1. Forensic and Investigative Accounting
Chapter 10
Commercial Damages
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2. 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 a result of the actions or lack of actions of the offending party.
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Forensic and Investigative Accounting

3. 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.
Foreseeability—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.
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4. 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.
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5. 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.
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6. 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.
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7. 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.
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8. 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.
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9. 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.
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10. Economic Framework for the Lost Profits Estimation Process
Macroeconomic analysis.
Industry analysis.
Company-specific analysis.
Financial analysis conclusion.
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11. Length of the Loss Period
Projecting lost revenues.
Measuring profitability.
Mitigation and offsetting profits.
Time value of money considerations.
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12. Forensic and Investigative Accounting
Components of Damages
Lost profits
Lost value
Lost cash flows
Lost revenue
Extra costs
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13. 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.
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14. 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 damage 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.
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15. 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.
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16. Expert’s Journey Through the Legal System
Testimony early in case
Pretrial summary judgments
Decision to try the case
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17. 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
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18. 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”
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19. 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
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20. 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
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21. 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
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22. 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.
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23. 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
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24. 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.
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25. Cost Behavior Categories
Fixed costs: Costs that are fundamentally unaffected by changes in the volume 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 or decrease in a step function.
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26. Communications Challenges in Forensic Accounting
Communications skills are essential in the world of Forensic Accounting. An inability to communicate effectively in the Forensic Accounting environment may well be a fatal career flaw.
As we know, effective communication skills are crucial for many, if not most, accounting professionals:
We often are the gatekeepers of accounting information and we are called upon to explain, discuss, and interpret accounting/financial information.
For example, the following slide is clear to us because we are accounting professionals, but non-accountants may have trouble understanding it.
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27. Why Is It a Challenge to Communicate Financial Information?
Some managers just don’t know much about financial information.
Some managers just don’t want to know much about accounting.
Some managers think financial information is all a bunch of “funny money.” Is that true?
Many accounting terms are used regularly in everyday life and we must overcome misconceptions:
Examples?
The concept of cost.
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28. The Unique Role of Communications in Forensic Accounting
To a large degree, Forensic Accountants are translators in the world of litigation and dispute resolution.
The communications challenges facing consulting/experts in cases typically are far more difficult than the accountants’ role in communicating accounting concepts/information in traditional business situations:
In part, that is true because Forensic Accountants provide insights and evaluations that other dispute participants are unable to provide on their own or to understand.
Forensic Accountants must provide a wide variety of communications in both friendly and adversarial environments.
Communications challenges can be very different in these two environments
Communications should be professional, understandable, and focused.
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29. An Overview of the Components of Communications
Communications components
Speaking
Writing
Listening
Typically, we think very little about any of these components; we just do them.
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30. Forensic Accounting Unique Listening Situations
During testimony: Deposition and Trial:
Precisely what is being asked of me?
Did I understand the question correctly and completely?
Should I have the question restated or asked again?
Most testimony is given in an adversarial environment.
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Forensic and Investigative Accounting