By Josh Shilts, CPA, ASA, ABV/CFF/CGMA, CFE
July 29, 2019
As stated in The Comprehensive Guide to Economic Damages: Volume One, “Lost profits are not an independent cause of action in business litigation. Rather, they are a damages remedy that a business can recover when a legal wrong has caused it to suffer lost profits. The types of claims for which lost profit damages are potentially available include torts, breach of contract, infringement of intellectual property, and some maritime claims. In addition, certain insurance policies provide for business interruption coverage.” Common elements of lost profits damages cases include P roximate Cause, Foreseeability, Reasonable Certainty and Mitigation. Those topics are deserving of their own analysis. The purpose of this article is to discuss the various methods accepted in the “community” and used by experts in calculating lost profits.
Calculation of lost profits involves analysis and research not just on revenues lost, but also the costs that would have been incurred. These include direct costs associated with selling or delivering a product or service along with other operating expenses that were avoided (e.g. rent, payroll). There are four commonly accepted methods financial experts use to estimate lost profits.
The Before-And-After Method
The Before-and-After method compares financial performance before and after the alleged event took place and compares the outcomes. For obvious reasons many experts and attorneys feel comfortable with this, assuming financial information is not flawed, as it is easy to show to a trier of fact the direct impact of the alleged action. Both experts and attorneys need to be aware of market and industry factors that may have impacted the subject company’s financials. Making a claim for lost profits and later realizing that the defendant also suffered “damages” due to unforeseen market conditions would severely impact the validity of the calculation.
Yardstick Method
Second, the Yardstick method (sometimes referred to as the “Comparable Company” method) compares what similar companies have achieved and serves as a proxy for what expected performance would have been. Similar to the Market Approach in business valuations the major flaw using this method is ensuring the comparable company is just that. Experts must show that their population of comparable companies have or had similar characteristics (i.e. management experience, customer demographics, working capital resources, etc.) as the subject company. An expert who does not research this fully is leaving themselves open to attack on cross.
Sales Projection Method
Next is the Sales Projection method. An expert will utilize company-specific forecasts. It is beneficial if the forecast was prepared not for the course of litigation, but prior to the alleged action. Experts need to be cognizant of bias. The AICPA’s Statements of Position 92-2 of the Task Force on Forecasts and Projections defines what a “reasonably objective basis” is and what factors need to be considered. It serves as a foundation for experts to consider when reviewing forecasts and their assumptions.
Market Model
Finally, the Market model is used by basing the percentage or dollar amount of the plaintiff’s market share prior to the defendant’s alleged act. This model is more prevalent in patent infringement cases. The expert needs to analyze the market and the subject company and competitor’s historical sales.
Experts and attorneys need to understand the applicability of each method and how it relates to the facts of the case. More importantly, an understanding of what data is available, and the usefulness of such data should be assessed to ensure reasonably certainty. Whichever method is determined to be applicable it is important that attorneys consult with experts at various stages of the case to determine what discovery methods need to be used and how data will be gathered.
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Information contained in this article is provided for informational purposes only. It should not be misconstrued as legal or accounting advice or intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion. It presents matters of general interest relating to business valuation, forensic accounting, and litigation support topics for educational purposes only. Shilts CPA, PLLC disclaims all liability concerning actions taken or not taken based on any or all of the contents of this article.
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