Forensic and Investigative Accounting

1
Forensic and Investigative Accounting
Chapter 10 Commercial Damages

• .

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 the
  results of the actions or lack of actions of the
  offending party.

3
Legal Framework of Damages

• Proximate (direct) causeThe damages caused were
  a direct result of the offending partys actions
  or lack of actions.
• Reasonable certaintyThat 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
• ForseeabilityThat 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.

4
Two Types of Harm

• TortThe occurrence of the harmful act itself is
  wrongful.
• Breach of contractA failure without excuse or
  justification to fulfill ones obligations under
  a contract.

5
Two Types of Damages

• RestitutionWhen the harmful act unjustly
  enriches the defendant at the expense of the
  plaintiff.
• RelianceWhen 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.

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.

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.

8
Lost Profits Methods

• Before-and-after methodTake sales or sales
  growth before the act and compare to the
  comparable figures afterward.
• Yardstick (or benchmark) methodCompare sales or
  sales growth of the company to other companies or
  to other industry averages.

9
Lost Profits Methods

• But-for methodThe difference in the estimated
  profits (but-for the actions of the defendant)
  and the actual profits.
• Direct methodAny agreement may indicate how to
  calculate.
• Combination methodMay use a combination of
  methods.

10
Economic Framework for the Lost Profits
Estimation Process

• Macroeconomic analysis.
• Industry analysis.
• Company-specific analysis.
• Financial analysis conclusion.

11
Length of the Loss Period

• Projecting lost revenues.
• Measuring profitability.
• Mitigation and offsetting profits.
• Time value of money considerations.

12
Components of Damages

• Lost profits
• Lost value
• Lost cash flows
• Lost revenue
• Extra costs

13
Defendants Damages Estimate

• The defendants 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.

14
Plaintiffs 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)

15
Plaintiffs 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.

16
Experts Journey Through the Legal System

• Testimony early in case
• Pretrial summary judgments
• Decision to try the case
• (continued on next slide)

17
Experts Journey Through the Legal System

• Defending the expert report
• Deposition testimony
• Trial testimony
• Questioning by clients attorney
• Questioning by opposing attorney
• Preparation for trial testimony
• Rebuttal testimony

18
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.

19
Developing a Theoretical Model for Damages

• Sometimes it is necessary to develop a
  theoretical model for damages
• Frequently actual damage calculations are
  measured against the theoretical model
• The theoretical framework should be supported by
  accounting foundations such as
• Incurred historical costs
• The matching concept
• Relevant costs
• Conservatism
• Differential or incremental costs