Forensic and Investigative Accounting Chapter 10 Commercial Damages © 2013 CCH Incorporated. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 CCHGroup.com

Legal Framework of Damages In order to win an award for damages, the injured party must generally prove two points: That the other party was liable for the damage. That the injured party suffered damages as the results of the actions or lack of actions of the offending party. Chapter 10 Forensic and Investigative Accounting

Legal Framework of Damages Proximate (direct) cause—The damages caused were a direct result of the offending party’s actions or lack of actions. Reasonable certainty—That it is “reasonably certain” that the injured party would have earned the claimed amount of damages “but-for” the actions of the other party. Courts tend not to create profits where none existed before Forseeability—That a prudent person could look into the future and see that the actions of the offending party would damage the other party to the litigation. Chapter 10 Forensic and Investigative Accounting

Forensic and Investigative Accounting Two Types of Harm Tort—The occurrence of the harmful act itself is wrongful. Breach of contract—A failure without excuse or justification to fulfill one’s obligations under a contract. Chapter 10 Forensic and Investigative Accounting

Forensic and Investigative Accounting Two Types of Damages Restitution—When the harmful act unjustly enriches the defendant at the expense of the plaintiff. Reliance—When the harmful act is fraud and the intent of damages is to restore the plaintiff to the position as if no promises had been made. Chapter 10 Forensic and Investigative Accounting

Damages Calculation Approaches The out-of-pocket loss refers to the difference between the actual value received and the actual value conveyed. The plaintiff can recover nothing beyond his or her investment. Under the benefit-of-the-bargain theory (or expectations remedy), the damages include not only the money invested but also other expenses such as increased costs, lost profits, and decreased value of the investment. Chapter 10 Forensic and Investigative Accounting

Damages Calculation Example Debra (defendant) sells Paula (plaintiff) an asset with an alleged value of $2 million for $1.8 million. However, the asset really had a market value of only $1.6 million. The fraud damages can be calculated in two ways: Out-of-pocket loss rule: $1.8 million - $1.6 million = $200,000. Benefit-of-the-bargain rule: $2 million - $1.6 million = $400,000. Chapter 10 Forensic and Investigative Accounting

Forensic and Investigative Accounting Lost Profits Methods Before-and-after method—Take sales or sales growth before the act and compare to the comparable figures afterward. Yardstick (or benchmark) method—Compare sales or sales growth of the company to other companies or to other industry averages. Chapter 10 Forensic and Investigative Accounting

Forensic and Investigative Accounting Lost Profits Methods “But-for” method—The difference in the estimated profits (but-for the actions of the defendant) and the actual profits. Direct method—Any agreement may indicate how to calculate. Combination method—May use a combination of methods. Chapter 10 Forensic and Investigative Accounting

Economic Framework for the Lost Profits Estimation Process Macroeconomic analysis. Industry analysis. Company-specific analysis. Financial analysis conclusion. Chapter 10 Forensic and Investigative Accounting

Length of the Loss Period Projecting lost revenues. Measuring profitability. Mitigation and offsetting profits. Time value of money considerations. Chapter 10 Forensic and Investigative Accounting

Forensic and Investigative Accounting Components of Damages Lost profits Lost value Lost cash flows Lost revenue Extra costs Chapter 10 Forensic and Investigative Accounting

Defendant’s Damages Estimate The defendant’s expert report would include his or her damages estimate along with support for the numbers presented. In order to arrive at a “zero” damages estimate, a defendant must demonstrate to the court that the plaintiff suffered no financial damages. Chapter 10 Forensic and Investigative Accounting

Plaintiff’s Damages Estimate Much of the support for the damages estimate for the plaintiff comes from various accounting records, but the use of those supporting data also shows that damages estimates are both an art and a science. The scientific part is primarily the understanding and appropriate use of accounting information. The art part of the process is in knowing how the accounting information is used in creating components of the damages estimate. (continued on next slide) Chapter 10 Forensic and Investigative Accounting

Plaintiff’s Damages Estimate In addition, expert witnesses frequently use many other kinds of information other than traditional accounting records in arriving at and defending damages calculations. Chapter 10 Forensic and Investigative Accounting

Expert’s Journey Through the Legal System Testimony early in case Pretrial summary judgments Decision to try the case (continued on next slide) Chapter 10 Forensic and Investigative Accounting

Expert’s Journey Through the Legal System Defending the expert report Deposition testimony Trial testimony Questioning by client’s attorney Questioning by opposing attorney Preparation for trial testimony Rebuttal testimony Chapter 10 Forensic and Investigative Accounting

The Art and Science of Computing and Defending Damage Estimates In any given case there are differences of opinion about the issues at hand. Some find this surprising. As a result your client will want/expect favorable treatment in damage estimates The other side in the case will expect the same There are a lot of different reasons that experts arrive at significantly different damage estimates Adversarial bias Conscious bias: opinions for hire “hired guns” Unconscious bias: wanting to help the side that is paying your bills Selection bias: the attorney has the ability to select from a wide range of expert positions “picking an unrepresentative expert for testimony” Chapter 10 Forensic and Investigative Accounting

The Art and Science of Computing and Defending Damage Estimates Other reasons why experts arrive at significantly different damage estimates Some experts can be bought Experts review and utilize different data/information in forming damage estimate opinions Different experts may devise different “theoretical frameworks” for their calculation of damages Sometimes events/data/circumstances can be viewed differently by equally competent and ethical professionals Attorneys and clients can persuade experts that certain components of the case can/should be viewed in a certain way Others Chapter 10 Forensic and Investigative Accounting

Ethical Challenges for an Expert Witness Independence and objectivity You are the expert for the court not a pawn of your client (Coping with lawyers) Confidentiality You will possess and use much confidential information Conflicts of interest Contingency fees

An Expert Witness Should “Stay the Course” with Ethical Issues Sometimes a role of the expert is made clear at trial Federal Tax Court Experience Often the issue is not raised directly but there are many possible consequences to not addressing the issue Daubert challenge Professional reputation Deposition or cross examination questioning of previous testimony Other

Developing a Theoretical Framework for Damages Often it is desirable to develop a theoretical model for damages Examples: A model to address the issues presented by the “theory of liquidated damages” A model to address the issues presented for a “model for cost reconstructions” A model that describes and discusses the difference between expensing and capitalizing repairs and maintenance Frequently actual damage calculations are measured against the theoretical model Also it is helpful to a jury to explain why the damages of the other side do not meet accounting measurement/reporting standards Chapter 10 Forensic and Investigative Accounting

Commonly Used Cost/Managerial Accounting Concepts in Cases Cost behavior Fixed/variable/mixed Strength of relationships Differential costs/incremental costs Relevant costs Matching concept Identifying the cost objective Direct costs Allocated cost The entity concept

Forensic and Investigative Accounting Cost Behavior Defined In its simplest form, cost behavior is the way that cost(s) change with respect to changes in the volume of activity. Cost behavior is a very important concept in the computation of damages. Chapter 11 discusses the process of estimating cost behavior for a company and defending it during litigation actions Chapter 10 Forensic and Investigative Accounting

Cost Behavior Categories Fixed costs: Costs that are fundamentally unaffected by changes in the colume of activity Variable costs: Costs that change directly and proportionately with the volume of activity Mixed costs: Costs that contain both a fixed and a variable component. Semi-variable costs: Costs that change with the volume of activity but not proportionately Semi-fixed costs: Costs that increase ot decrease in a step function Chapter 10 Forensic and Investigative Accounting