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Application of the Before-and-After Method Which Combines the Classic

Elements of Fraud Examination and Forensic Skepticism in the Valuation of
Commercial Damages

Peter L. Lohrey, Ph.D., CVA, CDBV

Assistant Professor of Accounting
Department of Accounting, Law & Taxation
School of Business
Montclair State University
One Normal Avenue
Montclair, NJ 07042
Phone (973) 655-3514
Fax (973) 243-2646
lohreyp@mail.monclair.edu

James A. DiGabriele, Ph.D./D.P.S., CPA/ABV/CFF

Professor of Accounting
Department of Accounting, Law & Taxation
School of Business
Montclair State University
One Normal Avenue
Montclair, NJ 07042
Phone (973) 655-7288
Fax (973) 243-2646
digabrielej@mail.montclair.edu
jim@dmcpa.com

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I. Introduction

Forensic accountants are routinely engaged to calculate damages when a personal economic loss
is the result of a harmful act. In a legal setting, the individual harmed (the plaintiff) and the
person who caused the harm (the defendant) are usually at odds regarding the amount of
financial damages. Forensic accountants try to help resolve these issues by presenting them in
court of law before a Trier of Fact.

There are two primary types of damages which occur when an individual or business is harmed.
Commercial or business damages range from lost profits, breach of contract, diminution in the
value of a business to patent and intangible losses. These types of losses require the forensic
accountant to apply accounting and finance techniques to quantify the proper amount of damages
to the business entity.

Personal economic damages are derived from cases involving wrongful death, employment
discrimination/wrongful discharge, complete or partial disabilities. These types of situations take
into account the economic value of an individual. The approaches used in these types of cases
usually require a combination of accounting and financial analytics. Theoretically, the objective
of calculating personal damages is to restore the plaintiff to the position that they would have
been in if they otherwise had not experienced a personal loss. 1

A contemporary definition of forensic accounting could be defined as the confluence of

accounting and finance in applying an investigative mindset within a litigation setting. This is
reinforced with forensic skepticism during the process of identifying, recording, extracting,
sorting, reporting and verifying historical financial data. The goal is to settle current or
prospective legal disputes by using past financial data to estimate monetary damages 2.

While applying methodological considerations in the application of forensic accounting

techniques to calculate damages, a parallel concern lies in enhancing the investigation with

1
(Crumbley, et al. 2011, DiGabriele, 2010).
2
(Crumbley, et al, 2011, DiGabriele, 2010).

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qualitative factors that reduce the risk of misspecification. These components are definitive
elements of fraud examination and forensic skepticism.

The objective of this paper is to illustrate the application of these techniques by using a case
study. This case looks at estimating commercial damages using lost profits as a result of a
business interruption. In the next section we introduce various forensic accounting concepts and
model them.

II. Classic Elements of Fraud Examination and Forensic Skepticism

The following sociological theory which identifies factors that lead to embezzlement also applies
to commercial damages.
Cressy3 describes the fraud triangle using three components; pressure, opportunity, and
rationalization. Pressure is derived from a business issue that generally cannot be solved in a
lawful manner. Frequently, a cheat resolves this problem by concealment. A variety of items
often cause pressure; eroding sales, excess debt and/or fierce competition are some examples that
may lead an individual’s behavior in this direction. 4

Opportunity surfaces when the fraudster recognizes a way to use his/her position to commit
fraud. In occupational fraud, opportunity is often created by weak internal controls. The
possibility of “cooking the books” in order to profit from a loss is an aspect of the process that
requires further reflection. Owners of privately held companies have the inherent capacity to
advance a loss recovery by having complete control over the books and records 5.

Rationalization is the process where a fraudster justifies the crime to themselves in a way that
makes it acceptable 6. Frequent rationalizations often center upon the individuals’ view that they
are undercompensated. Other cheats will tell themselves that the company can do without the

3
(Cressy, 1973).
4
(Filler & DiGabriele, 2012).
5
(Filler & DiGabriele, 2012).
6
(Cressy, 1973).

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money or won’t miss the asset. Or others may feel that the company should have the money
stolen due to bad acts it has committed against employees.

Wolfe and Hermanson 7 enhanced the fraud triangle by considering a fourth element, capability.
The authors define this component as having six attributes. First, a person’s position or function
within the organization could provide the ability to create or exploit an opportunity for fraud not
available to others. Second, a true fraudster is smart enough to understand and make the most of
the weakness and use it to their best benefit. Third, the right person has tremendous arrogance
and confidence they will not be detected. Fourth, the fraudster has the ability to influence others
to either commit or conceal the fraud. The fifth attribute is the fraudster must to be a good liar.
Finally, capability requires the ability to deal with the stress.

The normal intuition of a forensic accountant engaged in a litigation setting is to deductively

consider the four elements of classic fraud examination while balancing degrees of forensic
skepticism. Forensic skepticism in this context can be defined as an attitude that includes a
questioning mind frame and critical assessment of evidence 8. Within this prescription a model
for investigation can be exemplified as:

Figure 1.

Risk Reduction of
Classic Elements of Fraud
Misspecified Quantification of Damages
Examination
Damages
Forensic Skepticism

III. Case Study

A Case in Lost Profits due to a Business Interruption
Facts:
Exclusive Espresso Experience (EEE) was a closely held S Corporation formed 10 years ago to
provide the ultimate café experience to their customers. The café offered fresh ground exotic
7
(Wolfe and Hermanson, 2004).
8
(DiGabriele 2010)

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coffee’s from around the world with unique finger foods that suited breakfast, lunch and light
dinners. The café was located close to a local waterway further enhancing the ambiance.

The S Corporation was owned equally by two childhood friends. After a decade had passed, both
shareholders felt the grind of the business and desired to sell it for the right price. The facility
had begun to fall into disrepair and needed a makeover to appear more contemporary. This was
caused by a lack of revenue growth over the last 3 years. The café had been listed with a business
broker for the past year but the owners did not receive any suitable offers.

During the recent month of January 20X1 the building housing the café was completely
destroyed by a storm that moved through the area. The café had to discontinue operations.
Estimates of time to repair the facility ranged from 12 to 13 months. Fortunately, EEE had an
insurance policy that provided insurance for lost profits as a result of a business interruption. As
a result EEE retained the services of a public adjuster to submit the claim of loss to the insurance
company. The public adjuster is to be compensated at 10% of the value of the insurance payment
EEE receives. A claim for the loss was submitted by the public adjuster on behalf of EEE using
the before and after method for calculating a 12 month loss:

Summary of Loss

Lost Revenue : $ 4,675,000

Multiplied by:
Business Interruption Value × 23.49%

Business Interruption Loss: $ 1,098,158

The documents requested & reviewed by the forensic accountant were as follows:

1. Corporate income tax returns for past 2 years.

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2. Payroll tax returns pre & post loss date.

Forensic accountants most often use one or more of the following methods for calculating
business interruption losses: 1) The Before-and-After Method, 2) The Comparable Method (or
yardstick method), 3) The "But For" Method, and 4) The Breach of Contract Method.

They are frequently engaged to review business interruption or lost profits claims for insurance
matters. Generally, insurance policies consider the following reasoning in order to quantify a
loss: an insured is entitled to net income (loss) plus continuing expenses for the length of the loss
period, or, revenue less non-continuing expenses.

Application of The Before-and-After Method in the Context of Lost Profits due to a

Business Interruption

Corporate income tax returns for past 2 years.

Determinative Analysis: The corporate income tax returns (Form 1120S) for EEE were
provided by the company’s new accountants. All of the records located on the premises had been
destroyed in the storm. An amended corporate income return was submitted for the year
immediately preceding the loss. The explanation on the amended tax return stated that $975,000
of revenue was inadvertently omitted due to the lack of communication during the transition of
accounting firms. The amended return was dated subsequent to the business interruption date.
The addition of the omitted income increased net income as a percentage of sales creating a
potential larger recovery.

Payroll tax returns pre & post loss date.

Determinative Analysis:
The owners were interviewed by the forensic accountants regarding the key employees who were
included as a continuing payroll expense. The interview uncovered that the payroll tax returns
after the date of the storm were not filed with the taxing authorities along with the corresponding
payments. The owners stated that they would file the payroll tax returns and pay the taxes due on

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them - when they received the insurance proceeds. It was reasonable to assume that the
employees would collect unemployment compensation – since the loss was going to be long
term. The forensic accountants requested a statement of account from the Department of Labor
for EEE that provided specific names, dates and weekly unemployment benefits paid to
employees. Upon receipt of the report from the Department of Labor every employee listed as
continuing on the EEE payroll would also collect unemployment benefits

Model to Conclusion

Table 1 illustrates the fundamental reasoning process using classic elements of fraud examination
in combination with forensic skepticism to bring to light signals that identify items effecting the
loss calculation.
Table 1.
Signal Application Queries Inference
Was the amended tax return
1 Corporate income tax returns FS filed with tax authorites?
2 Payroll tax returns FS Determine if filed & tax paid.
Are employees collecting
3 Payroll tax returns FS umemployment benefits?
4 Owners CEFE Pressure of not able to sell company.
Opportunity to obtain a larger
recovery since they control the
5 Owners CEFE information submitted.
Rationalizing the belief they have
paid enough in past premiums to
6 Owners CEFE justify the claim.
* Forensic Skepticism=FS
** Classic Elements of Fraud Examination=CEFE

The consequential signals provide the qualitative factors to properly calculate the loss:

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Figure 2

Schedule of Business Interruption Value

Amended Tax Return Initial Tax Return

Net Income Net Income
Profit & Loss Plus Plus
Statement Continuing Profit & Loss Continuing
(adjusted) Expenses Statement Expenses
12 Months as a % of 12 Months as a % of
Preceding Loss % Sales Preceding Loss % Sales

Revenue $ 4,675,000.00 100.00% $ 3,700,000.00 100.00%

Cost of Goods Sold 2,805,000.00 60.00% 2,220,000.00 60.00%
Gross Profit $ 1,870,000.00 40.00% $ 1,480,000.00 40.00%

Expenses
Officer's Compensation - 0.00% -
Salaries & Wages 475,000.00 10.16% 10.16% 475,000.00 12.84%
Depreciation/Amortization 75,000.00 1.60% 75,000.00 2.03%
Linens & Laundry 99,000.00 2.12% 99,000.00 2.68%
Delivery 89,000.00 1.90% 89,000.00 2.41%
Insurance 75,000.00 1.60% 75,000.00 2.03%
Rent 250,000.00 5.35% 250,000.00 6.76%
Telephone & Utilities 87,000.00 1.86% 87,000.00 2.35%
Employee Bonus 97,000.00 2.07% 97,000.00 2.62%
Total Expenses $ 1,247,000.00 26.67% $ 1,247,000.00 33.70%

Net Income $ 623,000.00 13.33% 13.33% $ 233,000.00 6.30% 6.30%

Business Interruption Value

23.49% 6.30%
Net Income Plus Continuing Expenses

Figure 3
Schedule of Loss Differences

Per
Claimant Recommended Difference
Lost Revenue: $ 4,675,000 $ 3,700,000 $ (975,000)

Multiplied by:
Business Interruption Value × 23.49% × 6.30%

Business Interruption Los s: $ 1,098,158 $ 233,100 $ (865,058)

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Conclusion

As demonstrated in this case study, the application of the classic elements of fraud examination
in sequence combined with forensic skepticism provided significant results in the adjustment of
the calculated damages. The commercial damages could have been overstated by $865,058. The
model used in this case provided the forensic accountants with a tool to avoid the
misspecification of damages.

The key to applying this model rested in the use of forensic skepticism to determine the correct
amount of damages to be claimed. After review of the last 2 years’ corporate tax returns the
forensic accountants asked if the amended tax return had been filed with the tax authorities. The
answer was “no”, so this lead to the production of the amended Form 1120S by the company’s
new accountants. This first result served to reduce sales – due to the overstatement of $975,000
in revenue - which had been inadvertently omitted due to lack of communication during the
transition of accounting firms. Hence, this discovery reduced the amount to be recovered as the
result of an increase in net income plus continuing expenses to 23.49% of total revenue.

The second adjustment – if necessary – to the amount claimed could have resulted from the
forensic accountants’ request for a statement of account from the Department of Labor. After
interviewing the client the forensic accountants discovered that the payroll tax returns for EED
were not filed after the storm. The request to the Department of Labor was made in order to
determine the amount of payroll taxes that needed to be filed after the date of loss. This
application of forensic skepticism in the use of the model led to the result that there was no need
to increase expenses after the storm. The report that had been requested from the Department of
Labor verified that every employee listed as continuing on the EEE payroll would also collect
unemployment benefits. Hence, there was no need to increase the continuing expenses during the
business interruption.

The application of professional skepticism in applying the Before-and-After Model prevented the
client from overstating their losses by approximately $865,058.

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References

Cressy, D.R. (1973) Other People's Money: A Study in the Social Psychology of Embezzlement.
Montclair, N.J.: Patterson Smith.

Crumbley, D.L., Heitger, L.E. & Stevenson, S. (2011) Forensic & Investigative Accounting.
Chicago, IL. CCH.

DiGabriele, J.A. (2009). Core Components in Estimating Economic Damages. The CPA Journal.
79, 2, 54-64.

DiGabriele, J.A. (2010) Applying Forensic Skepticism to Lost Profits Valuations. Journal of
Accountancy. Apr.: 209:4: 32-41.

Filler, M.G. & DiGabriele, J.A. (2012). A Quantitative Approach to Commercial Damages,
Applying Statistics to the Measurement of Lost Profits. Hoboken, NJ. John Wiley & Sons.

Wolfe, D.T. & Hermanson, D.R. (2004) The Fraud Diamond: Considering the Four Elements of
Fraud. The CPA Journal. (December): 38-42.

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