Use visual aids to maintain attention

By the time the expert witness has finished testifying during direct examination, the jury should understand the following:

• Your conclusions and opinions
• The evidence upon which your conclusions and opinions are based
• How your work fits into the greater case narrative: who, what, when, where, how, and possibly why
• How your work explains the act, concealment, and conversion
• How your work considered the fraud triangle: pressure, opportunity, and rationalization
• How your work considered the motivation of the defendant to the extent possible: M.I.C.E.

Cross-Examination

Cross-examination is designed to be a search for the truth. The thinking goes that if testimony can withstand the onslaught of cross-examination by a skillful attorney, then the testimony must be credible. To a certain extent, that is true; however, skillful attorneys can lead unwary expert witnesses in directions they don’t want to go and to conclusions the expert doesn’t believe or intend to convey. Thus, in a perfect world, the truth may come out during cross-examination; but, it’s far better to be prepared and understand how opposing counsel may twist your testimony to their advantage.

The first goal of the opposing attorney during cross-examination is to challenge the expert’s credibility, if possible. As noted above, credibility is earned and derives its power from a number of sources. Opposing counsel can attack credibility on any number of fronts. For example, the opposing attorney may ask if you are an industry expert; the answer is “no.” If left at that, the expert’s credibility in the eyes of the jury may be damaged. The better answer is “No, but I am a forensic accountant and the tools of my trade are examining books and records, income statements, balance sheets, cash flows, and the like. With those tools and techniques, I am an expert and I applied my expertise to my work in this case.”

At the same time that opposing counsel is trying to challenge the other side’s experts, they are trying to enhance their own theory of the case and minimize the impact of the expert’s testimony. In contrast, the fraud examiner or forensic accountant should maintain a commitment to their objectives: keep teaching and using evidence-based conclusions and opinions while maintaining credibility and control of one’s own testimony. For instance, in the example above, an answer of “no” would have been accurate and defensible. Nevertheless, in the eyes of the jury it could have been misleading; thus, the need to answer “no … but.” That is an example of an expert not surrendering control of their testimony.

Opposing counsel may try to accomplish their goals by carefully controlling what they ask. Controlled confrontation occurs when opposing counsel continues to try to weave their own narrative by selectively asking questions of the expert. The opposing attorney may even go so far as to repeat his or her own narrative, using the expert to answer only selected inquiries where damage will be minimized. The question format for cross-examination is normally yes or no. While on direct, the attorney wants the expert to present the narrative and expound; on cross, opposing counsel does not want to give the opposing expert a chance to retell the opposition’s narrative; thus, the strategy of asking yes or no questions. This technique limits the opportunity for explanation. The questions are usually safe. The expert needs to listen carefully and give a yes or a no answer when appropriate but be sure to explain when a yes or no answer may be misleading or misinterpreted. Although the expert might prefer to explain every answer, it will appear argumentative if he or she does not concede yes or no answers when, in the eyes of the judge or jury, they are appropriate.

During cross-examination, the fraud examiner or forensic accountant has several goals:

• Be cooperative. An uncooperative expert diminishes his or her own credibility.
• Maintain the credibility of his or her conclusions and opinions.
• Be alert for reasonable and proper opportunities to provide explanation and disagree.

The fraud examiner or forensic accountant should understand that the opposing lawyer will do the following:

• Learn your field
• Know your report
• Know your resume
• Try to limit the scope of testimony
• Stress missing credentials
• Contrast your credentials with those of opposing experts
• Contrast your conclusions and opinions with those of opposing experts

Even if your work is completed to the highest quality levels and your conclusions and opinions are reasonable and are grounded in the evidence, opposing counsel will try nevertheless to “score points.” For example, they may ask you to agree with an opposing expert’s data or assumptions so that it appears you are agreeing with the opposing expert’s conclusions and opinions. The fraud examiner or forensic accountant may be asked to criticize the conduct of his or her client or the shortcomings of issues in question.

In addition, opposing counsel may attempt to get the opposing expert to acknowledge a lack of knowledge about certain aspects of the case, even if the expert was not expected to be knowledgeable in that area. This creates the appearance of credibility problems where none exist. The opposing attorney may also challenge the professional’s objectivity and the sources of information relied upon. It is also common for an opposing attorney in a position of weakness to offer “what if” scenarios that require facts and circumstances different from those of the examination you conducted. Such hypothetical questions must be answered, but it is also reasonable to point out where the facts and circumstances differ from those in the actual case.

Some of the techniques used in cross-examination are listed:

• The Primrose Path: Using only selected and possibly hypothetical facts, the opposing attorney paints a picture differing from the one that existed in the real case. This is done by limiting testimony to “yes” and “no” questions and then offering a different conclusion: “Well, if that were true, you must agree that … .”
• The Nodding Chicken: Similar to the primrose path, except the opposing attorney attempts to lull the expert into a false sense of security by asking a series of questions where the appropriate answer is “yes.” Then, once the expert is nodding his or her head and saying “yes,” a question that is better answered with a “no” or “yes, with explanation” is offered and the expert continues to answer “yes” before realizing what just happened.
• Ask Until You Admit: Using this technique, opposing counsel keeps reframing the question until they have it in such a way that the “yes” or “no” answers are favorable to their client, at which time, they are done asking questions.
• You’ve Got to Be Kidding!: Opposing counsel takes particular aspects of your testimony or report out of context and acts indignant about the conclusion or opinion because, out of context or without additional evidence, it appears nonsensical or unsupported.
• This Means Nothing: This is an attempt to get an admission that in the bigger picture, the findings are of minimal importance and have little bearing on the case or are applicable only to a small portion of it.
• You Really Didn’t Mean to Say … : Using this technique, opposing counsel attempts to minimize the impact of your testimony by suggesting that certain small aspects, taken out of context, seem to make little sense.

The fraud examiner or forensic accountant should remember to be alert for tricks such as these and to make sure to provide a response and an explanation when needed. For example, it may be okay to answer “yes” to two or three questions in a row, but after a few “yes” answers, the savvy expert tries to see where the opposing attorney is heading and limit his or her ability to score points that are form more than substance. At the same time, antifraud and forensic accounting professionals need to understand that skillful attorneys have destroyed many a good expert witness’s report—not because the work wasn’t excellent or the conclusions and opinions weren’t supportable and grounded in the evidence but because the opposing attorney was able to wage a war of words and win. The fraud examiner or forensic accountant needs to understand that our world is fundamentally composed of numbers and that understanding and interpreting them is second nature. Following the money through complex schemes that include skillful concealment is what we do, but when we walk into a deposition or courtroom, we move from an environment in which numbers are the primary focus to one in which words carry the day. Expert witnesses need to develop knowledge, skills, and abilities in this world of words.

How the expert witness deals with the world of words:

• Draw reasonable conclusions and opinions that are grounded in the evidence.
• Know your case and get the information that you need.
• Exhibit self-confidence.
• Maintain a steady focus and concentration.
• Listen and think.
• Stay in your sandbox!!!
• Periodically ask the attorney to clarify a question.
• Cooperate within limits, but stand your ground.
• Maintain your credibility.
• Do not shoot from the hip.
• Admit the unfavorable or unknown when it is reasonable to do so.
• Be a teacher.

Testifying Can Turn Nasty

Jacqueline Harper is a retired Internal Revenue Service, Criminal Investigator with more than 25 years of government service. She began her career as a special agent and ended her career as a supervisory special agent, overseeing approximately 10 to 12 agents and support staff. As an agent, her investigations included the financial investigations of organized crime families, narcotics, and various white-collar financial investigations. In the following, she notes that sometimes, questioning by opposing counsel may turn personal, and she offers advice to help you anticipate and respond to such attacks.

From Jackie Harper…

When an opposing attorney cannot argue the facts or evidence, he or she will frequently call the forensic accountant’s or fraud examiner’s credibility into question. The forensic professional is often held to a higher standard than a fact witness and, opposing counsel may hire investigators to find areas in the forensic accountant’s life—both professional and, possibly, personal—that can be exploited to discredit the forensic accountant in the eyes of a judge or jury. As an IRS Criminal Investigator, an agent with numerous years’ experience, an actual incident in an investigation clearly demonstrates this concern.

An agent who had direct knowledge of an illegal gambling business testified regarding placing bets with the subject(s) of the criminal investigation in an undercover capacity. The agent was cross examined by defense counsel.

Defense counsel in this investigation was a former government attorney, who had worked closely with the testifying agent on other, past investigations before leaving government service. When the agent and attorney worked together previously, they frequently got together with other friends and played poker “for fun and small bets.”

During cross examination, defense counsel questioned the agent about his fondness for playing cards. Defense counsel made effective use of their recreational card-playing days before the jury. While it is not illegal for a group of friends to play poker for entertainment, it is illegal for the “house” or unlicensed gambling business to take a percentage of the proceeds for the “house.” The agents and defense counsel who played for “fun and small bets” had done nothing illegal; but, to the jury, it looked otherwise, and former friends saw themselves at professional odds.

Defense counsel took advantage of a situation most people would consider part of their personal life that would not, or should not, have any impact on their professional life. It is situations, such as this—when defense counsel cannot attack the evidence—some will attack the witness. In this example, while undercover, the agent gambled with the individual(s) under investigation. Since the facts entered into evidence could not be argued, the attorney took a personal situation and used it to discredit the agent. It is unlikely the agent ever thought that such an inconsequential situation in his or her personal life would be used in such a manner.

With today’s social media, the forensic professional should be cautioned about their online posts and how they may be used to discredit them in the future. An innocent enough picture or post, which in hindsight the professional may view as stupid or inconsequential, can and will be used by opposing counsel to substantially disgrace or discredit the professional and his or her testimony.

In another situation, the government was prosecuting an individual for financial crimes. Voluminous documents and financial records had been entered into evidence to prove the government’s theory of the case. Most of the records were the subject’s own records and were corroborated through records of various third parties’ and witnesses’ testimony.

When defense counsel could not attack the records and third party testimony, they attacked the agent. For an approximate four (4) week trial, defense counsel referred to the agent as a “nut case.” During 5-6 hours of questioning, defense counsel repeatedly referred to the agent as a “nut case” who had a bias against the subject’s business and industry.

It is very difficult to not let situations such as this become personal. Fraud examiners and forensic accountants must maintain a professional demeanor, even when being personally attacked. If they understand that while this type of personal attack is uncomfortable and, sometimes, even painful, it is because the evidence gathered is so strong and persuasive that defense counsel has nothing else to attack.

Depositions are another avenue where defense attorneys will personally attack the agent. Because there is not a judge present, defense counsel can ask the agent anything and the agent must answer. The attorney representing your investigation can object to the question but the witness must still answer. The defense attorney may use the personally insulting questions just to shatter your confidence or composure.

As an example, an employee asked for a meeting with a supervisor. As the employee entered the supervisor’s office, he or she would close the door for privacy. During a deposition, opposing counsel asked why the office door was closed—was the supervisor having sex on the desk with the employee? Opposing counsel knew this was not true, and had no basis for the question; but while the government attorney objected, the question had to be answered in a calm professional manner.

One must understand, opposing counsel was trying to get an antagonistic or hostile reaction from the agent to use in their defense. As stated repeatedly in this chapter, maintain your professionalism and answer the questions in a calm and professional manner. Do not react in the manner in which they hoped you would respond.

Root Cause and Critical Thinking

The following is adapted from a post by Jonathan T. Marks, CPA, CFF, CFE to his blog, BoardandFraud.com, on February 2, 2018.

Mr. Marks has more than 30 years of experience working closely with clients, their board, senior management, internal audit, and law firms on fraud, misconduct, cyber (data breach), global bribery (FCPA, UKBA), and whistleblower matters and, when appropriate, conducting investigations (10A, cross-border, etc.), performing root cause analyses, developing remedial procedures, designing or enhancing governance, global risk management, and compliance systems, along with internal controls, and policies and procedures to mitigate future potential issues. Marks is a highly regarded speaker, author, and thought leader in the governance, risk assessment, risk management, compliance, and fraud areas.

From Jonathan Marks…

“If you don’t ask the right questions, you don’t get the right answers. A question asked in the right way often points to its own answer. Asking questions is the ABC of diagnosis. Only the inquiring mind solves problems.”—Hodnett

Root cause analysis is a tool to help identify not only what and how an event occurred, but also why it happened. When we are able to determine why an event or failure occurred, we can then recommend workable corrective measures that deter future events of the type observed.

When conducting a root cause analysis, many use the 5 Why’s technique. By repeatedly asking the question “Why”, you can peel away the layers of symptoms, which can help lead to the root cause of a problem. The 5 Why’s is a stand-alone technique, but is often used in connection with the fishbone (Cause and Effect or Ishikawa) diagram. The fishbone diagram helps explore potential or real causes that result in a single defect or failure. Once all inputs are established on the fishbone, you can use the 5 Why’s technique to drill down to the root causes.

It’s important the individual(s) conducting the root cause analysis is/are thinking critically by asking the right questions (sometimes probing), applying the proper level of skepticism and, when appropriate, examining the information from multiple perspectives.

In order to ask “why,” questions need to be asked, received, and feedback delivered. The use of Socratic questioning is a nice tool that could help in a variety of ways.

Socratic questioning is at the heart of critical thinking and is based on logic and structure that emphasizes that any single statement only partially reveals a piece of thinking underlying it. The purpose is to expose the logic of someone’s thoughts.

Socratic questioning is disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow logical implications of thought, or to control the discussion.

Over the years, I have cobbled together from various sources, some examples of Socratic questions, as follows:

• Questions for clarification – Prove the concepts behind their argument. Use basic tell me more questions that get them to go deeper.
  • Why do you say that?
  • How does this relate to our discussion?
  • Can you give me an example?
  • Can you rephrase that?
• Questions that probe assumptions – Probing their assumptions makes them think about the presuppositions and unquestioned beliefs on which they are founding their argument.
  • What could we assume instead?
  • How can you verify or disapprove that assumption?
  • What would happen if …?
• Questions that probe reasons and evidence – When they give a rationale for their arguments, dig into that reasoning rather than assuming it is a given. People often use un-thought-through or weakly understood supports for their arguments.
  • What would be an example?
  • What is … analogous to?
  • What do you think causes this to happen …? Why:?
  • What evidence is there to support what you are saying?
  • On what authority are you basing your argument?
• Questions about Viewpoints and Perspectives – Most arguments are given from a particular position. So attack the position. Show that there are other, equally valid, viewpoints.
  • What would be an alternative?
  • What is another way to look at it?
  • Would you explain why it is necessary or beneficial, and who benefits?
  • Why is this the best …?
  • What are the strengths and weaknesses of …?
  • How are … and … similar?
  • What is a counter argument for…?
• Questions that probe implications and consequences – The argument that they give may have logical implications that can be forecast.
  • Do these make sense? Are they desirable?
  • What generalizations can you make?
  • What are the consequences of that assumption?
  • What are you implying?
  • How does … affect …?
  • How does … tie in with what we learned before?
  • What is the best …? Why?
• Questions about the question – And you can also get reflexive about the whole thing, turning the question in on itself. Use their position against themselves. Bounce the ball back into their court, etc.
  • What was the point of this question?
  • Why do you think I asked this question?
  • What does … mean?

The key to distinguishing Socratic questioning from questioning per se is that Socratic questioning is systematic, disciplined, and deep, and usually focuses on fundamental concepts, principles, theories, issues or problems.

Overview of an Antifraud Environment

Creating an antifraud and compliant environment requires critical thinking and an ability to solve problems in an innovative way. If one can identify the risk, a system of internal controls, policies, and procedures can be created to prevent it or minimize negative impacts, if such acts occur. The challenge is to find out how others, for example, a potential perpetrator, might exploit the system for gain. To identify opportunities to exploit control weaknesses, the fraud examiner or forensic accountant must “think like a criminal.” Further, they should understand the effective antifraud and compliance environment and its related processes and controls: “tone at the top,” an ethical culture, a strong control environment, code of conduct, open communications with suppliers and customers, employee monitoring, hotlines, whistleblower protection, willingness to enforce penalties against perpetrators, and proactive fraud auditing.⁴ The professional must then analyze potential frauds to identify systemic vulnerabilities and implement procedures to reduce the risk.

Internal Control Policies and Procedures

A company should develop a system of internal controls that provides reasonable assurance that assets are protected and financial statements are fairly presented. Of course, even the best system of internal controls may be at risk when employees collude to beat the system or management and executives override that system. Thus, despite efforts to install and maintain a reliable and effective system of internal control, it is impossible to prevent all frauds and acts of noncompliance. That is not to suggest that antifraud procedures cannot be established to prevent most specific types of fraud; however, when considering the entire company, the focus needs to shift from prevention to deterrence to create an antifraud environment.

A good system of internal controls has four separate areas of responsibility: one person is responsible for safeguarding the assets; another person has authority over transactions associated with the asset; a third person is responsible for recording transactions for assets; and a fourth person should orchestrate a system of audits, physical inventories, and reconciliations. A system with these attributes will not eliminate fraud and noncompliance but can alert the appropriate individuals to the occurrence of bad acts at the earliest possible moment.

In addition to the above controls that are already in place, a system to constantly monitor the control environment is also necessary. The entity must undertake periodic risk assessment. What could go wrong? How could the system of internal controls be exploited? What new aspects of our business have arisen for which assets need identification and protection? A good control environment also generates information so that responsible persons can monitor it and facilitate communication. The control environment also includes the following⁵:

• Integrity and ethical values
• A commitment to competent employees
• An active board of directors and audit committee
• Clear signals from management about its philosophy and commitment to ethical operations
• An organizational structure that defines authority, responsibility, record keeping, and audit expectations
• Periodic assessment of the organizational structure
• Human resource policies and practices that facilitate a good control environment

Risk Assessment and Internal Control

At the inception of an examination, the fraud examiner or forensic accountant needs to develop an understanding of the control environment. This can be accomplished by discussing internal controls with executives, management, and other employees. Such an understanding can be documented in narrative form that addresses the origination or source of the documents, the processing that takes place, the disposition of those documents, their recording in the system, and an assessment of the control risk. This kind of narrative supplemented with a graphic, such as a flowchart, can be very helpful in assessing risk. Each step in the process can be identified on the flowchart and an assessment done at each important point in the process. Internal questionnaires, pre-developed checklists, and policy and procedures manuals can also be used to develop an understanding of the system of internal controls.

Once this has been completed, the professional can then test the system by tracing documents and information through that system to determine whether it functions as designed. Operational breakdowns indicate that even though the system may be properly designed, it may not be functioning as planned. Such tests should address each aspect of the internal control environment: responsibility for physical safeguard, authority for transactions, record keeping, and the audit (reconciliation) process. Tests require the professional to scrutinize not only the flow of paper but also to examine documents and records, observe activities as they occur, discuss policies and procedures with line personnel, and re-perform aspects of the procedures to ensure that the outcomes are accurate.

At this point, the fraud examiner or forensic accountant should also consider those key controls that should be in place but appear to be absent. Once vulnerabilities are identified, the professional needs to communicate those findings and assist management in developing an appropriate cost-justified response. Ultimately, success requires a questioning mind, examining policies and procedures at the operational level, and looking for opportunities for management override.

The Importance of Corporate Governance

Corporate governance is the set of processes, customs, and policies that affect the way an organization is directed. It also considers the relationships among the stakeholders and the goals of the organization. The principal organizational leaders responsible for corporate governance include the board of directors, the audit committee, executives, management, and the shareholders. Other stakeholders with an interest in corporate governance include employees, suppliers, customers, banks and other creditors, regulators, and the community in which the organization operates. In general, corporate governance deals with issues of accountability and fiduciary duty, essentially those attributes advocating the implementation of guidelines and mechanisms to ensure good behavior by the organization and the protection of shareholder value.

The corporate governance fabric is critical for creating an environment in which the risk of fraud is minimized through a combination of fraud prevention, deterrence, and early detection and resolution tools and techniques. At a minimum, corporate governance should address three issues⁶:

1. Creating and maintaining a culture of honesty and high ethics
2. Evaluating fraud risks and implementing programs and controls to mitigate them
3. Developing an appropriate antifraud oversight process

Based on the concept that employees follow their leaders, first responsibility of management and executives is to set an ethical “tone and conduct at the top,” creating a culture that reinforces honesty and integrity. Beyond that, good corporate governance also fosters the following:

• Establishing a positive work environment by implementing programs and initiatives to enhance employee morale
• Hiring and promoting employees who meet the high ethical standards of the entity (including background checks, verifying employment and education, and contacting personal references)
• Training
• Supervising
• Confirming commitment to the code of conduct by educating personnel
• Disciplining those employees who fail to follow the code of conduct
• Identifying and measuring fraud risks
• Mitigating fraud risks within reasonable limits of cost constraints
• Monitoring fraud prevention programs and controls

The audit committee is an integral player in corporate governance, especially when it comes to financial reporting. The audit committee should manage the annual audit and also have internal audit report directly to them.

The Risk of Management Override

One of the most disturbing aspects of the audit process and corporate governance responsibility is that a certain cohort can do almost anything they want despite the systems of checks and balances designed to prevent asset misappropriation and financial statement fraud. This is referred to as management override. This issue is of such a concern that in 2005 the AICPA issued “Management Override of Internal Controls: The Achilles’ Heel of Fraud Prevention.” Essentially, the audit committee and the board of directors have the responsibility to address fraud risk. The document tasks audit committees as follows:

• Maintain skepticism
• Strengthen the audit committee’s understanding of the business
• Brainstorm to identify fraud risks
• Use the code of conduct to assess the financial reporting culture
• Cultivate a vigorous whistleblower program
• Develop a broad information and feedback network including internal auditors, independent auditors, the compensation committee, and key employees

From a practical perspective, the audit committee should make sure that the auditors have examined journal entries and other adjustments for evidence of possible misstatement due to fraud, review accounting estimates for biases, and evaluate the business rationale for significant unusual transactions. Audit committees should be vigilant for the following⁷:

• Discrepancies in the accounting records
• Conflicting or missing evidential matter
• Problematic or unusual relationships between management and auditors
• Results from audit testing that indicate previously unidentified risks of fraud
• Responses to management inquiries that are vague or implausible

Early Reaction to Symptoms

Albrecht notes six types of symptoms that may indicate a fraud is occurring⁸:

• Accounting anomalies including irregular, unusual, or missing source documents, faulty journal entries, and inaccuracies in ledgers and subledgers
• Internal control weaknesses including the lack of segregation of duties, physical safeguards, independent checks, proper authorization of documents and records; override of existing controls by executives or management; and inadequate accounting and other (nonfinancial) information systems.
• Analytical anomalies including shortages of inventory and cash, deviations from design and quality specifications, excessive scrap, excessive voids, excessive purchasing levels, ratios that do not make sense, nonfinancial numbers that do not correlate with account balances and numbers presented in the financial statements, strange financial relationships, and excessive late charges
• Extravagant lifestyles including new and expensive cars, expensive clothing, new or remodeled homes, and expensive recreational toys such as boats, cabins, and motor homes
• Unusual behavior generated by stress including offering excuses for shortcomings, excessive frustration, being overly defensive, argumentative, irritable, suspicious or belligerent, complaints of sleeplessness, excessive drinking, or taking drugs
• Tips and complaints from employees, customers, suppliers, family, and friends

A good antifraud environment requires awareness of these types of symptoms and, once observed, quick reaction to ensure that any possible fraud or noncompliance is caught at the earliest possible moment. Eliminating fraud and noncompliance completely is impossible, but companies can be vigilant and react quickly by investigating the red flags that may indicate that a bad act is taking place. The following is a five-step approach to fraud prevention, deterrence, and detection:

1. Know the exposures (brainstorming, risk assessment, audit planning).
2. Translate exposure into likely symptoms.
3. Always be on the lookout for these symptoms.
4. Build supervisory, review and audit programs to look for symptoms.
5. Follow up on these issues to their logical, evidence-based conclusions.

AICPA Statement on Auditing Standard (SAS) No. 99, “Risk Factors Relating to Misstatements Arising from Fraudulent Financial Reporting”

The following are examples of risk factors relating to misstatements arising from fraudulent financial reporting.

AICPA Statement on Auditing Standard (SAS) No. 99 (AU 316), “Consideration of Fraud in a Financial Statement Audit” (Supersedes SAS No. 82, “Risk Factors Relating to Misstatements Arising from Misappropriation of Assets”) and SAS 109 (AU 314), “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement”

Both SAS 99 and SAS 109 formalize an auditor’s responsibility to (1) obtain knowledge about an entity’s business and the industry in which it works; and (2) make inquiries to identify the risks of material misstatement. Risk factors that relate to misstatements arising from misappropriation of assets are also classified according to the three conditions, generally present when fraud exists: incentives/pressures, opportunities, and attitudes/rationalizations. Some of the risk factors related to misstatements arising from fraudulent financial reporting may also be present when misstatements arising from misappropriation of assets occur. For example, ineffective monitoring of management and weaknesses in internal control may be present when misstatements due to either fraudulent financial reporting or misappropriation of assets exist. The following are examples of risk factors related to misstatements arising from misappropriation of assets.

Short Answer Questions

1. Of what offense was Scrushy ultimately convicted?
2. How long was Mr. Scrushy’s prison sentence?
3. What were the losses at HealthSouth associated with the fraud?
4. How many former HealthSouth executives testified against Mr. Scrushy?
5. How long was the Scrushy trial?
6. Despite Mr. Scrushy’s acquittal, how many other HealthSouth executives went to jail?

Discussion Questions

1. In your opinion, why did prosecutors fail to win a conviction of Scrushy in the HealthSouth accounting fraud case?
2. How can an expert witness protect their credibility?
3. An expert witness is hired by either the prosecution (plaintiff) or defense (defendant). Given that the expert witness has been hired by one side, how does he or she address challenges to their credibility?

NOTES:

• Some exhibits referenced in this example are not attached. The topics discussed in the report are available in the text.
• This example is not necessarily inclusive of all report elements.
• Each fraud and/or financial crime report should be reflective of relevant case attributes and examination outcomes.

1. Executive Summary

Franklin and Bridget Campanella are co-owners of an enterprise, Campos, LLC, equipped with legally registered gambling machines, Donnie’s Players Lounge. The local police conducted a raid on one of four establishments, believed to be the headquarters, based on a tip from a former employee that illegal forms of gambling were also taking place. During this raid, $18,000 in cash was seized.

The Campanellas and Campos, LLC have been linked to four video poker gambling establishments in central and southern West Virginia. For the year 20×8, cash deposits to four bank accounts labeled Campos, LLC are being made on a regular basis. The total deposits for the period January through December 20×8 are $1,449,097. This amount is larger than reasonable given the capacity of the gambling business operation. Five months of 20×8 surveillance (April, May, June, July, and August) yielded average video gambling machine usage of 62%. Given the average customer spend per visit (per WV Gaming Commission data) and 62% capacity utilization, the maximum revenue that could be generated from the businesses is $547,200, a difference of $901,897. Further, Campos reported cost of goods sold on the 20x8 tax return of approximately of $383,000. This corresponds to a gross margin of 30% (($547,200 – 383,000 = 164,200)/547,200 = .300). 30% gross margin ties to industry and WV Gaming Commission gross margins for small video gambling operations. See analysis of surveillance, gross margins, and WV/industry data on Exhibit 1 (not included).

With the exception of credit card payments received in the form of a check from the credit card company totaling $89,251 for 20×8, more than 98% of cash deposits for the business were greater than $9,000 but less than $10,000 thereby avoiding federal Currency Transaction Report (CTR) reporting requirements. See analysis of deposits on Exhibit 2 (not included).

Illegal narcotics sales evidence indicates employees are likely being compensated for selling illegal narcotics. One of the employees, Louis Roland, was stopped for a routine traffic violation. Three ounces of cocaine and $14,500 in cash were in his possession. An informant has also witnessed Franklin Campanella meeting with known heroin and methamphetamine dealers and then later the same day with James Henry. James Henry, a convicted drug trafficker, was stopped on entry to the Grand Caymans on July 26, 20×7. An inspection of his baggage revealed $135,000 in cash.

Investigators have obtained additional information relating to the Campanellas’ personal assets and the financial activities of the business operations. Personal assets owned by the Campanellas support the money laundering proceeds possibly associated with illegal gambling and narcotics sales. Asset holdings appear suspicious due to the amount, location, and method acquired. The lifestyle examination of the Campanellas also supports a 20×8 money laundering scheme. The money laundering proceeds that remain in the possession and/or control of the Campanellas are not reported on their 20×8 tax return, consistent with tax evasion.

The evidence is consistent with the conclusion that Franklin and Bridget Campanella are involved in money laundering scheme, possibly associated with the alleged sale and distribution of controlled substances as well as tax evasion (fraud). The evidences examined and presented herein suggest that, after sale and distribution of the product, the illegally obtained funds are laundered through four gaming locations in central and southern West Virginia.

2. Scope

A tip from a disgruntled ex-employee resulted in the local police opening an investigation and conducting an early morning raid. The local police requested an examination of the financial records seized during the raid, supplemented with records subpoenaed from Campos’ and Campanellas’ bank, tax returns, and other sources of evidence to determine whether that evidence is consistent with illegal activity having occurred in businesses operated by Bridget and Franklin Campanella.

3. Sources of Evidence

• 20×6, 20×7, 20×8 tax returns: Campos, LLC
• 20×7 and 20×8 bank account statements and canceled checks of the Campos, LLC
• 20×7 and 20×8 WV Gaming Commission records for Paula’s High Stakes Hotspot, Donnie’s Players Lounge, High Rollers Hang-out and Lou’s High Life
• 2017 and 2018 Campanella Personal tax returns
• Campanella credit card records subpoenaed from bank
• Surveillance records
• WV Secretary of States Corporate Filings records: Campos, LLC and Video Gambling America

4. Background

Starting in 20×6, Bridget and Franklin Campanella became co-owners of a small local restaurant that had a gaming room in the back. In late 20×6, the restaurant operations were almost completely shut down and the dining space repurposed for video gambling. The gaming room consists of five video poker and slot machines that pay winning customers in tickets redeemable by cashing-out. A woman who had been employed by the Campos described a high stakes poker game that allegedly took place twice a month. Surveillance documented that Franklin Campanella hosted a high stakes poker game at least two Fridays per month in the gaming room attended by several prominent local businessmen and a regional mob boss.

Evidence was discovered at a murder scene at the home of Franklin Campanella’s parents (John and Martha Campanella) as seen in the crime scene evidence log, Exhibit 3 (not included). Pictures of the crime scene document where physical, electronic, and document evidence were found within the home were included with the log. This evidence and additional evidence provided by Lilly Duanne, CPA, and SA Cafrelli is consistent with alleged drug activity as further discussed below.

A link analysis, Exhibit 4 (not included), shows that Franklin and Bridget Campanella are owners of or are connected to three additional gambling establishments in central and southern West Virginia. Bridget is listed with the WV Gaming Office as the manager and operator of both Paula’s High Stakes Hotspot and Donnie’s Players Lounge. Franklin is listed with the WV Gaming Office as the manager and operator of High Rollers Hang-out and Lou’s High Life list, an address that is also shared by a bank account that is the same as that of Campos, LLC. The primary full-time employee of each of the above (4) locations has prior known activity associated with narcotics trafficking.

Several hypotheses were developed in this case, and most were not supported by the evidence. A careful review and analysis suggests that two hypotheses were most likely to be relevant to the examination: (1) Franklin and Bridget Campanella are laundering money and committing tax fraud through their businesses, possibly from the sale of narcotics; (2) Franklin and Bridget Campanella are not laundering money through their businesses. Evidence was classified for each hypothesis within the triangle of fraud action: the act, the benefit (conversion), and the concealment.

5. Examination

6. Conclusion

The evidence examined and analyzed in this case is consistent with Franklin and Bridget Campanella being involved in alleged illegal activity of money laundering, structuring, and tax evasion (fraud). In addition, based on the evidence provided within the case, the source of the illegal funds may be illegal drug trafficking.

7. Caveat/Reservation

This report is based on the information received and examined as of the date of this report. Should additional information become available, facts become known, or additional inquiry arise, I reserve the right to modify or supplement the analysis as necessary. I may use graphics or other demonstrative exhibits, enlarged, colored, or otherwise adapted to illustrate or to help explain testimony at trial.

Respectfully,

{Electronic signature}

Richard A. Perot, CPA, CFE, CFF, CVA

Note: Exhibits 1, 2, 3, and 4 are not provided.

Note: Exhibits 6, 7, and 8 are not provided.

NOTES:

• The analyses to support this report were examined in the prior chapter.
• This example is not necessarily inclusive of all report elements.
• Each commercial damages case report should be reflective of relevant case attributes and examination outcomes.

RE: Genuine Coal Corporation (Genuine) v.

Western USA Mineral Rights, Inc. Civil No. 18-254

Dear Mr. Steven,

I have reviewed the “closing documents” (contracts) for the purchase and sale of Genuine Coal and various financial information for the purposes of expressing an opinion on Genuine’s financial performance and financial condition. While I was given additional information to review, my opinions are based primarily on the following:

1. Closing documents from the Agreement for Purchase and Sale
2. Internal financial information, general ledgers, journal postings reports, internal financial statements, payroll records, and tax returns
3. Depositions of Genuine’s former owner Mortar and new owner Pestle
4. Various related party contracts and their WV Secretary of State online filings

1. Genuine earned just shy of $12,250,000, recovering 5 million tons of clean coal, approximately $2.45 per ton, from mining operations between 2014 and 2018. The sales price for clean coal during this period was $20 per ton (per long-term base coal contract).
2. Despite these positive earnings, Genuine reported “book” and “tax” losses of ($1,250,000) or ($0.25) per ton on its 2014–2018 tax returns. The “book” losses agree to the amounts reported on internal financial statements for all years.
3. The reason for the disparity between reported earnings and estimated actual earnings is expenses (disbursements) to related party companies, related to either former owner Mortar and/or new owner Pestle. Positive cash inflow before related party transactions totaled approximately $13.5 million, approximately $2.70 per ton. Alternatively stated:
   • Related parties billed Genuine for operating expenses in excess of $13.5 million.
   • The differential ($1,500,000) was loaned back to Genuine by another related party, Mountain Finance, LLC.
   • Outstanding debt to Mountain Finance, LLC, which is owned and controlled by former owner Mortar, totaled $1.5 million by December 31, 2018. This amount was secured by the assets of Genuine.
   • Despite discovery requests and deposition inquiries, no invoices for the disbursements by Genuine to related parties were provided by the plaintiff (Genuine).
   • Further, these vendors did not exist prior to 2014.
   • Additionally, the vendors that had been providing services to Genuine during the 2009–2013 period, in general, continued to do so at level correlated with the amount of coal mined by Genuine.
   • No business purpose for the expenditures by Genuine to its related party vendors could be established by discovery interrogatories, requests for production of documents, nor deposition testimony.
4. Genuine’s reported losses and excess liabilities would likely give uninformed readers of the financial statements the impression of a failing company.
5. Genuine’s transfer of cash flow to related party companies created an environment where Genuine did not replace aging equipment.
6. The decline in tons produced, deteriorating financial condition, and lack of investment in mining equipment are consistent with Genuine’s cancelation of a coal supply agreement dated December 31, 2017 that included language that stated that Genuine determined to “discontinue its plans to pursue further mining/coal reserve activities.”
7. Genuine’s transfer of cash flow to related party companies, its decline in assets, its debt to Mountain Finance, LLC is such that Genuine will be unable to satisfy its pension and healthcare benefits obligations to retired employees and other unsecured creditors.

   Overall, given that over a period of years, Genuine’s clean ton production was declining, Genuine’s overhead was increasing, and significant cash flow was being disbursed for the benefit of related parties and replaced with a loan to another related party, Genuine’s operations were such that the company was bound to result in this type of poor financial condition. Such a sustained pattern of business operations and financial performance would necessarily result in a company that was no longer financially viable and would be unable to meet its remaining financial obligations.

Background

Genuine had been mining for Western since 2009. During the period 2009–2018, Genuine had two contracts to mine two separate tracts of coal for Western. The tracts of coal were contiguous, mined in the same seam of coal, and premining engineering studies indicated that the geological characteristics of the tracts were indistinguishable. The first tract was mined during the period 2009–2013 and Genuine was paid for 7,500,000 tons of clean coal averaging $20 per ton, the contract price. The second tract was mined during the years 2014–2018; Genuine was paid for 5,000,000 tons of clean coal averaging $20 per ton, the contract price. In 2018, Genuine bid on a third contiguous tract of land at $21 per ton; however, Western awarded the mining to a competitor of Genuine for $20 per ton. At that point, Genuine filed suit against Western, alleging three issues (see Complaint Civil No. 18-254):

1. The bidding process was unfair and that Genuine was entitled to the third contract with Western.
2. During the second contract, premining engineering studies consisted of “core” drilling. This core drilling indicated that approximately 50.6% of the core was coal. In contrast, during the second contract, Genuine was only paid for clean coal percentage averaging 44.6%. As such, Genuine was underpaid by 6% of the clean coal. Thus, instead of mining and being paid for 5,000,000 clean tons, Genuine alleges that during the period 2014–2018, the company should have been paid for 5,673,000 tons.
3. As a result of the underpayment and the failure to receive the third contract, Genuine was in a precarious financial position at the end of 2018 and may be forced to seek bankruptcy.

See Exhibit 1 for the Complaint Civil No. 18-254.

1. Impact of Sale of Genuine on December 31, 2014
   1. On approximately December 31, 2014, an “Agreement for Purchase: Genuine Coal” was executed between former owner Mortar and new owner Pestle. The terms of the agreement included the following:
      1. A fixed payment amount in the form of a $2,400,000 promissory note by Genuine (0% interest, payable over 5 years at the rate of $40,000 per month) payable to former owner Mortar—secured with the assets of Genuine and characterized as “salary.”
      2. New owner Pestle signed a notes payable to Genuine in the amount of $500,000. A review of the cash account and officer receivable accounts indicates that this amount was never paid to Genuine.
   2. In addition to the agreement outlined in (i) above, some of the other agreements with the closing documents included the following:
      1. Payment amounts for ten (10) years at 20% of “projected earnings” (2014–2023) payable to Administration Consultancy Group, LLC—controlled by former owner Mortar and secured with the assets of Genuine.
      2. A tonnage Royalty of $0.25 per ton of clean coal mined—payable to Coal Operations Consulting, LLC—controlled by former owner Mortar and secured with the assets of Genuine.
      3. A management fee of $25,000 per month payable to Management Consultants, LLC—controlled by former owner Mortar and secured with the assets of Genuine.
      4. An “Aircraft Time Share” with Aeronautical, LLC, which required Genuine for a term of 5 years (and thereafter, month to month) to pay $250,000 per year plus all maintenance, upkeep, and rebuilding of the aircraft or its systems. Aeronautical, LLC is controlled by former owner Mortar and secured with the assets of Genuine.
      5. A “Coal Sales Agreement” with Mountain Ridge Sales, LLC. Mountain Ridge was granted an exclusive right to market any and all coal produced from January 1, 2014, for a period of 10 years for a commission in the amount of 5% of net proceeds for each ton of coal produced. Mountain Ridge is controlled by former owner Mortar and secured with the assets of Genuine. All coal produced by Genuine was already under contract to Western and was unable to be sold to any other party.
      6. A “Supply Agreement” with Western Mine Supply. Western charged a fee equal to 10% of the amount of all purchases processed through accounts payable for a period of approximately 8 years.
      7. An “Employment Agreement” with new owner Pestle for a term of 5 years (and thereafter year to year) for compensation of $100,000 per annum. New owner Pestle had no coal mining experience and did not maintain an office at Genuine. Payroll disbursements and cash records indicate that Pestle was paid all amounts.
      8. Former owner Mortar maintained one office at Genuine for the years from inception through 2018.
   3. The commitments related to the purchase and other closing agreements with former owner Mortar and other related parties altered the cost structure of Genuine by adding or increasing the following expense line items:
      • Administration and Accounting Expense
      • Management Expense
      • Travel—Airfare Expense
      • Sales Brokerage Expense
      • CEO Salary Expense
      Prior to 2014 these deduction (expense) line items had zero balances.

      The impact of these expenses on the financial performance of Genuine during the period 2014–2018 is as follows:

      	2014–2018	Per ton
      Clean Coal in Tons	5,000,000
      Book income (loss) per tax returns	($1,250,000)	($0.25)
      Administration Consultancy Group, LLC	2,500,000	0.50
      Coal Operations Consulting, LLC	1,250,000	0.25
      Management Consultants, LLC	1,500,000	0.30
      Aeronautical, LLC	1,250,000	0.25
      Mountain Ridge, LLC	5,000,000	1.00
      Western Mine Supply	1,500,000	0.30
      Employment Agreement: Pestle	500,000	0.10
      Total	13,500,000	2.70
      Adjusted book income	$12,250,000	$2.45

   4. New owner Pestle became the sole shareholder by agreeing to contribute $500,000 for the purchase of one share of stock by tendering a demand note. According to the 2018 tax return, as of December 31, 2018, this amount had not been paid to Genuine. New owner, Pestle, admitted during deposition to playing a very small role in the management of the business and having no coal mining experience. Related party disbursements and expenses are summarized by year as follows:

      Accounting General Ledger	Related Parties	2009–2013	2014	2015	2016	2017	2018	5-Yr Total	Per Ton
      Administration & Accounting	Administration Consultancy Group, LLC	0	500,000	500,000	500,000	500,000	500,000	2,500,000	0.50
      Management	Coal Operations Consulting, LLC	0	375,000	312,500	250,000	187,500	125,000	1,250,000	0.25
      Management	Management Consultants, LLC	0	300,000	300,000	300,000	300,000	300,000	1,500,000	0.30
      Travel – Airfare	Aeronautical, LLC	0	250,000	250,000	250,000	250,000	250,000	1,250,000	0.25
      Sales Brokerage	Mountain Ridge, LLC	0	1,500,000	1,250,000	1,000,000	750,000	500,000	5,000,000	1.00
      Administration & Accounting	Western Mine Supply	0	450,000	375,000	300,000	225,000	150,000	1,500,000	0.30
      CEO Salary	Employment Agreement: Pestle	0	100,000	100,000	100,000	100,000	100,000	500,000	0.10
      			3,475,000	3,087,500	2,700,000	2,312,500	1,925,000	13,500,000	2.70

      The legitimacy of billings by related parties was not able to be established either through review of invoices nor through deposition testimony.

      In addition to the expenses added as part of the purchase and sale transactions, mining operations (tons produced) declined every year between 2014 and 2018. Nevertheless, mining profits per ton (revised upward for expenses added as part of the purchase and sale transactions) and total costs per ton declined almost every year. However, because overhead charged to the mining operations generally increased, reported losses were significant in the years 2017–2018.

      		2009-2013		2014	2015	2016	2017	2018	5-Yr Total
      Revised Operating Expenses		26,400,000	17.60	26,250,000	21,850,000	17,500,000	13,200,000	8,950,000	87,750,000
      				17.50	17.48	17.50	17.60	17.90	17.55
      Revised Net Income		3,600,000	2.40	3,750,000	3,150,000	2,500,000	1,800,000	1,050,000	12,250,000
      		2.40		2.50	2.52	2.50	2.40	2.10	2.45

      For a more comprehensive presentation of the above, see Exhibit 2. Panel A presents the financial performance for the years 2009–2018 with and without the related party transactions. Panel B presents the balance sheet as reported by Genuine, 2013–2018.

2. Impact of Financial Performance on Investments in Mining Equipment

   After a significant initial investment in equipment in 2009–2013, Genuine made very little investment in fixed assets during the period 2014–2018. This lack of investment was not offset by increased equipment rentals.

   		2009-2013		2014	2015	2016	2017	2018	5-Yr Total
   Investments in Property, Plant & Equipment		2,625,000		524,000	476,000	125,000	-	-	1,125,000
   Equipment Rental Expense		10,000,000		1,800,000	1,200,000	775,000	400,000	200,000	4,375,000

3. Impact of Related Party Cash Flows on Liabilities and Stockholders’ Equity

The assets of Genuine (before and after reduction for related party receivables) and stockholders’ equity declined. In contrast, net liabilities (including loans to Genuine from the related party Mountain Finance, LLP) increased. Based on the net of stockholders’ equity at December 31, 2018, Genuine was technically bankrupt and did not have the ability to pay its Retiree Employment Benefit Obligation of $5,000,000.

See Exhibit 2b.

Payments to related parties during the period 2014–2018 of $13,500,000 would have been sufficient to pay the Retiree Employee Benefit Obligation of $5,000,000 with $8,000,000 left to distribute to Genuine stockholders.

As the cash flow of Genuine was passed to related party companies, Genuine was required to borrow money from Mountain Finance, LLP (a former owner Mortar related party company) creating a debt of $1,500,000. Loans from Mountain Finance, LLP were secured by the assets of Genuine.

Reservation:

This report is based on the information received and examined as of the date of this report. Should additional information become available, facts become known, or additional inquiry arise, I reserve the right to modify or supplement the analysis as necessary. I may use graphics or other demonstrative exhibits, enlarged, colored, or otherwise adapted to illustrate or to help explain testimony at trial.

Respectfully,

{Henry Lester, Jr. electronic signature}

HENRY LESTER, JR., PHD, CPA, CFE, CFF, CVA

NOTES:

• The analyses to support this report were examined in the prior chapter.
• This example is not necessarily inclusive of all report elements.
• Each valuation report should be reflective of relevant case attributes and examination outcomes.

Executive Summary

Report Summarized: The valuation report summarized here contains 51 pages and was issued December 31, 2018 by C.A.D. Bell, Jr. The Exhibits and Appendices are integral parts of this report.

Introduction

Background Information

Economic Analysis and Outlook

The following sections summarize the current economic data from a national, regional, and local perspective.

Industry Analysis and Outlook

The following section summarizes the commercial florist industry. The discussion was developed primary from the First Research Industry report (Dunn & Bradstreet).¹

Companies in this industry sell cut flowers, floral arrangements, potted plants, and other gifts from physical retail establishments. The retail and commercial florist industry includes florist services done for outside customers on a job order (walk-in and delivery) and contractual basis. Mass plant and flower retailers (e.g., Lowes, Home Depot) are not included. Floral order-taking services such as 1-800-FLOWERS.COM and FTD provide orders to independent florists but are also competitors. Florists often provide contractual services to customers, such as wedding and corporate events as well as regular florist and plant maintenance and services to business customers. In general, commercial and retail florist is a local activity, because many vegetative materials are maintenance-sensitive, challenging to ship without special handling and/or require face-to-face collaboration between the florist and customer.

This U.S. industry comprises establishments primarily engaged in florist activities without gardening and outdoor plant and flower operations. This industry includes establishments engaged in job order and contractual sales.

For the past twenty years, the commercial florist industry has found itself on the wrong side of a technological revolution. The spread of personal computing, first to the office, factory, and home, combined with the steadily increasing power and convenience of communication devices, has increased Americans’ appetite for convenient forms of shopping (e.g., “apps”) but also florists have faced competition from new competitors such as confectionaries and fruit and vegetable edibles that can be delivered as gifts.

“Digital’s influence is now a constant and significant factor in every sector, segment and sub-segment of US business,” said James Khale, President of U.S. Florist Association. “At the same time as digital technology and innovation continue to spur growth in the florist industry and propel the industry forward. In addition, emerging digital monitoring are significantly changing consumption habits and maintenance needs among both institutional and consumer end-users. These developments will drive digital-related expenditures to constitute nearly 40% of the overall U.S. Florist Industry capital spending by 2020.”

Factors that affect the U.S. commercial and retail florist industry include general economic conditions, demographic trends, and corporate and consumer spending. A growing economy often leads to increased demand for commercial and retail florist products. It is expected that commercial and retail florists will gain business as corporations and similar organizations move to outsource more of their florist requirements.

Financial Analysis

Rosewood ownership has been conservative in its financial management of the company. The company has a large historical cash balance that has been increasing across the years 2014–2018 and far exceeds the industry comparable cash balances. Further, the company has no debt on the balance sheet. The company has a $1.50 million credit line at their bank, which they rarely need to utilize.

Accounts receivables and accounts payables have been increasing and declining in the same direction as changes in sales. Net income margins have generally been in line with those of the industry and the company sustained net income in 2015 through 2018.

According to information gathered from company sources, accrual basis financial statements for Rosewood Florist Shop, LLC are prepared annually and are reviewed by an outside CPA. Monthly financial statements are compiled by the outside CPA and are available two weeks after the end of each month. Tax planning is done annually.

Valuation Approaches and Methods

All relevant valuation approaches were considered in performing the valuation of Rosewood Florist. There are three recognized approaches to valuation: market approach, income approach, and asset approach.

Methods Considered and Rejected

Valuation Approaches and Methods Used

Determination of the Capitalization Rate—Cost of Equity

The rate used to capitalize the expected economic income is the expected rate of return that a buyer requires in order to make a particular investment. Most of the information for estimating the expected rate of return, or capitalization rate, comes from the investment markets. A build-up method was used to estimate the capitalization rate.

BUILD-UP CAPITALIZATION RATE
Risk-Free Rate of Return	2.50%
Equity Risk Premium	6.60%
Small Stock Risk Premium	6.00%
Company-Specific Premium	6.00%
Net Cash Flow Discount Rate	21.10%
Discount Rate		21.10%
Sustainable Growth		2.50%
Capitalization Rate to Apply to Next Year Stream		18.60%
Divide by 1 Plus the 2.5% to Get		1.025%
Capitalization Rate to Apply to Current Year Stream		18.14%
Selected Rate (rounded)		18.10%

Determination of such a rate begins with an estimate of the cost of equity capital (also known as Ke or the “discount rate”). The build-up method is one of several widely used methods to estimate the cost of common equity capital. It is an additive model in which the return on any asset is estimated as the sum of two or more components:

1. A “risk-free” rate of return
2. One or more premia for risk

The components used in the build-up method are shown in the following formula:

$$\mathrm{K}\mathrm{e}=\mathrm{R}\mathrm{f}+\mathrm{R}\mathrm{P}\mathrm{m}+\mathrm{R}\mathrm{P}\mathrm{s}+\mathrm{R}\mathrm{P}\mathrm{u}$$

where

• Ke = Cost of equity
• Rf = Risk-free rate
• RPm = Equity risk premium
• RPs = Risk premium for small size
• RPu = Company-specific risk premium (i.e., unsystematic risk)

The risk-free rate (Rf) of 2.50 is based on the annual yield of a 20-year United States Treasury Bond as of the valuation date, December 31, 2018, as published by the Federal Reserve in their statistical release.

The equity risk premium (6.6%) and the risk premium for small size (6.0%) are calculated as the average rate of return on common equity securities over the average income return earned on long-term treasury bonds over the same period and are ranked by five different measurements of size as found in the 2018 Ibbotson SBBI Valuation Yearbook. The total ERP plus risk premium used is 12.6% (6.6% + 6.0%).

The company-specific risk premium (RPu) is a subjective measurement of the unsystematic risk associated with the subject Company. This risk premium is based on factors such as industry risk, volatility of returns, leverage, size smaller than the smallest size premium group, and other company-specific factors. Some of the factors influencing the company-specific risk premium include the following:

• Size. Investments in small companies typically carry a greater expected rate of return.

  Rosewood is on the lower end of the size spectrum.

• Access to capital markets. Small, closely held firms generally have more difficulty raising money.

  Rosewood has an unused line of credit and no long-term financing.

• Breadth of customer base. Dependence on specific customers who can easily choose a competitor is a significant risk.

  While no single customer accounts for more than 3% of revenue, Rosewood’s largest 25 customers account for about 40% of 2018 revenue.

• Geographic location. Certain regions of the county or metropolitan areas underperform.

  The West Virginia economy and Morgantown in particular seem to offer improving economic conditions, though conditions that trails the nation.

• Key executive dependency. Smaller companies that rely on certain executives, particularly if these executives are older, may be vulnerable.

  The company is dependent on a few key management personnel.

• Limited product line. Single focus closely held companies are more risky.

  The company has little diversification, earning all revenues from the florist industry that is currently impacted with technological innovation.

• Litigation/regulating risk. Many profitable, otherwise healthy companies have been significantly affected overnight by lawsuits and legislation.

  No litigation has been identified.

• Volatility of the industry. Certain industries are subject to cycles or serve competitive pressures.

  The industry is changing due to the impact of technology and trends in florist services.

Rosewood has been operated by experienced leadership and has been financially conservative. There have been no major issues, such as environmental or labor problems, in the Company’s history nor does management foresee any issues arising in the future. Company-specific risk for an entity like this should be relatively low. Based on these factors and our analysis of the financial and operational characteristics of the Company, a company-specific risk premium of 6.0% was considered reasonable.

Company-Specific Risk
Further Size Adjustment
Depth of Management
Importance of Key Personnel
Stability of Industry
Diversification of Product Line
Diversification of Customer Base
Diversification/Stability of Suppliers
Geographic Location
Stability of Earnings
Earnings Margins
Financial Structure
Other
Company-Specific Premium

The build-up method resulted in a net cash flow discount rate of 21.1%. From this amount, the estimated long-term sustainable growth rate must be subtracted in order to determine the capitalization rate. The long-term sustainable growth amount of 2.5% was determined based on the forecast for the foreseeable future based on the estimated growth in inflation and revenue opportunities afforded Rosewood through its early transition to digital florist. Subtracting the 2.5% long-term sustainable growth rate from the discount rate of 21.1% resulted in a capitalization rate of 18.6% for next year. In order to determine the appropriate capitalization rate to apply to the historical earnings, the 18.6% was adjusted by dividing it by 1 plus the long-term sustainable growth rate of 2.5%, calculating a capitalization rate of 18.1%, which is appropriate for the historical income benefit stream.

As shown below, this capitalization rate was then applied to the adjusted net cash flows of the Company to estimate the fair market value of the Subject Interest.

Net of Debt After Tax Cash Flow	1,274,500
Sustainable Growth Rate	2.50%
Net of Debt After Tax Cash Flow		1,306,363
Capitalization Rate		18.10%
Subtotal		7,217,472
20% Minority Interest Discount		−1,443,494
Subtotal		5,773,978
30% Marketability Discount		−1,732,193
Subtotal		4,041,785
Excess/Nonoperating Assets
Cash	4,000,000
Land	900,000
Cash Surrender Value of Life Insurance	470,000
Excess/Nonoperating Assets	5,370,000
Apply 20% Minority Interest Discount	−1,074,000
Subtotal	4,296,000
Apply 30% Marketability Discount	−1,288,800
Adjusted Excess/Nonoperating Assets		3,007,200
Indicated Equity Value		7,048,985
SELECTED EQUITY VALUE (rounded)		7,049,000

Application of a Discount for Lack of Control (i.e., Minority Interest Discount)

A discount for lack of control is a reduction to the initial indicated value due to a lack of control prerogatives such as declaring dividends, liquidating the company, going public, issuing or buying stock, directing management, setting management’s salaries. As discussed in greater detail later in this report, a discount for lack of control of 20.00% is deemed appropriate to apply in this method.

Application of a Discount for Lack of Marketability

As discussed in this report, a discount of 30.00% is required for the lack of marketability of the Subject Interest. The discount reflects an expectation for the lack of a secondary market in which to negotiate a quick sale.

Adjustment for Excess/Nonoperating Assets

Excess or nonoperating assets represent the value of resources the company has control of but are not required to operate the business. Examples are excess cash on hand, real estate, or other securities. In our judgment, excess and nonoperating assets that need to be added back and are part of the entity’s value total $5,370,000.

Indicated Value

As calculated and based on this methodology, the indicated fair market value of $7,049,000 and 40% of the equity of the Company is $2,819,600.

Conclusion of Value

The conclusion of value is rendered in the context of the specific assignment described above and is applicable only for the period noted. The conclusion of value of the fair market value of a 40.0% ownership interest in Rosewood Florist Shop, LLC as of December 31, 2014, on a noncontrolling, nonmarketable basis is as follows:

The conclusion of value of the fair market value of a 40% ownership interest in Rosewood Florist Shop, LLC as of December 31, 2018, on a noncontrolling, nonmarketable basis was $2,820,000. The 20,000 shares of stock on a per-share basis have a corresponding fair market value of $141.00 per share.

Appendix A: Statement of Assumptions and Limiting Conditions

This valuation engagement and summary valuation report is subject to the following assumptions and limiting conditions:

1. The conclusion of value arrived at herein is valid only for the stated purpose as of the valuation date.
2. Financial statements and other related information provided by the Company or its representatives, in the course of this engagement, have been accepted without any verification as fully and correctly reflecting the enterprise’s business conditions and operating results for the respective periods, except as specifically noted herein. I have not audited, reviewed, or compiled the financial information provided, and, accordingly, I express no audit opinion or any other form of assurance on this information.
3. Public information and industry and statistical information, if obtained, has been derived from sources I believe to be reliable. However, I make no representation as to the accuracy or completeness of such information and have performed no procedures to corroborate the information.
4. The conclusion of value arrived at herein is based on the assumption, unless otherwise noted in the report, that the current level of management expertise and effectiveness would continue to be maintained, and that the character and integrity of the enterprise through any sale, reorganization, exchange, or diminution of the owners’ participation would not be materially or significantly changed.
5. This report and the conclusion of value arrived at herein are for the exclusive use of my client for the sole and specific purposes as noted herein. They may not be used for any other purpose or by any other party for any purpose. Furthermore, the report and conclusion of value are not intended by the author and should not be construed by the reader to be investment advice in any manner whatsoever. The estimate of value represents the considered opinion of the analyst based on information furnished by the Company and other sources.
6. Neither all nor any part of the contents of this report (especially the conclusion of value, the identity of any Valuation Analysts, or any reference to any of their professional designations) should be disseminated to the public through advertising media, public relations, news media, sales media, mail, direct transmittal, or any other means of communication without my prior written consent and approval.
7. Future services regarding the subject matter of this report, including, but not limited to testimony or attendance in court, shall not be required unless previous arrangements have been made in writing.
8. I am not an environmental consultant and take no responsibility for any actual or potential environmental liabilities. Any person entitled to rely on this report, wishing to know whether such liabilities exist, or the scope and their effect on the value of the property, is encouraged to obtain a professional environmental assessment. I do not conduct or provide environmental assessments and have not performed one for the subject property.
9. I have not made a specific compliance survey or analysis of the subject property to determine whether it is subject to, or in compliance with, the American with Disabilities Act of 1990, and this valuation does not consider the effect, if any, of noncompliance.
10. I have not made a specific compliance survey or analysis of the subject property to determine whether it is subject to, or in compliance with, any laws, regulations or any other legislation, code, ordinance, statute or other requirements, and this valuation does not consider the effect, if any, of noncompliance.
11. No change of any item in this valuation report shall be made by anyone other than the Firm, and I shall have no responsibility for any such unauthorized change.
12. Unless otherwise stated, no effort has been made to determine the possible effect, if any, on the subject business due to future Federal, state, or local legislation, including any environmental or ecological matters or interpretations thereof.
13. Unless otherwise informed or determined independently by me, it is assumed that there are no regulations of any government entity to control or restrict the use of the subject business’s underlying assets and that the underlying assets will not operate in violation of any applicable government regulations, codes, ordinances, or statutes. I also assume that, unless otherwise informed or determined independently, the subject business is in compliance with all federal, state, and local laws and regulations, as well as up to date in regard to all filing and reporting requirements.
14. I have conducted interviews with the Client and/or the current management of the Company concerning the past, present, and prospective operating results of the Company.

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NOTES:

• The analyses to support this report were examined in the prior chapter.
• This example is not necessarily inclusive of all report elements.
• Each forensic economic report should be reflective of relevant case attributes and examination outcomes.

Certification

I, Gabriele DiJames, hereby certify as follows:

• I am a Certified Public Accountant, Certified Valuation Analyst, Certified in Financial Forensics, PhD, among other designations. I am a partner in the accounting firm of DiJames, Froman & Co., LLC. Our firm was retained by Mason and Dixon, LLP to prepare an economic damage analysis.
• The following is a true copy of the Economic Damages analysis which I prepared.
• The statements of fact contained in this report are true and correct, subject to the assumptions and conditions stated.
• The reported analyses, opinions, and conclusions are limited only by the reported assumptions and limiting conditions and are our unbiased and professional analyses, opinions, and conclusions.

Our compensation is not contingent on an action or event resulting from the analyses, opinions, or conclusions in, or the use of, this report.

Contingent and Limiting Conditions

This report is subject to the following contingent and limiting conditions:

• Information, estimates, and opinions contained in this report are obtained from sources considered reliable; however, DiJames, Froman & Co., LLC has not independently verified such information, and no liability for such sources is assumed.
• All facts and data set forth in the report are true and accurate to the best of our knowledge and belief. I have not knowingly withheld or omitted anything from our report affecting our conclusion.
• Possession of this report, or a copy thereof, does not carry with it the right of publication of all or part of it, nor may it be used for any purpose without the previous written consent of DiJames, Froman & Co., LLC.
• The various estimates of loss presented in this report apply to this report only and may not be used out of the context presented herein. Any other use of this report may lead the user to an incorrect conclusion for which DiJames, Froman & Co., LLC assumes no responsibility.
• I assume that there are no hidden or unexpected conditions of the parties that would adversely affect loss, other than as indicated in this report.

Economic Damages Report