Forensic Aspects of Business Valuation

Portland Chapter of the American Society of Appraisers #39
Educational Event
Portland, OR May 5, 2009
Forensic Aspects of Business Valuation

The Combat CPA Series
Darrell D. Dorrell, CPA/ABV, MBA, ASA, CVA, CMA, DABFA financialforensics www.financialforensics.com
Today Session Description

3 categories:
1. Accelerate the valuation process 2. Applied forensic techniques, e.g. guidelines 3. Court cases re forensic accounting
Will preview in reverse order

1. Court cases re forensic accounting 2. Applied forensic techniques, e.g. guidelines 3. Accelerate (throughout)
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)
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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: www.znetix.com
$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
Forensic accounting defined

The art & science of investigating people & money.
Forensic Accounting Academy - April 2007 (financialforensics Newsletter, September 1993)
Forensic Accounting Foundational Discipline
Economic Damages Tax

PI, WD
Forensic Accounting Performance Auditing

Audit/Review/Comp Valuation
Fraud
Internal Audit
Everything that you see/hear today is:

Public record And/or Disguised
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How does forensic accounting affect valuation?
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.?


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 Trustees 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 managements 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 managements 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.
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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
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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 managements 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 email 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 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
Debtors expert:

Court reached its own conclusion after adjusting experts results per manipulation
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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 Wifes 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
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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. 2000 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 Graphics 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 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 Printers expert relied entirely on unverified data provided by owner who destroyed documents prior to trial Owner lacked credibility, therefore experts 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
Rebuttal expert found:

Court found:

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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 Kronos invoices for about 2 years Moods average gross annual sales to customer Kronos began selling to A general assertion that Moods usual profit margin was 20% Expert witness assertion that about 80% of Moods sales were from Kronos products Attempted to predict lost profits over 10 years, i.e. 2004-2014 Discrete revenue forecast per recent years net income and applied 17% discount rate
At trial Mood presented no direct expert testimony on first claim, using instead:
Mood presented expert to calculate breach damages

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 Moods claim of 20% gross margin (and 80% of overall sales from one product) lacked sufficient factual basis Moods 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 experts] analysis did not specifically address the economic impact of the summary termination of the distributorship agreement.
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Derby v. Commr, 2008 WL540271 (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 physicians allocation formula Appraiser adopted physicians 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
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Structural Polymer Group, Ltd. V. Zoltek Corp., 2008 WL 4489760 (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 Plaintiffs expert relied only on
Discussions with management Management summaries Internal budgets Projected sales compared to actual purchases Defendants annual report Defendants depositions & CEO statement But for case subtracting variable costs & then-market price Applied to plaintiffs 18-month gross profit margin
Jurys findings for plaintiff upheld in appeal
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Fluor Enterprises, Inc. v. Conex International Corp. 2008 WL 5860048 (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 Focused only on lost profits, not causation 5-year post assignment period 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
Contractor used economics professor for damages Professor apparently did not consider actual contracts company awarded contractor Professors other problems included:
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.
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Covert Forensic Tools

www.BlackBookOnLine.Info www.veromi.net www.statsoft.com http://www.fincen.gov Deposition Matrix Valuation Report Card
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www.BlackBookOnLine.Info
www.BlackBookOnLine.Info
www.veromi.net
www.veromi.net
www.statsoft.com
Statistics hacks
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http://www.fincen.gov
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Deposition Matrix
Valuation Report Card
Gap Detection (cont)
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1. Court cases re forensic accounting 2. Applied forensic techniques, e.g. guidelines
3. Accelerate (throughout)
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
35
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 www.BlackBookOnLine.Info Proof-of-Cash Deposition Matrix Entity(s) Chart Lev-Thiagarajan Techniques Damages Report Card Digital Analysis CATA/CRO MSSP
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The 250-300 techniques require a methodology
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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

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ICE
C Control
Bank Statements
Proof-of-Cash Timing Non-Cash
I Internal
PBC Financials Operating Reports
E External
Tax Returns Attest Reports
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Why Isnt ICE Sufficient?

You must be:
Thinking Outside the Triangle

That is where SCORE comes in
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SCORE
Flow of $ and/or Units Stakeholder S Suppliers C Customers O Owners
Investors/Lenders
In U $ $
n/a
Out $ U $ $ $
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R Regulators 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

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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
PostAssignment
Background Research
Undercover
Testimony & Exhibits
Purpose of Stage
Identify parties to the case Correlate the matters of law Confirm technical capabilities

Tasks to be Performed
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

Potential Issues
Identification of all parties Specification of key timelines Privilege determination Agreement on standards
References
AICPA/BVFLS Practice Aids Litigation Services Handbook, 4th & Cumulative Supplements NACVA Resources

Deliverables
Entity / Party Chart Signed engagement letter Retainer

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
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Entity Chart(s)
TARGET SUBJECT GROUP - Exhibit 1
Shares Owner Owner Children's Trust The Outside Investors Fund L.P. Legal Advisor 1,178,628 589,314 32,059 1,800,001
% 65.5% 0.0% 32.7% 1.8% 100.0%
Owner Owner Children's Trust The Outside Investors Fund L.P. Legal Advisor
Units 58,668 1,119,960 589,314 32,059 1,800,001
% 3.3% 62.2% 32.7% 1.8% 100.0%
Target Subject Company
Target Subject of Washington, LLC
Shell Acquisitions, Inc.

100% 100% 78.99% 100%
Transport Shell, Inc.
Target Subject of CITY #2, LLC Legend:
Target Subject of CITY #1, LLC
Bold, 12 pt - Named party

Holding Company Shaded - Operating Entity Inactive Company
100% 100% 19.748% 1.262%
Target Subject of
Target Subject of
Acquired Subject
CITY #3, LLC Entities Unaccounted For: Earlier Acquisition #1, Inc. Earlier Acquisition #1 Earlier Acquisition #2 Earlier Acquisition #2 Company Acquired Subject of CITY #1 Acquired Subject #1 Earlier Acquisition #3 Earlier Acquisition #3 Company Earlier Acquisition #4 Merchants Earlier Acquisition #5
CITY #4, LLC
#1, Inc.
Acquired Subject & Sons, Inc.
Notes: Entity structure based upon discovery materials indicating relationships as of July 2003 Entities unaccounted for listed from www.targetsubject.com, www.onesource.com and other sources

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
ASSETS Cash Accounts Receivable Inventory Other Current Assets Total Current Assets Fixed Assets Net Intangible Other Non-Current Non-Operating Assets Total Assets LIABILITIES & EQUITY Accounts Payable Short Term Notes Payable Current Portion of LT Debt Other Current Liabilities Total Current Liabilities Long Term Debt Other Non-Current Liabilities Non-Operating Liabilities Total Liabilities Total Equity Total Liabilities & Equity 1998 5,691,661 2,790,092 17,931,239 1,554,733 27,967,725 65,470,672 4,144,277 8,580,424 0 106,163,098 9,073,880 2,000,000 8,640,753 6,819,085 26,533,718 53,537,830 5,378,917 0 85,450,465 20,712,633 106,163,098 1999 9,096,568 2,112,593 19,354,858 1,593,958 32,157,977 71,456,327 5,628,798 7,832,273 0 117,075,375 10,261,718 5,000,000 11,349,930 8,077,217 34,688,865 53,578,935 6,364,733 0 94,632,533 22,442,842 117,075,375 2000 7,340,853 3,037,713 20,707,347 1,999,511 33,085,424 78,479,188 8,641,354 9,604,551 0 129,810,517 11,814,573 5,500,000 6,721,928 9,017,676 33,054,177 67,002,033 6,715,823 0 106,772,033 23,038,484 129,810,517 2001 9,000,141 3,531,609 21,186,365 2,208,786 35,926,901 82,986,383 8,274,062 8,448,813 0 135,636,159 10,301,276 4,000,000 9,503,629 13,135,508 36,940,413 66,935,421 7,268,366 0 111,144,200 24,491,959 135,636,159 2002 10,247,037 3,450,584 22,272,693 2,132,999 38,103,313 79,502,294 8,007,702 8,920,030 0 134,533,339 11,934,461 2,000,000 11,767,006 15,012,197 40,713,664 55,527,283 7,919,523 0 104,160,470 30,372,869 134,533,339 2003 10,612,505 4,066,189 23,672,161 2,160,575 40,511,430 69,918,680 13,192,621 12,707,889 7,252,562 143,583,182 13,292,947 3,000,000 6,037,797 12,996,169 35,326,913 70,863,356 8,294,939 0 114,485,208 29,097,974 143,583,182 2004 9,791,278 5,354,956 25,709,465 2,680,688 43,536,387 70,554,241 19,238,106 15,107,652 7,252,562 155,688,948 11,859,356 7,000,000 6,220,074 16,201,172 41,280,602 72,528,541 8,770,469 0 122,579,612 33,109,336 155,688,948 2005 9,071,235 4,681,143 27,993,935 2,599,862 44,346,175 79,566,514 24,625,266 15,732,002 7,252,562 171,522,519 14,958,034 10,000,000 8,049,385 17,138,682 50,146,101 75,292,777 8,546,452 0 133,985,330 37,537,189 171,522,519 2006 9,506,321 4,572,910 30,665,649 3,713,573 48,458,453 83,028,658 30,806,473 16,053,086 7,252,562 185,599,232 17,604,006 12,200,000 7,791,760 18,000,661 55,596,427 91,310,219 8,776,146 0 155,682,792 29,916,440 185,599,232 2007 9,355,655 7,772,786 34,983,241 4,912,371 57,024,053 83,160,134 40,535,222 9,822,844 0 190,542,253 21,615,144 13,175,000 5,272,364 15,418,704 55,481,212 95,182,879 8,873,705 0 159,537,796 31,004,457 190,542,253
Balance Sheet Conclusions:

Large sums into soft assets Hard assets declined
XYZ Historical Income Statements

1998 Revenue Cost of Goods Sold Gross Profit Operating Expenses Officers' Compensation Depreciation/Amortization Interest Expense Total Operating Expenses Operating Profit Other Income/(Expense) Income Before Taxes Income Taxes Net Income 1999 2000 2001 2002 2003 341,198,318 236,708,393 104,489,925 84,387,118 839,878 5,751,120 5,445,046 96,423,162 8,066,763 435,827 8,502,590 4,390,591 4,111,999 2004 361,434,956 246,858,110 114,576,846 92,285,289 830,235 5,516,684 8,450,906 107,083,114 7,493,732 178,091 7,671,823 2,251,513 5,420,310 2005 375,711,489 252,374,610 123,336,879 96,952,085 795,465 6,052,032 9,096,521 112,896,103 10,440,776 (27,316) 10,413,460 4,133,187 6,280,273 2006 423,455,160 285,797,507 137,657,653 112,592,318 521,241 7,010,348 12,157,828 132,281,735 5,375,918 (1,498,016) 3,877,902 1,120,966 2,756,936 2007 477,275,074 326,870,059 150,405,015 129,955,540 0 7,310,449 13,115,098 150,381,087 23,928 1,040,208 1,064,136 361,806 702,330 231,630,496 261,982,669 282,684,058 316,134,725 323,807,201 164,781,393 186,482,895 200,052,646 222,411,651 223,585,996 66,849,103 75,499,774 82,631,412 93,723,074 100,221,205 52,552,527 59,776,833 66,358,848 76,006,290 78,403,789 690,903 766,127 804,848 881,452 938,124 4,436,514 4,929,260 5,227,725 5,922,793 5,492,676 6,254,826 6,181,316 7,275,085 7,282,709 6,117,280 63,934,770 71,653,536 79,666,506 90,093,244 90,951,869 2,914,333 3,846,238 2,964,906 3,629,830 9,269,336 (1,386,326) (1,289,895) (1,146,303) (914,014) 187,403 1,528,007 2,556,343 1,818,603 2,715,816 9,456,739 504,242 1,116,677 563,764 1,020,347 3,281,760 1,023,765 1,439,666 1,254,839 1,695,469 6,174,979
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

Increase/(Decrease) in Cash Cash Provided by (Used for) Operations: Net Income/(Loss) Total Cash Provided by (Used for) Operations: Cash Provided by (Used for) Investing Activities: Total Cash Provided by (Used for) Investing Activities: Cash Provided by (Used for) Financing Activities: Total Cash Provided by (Used for) Financing Activities: Total Increase/(Decrease) in Cash Cash Balance at Beginning of Year Cash Balance at End of Year
1999 1,439,666 12,763,518
2000 1,254,839 5,371,528
2001 1,695,469 9,248,889
2002 6,174,979 12,427,953 -1,742,227
2003 4,111,999 -2,502,077
2004 5,420,310 10,937,989
2005 6,280,273 16,990,295
2006 2,756,936 11,706,653
2007 702,330 15,281,057
-12,399,436 -15,263,142 -10,062,696
-1,352,425 -12,197,730 -20,451,465 -16,653,699 -17,170,674
3,040,825 8,135,899 2,473,095 -9,438,830 4,219,970 438,514 2,741,127 5,382,132 1,738,951 3,404,907 -1,755,715 1,659,288 1,246,896 365,468 -821,227 -720,043 435,086 -150,666 5,691,661 9,096,568 7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235 9,506,321 9,096,568 7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235 9,506,321 9,355,655
Cash Flow Statement Conclusions:

Operating cash impacted 2003 Few fixed assets 2002 & 2003 Only financing outflow in 2002
Annual Financial Statement Indicators

1998 Balance Sheet Income Statement Cash Flow Statement Sum 1999 2000 1 2 3 2001 2002 1 2 3 2003 5 2 2 9 2004 3 2 5 2005 3 2 5 2006 5 2 7 2007 3 2 5
Annual Indicators
10 9 8 7 6 5 4 3 2 1 0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Balance Sheet
Income Statement
Cash Flow Statement
Financial Ratios Overall Assessment

LIQUIDITY RATIOS: Current Ratio Quick (Acid-Test) Ratio Revenue/Accounts Receivable Average Collection Period Inventory Turnover Days' Inventory COGS/Payables Days' Payables Revenue/Working Capital COVERAGE RATIOS: Times Interest Earned NI+Non-Cash Expenditures / Current L.T. Debt LEVERAGE RATIOS: Fixed Assets/Tangible Worth Debt-to-Tangible Net Worth Debt-to-Equity OPERATING RATIOS: Gross Profit Margin EBT/Tangible Worth EBT/Total Assets Fixed Asset Turnover Total Asset Turnover EXPENSE TO REVENUE RATIOS: % Deprtn., Depltn., Amort./Revenue % Officer's &/or Owner's Compensation/Revenue Cash Flow Ratios: Operating Cash Flows (OCF) Cash Interest Coverage Cash Flow to Total Debt Median Qrtl RMA Curr Yr 1.2 0.4 78.3 4.7 14.6 25.0 19.1 19.1 81.0 3.9 4.8 1.7 2.1 2.1 26.00% 22.60% 6.30% 9.1 4.5 1.50% 0.00% 1998 1.05 0.3 83.0 4.4 9.2 39.7 18.2 20.1 161.5 1.2 0.6 4.0 5.2 4.1 28.9% 9.2% 1.4% 3.5 2.2 1.9% 0.3% N/A N/A N/A 1999 0.93 0.3 124.0 2.9 9.6 38.0 18.2 20.1 -103.5 1.4 0.6 4.2 5.6 4.2 28.8% 15.2% 2.2% 3.7 2.2 1.9% 0.3% 0.4 3.2 0.2 2000 1.00 0.3 93.1 3.9 9.7 37.6 16.9 21.6 9046.8 1.2 1.0 5.5 7.4 4.6 29.2% 12.6% 1.4% 3.6 2.2 1.8% 0.3% 0.2 1.8 0.1 2001 0.97 0.3 89.5 4.1 10.5 34.8 21.6 16.9 -311.9 1.4 0.8 5.1 6.9 4.5 29.6% 16.7% 2.0% 3.8 2.3 1.9% 0.3% 0.3 2.4 0.1 2002 0.9 0.3 93.8 3.9 10.0 36.5 18.7 19.5 -124.0 2.5 1.0 3.6 4.7 3.4 31.0% 42.3% 7.0% 4.1 2.4 1.7% 0.3% 0.3 3.6 0.2 2003 1.1 0.4 83.9 4.4 10.0 36.5 17.8 20.5 65.8 2.6 1.6 4.4 7.2 3.9 30.6% 53.5% 5.9% 4.9 2.4 1.7% 0.2% (0.1) 1.3 (0.0) 2004 1.1 0.4 67.5 5.4 9.6 38.0 20.8 17.5 160.2 1.9 1.8 5.1 8.8 3.7 31.7% 55.3% 4.9% 5.1 2.3 1.5% 0.2% 0.3 2.6 0.1 2005 0.9 0.3 80.3 4.5 9.0 40.6 16.9 21.6 -64.8 2.1 1.5 6.2 10.4 3.6 32.8% 80.6% N/A 4.7 2.2 1.6% 0.2% 0.3 3.3 0.2 2006 0.9 0.3 92.6 3.9 9.3 39.2 16.2 22.5 -59.3 1.3 1.3 N/A N/A N/A 32.5% N/A 2.1% 5.1 2.3 1.7% 0.1% 0.2 2.1 0.1 2007 1.0 0.3 61.4 5.9 9.3 39.2 15.1 24.2 309.3 1.1 1.5 N/A N/A N/A 31.5% N/A 0.6% 5.7 2.5 1.5% 0.0% 0.3 2.2 0.1 Better Worse Same Pref. Direction Up Down 1998-2001 Better Worse 2002-2006 Better Worse
~ ~
~ ~ ~
~ ~ ~ ~
8 9 7 24 33.3% 37.5% 29.2% 100.0%
Risk Management Association, Philadelphia, PA 2003 RMA SIC Code is 4451, Supermarkets and Other Grocery (except Convenience) Stores ANNUAL STATEMENT STUDIES, (TM) RMA THE RISK MANAGEMENT ASSOCIATION, (TM) and the RMA Logo are trademarks of the Risk Management Association. RMA owns the copyright in the ANNUAL STATEMENT STUDIES(TM) data. The data is used under license from RMA.
Legend
Should increase Should decrease Should remain same
6 17 1 24
25.0% 70.8% 4.2% 100.0%
Overall Scoring 1998-2007
Grade Balance Sheet

Intangible assets not productive Inefficient use of long-term debt
CBD
Income Statement
Strong gross profit Heavy interest expense Expenses not managed
Cash Flow Statement

Inefficient capital structure Long-term to fix
Overall Financial Condition C-
Baseline Financials
55
Traditional Ratios Financials Reliable?
56
Forensic Tests - Simple
57
Surprises in Shareholders Equity
Year-to-Year Discrepancies
Total Assets Total Liabilities Equity Revenue Net Income 1998 106,163,098 85,450,465 20,712,633 231,630,496 1,023,765 1999 117,075,375 94,632,533 22,442,842 261,982,669 1,439,666 2000 129,810,517 106,772,033 23,038,484 282,684,058 1,254,839 As Originally Reported in Audited Financials 2001 2002 2003 2004 135,636,159 134,533,339 143,583,182 155,688,948 111,144,200 24,491,959 316,134,725 1,695,469 104,160,470 30,372,869 323,807,201 6,174,979 114,485,208 29,097,974 341,198,318 4,111,999 122,579,612 33,109,336 361,434,956 5,420,310 2005 172,353,872 134,816,683 37,537,189 375,711,489 6,280,273 2006 2007 185,599,232 n/a 155,682,792 29,916,440 423,455,160 2,756,936 n/a n/a n/a n/a
Total Assets Total Liabilities Equity Revenue Net Income
1998 106,163,098 85,450,465 20,712,633 231,630,496 1,023,765
1999 117,075,375 94,632,533 22,442,842 261,982,669 1,439,666
2000 129,810,517 106,772,033 23,038,484 282,684,058 1,254,839
As Subsequently Reported in Audited Financials 2001 2002 2003 2004 135,636,159 134,533,339 143,583,182 155,688,948 111,144,200 24,491,959 316,134,725 1,695,469 104,160,470 22,372,869 323,807,201 6,174,979 Differences 2002 (8,000,000) 114,485,208 29,097,974 341,198,318 4,111,999 122,579,612 33,109,336 361,434,956 5,420,310
2005 171,522,519 133,985,330 37,537,189 375,711,489 6,280,273
2006 n/a n/a n/a n/a n/a
1998 Total Assets Total Liabilities Equity Revenue Net Income -
1999 -
2000 -
2001 -
2003 -
2004 -
2005 (831,353) (831,353) -
Significant Increase in 2003

Asset Quality Index
2.000 1.800 1.600 1.400 1.200 1.000 0.800 0.600 0.400 0.200 0.000
1999 2000 2001 2002 2003 2004 2005 2006 2007
Significant Increase in 2002

Accruals to Assets Ratio
2.50 2.00 1.50 1.00 0.50 0.00
19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07
-0.50 -1.00
Pattern Contrary to Reported

1.1400 1.1200 1.1000 1.0800 1.0600 1.0400 1.0200 1.0000 0.9800 0.9600 1999 2000 2001 2002 2003 2004 2005 2006 2007
Sales Growth Index
2005 Contrary to Reported

Gross Margin Index
1.0400 1.0200 1.0000 0.9800 0.9600 0.9400 0.9200 1999 2000 2001 2002 2003 2004 2005 2006 2007
Contrary to Common-Size
1.1600 1.1400 1.1200 1.1000 1.0800 1.0600 1.0400 1.0200 1.0000 0.9800 0.9600 1999 2000 2001 2002 2003 2004 2005 2006 2007
Inventory Index
2005 Gross Profit Spikes Then Declines

Quarterly Revenues & Gross Profit Margin
$140,000,000 $120,000,000 $100,000,000 $80,000,000 $60,000,000 $40,000,000 $20,000,000 $0
10 0 10 3 10 2 10 4 10 1 10 6 10 7 10 5
35.00% 34.00% 33.00% 32.00% 31.00% 30.00% 29.00% 28.00% 27.00% 26.00% 25.00%
Rev enue
Gross Margin
Normal Is 1.0
A s s e t Qu ality In d e x - Qu ar te r ly C o m p ar is o n
1.04000 1.02000 1.00000 0.98000 0.96000 0.94000 0.92000 0.90000 0.88000
10
10
10
10
10
10
10
10
Dramatic Variations in 2005

Accrual to Assets Ratio
8.00 6.00 4.00 2.00 0.00
Q 10 0 Q 10 1 Q 10 2 Q 10 3 Q 10 4 Q 10 5 Q 10 6 Q 10 7
-2.00 -4.00 -6.00 -8.00 -10.00 -12.00
Cash Realization Ratio (CRO)

Operating Cash / Net Income.
Distressed, XYZ Cash Realization Ratio-CF (CRO)

10.00 8.00 6.00 4.00 2.00 0.00 2003 -2.00
68
2004
2005
2006
2007
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)
Distre sse d, XYZ

As s e t Quality Inde x (AQI)
2.00 1.00 0.00
04 02 03 20 20 20 20 20
-1.00 -2.00 -3.00 -4.00 -5.00
05
06
69
Depreciation Index (DI)

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

1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00
20 02 20 03 20 04 20 06 20 05
70
SGA Expenses Index (SGAEI)

SGAEI t / Sales t -----------------------------------------SGAEI t-1 / Sales t-1
Distressed, XYZ SGA Expenses Index (SGAEI)

1.20 1.00 0.80 0.60 0.40 0.20 0.00 2002 2003 2004 2005 2006 2007
71
Good Co. or Bad Co.? - CRO

AB C, In c. Cas h R e alizatio n R atio ( C RO )
30 20 10 0 -1 0 -2 0 -3 0 -4 0 -5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007
XYZ Cor poration Cas h Re alization Ratio (CRO)

1 0 .0 0 8 .0 0 6 .0 0 4 .0 0 2 .0 0 0 .0 0 -2 .0 0
19
19
20
20
20
20
20
20
20
72
99
98
00
01
02
03
04
05
06
Good Co. or Bad Co.? - GMI

ABC , In c . G ro s s M arg in In d e x (G M I)
1 .4 0 1 .2 0 1 .0 0 0 .8 0 0 .6 0 0 .4 0 0 .2 0 0 .0 0
99 00 01 02 03 04 05 06 20 07 20
20
19
20
20
20
20
20
XYZ C o r p o r atio n Gr o s s M ar g in In d e x (GM I)

1 .0 4 1 .0 2 1 .0 0 0 .9 8 0 .9 6 0 .9 4 0 .9 2
98
99
00
01
02
03
04
05
06 20
19
19
20
20
20
20
20
20
20
07
73
Good Co. or Bad Co.? - AQI

ABC, In c. Asse t Q u ality In d e x (AQ I)
1 .2 0 1 .0 0 0 .8 0 0 .6 0 0 .4 0 0 .2 0 0 .0 0
02 03 05 01 99 00 04 06 20 07 20
20
20
20
19
20
20
20
2 .0 0 1 .8 0 1 .6 0 1 .4 0 1 .2 0 1 .0 0 0 .8 0 0 .6 0 0 .4 0 0 .2 0 0 .0 0
XYZ Cor por ation As s e t Quality Inde x (AQI)
04
99
98
00
01
02
03
05
06
07 20
74
20
19
19
20
20
20
20
20
20
Good Co. or Bad Co.? - SGI

ABC, In c. Sale s G ro w th In d e x (SG I)
1 .6 0 1 .4 0 1 .2 0 1 .0 0 0 .8 0 0 .6 0 0 .4 0 0 .2 0 0 .0 0
05
03
99
00
01
02
04
06 20
20
19
20
20
20
20
20
20
07
XYZ Corporation
S ales G row th Inde x (S G I) 1.16 1.14 1.12 1.10 1.08 1.06 1.04 1.02 1.00 0.98 0.96
75
00 01 06 20 99 02 19 19 20 03 20 20 20 20 20 20 07 98 04 05
XYZ Quarterly
XYZ Corporation
S ale s G row th Index (S G I) 1.16 1.14 1.12 1.10 1.08 1.06 1.04 1.02 1.00 0.98 0.96
03 99 02 04 98 01 05 00 06 20 07 20
19
20
19
20
20
20
20
20
An n u al R even u e
$600,000,000 $500,000,000 $400,000,000 $300,000,000 $200,000,000 $100,000,000 $0
1998 1999 2000 2001 2002 2003 2004 2005 2006
76
2007
Good Co. or Bad Co.? - LI

ABC , In c. Le v e rag e In d e x (LI)
1 .1 0 1 .0 5 1 .0 0 0 .9 5 0 .9 0 0 .8 5
99
01
00
02
03
04
05
19
20
20
20
20
20
20
06 20
20
07
XYZ Corporation
Le v e ra ge Index (LI) 1 .1 0 1 .0 5 1 .0 0 0 .9 5 0 .9 0 0 .8 5
98 99 00 01 02 03 04 05 06 07 20
77
19
19
20
20
20
20
20
20
20
Decompose the Cash Flows

C om parison of C ash Flow s $600,000 $400,000 $200,000 $0 -$200,000 -$400,000 -$600,000 1999 2000 2001 2002
O perating cash Investing cash F inancing cash
78
Is Correlated Cash Flow Improving?

C om paris on of O perating C as h Flow to R evenues 0.100 0.090 0.080 0.070 0.060 0.050 0.040 0.030 0.020 0.010 0.000 1998 1999 2001 2002 2003
79

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

2004 Dr. Cr. Desc: Cash Contributions Remove excess Contribution in fiscal 1999, representing work done gratis on school construction. 2003 2002 2001 2000 1999 55,000 55,000 Dr. Cr. Desc: Officer Compensation Cash 134,974 134,974 Increase Officer Compensation in fiscal 2004 to maintain consistency with prior years.
Dr. Cr. Desc:
Other Income Cash
48,150 48,150
Remove excess "Other Income" item from 2004 and spread to applicable years, below.
Dr.
Cash Cr. Salaries and Related Expense
24,075 24,075
24,075 24,075
Desc:
Apply excess "Other Income" from 2004 to respective years.
The resultant impact of the normalizations is summarized by year below.
Historic Net Income Salaries and Related Expenses Contributions Salaries Other Income Adjusted Net Income
Year Year Year Year Year Year Ending Ending Ending Ending Ending Ending 9-30-04 9-30-03 9-30-02 9-30-01 9-30-00 9-30-99 768,398 598,466 307,138 267,377 417,797 29,475 -0 24,075 24,075 -0 -0 -0 -0 -0 -0 -0 -0 55,000 -134,974 -0 -0 -0 -0 -0 -48,150 0 0 0 0 0 585,274 622,541 331,213 267,377 417,797 84,475
82
Show Your Work
83
ICE
C Control
Bank Statements
Proof-of-Cash Timing Non-Cash
I Internal
PBC Financials Operating Reports
E External
Tax Returns Attest Reports
84
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)
85
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 www.bls.gov, Inflation and Consumer Spending
Net worth increase not supported
86
Financial Status Analysis
Formal Indirect Methods

Source & application of funds (IRM 4.10.4.6.3)
a.k.a. Cash T Analysis
Bank Deposits & Cash Expenditures (IRM

4.10.4.6.4)
Markup Method (IRM 4.10.4.6.5) Unit & Volume (IRM 4.10.4.6.7) Net Worth (IRM 4.10.4.6.7)

Source & application of funds
Bank Deposits & Cash Expenditures Markup Method Unit & Volume Net Worth
Source & Applications of Funds

United States v. Johnson, 319 U.S. 503 (1943)
Uses subjects 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

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

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.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)

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
Taxpayers 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 DItalia, Inc., l536 U.S. 238 (2002)
Reconstructs income:
Uses subject-specific percentages or ratios
Obtained from Bureau of Labor statistics or industry sources May use subjects 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.
111
Item Listing - Beginning

PART IE S Bank Statem ent Activity Sorted by "B ank & Account N um ber" Source: B ank S tatem ent D eposits & W ithdraw als of $500.00 or m ore. Stm nt Date Trans D ate 6/15/04 5/20/04 11/16/04 11/1/04 12/15/04 12/1/04 12/15/04 12/15/04 2/15/05 2/10/05 4/15/05 4/4/05 3/15/05 1/18/05 10/18/04 9/16/04 8/16/04 7/16/04 5/16/05 6/15/05 5/19/05 6/15/05 6/3/05 8/23/04 11/22/04 1/24/05 3/23/05 10/24/05 9/22/05 8/22/05 7/22/05 6/22/05 5/20/05 4/22/05 3/23/05 2/18/05 12/22/04 10/22/04 9/23/04 11/22/04 3/23/05 3/23/05 3/23/05 4/22/05 5/20/05 2/18/05 1/24/05 12/22/04 9/28/05 9/30/04 9/30/04 9/30/04 11/14/04 11/14/04 3/14/05 2/14/05 1/14/05 12/14/04 4/15/05 4/15/05 4/15/05 8/13/04 11/22/04 1/14/05 3/21/05 9/29/05 Acct N am e BW BW BW BW BW BW BW BW BW BW BW BW BW BW BW E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W E O /B W BW BW BW BW BW BW BW BW BW BW BW BW BW D eposit $ Am ount 20,000.00 W ithdraw al $ Am ount C om m ent/Source unknown source 871.66 cashiers check 1,764.89 cashiers check m aintenance 2,500.00 cashiers check 961.80 w ithdraw al no activity no activity no activity no activity no activity no activity no activity m aintenance 3,000.00 cashiers check 9,098.35 unknown source E state Title of S t. A ugustine E Q UIP M edical 4,679.40 no activity 309,197.66 close account no activity statem ent is m issing no activity no activity no activity no activity no activity no activity no activity no activity no activity 313,877.06 First Independent E Q UIP M edical E Q UIP M edical E Q UIP M edical 5,000.00 E O 24,867.16 close account no activity no activity no activity 29,867.16 IR A account unknown source E Q UIP M edical E Q UIP M edical E Q UIP M edical 16,342.37 w ithdraw al m issing statem ents m issing statem ents m issing statem ents m issing statem ents m issing statem ents 3,000.00 m issing statem ents 4,029.42 close account 23,371.79 B ank B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B O A-W A B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T B B& T Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Florida Acct# 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 763xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 1452xxxxx 4000xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx 4021xxxxx C om m ent perhaps from joint acct? 2,500.00
2,500.00 25,000.00 40,000.00 263,632.67 4,679.40 308,312.07 16,342.37 5,019.25 3,664.34 4,679.40
W achovia
10/29/04 3/11/05 3/21/05 3/21/05 4/5/05 5/9/05
to K ey Bank # ...5275
4/12/05 First Indep. 7/15/04 8/15/04 9/15/04 10/12/04 11/13/04 First First First First First First First First First 4/5/05 First 4/12/05 First 4/15/05 First Indep. Indep. Indep. Indep. Indep. Indep. Indep. Indep. Indep. Indep. Indep. Indep.
29,705.36 3,000.00 2,500.00 5,187.55 4,139.31 5,511.12
m aintenance?
6,025.34
D D A inquiry D D A inquiry
112
23,363.32
Net Worth Method

Very old method:
United States v. Frost 25 F. Cas. 1221 (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)
113
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
115
Net Worth Method

Modified Net Worth Method - Exhibit P Net worth as of December 31, 2002 Less: net worth as of December 31, 2001 Increase in net worth Add: Living expenses Total expenditures Less: Income from known sources Expenditures in excess of known sources of funds $$$,$$$ $$,$$$ $$,$$$ $$,$$$ $$$,$$$ ($,$$$) $$,$$$
116
Example Net Worth Method

Line 1 2 3 4 5 6 7 8 9 10 Hypothetical Modified Net Worth Method - Exhibit Q ASSETS Ref. 5/17/1999 2/20/2022 Cash Currency Checking accounts Other accounts Undeposited items Traveler's checks Time deposits 60-day CD 120-day CD Food stocks Firearms, ammunition, explosives Computers, cameras, software Automobile Total Assets LIABILITIES Automobile loan Net worth, beginning and end Less: Beginning net worth Increase in net worth Add: Personal living expenses Total expenditures Less: Funds carried into country Funds earned through employment Wire transfers from family Expenditures in excess of funds Test. BR BR SR BR BR SR SRS SRS BR unk 1,732 unk unk unk unk unk 1,732 1,732 $71,000 8,434 5,100 9,000 5,000 12,000 2,932 16,700 16,256 3,600 150,022 1,900 148,122 1,732 146,390 61,748 208,138 3,000 19,976 17,000 $ (168,162)
11 12 13 14 15 16 17 18 19 20
BR
CES Test. BR BR
117
Cash Inflows/Outflows Analysis

Line 1 2 3 Hypothetical Source and Use of Cash Method - Exhibit R 1999 2000 2001 2002 Known sources of cash Earned in various jobs $ 1,736 7,845 136 10,259 Wire transfers from family 4,000 700 11,000 1,300 Carried into country 3,000 Total known sources of cash 8,736 8,545 11,136 11,559 Total $ 19,976 17,000 3,000 39,976
Expenditures 4 Seized currency 5 Increase in checking account 6 Seized in other accounts 7 Increase in traveler's checks 8 Increase in time deposits 9 Seized food stocks 10 Seized firearms, etc. 11 Net automobile purchase 12 Personal living expenses 13 Total expenditures 14 Expenditures in excess of funds
71,000 6,702 5,100 9,000 unknown 17,000 2,932 32,956 1,700 9,952 14,871 16,589 20,336 9,952 14,871 16,589 166,726 (1,216) (6,326) (5,453) (155,167)
71,000 6,702 5,100 9,000 17,000 2,932 32,956 1,700 61,748 208,138 $ (168,162)
118
(Modified) Net Worth - Applied

Dual Integration of (Pat Perzel): Lifestyle Cash Flow Net Worth
119
Forensic Analysis:
Unreported Income Non-Business Expenditures
120
MR. & MRS. IMACHEAT LIFESTYLE EXPENDITURES

FUNDS AVAILABLE FOR LIFESTYLE: Funds Reported on 1040 Tax Returns: Husband's W-2 Gross W ages Interest, Dividends & Capital Gains 2005 2004 2003 2002
300,000 63,559 363,559
300,000 27,612 327,612
300,000 12,360 312,360
300,000 3,200 303,200
Less: 401K Pension Contribution Federal Income Tax W ithheld from W-2 Social Security & Medicare W ithheld from W-2 Employee Business Exp. Including 100% meals Fed. Inc Tax - Prior Yr. Balance (Paid) Refunded Funds from Additional Debt Borrowing Funds Available For Lifestyle: USES OF FUNDS Principal - Marital Mortgage Interest - Marital Mortgage Real Estate Taxes Contributions Tax Prep Fees H/O Insurance Condo Assoc Fees (for Husband's hidden Condo) Vehicle Lease & Insurance - W ife Vehicle Lease & Insurance - Child (H) Life & Disability Insurance
Electric, Telephone, Cable, Water, Lawn @ 1750/mo A vg.
(12,500) (75,000) (9,930) (22,726) 1,935 245,338
(12,000) (75,000) (9,682) (19,420) 7,286 218,796
(11,000) (75,000) (9,434) (27,945) 186 189,167
(10,500) (75,000) (9,310) (20,096) 7,439 195,733
Alimony Payments to former spouse -$2,000 mo Credit Card Payments- Includes College Tuition Other Expenditures paid by Check Deposits to Joint Brokerage Account Deposits to Husband's Hidden Brokerage Account Down Payment on Husband's Hidden Condo Total Estimated Uses of Funds
18,000 48,619 22,756 13,456 1,750 6,422 5,600 15,470 7,931 22,785 21,000 24,000 181,877 75,429 135,000 398,559 998,654
17,600 50,333 17,998 15,115 1,249 5,459 3,400 15,390 7,786 22,454 21,000 24,000 174,149 67,341 85,000 164,000 83,000 775,274
17,000 52,911 15,368 10,511 1,249 4,720 15,020 7,468 21,963 21,000 24,000 134,581 41,880 85,000 50,000 502,671
16,400 54,384 14,812 12,200 1,425 4,180 14,690 7,245 21,223 21,000 24,000 105,890 13,170 41,000 351,619
Cash Flow Ex ce ss (De ficit) from Incom e
(753,316)
(556,478)
(313,504)
(155,886)
121
MR. & MRS. IMACHEAT LIFESTYLE EXPENDITURES, CONT

Cash Flow Excess (Deficit) from Income
SOURCE OF CASH TO COVER DEFICIT: -Unreported Business Sales -Excess Payroll, net of tax 584,289 170,000 452,842 105,000 314,796 155,938 -
(753,316) (556,478)
(313,504)
(155,886)
Adjusted Cash Flow Excess (Deficit)
973
1,364
1,292
52
ACTUAL GROSS INCOME
1,117,848
885,454
627,156
459,138
122
MR. & MRS. IMACHEAT NET WORTH METHOD OF INCOME RECONSTRUCTION

Description
Assets at Cost: Bank Acct #1 - Reconciled Brokerage Account - Joint Brokerage Acct. - Husb. Hidden Personal Residence Husband's Hidden Condo Down Pymt. Vehicles are leased Furniture & Artwork Investment in Imacheat, Inc. Total Assets
12/31/2001
2002
2003
2004
2005
23,457 35,000 750,000 90,000 400,000 1,298,457
23,509 76,000 750,000 90,000 400,000 1,339,509
24,801 161,000 50,000 750,000 90,000 400,000 1,475,801
26,165 246,000 214,000 750,000 83,000 90,000 400,000 1,809,165
27,138 381,000 612,559 750,000 83,000 90,000 400,000 2,343,697
Liabilities: Credit Cards - Paid off Monthly Mortgage - Personal Residence Total Liabilities (600,000) (600,000) (583,600) (583,600) (566,600) (566,600) (549,000) (549,000) (531,000) (531,000)
NET W ORTH Less: Prior Year's Net W orth Increase in Net W orth Add Expenditures (excluding mortgage) Add Taxes & Pension Contr. & Employee Bus Exp. ADJUSTED INCOME FOR YEAR
698,457 -
755,909 (698,457) 57,452
909,201 (755,909) 153,292
1,260,165 (909,201) 350,964
1,812,697 (1,260,165) 552,532
294,219
350,671
425,674
447,095
107,467 459,138
123,193 627,156
108,816 885,454
118,221 1,117,848
123
IMACHEAT, INC. INCOME STATEMENT PER TAX RETURNS

2005 Sales Cost of Sales Gross Profit Expense: Officers Comp Salaries & Wages Auto Expense Credit Card Fees Depreciation Insurance Employee Benefits Interest Office Exp Professional Fees Rent Repairs Utilities Payroll Taxes Telephone Travel & Ent Utilities Total Expense NET INCOME 2,888,600 1,562,800 1,325,800
% 100% 54% 46%
2004 2,465,380 1,313,200 1,152,180
% 100% 53% 47%
2003 2,348,760 1,198,600 1,150,160
% 100% 51% 49%
2002 2,169,840 1,046,600 1,123,240
% 100% 48% 52%
300,000 779,922 32,000 69,458 37,000 21,000 64,000 24,000 19,067 59,000 52,000 9,437 29,812 107,992 31,610 14,100 9,882 1,660,280 (334,480)
10% 27% 1.1% 2.4% 1.3% 0.7% 2.2% 0.8% 0.7% 2.0% 1.8% 0.3% 1.0% 3.7% 1.1% 0.5% 0.3% 57% -12%
300,000 567,037 28,000 58,364 7,600 19,000 60,000 25,000 18,912 12,000 30,000 11,903 15,896 86,704 25,888 3,500 6,111 1,275,916 (123,736)
12% 23% 1.1% 2.4% 0.3% 0.8% 2.4% 1.0% 0.8% 0.5% 1.2% 0.5% 0.6% 3.5% 1.1% 0.1% 0.2% 52% -5%
300,000 328,826 14,000 53,271 8,900 17,000 30,000

-
13% 14% 0.6% 2.3% 0.4% 0.7% 1.3% 0% 0.7% 0.5% 1.2% 0.7% 0.7% 2.7% 1.0% 0.1% 0.2% 40% 9%
300,000 260,000 12,000 46,516 9,000 15,000 28,000 16,120 11,000 26,000 14,568 15,213 56,000 21,056 3,300 5,600 839,373 283,867
14% 12% 0.6% 2.1% 0.4% 0.7% 1.3% 0% 0.7% 0.5% 1.2% 0.7% 0.7% 2.6% 1.0% 0.2% 0.3% 39% 13%
17,430 11,500 28,000 15,612 15,568 62,883 23,412 3,400 5,800 935,602 214,558
124
IMACHEAT, INC. RECONSTRUCTION OF SALES

2005
Cost of Goods as Reported Cost of Goods Sold as determined Sales Recalculated based upon 45% cost of goods 1,562,800
2004
1,313,200
2003
1,198,600
2002
1,046,600
45%
45%
45%
45%
3,472,889
2,918,222
2,663,556
2,325,778
Reported Sales UNREPORTED SALES
2,888,600 584,289
2,465,380 452,842
2,348,760 314,796
2,169,840 155,938
125
IMACHEAT, INC. INCOME AS ADJUSTED 2005

Net Income as Reported (334,480)
-12%
2004
(123,736)
-5%
2003
214,558
9%
2002
283,867
Adjustments:
Unreported Sales (A) Fictitious Payroll (B) Automobile Exp (C ) Depreciation (D) Employee Benefits (E) Interest (F) Payroll Taxes (G) Professional Fees (H) Rent (I ) Travel & Ent (J) Telephone (K) Utilities T otal A djustments
584,289 250,000 14,000 30,000 28,000 24,000 25,000 47,000 20,000 14,100 4,500 3,100 1,043,989
452,842 170,000 12,000 30,000 25,000 17,000 3,500 710,342
314,796 3,400 318,196
155,938 3,300 159,238
INCOME A DJUST ED
709,509
586,607
532,753
443,105
(A) Add back excess payroll paid to girl friend that was returned to Husband (B) Add back Automobile lease paid for girl friend (C ) Add back Depreciation on furniture purchased for Husband's hidden Condo (D) Add back travel expense for Husband and girl friend coded to employee benefits (E) Add back interest expense for purchase of Husband's hidden Condo (F) Add back payroll taxes related to excess payroll (G) Add back Husband's divorce Attorney fees (H) Add back rent paid for girlfriend's apartment (I) Add back non-business travel & entertainment (J) Add back Husband's and girlfriend's home and cell phones (K) Add back Husband's hidden Condo utilities and girlfriend's utilities.
126
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
127
Example Proof-of-Cash (Annual)

PROOF OF CASH WORKSHEET/DOCUMENTATION
Period ended:
Beginning of Fiscal Year Bank Reconciliation (June 30, 2001) Fiscal year receipts Fiscal year disbursed End of Fiscal Year Bank Reconciliation (June 30, 2002)
Description
Balance per Bank: Deposits in transit: June 2001 June 2002 Outstanding Checks: per list 6-30-2001 per list 6-30-2002 ADJUSTED BALANCE Balance per Books: June Service charge: NSF Checks returned: Bank transfers, errors in recording, other adjustments Interest posted, by bank: ADJUSTED BALANCE
(same as line 4)
(1) (2a) * (3a) +
(1) (2a) (2b) -
(1)
(1) ( (2b)
(3a) (3b) (4) (5) (4) (5) (6) (7) (8) (9) + + (10) (8)
(3b) (4) (5)
(4) (5)
+ -
(6) (7)
++
+ - (8) (9) (10) **
(10) *shaded areas should not
(10)
need an entry
128
Actual Proof-of-Cash (Monthly)

EXAM PLE TAR G ET C OM PAN Y Proof of C ash Bank of Am erica Account N o. XXXXXX-XXXXX Line Begin 12/31/03 R eceived 2004 D isbursed 2004 End 12/31/04 Proof D ifference
$ 184,256 $ 676,073,010 $ (676,106,648) $ B alan ce p er B an k: 1 Less T ransfers to/from S weep A ccount #4XXXXXXXXXXX (22,910,848) 10,771,464 Less T ransfers to/from M aster XXXXXXXXXXX (3,155,662) 19,269,718 Less "S weep credits or debits" per statem ent (591,928,329) 596,668,006 Less T ransfers to/from XXX Ltd. Xx x x x x x x x x x x x x x x x x 2,487,765 D eposits in transit: B egin (com puted, do not hav e actual) 639,240 (639,240) 2a E nd 21,114 2b O utstanding C hecks: B egin (com puted, do not hav e actual) (826,589) 826,589 3a E nd (79,726) 3b A DJU S T E D B A LA N CE
4
150,618
$ 143,000
21,114
21,114
(79,726) 92,006 84,388
(79,726) $ 84,388 $ 84,388 $ $
$ $
(3,093) $
57,460,046
(46,162,832) $
B alan ce p er B o o ks: 5 Less T ransfers to/from S weep A ccount Less T ransfers to/from M aster XXXXXXXXXXXX Less T ransfers to/from XXX Ltd. Xx x x x x x x x x x x x x x x x x S erv ice charge: 6 N S F C hecks returned: 7 B ank transfers, errors in recording, other adjustm en 8 "S UR P R IS E " Interest posted, by bank: 9 A DJU S T E D B A LA N CE 10 (sam e as line 4) D ifference T ransfers to/from A F F ILIA T E
(3,093) $ 675,015,076 $ (675,497,228) $ (614,829,975) 607,432,665 (3,155,662) 19,269,718 2,487,765 11,254 (7,164) 565,543 (2,396) (3,093) $ 57,038,297 $ (45,748,700) $ 0.01 $ $ 421,749 67,495 $ $ (414,131) $ 9,809,541
7,618
92,006 7,618
$ 84,388 $
(0) $
7,618 0 7,618 0 7,618 7,618 0 7,618
N otes 1 F ebruary beginning balance per reconciliation does not tie to ending balance prior m onth. D ifference $4,090.05 2 M issing page 5 of the M arch 2004 B oA XXXXXXXXXXXXXXXXXXX statem ent. 3 B eginning in M ay, 2004 sweep credits and debits appear on the checking account and form at of bank statem ents changed. 4 C redit of $7,164 per bank on 5/10/05 & debit of $7,164 on 5/6/05 not shown in XXX disbursem ents. T ransactions wash. 5 B eginning in June transactions in and out of funds sweep account no longer appear on checking account statem ents. 6 A sweep debit of $2,936,986.86 appears as a sweep credit on July 1 - technically a sweep in transit but not tracked that way by XXX on bank reconciliations. 7 D o not hav e the Dec. checking account statem ent. P ages from internet show debits and credits. B alance colum n not readable. 8 Account D escription
B ank NEW B ank B ank
of A m erica A ccount N o. XXXXXX-XXXXX B A N K C hecking of A m erica F undS weep S tatem ents (A ccount N o. XXXXXXXXXXXX) of A m erica M aster S ettlem ent A ccount N o. XXXXX-XXXXX
129

Essential Concept of Statistics

The Field of Statistics
Descriptive Statistics
Inferential Statistics
131
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
132
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
133
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
134
3. The Objective of Statistics (cont)

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
135

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
136

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
137
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
138
4. Common False Inferences (cont)

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
139

4.2 Arithmetic errors and false inferences are found frequently in published studies (cont):
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 deemphasis small statistical margins
140

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
141

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 0.123456 rounded to .12 or 12.35% 1.234567 rounded to 1.23 Numbers should be rounded to significant digits 123,456 rounded to 123,500 123,456,789 rounded to 123,500,000 142

4.4 Fictitious Precision (cont)
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
143

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
144

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
145
5. Descriptive Statistics Methods

5.1 Frequency Distribution Definition A tabular summary of data showing the number (frequency) of items in each of several nonoverlapping classes is referred to as a frequency distribution.
146
5. Descriptive Statistics Methods

5.2
Soft Drink Coke Classic Diet Coke Dr. Pepper Pepsi-Cola Sprite Total
Examples
Pie Chart of Soft Drink Purchases
Relative Frequency .38 .16 .10 .26 .10 1.00 Percent Frequency 38 16 10 26 10 100
Coke Classic Diet Coke Dr. Pepper Pepsi-Cola Sprite
Relative and Percent Frequency Distributions of Soft Drink Purchases
Bar Graph of Soft Drink Purchases

20 18 16 14 12 10 8 6 4 2 0 Classic Coke Diet Coke Dr. PepperPepsi Cola Sprite
Frequency
Soft Drink
147
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
148
6. Measure of Central Tendency (cont)

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
149

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
150

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
151

6.3 Calculation of a mean and median
median
22
25
28
35
40
Mean = 30
Average = 22 + 25 + 28 + 35 + 40 = 150 = 30 5
152

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
153

6.5
25 20
Newspapers Read
Calculation of the Mode
15 10 5 0
N.Y. Times Washington Post Chicago Tribune L.A. Times
154

6.6 Some examples of frequency diagrams:

Normal distribution Bimodal Distribution Asymmetrical (with a tail) positive and negative skew
155

6.7 Normal Distribution
25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
156
The frequency is symmetric with a single mean, median, and mode mode

6.8 Bimodal Distribution The distribution has two modes
25
mode mode
20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
157
mean, median

6.9
25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
158
mode median mean
Distribution that is asymmetrical; in this case with a tail to the right positive skew

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
159

6.11 Quartiles (cont)
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.
160

6.12 Location of Quartiles
25%
25%
25%
25%
Q1
First Quartile (25th percentile)
Q2
Second Quartile (50th percentile)
Q3
Third Quartile (75th percentile)
161

6.13 New Clients by Sales Representatives:
2170 2755 2850 Q1
2880 2880 2890 Q2
2920 2940 2950 Q3
3050 3130 3325
First Quartile (2,865)
Second Quartile (2,905)
Third Quartile (3,000)
162
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
163
7. Measure of Variability (cont)

7.1 Range (cont)
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
164

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
165

7.2 Variance (cont)
Variance is the sum of squared deviations of observations around their mean:
Measurement of distance from the mean
20
data point
30
mean
(-10)
Variance
166

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 25 40 35 22 28 Mean = 30 Distance from mean 25 30 = (-5) 40 30 = 10 35 30 = 5
22 30 = (-8) 28 30 = (-2) Total -0167

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
168

Therefore, we must square each of these numbers, making them all positive:
Students per classroom 25 40 35 22 28 Distance from mean 25 30 = (- 5) 40 30 = 10 35 30 = 5 22 30 = (- 8) 28 30 = (- 2) Distance Squared (-5) = 25 10 = 100 5 = 25 (-8) = 64 (-2) = 4 Total: 218
169

The calculations would then be:
Mean = 30 Number of classrooms (n) = 5 Variance = (xi x) = 218 = 54.5 n-1 4 Variance = 54.5 Units
Standard Deviation = 54.5
Standard Deviation = 7.3824 Units

170

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
171

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
172

7.6 Coefficient of Variation (CV) (cont)
This ratio is useful when comparing the variability of variables that have different standard deviations and different means
CV = 7.3824 100% = 24.61% 30
173
Statistics in Valuation
Dispersion
Seller's Description Seller's Annualized Sale Type Revenues Seller's Annualized Net Income P/E P/R P/SE P/A P/CF P/EBITDA
Operates as a FREIGHT FORWARDER including air and sea export and import between NYC and Asian locations for various dry goods and apparel industries, HQ'd in NYC Domestic and international FREIGHT FORWARDING and project managment service business, HQ'd in Sterling, VA FREIGHT FORWARDING company offering a full range of international logistics services including international air and ocean transportation in the Republic of Singapore and the Kingdom of Cambodia Provides logistics and FREIGHT FORWARDING services, HQ'd in Des Plaines, IL Provides logistics and FREIGHT FORWARDING services, based in Sydney, Australia
Average Median Harmonic Mean Stddev CoVar +/- 2 Stddev
STOCK
29.1
0.6
6.5
0.1
0.0
1.5
22.0
6.1
ASSET
4.2
1.9
14.3
6.5
16.0
15.1
33.1
14.3
ASSET
15.5
1.4
7.9
0.7
5.3
1.6
5.8
6.2
STOCK
6.4
0.2
5.4
0.2
2.6
0.5
0.0
3.1
STOCK
25.1
16.06 15.50 9.38 11.02 0.69 38.11
0.1
0.83 0.57 0.23 0.79 0.96 2.41
49.3
16.69 7.93 9.00 18.56 1.11 53.80
0.1
22.9
0.7
0.0
13.9
8.72 6.17 6.34 5.08 0.58 18.88
1.52 9.36 3.88 12.19 0.16 5.29 1.48 5.84 0.22 #NUM! 1.06 #NUM! 2.78 9.71 6.30 14.76 1.82 1.04 1.62 1.21 7.08 28.79 ##### 41.70
Dispersion
SIC No Code 4731 4731 4731 4731 4731 4731 4731 NAICS 488510 541614 488510 488510 541614 488510 541614 Business Description Sale Date 3/19/2008 Freight Forwarder Involved in the Domestic and International Freight Forwarding 6/20/2003 Logistics and Freight Forwarder 4/25/2007 Logistics and Freight Forwarding Services 4/1/2005 Logistics Consulting and Transportation Brokering 2/17/2000 Provides Services for Ocean Freight Shippers and Non-Vesse 11/16/2007 2/1/2008 Third Party Logistics Provider, Coordinates, Tracks and Ensur Net Sales MVIC Price $9,979,020 $2,000,000 $4,163,293 $4,700,000 $1,895,460 $500,000 $6,358,932 $1,625,000 $1,945,488 $900,000 $2,300,000 $2,000,000 $2,918,192 $1,525,000 1,892,857 1,625,000 $1,251,117 $1,356,214 0.72 MVIC/ MVIC/ GC MVIC/N Sale Sales Flow et Inc Type 0.2 9.4 Asset 1.1 2.5 2.5 Asset 0.3 7.8 8.6 Asset 0.3 7.8 8.6 Stock 0.5 2.8 Asset 0.9 4.3 4.3 Asset 0.5 3.5 3.5 Asset 0.53 0.46 0.37 0.35 0.66 1.23 5.16 4.26 4.24 2.49 0.48 10.14 5.65 4.26 4.34 3.04 0.54 11.74 GrossCF $1,879,860 $63,971 $208,635 $470,000 $440,771 612,647 440,771 197,211 728,009 1.19 2,068,666 Net Income $213,384 $1,852,769 $58,252 $189,733 $320,480 $470,000 $440,771 506,484 320,480 198,976 610,994 1.21 1,728,472
Average 4,222,912 Median 2,918,192 Harmonic Mean $3,021,525 Stddev $2,991,724 0.71 CoVar +/- 2 Stddev SM Copyright 2006 Business Valuation Resources, LLC. All rights reserved. www.BVResources.com (888) BUS-VALU, (503) 291-7963 Rejects SIC No Code 4731 4731 4731 4731
NAICS 488510 488510 488510 488510
Business Description Sale Date Freight Forwarding 6/15/2000 Ground Transportation, Warehouse Services, Air, Rail, and O 12/6/2000 Shipping 1/16/1998 Provide Expedited Trucking, less than Truckload (LTL), Air Ca 12/31/2003
Net Sales MVIC Price $340,000 $115,000 $3,457,079 $200,000 $580,000 $200,000 $6,728,249 $2,000,000
MVIC/ Sales 0.34 0.06 0.34 0.3
MVIC/ GC MVIC/N Sale Flow et Inc Type #DIV/0! #DIV/0! Asset #DIV/0! 2.63 Stock 2.2099 2.34 Asset 28.2 -95.6 Stock
$90,500 $71,027
$76,157 $85,500 ($20,927)
Significance
Accounting Advertising Auto and Travel Bad Debts Bank Fees & Finance Charges Benefit Plan Expense Company Functions Contributions Dues & Subscriptions Employee Benefits Freight & Express Gifts Insurance Legal & Professional Fees Machine & Equipment Rental Meals & Entertainment Miscellaneous Office Supplies & Postage Other Taxes & Licenses Payroll Taxes Plane Lease & Operating Expense Printing & Reproduction Promotional Expense Purchased Services Reference Materials Rent Repairs and Maintenance Retirement Plan Expense Royalty Expense Salaries & Wages Shop Supplies Trade Show Expense Training & Seminars Utilities & Telephone Website Total Operating Expenses Year Year Year Year Year Ending Ending Ending Ending Ending 12-31-01 12-31-02 12-31-03 12-31-04 12-31-05 0 0 0 0 0 127,477 362,950 591,745 823,828 930,050 135,998 136,050 136,001 135,479 135,546 6,070 208 3,380 634 262 40,756 77,308 103,308 126,730 105,722 0 610,000 0 0 0 0 0 0 22,781 44,414 1,325 0 0 0 0 15,598 16,191 14,731 23,079 30,908 0 31,338 75,327 239,985 365,515 58,218 0 0 0 0 0 0 0 0 0 61,959 29,051 105,236 269,642 624,561 94,068 347,990 277,532 482,391 1,200,458 36,000 875 941 0 0 10,790 21,990 24,132 32,551 36,624 7,430 0 0 0 0 64,975 102,512 175,961 288,019 236,318 4,347 19,132 17,555 53,482 78,504 60,774 84,371 132,645 246,942 323,663 0 31,352 336,146 451,999 1,026,289 258,603 40,996 11,111 16,876 27,612 2,598 0 0 158,252 459,189 38,426 0 0 0 0 1,296 0 0 0 0 71,742 66,040 90,861 338,999 397,904 12,890 12,270 22,972 36,219 33,470 0 140,000 115,057 205,151 0 0 0 0 0 0 203,194 138,566 260,533 593,207 949,576 881 0 0 0 0 30,588 50,890 58,938 182,171 223,012 1,867 0 0 37,275 21,950 45,604 50,811 69,716 185,439 309,286 0 31,219 58,174 115,895 231,322 1,350,979 2,413,770 2,682,602 5,114,087 7,857,530 Mean 0 567,210 135,815 2,111 90,765 122,000 13,439 265 20,101 142,433 11,644 0 218,090 480,488 7,563 25,217 1,486 173,557 34,604 169,679 369,157 71,040 124,008 7,685 259 193,109 23,564 92,042 0 429,015 176 109,120 12,218 132,171 87,322 3,883,794 Median 0 591,745 135,998 634 103,308 0 0 0 16,191 75,327 0 0 105,236 347,990 875 24,132 0 175,961 19,132 132,645 336,146 27,612 2,598 0 0 90,861 22,972 115,057 0 260,533 0 58,938 1,867 69,716 58,174 2,682,602 Min 0 127,477 135,479 208 40,756 0 0 0 14,731 0 0 0 29,051 94,068 0 10,790 0 64,975 4,347 60,774 0 11,111 0 0 0 66,040 12,270 0 0 138,566 0 30,588 0 45,604 0 1,350,979 Max 0 930,050 136,050 6,070 126,730 610,000 44,414 1,325 30,908 365,515 58,218 0 624,561 1,200,458 36,000 36,624 7,430 288,019 78,504 323,663 1,026,289 258,603 459,189 38,426 1,296 397,904 36,219 205,151 0 949,576 881 223,012 37,275 309,286 231,322 7,857,530 Chi Square 11.07 #DIV/0! 763,729 2 12,557 47,998 2,440,000 118,204 5,300 9,455 676,911 232,872 #DIV/0! 1,103,788 1,511,855 133,758 16,006 29,720 195,231 107,766 295,793 1,869,567 626,323 1,282,301 153,704 5,184 541,435 21,224 353,827 #DIV/0! 1,076,150 3,524 278,447 92,342 395,102 379,912 7,035,179
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
177
8. Measure of Relative Location (cont)

8.1 Skewness for Two Distributions
Negative 0.3
0.3
Positive
0.2
0.2
0.1
0.1
178

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
179

8.3 Chebyshevs 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
180

8.3 Chebyshevs Theorem (cont)
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
181
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
182
8. Measure of Distribution Shape (cont)

8.4 Empirical Rule (cont)
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
183
8. Measure of Distribution Shape (cont)

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
184
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
185
Correlation
PRICE TO REVENUE
$5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 $0 $5,000
Thousands
Thousands
PRICE $
PRICE $
PRICE $
Thousands
y = 0.1053x + 1E+06 R = 0.0539
$10,000
$15,000
Thousands
$5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 0
PRICE TO GCF y = 2.1121x + 776026 R = 0.957
$5,000 $4,000 $3,000 $2,000 $1,000 $0 $0
PRICE TO NET INCOME y = 2.0813x + 838700 R = 0.8792
500
1000
1500
2000
$500
$1,000
$1,500
$2,000
Thousands
Thousands
REVENUE $
GROSS CASH FLOW $
NET INCOME $
10. Presentation of Data

10.1 Descriptive statistics
Methods of organizing and summarizing data to reveal patterns and facilitate interpretation Numeric statistics Pictorial statistics
187
10. Presentation of Data (cont)

10.2 Numerical statistics

Numeric values (measures) describing the data set Measurements include: Measures of central tendency Measures of variability
188

10.3 Pictorial statistics
Presents numerical statistics in the form of pictures and graphs

Tabular procedures Graphical procedures
189

10.3 Pictorial statistics (cont) 10.3.1Presentation 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 Best represents in Dot Plot or Histograms
Quantitative data can be measured in amounts
190

10.4 Types of graphical presentations
10.4.1 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
191

10.4 Types of graphical presentations (cont)
10.4.2 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
10
15
20
25
30
35
192

10.4.3 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
193

10.4.4 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
194
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
195

Digital Analysis
197
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

198
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 Benfords Law, duplicate numbers, round numbers, etc.
199
Benfords Law
Benfords Law is an analytical technique identified in the late 1800s and developed during the 1920s by Frank Benford, a physicist at General Electric research laboratories. He noted that the first few pages of logarithm table books were more worn than the later pages. In those days, logarithm table books were used to accelerate the process of multiplying 2 large numbers by summing the log of each number and then referring to the table for the requisite integer. Benfords Law states that digits and digit sequences in a dataset follow a predictable pattern. The technique applies a data analysis method that identifies possible errors, potential fraud or other irregularities. For example, if artificial values are present in a dataset the distribution of the digits in the dataset will likely exhibit a different shape (when viewed graphically), than the shape predicted by Benfords Law. Benford proved his theory by using 20 lists containing 20,229 numbers, and produced the statistical array that is still applied today.
200
Benfords 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
201
Benfords Law Major Digit Tests

Major Digital Tests The digital analytical tests applied through Benfords Law are comprised of the following: First Digits Test - The first Major Digital Test is a test of the first digit proportions, a test for reasonableness. The first digit of a number is the leftmost digit with the understanding that the first digit can never be a zero. For example, the first digit of 7,380 is 7. Second Digits Test - The second Major Digital Test is a test of the second digit proportions, also a test for reasonableness. The second digit of a number is likewise determined by its placement within the number, thus the second digit of 7,380 is 3. First 2 Digits Test This test is more focused than the 2 preceding tests and uses the first 2 leading digits, again excluding zeros. For example, the first 2 digits of 7,380 are 73 and the first 2 digits of 0.07380 are also 73. There are 90 possible first-two digit combinations: 10 to 99 inclusive. This test finds anomalies in the data that are not readily apparent from either the first or second digits seen on their own. First 3 Digits Test This test focuses on the 900 possible first 3 digit combinations: 100 to 999 inclusive. This highly focused test indicates abnormal duplications.
202
Benfords Law Major Digit Tests

Benfords 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.
203
First Digit Test

Benford's Law First Digit
9,000 8,000 7,000
Occurences
6,000 5,000 4,000 3,000 2,000 1,000 0 1 2 3 4 5 6 7 8 9
Digit
ACTUAL LOWBOUND HIGHBOUND EXPECTED
204
Second Digit Test

Benford's Law Second Digit
7000 6000 5000
O ccurences
4000 3000 2000 1000 0 0 1 2 3 4 5 6 7 8 9
Digit
205
First Two Digits Test

Benford's Law First Two Digits
2500
2000
O ccurences
1500
1000
500
0 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95
Digits
206
First Three Digits Test

Benford's Law First Three Digits
1,600 1,400 1,200
O ccurences
1,000 800 600 400 200 0 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800 850 900 950
Digits
207
Last Two Digits Test

Benford's Law Last Two Digits
0.20 0.18 0.16
% of Occurences
0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 00 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95
Digits
Actual Expected Upper Bound Lower Bound
208
Numeric Tests
NUMERIC TESTS The Numeric Tests are comprised of 2 key examinations, e.g. a Numeric Duplication Test and a Rounded Numbers Test. Once any significant duplication has been identified, meaningful inferences can be drawn through further investigation. The Numeric Duplication Test is used to identify abnormal recurrences of specific numbers. The objective is to draw attention to small groups of numbers that appear to be unusual. The Rounded Numbers Test operates on the same premises as the Numeric Duplication Test. However, the objective is to identify abnormal recurrences of rounded numbers. Abnormal recurrences of rounded numbers are good indicia of estimation since people tend to estimate when they create contrived numbers.
209
Duplicate Numbers Test

Amount 10.00 15.00 18.00 18.50 20.00 22.00 25.00 30.00 40.00 50.00 100.00 150.00 200.00 250.00 300.00 301.50 400.00 450.00 500.00 550.00 600.00 650.00 700.00 750.00 800.00 900.00 950.00 # of Records Total Amount 469 144 41 129 201 37 651 45 114 42 204 41 91 38 208 111 34 22 91 16 34 10 23 38 26 14 10 4,690.00 2,160.00 738.00 2,386.50 4,020.00 814.00 16,275.00 1,350.00 4,560.00 2,100.00 20,400.00 6,150.00 18,200.00 9,500.00 62,400.00 33,466.50 13,600.00 9,900.00 45,500.00 8,800.00 20,400.00 6,500.00 16,100.00 28,500.00 20,800.00 12,600.00 9,500.00 % of Records 2.21% 0.68% 0.19% 0.61% 0.95% 0.17% 3.07% 0.21% 0.54% 0.20% 0.96% 0.19% 0.43% 0.18% 0.98% 0.52% 0.16% 0.10% 0.43% 0.08% 0.16% 0.05% 0.11% 0.18% 0.12% 0.07% 0.05% % of Debits 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.00% 0.00% 0.00% 0.01% 0.00% 0.01% 0.01% 0.04% 0.02% 0.01% 0.01% 0.03% 0.01% 0.01% 0.00% 0.01% 0.02% 0.01% 0.01% 0.01%
210
Round Numbers
Number of Rounded Records 10s 6,287 25s 5,533 100s 4,054 1000s 2,369 Actual Expected Aggregate Proportion Proportion Direction Z-Statistic Withdrawals $108,667,550.00 0.25971 0.1 over 82.8198 $106,764,875.00 0.22856 0.04 over 149.6980 $104,427,800.00 0.16747 0.01 over 246.2083 $97,216,000.00 0.09786 0.001 over 476.7037
211

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
Facts about Lying

Lies are more likely to be detected when:
The lie is not expected The lie is challenged The liar has little experience The consequences are high The person being lied to is personally acquainted with the liar The person being lied to is not easily deceived
Communication
Early landmark study found that communication is
38% vocal (pitch, stress, tone, pauses) 55% physical (expressions, gestures) 7% verbal (content) Active listening required
Nonverbal
Subsequent studies have refined these numbers, but consistently find that at least of meaning is communicated nonverbally
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

Thats 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). Its written all over their faces. USA Today. READ FOR HOMEWORK! http://www.usatoday.com/money/companies/management/200802-24-ceo-faces_N.htm
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 Property Room Evidence and Case Building
Crime Lab
Review by DA and Defense
Property Returned to Owner
Court
Final Disposal
Computer Evidence
Protecting data in hardware seizures Insidious e-mails 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
2004 ASSETS Cash Accounts Receivable Inventory Other Current Assets Total Current Assets Fixed Assets Net Intangible Other Non-Current Non-Operating Assets Total Assets LIABILITIES & EQUITY Accounts Payable Short Term Notes Payable Current Portion of LT Debt Other Current Liabilities Total Current Liabilities Long Term Debt Other Non-Current Liabilities Non-Operating Liabilities Total Liabilities Total Equity Total Liabilities & Equity 49,864 3,478,610 0 246,618 3,775,092 213,964 0 0 0 3,989,056
2003 217,425 1,784,463 0 378,397 2,380,285 186,851 0 0 0 2,567,136
2002 295,085 1,710,553 0 154,869 2,160,507 192,191 0 0 0 2,352,698
2001 515,575 1,260,194 0 159,205 1,934,974 212,191 0 0 0 2,147,165
2000 242,268 1,556,638 0 75,818 1,874,724 261,815 0 0 0 2,136,539
1999 207,808 1,540,093 0 143,698 1,891,599 291,685 0 0 0 2,183,284
1998 321,789 1,669,359 0 95,732 2,086,880 195,303 0 0 0 2,282,183
1997 514,604 976,507 0 150,371 1,641,482 176,776 0 0 0 1,818,258
1996 958,572 446,189 0 275,253 1,680,014 166,922 0 0 0 1,846,936
1,785,235 104,863 500,000 579,563 2,969,661 69,753 0 0 3,039,414 949,642 3,989,056
971,126 89,298 100,000 688,143 1,848,567 1,375 0 0 1,849,942 717,194 2,567,136
1,008,839 91,811 248,205 369,618 1,718,473 7,118 0 0 1,725,591 627,107 2,352,698
1,007,173 107,602 0 390,010 1,504,785 22,577 0 0 1,527,362 619,803 2,147,165
1,106,364 96,619 500 327,301 1,530,784 60,185 0 0 1,590,969 545,570 2,136,539
782,508 137,265 255,315 475,738 1,650,826 95,972 0 0 1,746,798 436,486 2,183,284
744,508 102,474 50,000 668,708 1,565,690 28,919 0 0 1,594,609 687,574 2,282,183
759,731 125,321 0 146,291 1,031,343 43,299 0 0 1,074,642 743,616 1,818,258
827,449 84,146 0 144,117 1,055,712 65,043 0 0 1,120,755 726,181 1,846,936
235
Visual Balance Sheet

Historical Balance Sheets
4,000,000 3,800,000 3,600,000 3,400,000 3,200,000 3,000,000 2,800,000 2,600,000 2,400,000 2,200,000 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 1995 1996 1997 1998 1999 2000 2001 2002 Total Equity 2003 2004
Total Assets
Total Liabilities
236
Example Income Statement
2004 Revenue Cost of Goods Sold Gross Profit Operating Expenses Officers' Compensation Depreciation/Amortization Interest Expense Total Operating Expenses Operating Profit Other Income/(Expense) Income Before Taxes Income Taxes Net Income 11,555,862 9,996,523 1,559,339 763,038 49,920 7,302 23,330 843,590 715,749 52,649 768,398 0 768,398
2003 9,597,248 8,164,604 1,432,644 661,411 156,880 8,585 13,402 840,278 592,366 6,100 598,466 0 598,466
2002 7,115,191 5,971,627 1,143,564 648,862 174,688 8,298 13,576 845,424 298,140 8,998 307,138 0 307,138
2001 7,408,080 6,358,403 1,049,677 595,597 160,018 10,740 30,690 797,045 252,632 14,745 267,377 0 267,377
2000 6,952,089 5,765,815 1,186,274 577,534 160,000 13,326 29,111 779,971 406,303 11,494 417,797 0 417,797
1999 6,677,074 5,844,555 832,519 725,716 44,787 10,895 20,872 802,270 30,249 (774) 29,475 0 29,475
1998 7,062,412 5,681,643 1,380,769 607,463 160,000 7,286 7,171 781,920 598,849 19,862 618,711 0 618,711
1997 5,959,745 4,892,856 1,066,889 455,604 150,000 6,045 13,159 624,808 442,081 16,129 458,210 0 458,210
1996 5,649,363 4,709,492 939,871 343,862 150,000 4,272 7,998 506,132 433,739 23,109 456,848 0 456,848
237
Visual Income Statement

Historical Income Statements
12,000,000 11,000,000 10,000,000 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Revenue
Total Operating Expenses
Net Income
238
Side-by-Side Comparison
Historical Balance Sheets

4,000,000 3,800,000 3,600,000 3,400,000 3,200,000 3,000,000 2,800,000 2,600,000 2,400,000 2,200,000 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 1995 1996 1997 1998 1999 2000 2001 2002 Total Equity 2003 2004 Revenue 12,000,000 11,000,000 10,000,000 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 1995 1996
Historical Income Statements
1997
1998
1999
2000
2001
2002
2003
2004
Total Assets
Total Liabilities
Total Operating Expenses
Net Income
239
Cash Flow Statement

Increase/(Decrease) in Cash Cash Provided by (Used for) Operations: Net Income/(Loss) COGS Depreciation Depreciation Amortization (Increase)/Decrease in Accounts Receivable (Increase)/Decrease in Other Current Assets (Increase)/Decrease in Other Non-Current Assets Increase/(Decrease) in Current Liabilities Increase/(Decrease) in Long-Term Liabilities Increase/(Decrease) in Other Liabilities Total Cash Provided by (Used for) Operations: Cash Provided by (Used for) Investing Activities: Net (Additions to)/Disposal of Fixed Assets - Net Net (Additions to)/Disposal of Intangible Assets - Net Total Cash Provided by (Used for) Investing Activities: Cash Provided by (Used for) Financing Activities: Net Additions to/(Reductions in) Notes Payable Net Investment in/(Distribution of) Common Stock Net Investment in/(Distribution of) Retained Earnings Total Cash Provided by (Used for) Financing Activities: Total Increase/(Decrease) in Cash Cash Balance at Beginning of Year Cash Balance at End of Year Year Ending 9-30-04 768,398 69,153 7,302 0 -1,694,147 131,779 0 721,094 69,753 0 73,332 -103,568 0 -103,568 398,625 0 -535,950 -137,325 -167,561 217,425 49,864 Year Ending 9-30-03 598,466 74,448 8,585 0 -73,910 -223,528 0 278,299 0 0 662,360 -77,693 0 -77,693 -153,948 0 -508,379 -662,327 -77,660 295,085 217,425 Year Ending 9-30-02 307,138 75,591 8,298 0 -450,359 4,336 0 -34,517 0 0 -89,513 -63,889 0 -63,889 232,746 0 -299,834 -67,088 -220,490 515,575 295,085 Year Ending 9-30-01 267,377 77,080 10,740 0 296,444 -83,387 0 -25,499 0 0 542,755 -38,196 0 -38,196 -38,108 0 -193,144 -231,252 273,307 242,268 515,575 Year Ending 9-30-00 417,797 85,188 13,326 0 -16,545 67,880 0 134,773 0 0 702,419 -68,644 0 -68,644 -290,602 0 -308,713 -599,315 34,460 207,808 242,268 Year Ending 9-30-99 29,475 79,565 10,895 0 129,266 -47,966 0 -120,179 0 0 81,056 -186,842 0 -186,842 272,368 0 -280,563 -8,195 -113,981 321,789 207,808 Year Ending 9-30-98 618,711 53,865 7,286 0 -692,852 54,639 0 484,347 0 0 525,996 -79,678 0 -79,678 35,620 0 -674,753 -639,133 -192,815 514,604 321,789 Year Ending 9-30-97 Year Ending 9-30-96
458,210 456,848 41,886 32,674 6,045 4,272 0 0 -530,318 479,029 124,882 -113,371 0 0 -24,369 581,546 0 0 0 0 76,336 1,440,998 -57,785 0 -57,785 -21,744 0 -440,775 -462,519 -443,968 958,572 514,604 -81,600 0 -81,600 -5,289 0 -395,537 -400,826 958,572 0 958,572
240
Decomposing the Income Statement

Historic Benefit Stream Analysis
900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0
1995
1996
1997
1998
1999
2000 EBIT
2001
2002
2003 EBITDA
2004
Pretax Income
After Tax Income
241
Translate data into pictures & Opinions into sound bites.

Dominant, deliberate and declining Family, failure and fate
242
Key Indicators
$102,034,100 The total cash disbursed by SUSPECT-X for operating expenses, furniture and equipment and ownership interests during its existence. $91,154,854 The total cash that investors and lenders tendered to SUSPECT-X during its existence. Note that SUSPECT-X never produced a positive operating cash flow during its existence, thus operating cash does not apply. The book balance of SUSPECT-Xs various bank accounts as of the date of the financial statements, January 24, 2002. The total amount paid and categorized by SUSPECT-X as Investor Relations expense during its existence. The estimated number of inter- and intrabank transfers among the various SUSPECT-X bank accounts. The estimated number of individual investors identified as placing funds with SUSPECT-X during its existence. The total reflects 5,069 SUSPECT-X investors, 54 Znetix investors and 125 Cascade investors. The amount of interest earned by SUSPECT-X on the $102,034,100 that passed through managements hands. The estimated number of automobiles, boats, other watercraft, trucks, motorcycles, trailers and a fire truck purchased by SUSPECT-X during its existence. The number of entities formed during the existence of SUSPECT-X, including C corporations, LLCs, sole proprietorships, PLLCs, etc. The number of years of SUSPECT-Xs existence, i.e. beginning in 1995 through the Report date. The number of people named in the original TRO. The number of foreign countries where SUSPECT-X had an entity and still holds one or more bank accounts, i.e. Nevis and the Bahamas. The number of income tax returns filed by SUSPECT-X management for its 23 entities throughout its 6 years of existence. $165,475
$15,300 11,000 5,248
$3,910
130
23
6 5 2
243

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 www.BlackBookOnLine.Info Proof-of-Cash Deposition Matrix Entity(s) Chart Lev-Thiagarajan Techniques Damages Report Card Digital Analysis CATA/CRO MSSP
246
Forensic Accounting Foundational Discipline
Economic Damages Tax

PI, WD
Forensic Accounting Performance Auditing

Audit/Review/Comp Valuation
Fraud
Internal Audit
Forensic Accounting Organizations

ACFE Association of Certified Fraud Examiners: www.cfenet.com; ACFE American College of Forensic Examiners: www.acfe.com; AICPA American Institute of Certified Public Accountants: www.aicpa.org; CICA Canadian Institute of Chartered Accountants: www.cica.ca; IIA Institute of Internal Auditors: www.theiia.org; IMA Institute of Management Accounting: www.imanet.org; and NACVA National Association of Certified Valuation Analysts: www.nacva.com.
248
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
PostAssignment
Background Research
Undercover
Testimony & Exhibits
Purpose of Stage

Tasks to be Performed

Potential Issues
Continuous professional development
Obtain the results of the case Benefit from the experience
References
Learn from the experience Assess firms performance TASKS Evaluate performance of each party Update cv Extract show and tell as feasible\ Follow-up with counsel; grading form
Deliverables
Verdict Judges Ruling Lessons Learned Updated cv

Your previous results
249
Portland Chapter of the American Society of Appraisers #39
Educational Event
Portland, OR May 5, 2009
Forensic Aspects of Business Valuation

The Combat CPA Series
Darrell D. Dorrell, CPA/ABV, MBA, ASA, CVA, CMA, DABFA financialforensics www.financialforensics.com

Forensic Aspects of Business Valuation

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Portland Chapter of the American Society of Appraisers #39

Forensic Aspects of Business Valuation

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To spearhead forensic accounting innovation in civil, criminal and combat matters.

The definition of forensic accounting is:

The art & science of investigating people & money.

Some of our recent work using these techniques

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Economic Damages Tax

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How does forensic accounting affect valuation?

Secondary adjustments, e.g. DLOM, DLOC, Key Customer? Etc.?

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Testimony & Exhibits

% 65.5% 0.0% 32.7% 1.8% 100.0%

Units 58,668 1,119,960 589,314 32,059 1,800,001

% 3.3% 62.2% 32.7% 1.8% 100.0%

Target Subject Company

Target Subject of Washington, LLC

Shell Acquisitions, Inc.

Transport Shell, Inc.

Target Subject of CITY #2, LLC Legend:

Target Subject of CITY #1, LLC

Bold, 12 pt - Named party

CITY #4, LLC

Acquired Subject & Sons, Inc.

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