Last week’s blog inspired a lot of conversation regarding the economic impact of the coronavirus virus. I have received numerous phone calls and emails from attorneys and business owners inquiring about our damage calculation services.
Yesterday, my wife and I took a short walk near our New York City apartment. As we witnessed many store owners covering their windows with plywood in anticipation of their planned “temporary closure,” I wondered how many of these businesses would be able to weather the storm of this pandemic.
Our firm just reached our 30th anniversary. During this time, we have worked with businesses of various sizes and sophistication. One of the differences between the two, other than size, is that these businesses often differ by their access to capital. Small and medium-sized companies have always been considered riskier by lenders and investors. Many of those small business owners whose shops line Main Street, USA are covering their windows with plywood panes, and many may never open again. Only time will tell as to which ones survive.
With that being said, your business clients may now be considering filing a damage report. This analysis may look to calculate either lost profits or lost business. In either case, the objective is to restore the plaintiff to the position it would have been – “but-for” the event that caused the damages.
When calculating lost profits, damages are typically measured for a specific or limited period of time. In general, the loss is the difference between what the business would have produced during the loss period, minus what it actually did produce during this same time frame. All the business’s expenses are taken into consideration in both the “what would have happened” and “what did happen” scenarios.
Case law and statutes dictate what a business is required to demonstrate. In this instance, the task is to employ both a scientific and artistic interpretation of the facts and circumstances that will eventually tell a detailed, accurate story.
The approach to determine lost profits is multi-faceted and generally requires the following six steps:
- Calculate lost earnings by comparing profit history before and after a damaging event,
- Understand the subject company’s cost structure,
- Examine the calculated expenses for reasonableness,
- Determine causation (i.e., consider possible reasons for the drop in sales),
- Examine how things such as economic conditions, marketplace demands, and government regulations have impacted a sales loss,
- Present detailed information to support the assumed revenue, expense, and growth rates.
As an experienced forensic accountant, the steps of assessing lost profits can be simply stated. Still, more often than not, the process itself requires meticulous attention to detail and a sharp eye for any contradictory information. Often, one needs to step back to inquire about issues that arise during this endeavor.
Three that come to my mind are as follows:
- What influence does an immature line of business affect the overall operations of the entity?
- How does a weak performing sector influence the results?
- How influential should projections and forecasts that materially differ from historical results be, and how should they be utilized?
Credibility relevant to projected income and anticipated expenses is critical in supporting a lost profit claim. In this instance, we methodically work from business plans, market surveys, income projections, and other evidence of projected revenues to estimate future receipts. One may use data from industry sources, comparable companies, market data, or any other source that may help in predicting the company’s financial results. It is imperative to acquire an in-depth knowledge of the subject company early in the process: its products, markets, and competition, and the market forces to which it is subject.
In a case when an entire business is lost, we still need to determine the lost future cash flow. But in contrast to a lost profits case, the loss is now permanent. Just as in the lost profit calculation, one needs to consider all of the subject company’s expenses in the “what would have happened” vs. “what did happen” scenarios. The fair market value of a business is determined based on the assumption that an earnings stream would have continued into perpetuity, but for a specific event.
So, when you consider whether to look to recover both lost profits and lost value, one should consider a notable exception, when a business operates for a certain amount of time and then closes as a direct result of an event, thereby incurring a period of lost profits followed by lost business. In this case, the courts have found no “double-counting.”
Simply summarized, how does a lost profits case differ from a lost business case? Lost profits are usually measured over a specific time period (e.g., the estimated time it will take the plaintiff to restore “normal” profits). With lost business value, profits are projected into perpetuity. A lost profits analysis views a business from the perspective of the business owner; a business valuation views the company from the “hypothetical buyer’s” perspective.
We Are Here To Assist You
If we can be of any assistance to you and your clients in evaluating their economic damage during this time, please feel free to contact us. Every member of our team is now working from home. We are completely accessible and will continue to work for you.
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My best to you and your family.