John Wiley Accountants Handbook Volume 2_14 docx

Litigation consulting services involve any professional assistancenonlawyers provide to lawyers in the litigation process in connection with pending or potentialformal legal or regulator

CHAPTER 44

FORENSIC ACCOUNTING AND

LITIGATION CONSULTING SERVICES

Dennis S Neier, CPA

American Express Tax and Business Services, Inc.

Margaret R Kolb, CPA

American Express Tax and Business Services, Inc.

44.2 THE LEGAL CONTEXT 3

(a) The Adversarial Process 3

(ii) Consulting Standards 10(c) AICPA Consulting Services

44.5 FEDERAL RULES OF EVIDENCE 11

(a) Federal Rule of Evidence

(b) Effect of Daubert v Merrell Dow

Pharmaceuticals 11(c) Federal Rule of Civil Procedure 26 12

44 1

The authors would like to thank the following PricewaterhouseCoopers partners for their contribution

by having authored the predecessor chapter on forensic accounting and litigation consulting services:Jeffrey H Kinrich, CPA, M Freddie Reiss, CPA, and Elo R Kabe, CPA

44.1 INTRODUCTION

Forensic accounting can broadly be defined as the application of accounting principles, theories, anddiscipline to facts and hypotheses at issue in a legal context This legal context is generally litigation,but any dispute resolution proceeding (e.g., arbitration or mediation) is a candidate for the applica-tion of forensic accounting Litigation consulting services involve any professional assistancenonlawyers provide to lawyers in the litigation process in connection with pending or potentialformal legal or regulatory proceedings before a trier of fact in connection with the resolution of

a dispute between two or more parties A trier of fact is a court, regulatory body, or governmentauthority; their agents; a grand jury; or an arbitrator of a dispute Litigation consulting servicesinclude the application of specialized disciplines to the issues involved in a matter in order toexpress an expert opinion that would help the trier of fact reach an informed conclusion.Forensic accounting and litigation consulting services apply to both civil and criminal litigation.The principal focus of this chapter will be civil litigation because it is by far the most frequent dis-pute resolution proceeding in which the professional accountant will be involved

The terms “forensic accounting,” “dispute analysis,” “litigation support,” or “litigation ing” are sometimes used as synonyms For purposes of this chapter, “forensic accounting” and “liti-gation consulting services” include all financial and accounting analysis performed by a professionalaccountant to assist counsel in connection with its investigation, assessment, and proof of issues in adispute resolution proceeding

consult-This chapter provides a brief description of the litigation process and a discussion of the countant’s role in, and contribution to, that process In this chapter, the terms “accountant,” “prac-titioner,” “CPA,” and “litigation consultant” are used interchangeably to describe an accountantwho is providing litigation consulting services It includes a description of the types of cases in

(a) General Role of Accountant 12

(b) Business-Oriented Cases 13

(i) Breach of Contract 13

(ii) Business Interruption 13

(iii) Intellectual Property 13

(v) White Collar Crime and

(vi) Securities Act Violations 15

(vii) Bankruptcy and Bankruptcy

(viii) Lender Liability 17

(ix) Employment Litigation 17

(i) Marital Dissolution 18

(ii) Partnership Dissolution 19

44.8 SUPPORT FOR OPINIONS 22

(a) Sources of Information 22

44.10 SOURCES AND SUGGESTED

which professional accountants typically get involved, the types of services accountants usuallyprovide, and a discussion of the professional standards relevant to litigation consulting services.The last section of this chapter, “Testimony,” provides suggestions as to how to prepare and de-liver deposition and trial testimony.

44.2 THE LEGAL CONTEXT

(a) THE ADVERSARIAL PROCESS In civil disputes, it is generally up to the parties (the plaintiff

and defendant), not the court, to initiate and prosecute litigation, to investigate the pertinent facts,and to present proof and legal argument to the adjudicative body The court’s function, in general, islimited to adjudicating the issues that the parties submit to it, based on the proofs presented by them

(b) STAGES IN A CIVIL SUIT There are three basic phases or stages in a civil suit, barring

ap-peal These stages are the same for virtually all adversarial proceedings, whether in a federal, state,

or administrative court

(i) Pleadings A lawsuit is started by a complaint that is filed with the clerk of the trial court and

served on the defendants The complaint lays out the facts and causes of action alleged by the tiff The defendants may file a motion to dismiss (arguing that the defendant is not legally liableeven if the alleged facts are true) or an answer to the complaint The answer may contain a denial ofthe allegations or an affirmative defense (e.g., statute of limitations has expired) The defendant alsomay file a counterclaim which presents a claim by the defendant (counterplaintiff) against the plain-tiff (counterdefendant)

plain-(ii) Pretrial Discovery. The purpose of pretrial discovery is to narrow the issues that need to bedecided at trial and to obtain evidence to support legal and factual arguments It is essentially aninformation-gathering process Evidence is obtained in advance to facilitate presentation of an or-ganized, concise case as well as to prevent any surprises at trial This sharing of information oftenwill result in the settlement of the case before trial

The first step in discovery typically involves the use of interrogatories and document requests terrogatories are sets of formal written questions directed by one party in the lawsuit to the other.They are usually broad in nature and are used to fill in and amplify the fact situation set out in thepleadings Interrogatories are also used to identify individuals who may possess unique knowledge

In-or infIn-ormation about the issues in the case

Requests for production of documents identify specific documents and records that the ing party believes are relevant to its case and that are in the possession of and controlled by the op-posing party The opposing party is only required to produce the specific documents requested.Accordingly, when drafting these requests, care must be taken to be as broad as possible so as to in-clude all relevant documents but narrow enough to be descriptive It is not unusual for more thanone set of interrogatories and document requests to be issued during the course of a lawsuit The ac-countant is often involved in developing interrogatories and document requests on financial andbusiness issues

request-Depositions are the second step in the discovery process They are the sworn testimony of awitness recorded by a court reporter During the deposition, the witness may be asked questions bythe attorneys for each party to the suit The questions and answers are transcribed, sworn to, andsigned The testimony will allow the party taking the deposition to better understand the facts ofthe case and may be used as evidence in the trial The accountant expert witness may be heavilyinvolved at this stage, both in being deposed and in developing questions for the deposition of op-posing witnesses

(iii) Trial The third stage of the litigation/adversarial process is the trial It is the judicial

exami-nation and determiexami-nation of issues between the parties to the action In a jury trial, the trial begins

44.2 THE LEGAL CONTEXT 44 3

with the selection of a jury The attorneys for each party then make opening statements concerningthe facts they expect to prove during the trial Then the plaintiff puts forth its case, calling all of thewitnesses it believes are required to prove its case Each witness will be subject to direct examinationand then cross-examination by the opposing party’s attorney After the plaintiff has called all of itswitnesses and presented all of its evidence, the defendant will then present its case in the same man-ner The plaintiff then has an opportunity to present additional evidence to refute the defendant’s case

in a rebuttal The defendant can respond in a surrebuttal Finally, each party has the opportunity tomake a closing statement before the court

(iv) Settlement At any time in the litigation process, the parties can attempt to settle the dispute

without the intervention of the court This can be accomplished by participating in settlement sions or by using alternative methods of dispute resolution

discus-(c) ALTERNATIVE DISPUTE RESOLUTION. Alternative dispute resolution encompassesmediation, arbitration, facilitation, and other ways of resolving disputes focused on effectivecommunication and negotiation, rather than using adversarial processes such as the courtroom.Two basic types of alternative dispute resolution exist There are nonbinding methods, such asmediation, negotiation, or facilitation, which assist in reaching, but do not impose a resolution

of the dispute There are also more binding methods, such as arbitration or adjudication, inwhich a neutral decision maker rules on the issues presented Combinations of these methodsalso exist Alternative dispute resolution is often used because it is the vehicle prescribed in anagreement or contract for the resolution of a dispute

The U.S Constitution and most state constitutions provide for the right of trial by jury

in most cases This right does not have to be exercised, and many cases are tried without a jury (i.e.,

a bench trial where the judge is the trier of fact) In most states and in federal courts, one of the ties must request a jury or the right is presumed to be waived

par-(d) REQUIRED PROOFS In order for a plaintiff to succeed in a claim for damages, it must

sat-isfy three different but related proofs: liability, causation, and amount of damages if applicable If theburden of proof is not met on any one of these, the claim will fail

(i) Liability The plaintiff must prove that one of its legal rights has been transgressed by the

de-fendant It will present evidence attempting to prove that the actions of the defendant were in tion of the plaintiff’s legal rights Similarly, the defendant will present evidence in an effort to provethat the plaintiff’s rights were not violated, or at least were not violated by the defendant

viola-(ii) Causation If the plaintiff proves that the defendant has violated one of its legal rights, it must

be shown that this violation resulted in some harm to the plaintiff Here, attorneys for the plaintiffand defendant will try to prove or disprove the nexus between the defendant’s actions and some harm

to the plaintiff

(iii) Damages After presenting the evidence relating to the liability and causation issues, the

par-ties’ next step in most cases is to prove damages

Damages are one of a number of remedies that may be available to a prevailing plaintiff Othertypes of remedies include specific performance (performance of the act that was promised), injunc-tions (an order by the court forbidding or restraining a party from doing an act), and restitution (thereturn of goods, property, or money previously conveyed) Damages are the only type of remedy dis-cussed in this chapter

The general principle in awarding damages is to put the plaintiff in the same position it wouldhave been in if its legal rights had not been transgressed There are three main categories of dam-ages: compensatory, consequential, and punitive Compensatory damages compensate the injuredparty only for injuries or losses actually sustained and proved to have arisen directly from the vio-lation of the plaintiff’s rights Consequential damages are foreseeable damages that are caused by

special circumstances beyond the action itself They flow only from the consequences or results of

an action Punitive damages are intended to penalize the guilty party and to make an example ofthe party to deter similar conduct in the future They are awarded only in certain types of cases(e.g., fraud)

The quantification of damages is primarily a question of fact The burden of proving the damageamount normally falls on the plaintiff Although accountants can be used in cases in which damagesare not an issue, accountants are most frequently used in cases in which damages are an issue

44.3 THE ACCOUNTANT’S ROLE IN THE LITIGATION PROCESS

Typically the accountant is hired by attorneys representing either the plaintiff or the defendant Insome cases, however, an accountant may be engaged directly by one of the parties to the action Nomatter who engages the accountant, a number of possible roles might be played A litigation con-sulting practitioner can work as a testifying expert, a consultant, a trier of fact (e.g., an arbitra-tor), a special master (working for the court), or a court-appointed neutral party (an expert, notfor the parties to the dispute, but to the court as a neutral party) A detailed discussion of the role

of the testifying expert and the consultant follows

(a) THE TESTIFYING EXPERT Frequently, the accountant’s purpose in the case will be to

de-velop and render an opinion regarding financial or accounting issues Ordinarily, only facts and hand knowledge can be presented by witnesses at trial The only exception to this rule is thetestimony of experts, which can include an expression of the expert’s opinions as discussed in detail

first-in Section 44.3(a)

According to the courts and the law, experts are those who are qualified to testify authoritativelybecause of their education, special training, and experience Clearly, a professional accountant canqualify as an expert in issues relating to accounting and financial data

As discussed in Subsections 44.4(a–c) and 44.5(a–c), the accountant as expert may be asked todevelop and present evidence in support of any or all of the required proofs For example, the ac-countant can review and offer an opinion as to the adequacy of the work performed by another ac-countant in a professional liability suit (proof of liability) Or the accountant might review thefinancial records and the business environment of a company to determine whether a bank’s with-drawal of credit caused the company to go out of business (proof of causation) Most commonly,the accountant will be asked to provide an opinion regarding the economic loss suffered by theplaintiff in the case or to rebut the damages alleged by the plaintiff on behalf of the defendant (proof

of damages)

(b) NONTESTIFYING CONSULTANT In certain situations, the accountant will be asked to be a

consultant rather than a testifying expert The accountant will take on more of an advisory role andwill not provide testimony The work the accountant performs for the attorney as a consultant is gen-erally protected by the attorney’s work product privilege and as such is not discoverable by the op-posing party For this reason, accountants are often engaged initially as consultants This enables theattorney to explore avenues and conduct analyses from which he might want to shield his testifyingexpert However, once the accountant has been designated as an expert, all work products may besubject to discovery

(c) COMPARING LITIGATION CONSULTING SERVICES TO ATTEST SERVICES The role

of the practitioner in a litigation consulting engagement is different from that in an attestation gagement, where the CPA expresses a conclusion about the reliability of a written assertion of an-other party In a litigation consulting engagement, the practitioner is the asserter and must supportand defend any conclusions reached against challenge

en-In an attestation engagement, the audience is composed of all persons relying on the countant’s report, whereas in a litigation consulting engagement, the audience for the litigation

ac-44.3 THE ACCOUNTANT’S ROLE IN THE LITIGATION PROCESS 44 5

consulting practitioner’s opinion and work product is generally limited to the trier of fact andthe parties to the dispute who have the opportunity to evaluate and question the practitioner’sconclusions, working papers, documents, and methodology.

The standards for attestation engagements do not envision the practitioner as the asserterand were established to provide assurance to third parties about the assertion of another party.Litigation consulting engagements and attestations engagements differ in the purpose in en-gaging the practitioner and in the use of the practitioner’s conclusions Also, unlike an attes-tation engagement, there are usually no uninformed third parties in a litigation consultingengagement because all the parties (if the practitioner is an expert) generally have access tothe working papers of, and other documents relied on by, the practitioner and can question theconclusions

(d) CASE ANALYSIS AND PLANNING. Whether in the role as testifying expert or fying consultant, the litigation consulting practitioner can provide valuable assistance through-out the litigation process

nontesti-In many circumstances, the accountant can be of use to the attorney before the complaint is evenfiled The accountant can help the attorney understand the accounting, financial, and economic issuesinvolved in the case and can also assess the potential value of the claim by providing an estimate ofthe amount of damages In certain cases, the accountant may actually help to identify causes of ac-tion to be included in the complaint

Once a case has been filed, the accountant can help the attorney understand and evaluatecritical accounting, financial, and economic issues and assist with the formulation of an ap-propriate strategy Strategy formulation is a continual process; as new information is receivedand additional issues uncovered, the overall strategy is revised During the planning phase,the accountant will evaluate alternative approaches and determine the most reasonable ap-proach to take based on all available information At the same time, the accountant will assessthe strengths and weaknesses of the opponent’s case The accountant’s involvement in thisphase will help the attorney to focus on those issues that have the greatest impact on provingthe case

(e) DISCOVERY. Discovery is the information-gathering stage of the litigation process.During discovery, each party attempts to identify and obtain all the information and docu-ments necessary to prove its case The accountant’s initial assistance may be in formulatingspecific accounting and financially oriented questions to be included in interrogatories Theaccountant will also assist in drafting document requests by identifying in a very specificmanner the types of documents (particularly accounting records and reports) that would be ofinterest and that the opposing party is likely to have retained The more specific the requestsare, the more likely the response will be useful The accountant will also be able to assist theattorney with the preparation of responses to the opposing party’s interrogatories and docu-ment requests

A significant role that the litigation consulting practitioner can play during the discoveryphase is in the review and analysis of the documents During this review, the litigation con-sulting practitioner identifies key documents that are helpful or harmful to the parties thathave retained him It is also during this phase that the litigation consulting practitioner iden-tifies documents requiring further explanation that can be provided during deposition De-pending on the legal forum in which the case is being tried, expert reports are usuallydrafted, issued, and exchanged with the opposing party during or just after the discoveryphase

Depositions provide each side with an opportunity to elicit relevant facts and to identifyweaknesses in an opponent’s argument The accountant can be helpful in this area by assistingthe attorney in identifying subjects to be explored and in developing specific deposition ques-tions, especially when financial executives or experts are being deposed Frequently, an attor-ney will request the accounting expert to be present at these key depositions Here the

accountant can help the attorney understand and interpret the deponent’s responses and late follow-up questions to probe more deeply into the subject area Having the accountant pre-sent at the deposition will enable the attorney to completely understand and consider thefinancial issues.

formu-The accountant who will be a testifying expert may be subject to deposition by the opposing ney The opposition will attempt to gain a thorough understanding of the accountant’s analysis and con-clusions and, when possible, identify weaknesses and lay the groundwork for attack at trial Section44.9 presents a description of the deposition process and some pointers for giving deposition testimony

attor-(f) SETTLEMENT ANALYSIS. Settlement negotiations can occur at any point during the tion process They can be greatly facilitated by the use of an accounting expert The accountantcan be instrumental in evaluating existing alternatives and terms as well as in proposing otherstrategic approaches The accountant’s evaluation may involve (1) the determination of economicvalue and feasibility of various strategies or (2) an analysis of the strengths and weaknesses of thetwo sides’ positions

litiga-When determining value and evaluating feasibility, the accountant can estimate damages undervarious scenarios and help to assess the probability of occurrence for each, thereby giving the attor-ney a better understanding of the risks involved Just as importantly, the accountant can evaluate thetrue economic value of various settlement alternatives and determine possible tax effects of each.This will enable the attorney and client to make a more informed decision regarding settlement op-tions and perhaps offer alternatives that benefit both parties

The accountant also can provide an evaluation of the relative strengths and weaknesses of boththe plaintiff’s and the defendant’s positions, thereby helping the attorney strengthen his bargainingposition and anticipate potential problems

(g) PRETRIAL. When preparing for trial, the accountant can assist the attorney by: (1) ing courtroom graphics, presentations, and exhibits; (2) preparing witnesses for trial testimony;(3) preparing for the cross examination of opposing witnesses; and (4) fine-tuning the overallcase strategy

prepar-(h) TRIAL If the case does not settle, the final role of the accountant will be to assist during the

trial itself The accountant’s testimony in court is a key part of this role In testimony, the accountantpresents the opinions developed as a result of his information gathering, review, and analysis Thisrole is clearly the most important one the accountant will play in the process It is imperative that theaccountant present opinions in a straightforward, cogent, and concise manner The last section of thischapter describes the course of direct testimony and suggests ways to enhance the effectiveness ofthe testimony

Although opinion testimony is of paramount importance at the trial stage, the accountant can playother valuable roles For example, the accountant can be of tremendous value to attorneys during thecross-examination of opposing experts and financial witnesses The accountant can work with the at-torney to prepare cross-examination questions in an effort to undermine the testimony or the credi-bility of the witness The accountant will be important in this phase because of his ability toformulate accounting and financially oriented questions that will be difficult for the witness to evade

or deflect More importantly, the accountant will be able to assess the responses and provide

follow-up questions to “close the loop” on important issues

44.4 PROFESSIONAL STANDARDS RELEVANT TO

LITIGATION CONSULTING

Throughout the litigation process, the accountant will be asked to provide input, conduct ses, and offer advice or opinions regarding facts at issue in the case Clearly, the attorney-clientwill expect that appropriate standards of care are followed by the accountant during the course of

analy-44.4 PROFESSIONAL STANDARDS RELEVANT TO LITIGATION CONSULTING 44 7

the engagement However, although the litigation process itself is a formal, structured processwith many rules and procedures that must be followed, the nature of the accountant’s work istypically very unstructured and loosely defined.

However, the accountant should recognize that there is a hierarchy of standards that apply tolitigation consulting services as follows:

• AICPA Code of Professional Conduct

• AICPA Statement on Standards for Consulting Services

• AICPA Consulting Services Practice Aids

(a) AICPA CODE OF PROFESSIONAL CONDUCT The AICPA Code of Professional Conduct

applies to all professional services rendered by AICPA members Certain sections of the Code of fessional Conduct have particular applicability to litigation consulting services; they are the guidingprinciples of this practice area A greater understanding and appreciation of the importance of the ex-isting standards contained in the Code will assist practitioners in their efforts to provide opinions thatare relevant and reliable and that assist the trier of fact

Pro-(i) Rule 101: Independence When performing a litigation service engagement, independence is

not required However, the practitioner should be sensitive to the appearance of independence so thatthe trier of fact will accept conclusions and judgments as objective and impartial

(ii) Rule 102: Integrity and Objectivity. Although independence is not required in a litigationconsulting engagement, the accountant is required to comply with Rule 102 of the AICPA Code ofProfessional Conduct Rule 102 requires that members shall, in the performance of any profes-sional service, maintain objectivity and integrity, shall be free of conflicts of interest, and shall notknowingly misrepresent facts or subordinate their judgment to others The accountant should beaware of situations that would cause the trier of fact to question his integrity and objectivity; forexample, current, prior, or possible future relationships with either the attorneys or the parties tothe dispute, the rendering of contradictory opinions on the same subject matter at issue in the liti-gation, or having knowledge of facts obtained outside the normal discovery process could impairintegrity and objectivity

The accountant must also recognize how the roles and responsibilities of attorneys differfrom those of CPAs in the litigation process The litigating attorney is the client’s advocate

“The litigation process demands that the attorney take every available advantage for the client,put the client’s case in the best possible light, not offer evidence that is harmful to the client(with some exceptions) and challenge everything possible in the opponent’s case.”1

The accountant as an expert witness has a role that differs from that of an attorney The countant-expert does not serve as an advocate but rather is presented to the trier of fact as some-one with specialized knowledge, training, and experience in a particular area and presentspositions with objectivity The function of the accountant as an expert witness is to assist thetrier of fact in understanding complex or unfamiliar concepts The accountant-expert is not ex-pected to single-mindedly and one-sidedly offer only evidence and opinions that help the client.The accountant expert is expected to offer an objective opinion, based on knowledge and expe-rience, of how the issues at hand should be interpreted by the trier of fact.2When acting as aconsultant, the accountant can provide assistance that is more like that of an advocate

ac-(iii) Conflicts of Interest In a litigation services engagement, a conflict of interest exists when a

litigation consulting practitioner’s ability to objectively evaluate and present an issue for a client will

1AICPA Consulting Services Special Report No 93–2, Conflicts of Interest in Litigation Services

Engage-ments, ¶ 2/105.16, AICPA, 1993.

2AICPA Consulting Services Special Report No 93-2, Conflicts of Interest in Litigation Services

Engage-ments, ¶ 2/105.21.

be impaired by current, prior, or possible future relationships with parties to the litigation The rion for evaluating whether a conflict of interest is involved in a litigation services engagement is theability of the accountant to maintain integrity and objectivity A conflict of interest is based in fact,rather than appearance However, the accountant should be mindful of and deal with appearances ofconflicts before accepting the engagement.

crite-Unlike the legal profession, the accounting profession has developed little formal guidance

on conflicts of interest An attorney has a well-defined and documented concept of what tutes a conflict in the legal profession Consequently, this concept may be applied inappropri-ately to the accountant The standards of the legal profession concerning conflicts of interestshould not be applied to the accounting profession because the roles of the attorney and the ac-countant in litigation are entirely different

consti-If a conflict of interest does not exist in fact, the accountant must decide if a conflict in pearance exists of if business issues would prevent acceptance of the engagement For example,the accountant may decline to perform services because the position required by the prospectiveclient conflicts with the business interests of an existing client These determinations are based

ap-on the accountant’s judgment

Before accepting a litigation services engagement, the accountant should perform procedures thatwill enable him to determine if a conflict exists with any parties to the litigation All conflicts and po-tential conflicts must be disclosed to the retaining attorney for his evaluation Interpretation 102.2 ofthe AICPA Code of Professional Conduct provides that if a conflict exists and is disclosed to theclient and other appropriate parties, the accountant can accept the engagement with the consent of allparties The accountant should be aware that new federal regulations prohibit the performance of lit-igation consulting services for any audit client that is an SEC Registrant For more information re-

garding conflicts of interest refer to AICPA Consulting Services Special Report No 93-2, Conflicts of

Interest in Litigation Services Engagements.

(iv) Rule 201: General Standards The four general standards, professional competence, due

professional care, planning and supervision, and sufficient relevant data, under Rule 201 of the Code

of Professional Conduct apply to litigation consulting services In fact, these four standards are cluded in Statement on Standards for Consulting Services No 1 (SSCS No 1) and are discussed inmore detail below

in-(v) Rule 202: Compliance with Standards Pursuant to Rule 202 of the Code of Professional

Conduct, the accountant must comply with the standards promulgated by the Consulting ServicesExecutive Committee

(vi) Rule 203: Accounting Principles Rule 203 requires the accountant to demonstrate an

un-derstanding of generally accepted accounting principles To the extent that GAAP is applicable, theaccountant shall apply the appropriate accounting principles

(vii) Rule 301: Confidential Client Information Pursuant to Rule 301, the CPA in public

prac-tice may not disclose confidential client information without the client’s consent In litigation sulting services engagements, confidential client information obtained in prior engagements must beprotected Thus, the accountant has the dual responsibility to be both truthful and honest while pre-serving past and present client confidences Before the accountant relies on specific information ob-tained in an unrelated prior engagement and uses that information as the basis for his opinion, hemust either obtain the consent of the prior client to reveal its confidences or abandon any effort to usesuch information as the basis of his opinion

con-(b) STATEMENT ON STANDARDS FOR CONSULTING SERVICES. Litigation consultingservices are consulting services as defined in SSCS No 1 SSCS No 1 sets standards that must

be followed for all consulting engagements

44.4 PROFESSIONAL STANDARDS RELEVANT TO LITIGATION CONSULTING 44 9

(i) General Standards The general standards defined in Rule 201 of the AICPA Code of

Profes-sional Conduct are applicable to litigation consulting engagements

• Professional competence The practitioner should accept only those engagements he or the

CPA firm can reasonably expect to complete with professional competence The practitionermust have adequate knowledge, skills, training, and experience so that duties can be performed

in accordance with appropriate professional standards Litigation consulting services involvemany diverse issues As a result, the practitioner may need to rely on the assistance of other in-dividuals with the required education and experience in order to comply with this standard Forexample, a practitioner may have the required expertise to develop a model for computingdamages to a restaurant chain in a breach of contract litigation However, he may need the as-sistance of someone in the restaurant industry to provide key components that will be used inthe model, for example, the gross profit margin that is typical in the industry

• Due professional care The practitioner should make a conscientious effort in his

perfor-mance of the engagement by obtaining sufficient relevant data and applying reliable ples and methods to the facts of the dispute before reaching conclusions and findings andshould be able to present his conclusions and findings to the trier of fact in a concise, clear,and correct manner

princi-• Planning and supervision Planning and supervision have different implications for the

litiga-tion consulting practilitiga-tioner than for many of the other services a CPA may be engaged to vide A litigation consulting services engagement is usually far more dynamic than otherengagements The facts and circumstances of each litigation consulting engagement areunique Planning is essential in a litigation consulting engagement to control costs and focusthe practitioner’s work product on the engagement requirements Plans continually change in alitigation engagement and are usually not written because of the dynamic nature of the litiga-tion process

pro-Supervision ensures the quality of the engagement performance Since the testifying expertmust express the opinions and conclusions reached as his own, the testifying expert shouldclosely supervise the ongoing work that is performed by others

• Sufficient relevant data The practitioner needs to base his conclusions and judgments

on sufficient relevant data It is not only the practitioner’s opinion that is evaluated bythe trier of fact, but also the relevancy, sufficiency, and verifiability of the underlyingevidence supporting the opinion The practitioner can generally rely on documents thathave been authenticated by the parties to the proceeding or that are acceptable to thecourt under the various rules of evidence It is important to communicate to the attorneywhat evidence is necessary to properly support the practitioner’s conclusions and judg-ments, and it is incumbent upon the practitioner to advise the attorney of possible miss-ing or questionable documents and the lack of relevant data upon which to reach anopinion

Generally, the practitioner may look to the guidance of generally accepted auditing and otherattestation standards with respect to the sufficiency, relevancy, and reliability or evidentialmatter

(ii) Consulting Standards In addition to the general standards, SSCS No 1 also establishes

spe-cific consulting standards for consulting services

• Client interest The accountant should serve the interests of the client while maintaining

objec-tivity and integrity In addition, when acting as an expert, the accountant also has a duty to thetrier of fact

• Understanding with the client The accountant should establish a written understanding with

the client about the responsibilities of the parties and the nature, scope, and limitation of theservices to be provided

• Communication with client The client should be informed about:

• Conflicts of interest

• Significant reservations concerning the scope or benefits of the engagement

• Significant engagement findings or events

When acting as an expert, the accountant should be aware that all of his communicationswith the client, written or oral, are subject to discovery and must be provided upon request bythe opposing party All of the accountant’s work product, including draft reports and schedules,notes, supporting schedules, and correspondence, can be requested as part of the discoveryprocess

(c) AICPA CONSULTING SERVICES PRACTICE AIDS The AICPA has published

nonauthori-tative educational guidance for practitioners, including Consulting Services Special Report No

93-1, “Application of AICPA Professional Standards in the Performance of Litigation Services,”Report 93-2, “Conflicts of Interest in Litigation Services Engagements,” Report 93-3, “ComparingAttest and Consulting Services: A Guide for the Practitioner,” Report 93-4, “Providing LitigationServices,” Consulting Services Practice Aid 95-2, “Communicating Understandings in LitigationServices: Engagement Letters,” Consulting Services Practice Aid 96-3, “Communicating in Litiga-tion Services: Reports,” Consulting Services Practice Aid 97-1, “Fraud Investigations in Litiga-tion and Dispute Resolution Services,” Consulting Services Practice Aid 98-1, “ProvidingBankruptcy and Reorganization Services,” Consulting Services Practice Aid 98-2, “Calculation

of Damages from Personal Injury, Wrongful Death, and Employment Discrimination,” ing Services Practice Aid 99-1, “Alternative Dispute Resolution Services,” Consulting ServicesPractice Aid 99-2, “Valuing Intellectual Property and Calculating Infringement Damages,” andConsulting Services Practice Aid 02-01, “Business Valuation in Bankruptcy.”

Consult-44.5 FEDERAL RULES OF EVIDENCE

(a) FEDERAL RULE OF EVIDENCE 702 Most witnesses who testify in a litigation are fact

wit-nesses A fact witness can provide testimony based on what he has seen, heard, or otherwise served A fact witness may not offer opinions By contrast, an expert witness by reason of education

ob-or specialized experience possesses superiob-or knowledge about a subject and as such may offer ions at trial An accountant may testify as an expert witness if his opinion will assist the trier of fact

opin-in understandopin-ing the evidence or determopin-inopin-ing the issues opin-in a case

Federal Rule of Evidence 702 governs the admissibility of expert opinion testimony Rule

702 states that “if scientific, technical, or other specialized knowledge will assist the trier of fact

to understand the evidence or to determine a fact in issue, a witness qualified as an expert byknowledge, skill, experience, training, or education, may testify thereto in the form of an opin-ion or otherwise.”

(b) EFFECT OF DAUBERT V MERRELL DOW PHARMACEUTICALS. In Daubert v

Mer-rell Dow Pharmaceuticals, 113 S Ct 2796 (1993), the Supreme Court addressed the rules

per-taining to the admission of expert testimony

Since 1923, based on Frye v United States, 293 F.1013 (D.C Cir 1923), the federal courts

applied a test (the general acceptance test) by which scientific expert opinions should be ted into evidence Under this standard, an opinion was admitted only if it was based on gener-ally accepted methodology within the industry

admit-In the Daubert decision, the Supreme Court determined that in order for expert witness ions to be admitted under 702, they did not have to meet the Frye general acceptance test and

opin-clarified that Rule 702 does not establish general acceptance as a criteria for admissibility The

Daubert decision clarified the trial court’s role in determining the admissibility of expert

testi-mony In doing so, the court need not determine whether the methodology meets the general

ac-44.5 FEDERAL RULES OF EVIDENCE 44 11

ceptance test but must assess the validity of the methodology used and the applicability of thatmethodology to the specific facts of the case.

(c) FEDERAL RULE OF CIVIL PROCEDURE 26 If the accountant has been engaged to serve as

a testifying expert witness, he must become aware of the effect of Rule 26 of the Federal Rules ofCivil Procedure, which deals with the procedure for written disclosure of expert testimony.Pursuant to Rule 26, the identity of one side’s potential testifying experts, as well as infor-mation about the expected testimony, must be voluntarily disclosed at the outset of a case, with-out receipt of a formal discovery request

In addition, Rule 26 provides that the expert prepare and sign a written report This report must bedisclosed to the other parties before the expert will be allowed to testify at trial Unless the date bywhich disclosure of the written report must be made is decided by the trial judge, rules of the localcourt, or by agreement of the parties, the report must be disclosed at least 90 days before the date oftrial If an expert is retained solely to rebut the testimony of an opposing expert, the report of the re-buttal witness must be disclosed within 30 days of the disclosure of the other expert’s report.Generally, the expert witness will not be permitted to testify at trial to his opinions unless theopinions are contained in the expert witness’s written report Therefore, the content of the ex-pert’s report should contain all of his opinions and the bases for the opinions In addition, oncethe expert’s report is disclosed to the other side, any changes to the report must be disclosed be-fore the commencement of trial

Rule 26 requires that the expert’s report contain:

• A complete statement of the opinion to be expressed and the bases and reasons therefore

• The data or other information the witness considered in forming the opinions

• Any exhibits to be used as a summary of or as support for the opinions

• Qualifications of the witness, including a list of publications the witness authored within thepreceding 10 years

• The compensation to be paid to the witness for the study and testimony

• A list of all other cases in which the witness has testified as an expert at trial or in depositionwithin the preceding four years

• Signature of the expert

Pursuant to Rule 26, once the expert’s written report required by Rule 26 has been disclosed,the opposing side has the right to take the deposition of any person who has been identified as anexpert whose opinions may be presented at trial

The accountant who is engaged as an expert witness in a matter to be tried in a federal courtshould ascertain the current status of Rule 26 in the applicable federal district and discuss com-pliance with Rule 26 with the counsel retaining him

It is important to point out that the Federal Rules of Civil Procedure give local courts the option

of not complying with certain provisions, including the provisions of Rule 26 discussed above Theaccountant should consult with the retaining attorney to ascertain whether the case is to be tried infederal or local court and the local rules that apply to the case

44.6 TYPES OF CASES

(a) GENERAL ROLE OF ACCOUNTANT. An accountant may provide services in almostany case where there are accounting, financial, bankruptcy, or fraud issues Since most civillawsuits involve one or more of these issues, an accountant may be involved in almost any type

of litigation

Accountants are also used as experts in cases that require a knowledge of business records and actions However, there are certain types of cases in which accountants more likely to be involved

trans-A lawsuit typically requires proof of liability, causation, and damages trans-An accountant may

be involved in any or all of these areas Cases requiring an accountant’s testimony on liabilitytypically revolve around professional liability (e.g., was the audit performed properly?) or in-vestigatory accounting (e.g., can the accountant determine what really happened?) Cases in-volving an accountant’s testimony on damages usually involve the computation of losteconomic value, including lost profits, lost royalties, or loss of asset value This chapter dis-cusses the types of cases that typically involve accountants and the roles that the accountanttypically plays in those cases

(b) BUSINESS-ORIENTED CASES The accountant’s work often involves business disputes.

This section presents a summary of common types of cases and the accountant’s role

(i) Breach of Contract Typically, the plaintiff has a contract with the defendant that the

defen-dant is accused of breaching For example, the contract may call for the defendefen-dant to buy a certainquantity of product for a certain price The defendant, however, fails to make the required pur-chases Or the defendant may be accused of breaching a warranty on its goods or services The ac-countant may be asked to quantify the damages suffered by the plaintiff as a result of the breach.Usually, the damages are measured by lost profits, that is, the additional profits the plaintiff wouldhave earned but for the defendant’s breach Among the issues the accountant may address are lostrevenues, avoided costs, available capacity, and possible mitigating actions, including sale of theproduct to others

(ii) Business Interruption. A business interruption claim may arise from an accident, fire,flood, strike, or other unexpected event It may even arise from a contract or warranty claim wherethe defendant’s breach has caused the plaintiff to suspend operations Typically, these claims arefiled by a business against its insurance carrier, though a claim against the entity causing the event

is possible In a business interruption case, the plaintiff claims the event caused the business tosuffer losses

Often, the accountant is asked to quantify the loss Elements to be considered may includelost profits, loss of tangible assets, loss of intangible assets (including goodwill), loss of

an entire business or business line, cost to repair or reestablish the business, cost of time, or cost of wasted effort (time spent fixing the problem instead of generating operatingprofits)

down-(iii) Intellectual Property Intellectual property disputes involve the rights to use patents,

copy-rights, and trademarks The plaintiff claims that the defendant infringed on the plaintiff’s intellectualproperty by illegally using the patent, copyright, or trademark For patents, damages are defined bylaw to be plaintiff’s lost profits (if reasonably provable), but not less than a reasonable royalty Dam-ages in a copyright case are the market value of the infringed work, the profits that the owner lost orwill lose as a result of the infringement, or the defendant’s profit In a trademark case, where themark has been registered with the Patent and Trademark Office, the owner may recover actual dam-ages and also the infringer’s profits

Often computations are made separately for lost profits and for reasonable royalties Sometimesthe accountant can perform both analyses Other times the accountant’s opinion on reasonable roy-alty may be supplemented by another expert with experience in negotiating royalties in the particu-lar industry

(iv) Antitrust The plaintiff in antitrust litigation may be either the government or a private

party The government usually brings suit to oppose a merger or to break up a monopolist ernment suits are usually not for monetary damages Experts in these suits, particularly in liabilityissues involving monopolistic practices, relevant market share, and the like, are often economists,not accountants

Gov-44.6 TYPES OF CASES 44 13

In a private suit, the plaintiff accuses the defendant of violating antitrust laws, resulting in injury

to competition, including (or especially) injury to the plaintiff The accountant’s role again may bethe computation of lost profits

A company may be accused of violating antitrust laws by selling the same goods at differentprices to different parties in the same channel of distribution This ostensibly discriminatory pric-ing may be refuted if the defendant can show that the price differences are justified by differences

in cost of production, service, freight, and so on An accountant may conduct these cost tion studies

justifica-Accusations of predatory pricing also fall under the antitrust laws The defendant in a predatorypricing case is accused of pricing so low that competitors lose money and are driven out of business.Once the competition is eliminated, the defendant presumably raises prices and enjoys monopolyprofits One legal standard for predatory pricing is pricing below cost of production Depending onthe law, the standard may be either incremental costs or fully allocated costs An accountant mayhelp establish or refute this claim by studying product pricing and production costs and measuringthe resulting profit margins

(v) White-Collar Crime and Fraud This is a growing field within the area of litigation

consult-ing and covers a wide range of cases Examples of fraud and white-collar crime cases are schemes

by executives, employees, and customers to siphon funds from financial institutions for their sonal use, check kiting, lapping, computer fraud, embezzlement, defense procurement fraud, cost-ing fraud, schemes involving kickbacks, income tax frauds, charity and religious frauds, moneylaundering, insider trading cases, and fraudulent bankruptcy actions Additional examples includeinvestigations of “boiler room” operations that solicit funds from investors based on promises ofhigh investment return and Ponzi arrangements (i.e., arrangements in which there are no real prof-its; instead, funds from new investors are used to pay investment returns to existing investors, giv-ing the impression of profits)

per-The accountant’s work in this area centers on investigating what happened and establishingliability After the investigation is completed, the accountant may be asked to quantify theamount of the loss attributable to the fraud or crime

The accountant will typically review and analyze many types of data, including dence, e-mail, journal entries, financial statements, and financial schedules Many times, the ac-countant commences his investigation with little to no detail as to the extent of the situation andmust put the pieces of a puzzle together This involves developing and testing hypothesesthroughout the investigation Therefore, when reviewing documents and other data, it is impor-tant to keep an open mind and not dismiss any reasonable possibilities Very often, an investiga-tion in one area will lead to other problem areas

correspon-Although most litigation takes place in an unfriendly environment, this is especially true incases involving white-collar crime or fraud The accountant may conduct or assist the attorney

in conducting interviews of relevant parties Often, the accountant or attorney is attempting toobtain information from the persons who are the subject of the investigation and are attempting

to conceal their activities As such, the accountant should maintain the highest level of sional skepticism throughout the investigation

profes-Since the accountant’s investigation, work product, and conclusions may form the basis ofevidence in the case, it is critical to understand the importance of obtaining and preserving evi-dence and seek guidance from the retaining attorney about such matters whenever necessary Inaddition, the accountant may have to coordinate efforts with other areas of law enforcement thatmay have an interest in the matter

The circumstances of each engagement are unique Depending on the circumstances, the countant or retaining attorney may need to engage other specialists or experts Computer spe-cialists are frequently used in these types of cases to extract data that have been removed fromcomputer drives or to search the contents of computer disks using key word searches Private in-vestigators can also be of great assistance in performing detailed background checks or surveil-lance of potential suspects

ac-The following are specific examples of tasks that the accountant might perform in differenttypes of white-collar crime cases.

In white-collar crime cases where Ponzi schemes are suspected, the accountant will want to ument how the enterprise was structured and to develop organizational charts and flow charts Trac-ing transactions from the receipt of investor funds to their ultimate investment or disposition will berequired Analyses that illustrate the lack of any positive cash flow other than by raising additionalinvestor funds will be useful to the attorney in proving liability Documenting the flow of all cashtransactions or custodial arrangements is all within the accountant’s scope

doc-The accountant should also analyze cash disbursements to see whether any patterns indicatingself-dealing emerge or to identify possible related entities or personal use or benefit of company as-sets Unusual expenses should be vouched, and particular attention should be devoted to traditionallysensitive areas, such as travel and entertainment expenses Some suspicious transactions are easilydetected Many illegal activities involve disguised transactions, but it is just as likely that the paidbills and supporting evidence will be fairly explanatory

In the case of a penny stock fraud scheme, the accountant may shift greater attention to the cial results and reports to shareholders, press releases, and the like to determine if evidence existsthat such data were incorrect or inaccurate Income recognition abuses or improper capitalization ofexpenses are typical categories of abuses used by penny stock promoters to misstate the operating re-sults and mislead investors In addition, the accountant should analyze key contracts, employmentagreements, and other consulting arrangements A time-line analysis that reflects all key “publicizedevents” should be developed and used to determine if such events did occur From the time line it can

finan-be determined whether, in the same time frame, all acquisitions or dispositions of assets and other nancial transactions were accounted for properly

fi-(vi) Securities Act Violations Lawsuits in this area usually involve alleged violations of the

fed-eral acts, specifically Sections 11 and 12(2) of the Securities Act of 1933 and Section 10(b) of the curities and Exchange Act of 1934 These sections concern making false or misleading publicstatements about a company or omitting a material fact (either in a prospectus or in public state-ments, including financial statements), resulting in an alleged overvaluing of the company’s stock.Typically, when the correct information becomes public, the value of the stock drops Plaintiffs claimthat, but for the misleading statements, they would not have bought the stock or they would havebought at a lower price These lawsuits are often brought against officers, directors, investmentbankers, lawyers, accountants, and others who may have been party to misstatements

Se-Accountants may be involved in the liability, causation, and damages portions of securities cases.Involvement with liability issues is most common when an auditor has been accused of violatingSection 10(b)5 by failing to perform a generally accepted auditing standards (GAAS) audit and/or bygiving a clean opinion to non-GAAP financial statements The accountant will review the auditor’swork papers and other relevant materials to reach a conclusion as to the adequacy of the audit of thefinancial statements

The causation and damages phases of securities cases are closely linked They consist of mining whether the information had any impact on the stock price and quantifying the losses suf-fered by the plaintiff investors as a result Typically, this involves determining what the stock pricewould have been if the proper information had been released at the proper time The methods fordoing this are beyond the scope of this chapter; see de Silva et al for a treatment of this subject.3

deter-(vii) Bankruptcy and Bankruptcy Frauds Bankruptcy matters may require an accountant’s

ser-vices for many different tasks The role of the accountant and scope of serser-vices to be performed areinfluenced by the size of the company and by whether the accountant is working for the trustee,debtor in possession, secured creditors, or the creditors’ committee(s)

44.6 TYPES OF CASES 44 15

3Harinda de Silva, Nancy N Low, and Tara N Nells, “Securities Act Violations: Estimation of Damages,”

in Litigation Services Handbook: The Role of the Accountant as Expert, ed Romal L Weil, Michael J

Wag-ner, and Peter B Frank (John Wiley & Sons, New York, 1995)

Accountants for the debtor in possession may be asked to prepare analyses supporting the vency or insolvency of the debtor, which may affect creditors’ claims, recoveries, or security in-terests Such accountants also may be involved in preparing prospective financial informationfiled with the U.S Trustee’s Office or used in negotiating plans of reorganization with the parties

sol-of interest Another important role may require making analyses to support a debtor’s use sol-of cashcollateral and analyses showing that adequate protection is available to the secured creditor

An accountant for the creditors’ committee, in addition to reviewing any analyses prepared forthe debtor, will have additional responsibilities The accountant may initially be asked to determinethe cause for the business failure and may need to determine quickly whether the debtor’s operationmay be further depleting the assets available for creditors The creditors’ accountants also may need

to investigate the conduct of the debtor The scope and depth may vary significantly based on the lationship and confidence the creditors have with existing management At a minimum, a review todetermine possible preferential payments, fraudulent conveyances, and insider transactions is usu-ally performed The roles, definitions, and exceptions to preferences and fraudulent conveyances aredetailed in the Bankruptcy Code as well as in Newton.4

re-The work required to establish liability in bankruptcy cases is similar to that discussed in thesubsection on white-collar crime One difference is that liability issues in bankruptcy have thebenefit of explicit rules in the Bankruptcy Code (Title 11 USC, more specifically, Subsections543–549) These sections of the Bankruptcy Code detail the powers of a trustee to avoid transfersthat defraud, hinder, or delay creditors, give preferential treatment to certain creditors, or do notgive the bankrupt person or entity fair value for the transfer Since these Code sections define thescope of the trustee’s power, an accountant engaged by the trustee should first read and under-stand the relevant provisions before planning the work In addition, an accountant must obtain anunderstanding of certain sections of the Uniform Commercial Code and in particular the UniformFraudulent Transfer Act of the state where the business is situated The location of the businessmay influence the scope of the work since the time period under the bankruptcy statute only al-lows for recovery one year prior to the bankruptcy, whereas state laws vary from 3 to 10 years.Once the appropriate time period and scope have been determined, the accountant needs to reviewall material transactions to gain an understanding as to the economic benefit of the exchange to thebankrupt, including all monetary and nonmonetary exchanges In addition, the accountant needs to de-termine the timing and explanation for any liens or other security interest granted or recorded during thetime period This review should include any asset sales, purchases, foreclosures, and tax assessments.Transactions between related entities or commonly controlled entities or their affiliates must be re-viewed In a bankruptcy case, the accountant is trying to develop any evidence that might show fraud

or fraudulent intent

A preferential payment analysis covers a review of transactions within 90 days (one year for siders) prior to bankruptcy wherein a creditor is paid for an antecedent debt at a time the debtor is in-solvent and such payment is not in the ordinary course of business The definition of insolvency forthis purpose is the fair value of assets compared with the fair value of liabilities—a balance sheet ap-proach “Ordinary course of business” is not defined except by reference to case precedents For ex-ample, if creditors are routinely paid in 90 days but certain creditors get paid just before bankruptcywithin 30 days, such payments are probably not in the ordinary course of business

in-Certain leveraged buyouts (LBOs) have encountered financial difficulty shortly after tion, and some creditors have used various security law and bankruptcy law theories to unwind thesetransactions and seek recoveries from selling shareholders, secured creditors, and others

consumma-The accountant’s work in establishing or defending liability is critical Analyses that show thecash flow of the entity before and after the LBO help establish whether sufficient capital or workingcapital was available to the company Changes in a company’s borrowing, especially where a signif-icant amount of assets have been recently pledged, also illustrate the potential damage to unsecuredcreditors The accountant’s ability to distinguish operating losses caused by the form and structure of

4Grant W Newton, Bankruptcy and Insolvency Accounting, 5th ed (John Wiley & Sons: New York, 1994).

the buyout from losses due to the economy or other competing companies will also assist counsel indetermining whether the LBO can be attacked as a fraudulent transfer.

(viii) Lender Liability Common law verdicts in numerous states have established a duty

requir-ing banks to act in good faith and to provide a reasonable time period for a customer to arrange ternative financing should the bank no longer wish to continue the relationship Other cases involveinaccurate or incomplete responses from banks to inquiries by third parties or failure to honor fi-nancing commitments In some situations the bank’s activity, either as a member of the business’sboard of directors, or in selecting those members, or the bank’s insistence on designating workoutconsultants, places them in a position of being too close to operating the business; and they may findthemselves accountable for its losses or ultimate bankruptcy

al-The accountant’s role is to assist with liability, causation, and damage issues With respect toliability issues, the accountant may develop financial data to determine whether the borrower was

in compliance with various loan covenants at various intervals during the banking relationship,including at its commencement A review of debt and equity items in the financial statementscould identify differences in definitions or inconsistencies between GAAP and the bank loan doc-ument terminology

Accounting consultants working with defendants to lender liability actions may provide useful formation to show the bank was acting prudently in calling a loan or in refusing to extend it based onthe results of a financial analysis of the debtor On the causation issue, the accountant can determinewhether the bank’s actions caused the business failure or whether other circumstances were involved.The accountant’s role in damages is important for both the plaintiff and defendant Damage theo-ries may include both the actual cost of the termination of the credit relationship and more complexdamages, including punitive and racketeer influenced corrupt organizations (RICO) claims wherebusiness failure occurs

in-(ix) Employment Litigation Employment litigation typically involves claims of employment

discrimination (including discrimination on the basis of age, race, or gender) or wrongful discharge.Claims may involve discrimination in hiring, promotion, or wages

The accountant may be involved in both liability and damages phases of employment claims Forliability, the accountant may compile hiring rates, promotion rates, salary levels, or similar historicalinformation to prove or refute a claim of differential treatment This liability work often may be per-formed in conjunction with a statistician

On damages, the accountant may determine what the plaintiff’s income would have been had thealleged discrimination not occurred The accountant will consider the proper level of earnings, thelikely duration of the earnings, and any offset from amounts actually earned The issues are very sim-ilar to loss of earnings claims in personal injury cases Although specific approaches are not dis-cussed in this chapter, the methods are logically similar to lost profits claims

(x) Accountant’s Liability Most litigated claims against accountants have arisen from audit

work Recently, significant litigation has come from compilation, review, and prospective financialstatement engagements

Litigation over audited financial statements generally involves allegations that GAAP was not plied or that the audit was not conducted in accordance with GAAS, or both In class action securi-ties litigation, noncompliance with SEC Regulations S-X and S-K as well as Financial ReportingReleases may also be alleged

ap-During the discovery process, the accountant has the opportunity to explore the underlying ments and associate the facts with the accounting pronouncements The accountant will refer to acompany’s general accounting records and documents as well as to the work papers of the indepen-dent auditor Such a review process requires the expert either to be an auditor or to have some audit-ing background Issues related to the auditing firm’s consideration of GAAP, their consultation withparties in their firm who provide technical expertise, and the extent to which they have researched aspecific area of accounting should be documented in the auditor’s work papers

docu-44.6 TYPES OF CASES 44 17

The accountant may review and assess potential violations of GAAS or other applicable sional standards Such violations may range from the failure of the defendant auditing firm to ade-quately observe the physical inventory, to not confirming sufficient accounts receivable, to notperforming an adequate subsequent events review Liability issues related to a failure to perform anaudit in accordance with GAAS are usually not unearthed until a review of the auditing firm’s workpapers has taken place.

profes-In order to adequately address GAAP and GAAS issues, the accountant must stay current with counting and auditing literature issued by the FASB, the AICPA, and the SEC With these types ofcases, it often becomes necessary to consult with an accountant with relevant industry expertise

ac-(xi) Contractual Purchases Litigation Litigation often results from the purchase of a company.

With such purchases, the audited financial statements are used as the basis for the purchase or dition of the sale The issues often center on the valuation of assets or the quantification and disclo-sure of liabilities in those financial statements Asset values in dispute may include such issues asproper use of LIFO or FIFO, inventory write-downs, unrecorded liabilities, accounting for impairedassets, amortization of goodwill, replacement cost versus book value, and realizable value of ac-counts receivable

con-Many purchase and sale agreements contain a “postclosing adjustment” provision This vision allows for the purchase price to be adjusted based on events that occur or become knownafter the closing The accountant can serve as the expert for the buyer or seller with respect tothe arguments as to why the purchase price should or should not be adjusted The accountant canalso serve as the arbitrator or mediator on such cases

pro-The expert in these cases is usually called on to review the working papers of the dent auditor of the financial statements From these working papers and the notes to the financialstatements, the expert can determine what accounting methods were employed and whether theyare in conformity with GAAP and common industry practice

indepen-Liabilities are of critical importance since the buyer needs to be alerted to all potential andcontingent debts and encumbrances The accountant would determine whether there was ade-quate disclosure of the liabilities in the financial statements that were either issued or relied on

by the buyer The accountant may also need to evaluate whether subsequent events were ably foreseeable

reason-Contracts for the purchase and sale of a company sometimes include a provision regarding amaterial adverse change in the business In these cases, an accountant may be asked to reviewthe financial records of the company to search for any adverse changes in the business

(xii) Breach of Fiduciary Duty These cases involve the issue of whether a trustee, executor,

of-ficer, director, or other fiduciary has breached his fiduciary duties, thus causing damages to the trustestate or corporation The accountant can play a vital role in proving or rebutting liability on the part

of the fiduciary by demonstrating that the fiduciary acted correctly or incorrectly with respect to counting, financial, or economic issues or transaction

ac-(c) NONBUSINESS CASES Important nonbusiness issues include marital dissolution,

partner-ship dissolution, and personal injury matters

(i) Marital Dissolution In many states, the financial aspects of a marital dissolution are governed

by family law statutes that establish rules for sharing of income and the division of property The taxlaws have also greatly influenced the allocation of income and assets during and after a marital dis-solution Most states divide assets “equitably”; a few states are governed by community propertyrules Awareness of the local rules and practices is of critical importance to accountants in their fi-nancial analyses

In cases governed by community property laws, the accountant’s role is often to trace assets, ceipts, and disbursements to determine which assets are community property In cases governed by

re-equitable distribution law, the accountant may be asked to analyze the assets in order to determinewhich assets are subject to equitable distribution He may also be asked to help an equitable distrib-ution of marital assets

The “liability” role of the accountant is to identify all assets and liabilities of the parties sothat a fair and equitable distribution of assets results Most family law courts are equity ori-ented, so the substance of transactions should carefully be considered when analyzing financialdata The forensic accountant has to examine financial data with concern for diversion of assets,improper cash transactions, and padded payroll and other fringe benefits and perks that may de-prive the nonworking spouse of a fair share of the business’s net worth as well as a share ofspousal support

If financial statements do not exist for closely held companies, such financial statements mayneed to be prepared The accountant must be familiar with the local state family law The ac-countant must also be familiar with tax implications of various asset transfers or split-ups so thatneither spouse later finds unexpected tax consequences The accountant should be aware of theproper handling of pension plan assets, individual retirement accounts, 401(k) plans, and the like,

so that each party receives a fair share of assets and so that income tax or excise taxes are nottriggered unnecessarily

In community property states, the existence of separate property and the impact of prenuptialagreements may also require analysis Significant tracing of funds may become necessary if atotal segregation of separate property assets has not been maintained The marital communitymay have rights to a contribution for increased value of separate property that arises from ser-vices provided by the community after marriage Lastly, the community may have some interest

in separate property if joint tax returns have been filed and no separate tax cost was allocated toeach category of assets

Accountants often are asked to determine the value of the assets owned by the litigants as well asthe income sources from which spousal and child support can be calculated The valuation of assetsoften includes business valuation and, in the case of professionals, the value of their shareholdings,partnership interest, or professional licenses Issues such as professional goodwill or celebrity good-will are important and contested often in marital dissolution litigation

(ii) Partnership Dissolution. Partnerships sometimes break up in a manner similar to adivorce The accountant’s work is also similar, focusing on tracing, valuation, and fair appor-tionment of assets and liabilities, usually pursuant to the terms of the partnership agreement, ifone exists

(iii) Personal Injury Personal injury cases stem from automobile accidents, slip-and-falls, and

the like Typically, damage components include medical expenses, pain and suffering, lost earnings,and loss of consortium to the injured party’s spouse The accountant is usually involved in the calcu-lation of lost earnings and in calculations regarding the interest components of the judgment Foridentification of the issues involved, see Subsection 44.4(b)(ix)

44.7 CALCULATING DAMAGES

(a) GENERAL CONCEPTS. In proving liability, the plaintiff must demonstrate that the fendant’s actions were in violation of the plaintiff’s legal rights In moving from liability to cau-sation, the plaintiff must demonstrate that the illegal actions caused injury to the defendant.Only then can damages be calculated In discussing damages, we rely on the concept of the

de-“but-for” world The but-for world is the economic and physical environment that would haveexisted “but for” the actions of the defendant In other words, it is the “undamaged” world, incontrast to the “actual,” damaged world that did occur and in which the defendant performed thealleged illegal acts

44.7 CALCULATING DAMAGES 44 19

(b) MEASURING DAMAGES Depending on the case, there are many different standards by

which damages are measured, including the following four:

1 Lost profits (past profits, prospective profits, or both, including increased costs)

2 Lost asset value (the appraised value of identified assets, including goodwill, or other intangibles)

3 Lost personal earnings (wages, salary, etc.)

4 Lost royalties or licensing fees (amounts due for use of the plaintiff’s assets or rights) or share

of profits pursuant to participation agreements

In most cases, these approaches are all attempts to compute the difference between the but-forworld and the actual world That is, they attempt to measure the difference between what shouldhave happened and what actually did happen

Lost profits are the most common standard for business cases Valuations are used in bothbusiness disputes and marital dissolution proceedings Personal earnings is the damages stan-dard for the economic component of personal injury suits (Other components are medical costsand pain and suffering.) Reasonable royalty is used in intellectual property disputes, especiallypatent cases

(c) MITIGATION A plaintiff has the obligation to mitigate damages This means that the plaintiff

must take reasonable steps to minimize the damages suffered More specifically, the courts (and ages experts) will compute damages as if the plaintiff mitigated, whether the mitigation really oc-curred or not

dam-In many cases, reasonable mitigation will have occurred, and the expert may look at the ence between what should have occurred and what did occur as the measure of damages After all,the plaintiff’s recovery through litigation is uncertain, and plaintiff has every incentive to reducedamages to itself However, if reasonable mitigation did not occur, the accountant should make thenecessary adjustments

differ-(d) INTEREST ON DAMAGE AWARDS Some or all of most damage awards are to compensate

for past losses In order to be made whole in economic terms, it might be supposed that the plaintiffshould earn interest on past losses from the date of loss to the date of payment However, the lawdoes not always allow interest, and when it does, the interest rate is not always the rate applicable tothe economic circumstances

In general, the treatment of interest is governed by the applicable law The courts distinguishbetween prejudgment interest (accrued between the date of loss and the date of trial or final judg-ment) and postjudgment interest (accrued from the date of judgment to the date of payment,which can be years if the judgment is appealed) In some jurisdictions, the rate of interest is set

by law Depending on the case, some jurisdictions do not allow prejudgment interest; most allowpostjudgment interest

Some interest awards are within the province of the court Some judges may allow calculations ofinterest to go to the jury as part of the damage claim; others may reserve the right to separately com-pute interest (either at the statutory rate or at a rate depending on proof) after the jury awards dam-ages If the court allows economic testimony as to the amount of interest, what is the properapproach? The accountant should determine interest by recreating what would have happened to theplaintiff had the money been received at the times the damage claim asserts The issues to be ana-lyzed include the following:

• The amount of cash that would have been received This is not necessarily the amount of net

income Adjustments should be made for changes in working capital, capital expenditures, preciation, repayment of principal, and so on

de-• The income taxes that would be paid on the income Interest should be calculated on

after-tax cash available for investment, as that is the amount that would be available in the but-for