Does your legal team include a forensic accountant? If not, someone may be pulling the wool over your eyes. It has nothing to do with your competence, but rather the lack of financial transparency in a company's financial statements and/or the lack of integrity of a company's management. During 2002, stories of financial chicanery, accounting restatements and scandals, and the lack of transparency in many companies' financial statements were almost a daily headline in the business news. Disclosure of each new instance of criminal allegations eroded investor confidence in corporate America's financial statements. This erosion effectuated sweeping regulatory reforms, the most significant being the Sarbanes/Oxley Act.

Last year, U.S. public companies shattered bankruptcy records for a second straight year. All told, 191 public companies with a staggering $379 billion in assets filed for bankruptcy in 2002. The wreckage included five of the 10 largest bankruptcies ever, and more startling is that three of these five bankruptcies involved accounting scandals and fraud (Adelphia Communications Corp., WorldCom Inc. and Global Crossing Ltd.). A common denominator in each of these companies were their overly complicated financial statements. A lesson learned from Enron's failure during the prior year is that overly complicated financial statements may conceal problems. If this magnitude of chicanery and fraud can occur in a highly regulated environment, imagine what can happen in privately held corporations!

Accounting Records of a Financially Troubled Company

Most financially troubled companies do not get that way overnight. The financial decline begins slowly, and then accelerates as management fails to recognize or chooses to ignore early warning signs. The following are not the only indicators of failing financial health, but they are among the most important.

• restrictions in cash flow
• ballooning accounts receivable
• growing inability to pay bills on time
• using new borrowings to pay down trade debt
• decline in sales volume not attributable to historical cycles
• departure of key personnel
• growing inventories
• curtailed credit from suppliers
• shrinking profit margins
• a need to give deep discounts to keep customers
• overdue taxes
• incomplete or chronically slow accounting and bookkeeping.

Companies in financial crisis are often in a state of chaos. Frequently, the time, attention and focus of management is not on addressing the causes of the financial distress, but rather they are consumed with putting out fires. Moving from one fire to another, management tends to ignore the company's administrative needs, such as good record-keeping. More often in a financially distressed company, you will find that less attention is given to maintaining an organized set of accounting records. When a company is financially distressed, management will tend to eliminate those positions believed to provide the least amount of return. This is generally commendable, but the mistake is made when management believes that accounting personnel are expendable. In fact, more so than any other time in the business life of an operation, during a financial crisis accounting personnel are indispensable. When management slashes its financial staff, financial transactions are not recorded on a timely basis, paperwork becomes backlogged and the company's accounting system ends up in disarray.

What Is a Forensic Accountant?

Forensic accounting (or at least, accounting expert witnessing) can be traced as far back as 1817 to a court decision.¹

Meyer v. Sefton was inter alia an inquiry to determine the value of a bankrupt's estate. Here, a witness who examined the bankrupt's accounts was allowed to testify, since from the nature of the case such an inquiry could not be made in court.²

According to The Accountant's Handbook of Fraud & Commercial Crime, a forensic accountant is defined as:

the application of financial skills and an investigative mentality to unresolved issues, conducted within the context of the rules of evidence. As a discipline, it encompasses financial expertise, fraud knowledge and a strong knowledge and understanding of business reality and the working of the legal system.

Less formal definitions of a forensic accountant would include: a financial detective with a suspicious mind, a financial bloodhound, someone with a "sixth sense" that enables reconstruction of past accounting transactions and an individual who looks beyond the numbers.

A forensic accountant's primary duty is to analyze, interpret, summarize and present complex financial and business-related issues in a manner that is both readily understandable by the layman and properly supported by evidence. In addition, a forensic accountant must also be familiar with legal concepts and procedures, including the ability to differentiate between substance and form when grappling with any issue. Further, the forensic accountant must possess not only multiple disciplines but should have the qualities of curiosity, persistence, creativity, discretion, organization, confidence and sound professional judgment. Finally, a forensic accountant is trained in dealing with disorganized or incomplete records.

How Can a Forensic Accountant Contribute to Your Legal Team?

A well-trained forensic auditor can provide the following services:

• review of financial books and records for suspicious or unusual transactions warranting further attention
• search for potential preferential payments and fraudulent transfers³
• prepare analyses of pre- and post-petition financial statements
• locate diverted funds or assets of the debtor
• identify misappropriated assets
• identify reversible insider transactions
• analyze business operations and performance
• evaluate the factors contributing to the debtor's current financial condition and future viability
• analyze business plans and financial projections to determine the feasibility of reorganization
• analyze monthly operating reports to ascertain business trends and issues warranting further investigation
• analyze, interpret, summarize and present complex financial and business-related issues in a manner that is both readily understandable and supported by pertinent data and analyses performed in accordance with procedures recognized in the profession
• prepare visual aids to support trial evidence
• analyze questionable accounting practices
• provide analyses to support motions
• provide analyses of debtor's court motions
• validate the stated reasons for the bankruptcy filing
• provide expert testimony.

One can easily identify how forensic accountants can become an integral part of counsel's legal team and the role they can play in assisting counsel in a litigation strategy.

A Forensic Bankruptcy Accountant Is Trained to Detect Bankruptcy Fraud

A forensic bankruptcy accountant is trained in detecting and identifying bankruptcy fraud. Common bankruptcy fraud schemes used in the past include:

• bustouts—retail, distributor, credit card, tax, travel agency
• corporate raider bleedouts
• "white knight" bleedouts
• parallel entities
• assignment for the Benefit of Creditor/Insider Sales
• Ponzi schemes—investment, real estate, church and ethnic
• overseas funding needing U.S. investment
• advanced fee swindle
• bogus health care plans
• sham facilities
• rent/equity skimming
• property title skimming
• failure to schedule assets
• transfer of assets pre-petition
• transfer of assets post-petition
• straw buyer/fictitious bidder
• serial filers.

In addition to understanding the various bankruptcy fraud schemes, the forensic bankruptcy accountant is well versed in the indicia of bankruptcy fraud. Some of the warning signs include, but are not limited to:

• failure to keep usual business records
• incomplete or missing books and records
• unusual depletion of assets shortly before filing
• concealment of assets
• serial bankruptcy cases
• conduct outside ordinary business or industry standard practices
• starting a similar business near the time of the bankruptcy
• fire, theft or loss just prior or after filing
• failure to pay withholding or state sales taxes
• complicated corporate structure and relationships
• creditor confusion regarding corporate structure
• a record of litigation involving breach of contract, misrepresentations, fraud
• recent departure of debtor's officers, directors, or general partners
• frequent amendments to financial schedules, statement of financial affairs and monthly operating reports
• inability to contact principals of debtor at debtor's stated location
• frequent dealings in cash
• transfer of property to shareholders, insiders and relatives shortly before filing
• payoff of loans to directors, insiders, and relatives shortly before filing
• absence of knowledgeable officers to testify at the §345 meeting
• unanswered questions or incomplete information on debtor's schedules
• inconsistencies in recent financial statements, tax returns, and debtor's schedules and statements of financial affairs
• sudden depletion of inventory post-petition without a plausible explanation
• inflated salaries, bonuses or cash withdrawals made by directors, shareholders, insiders or relatives
• transactions with non-debtor subsidiaries, parent companies or affiliated companies owned by the same related persons or entities.

Conclusion

A great litigator is also a great strategist. A litigator is always thinking of both the next move and five moves down the road, and she or he anticipates the opponent's move. The inclusion of a forensic accountant on an attorney's legal team can assist counsel in executing those moves, both offensively and defensively.

---

Footnotes

¹ Journal of Forensic Accounting, 1524-5586/Vol. II (2001), pp. 181-182. Return to article

² Meyer v. Sefton, 2 Stark, 274 (1817); see McArthur, Clarence V., "Evidence—Accountants as Experts," Canadian Bar Review, Vol. XXVI, No. 5 1948, p. 873. Return to article

³ One field office of the FBI estimates that approximately 10 percent of all bankruptcy filings involve fraud. Two-thirds of bankruptcy fraud involves criminals hiding assets like cars, boats, jewelry and cash from the bankruptcy court and creditors. Return to article