Forensic and Investigative Accounting Chapter 10 Commercial Damages © 2007 CCH. All Rights Reserved W. Peterson Ave. Chicago, IL

Chapter 10Forensic and Investigative Accounting2 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. (continued on next slide)

Chapter 10Forensic and Investigative Accounting3 Legal Framework of Damages Proximate (direct) cause—The damages caused were a direct result of the offending party’s actions or lack of actions. 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. 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. 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. 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 10Forensic and Investigative Accounting4 Two Types of Harm Tort—The occurrence of the harmful act itself is wrongful. 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. Breach of contract—A failure without excuse or justification to fulfill one’s obligations under a contract.

Chapter 10Forensic and Investigative Accounting5 Two Types of Damages Restitution—When the harmful act unjustly enriches the defendant at the expense of the plaintiff. 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. 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 10Forensic and Investigative Accounting6 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. 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. 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 10Forensic and Investigative Accounting7 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 10Forensic and Investigative Accounting8 Lost Profits Methods Before-and-after method—Take sales or sales growth before the act and compare to the comparable figures afterward. 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. Yardstick (or benchmark) method— Compare sales or sales growth of the company to other companies or to other industry averages. (continued on next slide)

Chapter 10Forensic and Investigative Accounting9 Lost Profits Methods “But-for” method—The difference in the estimated profits (but-for the actions of the defendant) and the actual profits. “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. Direct method—Any agreement may indicate how to calculate. Combination method—May use a combination of methods. Combination method—May use a combination of methods.

Chapter 10Forensic and Investigative Accounting10 Standard Formula for Damages Earnings before trial, had the harmful event not occurred – Actual earnings before trial + Prejudgment interest = Damages before trial Projected earnings after trial, had the harmful event not occurred – Projected earnings after trial –Discounting= Damages after trial

Chapter 10Forensic and Investigative Accounting11 Economic Framework for the Lost Profits Estimation Process Macroeconomic analysis. Macroeconomic analysis. Industry analysis. Industry analysis. Company-specific analysis. Company-specific analysis. Financial analysis conclusion. Financial analysis conclusion.

Chapter 10Forensic and Investigative Accounting12 Length of the Loss Period Three outcomes of business damages: Three outcomes of business damages: –Closed –Open –Infinite 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.

Chapter 10Forensic and Investigative Accounting13 Components of Damages Lost profits Lost profits Lost value Lost value Lost cash flows Lost cash flows Lost revenue Lost revenue Extra costs Extra costs

Chapter 10Forensic and Investigative Accounting14 Defendant’s Damages Estimate The defendant’s expert report would include his or her damages estimate along with support for the numbers presented. 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. In order to arrive at a “zero” damages estimate, a defendant must demonstrate to the court that the plaintiff suffered no financial damages.

Chapter 10Forensic and Investigative Accounting15 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 10Forensic and Investigative Accounting16 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 10Forensic and Investigative Accounting17 Expert’s Journey Through the Legal System Testimony early in case Testimony early in case –Pretrial summary judgments –Decision to try the case (continued on next slide)

Chapter 10Forensic and Investigative Accounting18 Expert’s Journey Through the Legal System Defending the expert report Defending the expert report –Deposition testimony –Trial testimony –Questioning by client’s attorney –Questioning by opposing attorney –Preparation for trial testimony –Rebuttal testimony

Chapter 10Forensic and Investigative Accounting19 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.

Chapter 10Forensic and Investigative Accounting20 Common Types of Cost Behavior Fixed costs Fixed costs Variable costs Variable costs Mixed costs Mixed costs Semivariable costs Semivariable costs Semifixed costs Semifixed costs

Chapter 10Forensic and Investigative Accounting21 Cost Behavior Assumptions Basis of cost behavior estimates Basis of cost behavior estimates –Relevant range assumption –Time assumption Ways of estimating cost behavior Ways of estimating cost behavior –Account analysis method –High-low method –Regression analysis –Engineering or work-measurement method

Chapter 10Forensic and Investigative Accounting22 Discounting After-trial Damages There are two major approaches to discount amounts to present values. –One approach is to project a plaintiff’s hoped-for income stream by modifying losses to a realistic expectation by factoring in future losses to a present value at a risk- reduced relatively low discount rate. (continued on next slide)

Chapter 10Forensic and Investigative Accounting23 Discounting After-trial Damages –Another approach is to project the hoped- for-but-lost amounts and then apply a higher discount rate that already includes risk or uncertainty in order to determine the present value.