A recent ruling in a New Jersey federal court will no doubt serve as a warning for litigants who decline to employ the services of an expert to establish reasonable royalties.  In the matter of Unicom Monitoring, LLC (“Plaintiff”)v. Cencom, Inc. et al (“Defendant”) (Civil Action No. 06-1166 (MLC)), U.S. District Judge Mary L. Cooper granted Defendant’s motion for summary judgment based on Plaintiff’s failure to prove damages despite a finding of infringement.  The Court found that the fact witnesses Plaintiff offered were not capable of the providing the required information to calculate damages.  Without an expert to address the issues, damages were deemed appropriate, but not quantifiable.

Plaintiff successfully argued that Defendant infringed on its ‘647 Patent, which pertains to “security systems that communicate with a central monitoring station via a telephone line.”  However, when it came to damages, Plaintiff dropped the ball by failing to offer expert testimony.  Instead, Plaintiff offered two fact witnesses to testify regarding:

“Unicom’s ownership of the Patent-in-Suit, its policy not to license the ‘647 Patent, the various public means by which Cencom markets the DD2, Unicom’s test marketing of its product and resulting sales, Unicom’s damages and irreparable injury.” 

The April 19, 2013 Memorandum Opinion summarized the available damages evidence on the record (citations omitted):

“Unicom did not identify a damages expert, nor did it submit a damages report at any point in the duration of this case.  Unicom did not produce licenses for the patent-insuit or for a comparable technology.  The only evidence in the record with respect to the reasonable royalty rate that Unicom asks the factfinder to apply comes from a short statement of attorney argument in Unicom’s opposition papers and a brief calculation the Court painstakingly elicited during oral argument.  (“Since Cencom and Unicom were in the same business, Unicom would only have licensed Cencom for a royalty rate in the vicinity of 30% of revenues collected from DD2 customers, including monitoring fees.”);”

Defendant successfully argued that without expert testimony, there was no reasonable basis for an award.  Statute 35 U.S.C. § 284 governs the use of a reasonable royalty for patent damages.  It provides:

“[u]pon finding for the claimant the court shall award the claimant damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer, together with interest and costs as fixed by the court . . . .  The court may receive expert testimony as an aid to the determination of damages or of what royalty would be reasonable under the circumstances.” 

As described above, the statute does not specifically require expert testimony and the Court similarly did not indicate that use of an expert was a necessary condition to prove damages.  However, the Court found that the fact witnesses were not in a position to testify regarding a hypothetical reasonable royalty:

“Unicom does not have an expert to guide a factfinder through a hypothetical negotiation process to reach a reasonable royalty rate as a damages award.  Rather, the evidence Unicom intends to present regarding the hypothetical negotiation is contrary to the basic premise of those negotiations.  See Riles, 298 F.3d at 1312 (“A ‘reasonable royalty’ contemplates a hypothetical negotiation between the patentee and the infringer at a time before the infringement began.” (emphasis added)); see also Hanson v. Alpine Valley Ski Area, Inc., 718 F.2d 1075, 1078 (Fed.Cir. 1983) (stating that a “reasonable royalty may be based upon an established royalty, if there is one, or if not upon a hypothetical royalty resulting from arm’s length negotiations between a willing licensor and a willing licensee” (emphasis added)).  Unicom does not intend to present evidence that is competent to establish a reasonable royalty as it must be calculated: the witnesses will be testifying to the wrong time period; Unicom’s policy of not licensing the patent is at odds with the presumed voluntary negotiation; Unicom does not have an expert to delve into hypotheticals; Unicom does not have an analogous practice of licensing that can be uniformly applied; and Unicom has no rationale to support its suggested reasonable royalty calculation.”

The Court further explained how an expert could have provided needed assistance to the Court:

“Although there are many Georgia-Pacific factors which the Court can consider, the failure to present competent evidence regarding how the factfinder should perform the reasonable royalty calculation is fatal to [Plaintiff’s] claim for reasonable royalty damages. A factfinder cannot be asked to speculate from numbers unsupported by law and divorced from expert guidance, but rather the factfinder needs either clear guidance from an expert about how to apply complex calculations or simple factual proofs about what this patentee has previously accepted in factually analogous licensing situations.”

Accordingly, the Court found that despite the finding of liability and an entitlement to damages, Plaintiff did not meet its burden in proving the amount of damages and dismissed the case with prejudice.  This result should serve as a cautionary tale for those who decline to employ experts in such circumstances and put themselves at risk for a similar chain of events.

Fulcrum Inquiry regularly assesses damages in intellectual property litigation as a damages expert witness.

A recent study in The Journal of Financial Economics suggests that a compensation structure that relies on financial performance measures can be tied to incidences of fraud.  Generally, the study concludes that individuals are more likely to engage in financial misstatements when the there is little downside and high upside.  The implication is that this relationship can have predictive value and alert compliance officers and other interested parties to situations where vigilance should be heightened due to the increased likelihood that fraud may exist. The idea that there is more incentive for an executive to participate in financial misstatement when it seems achievable without detection and directly affects their pay (or continued employment) is reasonably intuitive.

Further, compliance officers and anyone else tasked with preventing and detecting fraud should already be aware of the predictive factors that are associated with fraud.  The fraud triangle is a relatively simple and well-established illustration of those factors, namely the interplay of three forces:

The fraud triangle originated from Donald Cressey’s hypothesis, as described in Other People’s Money (Montclair: Patterson Smith, 1973):

“Trusted persons become trust violators when they conceive of themselves as having a financial problem which is non-shareable, are aware this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds or property.”

While fraudulent activity is often associated with a pressing economic need, that need is not always a result of dire finances.  The high upside described above is a relief of Cressey’s financial pressure, also sometimes described as incentive or motivation.  This can manifest from various sources, whether a serious financial problem, such as pressing debt derived from family illness, gambling addiction, etc. or from a desire to maintain a certain lifestyle or from the realization that employment may not continue unless certain expectations are realized.

Opportunity can be synonymous with a belief that there is little downside, i.e. that there is situation, such as a lack of internal controls, where one can accomplish the fraud and will not be caught.  The fraudster perceives that there is a method to accomplish his deceit, solving his financial pressure without detection.

Rationalization is the third leg of the triangle and is important to the underlying psychology of fraud.  Many fraudsters do not see themselves as criminals, but rather as temporarily caught in unfortunate circumstances which their fraud can solve.  Often fraudsters who are caught indicate that it was their intention to repay the money in the future or that they were acting for the greater good to meet an important need (a Robin Hood mentality).  Others rationalize their behavior by justifying why they were truly entitled to the money, that the employer somehow deserved it, or that it was a victimless crime.

Understanding the circumstances which set the stage for potential fraud is an important component in its prevention and detection.  While the study described above is not necessarily ground breaking, it is a good reminder that evaluating the motivations and opportunities for fraud are key steps in assessing the risk of fraud.

Fulcrum Inquiry performs forensic accounting services.

The medical device industry (SIC 3840, NAICS 339112) consists of companies engaged in manufacturing medical and surgical instruments used to diagnose and treat healthcare patients. U.S. surgical and medical device manufacturers generate annual revenues of approximately $29 billion.[1]  Around 22 percent of industry sales are for surgical and orthopedic instruments, followed by catheters (18 percent), diagnostic apparatus (13 percent), syringes and needles (7 percent), blood transfusion and IV equipment (6 percent), and other apparatus (35 percent).[2]

The industry has been experiencing continued growth and was not severely affected by the recent recession.  On average, annual industry growth from 2007 through 2012 was 12.8 percent.[3] Analysts expect this growth to continue over the next five years.

The U.S. is both the largest producer and consumer of medical devices.[4] As of 2008, the U.S. medical device market as a whole was valued at over $100 billion, or 42 percent of the worldwide market.[5]  The U.S. exports over $30 billion in medical devices annually.[6]

The industry is heavily regulated.  In the United States, the Food and Drug Administration is responsible for oversight of the medical device industry.  In response, the industry devotes considerable resources to product approval processes, clinical trials, plant audits and inspections.  Medical device recalls are also common; there were 314 medical device recalls in the fourth quarter of 2012 alone.[7]  Recalls and lawsuits can have a significant impact on the value of medical device companies.

Research and development is also critical to medical device firms.  Companies compete by developing superior products and technology.  According to MPO Magazine, new product innovation plays the most prominent role in sustaining growth for medical device manufacturers.[8] Larger companies experience economies of scale in research and development, which is one of several factors that have led to increasing consolidation over the last five years.

The medical device industry is primarily composed of large corporations and start-ups, with few medium-sized companies.[9]  The top 10 medical device companies worldwide by sales revenue are:[10]

1. Johnson & Johnson
2. General Electric Co.
3. Siemens AG
4. Medtronic Inc.
5. Baxter International Inc.
6. Fresenius Medical Care AG & Co.
7. Koninklijke Philips Electronics
8. Covidien plc
9. Novartis AG
10. Cardinal Health Inc.

Industry Trends

Trends in the medical device industry have continued to change over the past several years, especially in response to shifting demographics and technology. A few of the most significant changes are:

1. The aging population will require increased medical attention
   Older populations use a disproportionate share of medical services. As the U.S. population ages, the incidence of health issues will increase and drive up the demand for medical devices. The ongoing increase in the older demographic will help maintain high growth in the industry over the next several years. The global population is also aging, with the United Nations estimating that people age 60 and up will make up more than 15 percent of the world’s population by 2025.[11]
2. Recent healthcare legislation will expand demand for medical devices
   Recent healthcare reform in the United States is expected to lead to an influx of newly insured patients which will in turn lead to increased demand for medical devices.
3. Taxes will begin to eat into profits
   In order to offset the cost of 2010’s Affordable Care Act, the federal government instituted an excise tax on medical devices as of the beginning of 2013. The tax requires medical device companies to pay 2.3 percent of total revenues whether or not they generate a profit.  The tax is anticipated to cost the medical device industry approximately $20 billion, and an AdvaMed study indicated that the tax could lead to a loss of over 45,000 jobs.[12]
4. Home health care product sales are expected to increase
   As a result of the aging population, medical treatment will be increasingly delivered out of medical facilities and in nursing homes, hospices and patients’ homes.  In turn, medical equipment that requires limited training and can be used in the home is expected to grow as a proportion of sales.[13]

Key Performance Metrics

The following are performance metrics that managers in the medical device industry use to benchmark their performance against others in the industry. These performance metrics are common to a broad range of industries:

1. Operating margin
2. Costs of goods sold percentage
3. Days of inventory on hand
4. Inventory turnover

Industry Organizations and Publications

Some organizations that publish helpful information about the medical device industry include:

1. Medical Device Manufacturers Association: www.medicaldevices.org, a national trade association of entrepreneurial medical technology companies
2. Advanced Medical Technology Association (AdvaMed): www.advamed.org, a trade association of medical technology companies representing 80% of the medical technology firms in the United States
3. Medical Device and Diagnostic Industry: www.mddionline.org, a magazine relating to medical device and in vitro diagnostic equipment manufacturers

Summary of Valuation Approaches

There are four commonly accepted valuation methods that should be considered when valuing a medical device manufacturing company.  These methods are:

1. Asset-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities. This approach is also sometimes referred to as a “cost based approach”; that is, the business’s value is equal to the cost of acquiring its physical assets. This approach is seldom used for a medical device company because its value is more closely related to its earnings and cash flow.

2. Income approach to value (capitalization of earnings): This method is most applicable to companies that face predictable and constant growth in earnings and have a long history of operations.  The business value under this method is equal to the cash flow projection for one year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate).

3. Income approach to value (discounted cash flow): The value of equity utilizing this method is equal to the present value of free cash flows available to equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new companies with higher rates of growth, but requires predicting changes in future cash flows.

4. Market approach to value: This method utilizes market indications of value based on metrics from guideline publicly traded device manufacturers and privately held businesses.  The financial metrics of public companies or those of private transactions can be used to create valuation multiples that are then used to calculate business value.

Benchmark Statistics

The following benchmarking data is based on the financial performance of various medical device manufacturers: [14]

Before using this data for specific valuation purposes it should be evaluated for appropriateness.

Availability of Publicly Traded Comparable Companies

Most of the top medical device manufacturers are publicly traded, and are often divisions or subsidiaries of large corporations with diverse holdings. The availability of financial data for publicly traded medical device manufacturers makes it possible to compare a subject company to industry benchmarks and apply industry multiples.  However, when valuing a medical device business, it is important to use benchmarks and multiples based on companies that are similar to the subject company and be aware that multiples of certain publicly traded corporations as a whole may not necessarily reflect those of their medical device divisions.

The top five publicly traded companies with significant medical device operations, ranked by market capitalization, are:[15]

1. General Electric Co. ($243.0 billion)
2. Johnson & Johnson ($209.9 billion)
3. Novartis AG ($161.6 billion)
4. Siemens AG ($87.2 billion)
5. Abbott Laboratories ($53.7 billion)

The price to earnings ratios of these companies range from 9.1 to 19.6.[16]  As a whole, publicly traded companies in the medical appliances and equipment industry have a price to earnings ratio of 15.8.[17]

Availability of Private Purchase Transactions

In addition to public companies, data regarding privately held companies can also provide a useful benchmark when valuing a medical device manufacturer.  The size and scope of private companies that have been bought and sold over the last five years varies greatly, both in terms of their sales and the purchase price paid for the companies.

Fulcrum identified 20 private purchases of medical device companies over the five year period from January 1, 2008 through December 31, 2012.  These transactions show the following ranges:[18]

1. Total deal values ranged from $2.5 million to $400 million.

2. Market value of invested capital (MVIC) to net sales ranged from 0.5 to 9.8 times with a median of 2.0.

3. MVIC to earnings before interest, taxes and depreciation (EBITDA) ranged from 9.1 to 75.5 times with a median of 11.3.

This range of market multiples is too variant to be useful without further analysis. As with selecting publicly traded guideline companies, care should be given to select private transactions that share similarities with the subject company.  The financial metrics of a potential guideline transaction should be compared with those of the subject. Additionally, industry economic conditions vary over time, which can affect medical device manufacturers as investment opportunities.  Specific factors that are unique for each business must be considered.

Fulcrum Inquiry performs business appraisals for medical device manufacturers and other businesses.

The online dating industry (SIC 7299, NAICS 812990) consists of companies engaged in online matchmaking services. Most companies generate revenue under a subscription model.  Often, “browsing” will be free, but messaging or contacting other users will require a subscription.  Alternatively, some websites generate revenue solely through advertising and are free for users. In all, the online dating industry generated approximately $1.2 billion in revenue in 2012.[1]

Computerized matchmaking for college students occurred as far back as the 1950s and ’60s with programs that used computer punch cards with student survey responses to find compatible matches.[2]  However, the industry did not begin to gain momentum until the launch of Match.com in 1995.[3] Now, some estimates suggest that the U.S. has over 2,500 online dating sites.[4]

As a result, the industry is highly competitive.  To be successful, new entrants must have a differentiated offering.[5] Attracting a large enough user base is the main hurdle – it is challenging for new companies to recruit new users when they do not already have a substantial pool of other users. As a result, marketing costs for new firms are disproportionally high.

The online dating industry is dominated by several large corporations with a handful of well-known websites.  The top 10 online dating companies as reported by comScore as of December 2012 are:[6]

1. Match (and affiliate sites)
2. PlentyofFish
3. Zoosk
4. Spark Networks
5. Xpress
6. Speeddate
7. eHarmony
8. DateHookup
9. LovePanky
10. Mate1

Industry Trends

The online dating industry has grown dramatically over the past decade, primarily in response to technological shifts. A few of the most significant industry trends are:

1. Online dating has become socially acceptable
   One in five relationships now begins online.  Over one third of single adults in the U.S. have an online dating profile.[7]  As of the end of third quarter 2012, 10% of total internet users visited an online dating website in a given month.[8] As the user base grows, the likelihood of finding a match increases and companies’ algorithms can improve due to more data.
2. Older users are a growing client base
   Approximately 16% of dating website customers are over age 50.[9]  In general, people who encounter fewer potential mates in their daily lives are more likely to turn to the internet.  In fact, older daters spend more time browsing dating sites and go on more dates than other users.[10]  In January 2013, the AARP launched its own online dating service, AARP Dating.
3. Mobile applications make online dating more accessible
   Mobile apps increase opportunities for users to communicate with their matches. Users spent more time on mobile dating apps than on dating websites in 2011.[11] By the third quarter of 2012, two out of ten smartphone users used an online dating app in a given month.[12]  Mobile technology can also allow companies to offer location-based dating, which suggest potential matches based on their proximity. Over the past three years, mobile dating revenue has grown at an annual rate of over 70%.[13]  Currently, mobile dating generates approximately $251 million in revenues each year, and this is expected to nearly double over the next five years as smartphone use increases.[14]

Key Performance Metrics

The following are performance metrics that managers in the online dating industry use to benchmark their performance against others in the industry:

1. Average daily visitors
2. Number of active accounts
3. Conversion rates
4. Customer loyalty rates
5. Number of dates or matches made

Industry Organizations and Publications

Some organizations that publish helpful information about the online dating industry include:

1. Online Personals Watch: www.onlinepersonalswatch.com, a source for dating industry news
2. Online Dating Magazine: www.onlinedatingmagazine.com, an industry publication for online dating customers
3. Online Dating Insider: www.onlinedatingpost.com, a source for online dating industry news and commentary

Summary of Valuation Approaches

There are four commonly accepted valuation methods that should be considered when valuing an online dating company.  These methods are:

1. Asset-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities. This approach is also sometimes referred to as a “cost based approach”; that is, the business’s value is equal to the cost of acquiring its physical assets. This approach is seldom used for an online dating company because its value is more closely related to its user base and cash flow.

2. Income approach to value (capitalization of earnings): This method is most applicable to companies that face predictable and constant growth in earnings and have a long history of operations.  The business value under this method is equal to the cash flow projection for one year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate).

3. Income approach to value (discounted cash flow): The value of equity utilizing this method is equal to the present value of free cash flows available to equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new companies with higher rates of growth, but requires predicting changes in future cash flows.

4. Market approach to value: This method utilizes market indications of value based on metrics from guideline publicly traded online dating companies and privately held businesses.  The financial metrics of public companies or those of private transactions can be used to create valuation multiples that are then used to calculate business value.

Benchmark Statistics

Online dating falls under NAICS 812990, personal care services.  The following benchmarking data is based on the financial performance of various companies in this category: [15]

Before using this data for specific valuation purposes it should be evaluated for appropriateness. Personal care services is a broad category that may include companies with significantly different business models than online dating websites.

As an additional point of reference, profit margins for the dating services industry as a whole (which also includes non-online services) averaged 18.5% in 2012.[16]

Availability of Publicly Traded Comparable Companies

Most of the top online dating websites are owned by publicly traded companies. The availability of financial data for publicly traded online dating companies makes it possible to compare a subject company to industry benchmarks and apply industry multiples.  However, when valuing an online dating company, it is important to use benchmarks and multiples based on companies that are similar to the subject company and be aware that multiples of certain publicly traded corporations as a whole may not necessarily reflect those of their online dating divisions.

The top four publicly traded companies with online dating operations, ranked by market capitalization, are:[17]

1. IAC/InterActiveCorp ($3.73 billion)
2. Jiayuan.com International Ltd ($164.52 million)
3. Spark Networks Inc ($146.62 million)
4. FriendFinder Networks Inc ($14.25 million)

The price to earnings ratios of these companies range from 17.32 to 24.15.[18]  As a whole, publicly traded companies in the internet information provider industry have a price to earnings ratio of 25.5.[19]

IAC/InterActive Corp.

InterActive Corp.’s Match division provides subscription-based and ad-supported online personals through branded websites. The company’s branded offerings include Match.com, Chemistry.com, OurTime.com, BlackPeopleMeet.com and OkCupid.com.  In addition, it offers mobile applications under the Match, OkCupid and DateHookup brands.  The division generated over $713 million in 2012.[20]

Jiayuan.com International Ltd

Jiayuan is an online dating company based in China.   Jiayuan.com is China’s largest online dating website.[21]  The company allows users to post profiles for free and charges an initial messaging fee and a periodic subscription fee. The company’s online services division generated $44 million in 2011.[22]

Spark Networks Inc

Spark Networks offers online desktop and mobile dating websites. The company’s largest websites are ChristianMingle.com and JDate.com.  The company offers free membership but requires a subscription fee to message other users. The company generated approximately $58 million from online dating services in 2012.[23]

FriendFinder Networks Inc

FriendFinder’s adult dating and social networking division is a provider of online dating, social networking and online personals services for different cultural, ethnic and interest-based groups. In order to communicate with other members and view full profiles, clients must pay a subscription fee. The company generated approximately $197 million from adult dating and social networking platforms in 2012.[24]

Availability of Private Purchase Transactions

In addition to public companies, data regarding privately held companies can also provide a useful benchmark when valuing an online dating company.

A database of private transactions lists one online personal services company that was sold during the five year period from January 1, 2008 through December 31, 2012.  This transaction had the following characteristics:[25]

1. Total deal value of $100 million.

2. Market value of invested capital (MVIC) to net sales multiple of 6.75.

This information is from only one transaction and as such should not be used without further analysis. As with selecting publicly traded guideline companies, care should be given to select private transactions that share similarities with the subject company.  The financial metrics of a potential guideline transaction should be compared with those of the subject. Additionally, technology and industry economic conditions vary over time, which can affect online dating companies as investment opportunities.  Specific factors that are unique for each business must be considered.

Fulcrum Inquiry performs business appraisals for online dating companies and other businesses.

The Bureau of Economic Analysis’ (BEA) report of Gross Domestic Product (“GDP”) is one of the most commonly used indicators of economic health.  It measures the total value of all finished goods and services produced in the U.S. within a specified period (normally a year).

And one thing is certain: It is guaranteed to be higher in July.  However, this may not mean much. While notable to those interested in such topics, the expected 3% larger size alone does not represent the positive signaling it otherwise might.  This is because this bump is coming from a change in the formula rather than real growth.

GDP is measured in two ways, both of which should lead to the same result.  The Expenditure Approach is defined as:

GDP = C + I + G + (X- M)

Where C is personal consumption, I is private investment, G is government spending (excluding transfer payments), and X-M is net exports (or exports minus imports).

The alternative is the Resource Cost/Income Approach, sometimes referred to as gross domestic income (“GDI”).  Its basic formula is:

GDI = wages + self-employment income + rent + interest + profits + indirect business taxes + depreciation + net income of foreigners

The formula generated growth will occur because, for the first time, GDP will include items such as spending on research and development (“R&D”).  Investment in R&D will now be part of a new asset category entitled “intellectual property products”, along with investment in software and entertainment, literary, and artistic originals.  While it may surprise some that such items are not already included, historically these intangible asset investments have not been part of the equation.

The major changes in definitions and classifications in this comprehensive revision are as follows:

• “Recognize expenditures by business, government, and nonprofit institutions serving households (NPISH) on research and development as fixed investment.
• Recognize expenditures by business and NPISH on entertainment, literary, and other artistic originals as fixed investment.
• Expand the ownership transfer costs of residential fixed assets that are recognized as fixed investment and improve the accuracy of the associated asset values and services lives.
• Measure the transactions of defined benefit pension plans on an accrual accounting basis by recognizing the costs of unfunded liabilities and showing the pension plans as a subsector of the financial corporate sector.
• Harmonize the treatment of wages and salaries by using accrual-based estimates consistently through­out the accounts.”

These revisions have the added benefit of increased international comparability, as many were inspired by updated international guidelines under the System of National Accounts 2008 (“SNA”). The BEA was instrumental in working with the international statistical community to update the SNA so that it could better serve the needs of global economic accounting systems. With these revisions, the United States has become substantially aligned with the SNA.  Most other developed economies expect to achieve similar comparability by 2014.

In order to preserve the usability of the data, the updated items will not be included as a one time surge.  Instead, the change will be backward implemented to 1929, so that year on year comparability is maintained.  This is a substantial and unusually impactful re-write of accepted economic history, but such change is not unprecedented. Comprehensive revisions occur every five years reflecting three major types of improvements:

(1)  “changes in definitions and classifications that update the accounts to more accurately portray the evolving U.S. economy and to provide for consistent comparisons with data for the economies of other nations,

(2)  statistical changes that update the accounts to reflect the introduction of new and improved methodologies and the incorporation of newly available and revised source data, and

(3)  changes in presentations that update the NIPA tables to reflect the changes in definitions and the statistical changes and to make the tables more informative”

While this change will represent an overall rise to the economic measurement statistic, the most notable difference may be how it affects previously reported comparisons between various geographic areas.  For instance, states with a large military R&D industry will see more improvement, while other areas might not change much at all.  This type of altered view of the economy and catalysts for its growth can foreseeably impact future policy decisions and resource allocations.  It will also impact many forecasting and business valuation exercises which consider expectations for overall economic growth.

Fulcrum Inquiry performs valuation and appraisal services.

On March 4, 2013, NASDAQ issued a proposed new rule (Release No. 34-69030; File No. SR-NASDAQ-2013-032) which would require listed companies to have an internal audit function:

“Each Company must establish and maintain an internal audit function to provide management and the audit committee with ongoing assessments of the Company’s risk management processes and system of internal control. The Company may choose to outsource this function to a third party service provider other than its independent auditor. The audit committee must meet periodically with the internal auditors (or other personnel responsible for this function) and assist the Board in its oversight of the performance of this function. The audit committee should also discuss with the outside auditor the responsibilities, budget and staffing of the internal audit function.

A Company listed on Nasdaq on or before June 30, 2013, must establish an internal audit function by no later than December 31, 2013. A Company listed after June 30, 2013, must establish an internal audit function prior to listing.”

The noble goals of this change were described as follows:

• “to prevent fraudulent and manipulative acts and practices,
• to promote just and equitable principles of trade,
• to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities,
• to remove impediments to and perfect the mechanism of a free and open market and a national market system, and,
• in general, to protect investors and the public interest”

The proposed rule was generally expected to be approved by the SEC.  It was not believed to be highly controversial, as it mirrored a requirement that already existed for NYSE listed companies.  In fact, many NASDAQ companies already have an internal audit function.  If desired, the internal audit function could be outsourced to a third party (although not to the external auditor), as long as it reported directly to the Audit Committee.

Not surprisingly, the Institute of Internal Auditors (IIA) enthusiastically supported the proposal:

“The IIA believes that a properly structured internal audit function can provide independent, objective assurance and advisory activities that add value and improve an organization’s operations. An adequately staffed and resourced internal audit function helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluating and improving the effectiveness of risk management, control and governance  processes.”

However, there was also resistance during the comment period.  This came mainly from the Smaller Reporting Companies, who are defined by having less than $75 million in public float or $50 million in annual revenue.  While these entities are excepted from certain SEC rules and reporting requirements, there was no such carve out under this proposal.  Many of the comments indicated this placed undue cost burden on these smaller entities.

The unexpected controversy seems to be weighing on the SEC, who has filed a notice to solicit additional comments and has extended its final decision date from April 22 to June 6.  Although some changes might improve the clarity and definition of the proposal, its goals and requirements should provide an overall value.  Internal audit is not simply an added level of bureaucracy.  A properly implemented internal audit function should provide a favorable cost benefit, improving management, control, and organizational performance by identifying, tracking, reporting, and proposing needed solutions with regards to

• Controls and control deficiencies
• Regulatory requirements and violations
• Governance and operational inefficiency
• Company policy and compliance

Having such activities performed internally and with a direct report to the audit committee allows the organization to take quick and well-informed action to correct threats to its safety, reliability and profitability.  It should improve the prevention and detection of fraud and other corporate malfeasance.  The proposal has substantial implementation flexibility, as it does not cite specific risks and controls that must be addressed.  Instead it properly makes the function scalable and responsive to the particular needs of the organization.

Fulcrum Inquiry performs forensic accounting services.

A discounted cash flow (DCF) analysis is a commonly-used and conceptually excellent method of performing a business valuation in which a projection is made of expected future results. However, it is possible to manipulate the inputs into the future projection to arrive at specifically-desired results. Once completed, it is also important to consider how heavily it should be weighted in the overall conclusion of value.  Recent court cases have more frequently underscored the need for appropriate application and consideration of both the income and market approach.

One such case is U.S. Bank National Association vs. Verizon Communications Inc in the US District Court for the Northern District of Texas (Civil Action No. 3:10-CV-1842-G, January 22, 2013).  In this ten-day bench trial, the only issue was the value of a Verizon spinoff (Idearc) on the day of the spinoff. The Court found that plaintiff’s witness “is highly qualified to offer an opinion”, yet rejected her conclusions because she provided (without proper justification) 70% reliance on what the Court described as a biased application of the DCF approach.  This resulted in an unusually low indication of value given the other information available. The Court summarized her approach as follows (citations omitted throughout):

“Taylor made three separate calculations of Idearc’s value on the date of the spinoff, one based on discounted cash flow (the “DCF method”), a second based on EBITDA multiples of a select group of public companies ostensibly similar to Idearc (the “market multiple method”), and a third based on EBITDA multiples implied by transactions involving public companies ostensibly similar to Idearc (the “comparable transaction method”). Using the DCF method, Taylor arrived at a value for Idearc ranging from $5.4 to $6.3 billion. Using the market multiple method, Taylor arrived at a value ranging from $11.7 to $13.2 billion. Using the comparable transaction method, Taylor arrived at a value ranging from $13.4 to $15.8 billion. By weighting the DCF method calculation at 70%, the market multiple method calculation at 15%, and the comparable transaction method calculation at 15%, Taylor ultimately arrived at a value for Idearc that ranged from $7.5 to $8.8 billion. The midpoint of that range is $8.15 billion, which Taylor concluded was the value of Idearc on November 17, 2006, the date of its spinoff from Verizon.”

The heavy reliance on the “outlier” valuation of Idearc under the DCF method was rejected by the Court, who was not impressed with the witness’ approach and conclusions. The Court summarized its criticisms as follows:

“At nearly every step in the DCF analysis, Taylor selected inputs that forced Idearc’s value lower. From her selection of only the most pessimistic projections of Idearc’s future performance, to her reliance on a “commercially unreasonable” terminal value projection and calculation, to her selection of a remarkably high discount rate, the method produced a valuation that is low in the extreme and that implied an incredibly low trading multiple for Idearc.”

In performing her analysis, the expert also completely eliminated from consideration the value of Idearc based on trading on the NYSE on the date of the spinoff.  This $12.8 billion total enterprise value of Idearc was within the range of the expert’s other market-based indicators.  The unusual nature of a decision to ignore this data point was acknowledged by the expert, who testified that “it would be customary for a valuation professional to consider the price of a company’s stock publicly traded on an efficient market as a prime indicator of its value” and that “this was the first time she had ever opined that the market price of stock was completely unreliable as to a firm’s value”. Her justification for her exclusion of this data point was that she believed material information was kept from the market:

“As part of her analysis of value, Taylor did not consider the trading price of Idearc on the NYSE on the date of the spinoff. She testified that, in her opinion, investors overvalued Idearc because of various alleged misrepresentations and omissions made by Verizon (conceding that her opinion “turn[s]” on the proposition that “the market was misled” into inflating Idearc’s equity value by at least $4 billion). First, Taylor concluded that Verizon failed to disclose the significant differences in the EBITDA margins generated by VIS’s incumbent print and electronic businesses. Second, she also concluded that Verizon concealed the year-over-year declines in revenue in specific northeastern urban markets.. Third, Taylor opined that the fact that management had consistently failed to meet its projections, but hadn’t disclosed these missed projections to the market, rendered Idearc’s stock price unreliable. Fourth, Taylor opined that the fact that Verizon did not disclose a pessimistic report by the consulting firm McKinsey about the directories business’s future prospects rendered Idearc’s stock price unreliable”

In summary the expert concluded the following indicators of value and respective weightings:

The Court instead found that the total enterprise value of Idearc on November 17, 2006 was at least $12 billion.

Data supporting each appraisal is different, and so customized decisions are needed for each assignment. But this example warns parties not to embrace an “outlier” because it provides a desired result, as plaintiffs attempted to do here.

Fulcrum Inquiry performs valuation and appraisal services.

Every fan loves his sport.  There is much debate over which sports are growing in popularity and which are on the decline.  Although popularity does not necessarily indicate superiority, it does tell us something about public opinion on the topic.  One way to approximate each sport’s relative popularity is to look at web search trends over time. Google Trends simplifies this task tremendously by reporting the relative frequency by which certain words or phrases are entered into Google’s search engine.

The chart below plots the raw data from Google Trends for the five major sports leagues in the United States: NBA, NFL, NHL, MLB, and MLS. The seasonal nature of these sports means that search frequencies vary dramatically over the course of each year, making some graphical comparisons difficult without further analysis.

To make the above series more usable, we can remove seasonality from the series in a process called time series decomposition. This process splits a time series into the following three components: (i) seasonal, (ii) trend, (iii) random noise. Depending on the data, seasonal trends are determined by summarizing patterns that occur yearly, monthly, or weekly. In the present case, we have weekly data from 2004 – 2013, which means that a particular week in any year should bear a resemblance to that same week in the remaining years. For example, the first week of 2004 should be similar to the first week of 2005, 2006, etc. The second component (the trend) is computed using a series of several local regressions called a loess procedure. Finally, the random noise is calculated by subtracting the seasonal and trend components from the original time series. For comparative purposes here, we ignore the random noise since it only distracts from the underlying trend.

Performing such an analysis on the search term NBA illustrates the improved clarity of the results. The chart below shows (i) NBA searches, (ii) seasonally adjusted NBA searches (calculated by subtracting the seasonal component from the original series), and (iii) the underlying trend of NBA searches.

While the blue line above makes discerning the underlying trend significantly easier, its real value in this analysis is in improving the ability to make comparisons between the five sports leagues, as demonstrated below:

The plot above is much more usable because the underlying trends are readily apparent and the erratic movements are smoothed. NBA and NFL searches are higher than the other sports and have generally increased considerably during the period under review. MLB and NHL searches are less common and relatively consistent with some fluctuations. MLS, which is often described as growing in popularity, is the only league with markedly decreasing searches.

For those whose interests lie with the college circuit, the analysis can also be applied to NCAA sports.  In a simple comparison of weekly search terms, the comparability is muddled by the spike in popularity associated with March Madness:

The above peaks certainly make an argument for the popularity of NCAA basketball.  But it turns out that time series decomposition tells a different story in recent years:

These types of analytics are useful in understanding seasonality and normalizing trends beyond the sports arena. For instance, the Bureau of Labor statistics often reports seasonally adjusted statistics in favor of raw data.  The same is true of many economic indicators and in many financial forecasting exercises.

Fulcrum Inquiry performs statistical analyses in litigation.

The IRS recently released its annual list of the top 12 tax related schemes, known as its “Dirty Dozen” and described in detail here. Both the top item on the list and a number of the others relate to the risk of identity theft and provide advice about how to protect against it.  In summary, the list includes the following warnings for taxpayers:

1. Identity Theft - For instance, a fraudster may use a legitimate taxpayer’s identity to fraudulently file a tax return and claim a refund.
2. Phishing – Phishing schemes employ an unsolicited email or a fake website to extract personal and financial information that may be used for identity theft.
3. Return Preparer Fraud – Tax preparers can prey on clients via refund fraud or identity theft. The IRS warns taxpayers that they should use only preparers who sign the returns they prepare and enter their IRS Preparer Tax Identification Numbers (PTINs).
4. Hiding Income Offshore – Financial accounts maintained abroad still have reporting and disclosure requirements. The IRS has pursued numerous individuals for evading U.S. taxes by hiding income offshore.
5. “Free Money” from the IRS & Tax Scams Involving Social Security – Scammers advertise free money from the IRS (often targeting low income and elderly individuals) and then charge for advice suggesting false entitlement to tax credits or non-existent Social Security refunds or rebates.
6. Impersonation of Charitable Organizations – Fraudsters may impersonate charities to get money from taxpayers or private information from disaster victims under the guise of assistance with the filing of casualty loss claims and special tax refunds.
7. False/Inflated Income and Expenses – Includes reporting income that was never earned in order to maximize refundable credits or filing excessive claims for the fuel tax credit.
8. False Form 1099 Refund Claims – In this ongoing scam, the perpetrator files a fake information return, such as a Form 1099 Original Issue Discount (OID), to justify a false refund claim on a corresponding tax return.
9. Frivolous Arguments – The IRS has a list of frivolous tax arguments that taxpayers should avoid, as they have been rejected by the courts.
10. Falsely Claiming Zero Wages – Filing a phony information return to lower the amount of taxes an individual owes.
11. Disguised Corporate Ownership – The improper use of third parties to disguise the true ownership of the business in an effort to underreport income, claim fictitious deductions, avoid filing tax returns, participate in listed transactions and facilitate money laundering and financial crimes.
12. Misuse of Trusts – Some highly questionable transactions involving trusts are primarily used as a means of avoiding income tax liability and hiding assets from creditors, including the IRS.

While the above warnings are valid, the IRS itself presents a security risk to personal information that could lead to identity theft.  According to the United States Government Accountability Office’s (“GAO”) March 2013 Report to the Acting Commissioner of Internal Revenue on Information Security, the IRS has made strides to improve security controls, but certain weaknesses persist.  Specifically, the GAO reports that “serious weaknesses remain that could affect the confidentiality, integrity, and availability of financial and sensitive taxpayer data.”  The GAO highlights that the IRS has not consistently

“(1) implemented effective controls for identifying and authenticating users, such as enforcing password complexity on certain servers;

(2) appropriately restricted access to its mainframe environment;

(3) effectively monitored the mainframe environment; or

(4) ensured that current patches had been installed on systems to protect against known vulnerabilities”

And further warns:

”Until IRS takes additional steps to (1) more effectively implement its testing and monitoring capabilities, (2) ensure that policies and procedures are updated, and (3) address unresolved and newly identified control deficiencies, its financial and taxpayer data will remain vulnerable to inappropriate use, modification, or disclosure, possibly without being detected.”

The GAO suggests the IRS fully implement the GAO’s prior recommendations, as well as take the following four actions:

• “Update policies and procedures to ensure that they address (1) both methods available for granting all users access to mainframe resources, (2) audit and monitoring of access from one processing environment to another, (3) use of appropriate accounts by multiple databases on a single server, (4) data storage shared between systems, (5) out-of-date security standards, and (6) reconciliation of access privileges;
• update test and evaluation methodology to ensure that it determines whether authentication controls are operating effectively;
• update mainframe test and evaluation processes to improve periodic monitoring of compliance with IRS policies; and
• fully document a continuous monitoring strategy that includes requirements and activities definitions at each organizational tier.”

In support of these recommendations, the GAO also provided 30 detailed recommendations in a separate limited distribution report.  Clearly, the IRS has significant work ahead to ensure the safety of taxpayer information with which it is entrusted.

Fulcrum Inquiry performs forensic accounting services, including fraud investigations.

On February 25, 2013, the Public Accounting Oversight Board (PCAOB) issued its summary report on smaller accounting firms. The PCAOB described its inspections and related reporting here as follows:

“This report covers domestic audit firms that audit the financial statements of issuers, and that regularly issue 100 or fewer audit reports each year. Such firms must be inspected at least once every three years (“triennially inspected firms”). This report describes inspection findings from 578 firms and 1,801 individual audits that were inspected in 2007-2010. … This report summarizes observations resulting from inspections of triennially inspected firms that took place from 2007 through 2010.”

Overall, the report showed a higher-than-acceptable rate of audit deficiencies, but improvement over the prior results. The PCAOB summarizes:

“The Board previously issued a report in October 2007, addressing observations from inspections of triennially inspected firms from 2004 through 2006 (“the 2007 report”). Overall, the results in this report compared to the 2007 report show a reduced rate of reported significant audit performance deficiencies. Approximately 44 percent of the audit firms inspected between 2007 and 2010 had at least one significant audit performance deficiency compared to the 2007 report where approximately 61 percent of the audit firms inspected between 2004 and 2006 were reported as having at least one significant audit performance deficiency. …

With respect to the inspections conducted from 2007 through 2010 that are the subject of this report, firms have remediated quality control deficiencies described in Part II of the inspection report to the Board’s satisfaction in approximately 90 percent of those cases in which the Board has concluded on the firm’s efforts. Firms’ remediation activities to address specific quality control deficiencies have encompassed a range of actions, including enhancements of quality control policies and procedures, developing technical guidance targeted to specific issues, developing and requiring training targeted to specific issues, developing new audit tools, and requiring additional audit procedures.”

The deficiencies covered a broad range of topics. The list of deficiencies was not changed much from the prior report and currently includes the following audit areas:

1. Revenue recognition;
2. Share-based payments and equity financing instruments;
3. Convertible debt instruments;
4. Fair value measurements;
5. Business combinations and impairment of intangible and long-lived assets;
6. Accounting estimates;
7. Related party transactions;
8. Use of analytical procedures such as substantive tests; and
9. Material misstatement due to fraud.

Specifically in regard to the valuation of intangible assets, the PCOAB states:

“Goodwill and other intangible assets that are not subject to amortization are required to be evaluated for impairment annually, or more frequently when events or changes in circumstances indicate that the asset might be impaired or that the fair value of a reporting unit had fallen below its carrying value.… Inspections staff have observed instances where firms’ procedures to test and conclude on the valuation of goodwill, other indefinite-lived intangible assets, and other long-lived assets were inadequate. In numerous cases in which the issuer was a small operating company or development stage enterprise, the firm concluded that there was substantial doubt regarding the issuer’s ability to continue as a going concern, and the issuer had earned minimal revenues, incurred significant net losses, and/or reported negative cash flows from operations. Inspections staff observed instances in which, despite the presence of that combination of factors, firms accepted the issuers’ conclusions that the intangible assets and/or long-lived assets were not impaired without performing procedures to test the process the issuer used to reach that conclusion or performing an independent impairment analysis.”

In 2011, these goodwill impairment tests became easier, as described here. However, the tests still need to be done, and benefit from outside valuation expertise.

Importantly, in an accompanying press conference, PCAOB member Jay Hanson indicated that the small firm deficiencies were no worse than what is seen with the larger firms. Mr. Hanson stated:

“Among the very smallest firms, we have inspections with no findings as well as inspections that reveal significant audit failures. Likewise, inspectors have encountered medium-sized and larger firms, even those with sophisticated clients that have billions of dollars reported on their balance sheets, with few or no findings, while multiple failures have been observed at other firms of similar sizes. Thus, we have no evidence of any correlation between the size of a firm and its ability to perform an audit that complies with PCAOB standards.” [Emphasis added]

Fulcrum Inquiry performs forensic accounting and business valuation services.