Financial Forensics - Thought Leadership

For Young Lawyers: Deconstructing Overhead Costs
Financial Forensics

Many damages claims may include some measure of overhead or indirect costs, and these costs may form a substantial part of the entire damages claim. However, overhead often receives less attention than it deserves.

When quantifying damages in a breach-of-contract case, two important questions need to be answered. First, is recovery of overhead costs necessary to make the non-breaching party whole? Second, if recovery is determined to be appropriate, what amount of overhead will put the non-breaching party in the same position it would have been in absent the breach? The answer to these questions requires understanding what types of costs are included in overhead and deconstructing the allocation methodology.

To read the complete article on understanding recovery and the allocation methodology in breach-of-contract cases, published by the American Bar Association, click here.

An Eye on Enforcement
Financial Forensics

There’s no rest for the weary in the world of financial fraud. Almost five years after the financial crisis, the U.S. Securities and Exchange Commission (SEC) has received more than $2.2 billion in penalties and other monetary relief associated with the conduct that led to or arose from the financial crisis.

Since 2010, more than two years after Bernie Madoff’s sons revealed to authorities their father’s multi-billion dollar Ponzi scheme, the SEC has brought more than 100 additional Ponzi scheme enforcement actions against other entities and individuals. As the financial crisis and Bernie Madoff are written into the financial history books, the SEC and other enforcement agencies such as the U.S. Department of Justice (DOJ), Public Company Accounting Oversight Board (PCAOB) and U.S. Federal Bureau of Investigations (FBI) have focused on new types of investigations aimed at protecting investors.

To read the entire article which begins on page 14 of the January-February 2013 issue of disclosures, published by the Virginia Society of Certified Public Accountants, click here.

Insurance Industry Update – Has the Dust Settled?
Financial Forensics

The insurance industry expected significant rating downgrades, impairments and insolvencies to occur in the aftermath of the 2008 economic downturn.  However, A.M. Best’s Special Report, 1969-2011 U.S. Impairment Review, released in July 2012, reflects not only a decrease in life and health impairments, but also that life and health (“L&H”) company impairments are at an all-time 50-year low.  The Report notes that the decrease in L&H impairments was largely the result of a recovering economy and improved performance of the financial markets - specifically, decreases in realized losses and increases in unrealized capital gains.

In contrast, A.M. Best released a similar study[1] in which it discussed Property & Casualty (“P&C”) company impairments, which have shown a sharp increase in 2011.  In addition to inadequate reserving and mismanagement, A.M. Best cites the impact from several natural catastrophe events in 2011 as responsible for an additional 10 points to the industry’s overall combined ratio.  Additionally, almost one-third of the 2011 impairments have the implosion of the real estate industry to thank.

While it may appear that L&H companies have largely survived the crisis, the industry is still facing challenges stemming from the depressed economy.  In particular, life and health insurers will be closely watching their investment portfolio yields.  Over time, the asset mix of an insurance company’s investment portfolio varies based on different macroeconomic factors and the ever-present need to appropriately match assets to liabilities while taking into consideration liquidity risk and duration.

Paramount in those investment decisions is the consideration of the balance between yield and risk.  The current economy makes those decisions even more challenging.  The Federal Reserve recently predicted little to no change in interest rates in the coming years[2], so alternative investment products are likely to be considered to assist the industry through the economy’s continuing down periods. Best Review[3] discussed this challenge and identified a few unlikely places where insurers may be able to find potentially higher yielding products.  For example, Mortgage Back Securities (“MBS”), thought by many to be undesirable, are back on the table.  Although the culprit for much of the trouble that occurred in 2008, new MBS products could provide less risk.  In addition, variable rate products could be a good option by providing a potential upside from rate increases with little downside risk in a market with current rates so low.

Yield is not the only factor the industry has to consider when making investment decisions.  An insurance company also has to balance the risk of an investment with an evaluation of its impact on its risk based capital (“RBC”) ratio. The RBC calculation is used to measure the amount of capital that an insurance company needs in order to support its overall business operations. The calculation weighs the risk associated with different aspects of an insurance company’s operations, including its investment portfolio, and assigns a risk factor to calculate an overall RBC ratio.

For example, A.M. Best explains a B-rated bond, normally considered speculative and subject to high credit risk, will likely provide a higher return with less impact on a company’s RBC capital needs than a similar equity investment which has greater volatility. This lesser variability occurs because of a more favorable RBC factor associated with bonds as compared to equity investments.

Whether the dust has settled is still unclear at this point.  Things appear to be improving for L&H but the number of P&C impairments raises questions
about the lingering impact of the economic downturn on that segment.  And, although L&H companies appear to have performed better than their P&C counterparts, the effect of current investment decisions may be the ultimate factor.  The impact of these decisions will take years to unfold.


Michelle Avery, CPA is an Executive Vice President and Managing Director at Veris Consulting, Inc. within the firm’s forensic accounting practice.
Michelle has extensive experience assisting clients in causation and damage assessments related to failed property/casualty and life and health
insurance companies.  Michelle is a Board member of IAIR and a member of the AICPA’s NAIC/AICPA Working Group Task Force.  Michelle can be reached at

[1] AM
Best, Best’s Special Report, 1969-2011 U.S. P/C Impairment Review, June 25,
2012:  P/C Financial Impairments Hit Near-Term Peak in 2011

ABC News “Federal Reserve Expects to Keep
Interest Rates Low Through Mid-2015”, Sept. 13, 2012

[3] AM
Best’s Best Review, September 2012, p 40

Will You Recognize Tomorrow’s Audit Report?
Financial Forensics

The audit report that we’re familiar with, the one we as accounting students had to memorize in college, is definitely changing. The changes that the AICPA’s Clarity Project will bring about will be effective as of the end of the year for audits of non-public entities. But the PCAOB’s Release No. 2011-003 may result in even more changes for public companies. Both accounting standard setters are dedicated to a more informative document and one that is recognized world-wide.

The Clarity Project

The AICPA’s Clarity Project began in 2007 with the expressed goals of:

Addressing concerns over length and complexity of standards;
Making standards easier to read, understand and implement;
Leading to enhancements in audit quality.

Additionally, the AICPA used the project as a means of achieving convergence with International Auditing and Assurance Standards Board standards. The result of the project are 47 new “AU-C” sections that, effective December 15, 2012, replace 58 AU sections. More AU-C sections are forthcoming and will be renamed to AU once the project is complete. The Journal of Accountancy noted that the most significant changes were:

A change to a consistent and more readable format for all standards;
A change in the authoritative status of the traditional generally accepted accounting standards;
Changes in standards for group audits; and
Changes in wording of the auditor’s report.

Each of the changes could be expanded upon but the focus here is on the changes to the auditor report. A new section with the required heading of “Management’s Responsibility for the Financial Statements” will expand upon the language now found in the audit opinion and address management’s responsibility for internal control “relevant to the preparation and fair presentation of the financial statements that are free from material misstatement, whether due to error or fraud.”

A second new section with the required heading of “Auditor’s Responsibility” will replace the old scope paragraph, and all reference to responsibility will be removed from the introductory paragraph. The opinion paragraph will also have a required heading (“Opinion”) but will not be otherwise changed. If necessary, a paragraph to explain an opinion other than unqualified is required with the appropriate heading –“Basis for Qualified Opinion”, etc – and the old “explanatory paragraph,” when required will be replaced by either an “emphasis of matter paragraph” or an “other matter paragraph” depending on the circumstances.

Overall, the changes to the report on non-public entities due the Clarity Project are not likely to be considered drastic with the clarifications of the responsibilities of management and auditors being the most significant change.


The deadline for comments on the PCAOB’s Release No. 2011-003 was last September. Not surprisingly, the organization received many comments as it presented significant changes to the audit report of public companies.  The changes, which were only referred to as “possible alternatives for changes” rather than something more authoritative at this point, can be summarized as follows:

• Inclusion of an Auditor’s Discussion and Analysis – The audit report would include a supplemental narrative report providing “investors and other financial statement users with a view of the audit and financial statements ‘through the auditor’s eyes.’” The “AD&A” would not provide separate assurance but would be tailorable to suit the circumstances of each audit. For example, the section could cover topics such as Audit Risk, Materiality, Difficult or Contentious Issues, etc.
• Required and Expanded Use of Emphasis Paragraphs – The currently optional emphasis paragraphs would be required to communicate matters “that the auditor is required to address as part of an audit pursuant to current auditing standards.”
• Auditor Assurance on Other Information Outside the Financial Statements – This alternative would require auditors to provide assurance on information outside of the actual financial statements and footnotes, such as MD&A, earnings releases, and non-GAAP disclosures.
• Clarification of the Standard Auditor’s Report – The audit report would be changed so as to clarify and address “what an audit represents and the related auditor responsibilities.”  The proposed alternative would resemble the new sections required by the Clarity Project of the AICPA.

While only “alternatives for change” at this point, a proposal for an actual standard is expected in 2012.   There appeared to be enough support (or lack of objection in some cases) for the alternatives presented in the release that it is almost certain the PCAOB will require some combination of the alternatives, in a future auditing standard.

The Audit Report of Tomorrow….

The audit report of nonpublic companies will be different as of the beginning of next year through mainly cosmetic changes.  Public companies will likely face more significant changes as the PCAOB responds to investors looking for more information from auditors while also trying to keep in step with international auditing standards.   Regardless of what those changes ultimately are, the audit report of the future won’t be the same.

Here to Stay: FCPA
Financial Forensics

The Foreign Corrupt Practices Act, or FCPA, has been around since 1977.  The law, however, sat largely dormant for decades, with very little enforcement from either the SEC or the DOJ until after the new millennium began.  The last five years, however, have been a different story, with the number of enforcement actions initiated by both the SEC and the DOJ accelerating rapidly.

The FCPA amended the Securities Exchange Act of 1934, though all U.S. companies, not just those registered with the SEC, are subject to its anti-bribery provisions. The FCPA essentially bans bribing foreign government officials in order to obtain or retain business, making it illegal to give anything of value in order to influence an official act or decision. The statute, however, does provide an exception for “facilitating payments” used to secure performance of a routine government action, such as obtaining licenses. This anti-bribery provision is enforced by the DOJ, but the FCPA also contains books and records provisions, which are enforced by the SEC. These accounting standards provisions contain both internal control requirements and record-keeping provisions, which are intended to prevent unrecorded assets and the disguising of bribes as otherwise legitimate transactions.

Penalties for violating the FCPA can be stiff, running into the millions for corporations and six figures for individuals, and violations can result in both criminal and civil proceedings. U.S. regulators have shown a willingness to bring actions not only against corporations, but also against individuals, even in cases where the individual’s former employer has already reached a settlement. And in the wake of allegations against Walmart, Morgan Stanley, News Corp., and other high-profile companies in 2012, the FCPA has become not only a hot enforcement item, but also a hot news item. Top domestic news outlets from The New York Times, which broke the Walmart story in April of this year, to The Wall Street Journal, CNN, The New Yorker, and The Atlantic have all given recent attention to the FCPA.

So what’s a company to do? In the end, a company’s best defense may simply be an effective FCPA compliance program. The U.S. Federal Sentencing Guidelines say as much, even noting that companies with effective compliance programs can be eligible for reduced sentencing in the face of FCPA violations. Naturally the decision to implement an FCPA compliance program should be based on an assessment of the company’s FCPA risk, which would include an evaluation of where business is conducted, the types of controls in place at foreign subsidiaries, the use of third party agents, and the type and frequency of interactions with “foreign officials.”

But for those already caught in the FCPA’s crosshairs, it is critical to be proactive. If a company becomes aware of known or suspected FCPA violations, investigation is essential. Hiring outside investigators, including lawyers and forensic accountants, is often the best approach. Retaining experienced professionals allows for a thorough investigation that generally includes a practiced and effective mitigation plan. Forensic accountants will be particularly adept at identifying potential violations of the FCPA’s books and records provisions, which can be overlooked in the investigatory phase, though they are rarely overlooked in the regulators’ penalty phase. Engaging an independent third party also sends an important message to the regulators, indicating the seriousness with which the company has addressed violations and demonstrating that those violations have been identified, vetted, and appropriately handled.

Whether setting up an FCPA compliance program or responding to FCPA allegations, staying proactive is the key. Given the uptick in enforcement and the increased attention it has received, it is clear the FCPA is not going away anytime soon.

Mandatory Audit Firm Rotation
Financial Forensics

On March 28, 2012, a subcommittee of the U.S. House of Representatives Committee on Financial Services heard testimony regarding the Public Company Accounting Oversight Board’s (PCAOB) concept release regarding mandatory audit firm rotation.  Through this concept release, which is part of a broader effort to improve auditor independence, objectivity and professional skepticism, the PCAOB seeks public comments regarding the need to limit the number of consecutive years an audit firm can audit the financial statements of a public company.

PCAOB Chairman, James Doty, testified that through the PCAOB’s inspections of registered public accounting firms each year it continues to find instances in which auditors did not apply the required independence, objectivity and professional skepticism.  In response to these concerns and in the wake of the financial crisis, in August 2011 the PCAOB issued a concept release titled Auditor Independence and Audit Firm Rotation.  The concept release encourages the public to comment on how the PCAOB can enhance auditor independence by proposing questions such as:

“Does payment by the audit client—inherent in the framework established by Congress in 1933—inevitably create, in the words of the European Commission, ‘a distortion within the system.’  Is it possible that distortion is amplified when auditors know at the outset of any new engagement that the stream of audit fees they could receive from a new client is unlimited?"

The concept release’s focus on mandatory audit firm rotation is not a novel concept, having been first proposed by regulators in the 1970s.  Most recently in 2003, at the direction of Congress, the Government Accountability Office (GAO) prepared a report titled Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation.  While the report concluded that “mandatory audit firm rotation may not be the most efficient way to enhance audit independence and audit quality,” it also determined that “it will take at least several years for the SEC and the PCAOB to gain sufficient experience with the effectiveness of the act in order to adequately evaluate whether further enhancements or revisions, including mandatory auditor rotation, may be needed to further protect the public interest and to restore investor confidence.” 

Now that almost a decade has passed since the GAO study, the PCAOB is again exploring the benefits and costs of mandatory audit firm rotation.  The reevaluation was prompted by encouragement from the PCAOB’s Investor Advisory Board and the implementation of similar standards and proposals in other international jurisdictions.  For example, the European Union is currently advancing a similar proposal which would limit engagements to six consecutive years.  As Mr. Doty stated during his testimony, “it is a fact that nations around the world are rushing to adopt mandatory rotation.” 

Proponents of mandatory auditor rotation believe that it would end an auditor’s ability to turn each new engagement into a long-term income stream and, consequently, enhance auditor independence.  As the PCAOB stated in the concept release, mandatory audit firm rotation would provide auditors with less incentive to succumb to pressure from management:

“A firm that knows at the outset that it is going to ‘lose the client’ eventually, no matter what it does, might have much less reason to compromise its independence, risking the firm's own reputation and potentially its continued viability, in order to preserve the relationship.”

Additionally, mandatory auditor rotation would allow for a fresh review of a public company’s financial reporting, providing the potential for more professional skepticism and objectivity since the new auditors are not associated with prior audits. 

 Many corporations have lobbied against mandatory auditor rotation citing increased audit costs and lower audit quality.  Studies, including the GAO’s 2003 report, found that audit costs increased by 20 percent during the first year of a new engagement.  Much of that cost is attributable to the new audit firm needing time to learn a company’s financial structure.  Additionally, certain audit firms specialize in particular industries and, consequently, public companies in those industries would lose the benefit of that specialization if the PCAOB enacted mandatory auditor rotation.

The concept release does not include proposed new auditing standards, but rather is a mechanism for the PCAOB to gauge the need for future standards.  According to Mr. Doty, “if this process results in the PCAOB proposing any rules, and I emphasize ‘if,’… any such proposed standard would be subject to further public comment and SEC approval.”  Additionally, Mr. Doty vowed that the PCAOB would perform a comprehensive analysis of the potential costs and benefits before moving forward with any proposed mandatory audit firm rotation standard; however, he warned that “many times you cannot monetize or quantify either the costs or the benefits.”  While the potential costs and benefits of mandatory audit firm rotation are uncertain, it is clear that such a standard would significantly alter the status quo for public companies and their auditors. 

To view the entire Auditor Independence and Auditor Firm Rotation concept release or follow the latest developments on mandatory auditor rotation, please visit the PCAOB’s website.

CPA Expert Witnesses: Not just for the courtroom
Financial Forensics

Litigation is a notoriously high-cost, slow-moving and uncontrollable process, so companies and individuals alike must evaluate how they manage conflict. At its core, effective conflict management should control costs while maintaining business relationships. Alternative dispute resolution (ADR) is a method that parties can use to achieve that goal, and CPAs can help.

ADR is any method of resolving conflict outside the courtroom, including arbitration and mediation.  By avoiding the court system, ADR can be more economical, private and streamlined than litigation. In fact, ADR offers the conflicting parties significant flexibility since they can often choose their preferred method of resolution, the length and complexity of the process and the designated neutral third party, among other things.

Similar to litigation, CPAs are often engaged to assist companies through ADR as expert witnesses, consultants or designated neutral third parties called arbitrators or mediators.   As expert witnesses or consultants, CPAs are engaged to assist attorneys and the ADR panel in understanding complex accounting and auditing issues, financial matters, business practices and damages assessments, among other things. 

For greater insight into the vital role a CPA can play in ADR, including case studies, you can read my full article on the topic from the May/June 2012 issue of Disclosures here.

Ex Ante or Ex Post Damage Calculation
Financial Forensics

An important consideration for forensic accounting experts is whether lost profits should be calculated using an ex ante or ex post approach.  In other words, an expert must decide whether to consider only the information available as of the date of a breach of contract or consider all known information as of the date of adjudication of the dispute.  Employing one approach versus the other can have a significant effect on the calculation and ultimately the amount of the damages.

The selection of the ex ante or ex post (or hybrid) approach will most likely depend upon the specific facts of the case and on applicable case law.  For counsel, it is imperative to understand the differences that can arise.  An experienced forensic accounting expert will have considered this issue and will be prepared to explain the basis of the selected approach to the trier of fact.

My article in AICPA’s FVS Consulting Digest (below) further illustrates this issue in the context of a hypothetical business dispute.

Battle of the Exes: Understanding the Effect of the Ex Ante and Ex Post Approaches on Damage Calculations