Where's Bob Today?

"He is having his deposition taken."

"Oh jeez, can you imagine anything worse than having your deposition taken?"

We heard this conversation in a client's offices; it reminds us that when we, as consulting experts, have assisted fact witnesses prepare for their depositions, we have learned they suffer from the same fears we do-the fear of being unprepared or wrong in an answer. This fear and the risk of a "bad" deposition are substantially reduced for all witnesses by preparation and supporting documentation with which the witness is familiar. For example, a witness who has a binder of supporting materials organized like an expert would organize his or her factual support, has a solid foundation from which to answer questions confidently and consistently.

Lawyers are good at coaching as to how to answer questions in a disciplined way. A consulting financial expert adds value by gathering, reviewing and organizing the documentary evidence to support the witnesses' recitation of events and instill confidence that the witnesses testimony is factually correct and supported by documents. Employee fact witnesses often don't have the time to prepare as they should for the facts, consulting experts can help.

As described in an article in the April 2004 issue of the ABI Journal by Paul Rubin of Herrick, Feinstein LLP, the Delaware bankruptcy court recently concluded in the Exide Technologies case that Delaware law would recognize a cause of action brought on behalf of a debtor’s estate against a lender for "deepening insolvency". Deepening insolvency has been described as "an injury to the [debtors’] corporate property from the fraudulent expansion of a corporate debt and prolongation of corporate life," and has had "growing acceptance among courts as a theory for recovery."

The article goes on to explain that the courts accepting of the notion of deepening insolvency recognize that where a company’s insolvency is fraudulently concealed, the company may be harmed by the artificial prolongation of corporate life and the fraudulent continuation of its business. Where the company’s debts are increased and its losses are deepened through concealment of its true financial condition, the company has been damaged if less value will be realized upon liquidation than if the company had shut down earlier without incurring the additional debt.

Although there does not appear to be a definitive judicial statement that specifies the precise elements for such a claim, the article cited the following factors as essential: (1) the life of an insolvent corporation was prolonged by hiding its true financial condition, (2) the corporation became more insolvent by incurring additional liabilities or dissipation of assets, (3) the liquidation value was reduced by improperly prolonging the business activity and (4) the corporation suffered harm distinct from that suffered by its creditors. Additionally, there does not appear to be a definitive methodology for measurement of deepening insolvency damages.

In an Audit Risk Alert included in the May 2004 edition of the Journal of Accountancy, financial managers and auditors alike can learn valuable lessons from accounting scandals and audit failures. These lessons help CPAs identify possible early warning signs and risks of accounting fraud, inaccurate financial reporting and business failure.

Typically, management that engages in deceptive accounting practices or fraudulent financial reporting often exhibits high levels of arrogance, pride and greed. They often have a reputation for being unusually aggressive, taking high risks, living close to the edge and swinging for the fences in business dealings. In some cases, management may believe that they are entitled to financial success and rewards no matter how they are achieved because they created the company and its past successes.

The article goes on to mention that effective internal control starts with a proper "tone at the top." Culture and values are critical elements of control because all other controls are derived from them. Culture drives behavior. Without proper internal controls, a few bad apples can cause even the largest of companies to come crashing down.

In a recent issue of the Wall Street Journal, an article describes how investors have used cash flow statements to gauge the credibility of earnings. The most closely watched portion of these reports is the part called cash flows from operating activities. If a company shows strong earnings but generates little cash from its core operations, it could be a warning sign that the earnings are illusory. Conversely, many investors take comfort in the quality of a company’s earnings if they also see robust operating cash flow.

According to a new report by the Georgia Tech Financial Analysis Lab, not all cash flow statements are created equal. Customer-related cash flows generally are supposed to be presented as part of operating activities, while cash flows related to loans are supposed to be part of investing activities. So what do you do with customer-related loans? Different companies often take different approaches to the same kinds of items.

Consider the issue of "vendor financing". Many companies lend their customers money to buy their products. Usually, the initial accounting is fairly simple. Revenue is recorded. Customer receivables go up. Inventory goes down and the company’s operating cash flow remains unchanged. Except that is not how everybody does it. For example, according to the article, Ford lends money to its dealers so they can buy wholesale inventory. Although Ford recognizes revenue on the sales, it classifies the loan as an investing cash flow. The result is that operating cash flow gets a boost by the decrease in inventory even if the dealer fails to pay what it owes. According to the Georgia Tech Financial Analysis Lab, all this can be pieced together from the numbers in the companies’ footnotes.

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