March 2006 Newsletter

Using Personal Financial Statements in Settlement

To resolve a dispute, one constraint may be the defendant's ability to pay, regardless of the damages and liability. In our experience, attorneys are generally unaware of Statement of Position 82-1 published by the American Institute of Certified Public Accountants. The Statement forms the generally accepted accounting principle used by CPAs to prepare financial statements for individuals. Unlike typical balance sheets that contain historical cost, likely much different from market value, personal financial statements use current or market values. The focus of a personal financial statement rests upon providing a market value balance sheet for an individual, specifically defining his or her net worth. Therein lies its value, facilitating settlement by defining the ability to pay from assets.

Because the personal financial statement describes categories of assets and liabilities like any balance sheet and moreover should provide footnote detail as to each category, a wealth of information regarding resources and obligations of an individual comes to light, including related party transactions. For example, a given interest in a closely-held business will be identified, described and valued as will real estate and even future interests.

The assets are listed in declining order of liquidity on the personal financial statement, adding additional information about the availability of resources. Similarly, the estimated income tax liability, if all the assets were sold, is calculated as a liability.

Certified Public Accountants typically prepare personal financial statements because the statements require a compilation, review or audit report-all of which in Texas must be issued by a CPA according to Title 5, Subtitle A, Chapter 901, Subchapter A, Sec. 901.456 of the Texas Occupations Code. Moreover, it must be a CPA who has a current peer-review (see below) according to Title 22, Part 22, Chapter 527, Rule 527.4 of the Texas Administrative Code. While the compilation report is the lowest level of service and does not offer an opinion as to the fairness of the information presented, the compilation does come with the requirement that the CPA follow the general standards of the profession; professional competence, due professional care, adequate planning and supervision of the work and sufficient relevant data. The use of a CPA, especially one familiar with the debtor, to prepare a personal financial statement should be considered in the settlement process.

The Peer Review

The peer review process of the American Institute of Certified Public Accountants provides continual monitoring of CPA firms to ensure quality standards. Individual states require that CPA firms issuing compilations, reviews or audits of financial statements maintain good standing in their peer review programs. A list of those firms is available at Caution should be taken when reviewing these websites because the review periods listed for a particular firm may appear out of date although they are not. The referenced website provides many other resources to learn the status of a firm in the peer review program.

Having a peer review means generally that a licensed CPA firm (peer reviews are not available to firms that contain CPAs but are unlicensed, such as consulting firms) has had an independent, specially trained and registered CPA analyze reports and relevant information of the subject firm looking for inadequacies in quality control, such as not titling a financial statement properly, omitting a needed footnote or more serious lapses such as violating independence standards. The results of the review are written and sent to the state licensing authority, which enforces corrective action if needed.

Peer review provides the monitoring and feedback opportunities to identify and correct problems with professional standard compliance.

Finding Fraud when it is Difficult to Discover

The increased emphasis on actively identifying potential fraud and internal control weakness during audits appears stymied by the historical reliance of auditors upon management representations instead of professional skepticism. An article in the March/April 2006 FRAUDMAGAZINE about a report from the Public Company Accounting Oversight Board lists this and other problems with the implementation of what is called broadly "Sarbanes Oxley".

The same magazine has a valuable article regarding the identification of more difficult fraud schemes by looking for missing data fields and other abnormalities in computerized vendor records e.g. a blank vendor tax identification number. Also mentioned as potential telltales are trends in account balances, including inventory adjustments and creating a report of descriptive statistics; all within Excel.

If you have an interest in obtaining more information about this topic, please contact Jesse Daves at 713-351-7130.

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