Top 5 Mistakes with Business Income Loss Claims

Keeping with my theme of fives (see The Accounting Fives), I've decided to write about the top 5 mistakes in business income loss claims. Insurance companies view certain business income loss claims as straightforward. As such, they tend to handle these claims internally. While certainly not intentional, mistakes sometimes arise. These mistakes ultimately overstate the loss. It is true that there are some mistakes that understate the loss; however, insureds are usually quick to recognize if the business income settlement appears too low. Accordingly, mistakes that understate the loss are usually just temporary. By contrast, insureds don't often see problems with settlements in excess of their expectations. This is not because they are trying to be sneaky. Rather, insureds may believe the "overage" is just a product of the insurance policy.

I've traveled around the country providing business income loss training for commercial insurance adjusters. In each of my sessions, I train participants to avoid the the top 5 mistakes discussed below.

1. Not using "net" income

The policy generally defines business income as the combination of net income and continuing, normal operating expenses. Net income represents the bottom line number after all expenses and costs. Mistakes arise when one uses gross profit or sales instead of net income. This is the most common mistake I see. In addition, it has a potentially greater impact on overstating the loss than any of the other mistakes discussed here.

This is an easy mistake when one is not versed in accounting. One may conclude that gross profit (sales minus cost of sales) is net income, since the costs of the product or service were deducted. Further, one may see a report that reflects "net sales" and believe this is tantamount to net income.

The impact of this mistake is extraordinary. I selected a sample of my recent business income loss calculations involving a relatively short loss period. On average, using gross profit plus continuing expenses overstated the loss by 197%! Even more staggering was the impact of sales plus continuing expenses. This ill-conceived method overstated the loss by an average of 413%!

2. Paying continuing expenses twice

Business expenses are the basis for several elements of an insurance claim. For instance, the insured's employees may spend time cleaning up after a fire. This clean-up labor expense may be covered and paid under the property portion of the claim (expenses to rebuild or restore property). If the insured also has a business income loss claim, this same labor expense may mistakenly be included as a continuing expense, and paid twice.

This is the second most common error I see. The potential for this error arises anytime the insured has other claims in addition to a business income loss claim. For instance, a valuable paper claim might include employee labor. An extra expense claim might include costs for the insured's machinery and equipment used to clean up or mitigate a loss. If these machinery and equipment costs include depreciation, lease payments, or repairs, odds are they will be picked up again in the business income loss claim as continuing expenses.

3. Paying for unproductive labor

In this case, an insured admits that the business did not lose sales, but incurred payroll expense even though employees could not work for a certain period of time. A claim for "lost payroll" usually follows. The business income loss policy states that business income includes continuing normal operating expenses, including payroll. Consequently, the adjuster may believe the claim for lost payroll is reasonable. However, there is no stand-alone coverage for payroll. It is a component of the business income loss, provided the insured suffers a business income loss. An insured incurs a business income loss only if there is a loss of sales. Therefore, from a policy standpoint, the claim for "lost payroll" is not covered.

This also makes sense from a practical standpoint. Payroll is a business expense. Business expenses are paid from a company's sales proceeds. Therefore, if the company did not lose sales, it is able to continue paying employees as normal, eliminating the need for an insurance reimbursement.

4. Errors in sales projections

A business income loss evaluation starts with a determination of lost sales. When the proper amount of scrutiny is not applied, mistakes abound. A common approach for non-accountants is to project sales using the corresponding period from the prior year. The problem with this approach is that sales are almost never identical from year-to-year. Factors such as trends, economic conditions, changes in business practices, inflation/deflation and the weather among other items have the potential to affect the comparability of a given day, week or month from one year to the next. If these kinds of factors are not considered, the sales projection is likely erroneous.

The errors in sales projections don't always involve prior year comparisons. Errors also arise when inappropriately using current year data to project sales for another period within the same year. For instance, one may use August's average daily sales for an apparel retailer to project September sales. August sales may be high due to back-to-school shopping, which would not occur at the same pace in September. Similarly, if one used June and July sales for an ice cream vendor to project sales for August and September, that projection would also likely be overstated due to the change in seasonal demand.

The solution to these problems lies in understanding the business and its sales patterns. Obviously, small claims do not require detailed and exhaustive sales analysis; however, they do require acknowledgment of issues that affect comparability of sales from one period to another.

5. Paying continuing expenses in excess of what was used to determine net income

This is the most technical of all of the top 5 mistakes. Given its nature, an example provides the best explanation. If a business pays, say $6,000, each year for property taxes, the monthly average is $500. So, for a one-month business interruption, one would deduct $500 in determining net income for the month. Since this expense would likely continue during the one-month period (i.e. no abatement), $500 would also be included in continuing expenses. Thus, $500 is deducted as part of determining net income, but is added back as a continuing expense.

If the affected month just happens to be the month that the insured pays its annual tax bill, the insured may present the bill for $6,000 and want to increase continuing expenses by $5,500 - the difference between the $500 included in continuing expenses and the $6,000 bill. If the insured is then paid $5,500, that's $5,500 too much! Increasing the expense to $6,000 is incorrect since the annual tax bill relates to more than one month. However, if the insured insists on including the extra $5,500, net income would have to be decreased by the same amount. Thus, there were be no net change to the combination of net income and continuing expenses (one decreases and the other goes up by the same amount).

This problem is brought to bear by the use of "cash basis" accounting. Cash basis accounting involves recording revenue when it's received, as opposed to when it's earned, and recording expenses when they are paid, instead of when they are incurred. While cash basis is not acceptable under generally accepted accounting principles, it is widely used by small businesses. As you can see, there is a large potential for this 5th mistake!

So there you have the top 5 mistakes with business income loss claims! These mistakes highlight the intricacies of such claims, along with the benefit of forensic accountants.

The Accounting Fives

A few months ago, I posted an article titled "Internal Controls and the Five Senses." More recently, I discussed the five methods used to project sales when performing an income loss evaluation. Two fives. A coincidence? Maybe not; as it turns out, five is quite popular in accounting. This is a strange observation since five is an odd number and accounting is all about symmetry and balance.

After the five senses of internal controls and five methods for projecting sales, the other five that comes to mind is the five components to a set of financial statements: balance sheet, income statement, cash flow statement, retained earnings statement and disclosures.

Speaking of financial statements, CPAs are the only licensed professionals allowed to express an authoritative opinion on them. They express this opinion by first conducting an audit. When a CPA performs an audit, he or she is validating a number of assertions inherent in the financial statements. How many assertions, you ask? Five, of course! The five financial statement assertions are listed below:

1. Existence or occurrence - Transactions reflected in the accounting records have actually occurred and assets reflected on the balance sheet actually exist.
2. Completeness - The financial statements include all material transactions.
   
3. Rights and obligations - The company has actual rights to its assets and is obligated for the balance sheet liabilities.
   
4. Valuation - All items are properly valued (historical cost, lower of cost or market, net realizable value, etc.).
   
5. Presentation/disclosure - The financial statements are presented properly and include all relevant and required disclosures.
   

The five assertions are drilled into every auditor's head. Every auditor was once an auditing student. As students, we learned the auditing procedures. Since there were so many auditing procedures, someone along the way created a clever acronym to package them - FIVE CARROTS. Another five! In case you are wondering, the acronym stands for: Footing/crossfooting, Inquiry, Vouching, Examination, Confirmation, Analytical procedures, Reconciliation, Recalculation, Observation, Tracing and Subsequent event review.

The occurrence of fives is interesting, so I considered this phenomenon further. While the five financial statement components, five assertions and the five-based acronym are an impressive string of fives, I thought there must be something bigger. So I looked back to the basis for all of accounting. The accounting equation: Assets = Liabilities + Equity. But that's only three components. Or is it?

Equity is a multilayered component. It includes contributed capital and earned capital. But even if we split equity into two pieces, that still just leaves four components to the accounting equation. Well, to make the equation clearer, equity needs another split. Earned capital is a nebulous sounding term. In essence, it represents profits. And even those who are not accountants know that profits represents the difference between sales and expenses. I have now laid out the world of accounting: assets, liabilities,contributed capital, sales and expenses. Thus, the accounting equation in its purest form is: Assets = Liabilities + Contributed Capital + Sales - Expenses. There you have it; while hidden from the untrained eye, the accounting equation actually does have five components!

I think I'm on to something with these fives. I'm beginning to think the "high-five" might have been started by a group of accountants after they performed the profession's first closing of the books. At this point, it might be worth googling!

Business Income Claims in a Recessionary Environment

There's been no shortage of reporting on the "global economic crisis" in the media. What started as a Wall Street problem of bad (or "toxic") loans and related write-downs culminated into a freezing of the credit markets in September 2008. This, in turn, spelled severe problems for Main Street.

At that point, consumer spending slowed dramatically, as did corporate profits; as a result, companies cut jobs, which hampered consumer spending even more. Companies then cut more jobs. And this vicious cycle continues. While the economic storm may have been brewing for some time, all of this happened rather rapidly. To the right is a chart that measures the year-over-year change in retail sales (excluding automotive and parts dealers) for 2008 relative to 2007 (click the chart to enlarge it). The chart shows that 2008 started out positive due to the effects of inflation and an increase in consumer demand. But then in October, the bottom fell out, so to speak. This data suggests that the economy is every bit as bad as the media portrays it.

The current state of the economy is having implications on the claims process, namely business income loss claims. These implications are both procedural and technical. From a procedural standpoint, time is of the essence like never before. Typically, the business income aspect of a significant property loss claim took a backseat to property repair or replacement. Insureds were more concerned about repairing/rebuilding property and/or replenishing inventory. This well-reasoned priority stemmed from the fact that resolving property aspects of the claim would prevent continued income losses. But with the current state of the economy, many companies are so strapped for cash that the slightest interruption in sales can wreak havoc on the day-to-day financial affairs. Thus, business income loss claims are now a serious priority.

Those businesses affected by the economy may pressure the adjuster for a quick settlement or advance. While a quick resolution to the claim is in all parties' best interests, the heightened pressure could lead to errors. For instance, if an advance is made to an insured based on pre-recession financial statements, the adjuster runs the risk of advancing more than the actual loss sustained. Most policies generally define business income as the combination of net income (or loss) and continuing normal operating expenses. Documentation of continuing expenses often serves as a basis for advances. However, if the business is operating at a loss (as is possible during a recession), or if operations are only partially suspended, the business income loss is less than the company's continuing expenses. Again, adjusters run the risk of over-advancing. With time sensitivity inherent in today's business income loss claims, a forensic accountant is paramount. If engaged early, the forensic accountant can gather basic information to estimate the loss, and facilitate advances. Even if current financial records are unavailable, a forensic accountant will be able to estimate the economic impact for the subject company.

From a technical standpoint, the recessionary environment is causing a need for increased scrutiny. The simple "comparison to last year" method for establishing a loss is now fraught with problems. For instance, comparing a retailer's December 2008 sales to its December 2007 sales may reflect a deviation. But how much of the deviation is due to the economy versus the circumstances of the loss? The answer will be found in a pre-loss trend analysis. Thus, year-over-year comparisons should not be used in isolation; they must be preceded by a trend analysis.

As a case in point, I was recently engaged in a case where a travel company experienced intermittent computer failures over an approximate 2-week period in December. There was a large gap between sales for December 2008 and December 2007, which was the basis for the claim. A pre-loss trend analysis revealed that sales were down between 30% and 45% in October and November 2008, relative to those months in 2007. Thus, I determined that most of the difference in December 2008 was due to the economy, not computer problems.

Trend analysis is critical. However, the trend must be correctly interpreted. For instance, if a company's sales were up say, 10%, for January through September 2008, but down 10% the rest of the year, a full year trend analysis may show an increase (9 months of an uptrend and 3 months of a downtrend). Recall the chart above, which revealed a rapid deterioration in consumer spending. Due to this change, sales trends prior to September 2008 are meaningless, in a lot of cases. Thus, one must carefully consider the intra-year trend, the changes in the trend, and the most likely trend during the claim period.

Business income analysis consists of both sales and expenses. Just as the sales part of the equation presents challenges in a recession, expenses do as well. For instance, if a company lowers its selling price to attract more customers, the gross margin and cost of sales ratios are affected. Thus, pre-recession margins are not an accurate indicator. In times of recession, companies typically first respond by reducing payroll. As a result, if one uses a pre-recession income statement to determine projected payroll expense, the projection may be overstated. Also, companies may be behind on rent payments. If the company keeps cash basis financial statements, rent expense is thereby understated. Accordingly, one may understate projected rent expense. The list goes on and on. The point is that one must be aware of which expenses have the potential to be impacted.

At some point, the economy will turn around. Claims subsequent to that period will have the inverse of the issues discussed in this article. For example, sales may be increasing so the trends experienced in the recession are irrelevant. Margins may expand, thus rendering the recession based cost of sales ratio useless. Payrolls will increase. And the pressure for quick advances and/or settlements may subside, as companies build cash reserves and favor accuracy over speed. Let's hope this time is just around the corner.

The New Assurance Forensic Accounting Website...6 months after

At midnight on May 8, 2008, we launched version 3 of the Assurance Forensic Accounting website--a feat nearly six months in the making! So, six months later, I thought I'd take a look back at the site, which has been a great success by all measures. For the current site, click here; the prior version of the site is located here.

The Goals

We wanted a clean, straightforward site that was also engaging. Our designer captured all of these elements. The visual design achieved the clean feeling we were after, and the text and navigational tools were simplified. We wanted to explain our services in the clearest way possible. This was a tall order considering the breadth of our services and the complexities of our work.

Forensic accounting includes a myriad of services: Business income loss, extra expenses, employee dishonesty (fraud), inventory verification, and cash tracing, to name a few. The insurance industry has various structures such as property, liability, fidelity and subrogation. In the end, we were able to collapse all of these services and structures into two categories: Income Losses and Asset Losses. An excerpt from the site follows (to view the service page, click here).

"While the labels and structures of claims vary, every commercial claim is either an income loss or an asset loss. That's because each loss ultimately finds its way onto one of the two primary accounting statements -- the income statement or the balance sheet. Income losses leave their mark on a company's income statement, while asset losses dent their balance sheets."

The new text delivered on our goals for clarity and simplicity. The site navigational framework also added an element of simplicity. The site uses slide-out panels to display text and different segments of information. This technology eliminates annoying scrolling issues, and allows the user to control the flow of information. We used the slide-out panels throughout the site, but the services and advantages pages are among my favorites.

To make the site engaging, we added various upgrades to our user features. Through the client tools panel, clients can check the status of their assignments and engage in instant messaging with our firm members.

The Result

The new site has made quite an impact. Visits and page views increased 108% and 120%, respectively, in the first 6 months! We also received no shortage of positive feedback:

"That's a great looking site!"

"Great choice of colors, everything is well proportioned and the pics of the dog are really well integrated."

"Absolutely amazing"

"I love the top dog!!"

The "new assignment" form is quite something!

The Dog

While the text and technical design of the website were impressive, the images of the bloodhound, our firm logo, made the site come alive. Featured prominently on almost every page is Vassar, a champion bloodhound.

Vassar, named for bluegrass fiddler Vassar Clemens, was born in Milford, New Jersey on October 14, 2005, and comes from a long line of champions. Many of his family members have been nationally ranked top show dogs. Hounds generally mature physically and mentally slower than other breeds, which is why Vassar's achievement of his Canine Good Citizen (CGC) Title is so impressive. He received his title at the remarkable age of six months! The CGC measures a dog's ability to obey several different commands and challenges that they may encounter in everyday life as well as the dog's ability to cope, obey and be under complete control of their owner. Vassar passed these tests with flying colors!

Vassar received his Championship on July 27, 2007 and has won 27 Best of Breed awards. Nationally ranked in 2007, Vassar was invited to the 2007 AKC/Eukanuba National Championship. Today, Vassar lives in North Georgia and is competing in AKC dog shows across the nation.

The Future

We are already at work brainstorming for version 4 of the site. Stay tuned!

New Credential For Forensic CPAs: A Good Thing

There's exciting news on the accounting front! The AICPA recently announced that it will offer a new specialized credential for CPAs beginning this fall. The new credential will be known as "Certified in Financial Forensics," or simply, CFF. The CFF joins the three other specialized credentials offered by the AICPA, which include: Accredited in Business Valuation, Certified Information Technology Professional and Personal Financial Specialist.

Personally, I'm pleased with the news of the credential. I entered the specialized forensic accounting field long before the popular TV series, CSI, made forensics cool. In fact, at that time, forensic accounting was a specialty pursued by only a small number of accounting firms. Today, it couldn't be more different. Just about every public accounting firm advertises that they now offer some type of forensic services in addition to their traditional accounting services. By contrast, forensic accounting represents 100% of my firm's work.

One can appreciate the difference between a specialist and a dabbler. For instance, if you are going in for brain surgery, would you trust someone who performs such surgeries from time to time, or would you demand a specialist? The question is rhetorical and the answer is, of course, obvious. With regard to forensic accounting, it is my hope that the new CFF credential will help to separate the forensic practitioners from the part-time pretenders.

The foregoing statements bring to light an interesting concept. Just what is the difference between a forensic accountant and a traditional accountant? We'll first explore the role of the traditional accountant. Traditional accountants perform services such as preparing financial statements (a service known as a compilation), preparing tax returns, and auditing (i.e. validating) client-prepared financial statements. In performing these services, the traditional accountant follows established rules, standards and laws. For instance, when performing an audit, the accountant will use what is referred to as an "audit program." The audit program lists a step-by-step set of procedures for performing the audit. When preparing a tax return, the accountant uses the forms provided by the IRS along with the rules of the tax code. In summary, the traditional accountant prepares standard reports or forms, and does so in strict compliance with specific rules.

For the forensic accountant, there is far less emphasis on preparing records. Instead, the forensic accountant focuses on analyzing records. For instance, a forensic accountant may analyze records to determine any of the following: if a fraud has occurred; how a fraud occurred; the projected sales and expenses results for an interrupted business; the level of inventory on-hand prior to a casualty; or the amount of cash stolen from a business. In a nutshell, the forensic accountant performs analysis to answer "what happened and how?" in the case of a fraud; or in the case of a business interruption, the forensic accountant answers the question, "what would have happened and why?"

Unlike the traditional accountant, the forensic accountant does not have a defined set of rules to follow. Since the circumstances of each case are different, it is up to the forensic accountant to determine the steps to follow, the methodologies to employ and the most appropriate manner upon which to communicate his or her findings.

Another area of difference between traditional and forensic accountants pertains to creativity. Due to the rule-based structure of their engagements, traditional accountants have very little latitude to exercise creativity. It's completely different for the forensic accountant. Not only does the forensic accountant not have a "rule book," he or she is often faced with incomplete information. Thus, the forensic accountant needs to be skilled in "figuring things out." This may involve solving for variables, much like an algebra equation. Forensic accountants also creatively find answers and fill gaps through accessing public records or performing industry research.

When a traditional accountant performs work for a client, he or she is rarely questioned. Often, his or her work is accepted by the client since he or she is "the expert." A forensic accountant does not enjoy this luxury. The work of a forensic accountant is questioned frequently and scrutinized heavily. Why? It all boils down to the nature of an engagement. A forensic accountant is hired when something goes wrong. And when things go wrong, there are often times parties on both sides of the situation do not agree. Therefore, the forensic accountant must be meticulous in documenting his or her opinion, and extremely well versed in defending that opinion. Since the traditional accountant is rarely questioned, he or she may not have honed these skills.

Given the contrast between a traditional and forensic accountant, one can appreciate the need to designate expertise and specialization within the accounting profession. The new CFF credential will help do just that.

Uses and Misuses of Industry Ratios

Ratio analysis is a powerful tool for the financial statement analyst. From a company's financial statements, one can calculate a host of meaningful ratios including profitability, efficiency and leverage. While one can calculate these ratios for a given company, there are services available that compile ratios for dozens, if not thousands, of companies within a given industry. These are often referred to as "industry ratios." Most services categorize the industries consistently with the North American Industry Classification System.

Industry ratios are often used in forensic accounting engagements such as business income loss evaluations or business valuations. When used correctly, they effectively buttress the accountant's conclusions. But on the flip side, using these ratios inappropriately will compromise an entire engagement. To provide insight into how to use these ratios, I've compiled the top three uses and misuses of industry ratios.

Top Three Uses

1. Gaining an understanding of an industry.

Balance sheet and income statement ratios are often a great first place to start when learning about an industry. Balance sheet ratios such as accounts receivable, fixed asset turnover and debt to equity allow the reader to determine if customer credit is an important element of the industry, and whether the industry is capital intensive. If accounts receivable turnover is high, then customer credit is not important and all sales proceeds are collected quickly. If, however, accounts receivable turnover is relatively low, one can conclude the industry is competitive, which causes customers to demand high terms, or the average selling price for the industry is high, thus requiring customer financing. A low fixed asset turnover ratio would imply the industry is capital intensive, as would a high debt to equity ratio.

The income statement ratios also paint a picture of the industry landscape. For instance, a net profit margin less than the average stock market return implies the industry is not especially profitable. The lack of profitability may stem from competition from within the industry, or outside competition which is causing downward pressure on the demand for the goods and services within the industry. In contrast, the ratios for a different industry may show a high gross profit margin. This could imply the presence of government protection (such as patents for drug companies), or the presence of intellectual capital that is not easily replicated (as is the case for the software industry).

2. Supplementing incomplete records.

When preparing a business income loss evaluation, sometimes the records of the insured company may require supplementation with industry ratios. There are several scenarios under which records for the insured business are incomplete. First and foremost, the company may not keep complete and accurate records. Also, the company's records may have been lost or destroyed by fire or other casualty. Finally, the business may be new and not have an extensive operating history.

When any of the foregoing situations arise, industry ratios are a valuable tool in preparing income statement projections. In these cases, sales are determined by bank statements, sales tax returns, or other third-party documents. One can obtain major operating expenses such as rent and payroll through lease agreements, payroll filings, and/or inquiries. Industry ratios are then used to construct the remaining unknowns on the income statement.

3. Correcting obvious errors.

I once evaluated a business income loss claim for a pizza restaurant that was closed due to a fire. The company's tax return reflected an approximately 15% cost of sales ratio, which is beyond abnormally low. I believe the company presented a doctored tax return, in order to make the business appear highly profitable and thus collect more insurance proceeds. However, I was able to correct the obvious error by relying upon an industry average cost ratio for a similarly-sized pizza restaurant of around 36%. Had every single expense item appeared out of line, I would not have used the industry averages. Rather, I would have performed a more exhaustive audit of the company's records to reveal the true numbers. However, industry ratios are especially useful when correcting only a few obvious errors within the records.

Top Three Misuses

1. Comparing a company to the industry average

The biggest misuse of industry averages is in fact something that is routinely done--comparing a specific company to an industry average and drawing a conclusion. I see this exercise performed in business valuation engagements. For instance, a practitioner may evaluate a retail store and conclude the subject company has an area of weakness in that its gross margin is 48% when the industry average is 41%. One has to recognize that the "industry average" company does not exist. It is simply the mathematical average (or median depending on the reporting service) of an aggregation of many different companies, with many different products, many different customers, many different goals/operating philosophies, and many different locations. An average is a collection of numbers that are higher and lower than the average. With this in mind, a flat out comparison of a given company to an industry average is meaningless.

There is an exception to this general premise, however. If the subject company is a franchised operation, a comparison of its ratios to the average ratios for other franchisees is meaningful. Why? Franchised operations have standardized procedures, training, products and marketing. Therefore, deviations from the averages of other franchised operations can be a good indicator of management effectiveness, customer loyalty or location.

In the context of a business valuation, it is meaningful to compare a company's own operating and balance sheet ratios over a period of several years. This highlights positive or negative trends within the organization. But, as previously stated, a comparison of the company's ratios to industry ratios is meaningless.

2. Adjusting records for slight deviations from the average.

Some practitioners may have cause for alarm with a 5% to 15% deviation between the subject company's ratios and the industry average. They may then be prompted to make adjustments. Deviations are not only acceptable, they are expected. For instance, a retailer with a high sales mix of house brands likely has a better gross margin than the industry average. Thus, there is no cause for alarm, and certainly no cause for adjusting the records. This concept differs from the example of the obvious errors that I explained earlier. The point is that practitioners must not treat industry averages as absolutes.

3. Using mismatched data

For those times when it is appropriate to use industry averages to correct obvious errors, or supplement incomplete records, it is critical that the practitioner use correct industry averages. I worked on a lost profits case for a startup retailer. Since there was no operating history both the opposing accountant and I developed a set of projections that involved industry averages. There was one huge difference, though. My data was based on the industry average for companies with an asset base similar to the subject company, while his was based on Wal-Mart. That's right Wal-Mart--the world's most efficient retailer. It wasn't too far into the case that his analysis was discredited.

The foregoing example was relatively obvious. But potential mistakes are often more subtle. For instance, if a restaurant has both dine-in and catering services, an industry average for restaurants probably wouldn't be meaningful. A breakfast-only restaurant is another good example. Breakfast foods enjoy huge margins. As such, industry average for restaurants wouldn't be meaningful for a breakfast-only restaurant. The point is that one has to obtain relevant information. Sometimes this involves multiple sets of industry data, if the subject company has more than one business. Some services offer industry ratios based on company size and location, which is also helpful. Simply, use the right ratios to avoid the garbage in, garbage out situation.

Fraud and the Small Business

Each year, my firm analyzes a significant number of employee fraud cases involving small businesses. I've observed that employee frauds most frequently occur with moderately successful small businesses. In this context, the profile of a moderately successful business is one in which the owners enjoy an above-average living, but at the same time are not so successful to bring the need for a structured environment with layers of management.

A fraud can also occur at a strugging small business; but from a practical standpoint, this is less likely. A struggling small business inherently has fewer assets available for misappropriation. Thus, the incentive for fraud is not relatively high. Also, the owners of struggling businesses tend to watch the dollars closely, so a loss due to fraud would get noticed fairly quickly.

So, we have the moderately successful small business in the crosshairs of fraudsters. There is another common thread among the victim companies: in almost every case of employee fraud at the small business, there is significant deficiency in internal controls. It makes one wonder-- do these companies intend to have weak controls? I'd venture to say no. Do the owners sit down and design a control structure that is highly flawed? Sometimes, but this is not often the case. So the problem is not due to ill intentions or failed designs. Instead, it boils down to priorities.

Small businesses are created by entrepreneurs. The profile of an entrepreneur is someone with great vision and great passion. Generally speaking, entrepreneurs are not driven by the quest for money. Instead, they have a passion for the product or service around which the business is formed. It is this passion that brings success. Therefore, money is simply a by-product of entrepreneurs pursuing their true passions. As a result, the financial side of the business is not a priority for the owner. The financial affairs are usually delegated to an employee with little or no oversight. And that's how it all gets started. Managing the financial aspect of the business is not a priority, or sometimes even a concern, for the owner.

With the moderately successful small business, the owner/entrepreneur enjoys an above-average living, and at the same time pursues his or her passion. And with this, life is pretty good. Even if there is a fraud, as long as the owner continues to make his or her above-average living and continues to pursue his or her passion, the stolen funds are not even missed.

Within my firm, we see a disproportionate number of fraud with small medical and dental practices. This is a case-in-point of my premise. The owners of these firms are doctors and dentists. These individuals have a passion for providing patient care. They often have limited financial knowledge, and almost zero passion for finances. Their days are consumed with providing care. The last thing on their minds is how and when deposits are made. They simply trust someone else to take care of it. It is just not their priority. The lack of priority cause the owners to turn a blind eye to the financial side of the business, thereby leaving a gaping hole for a filching employee.

Fraud can stymie the growth of the moderately successful small business, thus prohibiting its ascension. But if the business avoids fraud and expands, it can successfully move to a safer playing field. With a greater level of success, the company will require layers of management to operate smoothly. And within these layers, a better segregation of duties and controls often exists, which helps prevent fraud. In the meantime, what is the small business to do? Find out in my recent post "Internal Controls and the Five Senses."

Accounting is Life

I was drawn to the accounting profession when I heard the phrase "accounting is the language of business." I'm not sure who coined that phrase, but I'm taking credit for this one - "Accounting is Life."

What a bold statement. It's a statement that no doubt requires explanation. So here goes. We start our lives with basic everyday needs such as clothing, shelter and food. These items are provided by our parents or other custodians. These items do not come free and therefore require expenditures. Within the accounting world expenditures are characterized as "operating expenses," or "investments." In our early years, we are the beneficiaries of investments by our parents. That's right, our parents invested in us. They provided funds so that we could meet our basic needs, and perhaps a little beyond. One makes investments for the prospect of a future return. Our parents invested in us in return for the joys and experiences of raising us and the satisfaction of taking credit for helping us to achieve our goals in life. In accounting, the difference between an expense and an investment is generally that an investment will provide benefits in future periods, where the benefits of an expense pass quickly. For instance, a meal is an expense. What we eat for lunch will not likely provide much benefit after today.

As we progress in age, we stop receiving the benefits of investment. We begin working and paying for our own basic expenses. And in doing so, we engage in accounting transactions daily. Every hour we are on the job, we are accruing, or earning income. We spend those earnings on operating expenses or investments of our own. Thus, every single day, we are compiling transactions for our personal income statement, or balance sheet.

As we work and control our expenditures, we have savings, much like a corporation earns profits. We often invest those savings in a savings account, brokerage account or a house. A home is the ultimate accounting transaction for most of us. The price we pay for the home plants itself firmly on the asset side of our personal "balance sheet." It is not alone on the balance sheet, however. The mortgage is shown on the liabilities side of the statement. And the difference between the two represents our down payment through savings, which is our equity. And so it is: each time we invest, we change our balance sheets. The fact is that our balance sheets are continually changing. As we pay the principal on the house, the mortgage balance goes down and the equity goes up. We change our balance sheets more often than we change our bed sheets (don't quote me on that one).

Let's change the focus from investments to operating expenses. Our operating expenses include gas, home maintenance, supplies, food, entertainment and so on and so forth. These are all transactions for our "income statement." But it's even larger than that. Each time we purchase an item, somebody else receives a sale for the "income" section of his/her or a corporate income statement. The transactions in which we engage are included in the earnings reports published by large, publicly traded companies. These earning reports impact the companies' stock prices. The stock prices then have an impact on the entire capital market system, and affect the amount of capital available for lending or borrowing. The capital market system then has an impact on the economy. The economy then impacts everything from a company's expansion, to an individual's choice to invest in a child. This sounds like the circle of life. It's the circle of accounting.

One could also draw comparisons between life and other business disciplines. Take marketing, for instance. Marketing on a personal level could be how you present yourself in an interview or on a date. Likewise, business management theories may provide practical insights into running our family lives, or conducting our social network. But here's what separates these notions from accounting--accounting occurs naturally. A successful marketing campaign does not just happen. And the management of anything requires active attention. But accounting can occur while you sleep. That's right: the interest income in your investment account accrues while you sleep. In comparison, if you don't get out of bed for, say, three days, you will have accrued more interest expense on your mortgage payment than three days before. And at the end of three days, you are probably pretty hungry, so your need for food expenditures has not gone away.

Accounting occurs naturally. It is the natural result of running our lives. Accounting is all around us. It continues while we sleep. It engages us when we are awake. It can even occur without us knowing it. It's been here long before us, and it will survive us. Yes, accounting is life.

Chad Thompson Speaks at KSU

I received my undergraduate degree from Kennesaw State University (KSU), a school well known for its excellence in accounting education. Within the Masters of Accounting program, KSU requires a Forensic Accounting class. I am very happy about this requirement, since I believe all accountants benefit from some level of forensic exposure. I'd really like to see a forensic accounting class become a requirement for sitting for the CPA exam.

I was recently a guest speaker in the class. The class primarily focuses on the fraud detection and prevention side of forensic accounting. However, my speech was geared towards the analytical side of forensics with an emphasis on determining income losses for commercial entities. The students received exposure to making conclusions with limited documentation, identifying red flags within accounting reports, thinking critically about business operations, and how to defend their work product in a court of law.

I have no doubt that we will welcome some of the students into the forensic accounting world. Why am I so confident? My firm's last three hires were KSU graduates that had their interest sparked by the graduate level forensic accounting class. Keep up the great work, Dr. Hermanson!

Internal Controls and the Five Senses

Large scale corporate malfeasance over the past decade was a call to action for the executive and legislative branches of our government. They responded (as only our government can) with a massive piece of legislation called the Sarbanes-Oxley act. The act contained a myriad of new laws aimed at strengthening the internal control and reporting standards for public companies. All of this came with a hefty cost to American companies, and ultimately the taxpayers to whom they pass along their costs. And just what is the cost? A study by the law firm of Foley and Lardner found the Act increased costs for publicly held companies by 130 percent!

Money is often a solution for problems; and fraud is no different. With enough money, companies can implement processes and standards to prevent or reduce fraud. But small businesses are not covered under the Sarbanes-Oxley umbrella, which is actually a good thing since it would cost more than the typical small business could bear. While many small businesses are plagued by deficient internal controls, protecting the business from fraud does not have to be an expensive endeavor. To a degree, sufficient internal controls are as simple as the five senses: sight, hearing, touch, taste and smell.

We'll start with sight. When a small business finds itself the victim of employee fraud, I've found the business owner typically does not even look at the basic accounting documents. I was involved in a case in which the bookkeeper pocketed every single bit of cash received from customers for almost three years. During this time, only checks were deposited at the bank--never any cash. This company's cash sales were small in comparison to the check side of the business. However, the missing cash added up to about $300,000 over the relevant time frame. This fraud could have been prevented, or caught very early on by using the sense of sight. If the business owner simply looked at the prepared deposit tickets, or the deposit receipt validated by the bank, he would have seen rather quickly that cash was not being deposited. As it turns out, however, nobody other than the bookkeeper ever saw the deposit tickets.

The topic of sight reminds me of another case. The victim this time was an ophthalmologist. There were virtually no segregation of duties within the office; the office manager pretty much handled everything. And in this case, "everything" included stealing a healthy chunk of cash receipts. The company's monthly financial statements were compiled by a local certified public accountant. As such, the office manager knew that if the bank deposits did not match the computerized sales records, she would be discovered. So to cover her tracks, she created phony refund transactions commensurate with the amount of cash she was stealing. The first year during which she perpetrated the fraud, the company's refunds grew from around two percent of revenue to eight percent. This aberration was clearly shown in both dollar and percentage terms on the second line of the company's income statement. The business owner never even looked at the statements. Apparently, the accountant didn't either. But for the most extreme circumstances, refunds should never be so high for a professional practice. If only the owner had used the sense of sight and looked at the statements early in the life of the scheme!

The next sense is hearing. Small business owners should listen carefully to what they hear. I once evaluated a case where the company's office manager was stealing money using various methods. She racked up over a quarter-of-a-million dollars in ill-gotten gains. Her scheme was ultimately detected only by happenstance. When I interviewed the business owner, he recalled a time when he heard this employee talking about the new lake house, jet skis and other goodies that she and her husband were enjoying. Knowing what he paid his officer manager, he admitted that hindsight was 20/20. However, business owners need to turn hindsight into foresight. To do so, small business owners must listen carefully to what they hear in the office.

It is also important that the would-be perpetrator hear certain things. During the hiring process, employees should hear that the company has a zero tolerance policy for theft, and the company will prosecute any wrong-doers. If the business carries fidelity (a/k/a employee dishonesty) insurance, employees must hear about it. They need to be aware that some insurance policies require the company to report the incident to law enforcement. They also need to understand that the insurance company will pursue dishonest employees with civil action.

Touch is another one of the senses. This one is pretty straightforward. Business owners simply need to be a part of the accounting process. They do not have to serve an active role, per se. Rather, employees just have to believe that the owners are active in the process. For instance, if a business owner insists on being the person that opens the monthly bank statements, employees will think the owner is reading these statements. He or she does not actually have to read them. Also, if the business owner insists on having a copy of the daily deposit ticket, employees will believe he or she is reviewing the deposits. I could go on and on. These suggestions on touching documents center around what is known as "the threat of detection," which is a major fraud deterrent. If the business owner physically touches certain documents, employees will feel as though they are watched, and are less likely to venture down the fraud path.

We have discussed three of the five senses, which leaves smell and taste. For the purpose of internal controls, these senses are related. Our sense of smell and taste are often accompanied by expectations. We expect a glass of orange juice to taste a certain way. Likewise, we have a pretty good idea of what, smoke, smells like. When things "taste" or "smell" different than we expect, we have cause for alarm. The same should hold true with small businesses. When something in the business does not smell or taste right, there is likely a problem.

I once worked with a dental practice that grew its patient base approximately 30 percent from one year to the next. However, the owner of the practice, a dentist, actually made less money. Had she thought about it, she would have known something didn't smell or taste right with that scenario. That something was a bookkeeper who was siphoning cash out of the practice by paying for her extravagant lifestyle with company checks.

Accountants often talk about giving the records the "sniff test," which is a clever way of saying whether or not the records meet our expectations. Accountants are not alone. There's been many a cop movie in which a detective is on the verge of breaking a case, when moments before he or she stated "this really smells." Business owners need to pay attention to things that just don't seem right. The dentist who made less money in the face of a significant increase in business should have had the same reaction as sniffing a three-week-old carton of milk.

Who needs expensive government mandates to prevent fraud? If they are willing, small business owners can see, touch, hear, smell and taste their way into fraud prevention.

80's Movie Reveals Tips for Testifying

I've discovered some wisdom within the 1989 film, Roadhouse. In this film, Patrick Swayze's character James Dalton accepts the job of cleaning up a bar gone bad. After surveying the scope of the assignment, he summons his coworkers for a meeting to discuss the plan. He tells them reaching the desired result is as simple as these three things:

1. Never underestimate your opponent...expect the unexpected.
   
2. Take it outside...never start anything in the bar.
   
3. Be nice!
   

What great advice when testifying about the facts, figures and conclusions in a forensic accounting engagement!

In the context of litigation, accountants tend to underestimate their opponents for two reasons: (1) they are overly confident in their own case and (2) they do not view their opponents in the proper context. It's a wonderful thing to be completely confident in one's abilities and conclusions. However, when this occurs, a migration to "overly" confident occurs almost naturally. When preparing for testimony, it is critical for one to explore the potential weaknesses in his or her case. One should know each weakness in his or her case, and know why his or her ultimate conclusion negates this weakness. If one never considers the potential weaknesses, the "unexpected" questions will be met with an apparent lack of confidence as one ponders a response.

One can also expect the unexpected questions by understanding who asks and considers the questions. Accountants have a tendency to prepare for questions as if they are being asked by another accountant. This is a mistake! In the courtroom, the questions are asked by and considered by non-accountants. Why does this matter? If there is a simple, non-technical line of questioning that appears to compromise the accountant's conclusions, the jury will likely be inclined to side against the accountant. So, the accountant should always consider how a non-accountant will perceive his or her analysis.

Now, let's explore the next tip about "taking it outside." The point of this tip in the movie was to reinforce comfort zones. The bar is an uncomfortable place for fighting...especially for the guests! It's also no picnic for the bouncers. With too many people around, bouncers will lose focus, their movement may be limited, and weapons (such as chairs and bottles) abound. With testifying, it is critical that the accountant not leave their comfort zone, which is his or her field of expertise.

During cross examination, attorneys will try to take accountants outside their realm of expertise. The objective is simple: if the attorney can get the accountant to offer an opinion that is proven wrong, or that the accountant is not qualified to make, the attorney wins. The jury is left with the idea that the accountant will say anything. I testified in a fraud case involving the theft of linens. My analysis of how much linen was consumed by the operation relied on a factor for the number of times the linen could go through the wash cycle and still be used. That factor was provided by another expert. The smallest change in the factor, in either direction, caused a major change in the amount of damages. During my testimony, the attorney tried with great persistence for me to offer an opinion on the factor. However, each time I made it clear that any determination would be outside of my field of expertise. My client ultimately received a favorable settlement in the case.

The final tip is simple, but critically important: Just be nice. Attorneys know all to well that when it comes to expert testimony, jurors side with those experts that they like. One way to be liked is to explain concepts in the jurors' language. They will like and appreciate someone that offers understandable concepts, as opposed to confusion-filled jargon. Also, accountants should never "trash" the opposing accountant. Instead, seek out ways to compliment the opposing accountant and find common ground. The beauty of this approach is that it works no matter what type of demeanor the opposing accountant displays. For instance, if the opposing accountant is arrogant and not shy with insults, the jury will naturally dislike him. When the next accountant takes the high road, it will be an easy choice for the jury to decide which expert they preferred. But what if the opposing accountant is also nice? The theory works here too. If one compliments the opposing accountant and makes it clear that both accountants agree on most issues, the jury can then end up liking both of them. At that point, making the few limited areas of disagreement clear and concise will win the jury.

So, remember Swayze's three simple rules. I haven't found a practical use for the "pain don't hurt" line in the movie, but check back soon.

Business Income Loss Documentation

When faced with a business income loss claim, the most frequently asked question is “which documents are required?” I was recently a featured speaker at the Worley Companies' annual claims convention, and spoke on that very subject.

Most standard business income loss policies afford an element of coverage for the "likely" net income of the business during the period of restoration. What separates likely from unlikely is the quality of the documentation supporting the determination of the net income amount. All businesses prepare and maintain some level of financial/accounting documents. The range of documents prepared by businesses depends on such characteristics as the size and complexity of the business, the nature of the business, the regulatory environment and the level of financial sophistication of the owners/managers.

There are literally scores of different accounting documents. To understand documents from a practical standpoint, I have designed a category system. Thus, the multitude of business documents can fit into one of the following categories:

• Compliance
  
• Informational
  
• Corroborating
  

Compliance documents are those that the business is required to prepare. The requirement to prepare such documents is set forth by federal government agencies, state and local governments, and business partners such as a banks, franchisors or customers.

Informational documents are usually generated for internal use, meaning use by the owners/managers of the business. Since there is not a requirement to prepare such documents, information documents are subject to the record keeping practices of a given business.

Corroborating documents are those that serve to substantiate records, reports or transactions of the business. Corroborating documents are prepared by, or involve third parties.

The categories provide a way of grouping documents, and allow us to think about documents in a systematic manner. Now that we have a platform for understanding documents, we can apply that knowledge to claims with the following general rules:

1. Always obtain compliance documents.

The necessity of compliance documents is twofold. First, the business is required to prepare the documents, so they should be relatively easy to obtain. Next, compliance documents tend to have a high degree of accuracy. Since compliance documents are routinely prepared, and since these documents are often reviewed by others (IRS, CPA, bank), the probability for a material error is greatly reduced.

2. Obtain informational documents to the extent the business has them and to the extent that they will assist with the evaluation.

Informational documents are useful in a loss determination, but they are not always required. Moreover, some businesses may not have informational documents.

3. Obtain corroborating documentation when the records of the business are incomplete or believed to be inaccurate.

Corroborating documents can be difficult to obtain, as well as time consuming to evaluate. Therefore, corroborating documents are limited to those occasions when other business records need substantiation. Also, corroborating documents may be used when a business has no compliance or informational documents.

4. Consider the nature of the business.

It is important to understand the nature of the insured’s business in order to know the best information to request. If the insured’s operations are complex in nature, then it is likely that a more in-depth analysis will be required. As such, the amount of information requested should increase in order to assist with the analysis.

The nature of the insured’s business dictates the type of document that should be requested. For instance, if the business is a manufacturing company or medical practice, then production reports should be requested. Also, rent rolls should be requested for apartment complexes. In either case, it would be inappropriate to ask for a sales report. Asking for the wrong type of document can confuse the insured, and cause them to doubt that one understands the nature of the business.

5. Consider the length of the restoration period.

The length of the restoration period often dictates the amount of information requested. The longer the period of restoration, the more information should be requested to evaluate the operating history of the business and project the results of operations for a longer period of time. Because more expenses discontinue over a longer period, more documentation is required to perform an expense analysis.

The Impact of Non-recurring Gains

Chad was interviewed in an Atlanta legal newspaper on the subject of forensic accounting. He points out a case in which he discovered a claim misrepresented by the one-time gain. Read the interview here.

Burned Out-of-Sight Inventory May Hold Clues to Financial Motive

Sometimes, there are various financial incentives for a business owner or manager to commit arson at the business facility. Financial motive to commit arson can include the desire to liquidate excess or obsolete inventory, the desire to escape debt, or the desire to promptly stop an unprofitable venture. In the case of arson-for-profit, inventory is often times an integral piece of the financial motive puzzle.

Read Chad's full article from Fire and Arson Investigator magazine here.

Business Income Loss for Unprofitable Businesses

When an insured was unprofitable prior to a loss and is expected to continue operating unprofitably during the loss period, it can be easy to make mistakes when interpreting or applying business income loss coverage. To understand the root of these mistakes and ultimately appreciate the proper application of business income loss coverage, one must first understand the definition of business income. Most standard insurance policies define business income as:

1. Net income (net profit or loss before income taxes) that would have been earned or incurred; and
2. Continuing normal operating expenses, including payroll.

The readers of the policy sometimes conclude that an insured is at least entitled to recover the continuing expenses incurred during the loss period. The theory behind this argument is often the following: “since the coverage is two-pronged, the net income portion should be ignored because an unprofitable business does not have net income. Ignoring the net income portion leaves the coverage as continuing expenses.” Interpreting the policy to include only continuing expenses for an unprofitable business results in an erroneous business income loss determination. Such reasoning is also inconsistent with the wording of the policy.

From a policy standpoint, the coverage clearly states net profit or loss. Therefore, if the insured was expected to incur an operating loss during the restoration period, the business income loss calculation should begin with a negative number. Next, the policy contains the conjoining word “and” which explicitly states that the net operating loss (a negative number) should be combined with continuing expenses. Therefore, the resulting net number is less than continuing expenses alone. Thus, an insured is not entitled to recover its continuing expenses.

As stated above, the notion that an unprofitable business is at least entitled to recover continuing expenses under the business income loss policy is inconsistent with the wording of the policy. When an unprofitable business experiences an interruption, a business income loss recovery consisting of only continuing expenses makes the insured better-off than if no interruption occurred. Thus, reasoning that an unprofitable insured is always entitled to a recovery at least equal to its continuing expenses is flawed from an economic standpoint. To understand the issue from an economic standpoint, consider the following scenario for an unprofitable business:

Under this scenario, the insured’s continuing expenses are $40. Hence, one may believe that the business income loss recovery should at least be $40. However, the correct application of the policy is shown below:

As shown, the business income loss is $20, which is less than continuing expenses of $40. A $40 recovery would make the insured better off than if no loss occurred, which is inconsistent with the intent of the policy. The “better off” position is illustrated below:

As shown in the table above, if no incident occurred, the insured would have experienced a net loss of $20. If, as a result of the loss, the insured received $40 for continuing expenses, it would achieve a break-even, as opposed to losing $20. Accordingly, a recovery of only continuing expenses over-indemnifies the insured.

The above scenario showed that an unprofitable business can experience a business income loss. However, in the event that the insured is unprofitable and abated expenses exceed continuing expenses, the insured does not sustain a business income loss. An example of such a situation is shown below:

Based on the figures reflected in the table above, the business income loss is calculated as follows:

As shown, the insured was expected to lose $20 had no incident occurred. However, the insured actually lost $10 (the amount of continuing expenses). Thus, because of the un-profitability of the business and the cost structure, the business was better off following the incident. Therefore, there is no business income loss.