Forensic Accounting

#1: Collusion and Fraud to Attract Business Investors
#2: Embezzlement – What the Auditors Could Not Find!
#3: Comparative Analysis for Family Law Dispute
#4: Found the Income! Asset Tracing in Family Law Cases
#5: Creative Resolution to Real Estate Dispute
#6: Probate Dispute – Hidden & Stolen Assets

#1: Collusion and Fraud to Attract Business Investors

Summary of issue: Arxis Financial was retained to quantify the effect of an alleged fraud and breach of contract. The organizers of a new business made multiple and extensive representations about intellectual property that was owned by the business and the prospects of converting that ownership into rather healthy cash flows in the future. Our client was persuaded to invest hundreds of thousands of dollars in stock and then, in subsequent years, over a million more dollars in the form of loans. The loans were convertible to equity.

In the course of attracting investors, the defendants presented an image of success and a high profile celebrity presence. A valuation firm was even retained that opined in writing that the business was worth more than $20,000,000. All of this masked the reality that the business never made a profit. In fact most, if not all, of the revenue was simply business diverted from another business controlled by one of the defendants. The intellectual property that was the basis for the entire business venture was owned by some of the defendants – but not the business that was issuing stock and borrowing money.

Arxis work: Our initial involvement was to re-create accounting records and attempt to identify a pattern of transactions that would suggest or support a case of collusion and fraud. Because of the financial constraints our work was very targeted and limited. Our work was used to support and assist the work of the team of lawyers in depositions, interrogatories, and other discovery. Our work was also useful in identifying the realizable value of the funds loaned to the business. We also calculated the value of the business for purposes of determining the value of the equity investments of the plaintiffs. Needless to say, the value of the debt and equity was zero.

Result: A jury trial was held. Arxis Financial presented testimony at trial that was focused mostly on the valuation of a business and, more specifically, intellectual property. The trial lasted several days and the jury came back with verdicts for the plaintiffs.

#2: Embezzlement – What the Auditors Could Not Find!

Type of Matter: The Board of Directors and senior management of a large company with several divisions began to suspect that a division controller was embezzling significant amounts of cash. They initially brought in the outside auditors to review bank reconciliations and other reporting for the division. The company spent material amounts of money for up to 6 staff members from the outside audit firm reviewing bank reconciliations for over a week. The Board members began to get uncomfortable with the results of that review and decided they needed a focused fraud examination and called Arxis Financial.

Arxis Work: At the initial meeting with Arxis Financial, the bank reconciliations were specifically excluded from the work scope approved for Arxis. While this was understandable due to the enormous cost of reviewing them already, it became a point of significant contention. Ultimately, we refused to take the engagement unless we were allowed to review the bank reconciliations – essentially covering the same territory as the outside audit firm. Either the reconciliations accurately reflected the activity in the accounts or they were being fabricated to hide illicit activity. Either way, it was the logical starting point.

Once we were authorized to review the bank reconciliations we began work. On the first day it was determined that the reconciliations were indeed problematic. What became apparent very quickly was that the beginning cash balance on any given reconciliation did not agree with the prior month’s ending cash balance. The client was relieved that it did not require a week of Arxis Financial’s time to evaluate the reconciliations.

Once we had proof that there were anomalies in the accounting for cash, further investigation was initiated to determine if the discrepancies were the result of human/software error or the result of intentional manipulation and misrepresentation.

Result: We found that material and significant misappropriation of company assets had taken place over an extended period of time. As a result of our fraud investigation, the Controller was terminated, arrested, subsequently convicted, and is serving time in state prison. The method of hiding the embezzlement was so simple that apparently 6 auditors didn’t think to check it, which although disappointing to the company, is a key reason why a professional fraud investigation team should be engaged to investigate such suspicions.

We provided several recommendations for company management in order to minimize the chances of future embezzlement. The company was greatly pleased with Arxis Financial’s expertise, expediency, successful investigation and recommendations.

#3: Comparative Analysis for Family Law Dispute

Issue: Arxis was contacted to assist in a family court matter involving complex tracing matters. There was an ongoing dispute regarding whether certain material assets were separate or community. Determining the nature of the assets affected the division of assets and, because the cash flow associated with those activities were substantial, reimbursement claims would be significantly affected. Both parties came into the marriage with considerable separate assets.

Arxis work: The case had been active for over a year before Arxis was brought into the matter. The correspondence in that year included settlement offers from both sides. Both offers were immediately rejected as preposterous and even insulting. After this “attempt” to settle, forensic accountants were retained and the forces were being marshalled for battle in court. Each side made substantial commitments to preparing tracings to prove respective claims in trial.

Arxis immediately began the work of preparing the tracings for several bank accounts covering the period of the marriage and the year since separation. Based on some of the data and the conclusions becoming evident from the records, Arxis suspended the tracing work and analyzed the two rejected settlement proposals more closely. To understand the two offers, side-by-side marital balance sheets were prepared. On the left was the Petitioner’s version of assets, debts, and reimbursement claims as reflected in their Section 1152 offer letter. Similarly, on the right was Respondent’s version of assets, debt, and reimbursement claims. At the bottom of each balance sheet was a calculation of the net equalization payment due based on each party’s assumptions and conclusions.

Amazingly, what the parties perceived to be a massive gap between the two positions (millions of dollars) was actually, when put in a side-by-side analysis, a relatively narrow difference of a couple hundred thousand dollars. The emotional attachment to some of the issues by both parties and the enormous accounting complexity had masked the proximity of potential compromise.

Result: Arxis approached our client and presented the prospect that staggering legal and accounting fees could be saved if there was an openness to compromise on a much smaller difference than the litigants previously perceived. Our client approached opposing counsel and requested a settlement conference with both sets of attorneys and forensic accountants. It took most of an eight hour day, but the case settled. The two litigants were initially stunned at how close their two seemingly opposite positions actually were. Significant fees were saved and it is likely that at least two years were cut from the dispute resolution process.

#4: Found the Income! Asset Tracing in Family Law Cases

Type of Matter: In a divorce matter the “in-spouse” who controlled family business, real estate, and all other assets claimed minuscule monthly income, poverty, and no records. His wife knew better and didn’t believe any of it.

Background: After a lengthy marriage Mr. Husband decided to make some major changes in his life – including divorcing his wife. In the initial court filings, declarations of assets and debt as well as income and expenses are filed by both parties. In those disclosures Mr. Husband claimed minimal assets and poverty level income. He provided the filed joint tax returns for the previous several years to support his claims. These filings were contrary to the lifestyle described by his wife that included round-the-world travel, expensive cars, fine dining, and a growing inventory of real estate.

Arxis Work: After Mr. Husband filed financial disclosures with the court, his wife retained an attorney to provide some guidance. The attorney immediately knew something was wrong and called Arxis for assistance. A demand for production of documents was prepared and sent out. Buried in Mr. Husband’s response was the claim that all (everything) accounting records were unavailable because of a stolen computer. His wife had a decision to make – accept his story and her “fate” (poverty) or pursue the case at great risk and cost.

She decided to borrow the money to proceed with the case and that began the process of issuing subpoenas to all banks, escrow companies, credit card companies, etc. Once the records began rolling in Arxis began a full reconstruction of the accounting for the businesses and their personal accounts. The accounting was being recreated to cover as much of the marriage as possible as well as the separation period. Thousands of transactions were entered, reconciled, analyzed, and categorized. As records arrived in response to subpoenas, more data was included in the accounting.

What emerged from all the work was solid evidence of substantial assets, the marital standard of living, and evidence of preemptive sale and/or transfers of assets in anticipation of the divorce. Perhaps the most startling development was proof of average monthly income that was within $500 of what our client told us it was going to be.

Result: Our client took a significant risk to invest in a long and tedious forensic accounting process. That decision to move ahead with the accounting was vindicated when evidence was found supporting all her claims. The court was not happy with Mr. Husband. Likewise, he probably wasn’t happy with the court either as he was ordered to pay fees, sanctions, and sizeable monthly support – prospectively and retroactively.

#5: Creative Resolution to Real Estate Dispute

Summary of Issue: Attorneys representing multiple family members involved in litigation against each other contacted our office to request assistance with accounting. The accounting issues involved were complex and all parties had come to understand that they needed forensic accounting expertise. With the court’s approval, all parties and their legal representatives agreed to retain Arxis as the case expert to see if that might facilitate a resolution.

Why the Request?: Several pieces of real estate were involved in a dispute where the family members had equal ownership interests in all the property. There were no partnership or operating agreements. Unfortunately, there were, as a result, several different expectations of what should have happened as well as different versions of what had happened over several decades. The one undisputed fact was that all properties were owned equally, even though not all family members controlled or even had access to all the properties. The problem was that over many years the properties were, at various times, rentals or the primary residence of extended family members. For properties converted to residences, there was the demand for rent or other compensation for lost income to the other owners. For rental properties, there was a demand for full accounting of rent income, expenses, and the disposition of cash profits.

Arxis Analysis: Current deed, debt, and occupancy data was initially reviewed. It was immediately apparent that the recorded property deeds did not reflect the ownership intent of the parties; there were significant reimbursement claims by at least two of family members; and nobody had accounting records that were relevant, complete, or reliable to allow for a full accounting. Further, after several conference calls, it was clear that most of the family members had no interest in the cost and effort involved to obtain those records.

Extensive time was spent understanding each party’s claims and discussing the documents needed to substantiate the claim. For example, significant improvements and repairs had been done by individual family members to maintain and increase the value of properties. They each did it with the expectation that since all the family benefited, there would be reimbursement. However, as is typical in informal real estate partnerships, there are a lot of assets but very little cash to repay partner loans and reimburse expenses. The family members came to understand that, in the absence of documented evidence, the court was likely to order the sale of all the properties with an equal division of the proceeds. Because of the family legacy represented by the real estate, nobody wanted this to happen. Still, it was an effort to maintain the involvement of the family members needed to resolve the dispute.

As a result of these divergent expectations, inadequate top level management and incomplete accounting processes, it became obvious that there would not be a basis for reliable accounting.  In many situations, this would indicate that the next step would be extensive litigation to remedy the situation.

However, in order to jump-start a dying attempt to resolve the disputes, Arxis proposed a different and creative approach to resolving the dispute through our experienced involvement. A spreadsheet was prepared that projected the financial results of selling all the properties. In other words, the analysis answered the question of what would happen in a coordinated liquidation of all the properties should the court make such an order. Current values of the properties were used based on appraisals. All known reimbursement claims were included in the calculation (including notes indicating which were supported by documents, and those that were unsubstantiated) with the result showing how much cash each partner would be due, or owed.

Result: The liquidation projection was panned by the litigants since none of them wanted to liquidate the properties. However, the family members and their legal representatives met to attempt a settlement and the liquidation spreadsheet became the template used to accomplish a settlement. The individual family members agreed to divide the properties between them. Once that division was decided, the calculations on the liquidation spreadsheet were used to calculate cash due to/from each family member. The result was that none of the properties were sold, each of the family members obtained ownership of the property(s) they wanted, and equalization payments were calculated.

Extraordinary litigation costs, as well as months of heart-wrenching personal time for each of the family members, were avoided by the pre-trial settlement in this case. It turned out that projecting the economic results of a court ordering the sale of all the properties was the linchpin that  finally motivated that settlement.

#6: Probate Dispute – Hidden & Stolen Assets

Summary of Issue: Attorneys representing a family member being threatened with litigation from siblings, step-siblings, and even grandchildren contacted us for some forensic accounting help. The issue was the handling of an estate starting with the death of one parent over 25 years ago and the death of his wife (not the mother of his children) five years ago. The suspicion was fairly typical: estate assets had been hidden and stolen. The law firm retained Arxis to do an independent review to see if there was any truth to the accusations.

Why the Suspicion?: The family involved in this matter had a long history of disputes and distrust stemming from the husband’s multiple marriages and children from those marriages. When the father passed away a quarter of a century ago, certain of his assets transferred to his wife and specified assets were placed into a separate trust that was to provide for the maintenance of his wife for her lifetime. To the extent anything in the trust remained at his wife’s death, the assets would be transferred to the beneficiaries of the trust. A few years after the wife’s death, distributions were made from the trust as directed. But the distributions were not as much as the beneficiaries thought they would be or should be. Thus, began questions that led to suspicions and resulted in legal accusations and lawyers. The original questions were not readily answered because of a scarcity of records and the lack of financial sophistication of the family member who became trustee of the trust. Additionally, our client had only assumed “trustee” status and access upon the second death.

Arxis Analysis: Somehow, analysis needed to be done to meet the request of our client to establish whether there were missing assets or other financial malfeasance involving the trust assets and income. The trustee provided every document that could be located from the family home. This resulted in thousands of pages that needed to be sorted, indexed, and scanned. The scanning process allowed the documents to be searched with data at certain dates isolated. This process also affirmed that the lack of complete transactional records was a simple reality that could not be changed and we would have to work around the many holes in the record.

There were three relevant dates to address. The value of assets at the death of the husband (25 years ago), the value of the assets at the date of death for the wife (trustee), and then the current value of the assets. The lack of records precluded the ability to identify the value of the trust assets at death. The estate was small enough that an estate tax return was not required or filed. In the alternative, a listing of assets and debt was assembled as of a date within five years of the husband’s death. The same was created from records as of the date of death of the wife, while the current date was much easier. These three balance sheets were presented side-by-side showing the net change in assets over the approximate twenty-year period and in the five years since the wife passed away.

Result: The side-by-side presentation was compelling. In the first twenty-year period, the net assets of the trust actually increased, and then dramatically increased in the last five-year period. The bank and investment accounts that had gone to a zero balance had been replaced by other bank and investment accounts that had done quite well. Beneficiaries who had seen only part of the picture were understandably concerned about the seeming “disappearance” of money. Seeing the whole picture on one piece of paper settled the matter.

Unfortunately, from a professional fees perspective, the amount of money that was at issue ended up being only $200,000; the legal and accounting costs were probably about half that amount. Although the disputed amount was relatively low, the investigation resolved the issue, and family relationships now have an opportunity to heal.

It should be noted that this case is typical of similar matters involving many millions of dollars. These costs would have likely been unnecessary if there was not a state of mistrust and lack of cooperation amongst the trustee and beneficiaries, yet this is actually quite common in probate litigation. In such situations, the involvement of legal and accounting professionals is often the only effective remedy to adequately resolve these contentious disputes.