April 27, 2007 The Business Edge PRINT

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1 Page 1 of 6 April 27, 2007 The Business Edge PRINT Thinking Outside the Accountant s Box Kenneth R. Neumann, CPA, CFE Traditional accountants tend to think in debits and credits, relying on the basic double entry bookkeeping system that has been around for years. They are accustomed to disbursement journals, payroll registers, and general ledger entries, and can prepare a trial balance, which ultimately provides the basis of financial statements. When reporting on a company s performance, traditional accountants work with the hard, salient facts found in the financial statements to develop a report card on the company s financial performance. This report card, and the financial systems that support it, encompass the contents of what I call the Accountant s Box. Forensic accountants, on the other hand, are trained to think outside the Accountant s Box. While the information still provides the foundation for their work, forensic accountants look beyond traditional source documents and explore peripheral and operational connections to determine economic truths that may not be readily apparent through analysis of information found within the Accountant s Box. Why Forensic Accountants Need to Think Outside the Box In the traditional accounting role, we use the Accountant s Box (Box) to provide answers to questions: What happened? What were sales in each of the last five years? How were expansion activities funded? What profits were generated from each business segment? These questions provide the typical historical perspective of operations for accountants. However, for a forensic accountant, the questions change. What was the cost to operations after losing the use of a key piece of equipment? Is there a causal relationship between specific increased costs and certain events? These questions still relate to historical activities, but seek answers to very focused issues. The questions are sometimes so specific that the information needed may not be detailed in records routinely used by the accounting department. This means the forensic accountant must search outside the Box for support. This is not to say that the traditional accounting records should be ignored. Forensic accountants use information from within the Box to

2 Page 2 of 6 answer many questions: Where did the cash go? How was the internal system of controls circumvented? How did the financial results change after the contract was cancelled? But the forensic accountant is also asked to answer hypothetical questions: What would have happened to sales but for certain events? What will likely happen to profits because of this action? Answers to these questions are not going to be found in the historic records and the forensic accountant will have to go outside the Box and sometimes even outside the company itself to find the answers. What Does Looking Outside the Box Really Mean? A company s source records and internal financial reports provide a vast resource for historical financial activity and are relevant to the forensic accountant for discovering hidden assets or identifying fraudulent financial activities. However, these records are only a starting point for the kind of what if questions that need to be considered when performing economic damage analyses. Armed with an understanding of the company s operations, its internal accounting systems and associated reports and data, the forensic accountant can often uncover documents, reports and data systems dealing with significant factors considered critical by management. Much of this operational information is found within the traditional financial systems inside the Box but is only readily available from sources outside the Box. For example, an accounting system for the revenue cycle will usually include a sales journal summarized in the general ledger and, ultimately, in the income statement. There will also be reports summarizing sales by state that may be sent to the tax accountant for purposes of filing state tax returns. This is all information that is in the Box. But some of the information captured in the accounting system, such as zip codes, may end up only in detailed sales reports used by the sales department for assessing regional market penetration, thereby falling outside the Box. Additionally, there are often parallel and concurrent non-financial systems created for one purpose only: management of the business. A contact management system would fall into this category. The forensic accounting team will also consider the relevance and reliability of the information that falls outside the Box based on questions and answers presented to it. Depending on the significance of the information, the team may consider the source of information and the testing it was subjected to, or it may consider performing independent tests against known data.

Connecting the Dots A frequently overlooked benefit of forensic accountants is that they help connect the dots of cause and effect.

3 Page 3 of 6 Diagram A illustrates this concept. Each business cycle generates information both inside and outside the Box. By understanding the business, its operational systems and the fact patterns at issue, the forensic accountant can usually identify numerous sources of pertinent information. Connecting the Dots A frequently overlooked benefit of forensic accountants is that they help connect the dots of cause and effect. There are many forces that impact the operations of a business; forensic accountants can often assess the strength of the connection between the investigated event and the subsequent changes in financial performance. In performing this analysis, the forensic accountant will look outside the Box and ask, Are there other explanations for the change? Consider the company that experiences sharply dropping sales and ends up in liquidation. The owner blames the business loss on a neck injury. The injury resulted from an accident, and there were numerous documented trips to a chiropractor in an effort to alleviate pain. The

4 Page 4 of 6 owner claimed the pain rendered him ineffective in running his business. Charting actual sales before and after the accident appeared to support the owner s claim of a direct relationship between the injury and the decline in sales. But thinking outside the Box, the forensic accountant sees another story. It is discovered that six months prior to the injury, the owner had invested substantial funds in a new venture that overran cost projections, drying up every bit of available cash. The owner s vendors got caught in the squeeze and had refused to ship new seasonal products until they had received payment on past due balances. By reviewing loan applications, correspondence with vendors, industry publications and trade journals, the forensic team was able to correlate the declining sales to inventory problems that predated the accident. It was only coincidence that the accident occurred as new product shortages began negatively impacting sales. Striking Gold in Administrative Reports In the process of pulling financial information together, accountants use their analytic skills to categorize and organize information. Internal accounting systems are often defined based on the operational functions under which they are generated such as Revenue, Inventory/Production, Purchasing, Treasury, and Payroll Cycles (refer to earlier Diagram A). These systems not only assist the accountant in evaluating internal accounting controls, but also serve as the operational groupings that management uses to manage business. As a result, the accounting systems that capture and catalog financial data in the Accountant s Box also tend to capture and report information for operational management. These operational reports often contain hidden treasure for the forensic accountant. Consider the revenue/cash receipts cycle. In a typical company, this cycle produces documents that record the sale in the accounting system. These records usually include information that management needs to ship the product, collect from the customer, identify the sales representative and monitor and evaluate its sales force. In most cases, the accounting system accumulates sales by month and produces reports used to record sales to the general ledger; in other words, to feed the Accountant s Box. At the same time, the accounting system generates volumes of nonfinancial operational reports for management. These reports may never be reviewed by the accountant and distributed to the controller s office. Still, they contain a wealth of important information, including sales information broken down by product, sales representative, and/or region. These reports, which fall outside the Accountant s Box, often contain critical information on operations and are relied upon by management as it monitors sales and staff performance and evaluates market share.

5 Page 5 of 6 Operational managers may slice and dice the information they obtain from the internal accounting systems and prepare additional analyses that compare company performance across regions or to industry data and competitor information. This information may not be relevant to the company s audit team but, for the forensic accountant investigating the financial impact of a disputed event within one region of a company, these reports from outside the Box are invaluable. The Last Piece of the Puzzle Forensic accountants love the challenge of a puzzle. When only a portion of the facts is disclosed, it is up to the forensic accountant to think outside the Box to complete the puzzle. While the accounting records still form the foundation of our work, it is often the nontraditional sources of data that can bring clarity and resolution to financial investigations. Forensic Accountants in Action Case #1: Cracking the Commission Mystery An independent sales representative at an office equipment company contended that she had not been paid all of her commissions. A review of financial statements did not provide sufficient detail to assess the allegation; however, forensic accountants noted that the total commission expense recorded in the financial statements was significantly less than the standard commission rate. The company contended that the amount expensed and paid was appropriate, explaining that the apparent discrepancy on the face of the financial statements was due to the existence of special sales to target companies that were not subject to commissions. Reconstruction of commissions through the analysis of actual sales data was unsuccessful due to incomplete records, so forensic accountants reviewed management reports prepared contemporaneously with the sales, as well as numerous internal communications ( s and memos) between sales management and the sales force. Management s internal reports did not match with commission payment logs and, in fact, documented the several causes for unpaid commissions. Furthermore, management was not able to provide evidence of target company non-commissionable sales. The forensic review of internal communications identified numerous weaknesses in the accounting controls and was able to demonstratively show how sales had been overlooked in the commission calculations. Armed with this evidence, the sales representative was able to reach a favorable settlement. Case #2: Loss of Business Income or Creative Estate Planning? When a seventy year-old business owner was injured in an accident, he claimed he was unable to sustain operations and had to close his doors. The claim was based on the loss of business income for three years and amounted to more than $1 million. The forensic accountants, thinking

6 Page 6 of 6 outside the Box, pored through business records and discovered several business development plans that outlined new industry factors having a negative impact on the business s ongoing operations. Significant preexisting operational problems were discovered, including a previous bankruptcy and an anticipated loss of the major client. In a search of public records, they also discovered that the owner s son, who had recently become more active in the daily operations, had since registered with the Secretary of State for a new corporation within weeks of his father s accident. During a routine search of the Internet, the forensic accountants discovered that the son s new company web site forwarded all inquiries to the father s company web site. Interviews of key employees confirmed that, after shutting down, the son and several employees began operating a similar business less than five miles away from the original operation. What was being claimed as a loss of business was no more than a creative estate planning tool to transfer the business to the son. About the Author Kenneth R. Neumann is Director of Litigation, Valuation and Technology Services at the international forensic accounting firm, RGL Forensic Accountants & Consultants, located in Chicago, Illinois. Readers may contact him at kneumann@us.rgl.com. The information contained in The Business Edge is for guidance only. The opinions and observations are solely those of the authors and do not reflect the opinions or official positions of the Michigan Association of Certified Public Accountants. Readers are encouraged to contact the authors, or their professional advisors, directly Corporate Drive, Suite 200, Troy, MI Phone: Fax: businessedge@michcpa.org

APPENDIX 2 COMMUNITY DEVELOPMENT COMMISSION FINANCIAL CHECKLIST REQUIRED FOR ALL APPLICANTS (A SITE VISIT MAY BE CONDUCTED LATER)

APPENDIX 2 COMMUNITY DEVELOPMENT COMMISSION FINANCIAL CHECKLIST REQUIRED FOR ALL APPLICANTS (A SITE VISIT MAY BE CONDUCTED LATER) REQUIRED FOR ALL APPLICANTS (A SITE VISIT MAY BE CONDUCTED LATER) AGENCY NAME: AGENCY ADDRESS AGENCY PHONE: DATE PREPARED: PREPARED BY: TITLE: EMAIL: AGENCY GENERAL INFORMATION EXECUTIVE DIRECTOR /CITY