The Legal Intelligencer Blog

Red Flags in the Analysis of Balance Sheets – Inventory

By Colleen S. Vallen
Special to the Legal

In recent blogs, I have been discussing red flags in financial data. Red flags are circumstances unusual in nature or deviations from customary activity. In this blog, I want to focus on one specific balance sheet item: the current asset inventory. For manufacturing and merchandising firms, inventory can be a significant balance sheet item.

Defining Inventory

In order to discuss the red flags related to inventory, it is important to understand what inventory is and how it relates to the financial statements of a business. Inventory represents goods produced or purchased for the purpose of resale. In a manufacturing situation, inventory can include raw materials, work-in-process and finished goods. Inventory in simplest terms is product a business owns but has not sold. Inventory is carried on the balance sheet at cost and is considered a current asset because it is expected to be sold in the relatively near future.

Components of Inventory

The two key components of inventory are quantity and price. While these seem to be simple concepts, the nature of inventory can cause quantity and price to be confusing. The inventory process involves purchases and sales over time. In addition, for many businesses, transfer of inventory between locations is also a regular occurrence. Depending on the accounting procedures a business utilizes, determining the goods on hand at any point in time may involve a number of procedures. For example, some companies do not track inventory movement on a transaction-by-transaction basis, but perform physical counts of inventory periodically to obtain that information.

In addition, the cost of inventory has its own complexities. Costs fluctuate over time. Further, tracking of costs, as with quantity, may not be done on a transaction-by-transaction basis, but may involve the use of accounting procedures.

Finally, inventory is connected to the balance sheet as well as the income statement. Merchandise prior to being sold is reported as inventory; however, when merchandise is sold, the cost of the items sold is reported on the income statement as “cost of goods sold.”

As a result, analyzing red flags related to inventory involves two general areas: theft of inventory and financial statement fraud involving the inventory account.

Theft of Inventory

Theft of inventory is more often than not done by an employee or group of employees and involves actual physical loss of inventory. Inventory is taken for personal use or for resale. For most businesses, the loss of inventory by employee theft is the largest component of inventory shrinkage. Inventory shrinkage includes physical loss of inventory related to a variety of events, including theft, bookkeeping errors and damage.

Examples of red flags related to inventory theft include unexplained inventory variances, missing documentation, particularly related to the receiving and shipping processes, unexplained credits and write-offs to inventory.

Those who want to defraud a company via theft of inventory often use more than one scheme when manipulating inventory. For example, they create fictitious purchase orders, alter inventory physical counts and use journal entries to artificially inflate the inventory account.

Overstatement of Inventory

Overstatement of inventory is a common financial statement fraud. To illustrate this concept, consider the income statement equation. The income statement provides information on a business’ profitability. The formula: Revenues minus expenses equals net profit or net loss. In a simple world, if expenses are lower, profitability is improved. Inventory is connected to the expense (i.e., cost of goods sold). When inventory is sold, the corresponding cost is taken as an expense on the income statement. Therefore, when ending inventory is overstated, the costs for the period are understated and result in reporting higher profit. Conversely, at times, companies may understate inventory, as there are motivations to show lower profit in a particular period.

Red flags to consider include inventory values that do not change or minimally change from period to period and gross profit percentages that remain consistent period to period.

To better understand inventory, consider comparing the inventory and cost of goods sold accounts from period to period to help identify areas of potential concern and areas that need to be considered in more detail. In addition, using ratio analysis can also help identify trends and patterns as well as variances that should be questioned and discussed.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents, as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at cvallen@citrincooperman.com or 215-545-4800.

 

Understanding Your Business’ Financial Statements Is the First Step Toward Preventing Fraud

By David A. Anderson
Special to the Legal

Many of my recent forensic and litigation engagements have arisen when business owners (including legal and other professional firms) suddenly learned that trusted individuals within their businesses had perpetrated a fraud upon the business. Most of these business owners had received regular monthly or quarterly financial statements for the business but had failed to read and understand them. Had they done so, they could have caught the fraud earlier or prevented it altogether.

Why does this happen? My experience reveals that most of these business owners had minimal knowledge and understanding of their business’ financial statements, and instead relied upon another owner/partner or trusted employee to handle all of the business’ financial matters. In each case, a careful analysis of the financial statements would have identified that something was wrong. Furthermore, when the economy was booming (as in the early to mid-2000s) and/or the company was growing, the fraud could be more easily hidden. However, when revenues and cash collection slowed down, it became more difficult to hide the fraud.

Let’s look at two examples.

Financial Fraud: Destroyed Cash Sales Invoices and Pocketed Cash

In one instance, the trusted employee in a business that generated a significant amount of cash sales destroyed cash sales invoices (so they were never entered into the accounting system) and pocketed the cash. In addition, at the end of each quarter (when he produced financial statements for the owners), the trusted employee made a large journal entry to increase the cash account balance so it appeared as if the business had more cash than it did. If the business owners had understood the quarterly financial statements, they would have noticed that: (1) the gross margin on sales had begun to decline significantly even though neither selling prices nor purchase prices had changed (because sales costs were entered into the accounting system, but the corresponding sales were not); and (2) the accounts payable balance kept growing significantly (because there was insufficient cash to pay the bills). Also, if any of the business owners had reviewed the monthly bank statements, they would have noticed that the cash balance shown on the bank statements was significantly lower than that shown in the financial statements.

Financial Fraud: Cash Distributions Without Informing Partners

In another instance, one business partner took significant cash distributions from the business without informing his other business partners. Because this business partner controlled the financial matters of the firm, he was able to mask these cash distributions by recording the distributions as increased operating expenses of the firm. If the other business partners had read and understood the financial statements, they would have noted that certain expense balances were much higher than expected, and they would have raised the issue with the financial management partner. (For example, more than $25,000 in office supply purchases in one month for this 10-person company or more than $20,000 in travel expenses in a month when no one in the company had traveled out of town.)

Business owners who regularly read and understand their business’ financial statements can identify warning signs in those statements and stop or prevent fraud from occurring.

David A. Anderson is a director in the valuation and forensic services group of Citrin Cooperman, an accounting, tax and business-consulting firm in Philadelphia. He has more than 30 years’ combined experience in public accounting and consulting as well as service at the CFO and COO levels in private and public companies. He specializes in fraud detection and prevention, business valuations, insolvency and reorganization and litigation support, including commercial and matrimonial litigation. He can be reached at danderson@citrincooperman.com or 215-545-4800.

 

Common Mistakes in Valuing a Business

By Terry Silver
Special to the Legal

In the past, I have written about business valuation matters such as types of engagements and reports, assessment of risk, the management interview and where business valuation meets forensic accounting. However, when discussing this topic, I would be remiss not to share the common mistakes that are often made during this process.

Expert Selection: Once there is a decision to value a business, the valuation analyst selection process begins. How do you know if your expert is in fact an expert? The first mistake is the selection of an unqualified valuation analyst. The first acid test is credentials, including:

• Accredited in Business Valuation, ABV, issued by the AICPA
• Certified Valuation Analyst, CVA, issued by the NACVA
• Accredited Senior Appraiser, ASA, issued by the ASA
• Chartered Financial Analyst, CFA, issued by the CFA Institute

Once a properly credentialed valuation analyst is identified, the analysis of his or her judgment, which comes from experience and prior involvement in the litigation process, will narrow the field of selection.

Standard of Value: Every valuation must represent the standard of value utilized. Typically, the standard of value is either fair-market value, fair value or investment value. A common valuation mistake is mismatching the purpose of the valuation to the standard of value used. Various reasons to value a company include mergers and acquisitions, family gifting, divorce, shareholder oppression, shareholder dissent, damages, bankruptcy, shareholder agreements and financial statement purposes. Having the knowledge to properly match the reason for the valuation to the appropriate standard of value is key to establishing a credible conclusion of value.

Risk: Generally, the valuation discount rate is equivalent to risk. We comprehend risk more easily in public markets. For example, in municipal markets, would we consider a bond issued by Harrisburg, Pa., equal to the risk of a New York City bond? The valuation analyst is truly an assessor of risk. The level of risk dictates the rate of return. Mistakes in the calculation of the discount rate are common, but admittedly, sometimes subjective. Misstating the discount rate can make a significant change in the value conclusion.

Discount Rate vs. Capitalization Rate: Confusing the discount rate with the capitalization rate is a common error. While the discount rate is developed via the identification and quantification of various risk components, the capitalization rate adjusts the discount rate for a growth factor. In order to convert a discount rate into a capitalization rate, we must subtract growth because the discount rate is designed to be applied to future income streams. The discount rate is used in the discounted cash flow method, which assumes growth, while the capitalization rate is used in the single-period capitalization of income method, since no growth is assumed.

Normalization Adjustments: Another valuation error is accepting financial statements/tax returns without questioning the need for normalization adjustments. For example, in privately owned companies, certain expenses may not be representative of market value, including owner compensation, owner perquisites, rents paid to related parties, etc. Normalization adjustments may also be necessary to adjust tax-motivated accounting methods, non-recurring income or expenses, unusual litigation costs or settlements.

These five common valuation mistakes are by no means all-inclusive. In my future blog posting, I will elaborate on other commn valuation mistakes.

Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at tsilver@citrincooperman.com or 215-545-4800.

Red Flags in the Analysis of Balance Sheets

By Colleen S. Vallen
Special to the Legal

A financial statement is a record of the financial activities of a business. Attorneys often find themselves in situations that require them to be able to ask questions about, discuss and explain financial statements.

Financial statements typically include the income statement, balance sheet, statement of cash flows and statement of retained earnings. In a previous post, I discussed examples of red flags that can be identified on an income statement . In this post, I focus on sample red flags that can be identified on the balance sheet.

Red flags are circumstances that are unusual in nature or deviate from customary activity. Being able to identify and understand red flags allows the attorney to ask questions about the situation. Some red flags will have an explanation, while others may be indicative of a business problem such as mistakes, errors or omissions in the financial data or, in some cases, fraud. The information obtained from asking questions can provide valuable data about the business.

The balance sheet provides information about a business’ assets, liabilities and shareholders’ equity. The balance sheet reflects a specific point in time. Comparing balance sheets for multiple periods and analyzing the overall changes as well as account-specific changes can identify red flags. Unexpected or unusual changes in the balance sheets need to be further analyzed. Below, I discuss the balance sheet item – accounts receivable – and the questions that should be considered when unexpected or unusual changes in this account have been identified.

Accounts receivable is found on the balance sheet under current assets. From a business perspective, accounts receivable should ultimately be converted to cash as part of the business’ normal operations.

Accounts receivable is money a business is owed by its customers (i.e., goods and/or services were provided by the business, but the business has not yet been paid). When evaluating accounts receivable, you should consider changes between periods as well as the relationship between accounts receivable and sales. One specific red flag to be aware of is a large upward change in accounts receivable. Areas for questioning include:

• What is driving the change in receivable?
• Is there a valid reason for the increase or could it be an indicator of a business problem?
• Does the business age its receivables – categorizing receivables by how long they have been outstanding? If an aging is prepared, are the receivables in the older categories growing?
• What is the business’ credit policy and how does the policy relate to what is actually happening with the accounts receivable?
• What is the business’s write off policy for uncollectible accounts receivable?
• Are write-offs increasing?

The analysis of accounts receivable can identify cash-collection issues that can significantly impact a business. The inability to turn the sale of goods or provision of services into cash can inhibit a business’ ability to pay its bills, to fund growth, etc. In addition, changes in accounts receivable can be a red flag of fraudulent activity, including embezzlement and fraudulent financial reporting schemes.

When analyzing the balance sheet across multiple periods, identify trends and changes in performance not just for the accounts receivable, but for all accounts. It is also helpful to consider balance sheet red flags with other financial data analysis such as income statement red flags. Use this analysis to ask questions about the business’ performance and how these changes will impact it. Having the knowledge to decipher changes to financial performance will provide the attorney with a better understanding of where the business has been and where it is going, as well as highlighting potential financial problems that need to be considered.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents, as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at cvallen@citrincooperman.com or 215-545-4800.

 

Business Valuation: The Management Interview

By Terry Silver 
Special to the Legal

At the appropriate stage in the business valuation process, an interview of company management is necessary, and required by business valuation standards. The interview should be scheduled at the point when the valuation analyst has received and analyzed sufficient company data to render the interview most meaningful, and should be conducted on the company premises.

The inception of the business valuation process involves the procurement of specific company documents such as financial statements, income tax returns, entity formation and governance documents, etc., referenced collectively as discovery. Once there has been adequate discovery production, the valuation analyst should record and trend relevant data, and become familiar with the company being valued and its specific industry. It is only after adequate preparation that the valuation analyst is ready to meet and interview company management and owners. I recommend having an additional person to record the responses of the interviewee, if possible.

In preparation for the management interview, the valuation analyst will usually begin with a questionnaire containing typical business valuation inquiries, after having made modifications relevant to the specific company being valued. When I create a questionnaire to conduct a management interview, I am mindful of whether the interviewee will be cooperative or combative, and structure and pose my questions accordingly. Even with a recalcitrant interviewee I usually achieve my desired results via:

•  An explanation of what I am doing and why.
•  Keeping my questions on point.
• Consistently maintaining a professional, but firm demeanor.
• Setting a realistic time span for the interview.
•  Being respectful of the interviewee and the time he/she is devoting to the process.
•  Not allowing myself to be deterred from the process.

As in any interview, my questions must be open-ended to solicit a full response. Questions that yield “yes” or “no” responses should generally be avoided. In my experience, questions that solicit responses that can lead to unscripted questions represent opportunities to gain important information. Scripted questions will yield valuable information, but being better prepared allows the valuation analyst to contemporaneously move off script. It is the new and additional follow-up questions that usually provide a deeper insight into the company, its industry, its management and its overall condition.

The questions posed should be meaningful for the process; making insignificant inquiries will lead to a breakdown in the interview. Questions not adequately answered must be asked again, either in the same form or restated. An interviewee who is disposed to be uncooperative will attempt to avoid making meaningful responses. In my experience, many interviewees will eventually respond to an interviewer using a very persistent approach.

The management interview for a business valuation begins as a science and maintains many scientific aspects, although the ability of an interviewer to be patient and react to ongoing events represents the art of the interview.

Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at tsilver@citrincooperman.com or 215-545-4800.

The Impact of Different Conventions for Projecting Future Damages, Part II

By David A. Anderson
Special to the Legal

The valuation of damages is designed to put the harmed party back into the same economic position that would have existed if the harm had not occurred. The most difficult part of that equation is to project the economic conditions one would have expected without the harm. An analysis of historical results is often used to assist in making that forecast. In my last blog post, I discussed the pros and cons of four of the most commonly used methods to analyze a series of events, namely the mean, the median, exponential smoothing and regression analysis. This post will present two examples and show how each method impacts the damages calculation under each.

Example: Projecting Damages From Theft of Customer Lists – Upward Trend

Hypothetical ABC Co. is a distributor of household cleaning products to small retail stores. Although sales and profits fell during the beginning of the financial crisis in 2007, since then both have steadily increased. At the beginning of 2011, the national sales manager left ABC and took with him all of the contact information for ABC’s customers. He then went to work at a competitor and ABC experienced a drop in sales and profits. ABC has sued to recover damages from 2011 for lost profits caused by this theft of customer lists. Net profits from 2007 through 2011 were:

Year	2007	2008	2009	2010	2011
Net Profit	($50,000)	($5,000)	$35,000	$100,000	$5,000

Let’s apply each of the four methods to project what 2011 profits would have been but for the theft of customer lists:

• Mean – the average of 2007 to 2010 profits is $20,000 (the sum of the four year’s profits divided by four).
• Median – there are two midpoints – ($5,000) and $35,000 – so the median would be the point halfway between the two or $15,000.
• Exponential smoothing – applying weights to each of the four years (1 for 2007, 2 for 2008, and so on) and then dividing the total by 10 – the sum of the weights – yields a projection of $44,500.
• Regression analysis – there is a clear upward trend that would imply that 2011 profits should be higher than previous year’s profits. Regression analysis yields a projection of $142,500.

In this example, regression analysis not only yields the highest projected value, but it supports the fact that profits had been steadily increasing over each of the past several years.

Example: Projecting Damages From Theft of Customer Lists – Fluctuating Levels of Profits

Using the same facts as in the first example, suppose that profits were fluctuating up and down over the past few years:

Year	2007	2008	2009	2010	2011
Net Profit	($10,000)	$60,000	($85,000)	$50,000	$5,000

Applying each of the four methods to calculate damages for 2011 provides the following results:

• Mean – the average of 2007 to 2010 profits is $3,750.
• Median – the median would be the point halfway between ($10,000) and $50,000 or 20,000.
• Exponential smoothing – yields a projection of $5,500.
• Regression analysis – yields a projection of $12,500.

In this example, the median yields the highest value. Because there is no clear trend of growth or decline and a wide range of swings in value, the mean may be the most supportable of the values.

The above calculations are made in a vacuum and clearly there is not enough information in the fact patterns to suggest the best option in each case. The illustrations do highlight some of the mechanics behind the damages calculation, and the impact of using different conventions.

David A. Anderson is a director in the valuation and forensic services group of Citrin Cooperman, an accounting, tax and business-consulting firm in Philadelphia. He has more than 30 years’ combined experience in public accounting and consulting as well as service at the CFO and COO levels in private and public companies. He specializes in fraud detection and prevention, business valuations, insolvency and reorganization and litigation support including commercial and matrimonial litigation. He can be reached at danderson@citrincooperman.com or 215-545-4800.

Filing Your Business Insurance Claim in the Wake of Sandy

By Colleen S. Vallen
Special to the Legal

The past few days have been tremendously heartbreaking and overwhelming for the Northeast region. As we transition from storm to cleanup, it is clear that Hurricane Sandy has caused unprecedented damage and destruction throughout the area. My thoughts are with all those who have been affected. The road to recovery can be challenging and I want to provide some thoughts on ways to make things a little smoother for businesses that experienced a loss.

For many businesses, this will involve filing an insurance claim for property damage, extra expense and business interruption. Many businesses have obtained business interruption and extra expense insurance in addition to their commercial property coverage. In general terms, business interruption insurance protects against losses that occur because of a shutdown of a business as a result of a specific event. Extra expense coverage can provide reimbursement for additional expenditures that are incurred as a result of the event.

Understanding the insurance process will help the insured to facilitate an effective course of action. An important element in the process is to understand the insurance carrier’s expectations. A key expectation in the process relates to documentation. As the ability to generate and maintain information has grown, insurer expectations related to the level of documentation provided to support a claim have also increased. Further, the level of review of a claim has increased as the insurance market has expanded. As a result, gathering supporting documentation is an important element of claim submission.

During these early days, business owners will be pulled in many different directions. Dealing with the event plus normal business issues can be a significant challenge. However, there are some things that a business can focus on, related to documentation, that will facilitate the claim submission process. First, re-familiarize yourself with your policy. This will provide you with important information about your coverage.

Second, keep documentation, financial and correspondence, related to Hurricane Sandy separate from other documentation. On the financial side, consider setting up specific accounts in the accounting system or separate files to track these expenditures. Documents that will likely be important include, but are not limited to, financial statements, budgets/forecasts, purchase orders and invoices, general and subsidiary ledgers, correspondence and key contracts among other data. The insurance carrier will most likely require financial data both pre- and post-event in order to analyze and evaluate the business’ performance before and after the event.

Third, identify key business indicators (i.e., what drives your business) and monitor them. Make sure to track particular Hurricane Sandy-related events. For example, if you have specific customer complaints or cancellations related to Hurricane Sandy and its aftermath you want to identify and segregate these events.

In order to effectively do the above, consider identifying a team to handle the claim. Evaluate your resources – internal and external (consultants, brokers, etc.). Communication and planning among these resources will facilitate the submission of the claim as well as interactions with the insurance carrier.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at cvallen@citrincooperman.com or 215-545-4800.

 

Employee Theft of Cash – Limiting the Exposure

By B.J. Hoffman
Special to the Legal

Last week, I ordered my usual lunch at a popular restaurant chain – a salad and drink. The total charge, $9.27, was the same price as it has always been. I handed the cashier a $10 bill and received 73 cents in change, without a receipt. The cashier hadn’t bothered to ring up the sale, however. A small pile of change was sitting behind the register. These are telltale signs of a retail cash skimming theft. It also marked the third time that I had witnessed the same scheme at that restaurant.

Employee theft of cash presents a major problem for companies with significant volumes of currency transactions. Retailers and food service providers are the typical industries susceptible to cash skimming, but other enterprises also commonly collect cash; medical practices, for instance, charge co-payments to patients and tend to accumulate currency. Though the dollar magnitude of individual cash-skimming cases is usually lower than other frauds, the frequency of such schemes tends to cause losses that become material. In today’s economy, with company profit margins under pressure, losses from employee theft present a cost that enterprises are bearing unnecessarily.

The theft of cash by employees can either occur before funds have entered a company’s accounting system (skimming), or after, (larceny). Exposure to both types of theft can be limited by the adoption of an effective internal control system.

Pure larceny can be quickly detected by a company through the adoption of basic internal controls. For instance, the matching of daily cash register sale report totals with the cash collected from the register can identify the pocketing of funds by an employee, assuming that the original register sale was properly rung up. Reconciling overall company daily recorded sales with the ultimate deposit of cash in bank accounts also tends to quickly identify cash discrepancies. Such tasks, when regularly performed by company personnel independent of the cash register and bank deposit function, tend to increase the perception of detection among potential thieves, dissuading the scheme from ever occurring.

Skimming is a more challenging fraud to detect, because the company never has evidence of the original sale, and accordingly would not know that cash is missing. When a lunch is not rung up at a cash register, there is no ability for a company to match bank deposits with reported daily cash register sales. Accordingly, it becomes vital for the company to ensure that all sales are initially recorded. A particularly effective way to compel cashiers to record sales is through the posting of signs indicating “your purchase today is free if you do not receive a receipt.”

Other cash-skimming schemes involve voided sales, or fictitious refunds of merchandise. Cashiers may initially record a sale properly, but then subsequently void the sale, pocketing the cash. When cashiers have the ability to issue cash refunds to customers for items returned, there exists an opportunity for a dishonest employee to again pocket the refund.

A key defense against these skimming frauds is timely financial ratio analysis of transactions on a cashier-by-cashier basis. Does one particular cashier have a significantly higher rate of voided sales than his or her peers? Or, perhaps, consistently lower overall sales? If so, additional scrutiny of the cashier might be warranted. Similarly, if a particular cashier is associated with an inordinately high rate of product returns and related refunds, company management should investigate the anomaly. In a retail environment, legitimate returns should be associated with a corresponding increase in inventory (clothing, for instance). Missing product inventory could be a sign that product returns as recorded on a cash register were indeed fictitious.

Some of the best defenses against cashier theft are the implementation of thorough background checks at the time employees are hired. Unfortunately, though, employees caught stealing are often merely terminated, allowing the fraudster to move on to the next unsuspecting employer. Physical surveillance measures can also be effective deterrents to cash-skimming schemes. In short, companies need to closely monitor cashiers and those handling currency in order to deter theft.

As for the cashier who failed to ring up my lunch, I notified the manager, who proceeded to shut the cash register down in order to perform a surprise cash count. The count revealed significantly more money in the cash register than there should have been (a result of the money collected by the cashier that had not been rung up as sales). The pile of coins behind the register was the employee’s method of keeping track of the number of unreported sales, so that she would know the correct amount of funds to later steal from the register. She was promptly terminated by the restaurant.

B.J. Hoffman is a certified public accountant and certified fraud examiner for Citrin Cooperman, an accounting, tax and business consulting firm. He is a partner in the Philadelphia office. Hoffman provides clients with a mix of audit, tax and litigation support services. He often works with closely held entities in a variety of industries, including professional service firms and real estate enterprises. He can be reached at bjhoffman@citrincooperman.com or 215-545-4800.

 

Red Flags in the Analysis of Income Statements

By Colleen S. Vallen
Special to the Legal

Financial analysis is a complex and broad topic, so much so that books have been written solely on the subject. In this post, I highlight sample red flags that can be identified on an income statement. Attorneys often don’t need to understand all of the issues or answers when it comes to financial analysis of income statements; rather, they need to know how to identify red flags and what questions can be used to obtain additional information.

Red flags highlight potential areas of concern. Asking the right questions will provide valuable information about a business. Some red flags will be readily explained, while others may be indicative of business problems including the potential for errors, omissions and fraud. Developing the ability to know when to ask questions is an important skill when working with financial data.

The financial data of a business includes the financial statements (i.e., balance sheet, income statement, statement of cash flows and statement of owner’s equity). In addition, transaction-level data will be maintained in subsidiary ledgers and journals. The income statement shows the operational results of a business (i.e., the revenues, expenses and profits of a business).

One of the primary categories of the income statement is revenue. Comparing the revenue for multiple periods and analyzing the changes in those revenue figures provides information about a business’ growth. A red flag identified through this analysis is a declining revenue trend. If a business has a declining revenue trend, questions you may want to investigate include:

• What caused the declining revenue?

• Is there a valid reason for the decline (i.e., loss of a product line) or could it be an indicator of other problems?

• Does the business have a plan to address the revenue decline?

• Will the business be able to pay its bills?

• Is the business viable?

Another red flag related to the income statement is unexplained business performance, which can exist with revenues, expenses or profits that are outside the norm. When looking for unexpected performance, consider changes from prior periods, deviations from budget and performance out of sync with the business’ market and/or industry. For example, if the business’ revenues for the last several years were relatively flat (i.e., minimal or no growth) and in the current year there is significant growth, questions you may want to ask include:

• What caused the increased revenue growth?

• Is the growth sustainable or is this a one-time event?

• Why did the business have relatively flat growth historically?

Finally, large, unusual or nonrecurring items on the income statement are a red flag. Comparing the income statements of a business for multiple periods will assist in identifying these types of items. Crucial questions to ask include:

• What occurred?

• How did and will the event impact the overall performance of the business?

For example, a company may sell off a division that can have a positive impact on the profits in the current year, but in the long term it may or may not be beneficial.

When analyzing financial data, identify trends and changes in performance and ask questions about your findings to further understand what these trends and changes mean to a business. The goal is to learn about the business and how these trends and changes will impact it now and in the future.

Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at cvallen@citrincooperman.com or 215-545-4800.

The Impact of Different Conventions for Projecting Future Damages, Part I

By David A. Anderson
Special to the Legal

When calculating damages for future periods – such as for lost profits, loss of income in wrongful death cases, etc. – experts are often charged with expressing an opinion as to what would happen in the future but for the wrongful act. These projections typically rely upon either industry trends or on the historical operating results of the injured party. Four of the most commonly used projection conventions when relying upon the operating results of the injured party are: the mean, the median, exponential smoothing and regression analysis. This blog post will define each of these conventions and discuss the pros and cons of each.

The Mean

The mean describes the central tendency of a set of numbers and is calculated as the arithmetic average. When there is only a limited amount of historical data available and no clear trend of growth or decline exists, relying upon the mean may be the most reliable method to project future periods. However, if more historical data is available and/or there is a clear trend of growth or decline shown in the historical data of the injured party, then using the mean will render projections that are less reliable or indicative of the future than other projection conventions and will be difficult for the expert to defend.

The Median

The median also represents the central tendency of a set of numbers, but in this convention it is calculated by reference to the middle number after the set of numbers are arranged from highest to lowest in value. Because the inclusion of extreme outlying values (e.g., if the historical data is 5, 6, 8, 9, 40) can render distorted projections, relying upon the median may be the most reliable convention to project future periods. However, once again when there is a clear trend of growth or decline, using the median will produce projections that are less reliable than exponential smoothing or regression analysis.

Exponential Smoothing

The mean and the median conventions treat each observation equally. The exponential smoothing convention (also known as weighted averaging) assumes that the oldest observation should receive the least weight and the most recent observation should command the most weight in projecting future performance. It applies a weighting factor to each historical observation and then calculates an arithmetic average of the weighted historical observations. For example:

 

 

 

 

Use of exponential smoothing can be particularly effective if sufficient historical data exists and there are no extreme outlying values.

Regression Analysis

Regression analysis uses mathematical calculations to fit a line or curve to a set of historical numbers. The more common form of regression analysis used to project future periods is known as trend-based regression analysis or least squares analysis. This methodology seeks to fit a straight line to a set of historical numbers and then project future periods along that line. Like exponential smoothing, regression analysis can be particularly effective if sufficient historical data exists and if there are no extreme outlying values.

When calculating future damages based upon historical information, experts may rely upon a variety of conventions and projection methods. This post has discussed four of the most commonly used conventions – the mean, the median, exponential smoothing and regression analysis. In the next part, I’ll provide specific examples and show how each method impacts the damages calculation under each example.

David A. Anderson is a director in the valuation and forensic services group of Citrin Cooperman, an accounting, tax and business-consulting firm in Philadelphia. He has more than 30 years’ combined experience in public accounting and consulting as well as service at the CFO and COO levels in private and public companies. He specializes in fraud detection and prevention, business valuations, insolvency and reorganization and litigation support including commercial and matrimonial litigation. He can be reached at danderson@citrincooperman.com or 215-545-4800.