Measure Economic Damages with Forensic Accountants
By Professor J.W. Verret, JD, CPA/CFF, CVA, CFE, CCFI
When legal disputes involve commercial economic damages, the expertise of a forensic accountant is invaluable. Forensic accountants hold licenses like the CPA, the CFF (certified in financial forensics) and the CVA (certified valuation analyst). These licenses and the standards under which professionals who use them work have been designed to survive vigorous Daubert review by courts as gatekeepers for witness expertise.
These professionals navigate the complex interplay between law and finance to unearth the economic truths underlying cases of lost profits, asset devaluation, or goodwill erosion due to wrongful acts by defendants. This guide aims to demystify the role of forensic accountants in calculating damages within the commercial sphere, providing legal practitioners with a road map to leverage this expertise effectively.
Understanding the Scope of Damages
At the heart of commercial damages calculation is the determination of lost profits or the diminution in asset value resulting from a defendant’s misconduct. Such assessments may extend to the erosion of goodwill, a crucial asset for many businesses.
In breach of contract scenarios, damages often focus on three primary types: expectation damages, consequential damages, and, where specified by the contract, liquidated damages. These categories encapsulate the anticipated benefits from the contract, the fallout of a breach (e.g., lost profits due to undelivered business equipment), and contractually agreed upon damages, respectively.
Legal Framework and Methodological Approaches
Forensic accountants commence their work by delving into the legal frameworks governing damages in the relevant jurisdiction. This foundational step ensures the selection of appropriate methods for estimating damages, informed by statutes, case law, and other legal parameters. Collaboration with legal counsel is pivotal at this stage, ensuring the forensic accountant’s approach aligns with the legal context of the case.
The methodologies for quantifying economic losses in commercial cases typically bifurcate into two streams: measuring lost profits and assessing changes in business value. Selecting the most fitting path requires a nuanced understanding of the case specifics and the objectives of the damages calculation.
Gathering Essential Information
The investigative phase for a forensic accountant involves a deep dive into the financial heart of the business in question. This exploration often begins with an analysis of balance sheets, income statements, and GAAP-compliant financial statements. In their absence, tax returns may serve as a starting point, although adjustments are frequently necessary to reflect the true financial health of the business accurately.
A comprehensive understanding of the business also necessitates examining customer lists, invoices, and industry dynamics, including growth trends and economic factors affecting the industry and region. Benchmarking against datasets such as Pratt’s Stats and Bizcomp provides additional insights into the company’s standing relative to its peers.
Framing the Forensic Accounting Opinion
In framing their opinion, forensic accountants must synthesize the facts of the case, legal arguments, and economic realities. This process includes identifying unresolved issues, clarifying the engagement’s scope, and determining the applicable standard of value — be it Fair Market Value, Fair Value, Investment Value, or another relevant metric. The choice between viewing the business as a going concern or appraising it for liquidation impacts the valuation and, consequently, the damages calculation.
Methodologies for Calculating Lost Profits
The approach to estimating lost profits hinges on the nature and duration of the business interruption. This can range from temporary setbacks to permanent destruction. Methods like regression analysis may be employed to project lost revenues, incorporating variables that mirror demand and economic conditions.
The before-and-after method, yardstick comparison, and hybrids thereof offer flexible frameworks for quantifying economic harm. The typical lost profits calculation will focus on changes in revenue and changes in variable costs resulting from the loss or the wrongful act, with avoided variable costs acting to decrease the ultimate lost profits calculation. Significant fixed costs resulting from the wrongful event or loss event can be added to a damages determination.
Business Valuation vs. Lost Profits Analysis
In instances where the entire value of a business is compromised, a shift towards business valuation methodologies becomes necessary. These include the asset (or balance sheet) method, the market approach, and the income method, each with its nuances and requisite expert judgment. The chosen method may further adjust for tangible and intangible assets, employing external appraisals when necessary.
In the event a comparative market method is used, expert judgement will be necessary to determine the appropriate comparable companies to use to determine a relevant market multiplier to use to derive a valuation target’s value. In the event a discounted cash flow model or income model is used, much of the model will focus on use of professional judgment to determine the appropriate discount rate to use to discount future cash flows to their present value.
Incorporating Economic and Industry Trends
A nuanced approach to damages calculation involves a thorough analysis of economic and industry-specific trends. Forensic accountants leverage this analysis to adjust their models to reflect the broader economic context and the specific dynamics of the industry in which the business operates. This might include considering inflation rates, market volatility, and shifts in consumer behavior that could impact the business’s performance. Similarly, understanding industry benchmarks and how peer companies have navigated similar challenges can provide valuable insights into potential lost profits or valuation impacts.
Utilizing Advanced Econometric Models
Forensic accountants increasingly rely on sophisticated econometric models to simulate scenarios and predict outcomes. These models can incorporate a wide range of variables, from market demand and supply dynamics to regulatory changes and competitive actions. Techniques such as Monte Carlo simulations offer the ability to assess damages under various scenarios, providing a probabilistic range of outcomes rather than a single-point estimate. This approach is particularly useful in cases with significant uncertainty or where multiple factors contribute to the economic loss.
Challenges in New Business Valuations
Valuing damages for new or early-stage businesses presents unique challenges, as these entities lack a historical financial track record. Forensic accountants must employ creative and methodologically sound approaches to estimate what the business’s economic performance might have been but for the wrongful act. This often involves comparing the business to similar startups, adjusting for industry-specific growth rates, and possibly applying a higher discount rate to reflect the increased risk associated with new ventures. The objective is to construct a credible model of potential success, tempered by the realities of startup mortality rates.
Legal and Jurisdictional Nuances
The legal context in which damages calculations are performed cannot be overstated. Forensic accountants must be adept at navigating the nuances of different jurisdictions, understanding how local laws and court precedents influence the admissibility and relevance of their findings. This includes being versed in the specific standards of evidence required to support their conclusions, as well as any limitations imposed by statute or case law on the types of damages that can be claimed. The attorney client in the matter will ultimately provide the forensic accountant with the legal parameters they will rely on in preparing the expert report, but the forensic accountant needs to have sufficient knowledge of the legal environment to flag the appropriate questions for the lawyer on the job to consider.
Communication and Collaboration with Legal Teams
A critical aspect of the forensic accountant’s role is effective communication and collaboration with legal teams. This includes not only conveying complex financial concepts in understandable terms but also aligning their analysis with the legal strategy of the case. It often involves preparing detailed reports, visual aids, and other materials that can be used in negotiations or court proceedings. The forensic accountant may also need to stand as an expert witness, where their ability to convincingly present and defend their analysis can be crucial to the outcome of the case.
Ethical Considerations and Standards Compliance
Forensic accountants operate under strict ethical guidelines and professional standards. This includes ensuring objectivity, confidentiality, and integrity in their work. They must also adhere to the professional standards set by organizations such as the National Association of Certified Valuators and Analysts (NACVA) and the American Institute of Certified Public Accountants (AICPA). Compliance with these standards not only enhances the credibility of their findings but also ensures that their work can withstand legal scrutiny.
Conclusion
The application of forensic accounting in the calculation of commercial damages is a sophisticated process that requires deep financial expertise, an understanding of legal principles, and the ability to apply advanced analytical techniques. By considering economic and industry trends, employing econometric models, navigating the challenges of new business valuations, and effectively collaborating with legal teams, forensic accountants provide invaluable insights into the financial impacts of wrongful acts. As legal professionals seek to represent their clients’ interests in commercial disputes, the strategic use of forensic accounting can significantly enhance the persuasiveness and accuracy of damages claims.
