Forensic and Investigative AccountingForensic and Investigative Accounting

Chapter 10

Commercial Damages

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Legal Framework of DamagesLegal Framework of Damages

In order to win an award for damages, the In order to win an award for damages, the injured party must generally prove two injured party must generally prove two points:points:

– That the other party was liable for the That the other party was liable for the damage.damage.

– That the injured party suffered damages That the injured party suffered damages as the results of the actions or lack of as the results of the actions or lack of actions of the offending party.actions of the offending party.

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Legal Framework of DamagesLegal Framework of Damages Proximate (direct) causeProximate (direct) cause—The damages caused —The damages caused

were a direct result of the offending party’s actions were a direct result of the offending party’s actions or lack of actions.or lack of actions.

Reasonable certaintyReasonable certainty—That it is “reasonably —That it is “reasonably certain” that the injured party would have earned certain” that the injured party would have earned the claimed amount of damages “but-for” the the claimed amount of damages “but-for” the actions of the other party.actions of the other party.

ForseeabilityForseeability—That a prudent person could look —That a prudent person could look into the future and see that the actions of the into the future and see that the actions of the offending party would damage the other party to offending party would damage the other party to the litigation.the litigation.

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Two Types of HarmTwo Types of Harm

TortTort—The occurrence of the harmful act —The occurrence of the harmful act itself is wrongful.itself is wrongful.

Breach of contractBreach of contract—A failure without —A failure without excuse or justification to fulfill one’s excuse or justification to fulfill one’s obligations under a contract.obligations under a contract.

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Two Types of DamagesTwo Types of Damages

RestitutionRestitution—When the harmful act unjustly —When the harmful act unjustly enriches the defendant at the expense of the enriches the defendant at the expense of the plaintiff.plaintiff.

RelianceReliance—When the harmful act is fraud —When the harmful act is fraud and the intent of damages is to restore the and the intent of damages is to restore the plaintiff to the position as if no promises plaintiff to the position as if no promises had been made.had been made.

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Damages Calculation ApproachesDamages Calculation Approaches

The The out-of-pocket lossout-of-pocket loss refers to t refers to the difference he difference between the actual value received and the between the actual value received and the actual value conveyed. The plaintiff can actual value conveyed. The plaintiff can recover nothing beyond his or her investment.recover nothing beyond his or her investment.

Under the Under the benefit-of-the-bargain theory benefit-of-the-bargain theory (or(or expectations remedyexpectations remedy), the damages include not ), the damages include not only the money invested but also other only the money invested but also other expenses such as increased costs, lost profits, expenses such as increased costs, lost profits, and decreased value of the investment.and decreased value of the investment.

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Damages Calculation ExampleDamages Calculation Example

Debra (defendant) sells Paula (plaintiff) an asset Debra (defendant) sells Paula (plaintiff) an asset with an alleged value of $2 million for $1.8 with an alleged value of $2 million for $1.8 million. However, the asset really had a market million. However, the asset really had a market value of only $1.6 million. The fraud damages can value of only $1.6 million. The fraud damages can be calculated in two ways:be calculated in two ways:– Out-of-pocket loss rule: $1.8 million - $1.6 Out-of-pocket loss rule: $1.8 million - $1.6

million = $200,000.million = $200,000.– Benefit-of-the-bargain rule: $2 million - $1.6 Benefit-of-the-bargain rule: $2 million - $1.6

million = $400,000.million = $400,000.

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Lost Profits MethodsLost Profits Methods

Before-and-after methodBefore-and-after method—Take sales or —Take sales or sales growth before the act and compare to sales growth before the act and compare to the comparable figures afterward.the comparable figures afterward.

Yardstick (or benchmark) methodYardstick (or benchmark) method——Compare sales or sales growth of the Compare sales or sales growth of the company to other companies or to other company to other companies or to other industry averages.industry averages.

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Lost Profits MethodsLost Profits Methods

““But-for” methodBut-for” method—The difference in the —The difference in the estimated profits (but-for the actions of the estimated profits (but-for the actions of the defendant) and the actual profits.defendant) and the actual profits.

Direct methodDirect method—Any agreement may —Any agreement may indicate how to calculate.indicate how to calculate.

Combination methodCombination method—May use a —May use a combination of methods.combination of methods.

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Standard Formula for DamagesStandard Formula for Damages

Earnings Earnings before trial, before trial,

had the had the harmful event harmful event not occurrednot occurred

––

Actual Actual earnings earnings before before trialtrial

++ Prejudgment Prejudgment interestinterest

==

Damages Damages before before trialtrial

Projected Projected earnings after earnings after trial, had the trial, had the

harmful event harmful event not occurrednot occurred

––

Projected Projected earnings earnings after trialafter trial

–– DiscountingDiscounting ==

Damages Damages after after trialtrial

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Economic Framework for the Economic Framework for the Lost Profits Estimation ProcessLost Profits Estimation Process

Macroeconomic analysis.Macroeconomic analysis. Industry analysis.Industry analysis. Company-specific analysis.Company-specific analysis. Financial analysis conclusion.Financial analysis conclusion.

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Length of the Loss PeriodLength of the Loss Period

Three outcomes of business damages:Three outcomes of business damages:– ClosedClosed– OpenOpen– InfiniteInfinite

Projecting lost revenues.Projecting lost revenues. Measuring profitability.Measuring profitability. Mitigation and offsetting profits.Mitigation and offsetting profits. Time value of money considerations.Time value of money considerations.

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Components of DamagesComponents of Damages

Lost profitsLost profits Lost valueLost value Lost cash flowsLost cash flows Lost revenueLost revenue Extra costsExtra costs

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Defendant’s Damages EstimateDefendant’s Damages Estimate

The defendant’s expert report would The defendant’s expert report would include his or her damages estimate along include his or her damages estimate along with support for the numbers presented.with support for the numbers presented.

In order to arrive at a “zero” damages In order to arrive at a “zero” damages estimate, a defendant must demonstrate to estimate, a defendant must demonstrate to the court that the plaintiff suffered no the court that the plaintiff suffered no financial damages.financial damages.

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Plaintiff’s Damages EstimatePlaintiff’s Damages EstimateMuch of the support for the damages estimate for Much of the support for the damages estimate for the plaintiff comes from various accounting the plaintiff comes from various accounting records, but the use of those supporting data also records, but the use of those supporting data also shows that damages estimates are both an art and shows that damages estimates are both an art and a science. The scientific part is primarily the a science. The scientific part is primarily the understanding and appropriate use of accounting understanding and appropriate use of accounting information. The art part of the process is in information. The art part of the process is in knowing how the accounting information is used knowing how the accounting information is used in creating components of the damages estimate.in creating components of the damages estimate.

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Plaintiff’s Damages EstimatePlaintiff’s Damages Estimate

In addition, expert witnesses frequently use In addition, expert witnesses frequently use many other kinds of information other than many other kinds of information other than traditional accounting records in arriving at traditional accounting records in arriving at and defending damages calculations.and defending damages calculations.

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Expert’s Journey Through the Expert’s Journey Through the Legal SystemLegal System

Testimony early in caseTestimony early in case– Pretrial summary judgmentsPretrial summary judgments– Decision to try the caseDecision to try the case

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Expert’s Journey Through the Expert’s Journey Through the Legal SystemLegal System

Defending the expert reportDefending the expert report– Deposition testimonyDeposition testimony– Trial testimonyTrial testimony– Questioning by client’s attorneyQuestioning by client’s attorney– Questioning by opposing attorneyQuestioning by opposing attorney– Preparation for trial testimonyPreparation for trial testimony– Rebuttal testimonyRebuttal testimony

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Cost Behavior DefinedCost Behavior Defined

In its simplest form, In its simplest form, cost behaviorcost behavior is is the way that cost(s) change with respect the way that cost(s) change with respect to changes in the volume of activity.to changes in the volume of activity.

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Common Types of Cost BehaviorCommon Types of Cost Behavior

Fixed costsFixed costs Variable costsVariable costs Mixed costsMixed costs Semivariable costsSemivariable costs Semifixed costsSemifixed costs

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Cost Behavior AssumptionsCost Behavior Assumptions

Basis of cost behavior estimatesBasis of cost behavior estimates– Relevant range assumptionRelevant range assumption– Time assumptionTime assumption

Ways of estimating cost behaviorWays of estimating cost behavior– Account analysis methodAccount analysis method– High-low methodHigh-low method– Regression analysisRegression analysis– Engineering or work-measurement Engineering or work-measurement

methodmethod

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Discounting After-trial DamagesDiscounting After-trial Damages

There are two major approaches to discount There are two major approaches to discount amounts to present values.amounts to present values.

– One approach is to project a plaintiff’s One approach is to project a plaintiff’s hoped-for income stream by modifying hoped-for income stream by modifying losses to a realistic expectation by factoring losses to a realistic expectation by factoring in future losses to a present value at a risk-in future losses to a present value at a risk-reduced relatively low discount rate.reduced relatively low discount rate.

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Discounting After-trial DamagesDiscounting After-trial Damages

– Another approach is to project the hoped-Another approach is to project the hoped-for-but-lost amounts and then apply a for-but-lost amounts and then apply a higher discount rate that already includes higher discount rate that already includes risk or uncertainty in order to determine risk or uncertainty in order to determine the present value.the present value.