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The road to success in a business litigation matter may require support from many different resources in order to reach a favorable outcome. In addition to the important areas of legal research, case studies, interviews and client preparation, a key component is often the forensic accounting of the underlying books and records of a business. Forensic accounting is the application of financial facts to business problems presented within a legal setting. A forensic accounting specialist needs to be familiar with business information and record keeping, financial reporting systems, accounting and auditing standards, evidence gathering and investigative techniques. A full understanding of the entire litigation process is essential to providing meaningful information to counsel in business litigation.

As a case is started, the litigator should seek out a reputable forensic accounting firm and work with the expert to establish the goals and objectives. These goals and objectives will guide the process and determine what discovery procedures the forensic specialist needs to perform. Case objectives could be to gain insight into the financial condition of an entity, or to investigate all of the financial transactions and events prior to and during a triggering event. Your case may involve properly quantifying any damages as a result of an event or uncovering hidden assets and liabilities in order to determine the true value of a business interest. A forensic accountant can also be a valuable asset during the discovery process by knowing which records, documents and files to request, as well as assisting counsel in critiquing or deposing the adversary’s financial expert. The financial expert should be capable of providing credible expert testimony when needed.

There are many different types of engagements that could benefit from the utilization of a forensic accountant. The following are just a sampling of the myriad of engagements that may need a forensic accountant:

• Cases involving the misappropriation of assets, including intellectual property or theft of trade secrets.
• Disputes involving the legitimacy of financial transactions such as unreported income, diversion of income or improper expenditures and liabilities.
• Matters where there are allegations of fraud by senior management in the areas of revenue recognition or inappropriate application of accounting principles.
• The valuation of a business entity where the economic income of the business is not fully reported.
• Matrimonial matters involving hidden assets or underreported income.
• Allegations of employee embezzlement.

In almost any case, there are certain records that will be requested. The forensic accountant often will ask to review business income tax returns, financial statements, agreements/contracts, company bank statements, canceled checks, deposit tickets, general ledgers, cash receipts journals, cash disbursement journals, payroll records, vendor invoices, and loan documents, to name a few. Generally, five years worth of records are initially requested, but this is only a guideline. There may be instances where records for only one to two years are necessary. Other cases may involve tracing the flow of funds through the entire life of a company. Audited financial statements are the most reliable and provide better disclosure into the company’s operations. The footnotes to the financial statements can be as important as the numbers. Reviewed or compiled financial statements can provide valuable information as well, although the procedures performed by the company’s accountant to prepare those financial statements may be limited.

Once the records are obtained, investigation into the underlying documents begins. Areas to be explored may include any off-balance sheet accounts. An off-balance sheet account is an account where transactions are occurring, but are not being included on the books of the business. Sometimes it takes just one unexplained entry on the business’s general ledger to uncover such an account. Are there fictitious vendors on the books of the business? A thorough analysis of an approved vendors list, a comparison to employee addresses and a review of the check authorization process, may disclose fictitious expenses. Are there unexplained transactions between related parties or companies? Related party transactions are almost always an area of concern. Financial statement disclosures are helpful in determining any related entities. Information disclosed on a company’s income tax return can also help in the investigation of related parties. Analysis of the balance sheet may disclose improper accruals or the use of an exchange account. Investigation into the income statement may disclose ghost employees, padded expense reports, excessive bad debts or duplicate vendor payments. Knowing where to look, and what to look for, is key.

The forensic accountant looks at the controls in place and whether or not those controls can be overridden. Assessing the internal controls over the business checking account and underlying record keeping, often can provide insight into areas of concern for a forensic accountant.

The forensic accountant should be able to observe and explain significant trends in the financial information. Changes in year-end classifications could be important, as can inconsistencies in line item posting of revenues and expenses. A close examination of year-end journal entries may show where questionable transactions get posted and then reclassified. A year over year change in balance sheet items could prove to be very telling, as can a comparison of financial statements to income tax returns for consistency. Comparing the business’s operations to the industry may disclose irregularities. A forensic accountant should have access to industry analysis, peer group databases and benchmarking capabilities. Investigation and analysis of all of the business records and documents requires experience in order to read between the lines and see behind the numbers.

Bringing an experienced forensic accounting firm to the table from the beginning, is an extremely valuable resource as you go through the steps of the litigation process. The information they derive through their investigation may make all the difference in your case.

Terry Simonds is a Partner in the Litigation and Valuation Services Department at Amper, Politziner & Mattia, LLP She specializes in forensic accounting and business valuations, and she can be reached at (908) 218-5002 or via e-mail at simonds@amper.com.