Dr Barry Jay Epstein, Accounting Expert at Epstein + Nach LLC

Civil litigation involving asset misappropriation, fraudulent disbursements and other complex accounting matters benefit from the engagement of a forensic accountant and/or a fraud examiner. Just as attorneys would not attempt to decipher complex engineering or scientific intricacies at issue in a matter being contested, so too should they – many of whom have studied business, including accounting, as undergraduates – seek expert assistance on accounting-related disputes.

Recently, the authors provided forensic accounting and expert witness services in a civil litigation matter involving claims against the operating manager and majority shareholder of a small – but successful and growing – privately-held internet retailing company. The allegations ranged from failure to make distributions to the minority shareholder, to fraud, unjust enrichment and fraudulent disbursement. The minority shareholder – in this case the plaintiff and our client – knew that “something was wrong” with the accounting records and that “large dollar amounts” were being improperly extracted from the company. However, the client did not possess the expertise and technical knowledge necessary to navigate the company’s complex and convoluted accounting records and, further, to pinpoint, analyze and articulate the substance of the manager’s questionable accounting transactions.
Our investigation revealed that the majority shareholder, then also the operating manager of the company, did indeed make numerous material disbursements, both directly and indirectly, from the company to himself, as well as various payments to related-party employees. Furthermore, the inconsistent and often misdirected categorization of these transactions suggested that the manager intended to disguise these transactions.

Disbursement transactions, in excess of the manager’s contractual salary, ranging over a period of more than six years, totaled upwards of US$7 million. These transactions were recorded in myriad balance sheet asset accounts such as due to member – nominally a liability on the company’s balance sheet, when in fact the substance of the transactions being recorded to the account were for amounts due from member. This liability account perpetually carried a debit balance, indicating that the company was owed money, until a point well into the disbursement scheme when the manager recorded fictitious liability accruals to offset the debit balance.
In one particular series of transactions, the manager withdrew US$988,000 in company funds, which were dubbed by the manager as “loans to officer” in journal entry descriptions, without proper disclosure and inappropriately categorized in the company’s accounting records. US$788,000 was withdrawn from the company in a single transaction, and the additional US$200,000 was withdrawn with several smaller subsequent transactions. Of interest is the method of recording the disbursement in the company’s accounting records. First, this withdrawal was not associated with any employee or vendor identification codes and was therefore difficult or impossible to locate within the voluminous accounting records using a search of disbursement records by means of the previously regularly used vendor and employee identification codes.

Additionally, these withdrawals of cash were inappropriately coded to an Other Assets account, when, in actuality, the transaction represented a withdrawal of funds by the majority member, with a line description as “loans to member” and should have been coded to a Notes Receivables from Director or Owner account. Clearly, from an accounting standpoint, these cash payments to the member did not create an “other asset” for the company and were, essentially, compensation payments or advances thereupon.

Our investigation of the company’s disbursements records did not reveal this transaction; instead we conducted an in-depth vertical and horizontal analysis of the company’s financial statements. Specifically, an analytical review of drastic changes in the assets of the company was noted as unusual, both in terms of the industry norm as well in consideration of the historical financial operations of the company. These observations, we felt, merited further investigation. Upon examination of the underlying transactions accounting for the increase in the balance sheet we quickly became informed of yet another method by which the manager had discretely extracted funds from the company. This evidence has been captured in our expert report, and will shortly be presented in court.

Whether you are a litigator, a business owner, or hold a passive interest in a business, it is important for you to be aware of signs of fraudulent financial reporting and fraudulent disbursements – and it could be vital to have an expert in your corner to shed light on complex transactions and convoluted accounting practices. That is the role of the forensic accountant.