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Forensic Accounting and the Art of Courtroom Avoidance

By Brian Harris

By Terry Silver
 
As a forensic accountant, our accounting, tax and consulting firm is often charged with valuing companies, especially as a part of adversarial divorce actions. In a matter where we represented the non-equity spouse in a matrimonial action, it was our job to handle the forensic accounting and valuation of a midsized professional service company. The company ad "reviewed" financial statements prepared by a regional CPA firm whose reputation was considered good. This forensic accounting was undertaken to normalize adjustments in order to understand the context in which the company's books and records were kept.
 
The company employed a controller who was a CPA and a regional CPA, both with good reputations. Despite these positive indications, we were engaged to review the company books and records in detail. One step that we undertook in this forensic analysis was to visit the CPA firm?s offices to review the year-end work papers they had prepared.
 
During our visit to the firm, we were provided with annual work-paper binders, including the CPA-prepared materials on one side and information supplied to the CPA firm by the company on the other. After a review of what appeared to be normal accounting by the CPA firm, we found a multi-million dollar adjustment to accounts receivable during the month of December of that year within the company prepared records. This adjustment also reduced accounts receivable and sales in a multi-million dollar amount. After a review, we found this large and extraordinary adjustment contained in each year of the other four years in our study. 
 
Once these substantial adjustments were discovered, the company's annual net income was sizably reduced. We then asked the CPA firm?s partner about the reason for the adjustments. Several days later we were told the company expensed all receivables in excess of 30 days old as of the end of December of each year. Interestingly, in addition to this large reduction to accounts receivable and sales at the end of each year, we also found identical positive adjustments occurring in the first week of January of the following year. In essence, the receivables that were deemed uncollectible one week earlier, were restored to collectible status in the early part of the next year. A quite interesting, not to mention questionable, accounting practice.
 
From this discovery, it was clear that the company was manipulating its income by writing off receivables and restoring them at the beginning of the following year. This discovery resulted in what we can only characterize as an all out war between the litigants. 
 
After documentation of our findings to our client?s attorney, there was a meeting among several attorneys, two partners from the CPA firm who prepared the reviewed financial statements and me. Opposing counsel proceeded to accuse me of taking the position that the company perpetrated a tax fraud. I indicated that I had done no such thing. I uncovered an accounting irregularity that had reduced the company's profit each and every year during the five-year study period.  I was told, by the CPAs, that the company had adopted a basis of accounting known as the ?modified accrual basis of accounting,? although when questioned they could neither define this method, nor how the company used it.
 
Both sides of the litigation understood the sizable risk that would be taken if the company?s accounting practices reached the courtroom. Accordingly, settlement ensued swiftly. 
 
Terry Silver is a Certified Public Accountant and Certified Valuation Analyst, for Citrin Cooperman & Co., 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

Full post as published by The Legal Intelligencer Blog on July 13, 2010 (boomark / email).