Business interruption claims are generally closely scrutinized by insurance carriers and can range from thousands of dollars to claims exceeding $100 million. Insurance carriers often seek the assistance of either internal or external forensic accountants to analyze such claims. In the course of their analysis, forensic accountants often detect the possibility of fraud in a claim, prompting further investigation by the carrier.
This paper details the role forensic accountants play in identifying and analyzing fraud in business interruption claims and explains the considerations by insurance carriers when hiring external accountants. It offers step-by-step guidance for forensic accountants who are brought on to these complex engagements by insurers.
This discussion begins by defining some of the terms and potential players in business interruption claims that are examined for fraud. First, what is a business interruption? Generally, a business interruption occurs when a specific event (examples include fires, floods, explosions, hurricanes, tornados, and pandemics) causes a negative financial impact to the operations of a business over some period.
Second, what is forensic accounting and what does a forensic accountant do? The AICPA (the governing body of professional accountancy in the United States) defines forensic accounting as “…the application of specialized knowledge and investigative skills possessed by CPAs to collect, analyze, and evaluate evidential matter, and to interpret and communicate findings in the courtroom, boardroom or other legal or administrative venue.”  Therefore, professional accountants, mostly CPAs, conduct forensic accounting engagements. A subcategory of forensic accounting is fraud examination, which may be conducted by either accountants or nonaccountants.
Third, what is fraud? According to Black’s Law Dictionary, fraud is “a knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.” The four major elements of fraud are: (1) false statement of a (2) material fact which is (3) willfully made with an (4) intent to deceive.
While fraud may not be present in every business interruption claim, it is more often discovered in claims examined by forensic accountants who are both experienced and knowledgeable in fraud detection. The ACFE reported in its 2020 Global Study on Occupational Fraud and Abuse, Report to the Nations, that fraud is a global problem affecting all organizations worldwide. The 2020 study, covering 2,504 cases from 125 countries, found fraud caused total losses exceeding $3.6 billion USD . The same study estimated that organizations lose five percent of their revenue each year to fraud .
Business Interruption Claims
A business interruption is the loss sustained by a business or entity due to incidents beyond their control which result in the inability to carry out business functions. Such losses may trigger business interruption coverage through various policies with the entity’s insurance carrier and can be defined as the “necessary interruption of business caused by loss, damage, or destruction by perils insured against real and personal property.” 
The relevant policy defines the actual coverage, loss calculation methods, and limits of coverage for business interruption claims. But generally, the insured loss is calculated by one of the following three methods:
Each of these methods are addressed in greater detail later in this discussion.
Financial Statement Analysis
The first step in preparing a business interruption claim is the analysis of the insured’s financial statements both prior to and after the loss. Such analysis may be performed internally by the business entity or by forensic accountants retained by the carrier (or both if there is a dispute regarding the claim amount). The following details the types of financial analysis generally performed.
While an analysis of the entity’s balance may be performed, much of the relevant information for a business interruption claim resides in the income statement. The income statement (often referred to as the Profit and Loss statement, or “P&L”) is the statement of revenues, expenses, gains, and losses for the period ending with net income (or loss) for the period. The income statement formula of revenues less cost of sales less operating expenses +/- gains or losses equals net income/loss before income taxes. The cost of sales and operating expenses are comprised of both fixed and variable components. Or more simply,
Components of the income statement are defined as follows:
The characteristics of the entity’s expenses differ based on the type of business. Service type businesses, such as a landscape concern, do not produce a product and will therefore likely have a higher labor cost percentage as part of the cost of sales than a manufacturing concern. Alternatively, a manufacturing entity, such as a smart phone producer, will have significant raw materials within cost of sales.
An analysis of fixed and variable expenses is also performed in business interruption claims. This information is generally not readily apparent within the income statement and is typically performed through interviews with management and the accounting staff or through statistical analysis. The reason this analysis is important is that variable expenses may not occur during the business interruption and would therefore be excluded from the claim.
What Expenses Are Allowed and Not Allowed in Business Interruption Claims
Generally, continuing (fixed) and incremental (mitigation) expenses are allowed and included in business interruption claims. Continuing (fixed) expenses are all expenses which are incurred despite the interruption. These expenses are fixed in nature, meaning that they are not able to change in the short term based on management’s decisions. Incremental (mitigation) expenses are necessary expenses incurred during the period of restoration that would not have been incurred had the event not occurred.
Non-continuing (variable) expenses are not normally included in a business interruption claim. Such expenses vary directly, sometimes proportionally, with business volume. These expenses would not ordinarily be incurred during the period of loss. There are certainly exceptions to this guideline. For instance, if an hourly employee (ordinarily considered a variable expense) was needed to keep portions of a factory operating, the relevant expenses may be considered fixed during the loss period. Examples of non-continuing (variable) expenses include the following:
A convenience store that specialized in Twinkie sales (Twinkie, Inc.) submitted a claim to XYZ Insurance Company with the following details:
What is the amount of loss?
Upon receipt of the assignment, the forensic accountant will generally research the business, the market, the competitors, market trends, and the general economy of the region where the business is located. Below are examples of documentation and information from the carrier and business that the forensic accountant may request:
Generally, when calculating a business interruption loss, the first step is to determine the amount of income the business would have made “but for” the loss. The second step is to calculate the actual loss. The actual business loss claim is calculated as the difference between the “but for” income and the actual income.
There are three methods to calculate a business interruption loss as follows:
In all three methods, the period of loss needs to be ascertained. In this example, the period of loss:
The next step is to examine historical trends leading up to the period of loss:
The next step is to project sales growth for the period of loss:
After the completion of the above analysis, the next step is to review findings before proceeding with the financial statement analysis and loss calculations:
The following step is to analyze the historical financial statements and compute the historical compound annual growth rate (CAGR). Twinkie Inc.’s historical income statements for the years ended 2018, 2019, and 2020 are shown below:
The CAGR is generally calculated using the formula below:
CAGR = (FV/PV) ^ (1/N) - 1
Based on the above formula, Twinkie’s CAGR from 2018 to 2020 is 15.47%.
The next step involves identifying the company’s fixed (continuing) and variable (non-continuing) expenses. The goal is to determine each variable cost’s historical percentage relative to sales and to establish the fixed costs during the loss period.
In this example, Twinkie’s rent, advertising, and insurance costs appear to be fixed (continuing) costs. Therefore, the forensic accountant would only expect small variations in these costs for any projected increases in sales.
For this analysis, increase projected sales for fiscal 2021 by the CAGR and calculate the cost of goods sold (COGS) and wages by the historical percentage of sales as follows:
The final steps are to assess reasonableness and reliability of the calculated results. Below is a non-comprehensive list of questions that the forensic accountant and the insurance company should consider:
In this example using the first method, the business interruption loss for Twinkie, Inc. is calculated as follows:
Fraud risk is listed last in the items above for the forensic accountant and the insurance company to consider, but such risks are certainly not the least important. In the Twinkie, Inc. example, there are several areas where a forensic accountant may uncover “red flags” of potential fraud, including:
Other specific analysis for Twinkie, Inc. may include the following:
If fraud is suspected (or detected) by the forensic accountant hired to conduct the business interruption claim, then the client/insurance carrier should determine whether further investigation is warranted. Since a fraud investigation is generally outside the scope of the forensic accountant retained for the original business interruption analysis, the insurance carrier may utilize their own Special Investigation Unit (SIU) team or retain outside forensic accountants to assess the potential fraud issues. In either case, the investigation is generally conducted in three phases:
The interview of the target of the investigation is generally conducted last so that the forensic accountant has all available information prior to the interview. This process makes it difficult for the target to either lie or conceal additional relevant facts.
According to the National Insurance Crime Bureau (NICB), other general indicators of insurance fraud in the inventory loss areas may include the following :
Business interruption claims can be complex and have areas where fraud exists. It may be customary for the insurance company to utilize forensic accountants with fraud experience to minimize the risks associated with such claims. When brought into such investigations, forensic accountants must know how to recognize the various red flags that indicate possible fraud. In these matters, they must also gain a unique understanding of how the insured’s business works, and how it realizes income, expenses, profit, and loss on a historical basis. Armed with this knowledge and insight into the insured’s financial circumstances, a forensic accountant can detect instances of fraud within a business interruption claim.
F. Dean Driskell III is an Executive Vice President in J.S. Held’s Economic Damages & Valuations Practice. He specializes in performing consulting services for clients involved in various types of accounting, economic, and commercial disputes as well as fraud and forensic accounting matters. With more than 30 years of experience in financial analysis, accounting, reporting, and financial management, Dean has served clients and their counsel in both private and public sectors, providing technical analyses, accounting/restatement assistance, valuation services, and litigation support across a variety of industries, and as an expert witness in litigation.
Dean can be reached at [email protected] or+1 470 690 7925.
Peter S. Davis, CPA, ABV, CFF, CIRA, CTP, CFE, is a Managing Director in J.S. Held’s Corporate Finance Practice. He has served as Receiver in regulatory matters brought by the SEC, FTC, Arizona Corporation Commission, the Arizona State Board of Education, as well as lenders and shareholders. His areas of expertise include understanding and interpreting complex financial data, fraud detection and deterrence, and determination of damages. Peter has provided expert testimony in numerous federal, bankruptcy, and state court matters.
Peter can be reached at [email protected] or +1 602 295 6068.
 AICPA Practice Aid 10-1, Serving as an Expert Witness or Consultant.
 ACFE 2020 Global Study on Occupational Fraud and Abuse, Report to the Nations, page 8. Report may be downloaded for free at https://www.acfe.com/report-to-the-nations/2020/.
 Ibid, page 4.
 The Business Interruption Book, Torpey, Lentz & Barrett, page 57.
 The application of policy provisions is generally determined by and communicated to the forensic accountant by the insurance carrier.
 Personal tax returns are not generally requested for large commercial claims but may be useful in the assessment of potential fraud issues for smaller family-type business claims.
 Benford’s Law analysis is an analytical and statistical tool to predict expected digit frequencies in lists of numbers. Such analysis may be utilized to predict fraudulent activity in large number sets, such as financial statements, general ledgers, etc. A full analysis of Benford’s Law is outside the scope of this discussion.
 NICB “Indicators of Property Fraud”
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