Foundation for Accounting Education – FAE

Foundation for Accounting Education – FAE
2009 Business Valuation Conference New York, New York – May 21, 2007 Forensic Valuation: Faster, Better, Higher Return© The “Combat CPA©” Series… Darrell D. Dorrell, CPA/ABV, MBA, ASA, CVA, CMA, DABFA financialforensics®

Today – Session Description…
3 categories: Accelerate the valuation process Applied forensic techniques, e.g. guidelines Court cases re forensic accounting Will preview in reverse order Accelerate (throughout) 2

Our offices…

Who worked on this material?

The art & science of investigating
financialforensics® Our mission statement: To spearhead forensic accounting innovation in civil, criminal and combat matters.© (financialforensics® October 2002) The definition of forensic accounting is: The art & science of investigating people & money.© (financialforensics® Newsletter, September 1993)

Some of our recent work using these techniques…
US Department of Justice (USDOJ) – USA Bulletin: Forensic accounting - counter-terrorism Federal Bureau of Investigation (FBI) Forensic accounting - money laundering/white-collar crime Oregon Department of Justice (ORDOJ) HMC/Znetix, Inc. for SEC/Receiver - $106 million 2nd largest Washington securities fraud More than 12 executives; serving 910 months in aggregate Forensic Accountants’ Report: $400 mm for-profit: alter-ego/fraudulent conveyance - $20 million $100 mm for-profit: purchasing agent embezzlement $14 mm for-profit: controller embezzlement - $5.5 million $10 mm city: Finance Director embezzlement - $1.4 million $7 mm for-profit: CFO embezzlement $2 mm non-profit: controller embezzlement - $140,000 $1 mm for-profit: office manager embezzlement Dental practice: wife embezzlement - $70,000 Auto repair shop: owner embezzlement - $1,500 Law & Order TV series – technical advice Large Police Bureau – Financial Crimes

CAN YOU GIVE US AN EXAMPLE OF HOW FORENSIC ACCOUNTING IS USED IN COUNTERTERRORISM?
USDOJ… HAVE YOU TRAINED FEDERAL AGENCIES? FBI… WHERE WAS FA/IM© “FORENSIC ACCOUNTING/INVESTIGATION METHODOLOGY©” FIRST PUBLISHED? We wrote “Bulletin” for USDOJ

Selected Valuation/Forensic Accounting Cases:
alter ego: Forest products, services businesses, merger & acquisition Anti-trust: Forest products Bankruptcy dismissal (Chapter 13): Health care Beach of contract: Manufacturing, distribution, health care, banking, transportation Copyright: Art work, publications ESOPs, 401(k) share redemption: Dealerships, manufacturing Estate 706: manufacturing, distribution, construction, raw land, electronics, apartments Forensic accounting: Civil and criminal; private sector, public sector Fraud: Civil and criminal; private sector, public sector Fraudulent conveyance/transfer: Health clubs, finish carpentry Gifting 709: Securities, real property (residential/commercial) Information technology: Software, hardware Internet companies: B2B, B2C ISOs/ESOs: Black-Scholes, lattice/binomial Lending/Financing: Banks, borrowers Lost profits: Construction, manufacturing, distribution Marital Dissolution: Equitable distribution, community property Merger/Acquisition: Pre-transaction and post-transaction analysis Patent: Reasonable royalty, et al Public Sector: Jail Costing/Pricing Study, Public Funds Mismanagement Solvency/Insolvency: Wholesale distribution, agricultural Trademark; Trade Dress: Specialized tools Trade Secrets: Cell phone software

Forensic accounting defined…
The art & science of investigating people & money.© Forensic Accounting Academy© - April 2007 (financialforensics® Newsletter, September 1993)

AICPA Latest “Definition”
“generally involving the application of specialized knowledge and investigative skills possessed by CPAs to collect, analyze, and evaluate evidential matter and to interpret and communicate findings in the courtroom, boardroom, or other legal or administrative venues.” CPA Expert, Winter 2009, page 2

Forensic Accounting – Foundational Discipline
Economic Damages Tax PI, WD Performance Auditing Forensic Accounting Audit/Review/Comp Valuation Internal Audit Fraud

Everything that you see/hear today is:
Public record And/or Disguised

How does forensic accounting affect valuation?

How does forensic accounting affect valuation, attest, litigation, tax, fraud, et al? i.e. virtually ALL of your practice areas

Forensic Accounting & Valuation, et al…
Your clients’ expectations reach beyond your core expertise whether auditing, tax, valuation or litigation. Such expectations are no surprise since forensic accounting is now a household term. Thanks to extensive media coverage of several high profile corporate collapses and showcasing of forensic accounting specialists the public “thinks” that all CPAs have such expertise. Consequently, the public, i.e. your clients “think” that you deliver professional services from a foundation of forensic accounting. The accounting profession has reinforced such perceptions despite failing to provide guidance. Specifically, virtually every accounting periodical devotes space to forensic accounting and related subjects. Further, all CPE providers offer various courses on the subject or some derivative. Finally, accounting graduates are increasingly attracted to firms offering such services. Paradoxically, the accounting profession has yet to embrace (or even offer) a cogent, comprehensive, forensic accounting methodology comprising the forensic tools by which accountants can guide and refine their forensic accounting craft. Likewise, defending one’s core expertise continues to be more challenging without independently codified benchmarks.

How does forensic accounting affect valuation?
Does valuation require: Veracity or reliability of the financial statements Financial analysis, e.g. ratios, trending? Designed by lenders; lack cash & forensic tests; unfamiliar to valuators Benchmarking against subject, peers? Normalizations; (do you analyze before & after?) Do you normalize with journal entries? Earnings projections/estimations - feasible? Tested against cash generated? Economic benefit stream reliability? Discount/capitalization rate development? Management assessment/performance? Facilities and operations walkthrough? Guideline company comparison/selection? Market transactions statistical “fit” Secondary adjustments, e.g. DLOM, DLOC, Key Customer? Etc.?

Will preview in reverse order Court cases re forensic accounting Applied forensic techniques, e.g. guidelines Accelerate (throughout) 17

Example Court Cases – Forensic Accounting
In re Coram Healthcare Corp., 2004 Bankr. LEXIS 1516 (Oct. 3, 2004) Valuation issue was Debtors’ value which would determine whether Trustee’s plan was “fair and equitable.” Both parties experts’ used same methodologies, guideline public company analysis, guideline transaction analysis, and DCF – but conclusions disparate Court noted: “Big 4 firm [for equity committee] and investment banker team [for trustee] included different assets in reaching their valuation conclusions, attached different weights to the three valuation methodologies, and took different positions regarding management’s projections.” Equity Committee argued: investment banking team deflated Debtors’ value by relying on conservative projections because of flawed assumption and errors investment banking team did not conduct independent review of projections consistency or actual performance Big 4 valuation used “upside projections” including EBITDA adjustments deemed to be irregular, including growth, cash flow and management’s established reserves; total adjustments increased EBITDA by 40% Court: “Although valuations are subjective, (sic) there are proper and improper methods of performing a valuation.” “[Big 4 firm] took aggressive and optimistic views regarding the valuation and strength of the Debtors. Therefore, we do not find that the [Big 4 firm] valuation is an accurate reflection of the Debtors’ value.”

Susan Fixel, Inc. v. Rosenthal & Rosenthal, Inc., 2005 Fla. App. LEXIS 1101 (Feb. 1, 2006) Claims for breach of fiduciary duty and negligent misrepresentation – total loss Expert calculated damages with client-prepared revenue and cash flow projections Court: “[expert] never verified those projections nor prepared his own.” Court: “…too speculative…” Court: expert made critical error in date of valuation; 1 year prior to damages date Court: excluded his testimony at trial Company argued while lost profits may require more evidence, a market valuation could rely on forecasts Court: disagreed – “It is as inappropriate to use purely speculative forecasts of future revenue to determine the market value of a business as it is to use such speculative forecasts in determining future lost profits.” Appeals Court: Affirmed expert exclusion as unreliable when expert used improper date and relied on speculative income projections

In re Nellson Nutraceutical, 2007 Bankr. LEXIS 99 (January 18, 2007) Chapter 11 case; private manufacturer of nutrition bars and supplements Expert learned after-the-fact that management’s long-range financial plans did not represent their “best and most honest thinking.” Principal equity holders “ needed” a “value” exceeding $365,000,000 Principal equity holders screened valuation analysts to pre-determine their methodologies Investors & attorneys sent selected expert values to be attributed to growth plans Privately and via discussed how to “figure out a way” expert could assist investors Investors pushed through a “puffed up” business plan for debtors Plan inflated revenues/EBITDA projections, ignored price compressions… … ignored increased market competition, eliminated “millions” of CapEx Court: “In sum, [the investors] utilized [their] control over [the debtors] to manipulate both the business planning and valuation process to come up with an artificially inflated enterprise value… to claim some residual value for their existing equity position. There is no other credible interpretation of the evidence before the Court.” Court specifically exonerated three experts All three testified that there results would require reduction to reflect flawed projections One unable to recite the Gordon Growth model on cross examination Debtors’ expert: Expert sent draft DCF analysis that did not reach desired equity During telecon Board convinced appraiser to use CapEx methodology One week later, appraiser sent Board “new” report using CapEx methodology Court reached its own conclusion after “adjusting” experts’ results per manipulation

Aukeman v. Aukeman, 2007 Mich. App. LEXIS 1524 (June 12, 2007) Husband/owner testified weekly business sales averaged $58,000 with slight growth His expert used the numbers to value the three grocery stores at $1.53 million Wife’s expert used sales projections husband/owner used to obtain financing Her expert used weekly sales of $122,000 to value stores at $3 million+ Court: arrived at $2,225,000

Imaging International v. Hell Graphic Systems, Inc., 2007 N.Y. Misc. LEXIS 7368 (October 29, 2007) Business owner supplied most/all of financial information – previously convicted of tax fraud Expert initially calculates damages at $11 million, but revises to $4 million Printer purchased printing equipment that never worked properly, but kept using it 3 years later filed bankruptcy Jury awarded liability to printer who had sued for fraud Printer used expert for damages: Prepared two reports, i.e and 2005 – widely disparate results First used “ex post” approach, projecting revenue for 15 years from 1990, 6% annual growth: $11 million Second used “ex ante” with DCF and 12% growth rate + 4% premium: $4 million Expert assumed Hell Graphic’s fraud was sole cause of business’ failure For both reports, expert relied on information provided by the owner, without any independent review or access to underlying financial documentation Rebuttal expert found: Printer lost two major customers for reasons unrelated to allegation Owner refused to make staffing changes recommended by turnaround firm Owner found guilty of tax fraud two months before bankruptcy Industry shifted from analog to digital technology during relevant period Printer’s expert relied entirely on unverified data provided by owner who destroyed documents prior to trial Court found: Owner lacked credibility, therefore expert’s damage analysis lacked credibility Expert failed to explain variance in growth rates and failed to account for other possible causes of decline Failed to provide a preponderance of evidence

Mood v. Kronos Products, Inc., 2007 Tex. App. LEXIS 9243 (November 27, 2007) After 11 years exclusive agreement, both parties breached Kronos terminated without adhering to 60-day notice Mood counterclaimed for unauthorized sales to a Mood customer & breach damages At trial Mood presented no direct expert testimony on first claim, using instead: Kronos invoices for about 2 years Mood’s average gross annual sales to customer Kronos began selling to A general assertion that Mood’s “usual” profit margin was 20% Expert witness assertion that about 80% of Mood’s sales were from Kronos products Mood presented expert to calculate breach damages Attempted to predict lost profits over 10 years, i.e “Discrete revenue forecast” per recent year’s net income and applied 17% discount rate Jury awarded $1.1 million; judge vacated for a “take nothing” verdict Mood appealed; Kronos defended and Appeals Court agreed: Kronos’ gross sales to one customer insufficient evidence of lost profits; did not show same product/volume/price Gross sales “estimate” was based on “hypothetical statement by counsel at trial, i.e. “no evidence” of actual sales Mood’s claim of 20% gross margin (and 80% of overall sales from one product) lacked sufficient factual basis Mood’s expert relied on history for 10 year projection & did not differentiate between direct and consequential Expert failed to address loss of goodwill and/or going concern value resulting from the breach Court commented: “Put another way, [the expert’s] analysis did not specifically address the economic impact of the summary termination of the distributorship agreement.”

Derby v. Comm’r, 2008 WL (U.S. Tax Ct.) (Feb. 28, 2008) Northern California physicians sold their practice to a non-profit medical foundation in 1994 To maintain professional autonomy physicians refused to sign non-compete Foundation did not want to pay for goodwill, and wanted to avoid kick-back laws Attorney suggested donating intangible value to foundation as charitable donation National valuation firm derived intangible result and “certification of appraisal” to each Allocation formula derived by one physician used for each personal tax return After IRS audit 3rd appraiser enlisted who used physician’s allocation formula Appraiser adopted physician’s allocation formula Tax Court cited various appraiser deficiencies: Failed to distinguish between personal and professional goodwill Failed to account for non-compete Adopted physician formula without any independent analysis Ignored physician access bonus

Structural Polymer Group, Ltd. V. Zoltek Corp., 2008 WL (8th Cir.) (Oct. 8, 2008) Plaintiff contracted with defendant for all their carbon fiber needs for 10 years, subject to certain limitations Alleged breach in years 5 & 6 Plaintiff sought damages years 5 & 6 and remaining 4 years Plaintiff’s expert relied “only” on Discussions with management Management summaries Internal budgets Projected sales compared to actual purchases Defendant’s annual report Defendant’s depositions & CEO statement “But for” case subtracting variable costs & then-market price Applied to plaintiff’s 18-month gross profit margin Jury’s findings for plaintiff upheld in appeal

Fluor Enterprises, Inc. v. Conex International Corp WL (Tex. App.) (Dec. 18, 2008) Petrochemical company hired mechanical contractor & Fluor Enterprises, Inc. At completion company failed to pay about $2 million to contractor Contractor sued Fluor for “business disparagement” and “interference” Jury awarded contractor $98 million; Fluor appealed Contractor used economics professor for damages Focused only on lost profits, not causation Professor apparently did not consider actual contracts company awarded contractor 5-year post assignment period Professor’s other problems included: Downturn in refinery business for the relevant period Not familiar with “normal” profit margin for the industry Did not analyze job cost analysis Did not include overhead Incorporated a contract that expired 3 years prior to initial project Failed to apply his methodology consistently and with objectivity Averaged profit margins but not expenses and costs Court commented: “…based his opinion of lost future profits on past performance only when it benefitted [the contractor.” “In other words, [the expert] provides no evidence of specific lost sales..,” “Thus, he did not supply one complete calculation, but provided computations based on different methods of calculation.”

Cookies on the bottom shelf…

“Covert” Forensic Tools
Deposition Matrix© Valuation Report Card©

Statistics “hacks”

Deposition Matrix©

“Valuation Report Card©”

Gap Detection (con’t)

How/Where do you start/stay?

Pictures…

Is this cash “lockbox” secure?

Finding the bodies…

You May Want To Receive…
Sarbanes-Oxley (SOX) Compliance Journal “Financial Hieroglyphics – The Numbers “Speak” to Me” American Journal of Family Law “Is The Moneyed Spouse Lying About The Money?©” Value Examiner 2008 Update: Marketability Discounts - A Comprehensive Analysis National Litigation Consultants’ Review “Valuation Forensics”

25+ “New” forensic accounting/valuation techniques…
Full-and-False Inclusion Genogram TATA/TARTA/TITA/TDTA/TAPTA AQI Behavior Detection FACS Styleometry ICE©/SCORE© Link Analysis Articulated Cash Flow Dechow-Dichev Techniques Timeline Analysis IRS Formal Indirect Methods A(5) “Cash-T” (Modified) Net Worth Bank Deposits & Cash Expenditures Markup Unit & Volume Expectations Attributes Gap Detection Proof-of-Cash Deposition Matrix Entity(s) Chart Lev-Thiagarajan Techniques Damages Report Card Digital Analysis CATA/CRO MSSP

The 250-300 techniques require a methodology

What Is A Methodology? Basic Example – for the Cops
A way of doing things, a process… Criminal Investigation 7-Step Method Others Forensic Accounting Investigation Combined Criminal/Forensic Accounting

“ICE©” C - Control E - External I - Internal

“ICE©” Closely-Held Business Example
C – Control Bank Statements E – External Tax Returns Attest Reports I – Internal PBC Financials Operating Reports

“ICE©” C – Control E – External I – Internal Bank Statements
Proof-of-Cash Timing Non-Cash E – External Tax Returns Attest Reports I – Internal PBC Financials Operating Reports

Why Isn’t ICE©” Sufficient?
You must be: “Thinking Outside the… Triangle©” That is where SCORE© comes in

“SCORE©” Flow of $ and/or Units Stakeholder In Out S – Suppliers U $
C – Customers O – “Owners” Investors/Lenders R – Regulators n/a E – Employees

What Is A Methodology? Forensic Accounting Example
A way of doing things, a process… Criminal Investigation 7-Step Method Others Forensic Accounting Investigation Combined Criminal/Forensic Accounting

What Can You Expect This Week (Today)?
Uncertainty… Vocabulary – a common language… VERY hard work… possible growth… Leave your ego at the door…

DATA COLLECTION AND ANALYSIS
Forensic Accounting/Investigation Methodology (FA/IM)© FOUNDATIONAL INTERPERSONAL DATA COLLECTION AND ANALYSIS TRIAL Interviews & Interrogation Surveillance -Electronic, Physical Trial Preparation Assignment Development Scoping Data Collection Confidential Informants Laboratory Analysis Analysis of Transactions Post- Assignment Background Research Undercover Testimony & Exhibits Purpose of Stage Tasks to be Performed Potential Issues Identify parties to the case Correlate the matters of law Confirm technical capabilities Clear conflict Insure matching of expectations between counsel and facts and circumstances of matter Determine whether engaged as consultant or expert Prepare and secure engagement letter Establish concrete timelines, e.g. discovery cutoff, report submittal, etc. Establish counsel communications protocol, e.g. whether/how subject to discovery Identification of all parties Specification of key timelines Privilege determination Agreement on standards References Deliverables AICPA/BVFLS Practice Aids Litigation Services Handbook, 4th & Cumulative Supplements NACVA Resources “Entity / Party Chart” Signed engagement letter Retainer

Contributing Authors and/or Instructors
Thomas F. Burrage CPA/ABV, CVA, DABFA Burrage & Johnson, CPA’s, LLC – Albuquerque, NM Darrell D. Dorrell, CPA/ABV, MBA, CVA, ASA, CMA, DABFA financialforensics® – Lake Oswego, OR Gregory A. Gadawski, CPA/ABV, CVA, CFE Katherine Heekin – JD, CFE The Heekin Law Firm – Portland, OR Dr. Diane A. Matthews, CPA, CFE Carlow University – Pittsburgh, PA Patricia A. Perzel, CPA, CVA, CFFA, CFD Perzel & Lara Forensic CPA’s, P.A. – Clearwater, FL Gabriel H. Shurek, Manager Gettry Marcus Stern & Lehrer, CPA, P.C. – Woodbury, NY Mark S. Warshavsky, CPA/ABV, MBA, CVA, CBA, CFE, DABFA, CFFA Paul E. Zikmund – MBA, MA, CFE, CFD Solomon Edwards Group, LLC – Philadelphia, PA

Forensic Accounting/Investigation Methodology (FA/IM)© FOUNDATIONAL INTERPERSONAL DATA COLLECTION AND ANALYSIS TRIAL Interviews& Interrogation Surveillance -Electronic, Physical Trial Preparation Assignment Development Scoping Data Collection Confidential Informants Laboratory Analysis Analysis of Transactions Post- Assignment Background Research Undercover Testimony & Exhibits Purpose of Stage Tasks to be Performed Potential Issues Identify parties to the case Correlate the matters of law Confirm technical capabilities Clear conflict - firm-wide database Insure matching of expectations between counsel and facts and circumstances of matter Determine whether engaged as consultant or expert Prepare and secure engagement letter & retainer Establish concrete timelines, e.g. discovery cutoff, report submittal, etc. Establish counsel communications protocol, e.g. whether/how subject to discovery Identification of all parties Specification of key timelines Privilege determination Agreement on standards References Deliverables AICPA/BVFLS Practice Aids Litigation Services Handbook, 4th & Cumulative Supplements NACVA Resources Conflict Resolution Form “Entity / Party Chart” Signed engagement letter & retainer Retainer

Forensic Accounting/Investigation Methodology (FA/IM)© FOUNDATIONAL INTERPERSONAL DATA COLLECTION AND ANALYSIS TRIAL Interviews & Interrogation Surveillance -Electronic, Physical Trial Preparation Assignment Development Scoping Data Collection Confidential Informants Laboratory Analysis Analysis of Transactions Post- Assignment Background Research Undercover Testimony & Exhibits Purpose of Stage Tasks to be Performed Potential Issues Identify parties to the case Correlate the matters of law Confirm technical capabilities Clear conflict - firm-wide database Insure matching of expectations between counsel and facts and circumstances of matter Determine whether engaged as consultant or expert Prepare and secure engagement letter & retainer Establish concrete timelines, e.g. discovery cutoff, report submittal, etc. Establish counsel communications protocol, e.g. whether/how subject to discovery Identification of all parties Specification of key timelines Privilege determination Agreement on standards References Deliverables AICPA/BVFLS Practice Aids Litigation Services Handbook, 4th & Cumulative Supplements NACVA Resources Conflict Resolution Form “Entity / Party Chart” Signed engagement letter & retainer Retainer

Forensic Accounting/Investigation Methodology (FA/IM)© FOUNDATIONAL INTERPERSONAL DATA COLLECTION AND ANALYSIS TRIAL Interviews & Interrogation Surveillance -Electronic, Physical Trial Preparation Assignment Development Scoping Data Collection Confidential Informants Laboratory Analysis Analysis of Transactions Post- Assignment Background Research Undercover Testimony & Exhibits Purpose of Stage Tasks to be Performed Potential Issues Identify parties to the case Correlate the matters of law Confirm technical capabilities Clear conflict - firm-wide database Insure matching of expectations between counsel and facts and circumstances of matter Determine whether engaged as consultant or expert Prepare and secure engagement letter & retainer Establish concrete timelines, e.g. discovery cutoff, report submittal, etc. Establish counsel communications protocol, e.g. whether/how subject to discovery Identification of all parties Specification of key timelines Privilege determination Agreement on standards References Deliverables AICPA/BVFLS Practice Aids Litigation Services Handbook, 4th & Cumulative Supplements NACVA Resources “Entity / Party Chart” Signed engagement letter & retainer Retainer

Forensic Accounting/Investigation Methodology (FA/IM)©
INTERPERSONAL DATA COLLECTION AND ANALYSIS TRIAL/REPORTS FOUNDATIONAL Interviews & Interrogation Surveillance -Electronic, Physical Trial Preparation Assignment Development Scoping Data Collection Confidential Informants Laboratory Analysis Analysis of Transactions Post- Assignment Background Research Undercover Testimony & Exhibits Purpose of Stage Tasks to be Performed Potential Issues Obtain sufficient relevant data to provide credible evidence Summarize and analyze the findings of all deliverables and observations Identify any missing information or “gaps” DRAFT the Forensic Accountant’s Report TASKS Common-sizing Horizontal analysis Vertical analysis Statement analysis (written) Accept-reject testing Stratified mean-per-unit (MPU) Attributes sampling Link Analysis/Root Tracing Item Listing Forensic Accountant’s Report does not support the indictment Additional techniques do not substantiate missing gaps References Deliverables Bragg, Steven M., Business Ratios and Formulas (Wiley) Benford’s – IDEA software “Gap” Analysis Indictment Matrix WPN (words/pictures/numbers)

Full-and-False-Inclusion
…the yellow crime scene tape of forensic accounting…

Chain of Custody Gaps in the chain or mishandling of evidence can damage a case Evidence may still be admissible if it can be authenticated by an identifying feature, but a mistake in custody affects the weight of the evidence In fraud cases, maintaining custody is particularly significant for electronic evidence (concern regarding alteration) – hand-to-hand chain of custody detailing how it was stored and protected from alteration

Genogram

Consolidated Operations
W W P W P W Fr W W P P P Fr W P Fr Red font – Family Fr – Friends since high school P – “Pajama party” participant W – Worked together many years

Entity Chart(s)

Timeline Analysis

Preliminary Analysis – “Surprises”
Shareholders’ Equity section Reconciliation yielded discrepancies Quarter-to Prior Year Quarter Changes Year-to-Year Changes

XYZ Historical Balance Sheets Source: Audited Financial Statements
Balance Sheet Conclusions: Large sums into “soft” assets “Hard” assets declined

XYZ Historical Income Statements Source: Audited Financial Statements
Income Statement Conclusions: Solid gross profit Very heavy debt load Heavy losses in entity investments Heavy debt restructuring Heavy losses in store open/close

XYZ Historical Cash Flow Statements Source: Audited Financial Statements
Cash Flow Statement Conclusions: Operating cash impacted 2003 Few fixed assets 2002 & 2003 Only financing outflow in 2002

Annual Financial Statement Indicators

Financial Ratios – Overall Assessment

Overall Financial Condition C-
Overall Scoring – Grade Balance Sheet C- Intangible assets not productive Inefficient use of long-term debt Income Statement B- Strong gross profit Heavy interest expense Expenses not managed Cash Flow Statement D Inefficient capital structure Overall Financial Condition C- Long-term to “fix”

Baseline Financials

“Traditional Ratios” Financials Reliable?

Forensic Tests - Simple

Earnings Manipulation Tests - Annual
Asset Quality Index Total Accruals to Total Assets Index Days’ Sales in Receivables Index – n/a Inventory Index Sales Growth Index Gross Margin Index

Earnings Manipulation Tests - Quarter
Comparison of Revenue & Gross Margin Asset Quality Index Total Accruals to Total Assets Index Days’ Sales in Receivables Index – n/a Inventory Index Sales Growth Index Gross Margin Index

Surprises in Shareholders’ Equity

Year-to-Year Discrepancies

Equity Declined in 2002

Long-Term Debt Increases

Other Non-Current Assets Increased

Net Intangible Assets Increased

“Soft” Assets Grew Dramatically

Large Sums into “Soft” Assets

Revenue-Producing Assets Declined

Large Swings in Net Income

Impact of Heavy Debt Load

Solid Gross Profit

Operating Expenses Increased

Revenues Increased

Cash Earned from Operations

Largest Operating Cash Impact

Cash Used for Investing

Cash In/Out for Financing

Only Cash Out in 2002

Significant Increase in 2003

Significant Increase in 2002

Pattern Contrary to Reported

2005 Contrary to Reported

Contrary to Common-Size

2005 Gross Profit “Spikes” Then Declines

“Normal” Is 1.0

Dramatic Variations in 2005

Cash Realization Ratio (CRO)
Operating Cash / Net Income.

Asset Quality Index (AQI)
(1-Current Assets t + PPE t / Total Assets t divided by: (1-Current Assets t -1 + PPE t -1 / Total Assets-1)

Depreciation Index (DI)
(Depreciation t-1+Net PPE t-1) / (Depreciation t +Net PPE t)

SGA Expenses Index (SGAEI)
SGAEI t / Sales t SGAEI t-1 / Sales t-1

Good Co. or Bad Co.? - CRO

XYZ Quarterly

Good Co. or Bad Co.? - GMI

XYZ Quarterly

Good Co. or Bad Co.? - AQI

XYZ Quarterly

Good Co. or Bad Co.? - SGI

XYZ Quarterly

Good Co. or Bad Co.? - LI

XYZ Quarterly

Decompose the Cash Flows

Is Correlated Cash Flow Improving?

Cash Flow Correlation IBE - Income before extraordinary items and discontinued operations. CFO - Cash flow from operations. CI - Comprehensive income defined as the change in owners' equity plus dividends net of capital contributions. FCF - Free cash flow is measured by cash flow from operations (CFO) minus net capital expenditures plus net interest payments.

Where are the holes? What do you see?
Reconcile Equity Where are the holes? What do you see? 2004 2003 2002 2001 2000 1999 Beginning Shareholders' Equity 641,000 534,900 412,897 350,570 317,049 287,574 Net Income/(Loss) 768,398 508,400 467,138 267,377 27,797 29,475 Dividends Paid Common Stock (500,500) Dividends Paid Common Non-Voting Stock Dividends Paid Preferred Stock Common Stock Issued Common Non Voting Stock Issued 500,500 Treasury Stock Purchased (402,300) (367,050) (205,050) (27,797) Distributions to Shareholder (100,000) Foreign currency translation adj 5,500 Min. pension liability adj. Unreal gains on marketable sec Prior Period Adjustments Other Restatements, Net (298,632) Ending Shareholders' Equity 1,016,666 512,985

Journal Entries to Normalize
The resultant impact of the normalizations is summarized by year below.

“Show Your Work”

“ICE©” C – Control E – External I – Internal Bank Statements
Proof-of-Cash Timing Non-Cash E – External Tax Returns Attest Reports I – Internal PBC Financials Operating Reports

Internal Revenue Service, Part 4 Chapter 10
FSAT – Financial Status Audit Techniques Financial Status Analysis Formal Indirect Methods Not precluded by books and records. See Lipsitz v. Commissioner, 21 T.C. 917 (1954)

When to Use Formal Indirect Methods
Financial Status Analysis – unbalanced Irregularities – books & records; weak internal controls Gross margin – significant changes; by period or peer group Unexplained deposits in bank accounts Cash deposits See “Inflation and Consumer Spending” Net worth increase – not supported

Financial Status Analysis

Formal Indirect Methods
Source & application of funds (IRM ) a.k.a. “Cash T” Analysis Bank Deposits & Cash Expenditures (IRM ) Markup Method (IRM ) Unit & Volume (IRM ) Net Worth (IRM )

Source & application of funds a.k.a. “Cash T” Analysis Bank Deposits & Cash Expenditures Markup Method Unit & Volume Net Worth

Source & Applications of Funds United States v. Johnson, 319 U. S
Uses subject’s cash flows to compare: All known expenditures Estimates personal living expenses All known receipts Takes into account: Net changes in assets & liabilities Non-deductible expenditures (for tax matters) Non-taxable receipts (for tax matters) If expenditures > receipts: unreported

Source & Applications of Funds
Typical uses Deductions/expenditures out of proportion Cash does not flow from a bank account Common use of cash – in or out

Source & Applications of Funds
Accrual impacts Beginning A/R shown on “debit” side i.e., collected during period Ending A/R shown on “credit” side i.e., effects a noncash income increase Beginning A/P shown on “credit” side i.e., current period cash out Ending A/P shown on “debit” side i.e., current period income reduction

Source & Application of Funds

“Cash T” Example

Bank Deposits & Cash Expenditures Gleckman v. United States, 80 F
Bank Deposits & Cash Expenditures Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935) Differs from Bank Account Analysis: Depth of analysis of ALL bank account transactions Accounts for cash expenditures Estimates actual personal living expenditures Theory: only 2 things can occur with $$$: deposit or spent (including hoard)

Bank Deposits & Cash Expenditures
Assumptions: Bank deposits, adjustment for non-applicable items reflect taxable receipts (for tax matters) Outlays on tax return were real: Could only occur from check, cash or credit card If cash, presumes taxable source Taxpayer’s burden to demonstrate nontaxable

Used for business & nonbusiness May lead to additional sources If method indicates understatement of income: Underreported income AND/OR Overstated expenses

Typical uses: Books & records unreliable Deposits suggest income sources Most expenses paid by check Account previously used as reporting base Comments: Significant cash reliance may preclude Cannot take shortcut Method incomplete unless cash accounted for

Gross Receipts Defined
Deposits into accounts Funds expended, but not deposited Funds accumulated, but not deposited

Markup Method United States v. Fior D’Italia, Inc. , l536 U. S
Reconstructs income: Uses subject-specific percentages or ratios Obtained from Bureau of Labor statistics or industry sources May use subject’s actual markups May overcome weaknesses of other Formal Indirect Methods when cash is unknown Cost of Goods Sold verified and used to derive Revenues

Markup Method Typical uses:
Inventories are principal income-producing asset and subject records unreliable Cost of Goods Sold readily ascertained and reasonable certainty re sales prices Cash-based business, e.g. gasoline retailers, liquor stores, taverns, restaurants, jewelry stores, et al

Markup Method Gross Profit Margin to Sales:
(Sales-Cost of Goods Sold)/Sales

Markup Method - Example

Unit & Volume Irby v. Commissioner TC Memo 1997-347
Apply sales price to volume of subject business Carryout pizza, coin operated laundry, mortuaries

Unit & Volume Typical uses:
Units readily ascertained and pricing apparent Few types of products/services with little variation and price

Unit & Volume – Example

Item Listing Method Logical starting point Very easy to modify
Provides a trail of investigation Leads to other evidence Simple for the “court,” jury, judge, etc.

Item Listing - Beginning

Net Worth Method Very old method:
United States v. Frost 25 F. Cas (N.D. III. 1869) First criminal case involving method: United States v. Beard, 222 F.2d 84 (4th Cir. 1955) Approved by U.S. Supreme Court: Holland v. United States, 348 U.S. 121 (1954)

Holland Requirements:
Establish opening net worth, i.e. “base year” with reasonable certainty Negate reasonable taxpayer explanations inconsistent with guilt; e.g. non-taxable funds Establish net worth increases attributable to taxable income If no books and records willfulness may be inferred from that fact couple with income understatement If books & records ok on face willfulness might not be inferred from net worth increase alone Government must prove beyond reasonable doubt, but not mathematical certainty

(Modified) Net Worth Method
Long-recognized by the courts Implied income based upon changes in cost-based net worth (equity) Intuitively understood “Relatively” simple to prepare Straightforward to explain in court aka “Indirect Method”

Net Worth Method

Example Net Worth Method

Cash Inflows/Outflows Analysis

(Modified) Net Worth - Applied
Dual Integration of (Pat Perzel): Lifestyle Cash Flow Net Worth

Non-Business Expenditures
Forensic Analysis: Unreported Income Non-Business Expenditures

LIFESTYLE EXPENDITURES, CON’T
MR. & MRS. IMACHEAT LIFESTYLE EXPENDITURES, CON’T

Proof-of-Cash Traces “reported” receipts and disbursements to bank statement(s) Relatively simple to prepare Excellent validation tool Intuitively understood Start with annual, “drill-down” to monthly

Example Proof-of-Cash (Annual)

Actual Proof-of-Cash (Monthly)

Essential Concept of Statistics
Attributes Necessary to Prepare a Business Valuation Judgment Analytical skills Financial expertise Judgment is Key Element During the valuation process, certain information will be readily available and unquestionable. Other information will require the valuator to use judgment. The elements of common sense, informed judgment, and reasonableness all work together in formulating the opinion of value, regardless of the nature or purpose of the valuation.

1. Descriptive Statistics
1.1 A meaningful way to summarize a collection of data: May be presented in tabular, graphic or numerical format Used to provide summaries of the information in a data set Makes the data easier to interpret Attributes Necessary to Prepare a Business Valuation Judgment Analytical skills Financial expertise Judgment is Key Element During the valuation process, certain information will be readily available and unquestionable. Other information will require the valuator to use judgment. The elements of common sense, informed judgment, and reasonableness all work together in formulating the opinion of value, regardless of the nature or purpose of the valuation.

2. Inferential Statistics
2.1 Inferential statistics relate to: The process of using data from a sample To make estimates and test hypotheses concerning the characteristics of a population 2.2 Inferential statistics uses the following groups: Population – is a set of all elements in a particular study Sample – is a subset of the population Important IRS Guidelines Revenue Ruling – Valuation of closely held companies Revenue Ruling – Excess Earnings Method Revenue Ruling – Minority stockholder of family – controlled company is not subject to family attribution rules

3. The Objective of Statistics
3.1 Statistical inference is a logical method by which relative truth can be extracted from numerical data: Describes sets of numbers or objects Make reasonable inferences about groups based on incomplete and/or limited information Inferences about the characteristics of a parent group by studying a limited amount of data from a smaller group Reasons for Business Valuations Business Selling all or partial interest of a business Buying all or a partial interest of a business Mergers/Acquisitions Corporate or partnership dissolutions Obtaining financing Buy-sell agreements Purchase price allocations Gift and Estate Area Estate planning Estate and gift tax returns Family limited partnerships Litigation Marital dissolutions Dissenting stockholder suits Insurance claims Determining damages in litigation Other Charitable contributions Preparing personal financial statements

3. The Objective of Statistics (con’t)
3.2 An inference is an educated statistical guess used to solve a particular problem: Relates to the degree of probability of a thing being true or that a particular event will occur Statistics are only mathematical estimates Case Examples Estate Tax Valuation A father and two sons each owned a one-third interest in a wholesale jewelry manufacturing company. When the father died, we valued the father’s one-third interest in the Company for estate tax purposes and were able to reduce the value and the estate tax by applying minority discounts. Acquisition of a Business We were retained to value a dental practice for the purpose of a purchase. The scope of our review included normalizing the earning stream and the preparation of a cash flow analysis to determine disposable income to meet the buyer’s debt requirements. We were able to reduce the purchase price due to various risk factors inherent in the practice. Gifting to Family Members The owner of a wholesale hardware distribution company wished to gift shares of his Company’s stock to his son who worked for the Company for many years. We valued the Company’s shares of common stock for the father’s gifting program. A client who owned the general and limited partnership interests of a Family Limited partnership (FLP) that had real estate and marketable securities wished to gift limited partnership interests to his children and grandchildren. We valued their limited partnership interests in the FLP and were able to transfer any future appreciation of the assets out of our clients estate. Matrimonial A business owner had a valuation done on his business to determine its value for equitable distribution purposes. We were retained by the spouse to have the business independently valued. We valued the business significantly higher due to significant personal expenses in the business.

3.3 Statistics are rarely presented, absent a statement of precision (confidence). These are related issues: Precision relates to the probability associated with the estimate and the degree upon which the user can rely on the inference Any statistical study that omits a statement of precision should be scrutinized for bias or prejudice Precision is dependent on: Properly selected sample or samples Correctly applied statistical methods Standard of Value · Fair market value – willing buyer and willing seller · Fair value – varies in each state; most common in minority shareholder cases · Investment value (intrinsic value) – incorporates synergies and other factors

3.4 Therefore, to a statistician, precision is used in two contexts: the variability of an estimator (e.g. the mean) or in regards to the probability of estimating something to within a certain error Standard of Value · Fair market value – willing buyer and willing seller · Fair value – varies in each state; most common in minority shareholder cases · Investment value (intrinsic value) – incorporates synergies and other factors

4. Common False Inferences
4.1 Statistical analysis is subject to: Manipulation Errors in the application of formula, methods and procedures Erroneous or false inferences from incomplete or tainted data Random chance, unanticipated events and unintended consequences Revenue Ruling 59-60 The most widely used set of business valuation guidelines in existence today. Ruling mentions eight factors to be considered: Nature of business; history of enterprise Economic outlook in general, and specific industry outlook Financial condition of the business Earning capacity of the company Dividend paying capacity Enterprise’s goodwill and other intangible values Sales of the stock and the size of the block of stock to be valued Market price of stocks of corporations engaged in the same or a similar business

4. Common False Inferences (con’t)
4.2 Arithmetic errors and false inferences are found frequently in published studies: The public is conditioned to accept published studies as authoritative, error free and absolute truth Random and systematic errors occur frequently in published surveys and studies Published studies are regularly challenged, recanted and redacted Standards of Business Valuation Profession American Society of Appraisers (ASA) has Standards 9 (procedural requirements) and 10 (reporting requirements) of the “Uniform Standards of Professional Appraisal Practice” (USPAP) National Association of Certified Valuation Analysts (NACVA)

4.2 Arithmetic errors and false inferences are found frequently in published studies (con’t): It is essential to understand the objective, procedures applied and inferences asserted in published studies and surveys The limiting conditions published with a study or survey must be reviewed Adjectives are frequently used to emphasis or de-emphasis small statistical margins Standards of Business Valuation Profession American Society of Appraisers (ASA) has Standards 9 (procedural requirements) and 10 (reporting requirements) of the “Uniform Standards of Professional Appraisal Practice” (USPAP) National Association of Certified Valuation Analysts (NACVA)

4.3 False Percentages Addition of unrelated percentages to achieve a total percentage Large percentages based on small data samples Percentages presented absent actual numbers Market Approach Guideline Company Method uses price to earnings ratios of public companies Transaction Method compares similar companies that have been bought or sold to the subject company Industry Methods (Rules of Thumb) provides a representation of the perception that people have in the marketplace Various data bases

4.4 Fictitious Precision Precision of an estimate does not increase proportionally with the number of decimal places: Verify that the degree of precision claimed is warranted by the data Percentages should be rounded to significant decimal places rounded to .12 or 12.35% rounded to 1.23 Numbers should be rounded to significant digits 123,456 rounded to 123,500 123,456,789 rounded to 123,500,000 Asset-Based Approach Adjusted book value Adjusted book value method revalues the company’s assets and liabilities to fair market value Liquidation methods Liquidation value assumes that a business has a greater value if its individual assets are sold to the highest bidder and the company ceases to be a going concern Asset based methods are generally used when value of business is in its assets

4.4 Fictitious Precision (con’t) However – from a pure statistical viewpoint, precision of an estimator does increase with sample size Remember! Precision is used in two different ways in statistics Income Approach Capitalization of earnings or cash flows methods Capitalization is the process of converting historical benefits stream into value Discounted earnings or cash flow method Conversion of expected future economic benefit streams into present value Excess earnings method – income and asset approach

4.5 Faulty Comparisons Comparisons are relevant only when made between groups genuinely suitable for comparison Statistics of one group can not be used to infer characteristics of an untested and dissimilar group Both groups must be measurable to demonstrate a correlation Publicly traded companies compared with small closely-held companies Income Approach Capitalization of earnings or cash flows methods Capitalization is the process of converting historical benefits stream into value Discounted earnings or cash flow method Conversion of expected future economic benefit streams into present value Excess earnings method – income and asset approach

4.6 Improper Sampling The most common cause of misleading and false inferences Biased and/or non-random sample Exclusive or skewed samples Arbitrary sampling is not random Systematic non-responses or anomalies in sample are not investigated Normalizing Adjustment to Value Adjusting items in the income statement that are not considered to be normal operating income or expenses for the core business Adjusting items on the balance sheet to reflect the true net worth of the business The result should be economic financial statements rather than those that are oriented to either GAAP or tax considerations. Common Normalizing Adjustments Nonoperating/nonrecurring adjustments Discretionary adjustments Owner’s compensation Owners’ perquisites Compensation to family members Entertainment, automobile, et al Rent expense (if not at arm’s length lease) Inter-company transactions Property and equipment adjustments to fair market value Contingent liabilities Off balance sheet items Deferred taxes payable

5. Descriptive Statistics Methods
5.1 Frequency Distribution – Definition A tabular summary of data showing the number (frequency) of items in each of several non- overlapping classes is referred to as a frequency distribution. Normalizing Adjustment to Value Adjusting items in the income statement that are not considered to be normal operating income or expenses for the core business Adjusting items on the balance sheet to reflect the true net worth of the business The result should be economic financial statements rather than those that are oriented to either GAAP or tax considerations. Common Normalizing Adjustments Nonoperating/nonrecurring adjustments Discretionary adjustments Owner’s compensation Owners’ perquisites Compensation to family members Entertainment, automobile, et al Rent expense (if not at arm’s length lease) Inter-company transactions Property and equipment adjustments to fair market value Contingent liabilities Off balance sheet items Deferred taxes payable

5. Descriptive Statistics Methods
5.2 Examples Relative and Percent Frequency Distributions of Soft Drink Purchases Pie Chart of Soft Drink Purchases Soft Drink Relative Frequency Percent Frequency Coke Classic .38 38 Diet Coke .16 16 Dr. Pepper .10 10 Pepsi-Cola .26 26 Sprite Total 1.00 100 Normalizing Adjustment to Value Adjusting items in the income statement that are not considered to be normal operating income or expenses for the core business Adjusting items on the balance sheet to reflect the true net worth of the business The result should be economic financial statements rather than those that are oriented to either GAAP or tax considerations. Common Normalizing Adjustments Nonoperating/nonrecurring adjustments Discretionary adjustments Owner’s compensation Owners’ perquisites Compensation to family members Entertainment, automobile, et al Rent expense (if not at arm’s length lease) Inter-company transactions Property and equipment adjustments to fair market value Contingent liabilities Off balance sheet items Deferred taxes payable Bar Graph of Soft Drink Purchases

6. Measure of Central Tendency
Also known as the measure of location 6.1 Mean – definition and use: The average value of the numbers selected; obtained by summing the numbers and dividing by n, where n is how many numbers there are in the collection The only measure of central tendency that is sensitive to all values in the distribution Developing a Capitalization Rate Buildup method Five components of risk Ibbotson data used in calculation

6. Measure of Central Tendency (con’t)
6.2 Median – by definition: The halfway point in the following sense: half of the numbers lie below the median, and half of them lie above it Not sensitive to any values in the distribution, only the number of elements Discounts and Premiums One of the most difficult tasks facing the valuator Minority discount (control premium) Lack of marketability discount Key person

6.2 Median is preferable when: The distribution of quantitative data is extremely asymmetrical The precise location of the bisected halves of the distribution is material Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

6.2 Median is calculated by: Sort the observations in ascending order Locate the middle observation For odd number distributions the median is the middle observation For even number distributions the median is the midpoint between the two middle observations Middle observation = .5(n+1); where n is the number of observations Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

6.3 Calculation of a mean and median median 22 25 28 35 40 Mean = 30 Average = = 150 =

6.4 Mode – definition and use: The number that occurs most frequently in a collection of numbers The mode is not sensitive to any values only the frequency of specific elements Used in situations which preclude the use of the mean or median Data is qualitative and not ordered Identification of the most frequent responses or occurrences are material Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

6.5 Calculation of the Mode

6.6 Some examples of frequency diagrams: Normal distribution Bimodal Distribution Asymmetrical (with a tail) – positive and negative skew Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

6.7 Normal Distribution The frequency is symmetric with a single mode mean, median, and mode

6.8 Bimodal Distribution The distribution has two modes mode mode mean, median

6.9 Distribution that is asymmetrical; in this case with a tail to the right – positive skew mode median mean

6.10 Quartiles It is often desirable to divide data into four parts With each part containing approximately one fourth, or 25% of the observations

6.11 Quartiles (con’t) The division points are referred to as the quartiles and are defined as: Q1 = first quartile, or 25th percentile Q2 = second quartile, or 50th percentile (also the median) Q3 = third quartile, or 75th percentile.

6.12 Location of Quartiles 25% 25% 25% 25% Q1 Q2 Q3 First Quartile (25th percentile) Second Quartile (50th percentile) Third Quartile (75th percentile)

6.13 New Clients by Sales Representatives: Q1 Q2 Q3 First Quartile (2,865) Second Quartile (2,905) Third Quartile (3,000)

7. Measure of Variability
7.1 Range The simplest measure of variability The difference between the largest and smallest numbers in a group Seldom used as the only measure Based on only two of the observations Therefore, influenced by extreme values Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

7. Measure of Variability (con’t)
7.1 Range (con’t) Largest value – smallest value = range 5,000 – 3,000 = 2,000 10,000 – 3,000 = 7,000 Refer to 6.13 for new clients: Range is 3,325 – 2,710 = 615 10,000 new clients instead of 3,325, the range would be: 10,000 – 2,710 = 7,290 11 of the 12 sales representatives within 2,170 and 3,130 Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

7.2 Variance The variance is a widely used measure of dispersion A measure of variability that utilizes all the data Based upon the difference between the value of each observation and the mean. If the numbers in the list are all close to the mean, the variance will be small If they are far away, the variance will be large Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

7.2 Variance (con’t) Variance is the sum of squared deviations of observations around their mean: Measurement of distance from the mean 20 30 data point mean (-10) Variance

7.3 Calculating the Variance For the number of students in a classroom, we first find the distance from the mean for each element: Students per classroom Distance from mean 25 25 – 30 = (-5) 40 40 – 30 = 10 35 35 – 30 = 5 22 22 – 30 = (-8) 28 28 – 30 = (-2) Mean = 30 Total -0-

7.4 As observed in the previous slide: We cannot add distances up and average them Negative numbers and positive numbers cancel out Resulting in zero We must square each of these numbers, making all positive numbers

Therefore, we must square each of these numbers, making them all positive: Students per classroom Distance from mean Distance Squared 25 25 – 30 = (- 5) (-5)² = 25 40 40 – 30 = 10 10² = 100 35 35 – 30 = 5² = 25 22 22 – 30 = (- 8) (-8)² = 64 28 28 – 30 = (- 2) (-2)² = 4 Total: 218

The calculations would then be: Mean = 30 Number of classrooms (n) = 5 Variance = (xi – x)² = 218 = n Variance = 54.5 Units² Standard Deviation = Standard Deviation = Units

7.5 Standard Deviation The measure of dispersion in original units The positive square root of the variance Variance is in squared units Standard deviation is in original units Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

7.6 Coefficient of Variation (CV) A descriptive statistic that indicates how large the standard deviation is relative to the mean It is usually expressed as a percentage The formula is CV = standard deviation x 100% mean Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

7.6 Coefficient of Variation (CV) (con’t) This ratio is useful when comparing the variability of variables that have different standard deviations and different means Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony. CV = % = 24.61% 30

Statistics in Valuation Dispersion

Statistics in Valuation Significance

8. Measure of Relative Location
8.1 The measure of the shape of the distribution is also important Skewness is an important numerical measure of the shape of a distribution Compliment the measures of location and variability In a symmetric distribution – mean and median are equal When positively skewed – mean greater than median When negatively skewed – mean less than median Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

8. Measure of Relative Location (con’t)
8.1 Skewness for Two Distributions Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

8.2 Z-score Expresses a measure in terms of the number of standard deviations the measure is from the mean Often called standardized value Z1 = 2.2 would indicate that X1 is 2.2 standard deviations greater than the mean Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

8.3 Chebyshev’s Theorem Allows us to make statements about the proportion of data values that must be within a certain number of standard deviations of the mean Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

8.3 Chebyshev’s Theorem (con’t) Some of the implications of this theorem, with z = 2, 3, and 4 standard deviations, follow. At least .75, or 75%, of the data values must be within z = 2 standard deviations of the mean At least .89, or 89%, of the data values must be within z = 3 standard deviations of the mean At least .94, or 94%, of the data values must be within z = 4 standard deviations of the mean Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

8. Measure of Distribution Shape
8.4 Empirical Rule Based upon the normal probability distribution Distributions are symmetric mound-shape or bell shaped Determines the percentage of items that must be within a specific number of standard deviations of the mean Formula - When the distribution of data approximates a normal (symmetrical) curve, the percentage of items that must be within a specified number of standard deviations of the mean can be estimated Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

8. Measure of Distribution Shape (con’t)
8.4 Empirical Rule (con’t) Application - For normally distributed data: Approximately 68% of the items will be within one standard deviation of the mean Approximately 95% of the items will be within two standard deviation of the mean Approximately 100% of the items will be within three standard deviation of the mean Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

8. Measure of Distribution Shape (con’t)
8.5 Outliers Represents a data set where one or more observations have unusually large or small values May represent a data value that has been incorrectly recorded May be from an observation that was incorrectly included in the data set May be an unusual data value that has been recorded incorrectly and belongs in the data set, and should remain Minority Interest Discount A minority interest discount is a reduction in the control value of the subject Company to reflect the fact that a minority stockholder cannot control the daily activities or company policy decisions of an enterprise. The size of the discount will depend on the size of the interest, the amount of control, the stockholder’s ability to liquidate the company, and other factors. Size of Ownership Interest and The Impact on The Final Value The percentage of ownership interest being valued is of crucial importance to the interest’s ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relationship to the overall distribution of ownership? Distribution of Ownership A 49%block may have little or no control value if there is one 51% block. A 49% block may have effective control if all other ownership is highly fragmented. A 20% owner is in a much better position with four other 20% owners than with one 80% owner. Swing Vote A 2% block would have some value as a swing vote block if there were two 49% interests. The potential value of a swing vote increases with disharmony.

9. Relation Between Two Sets of Measures
9.1 Types of Measurement Charts Scattergram – is used to display graphically the relationship between two different measures in a sample Dot Plot – one of the simplest graphical summaries of data Scatter Diagram – a graphical presentation of the relationship between two quantitative variables Trendline – a line that provides an approximation of the relationship between two variables Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

Statistics in Valuation Correlation

10. Presentation of Data 10.1 Descriptive statistics
Methods of organizing and summarizing data to reveal patterns and facilitate interpretation Numeric statistics Pictorial statistics Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

10. Presentation of Data (con’t)
10.2 Numerical statistics Numeric values (measures) describing the data set Measurements include: Measures of central tendency Measures of variability Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

10.3 Pictorial statistics Presents numerical statistics in the form of pictures and graphs Tabular procedures Graphical procedures Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

10.3 Pictorial statistics (con’t) Presentation depends on the type of data Qualitative data is numerical data about categories that vary significantly in kind Best represented in Bar Charts and Pie Charts Quantitative data can be measured in amounts Best represents in Dot Plot or Histograms Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

10.4 Types of graphical presentations Bar chart A graphical device for depicting qualitative data summarized by frequency Can be arranged horizontally or vertically Ordering is ascending or descending Spaces are present between bars to define categories Bars are of equal width Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

10.4 Types of graphical presentations (con’t) Dot plot A graphical device for depicting quantitative data summarized by frequency Generally used for a small set of values or data Dots, representing a measure of value, are placed above a reference number on a horizontal axis Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis. 10 15 20 25 30 35

10.4 Types of graphical presentations (con’t) Pie chart A graphical device for depicting qualitative data summarized in a frequency distribution or a relative frequency distribution Sections are presented in ascending order Effective when the elements or classes are few in number Addresses the limitations of bar charts and dot plots by representing the proportion of each element or class Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

10.4 Types of graphical presentations (con’t) Histogram A graphical device for depicting quantitative data summarized in a frequency distribution or a relative frequency distribution Sections are presented in ascending order The range of values are divided into non-overlapping, equal length class intervals The number of intervals should be more than 5 and less than 20 Class intervals are not separated by spaces as with a bar chart Minority Versus Control Elements of Ownership Control Following are some of the more common prerogatives of ownership control. If you have the ability to make the following decisions, it would indicate control. Appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out, or re-capitalize the company Sell or acquire treasury shares Register the company’s stock for a public offering Declare and pay dividends Change the articles of incorporation or bylaws The value of these rights varies greatly from one situation to another, depending on the benefit a control owner can realize by exercising such rights, and must be analyzed on a case-by-case basis.

11. Conclusion 11.1 Statistics are not truth
Statistics are relative truth extracted from numerical data Statistics are estimates based on incomplete information Statistics are subject to manipulation and misinterpretation Statistical information must be sufficiently evaluated before use as a foundation for an opinion 11.2 Statistical analysis is not a substitute for common sense and logical reasoning Discount for Lack of Marketability A discount for lack of marketability (DLOM) is used to compensate for the difficulty of selling shares of stock that are not traded on a stock exchange compared with those that can be traded publicly. IPO studies Restricted stock studies

Digital Analysis

Use Of Technology To Uncover Fraud
Master Employee File Master Vendor File Input Forensic Software Database Output Match of similar characteristics such as: Telephone number Address

Digital Analysis Procedures used to analyze the digit and number patterns of data sets, with the aim of finding anomalies and reporting on broad statistical trends Benford’s Law, duplicate numbers, round numbers, etc.

Benford’s Law

Benford’s Law - Requirements
Sizes of similar phenomena e.g. Revenues for corporations on the NYSE No built-in minimum or maximum numbers Zero is an acceptable as a minimum No assigned numbers i.e. social security numbers or zip codes Follow geometric pattern when ranked smallest to largest More small items than larger items The numeric mean should exceed the numeric median

Benford’s Law – Major Digit Tests

Benford’s Law – Major Digit Tests
Benford’s Law tests results can provide a roadmap for the investigation as well as provide indirect evidence. The 1st and 2nd digit test are high level and not used to select samples. The 1st two and 1st three digits tests are designed to select audit samples. The last two digits test detect excessive rounding or numeric invention. Existence of a pattern or benchmark Not necessarily one consistent pattern, but some pattern which false or wrong data will deviate from. “Before and After” Testing.

First Digit Test

Second Digit Test

First Two Digits Test

First Three Digits Test

Last Two Digits Test

Numeric Tests

Duplicate Numbers Test

Round Numbers

Behavior Detection: Interviewing & Interrogation

Facts about Lying Individuals are trained liars
People will defend themselves by lying until the pain of their conscience becomes unbearable or until outside influences prompt to reveal their guilt Completely voluntary confessions are a myth Lying is a stressor, which exhibits signs/symptoms. Lying is hard work, which is revealing Lying subjects will issue qualifiers

Lies are more likely to be detected when:
Facts about Lying Lies are more likely to be detected when: The person being lied to is personally acquainted with the liar The person being lied to is not easily deceived The lie is not expected The lie is challenged The liar has little experience The consequences are high

Communication Nonverbal
Early landmark study found that communication is 38% vocal (pitch, stress, tone, pauses) 55% physical (expressions, gestures) 7% verbal (content) – Active listening required Subsequent studies have refined these numbers, but consistently find that at least ⅔ of meaning is communicated nonverbally Nonverbal

Generally Truthful Behavior
Direct answers – nothing to hide, facts are allies Spontaneous answers – nothing to think about Generally attentive and interested – not distracted Nonverbally engaged – oriented toward the interviewer Verbal and nonverbal consistency – words and behavior in agreement

Clustering Deceptive behaviors usually occur in clusters of two or more Clusters Disregard transient (isolated or individual) behaviors The first deceptive behavior must begin within 5 seconds of stimulus The second behavior must follow shortly thereafter The greater the number of behaviors in the cluster the greater the likelihood of deception

Deceptive Verbal Behaviors
Failure to answer the question – influence Failure to deny – involves an act of wrongdoing Repeating the question (as opposed to seeking clarification) – buys time Overly specific answers Narrows the question – selectively excludes negative information Attempt to influence, mislead, buy time

Classic Overly Specific Answer
“I did not have a twelve-year affair with Ms. Flowers.” William Jefferson Clinton1992 presidential campaign “The fact is, there was no twelve-year affair.” William Jefferson Clinton, My Life “We are going to cut taxes for 95 percent of Americans.” Barack Hussein Obama 2008 campaign “promise”

Inappropriate level of concern – influence Verbal attacks directed at the accuser – attempt to influence Detour statements “As I said before …” “However, in this [other] instance …” “That reminds me of something that happened last week …”

Invoking religion “I swear to God” “As God is my witness” (AFI Top 100) Failure to understand a simple term or question – attempt to buy time Selective memory “Not that I can recall/remember” “To the best of my knowledge” Statements that fail to answer a question “That’s a good question” “I knew you were going to ask me that”

Deceptive Nonverbal Behaviors: Grooming Gestures
Adjusting clothes, hair, jewelry, glasses Inspecting hands and nails Cleaning up surroundings Lint picking Scratching Smoothing

Deceptive Nonverbal Behaviors: The Telltale Face
Touching the face Covering mouth or eyes Biting lips Clearing throat Labored swallowing Coughing Wiping sweat

Deceptive Nonverbal Behaviors: The Telltale Face
Facial Mapping: Paul Ekman—(born 1934) psychologist studied emotions and their relation to facial expressions One of the100 most eminent psychologist of the 20th century Facial expressions are not culturally determined but universal …including anger, disgust, fear, joy, sadness, surprise, & contempt Developed the Facial Action Coding System (FACS) to taxonomize every conceivable human facial expression FACS: interpreting involuntary expressions to understand our real emotions, reactions, intentions; careful analysis can be used to gauge a subjects real reaction Also contributed significantly to the study of lying Jones, D. (2008, February 25). It’s written all over their faces. USA Today. READ FOR HOMEWORK!

Business Records Authentication – someone must be familiar with the content and record made in ordinary course of the business Witness has personal knowledge of record Witness removed a record from a file Witness recognizes the record as the one removed Witness can explain the document FRE 803 – Business Records

Exclusionary Rule Evidence illegally obtained or analyzed is inadmissible in criminal trials Constitutional basis Fourth Amendment – protection from unreasonable search and seizure Fifth Amendment – protection from compelled self-incrimination Fourteenth Amendment – “due process” clause extended the exclusionary rule to state courts

Illegally-Seized Evidence
Specifically, the Fourth Amendment excludes evidence obtained by authorities without a warrant or authorization from the owner This rule generally only applies in criminal cases or to government employers There is no prohibition against a private employer admitting evidence that was seized illegally However, the employer may be exposed to litigation for invasion of privacy or trespass

Chain of Custody Gaps in the chain or mishandling of evidence can damage a case Evidence may still be admissible if it can be authenticated by an identifying feature, but a mistake in custody affects the weight of the evidence In fraud cases, maintaining custody is particularly significant for electronic evidence (concern regarding alteration) – hand-to-hand chain of custody detailing how it was stored and protected from alteration

Chain of Custody Tagged at Scene Evidence and Case Building
Property Room Review by DA and Defense Crime Lab Property Returned to Owner Court Final Disposal

Computer Evidence Protecting data in hardware seizures
Insidious s Computer log files Electronic documents and files Internet log files Insure expertise is present to process electronic evidence

Computer Forensics Art and science of applying computer science to aid the legal process. Computer forensics = Crime scene investigations (apply the same principles). Establish parameters of the scene Physically secure the scene. Physically secure evidence.

Electronic Evidence What forms of electronic evidence do you come in contact with? Who processes this evidence? What potential hurdles do you face? How do you guarantee chain of custody requirements? Will your collection standards/procedures meet all legal challenges?

Example Balance Sheet

Visual Balance Sheet

Example Income Statement

Visual Income Statement

Side-by-Side Comparison

Cash Flow Statement

Decomposing the Income Statement

Translate “data into pictures” & “Opinions into sound bites
Translate “data into pictures” & “Opinions into sound bites.” “Dominant, deliberate and declining…” “Family, failure and fate…”

Key Indicators…

LSAT – Linguistic Style Analysis Technique

Valuation Representation Letter

25+ “New” forensic accounting techniques…
Full-and-False Inclusion Genogram TATA/TARTA/TITA/TDTA/TAPTA AQI Behavior Detection FACS Styleometry ICE©/SCORE© Link Analysis Articulated Cash Flow Dechow-Dichev Techniques Timeline Analysis IRS Formal Indirect Methods A(5) “Cash-T” (Modified) Net Worth Bank Deposits & Cash Expenditures Markup Unit & Volume Expectations Attributes Gap Detection Proof-of-Cash Deposition Matrix Entity(s) Chart Lev-Thiagarajan Techniques Damages Report Card Digital Analysis CATA/CRO MSSP

Forensic Accounting Organizations
ACFE – Association of Certified Fraud Examiners: ACFE – American College of Forensic Examiners: AICPA – American Institute of Certified Public Accountants: CICA – Canadian Institute of Chartered Accountants: IIA – Institute of Internal Auditors: IMA – Institute of Management Accounting: and NACVA – National Association of Certified Valuation Analysts:

Forensic Accounting/Investigation Methodology (FA/IM)©
FOUNDATIONAL FOUNDATIONAL INTERPERSONAL INTERPERSONAL DATA COLLECTION AND ANALYSIS DATA COLLECTION AND ANALYSIS TRIAL TRIAL Interviews & Interrogation Surveillance -Electronic, Physical Trial Preparation Assignment Development Scoping Data Collection Confidential Informants Laboratory Analysis Analysis of Transactions Post- Assignment Background Research Undercover Testimony & Exhibits Purpose of Stage Tasks to be Performed Potential Issues Obtain the results of the case Benefit from the experience Learn from the experience Assess firm’s performance TASKS Evaluate performance of each party Update cv Extract “show and tell” as feasible\ Follow-up with counsel; grading form Continuous professional development References Deliverables Verdict Judge’s Ruling “Lessons Learned” Updated cv Your previous results

Foundation for Accounting Education – FAE
2009 Business Valuation Conference New York, New York – May 21, 2007 Forensic Valuation: Faster, Better, Higher Return© The “Combat CPA©” Series… Darrell D. Dorrell, CPA/ABV, MBA, ASA, CVA, CMA, DABFA financialforensics®

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