Commercial Damages: Assessing, Estimating, and Quantifying Losses

1. Chapter 15 Consulting, Litigation Support and Expert Witnesses: Damages, Valuations and Other Engagements

2. Critical Thinking Exercise How many outs are there in an inning?

3. Professional Standards and Guidance • AICPA’s Forensic and Valuation Services Section • Litigation support and valuation engagements • “Practice aid” • Special reports • Other publications

4. Engagement Issues and Professional Responsibility • Consider the implications • CPAs need to ensure they have or can obtain necessary skills, training, and experience • Engagement letter • Nature and extent of professional services to be provided • Outline degree of responsibility assumed • No opinion about guilt or innocence

5. Types of Consulting and Litigation Support Activities • Assessing the risk of fraud and illegal acts’ • Evaluating the adequacy of internal control systems • Substantive testing of transactions during an attest or general consulting engagement • Designing and implementing internal control policies and procedures • Proactive fraud auditing when fraud is not suspected • Preparing company codes of business ethics and conduct • Consulting about employee bonding • Developing corporate compliance programs

6. Tools and Techniques – General Discussion • AICPA Practice Aid 07-1 • Public Domain Reviews and Background Investigations • Interviews of Knowledgeable Persons • Confidential Sources of Information and Evidence • Laboratory Analysis of Physical and Electronic Evidence • Physical and Electronic Surveillance • Undercover Operations • Analysis of Financial Transactions

7. Commercial Damages • Estimating damages on a case-by-case basis • Understanding and appropriate use of proper accounting methods • Understanding how accounting information is used to create the required components of the damages estimate • Accurate, timely, and professional advice will help attorney formulate effective strategies

8. Legal Framework for Damages • To pursue legal damages, injured part must prove 2 points • Liability: That the other party was liable for all or part of the damages claimed • Damages: That the injured party suffered damages as the results of the actions or lack of actions of offending party • To prove damages were sustained, injured party must prove 3 additional elements • Accused party was the direct or proximate cause of the damages • Amount must be calculable to a reasonable degree of certainty • Accused parties should have been reasonably able to foresee that damages were likely to accrue

9. Types of Commercial Damages • Compensatory • Economic loss or restitution • Lost wages • Incremental or incidental expenses • Lost profits • Lost Value • Reliance • Punitive • Special

10. The Loss Period • One of the first steps to measuring commercial damages is to determine the loss period • For breach of contract, it is generally the remaining term of contract • If the contract term is very long, courts may be reluctant to enforce it because of issues of uncertainty • The damages may extend beyond the contract term because the parties have a history of extending or renewing prior contracts

11. Economic Framework for Damages • Amount of loss may be affected by the economy or conditions of the industry • Give consideration to the appropriate economic conditions as a starting point • Next level of consideration is the industry • Performance of entity compared to competitors • Gather financial statement data, breakdowns, non-financial data, and tax returns • Consider historical performance • Assessment of cash flows

12. Quantifying Lost Revenues and Increased Expenses • Decisions that need to be made • Base amount of revenues or expenses • Choose revenue or expense growth rates • Are historical rates of growth applicable to the damage period? • Use straightforward method or more sophisticated method • Methods used to develop estimates of lost sales and incremental expenses • The Before and After Method • The Benchmark (“Yardstick”) Method

13. Determining Lost Profits • Consider impact on “bottom-line” net income • Incremental costs subtracted from incremental revenues • Damaged party must mitigate its damages • AICPA practice Aid No. 7 “Litigation Services” • Losses characterized as lost profits, lost value, lost cash flows, net revenue and incremental costs

14. Determining Incremental Costs • Incurred as a result of plaintiff’s action or inaction that would otherwise not be incurred • Infrastructure requirements in order for the plaintiff to have the capacity necessary • Cost Behavior • Fixed • Variable • Relevant range • Allocated costs • Accounting estimates

15. Determining Incremental Costs • Methods for determining cost behavior • Account analysis • High-low method • Graphics • Statistical (regression, survey and sampling) • Engineering

16. The Time Value of Money • Lost incremental profits before the matter can be resolved between the parties • Pre-judgment interest • Amounts that would only be realized in future periods after the dispute has been resolved • AICPA Practice Aid 06-4 “Calculating Lost Profits” • Cost of equity

17. Communicating and Defending the Results of Commercial Damage Estimates • “Tire-hits-the-road” • Venues to be evaluated, scrutinized or challenged • Periodic meetings with attorneys for whom you have been engaged • Pre-judgment testimony related to summary judgment • Meetings with counsel where they determine how to proceed with the case • The written report • Deposition testimony • Regulatory or administrative hearings • Alternate dispute resolution forums • Trial testimony • Critique opposing side expert • Neutral and objective position

18. Valuations • Value business, business ownership interest, security, or intangible asset • Statement on Standards for Valuation Services No.1 • Overall engagement considerations • Development of the valuation • Valuation report and appendices • Organization certificates

19. Overall Engagement Considerations • Assessment of economic and industry conditions • Ability to identify, gather and analyze relevant data • Simplified versus complex valuation methods • Limitations • Assumptions • Understand nature of client’s expectations and planned use for valuation services outcomes

20. Type of Valuation Engagements • Two types of engagements • Valuation • Data and information are continually gathered, updated, incorporated and analyzed • Use most appropriate methods and approaches • Calculation • Outline assets, valuation methods and other aspects of the engagement • Service provider agrees in advance • Professional proceeds to apply agreed-upon procedures

21. Measures of Value • Book value • Balance sheet value • Liquidation value • Cash likely received by owner under pressure to sell item quickly • Market value • Willing buyer and seller come to terms under normal market conditions

22. Determining Market, Fair Market and Fair Value • Two considerations that determine market and fair market value of an asset • Future income stream • Difference between future income stream and alternative investment options • Three methods used to determine fair market values • Discounted earnings and cash flows • Market comparables valuation • Asset and liability market valuation

23. Discounted Earnings and Cash Flows

24. Estimating the Risk-adjusted Discount Rate Four methods to develop risk adjusted discount rate and its related cash flows • CAPM • Weighted average cost of capital (WACC) • Bond-equity additive method • Build-up method

25. Forecasting Income and Cash Flows • Consider data in the following areas • Nature of the business • General economic and industry outlook • Book value of equity • Earnings capacity of the company • Dividend paying capacity • Goodwill and other intangible assets • Previous sales of company securities • Market prices of comparable companies • Number, type and age of organizational facilities • Classes of debt or equity and their associated rights • Industry markets and conditions • Business risks

26. Forecasting Income and Cash Flows • Grounded in historical financial performance • Free cash flows • Related parties • “Arm’s length” • Attempt to gather the following • Forecasts of projected financial results • Articles on industry-related valuation issues • Relevant client information • Calculate applicable ratios and analyze trends

27. Asset Valuation Models • Assumes balance sheet reasonably identifies company’s assets and liabilities • Appraisers value assets • Net present value techniques estimate liabilities • Two shortcomings • Does not account for benefits associated with asset synergy • Fails to account for significant intangible assets

28. Market and Accounting-based Comparable Models • Benchmarks, guidelines and rules of thumb • Useful as a reasonableness check on results of other analyses • Should not be used as stand-alone method unless other method is not possible • Address shortcomings if used as stand-alone method

29. Valuation Discounts and Premiums • Majority and minority owners with various control rights • Asset ownership interests have differing marketability or liquidity attributes

30. Other Ownership Interests Subject to Valuation • Valuing debt • Preferred stock • Convertible debt • Stock • Warrants • Options • Intangible assets

31. Conclusion of Value • Number or specific range • Reconcile and correlate results from more than one methodology or assumption • Consider reliability of the valuation outcome • Valuation professional has 2 choices • Primarily rely on 1 method using other methods as reasonableness checks • Rely on multiple methods to determine the value or specified range

32. The Valuation Report Accredited Senior Appraiser’s (ASA’s) Principles of Appraisal Practice • Description of the property • Objectives of the appraisal work • Statement of contingent and limiting conditions • Description and explanation of appraisal method • Statement of appraiser’s disinterestedness • Appraiser’s responsibility to communicate each analysis, opinion and conclusion • Mandatory recertification statement • Signatures and inclusion of dissenting opinions

33. The Valuation Report • Uniform Standards of the Professional Appraisal Practice (USPAP) • Identify and describe business enterprise, assets or equity • State purpose and intended use of appraisal • Define the value to be estimated • Set forth the effective date of the appraisal and report • Describe the extent of the appraisal process employed • All assumptions and limiting conditions that affect analyses opinions and conclusions • The information considered, appraisal procedures followed and reasoning that supports the analyses, opinions and conclusions • Any additional information that may be appropriate to show compliance • Rationale for the valuation methods and procedures used • A certification in accordance with Standards Rule 10-3

34. Personal Injury, Wrongful Death and Survival Actions • Three types of damages that may ensue • Losses to the individual • Losses to survivors • Losses to the estates of decedents • More technical than analytical • Guidelines are relatively straight forward do to their common nature • Inflation is a major challenge

35. Losses: Personal Injury • Injured person survived and subsequently lost income • Experts estimate reduced earnings and other forms of support as a result of the injury • May incur future costs or earnings capacity may be reduced as part of a permanent injury • Injured person may suffer 5 types of losses • Loss of earnings • Loss of employment benefits • Losses associated with ability to perform “non-market services” • Medical costs • Life care costs

36. Losses: Wrongful Death and Survival Cases • Death of a person where another party may be held accountable can result in two types of cases • Wrongful death • Primary right of recovery resides with survivors • Survival actions • Estate of deceased has primary right of recovery • “What if” • No need for medical or life-care costs

37. Analysis of Earnings Losses • Investigation of five areas • Determining the basis for earnings losses • Analysis of employment history and related past earnings • Projection of probable career paths • Determining the proper earnings for each projected career path • Consideration of other factors on earnings losses • Three methods for projecting earnings • Case-by-case method • Below-market discount method • Total offset method

38. Analysis of Lost Employment Benefits Associated with Lost Earnings • Generally, not all employment benefits are lost when an injury occurs • Applicable standard are those benefits the injured party has lost • Value to employee not cost to employer • Additional analysis is required for benefits mandated by government laws and regulations

39. Analysis of Lost “Non-Market Services” • Approaches used to estimate costs • Actual cost to develop and utilize substitute services • Accumulate hours associated with activities and multiply by reasonable rate • Issues with “non-market services” • Injured person may have provided services well into retirement • Injured party may not have provided services for remainder of life

40. Analysis of Medical and Life Care Costs • Identify requirements in the following areas • Types of needs the injured person will have • How long those needs are likely to continue • Changes in those needs over time • How often those needs will require services • Special equipment required • Types of professionals who will need to provide services • Once listing is complete, estimates of costs can be developed • Seek out bids for a life care annuity

41. Injured Children, Homemakers and Retired Persons • Generally have limited earnings and no W-2’s • Children • Have made few decisions that would determine his or her future • U.S. Bureau provides statistics based on educational assumptions • Homemakers • Estimate cost of home services that will need to be contracted with outside parties • Retired persons • Earning capacity • Will retiree ever enter work force again?