Demystifying Damages in Uncertain Cases
The Role of the Forensic Accountant
There are a number of instances where damage estimates are uncertain and where a customer is lost. What should one do in these instances? Losses sometimes require reasonable estimates, as well as a reasonable forecasting of the market—both for the generation of revenues and for mitigation. In the case where there is greater perceived loss than a single contract, a forecast is necessary to determine the long-term future lost net profits for the value of the lost customer. Dr. Kreuter shares his views on how to address these more complicated engagements.
[su_pullquote align=”right”]Resources:
Forensic Accounting Academy™
Avoid the Hot Seat—11 Common Pitfalls in Lost Profits and Business Damages Analysis
10 Common Errors in Lost Profits Calculations and Business Damages
Elements of Lost Profits and Introduction to Lost Profits
[/su_pullquote]
Take a clear-cut case where the owner of a small business has a contract with a customer to deliver $250,000 worth of goods. The customer promises to pay promptly upon receipt of goods, as ordered. However, the customer then cancels the order on the day the small business (the supplier) is ready to load them onto their trucks for delivery. Upon learning of the sudden cancellation, the supplier calls the customer to find out what happened, and why they cancelled. After a heated discussion, the supplier reminds the customer of the signed contract, insisting that the order be maintained, accepted, and paid for. The customer provides no valid reason for the cancellation and steadfastly refuses to go forward with the order. Is the supplier stuck?  If not, what are the remedies?[/su_pullquote]
The supplier hires a lawyer, who in turn retains a forensic accountant, to explore potential damages in the case. The forensic accountant is advised by counsel that the contract is enforceable and that the supplier has recourse against the customer for breach of contract,[1] resulting in recoupable economic damages. Among the early questions the forensic accountant should ask are: what efforts the supplier made to mitigate damages—or did the supplier take appropriate action to overcome the damage purportedly caused by the defendant by attempting to resell the completed goods to a different customer?
It becomes clear that the goods were able to be sold for $175,000, after several bids were received and reviewed. This equates to mitigation, which serves to reduce whatever theoretical damages are claimed to the amount of actual damages after the person claiming loss makes every reasonable and prudent effort to mitigate or assuage its burden. Consequently, the damages are computed to be $75,000 ($250,000 less the $175,000) to start the composition of the total damage claim. Adding to that amount are additional selling costs of $5,000 and additional storage and maintenance costs of $2,000. The time between the expected delivery and payment of the original order and the actual sale is six months. Are there additional damages for the delayed receipt of the actual sale price of $175,000—and for what time periods are damages quantifiable?
Considering that the actual post-mitigation loss is $75,000―plus the additional cost of selling ($5,000) and storage and maintenance ($2,000), or $82,000―the forensic accountant computes the loss first by considering the date of loss as the date the net sales price reduction (loss) of $75,000 is known. Then, the accountant multiplies the loss amount by the effective borrowing rate of the supplier (eight percent)—on the basis that the supplier has outstanding debt covering their operations inclusive of the hoped-for sale of the goods. Therefore, the delay economically affected the company by forcing it to incur additional finance costs for a longer period of time. Calculating this extra interest for a half-year equates to additional finance costs of $3,000 ([$75,000 * 8%]/2).
Therefore, the delayed receipt of the sales price equals the differential between the original contractual sales proceeds of $250,000, less the offset of the actual proceeds six months later of $175,000, or $75,000 delayed receipt of revenue. Additionally, there are $7,000 of selling, storage, and maintenance costs equating to total damages of $85,000. The total loss of $85,000 can be fixed as a date certain and, to that figure, pre-judgment interest can be added up to the date of trial, if counsel so advises. After the trial, additional interest may be awarded for post-judgement interest from the date of trial to the date of satisfactory payment. But, what about cases where there is uncertainty, and what are typical uncertainties?
Evaluating Damages in Uncertain Cases
Losses sometimes require reasonable estimates, as well as a reasonable forecasting of the market—both for the generation of revenues and for mitigation.[2] For example, instead of the simple scenario above, where the damage done to the Company is the known value of a lost contract—damages could extend to the loss of the entire customer expressed as the loss of goodwill. In the case where there is greater perceived loss than a single contract, a forecast is necessary to determine the long-term future lost net profits for the value of the lost customer. Assuming there is no possible or quantifiable mitigation, once the valued customer arranges new loyalties to a different supplier.
In this more complicated scenario, the damage expert reviews the historical rate of retention of customers, as well as any data applicable to the lost customer.[3] As an example, perhaps the forensic accountant may find a reasonable basis to claim the life expectancy (retention) of a customer is five years. Assuming the Company can reasonably support such retention at five years, then the damage expert considers the costs saved by retaining that customer and determines a gross profit rate. From this figure, there needs to be consideration of offsetting saved costs that are associated with the lost revenue. To calculate such costs, a forecast of overhead expenses applicable to the Company is considered with a determination made as to which portion of costs were borne by the Company and not absorbed by revenues, and which costs were not avoidable. Avoidable costs are those which are saved because of reduced revenues. The cost of operating a building, for example, may likely not be controllable with changes in volume.
In this scenario, the lost customer is viewed in terms of the net economic impact on the Company. This value is calculated as the accumulated lost net revenue for the projected five-year period discounted to net present value (NPV). NPV determines the value of future loss in terms of today’s dollars, accounting for the time value of money; thereby, reducing claimed future loss by the risk of achieving those revenues in today’s dollars. Otherwise, it is unfair to charge the defendant with paying future lost net profits, computed in tomorrow’s money to today. However, choosing the right discount rate is subjective. Some experts use the cost of equity, which involves making use of the build-up method to compute risk, starting with the lowest level of risk—the U.S. short-term Treasury rate—and adding risks specific to the size and complexity of the Company and other factors.[4]
Damage calculations always need to be reasonable and based on the best available information. The calculation of lost profits does not have to be precise, and estimates of damages can be made. However, the loss calculated cannot be wholly speculative. Lost profits that are speculative, such as those using unreasonable growth rates, may not be recoverable. This is especially true when calculating lost profits for newly established businesses. In such cases, Courts tend to review the quality of the evidence submitted in determining whether there is an adequate basis for a reasonable estimate of damages. The Plaintiff still has to show―with reasonable certainty―that they would have made a profit. These types of cases are challenging because there is usually less data to work with. As a result, great emphasis may have to be placed on projections, business plans, the Plaintiff’s experience in this area, industry research and statistics, and examples drawn from similar businesses. In calculating damages, one will need to make many more assumptions, such as the ready market for the Company in which to earn revenues, competition, the economy, laws and regulations, and changing technology. These factors help the damages expert determine provable damages and ensure that there is a basis for those assumptions, which should be reasonably supported.
In computing future net profits, it is important to consider the time-period and risk. Both factors are so subjective that they can be manipulated in order to reach conclusions that might reasonably be challenged. It is wiser to approach the quantification of the damage claim by assembling hard evidence supportable in court and strong logic to back up positions taken. Then, the Expert Report, inclusive of the damage computation, can fully support the evidence and be further reinforced by the documents contained in the court record.
[1] Damages for lost profits are recoverable (in contract damages) only if they are reasonably foreseeable by the breaching party at the time of contracting.
[2] This is especially significant in newly established businesses wherein the Plaintiff must show with reasonable certainty that, but for the actions of the defendant, it would have made a profit.
[3] Other factors that can be considered include business plans, industry research, etc.
[4] Other approaches typically used also include the cost of debt and the weighted average cost of capital.
Eric Kreuter, PhD, CPA, CGMA, CFE, CBA, is a Partner in the Financial Advisory Services group at Marks Paneth LLP. He specializes in litigation and forensic services including commercial damages and fraud investigations. He has worked in professional services firms since 1983 and has testified in state courts and the U.S. Bankruptcy Court as well as arbitrations and depositions. He has written seven books, a number of book chapters and numerous articles covering a wide range of topics.
Dr. Kreuter can be reached at (212) 201-3117, or by e-mail to ekreuter@markspaneth.com.
