Forensic Accounting Perspectives : New York Business Valuation, Divorce, Business Disputes, Shareholder Disputes, Litigation Support & Accounting Forensics in Connecticut, New York & New Jersey

In 2010 we saw a number of high profile celebrity divorces and break ups occupying the tabloids and evening news. Tiger Woods and Elin Nordegren’s divorce was just the beginning. As the year closed we saw Sandra Bullock’s marriage crash and burn. Even Hollywood’s starlets like Elizabeth Hurley, Eva Longoria and Scarlett Johansson couldn’t avoid the hazards of matrimonial failure. In some instances these divorces may have ended inauspiciously due to a prenuptial agreement or the ability of the parties to cut ties financially without disrupting their lifestyle.

For attorneys representing clients in a divorce the breakdown of this economic partnership may require a forensic accountant and business valuation expert. But how does the matrimonial practitioner use this resource to better serve their client? Here are four things to consider, along with cases that illustrate the issues.

Always Use a Qualified Business Valuation Expert.

In Brooks v. Brooks, the husband owned minority interests in his family’s limited liability companies (LLCs), which held commercial property. At trial, the wife presented the companies’ financial statements and a real estate expert, who appraised the LLC’s underlying property at $61 million. Notably, the expert testified that his appraisal was only the first step in a fair market valuation (FMV), which required assessing the companies’ outstanding debt and closely held stock.

At the close of the wife’s case, the husband decided not to call his BV expert, saying there was “no valuation testimony” to rebut. Instead, he presented only the operative buy-sell agreements plus his tax returns, which essentially showed a book value of $400,000 for his LLC interests.

The court asked the wife if she wanted to call the husband’s expert to testify regarding the LLCs, including the effect of non-marketability and minority shares, but she declined. Thus the court was faced with the buy-sell and book values, on one side, and the broad real estate appraisals and financials on the other.

Finding the former “simply would not do justice,” the court took the appraised value of each property and multiplied it by the husband’s share in the LLC, less the mortgage debt on each property plus the value of cash-on-hand.

The husband appealed, claiming the trial court improperly equated the FMV of the properties with that of his LLC interests, thereby ignoring three “critical” features: lack of marketability, lack of control, and the effect of the restrictive buy-sells. The wife argued that since he’d neglected to present valuation evidence at trial, he couldn’t complain about its omission—but the appellate court disagreed.

The husband had “vigorously objected” to the wife’s real estate appraisals at trial, and her own expert conceded a lack of expertise to value the husband’s interests. The wife also rejected the chance to call the husband’s BV expert. At the same time, the trial court failed “to follow some reasonable path” in ascertaining FMV, which required assessing the marketability and minority aspects of the husband’s interests as well as any contractual restrictions, and the appellate court remanded the case for a new trial on valuation.

Use Your Expert to Facilitate Proper Discovery and Disclosure

In Hissa v. Hissa, the husband’s expert valued his orthopedic practice at approximately $320,000. By contrast, the wife’s expert valued it at $650,000, based in part on a comparison to industry averages. Both experts relied on the applicable FMV standard, and both agreed that accounts receivable (AR) were an important element. However, the husband failed to provide the wife’s expert with the same information concerning AR that he’d given his own expert, forcing the wife’s expert to estimate their value. The husband also provided flawed tax and financial information to both experts, and a result, the trial court found his evidence less convincing than the wife’s, and adopted her expert’s value.

The husband appealed, alleging the trial court erred by crediting the wife’s expert over his own. But, “the [trial] court determined that [the husband’s] failure to be forthcoming about his business expenses led it to discredit the information he provided his own expert,” the appellate court found, “particularly given his expert’s valuation of the medical practice at nearly one-half of what [the wife’s expert] determined the value to be,” and it affirmed the latter’s value.

Use the Expert to Educate the Court

In re Marriage of Armour, the vast majority of the parties’ wealth was tied up in the husband’s 50,000 shares of stock in his employer, which were subject to the company’s right of redemption at a below market price. Like many jurisdictions, California family courts prefer an in-kind division of marital assets unless economic circumstances warrant another method.

Here, the wife’s valuation expert analyzed the consequences of an in-kind division: Assuming the husband retained his stock for a reasonable time until retirement, his 50% share would produce a present value of $36 to $40 million, but the wife’s share would net only $18 million at the forced redemption price.

Despite this evidence, the trial court ordered a simple in-kind division and the wife appealed. Based on the wife’s valuation evidence, the appellate court found this “disregarded economic realities” and ordered a division that ensured an equal result for both parties.

Use Your Expert to Rebut the Other Side

In Gupta v. Gupta, the husband owned three medical practices and an imaging center in rural Texas. At trial, his expert valued the practices at $359,000 and the imaging center at zero, due to its significant debt service and operating losses. By contrast, the wife’s expert valued all the businesses at $780,000, excluding goodwill and a marketability discount.

In addition, the wife’s expert submitted a separate report to rebut the husband’s expert, highlighting his errors regarding valuation of revenue, AR, equipment, depreciation, and his misuse of historical financial statements. As a result, the trial court accepted the wife’s expert value, and the husband appealed, claiming the wife’s expert failed to visit the practices, interview his staff, or view the equipment. She also misclassified his practice, comparing it to “specialty medical practices” rather than a “general physician office,” and failed to factor the debts and losses of the imaging center. His rebuttal was too late, however, and the appellate court upheld the wife’s expert evidence in full.

Conclusion.

The valuation of a business is often a difficult issue; but it is crucial for attorneys to understand the role of the business valuation expert in marital dissolution so that they can effectively counsel their clients in achieving their goals in asset distribution and financial support. To learn more how our business valuation and forensic accounting team can assist you please call our offices at 516-829-4936 (New York), 203-357-1500 (Connecticut), 973-226-4500 (New Jersey) or visit our website at www.msgcpa.com.

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The popular media have devoted countless hours to storylines that portray fraud in the workplace as an important plot device. From the early TV series Perry Mason and Arrest and Trial to the ubiquitous “ripped from the headlines” stories of the Law and Order franchise, as well as new series on cable such as White Collar, we’ve never lost our fascination for stories that involve fraud and how the perpetrator is finally caught. What compels the senior level manager, the low level employee or the longtime middle manager to ultimately risk everything, convinced that their crimes will go undetected? The characters in  popular fiction, as in the real world, are frequently motivated by financial need caused by avarice, gambling debts, business reversals, poor investments or trying to maintain a lifestyle well beyond their means. Now it seems that almost every day in the business media there are new reports on workplace fraud in all its forms. The frequency of such reports now seem to be outpacing the tv episodes that draw from the “true stories,” and underscoring that truth is stranger than fiction.

In a time of massive Ponzi schemes and burgeoning white-collar crime, one can understand why fraud is not uncommon in the business world. In fact, employee fraud costs businesses billions of dollars each year. Employee fraud is an ongoing, widespread and varied problem, one that comes in all sizes for all kinds of companies. It can significantly impact a company’s productivity and profitability. The reasons for fraud are not always obvious to the business owner or even their attorneys. However, what is obvious is that it is often overlooked, ignored, and even undetected.

The current statistics for fraud in the workplace are staggering (source: ACFE Report to the Nations):

·         The typical organization loses 5% of revenue due to occupational fraud;

·         The median loss per case was $160,000, and it took an average of 18 months for it to be uncovered;

·         Fraud is much more likely to be detected by tips, than by any other means;

·         Smaller companies are disproportionately victimized by fraud, as they usually lack a sufficient level of checks and balances;

·         Fraud is more likely to be committed by a single individual, without a prior history of fraud, who often raises a red flag because they are living beyond their means and are experiencing financial difficulties.

To better understand why these statistics are so alarming one should be familiar with the three categories of fraud; Management Fraud, Employee Fraud, and External Fraud.

Management Fraud often involves a senior management’s intentional misrepresentation of financial statements, theft or improper use of company resources. Employee Fraud involves a non-senior employee theft or improper use of company resources. Lastly, External Fraud is the theft or improper use of resources by people who are neither management, nor employees of the firm.

Indications of fraud generally fall into a few categories: Accounting Anomalies, Internal Control Symptoms, Analytical Symptoms, Lifestyle Symptoms and Behavioral Symptoms. The prevalent warning signs of fraud may include accounting record discrepancies, unusual transactions, and conflicting or missing evidential/supporting documentation. If a business has not been producing the profits it anticipated, it might be advisable to conduct a fraud audit sooner rather than later. One can draw a direct connection between unexpectedly lower revenues (or business losses) and possible patterns of fraud.

It is very important to maintain strict confidentiality regarding such matters. Some common mistakes businesses make is failing to retain counsel when fraud is uncovered or suspected, and/or not engaging the services of independent fraud investigators or a forensic team. If criminal or civil charges are pursued, an independent forensic accounting firm may be necessary.

Employee fraud is common, but not as inconsequential as the common cold. To help protect their clients, attorneys should be more cognizant of the various types of employee fraud.

To read about “The Fraud Triangle” and learn more about the forensic accounting services MSG provides, please visit our Web site at www.msgcpa.com.

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Until this past summer, the idea that YouTube might turn a substantial profit at long last may have been as improbable as Jon Stewart friending Glenn Beck on Facebook. But a federal judge’s recent ruling in YouTube’s favor in the 3-year-long copyright dispute with Viacom, the owner of such profitable brands as Paramount, Nickelodeon and Comedy Central, is a major victory in what some are calling a landmark copyright case.

The much-discussed suit revolved around Viacom’s allegations that YouTube only became the Internet’s most viewed video site by posting copyright-protected clips “stolen” from its shows. But in evoking a law that shields Internet services from claims of copyright infringement as long as the illegal content is removed,the Court noted that YouTube had removed about 100,000 videos the day after Viacom sent a mass takedown notice. If the Court in this case had agreed with Viacom, and ordered Google to pay the more than $ 1 billion in business damages the media conglomerate was seeking, the impact on YouTube’s future profitability could have been considerable.

For a media conglomerate such as Viacom, however, copyright infringement on a site that might attract well over a billion visitors a day, could translate into lost revenue from DVD sales and rentals, worldwide TV syndication, and paid online distribution of their content. When copyrighted content is readily available for free on YouTube, for example, the Court may take into account what profits, if any, would have been generated by Viacom if not for the alleged copyright infringement. But is this a case of lost profits or lost business for a media conglomerate--or perhaps both?

In considering whether a case merits a claim for either or both, one must examine the facts and circumstance early in the litigation process to analyze the appropriate theory of recovery. The final determination can directly affect the appropriate damage calculations as well as the identification of proper claimants to the litigation. In some instances, the courts have allowed both lost profits and the decrease of the market value of the subject business; however, on some occasions, the court has allowed one or the other.

Whether business damages are calculated by the financial expert as lost profits or lost business, the objective is to restore the plaintiff to the position it would have been --“but-for” the defendant’s actions that caused the damages. When calculating lost profits, damages are typically measured for a specific or limited period of time. In general, the loss is the difference between what the business would have produced during the loss period, minus what it actually did produce during this same time frame. All the business’s expenses are taken into consideration in both the “what would have happened” and “what did happen”scenarios.

Case law and statutes dictate what a plaintiff needs in order to demonstrate lost profits. It is the financial expert’s task to employ both a scientific and artistic interpretation of the facts and circumstances that will eventually tell a detailed, accurate story.

The approach to determine lost profits is multi-faceted and generally requires the following 6 steps:

1. Calculate lost earnings by comparing profit history before and after a damaging event,
2. Understand the subject company’s cost structure,
3. Examine the calculated expenses for reasonableness,
4. Determine causation (i.e. consider possible reasons for drop in sales),
5. Examine how things such as economic conditions, marketplace demands and government regulations have impacted a sales loss,
6. Present detailed information to support the assumed revenue, expense, and growth rates.

As an experienced practitioner, the steps of assessing lost profits can be simply stated; but more often than not, the process itself requires meticulous attention to detail and a sharp eye for any contradictory information. Often, one needs to step back to inquire about issues that arise during this endeavor.

Three that come to mind are as follows:

1. What influence does an immature line of business affect the overall operations of the entity?
2. How does a poor performing sector influence the results?
3. How influential should projections and forecasts that materially differ from historical results be, and how should they be utilized?

The financial expert knows that the credibility relevant to projected income—and anticipated expenses—is absolutely critical in supporting a lost profits claim. The analyst works methodically from business plans, market surveys, income projections, and other evidence of projected revenues to estimate future receipts. One may use data from industry sources, comparable companies, market data or any other source that may help in predicting accompany’s financial results. It is imperative that the expert acquires in-depth knowledge of the subject company early in the process: its products, markets and competition, and the market forces to which it is subject.

In a case when an entire business is destroyed, the analyst’s task is still to determine the lost future cash flow. But in contrast to a lost profits case, the loss is now permanent. Just as in the lost profit calculation, the expert considers all of the subject company’s expenses in the “what would have  happened” vs. “what did happen” scenarios. The fair market value of the subjectcompany is determined based on the assumption that an earningsstream will continue into perpetuity.

So when the attorney considers whether a plaintiff may recover both lost profits and lost value, I can tell you of an important exception: when a business operates for a certain amount of time and then closes as a direct result of the defendant’s behavior, thereby incurring a period of lost profits followed by lost business. In this case, the courts have found no “double-counting” of the plaintiff’s allowable recovery.

Simply summarized, how does a lost profits case differ from a lost business case? Lost profits are usually measured over a specific time period (e.g. the estimated time it will take the plaintiff to restore “normal” profits).With lost business value, profits are projected into perpetuity. A lost profits analysis views a business from the perspective of a plaintiff; a business valuation views the business from the “hypothetical buyer’s” perspective.

Drawing from the analyst’s skills in finance, accounting and economics, the financial expert—reasonable and objective-- can distill complex data into an  understandable, accessible communication that can prove invaluable to the litigation team.

This past August, Viacom filed an appeal in the U.S. Circuit Court of Appeals for the Second Circuit in New York; any decision, however, is likely several years away. Did YouTube build its business, in part, at Viacom’s expense, thus depriving the media conglomerate of significant revenue? Could YouTube have done more to keep illegal content off its site with the help of copyright detection tools it later developed after its sale to Google? Will Jon Stewart ever have Glenn Beck on his show? And could a clip still find its way on YouTube? Stay tuned. 

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In a recent meeting with some of my colleagues in the legal community, the question came up: Why is the analysis of lost profits deferred until late in the litigation process? One colleague is of the opinion that often the financial issues associated with damages will sometimes take a back seat to liability issues because attorneys will frequently tend to focus on the legal procedures and on discovery procedures. But based on my 20+ years experience in forensic accounting, business valuation and expert testimony, early involvement by the financial expert is often crucial to an effective analysis in a lost profits case—and ensures that all aspects of the lost profits case are covered.

Forensic experts are typically involved in complex commercial litigation where economic damages or lost profits are at issue. They’re also involved when a case requires forensic accounting skills such as in a fraud or embezzlement case or the value of a business is at issue such as in a shareholder dispute or marital dissolution. The forensic expert may also be called upon to explain an accounting, tax or financial issue to the judge or jury.

Forensic experts often are also hired by attorneys to provide expert testimony as litigation support consultants. The expert witness can play a variety of roles in lost profits cases including performing damage calculations to coordinating complex research and analysis and creating case strategies. To do this, the forensic expert must select an approach in the pretrial planning phase that helps develop and integrate facts and legal theories presented later in trial testimony. Involving the forensic expert early on in the litigation process helps to ensure that all the financial issues are identified and related documents obtained.

As I’ve written, forensic experts are sometimes not designated by counsel until late in the lost profits case; often at that point, the discovery process is closed and data that would have been relevant and potentially helpful to the analysis was not obtained. To some attorneys, determining lost profits in a case may seem at times to be relatively straightforward; yet opposing forensic experts can come up with vastly different numbers.

The forensic—or financial—expert may assist legal counsel in identifying the particular financial issues related to the case. The expert may also assist legal counsel in creating discovery requests, preparing for depositions of financial witnesses, or helping with trial exhibits and settlement negotiations. The expert can also help the legal team make a determination of the possible range of recovery before incurring a substantial amount of fees pursuing a claim. Involving the forensic expert early on in the process helps to ensure that all the financial issues are identified and related documents obtained.

The expert must first have a comprehensive understanding of the operations and financial dynamics of the subject company, the markets in which the company operates, and the economics of the related industry. It’s the expert’s task to gather the relevant underlying evidence, apply the appropriate methodology, and exercise professional judgment. The goal of the expert in the lost profits case is to accurately calculate the most reasonable measurement of damages that also meets the legal standard of “reasonable certainty.”

It is also the forensic expert’s responsibility to recognize that financial records provided can be inaccurate, incomplete or misleading. Applying the appropriate tests will help the expert avoid relying on any faulty or flawed records. Suffice to say, the forensic expert whose opinions are well-supported by forensic evidence can be effective in serving the case and the client.

I believe that if attorneys truly want to advance their clients’ desires to resolve business disputes early on in the process, it is important to focus as early as possible on the key issues associated with damages claims. In business litigation cases, that means an early focus on lost profits claims, because it’s those claims that tend to drive whether the case is tried or settled.

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