1. Forensic and Investigative Accounting Chapter 11 Litigation Support in Special Situations © 2013 CCH Incorporated. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 CCHGroup.com

2. Chapter 11Forensic and Investigative Accounting2 Antitrust Laws Antitrust laws are an outgrowth of the early years of the Industrial Age in the United States when a small number of powerful businessmen used any tactic at their disposal to force competitors out of business. Because such business practices were not in the best interest of the country, federal legislation was passed that prohibits the formation and continuation of monopolies except when in the best interest of the public.

3. Chapter 11Forensic and Investigative Accounting3 Role of Accountants in Antitrust Litigation Accountants may be called upon to determine whether there is liability under the antitrust laws. The primary issue that forensic accountants address is whether the defendant has engaged in predatory pricing. Accountants may be called upon to determine whether there is liability under the antitrust laws. The primary issue that forensic accountants address is whether the defendant has engaged in predatory pricing. After liability is proved in an antitrust case, then the forensic accountant will be asked to estimate damages. After liability is proved in an antitrust case, then the forensic accountant will be asked to estimate damages.

4. Chapter 11Forensic and Investigative Accounting4 Predatory Pricing Predatory pricing is the act of pricing a product so low that the only logical explanation is that the pricing is designed to drive competitors out of business. Predatory pricing is the act of pricing a product so low that the only logical explanation is that the pricing is designed to drive competitors out of business. The operational definition is whether a company prices its products or services below “average variable cost” and, if so, predatory pricing is present. The operational definition is whether a company prices its products or services below “average variable cost” and, if so, predatory pricing is present.

5. Chapter 10Forensic and Investigative Accounting5 Cost Behavior Defined In its simplest form, cost behavior is the way that cost(s) change with respect to changes in the volume of activity.

6. Chapter 10Forensic and Investigative Accounting6 Common Types of Cost Behavior Fixed costs Fixed costs Variable costs Variable costs Mixed costs Mixed costs Semivariable costs Semivariable costs Semifixed costs Semifixed costs

7. Chapter 10Forensic and Investigative Accounting7 Cost Behavior Assumptions Basis of cost behavior estimates Basis of cost behavior estimates –Relevant range assumption –Time assumption Ways of estimating cost behavior Ways of estimating cost behavior –Account analysis method –High-low method –Regression analysis –Engineering or work-measurement method

8. Reasons Why Managers Want to Know About Cost Behavior Patterns To use in many different types of cost-volume-profit (CVP) analyses. To use in many different types of cost-volume-profit (CVP) analyses. For use in flexible (dynamic) budgeting activities. For use in flexible (dynamic) budgeting activities. For use in standard costing, in particular, MOH variance analysis. For use in standard costing, in particular, MOH variance analysis. For use in determining Manufacturing Overhead (MOH) application rates. For use in determining Manufacturing Overhead (MOH) application rates. For use in litigating or defending a wide variety of cost- related legal issues: For use in litigating or defending a wide variety of cost- related legal issues: –Federal antitrust cases - predatory pricing. –Alleged contractual violations. –Measurements of damages for lost sales/profits/etc. 8IES-Tomkins College

9. Common Types Of Cost Behavior FIXED COSTS: Costs that fundamentally are not driven by changes in volume. FIXED COSTS: Costs that fundamentally are not driven by changes in volume. Y = Total Cost Y = Total Cost Y = a, where a is the amount of fixed cost Y = a, where a is the amount of fixed cost Common examples of fixed costs - Depreciation, Property taxes, Supervisor salaries Common examples of fixed costs - Depreciation, Property taxes, Supervisor salaries 9IES-Tomkins College

10. Common Types Of Cost Behavior VARIABLE COSTS: Costs that change directly and proportionately with the volume of activity. VARIABLE COSTS: Costs that change directly and proportionately with the volume of activity. Y = bX, where b is the slope of the line (the increase in cost relating to the increase in volume) and X is the measure of the volume of activity. Y = bX, where b is the slope of the line (the increase in cost relating to the increase in volume) and X is the measure of the volume of activity. Common examples of variable costs - Direct materials, Direct Labor, Sales Commissions Common examples of variable costs - Direct materials, Direct Labor, Sales Commissions 10IES-Tomkins College

11. Common Types Of Cost Behavior MIXED COSTS: Costs that contain both a fixed and a variable component. MIXED COSTS: Costs that contain both a fixed and a variable component. Y = a + bX, Where a equals the fixed component and bX is the variable component. Y = a + bX, Where a equals the fixed component and bX is the variable component. Common examples of mixed costs - Some lease agreements, some utility costs, many overhead costs. Common examples of mixed costs - Some lease agreements, some utility costs, many overhead costs. 11IES-Tomkins College

12. Common Types Of Cost Behavior SEMI-VARIABLE COSTS: Costs that change but not proportionately with the volume of activity. SEMI-VARIABLE COSTS: Costs that change but not proportionately with the volume of activity. Learning curve costs - are costs that increase at a decreasing rate with the volume of activity. Learning curve costs - are costs that increase at a decreasing rate with the volume of activity. When graphed, learning curve costs slope upward and to the right but not in a straight line; Instead they curve downward. When graphed, learning curve costs slope upward and to the right but not in a straight line; Instead they curve downward. 12IES-Tomkins College

13. Common Types Of Cost Behavior SEMI-FIXED COSTS: Costs that increase in steps or jumps. SEMI-FIXED COSTS: Costs that increase in steps or jumps. Also called set function costs Also called set function costs Some argue that all fixed costs are step function costs over the long run Some argue that all fixed costs are step function costs over the long run 13IES-Tomkins College

14. Cost Behavior Assumptions Relevant Range: Cost behavior estimates are usually based on historical cost observations and analyses. If cost behavior characteristics are projected outside of the observed range of activities, the projections may not be accurate. Relevant Range: Cost behavior estimates are usually based on historical cost observations and analyses. If cost behavior characteristics are projected outside of the observed range of activities, the projections may not be accurate. Time assumption: As time passes, the business environment changes, and cost behavior may change as well. Time assumption: As time passes, the business environment changes, and cost behavior may change as well. 14IES-Tomkins College

15. Cost Behavior Estimation Methods Most organizations have very little cost information that is captured and reported by type of cost behavior pattern. In order to determine cost behavior characteristics, accountants must use a variety of methods to estimate cost behavior patterns. Most organizations have very little cost information that is captured and reported by type of cost behavior pattern. In order to determine cost behavior characteristics, accountants must use a variety of methods to estimate cost behavior patterns. –EXPERIENCE: Often a working knowledge of a firm’s accounting system will provide some knowledge of the nature of cost behavior in the firm’s accounting system. –Merely trying to separate all current cost accounts into fixed and variable costs is usually not a very accurate method of estimating cost behavior. 15IES-Tomkins College

16. Cost Behavior Estimation Methods PLOTTING COST DATA: “A picture is worth a 1,000 words”, is an old saying that has some merit in describing cost behavior patterns. PLOTTING COST DATA: “A picture is worth a 1,000 words”, is an old saying that has some merit in describing cost behavior patterns. –It is really easy now to take accounting cost data and use many different software packages to plot data. –The resulting graphs can provide a good idea of the general nature of the cost volume relationships, although precise descriptive cost models are not provided. 16IES-Tomkins College

17. Cost Behavior Estimation Methods HIGH-LOW METHOD: HIGH-LOW METHOD: The highest and lowest costs are identified along with their related volume levels. These are used to estimate fixed and variable costs: The highest and lowest costs are identified along with their related volume levels. These are used to estimate fixed and variable costs: Example: Example: Variable cost = $300,000 - $280,000 Variable cost = $300,000 - $280,000 100,000 un. - 90,000 un. 100,000 un. - 90,000 un. = $20,000 = $2.00 / unit = $20,000 = $2.00 / unit 10,000 un. 10,000 un. 17IES-Tomkins College

18. Cost Behavior Estimation Methods HIGH-LOW METHOD (cont.) Fixed cost = $300,000 - (100,000 units x $2.00 unit) = $100,000 = $100,000 Total cost = $100,000 + $2.00 X 18IES-Tomkins College

19. Cost Behavior Estimation Methods REGRESSION/CORRELATION ANALYSIS REGRESSION/CORRELATION ANALYSIS –An analytical tool for measuring the degree of association between two or more variables. It is a two-step process: It is a two-step process: –Regression measures the nature of the association between the variables. –Correlation measures the strength of the association between the variables. 19IES-Tomkins College

20. Regression/Correlation Analysis TYPES OF REGRESSION: TYPES OF REGRESSION: Simple Linear Regression or Bi-Variate Regression Simple Linear Regression or Bi-Variate Regression –Two variables: »A dependent variable which is usually cost in our analyses. »An independent variable or predictor variable which is usually the measure of the volume of activity in our analyses. 20IES-Tomkins College

21. Regression/Correlation Analysis A positive (+) value for b indicates that the dependent and the independent variables are positively correlated (moving in the same direction). A negative (-) b value indicates that the dependent and the independent variables are moving in opposite directions. (Example, and increase in interest rates is related to a decrease in construction costs.) A positive (+) value for b indicates that the dependent and the independent variables are positively correlated (moving in the same direction). A negative (-) b value indicates that the dependent and the independent variables are moving in opposite directions. (Example, and increase in interest rates is related to a decrease in construction costs.) The a value indicates point where the regression line crosses the “Y” axis. What does a negative? positive? value for a indicate? The a value indicates point where the regression line crosses the “Y” axis. What does a negative? positive? value for a indicate? 21IES-Tomkins College

22. Regression/Correlation Analysis The coefficient of determination measures the amount of explained variance (i.e. Of the total variance of the dependent variable about its mean (average) value, the amount of that variance that can be explained by changes in the volume of activity is measured by the coefficient of determination.) For example, a coefficient of determination of.84 or 84% means that 84% of the dependent variable’s total variance can be explained by changes in the volume of activity. The coefficient of determination measures the amount of explained variance (i.e. Of the total variance of the dependent variable about its mean (average) value, the amount of that variance that can be explained by changes in the volume of activity is measured by the coefficient of determination.) For example, a coefficient of determination of.84 or 84% means that 84% of the dependent variable’s total variance can be explained by changes in the volume of activity. Association vs. Causation - Regression/correlation analysis shows the degree of association between variables, but it does not prove causation. Association vs. Causation - Regression/correlation analysis shows the degree of association between variables, but it does not prove causation. 22IES-Tomkins College

23. Regression/Correlation Analysis Standard Error of the Estimate: Indicates the variability of the data used in the regression calculations. The greater the variability of the data, the less precision that results from estimates made from the regression data. Standard Error of the Estimate: Indicates the variability of the data used in the regression calculations. The greater the variability of the data, the less precision that results from estimates made from the regression data. –Point estimates are made and confidence intervals are used to achieve desired levels of precision. –t-tables and z tables: Used to provide desired precision levels. Chapter 11Forensic and Investigative Accounting23

24. Using Regression Analysis for Damages in General Virtually all cases in which liability is found has a damages phase to the case. Virtually all cases in which liability is found has a damages phase to the case. Most scenarios require an analysis of what would have happened absent the act that caused the liability. Most scenarios require an analysis of what would have happened absent the act that caused the liability. –Regression analysis gives an expert a foundation from which to develop and support costs behavior assertions. –There is a solid analysis approach which describes the nature of the analysis so the expert can present his/her findings clearly to the jury/judge in order to gain support of the expert’s opinions. Chapter 11Forensic and Investigative Accounting24

25. Regression/Correlation Analysis USING REGRESSION/CORRELATION ANALYSIS USING REGRESSION/CORRELATION ANALYSIS MULTIPLE REGRESSION MULTIPLE REGRESSION –More than one independent variable. –Most medical research uses multiple regression. –Still one “a” value and “r” value. Chapter 11Forensic and Investigative Accounting25

26. Chapter 11Forensic and Investigative Accounting26 Reasons for the Unexpected Some of the accounting reasons that regressions may yield unexpected or perplexing results include: – –When and how allocations are made. – –The nature of transfer prices in an organization. – –Entity concept: what part of the business is involved in the case? – –Accounting policies can make a big difference in cost behavior analysis. Forensic accountants must be adequately informed about the nature and operation of the accounting system for each and every business that they are evaluating.

27. Chapter 11Forensic and Investigative Accounting27 Federal False Claims Act The Federal False Claims Act was passed to protect the government from the unscrupulous acts of a few government contractors that intentionally or carelessly overcharge the government for goods or services.

28. Chapter 11Forensic and Investigative Accounting28 Federal False Claims Act Litigation Fraud allegations from audits or other sources Fraud allegations from audits or other sources Fraud allegations from Whistleblower (relator) Qui tam suits Fraud allegations from Whistleblower (relator) Qui tam suits »Filed on behalf of the US Government Filed under seal along with a disclosure statement documenting the alleged fraud(s) Filed under seal along with a disclosure statement documenting the alleged fraud(s) »The US Department of Justice (USJD) evaluates the claims and decides whether to intervene in the case »Once the USJD makes its decision, the case is unsealed and the relator and the alleged issues in the case becomes known to the public and the defendant –Reasons for bringing action »Financial gains »The right thing to do »Other

29. Chapter 11Forensic and Investigative Accounting29 The Special Nature of Fraud in a FFCA Case Under the Federal False Claims Act, a person acts knowingly with respect to information if the person has: –Actual knowledge of information. –Acts in deliberate ignorance of the truth or falsity of the information. –Acts in reckless disregard of the truth or falsity of the information. In criminal fraud case the standard for conviction is “beyond a reasonable doubt”, but in a FFCA case the standard is “preponderance of the evidence” In criminal fraud case the standard for conviction is “beyond a reasonable doubt”, but in a FFCA case the standard is “preponderance of the evidence” –The latter is a much lower hurdle to cross when trying to prove fraud under the FFCA

30. Chapter 11Forensic and Investigative Accounting30 Accountants may act as an expert witness for the defense, the government, or a whistleblower litigating the qui tam parts of the case. Accountants may act as an expert witness for the defense, the government, or a whistleblower litigating the qui tam parts of the case. The dynamics of FFCA cases can be quite different than typical cases. The dynamics of FFCA cases can be quite different than typical cases. Accountants have a unique role to play in FFCA cases. Accountants have a unique role to play in FFCA cases. Accountant’s Role in Federal False Claims Act Litigation

31. Chapter 11Forensic and Investigative Accounting31 Accountant’s Role in Federal False Claims Act Litigation Typical questions that accountants help courts to answer are: –What costs should be included in the contract? –How should costs be measured under the contract? –What is the correct timing of the costs and/or revenues under the contract? –What accounting concepts, rules, etc., apply under this contract? –What is the magnitude of the damages that occurred because of the fraud that took place?

32. Chapter 11Forensic and Investigative Accounting32 Accountant’s Role in Federal False Claims Act Litigation Under the Federal False Claims Act, a person acts knowingly with respect to information if the person has: –Actual knowledge of information. –Acts in deliberate ignorance of the truth or falsity of the information. –Acts in reckless disregard of the truth or falsity of the information.

33. FFCA Case Outcomes “Fraud” as defined by the FFCA typically result in damages being tripled and “Fraud” as defined by the FFCA typically result in damages being tripled and –May result in the defendant no longer being able to contract with the Federal Government –Triple damages result because it is thought that if the court found some fraud damages there might well be other FFCA damages that were not uncovered and the triple damages are viewed as a deterrent to others Simple contract damages are assessed if there was an error in government billings but it did not rise to fraud as defined by the FFCA Simple contract damages are assessed if there was an error in government billings but it did not rise to fraud as defined by the FFCA The impact on rewards to the Whistleblower The impact on rewards to the Whistleblower –Whistleblowers typically are rewarded for case issues in which the court find fraud under the FFCA guidelines

34. Intellectual Property Intellectual property includes copyrights, patents, trademarks, trade secrets, business processes and other intangible rights that are conveyed to owners via laws and regulations. Intellectual property includes copyrights, patents, trademarks, trade secrets, business processes and other intangible rights that are conveyed to owners via laws and regulations. Most intellectual rights are conveyed for a specified period of time: Most intellectual rights are conveyed for a specified period of time: –Patents are twenty years –Copyrights on property created after January 1, 1978 are for the creators life plus 70 years. Companies hold copyrights for 95 to 120 years. –Other intellectual property such as trademarks may have an indefinite life Chapter 11Forensic and Investigative Accounting34

35. Enforcing Intellectual Property Rights Because of the varying nature and related differing laws and regulations associated with intellectual property, when intellectual property laws are breeched the determination of damages can be complex Because of the varying nature and related differing laws and regulations associated with intellectual property, when intellectual property laws are breeched the determination of damages can be complex –Unlike tangible assets, intellectual property may be taken and used without the owner even knowing about it for some time –Like damages in tangible property cases, intellectual property damages may include lost sales and lost profits –In addition, there may be other damages such as loss of reputation, lost company value and lost customers Chapter 11Forensic and Investigative Accounting35

36. Assessing Damages in Copyright Infringement Cases In the United States, original works are instantly copyrighted without the author doing anything except putting the work into tangible form. In the United States, original works are instantly copyrighted without the author doing anything except putting the work into tangible form. –In a copyright infringement case, however, the author is on much firmer ground if the copyright is “registered” with the U.S. Government –The owners of registered pacopyrights can seek “statutory damages” which are set by law –Statutory damages range for hundreds of dollars to thousands of dollars per infringement regardless of the actual damages suffered in the case –If the copyright is not registered or statutory damages do not apply, actual damages must be computed in much the same fashion as other damage calculations in contract cases Chapter 11Forensic and Investigative Accounting36

37. Common Issues in Proving or Defending Patent Infringement The Georgia-Pacific Factors The Georgia-Pacific Factors –These are 15 different factors that the court considered in measuring damages in the Georgia- Pacific patent infringement case –These rules have been widely adopted in many other similar patent infringement cases by courts The 25 percent rule – –This rule was used by the courts to assess damages in patent infringement cases, but federal courts are no longer using this rule in cases Chapter 11Forensic and Investigative Accounting37

38. Common Issues in Proving or Defending Patent Infringement Cost of next best alternative refers to the application of opportunity cost to measure damages in a patent infringement case Cost of next best alternative refers to the application of opportunity cost to measure damages in a patent infringement case –This approach has a simple and logical basis, but sometimes it is very difficult to identify and cost the next best alternative Running Royalty vs. Upfront Payments refers to the need to evaluate the total royalty package in assessing damages Running Royalty vs. Upfront Payments refers to the need to evaluate the total royalty package in assessing damages –If there are significant upfront royalty payments, those amounts should be allocated over the life of the patent agreement Chapter 11Forensic and Investigative Accounting38

39. Common Issues in Proving or Defending Patent Infringement Cost of Designing Around Cost of Designing Around –It is perfectly legal to design around a patent (that is to “invent a different item that is designed to replace the item covered by the patent) –In doing so, the new inventor must be carful not to infringe on any part of the patent or other intellectual property item covered by the patent Chapter 11Forensic and Investigative Accounting39

40. Common Issues in Proving or Defending Patent Infringement Anti-Trust Issues Anti-Trust Issues –Patent laws and other intellectual property laws and regulations are designed to provide a limited “monopoly” to those holding the rights to patents, copyrights, trademarks, etc. –However, the government has strong anti-trust laws that are designed to encourage fair competition –Many Patent Infringement cases have anti-trust issues in which plaintiffs contend that the intellectual property rights holders have exceeded the protection offered under the law and are in fact engaged in anti-trust activity –Courts attempt to identify the fine line between these two positions and rule in a way that protects both components of the law Chapter 11Forensic and Investigative Accounting40