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March 29, 2012 Articles

Working With Forensic Accountants to Control Litigation Costs

Use the "phase" approach to keep your costs from spiraling out of control.

By Don R. Bays

Gil and Doug had a lucrative partnership selling dental supplies. They made a lot of money. Unfortunately, Gil could have made much more—if he had only known what Doug was doing.

The Operators

Gil was an absentee owner of the Gilbert and Douglas Dental Supply Company, more commonly known in the area as G & D Supply. Gil owned two other companies in another city and spent much of his time overseeing the operations of those two companies. In addition, when he wasn’t spending time at his other businesses, he liked to travel with Mrs. Gil overseas. He didn’t pay too much attention to G & D Supply.

G & D Supply was operated by Doug. Doug also was the chief financial officer of the company and oversaw the popular accounting software package used by G & D Supply. Doug also prepared the bank reconciliations and made the daily bank deposits for the company. He also controlled all checks written and any accounting entries to G & D’s customer ledgers.

The Accident
One weekend, while on a skiing trip to his favorite resort, Doug lost control of his skis while heading down a very difficult slope and, to his great dismay, crashed into a large tree that seemed to appear out of nowhere. This was a most unfortunate accident for Doug. His hip and a leg were broken in the mishap. Doctors would later tell Doug that he would not be able to go to work for at least six weeks. Doug was beside himself. He couldn’t possibly miss six weeks of work. G & D Supply would suffer greatly in his absence.

When Gil heard the news of Doug’s accident, he was concerned for his partner’s health and well-being—more than worrying what would become of G & D Supply during the next six weeks. Gil told Doug not to worry about the business because he would make sure he kept everything under control until Doug could return. Doug argued with Gil and told him he didn’t need to come into the office because Patty, the office manager, could run things just fine until Doug was healthy enough to return to work.

Patty Doesn’t Have Access
Patty had a bookkeeping background but was not allowed access to the accounting records of G & D Supply. She did know enough about the company’s operations, however, that she could keep the company’s four salesmen busy making their normal sales calls. She also could make the daily bank deposits and prepare hand-written checks to pay bills. Doug could catch the accounting up when he returned.

Gil Wants to Help
Despite Doug’s arguing, Gil was determined to help his partner out, and to operate the business until Doug could return. Doug seemed quite perturbed at Gil’s insistence. Gil would soon find out why.

Gil Had Some Experience
Gil was an old-school business operator. He learned to do accounting by hand and did not fancy the electronic accounting software used by G & D Supply. Gil did, however, have a pretty good understanding of bank statements, bank deposit slips, and cancelled checks. He also knew the mechanics of a bank reconciliation—enough to know how the numbers added up—and, if the reconciliations were being prepared on a timely basis.

A Clue
Gil got his first clue that something might be amiss with the accounting of G & D Supply when he opened a bank-statement envelope one day. Copies of cancelled checks were in the envelope. Gil started looking at the cancelled checks and noticed one particular supplier to whom several checks had been written. The checks to the supplier for just one month totaled almost $10,000. Gil did not recognize the name of the supplier as being a company from which G & D Supply normally bought product.

Getting Suspicious
Gil decided to look at other months’ bank statements. He found many checks had been written in those months to this same unknown supplier as well. Gil started to get suspicious.

Playing Detective
Gil then wanted to look at the bank reconciliations prepared by Doug over the last 12-month period. Patty advised Gil that there were no hard copies of the reconciliations because Doug always prepared them on the computer right from the accounting software used by the company. Doug asked Patty if she knew how to print out paper copies of the reconciliations. She said she did and printed the reconciliations for the last twelve months for Gil to review. What Gil found confirmed his suspicions: that Doug might be stealing money from the company.

The bank reconciliations had deposits in transit and cancelled checks that had not cleared for months and months. Gil asked Patty to print out monthly balance sheets for the last 12 months. The cash balances on the balance sheets did not agree, even remotely, with the balances on the reconciliations.

The Secret Is Out
Gil then approached Doug and told him what he was finding and that he had a suspicion that Doug was taking money, inappropriately, from the company. He told Doug that he suspected Doug of sending G & D Supply money to a supplier that was none other than Doug himself. He also told Doug that he thought Doug was taking checks received from customers and cashing them; and then reducing the customers’ receivable balances by simply transferring the receivable balance to an old inactive receivable account. Doug was furious at Gil’s allegation and told Gil he simply did not understand the nuances of modern-day electronic accounting. Gil told Doug that he was going to hire a forensic accountant to look at the accounting records of the company.

Enter the Forensic Accountant
Gil located a forensic accountant in the city based on a name given to him by a friend. Gil told the forensic accountant, who went by the name of Frank, what he had found and asked Frank to dig into the accounting records of the company and find out just how Doug was taking money out of G & D Supply; also, what the dollar amount was.

Not an Open Checkbook
Gil asked Frank how much he thought the fees would be for Frank to do the work and even possibly to testify in court as to what he might find. Gil mentioned to Frank that several years ago he was involved in a litigation case involving an opposing party who had sold Gil a business based on fraudulent financial statements. Gil hired a forensic accountant back then to find out just how fraudulent the financial statements were. The forensic accountant requested thousands of documents of records and seemed to meticulously go through every page looking for anything that appeared unusual.

When Gil started receiving the bills from the forensic accountant he was astounded by the huge dollar amounts summarized on the bills. The engagement had gotten out of control. The forensic accountant continuously performed additional procedures; procedures not originally agreed to by Gil. The accountant made it clear to Gil that he would not release his written report on his findings, or testify, without all outstanding fees being paid first.

This made for an uncomfortable relationship between Gil and the forensic accountant. The situation could have been avoided by: a) intentionally structuring the forensic accountant’s work in a manner that would control the hours expended and the resulting fees; and, b) by having the forensic accountant agree that he would not do any work not contemplated by the accountant’s letter of engagement unless Gil approved the additional hours to be spent.

Frank Has a Suggestion
Frank, the forensic accountant, who Gil was now hiring for this engagement, told Gil he understood Gil’s concerns perfectly regarding uncontrolled fees. Frank mentioned to Gil that it typically is very difficult to estimate the total hours to be expended by a forensic accountant in forensic engagements. However, he had a suggestion: Why not do the engagement in phases?

Phases Explained
Gil asked Frank to explain. He’d never heard the word “phases” used for forensic work. Frank suggested that this particular engagement be broken into two phases of hours. The first part, called Phase I, would simply be to obtain a backup copy of the electronic accounting software file used by G & D Supply and to review it for any “smoking guns” that would indicate fraud was being perpetrated by Doug.

Phase I might involve:

  1. preparing a list of all payees and the dollar amounts paid to them for the past 12 months and presenting the list to both Gil and Patty and asking them if they recognized the payees
  2. compiling a list of those payees not recognized and to whom a threshold of money was paid, and sending letters to them, signed by Gil, asking the payees to confirm the amount of funds paid to them, and the purpose of their payments, during a specific period of time
  3. reviewing the adjusting journal entries made to the accounting records to determine whether the entries appear to be covering up cash shortfalls; also, whether past journal entries had been erased or modified
  4. looking at the bank reconciliations and determining whether they had been properly completed
  5. reviewing the customer accounts-receivable records to determine whether balances owing to G & D Supply had been transferred to old, non-active receivable accounts, or written off to expenses
  6. providing a verbal report to Gil regarding what the forensic accountant found, after which Gil could decide whether to proceed with further forensic procedures in Phase II

The foregoing procedures are not all inclusive of what Frank could do in Phase I. However, they may give a good indication of whether fraud appears to exist in the accounting records. Frank can actually prepare a budget of the hours he expects to incur in performing the steps for Phase I and get agreement from Gil as to the range of hours—and fees, to be expended for this phase. Phase I might limit the fees to be charged to an amount not to be exceeded by Frank, as well.

Phase II Might be Needed—or, Not
If Phase I, indeed, indicates strongly that fraud had been committed by Doug, Frank can make suggestions for proceeding with a Phase II. Phase II may involve making actual physical visits to the addresses of payees that cannot be initially identified by Gil and Patty; or, sending confirmation letters to customers with large or randomly selected receivable balances asking the customer to validate the amounts due to G & D supply. If the Phase II work ends up indicating Doug inappropriately took money from G & D Supply, Frank would likely summarize the work he did, and his findings and conclusions, in a written report with accompanying supporting schedules as appropriate. Frank also may be able to prepare a budget for Phase II that will help Gil control his fees.

The foregoing story is meant to describe to attorneys, their clients, and to forensic accountants a practical way to control costs on forensic engagements. The process may not be for every forensic engagement but can be used effectively on many. Clients like the phase approach to their engagement because they feel they are more in control of the fees they will pay.

In the event the scope of a forensic engagement is changed after it starts, it is mandatory that the forensic accountant prepare an addendum to his or her original engagement letter explaining that there are additional procedures that have been suggested by the client and that there will be additional fees to be charged. The client, of course, should sign off on the additional procedures requested.

Keywords: litigation, corporate counsel, forensic accounting

Don R. Bays, CPA, ABV, CVA, CFF, is a director with Henry & Horne, LLP, an accounting firm in Tempe, Arizona.