Stephen L. Ferraro, BridgeTower Media Newswires
This article provides an overview of litigation matters involving commercial damages and offers an introduction to the calculation of lost profits from the perspective of the forensic accounting expert.
Commercial damages can occur in breach of contract and business tort cases and result in claims for lost profits or diminished business value. Intellectual property infringement, securities fraud and antitrust cases also can involve such loss claims.
The measure of damages in commercial cases follows generally accepted methodologies. Financial models are prepared to provide an estimate of the economic damages experienced by the plaintiff as a result of the wrongful act of the defendant. To prove economic damages the plaintiff must successfully address the following legal principles:
• Proximate cause
• Reasonable certainty
• Foreseeability
These governing principles, which have been well established and reinforced by case law, should be woven into the financial analysis in a manner that shows their applicability to the case at hand. Specific supporting case law and practical approaches to demonstrate the relevance to financial models will be addressed in a future article.
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Lost net and gross profits
Lost net profits are determined by first estimating the lost gross revenue (or lost sales) due to a wrongful act or incident. The lost revenue is then reduced by the avoided (or saved) costs, which entails evaluating all the direct and other costs related to providing goods or services. This results in the lost net profits that would have been enjoyed had the loss of sales not occurred.
Some experts like to use lost gross margin or gross profits as the measure of damages, but this usually isn’t the correct way to value damages. Gross margin only covers revenue reduced by cost of goods sold. This potentially overstates the damages because it fails to consider other costs of a business that may be associated with providing a good or service and thus were avoided.
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Lost revenue
As mentioned, the first, and usually primary, element of a lost profits calculation is the determination of the revenue lost due to the wrongful act or incident. The method used for calculating lost revenue will vary depending on the industry, the data available for the calculation, and the type of loss. There are few typical methods for calculating lost revenue. A brief description of each follows.
The “before and after” method: Under this approach, the expert compares the revenue of the business before and after the event. The underlying theory is that “but for” the event, the business would have experienced the same level of revenues and profits after the event as the business did before that event. Some consideration for other factors that could have affected the level of revenues is also warranted, such as the potential future impact of the trends in revenue in place prior to the event.
The “yardstick” (or “benchmark”) method: Under this approach, the expert uses a “yardstick” to estimate what the revenues and profits of the affected business would have been. Examples of potential yardsticks that could be used include comparing the revenue trends and results of the business to a similar business; comparing to other unharmed locations of the business; and using the actual experience versus budgeted results or industry averages.
Contract terms: In some instances, the expert can reference a specific contract that may set forth terms that determine anticipated revenue levels. A model might be developed that calculates the revenues and profits anticipated under the terms of the contract.
Defendant’s profits: In cases involving unfair competition or intellectual property infringement, an accounting of the profits realized by the defendant may be used as the measure of damages. The plaintiff is entitled to receive the value of unjust enrichment of the defendant through disgorgement.
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Deductible direct costs, other expenses
To arrive at an accurate lost profit amount, the forensic accounting expert must determine and deduct the direct costs and other expenses associated with generating revenue. For example, many businesses incur direct material costs, labor costs, utilities, supplies and other expenses to make and deploy their product and services. To the extent that the company lost sales, the company also did not incur the expenses associated with those sales. These avoided (or saved) costs need to be calculated and factored into the lost profits calculation.
It’s important for the forensic expert to understand the company’s cost structure, and the degree of detail required in estimating costs will vary from business to business. It is necessary to understand how the company’s costs relate to the sales and what factors affect the costs and how. The accounting concepts involved in understanding and unraveling the cost structure are many and require thoroughness on the part of the expert.
As with the calculation of lost revenues, it is always important for the expert to examine the calculated expenses for reasonableness. They must be satisfied that the numbers make sense considering the information available in the case.
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Period of recovery
Another important aspect of a damage calculation is correctly assessing the loss period. The loss period normally begins on the date the event occurred, which should be easy to determine.
The ending date of the loss period may be more difficult to estimate. It will likely be based on the date the business resumed to normal operating levels or the end of the term of a contract.
The requirement for mitigation also may come into play in the determination of the loss period.
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Other important considerations
Other areas relevant to the calculation of lost profits that may need to be addressed by the forensic accounting expert include:
• Pre-judgment interest on past losses
• Discounting of future lost profits to present value
• Income tax treatment on damages
• Mitigation of damages
• Alternative damage measures other than lost profits
• Specialized damage areas
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Summary
The calculation of lost profits can be a very subjective, detailed and time-consuming process. It is necessary to be as thoughtful and accurate as possible when estimating lost sales and the related saved costs or expenses.
Maybe most significant is the fact that this is not an exact process and relies on significant estimates. A forensic accounting expert must calculate damages that are reasonable and that use reliable information and widely accepted methodology.
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Stephen L. Ferraro is a partner at Ferraro, Amodio & Zarecki CPAs, based in Saratoga Springs, New York. He can be contacted at sferraro@fazcpas. com.
