Articles

Lost Profits: Calculating the Damage

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When a business has been damaged by another party, an expert may be needed to estimate the damages. Photo by Dovis from Pexels

Financial experts are often hired to measure economic damages in contract breach, patent infringement and other tort claims. Here’s an overview of how experts quantify damages, along with some common pitfalls to avoid.

Estimating Lost Profits

Where would the plaintiff be today “but for” the defendant’s alleged wrongdoing? There are three ways experts address that question:

1. Before-and-after method. Here, the expert assumes that, if it hadn’t been for the breach or other tortious act, the company’s operating trends would have continued in pace with past performance. In other words, damages equal the difference between expected and actual performance. A similar approach quantifies damages as the difference between the company’s value before and after the alleged tort occurred.

2. Yardstick method. Using this technique, the expert benchmarks a damaged company’s performance to external sources, such as publicly traded comparables or industry guidelines. The presumption is that the company’s performance would have mimicked that of its competitors if not for the tortious act.

3. Sales projection method. Projections or forecasts of the company’s expected cash flow serve as the basis for damages under this method. Damages involving niche players and start-ups often call for the sales projection method, because they have limited operating history and few meaningful comparables.

Experts will consider the specific circumstances of the case to determine the appropriate method (or methods) for the situation.

Discounting Damages

After experts have estimated lost profits, they discount their estimates to present value. Some jurisdictions have prescribed discount rates, but, in many instances, experts subjectively build up the discount rate based on their professional opinions about risk. Small differences in the discount rate can generate large differences in valuators’ final conclusions. As a result, the discount rate is often a contentious issue.

Mitigating Factors

Another key step is to address mitigating factors. In other words, what could the damaged party have done to minimize its loss?

For example:

• A manufacturer that suffers a business interruption should minimize the impact by resuming operations at a temporary location or outsourcing production to another company, if possible.

• A wrongfully terminated employee needs to make a reasonable effort to find another job.

• An antitrust plaintiff prevented from entering a particular market should explore opportunities to invest in alternative markets.

• A plaintiff in a breach-of-contract case should make a reasonable effort to replace the business lost as a result of the defendant’s wrongdoing.

Most jurisdictions hold plaintiffs at least partially responsible for mitigating their own damages. Similar to discount rates, this subjective adjustment often triggers widely divergent opinions among the parties involved.

Avoiding Potential Pitfalls

Some key factors need to be considered to avoid over- or underestimating a plaintiff’s loss. For example, the taxation of damages can have a significant impact on an expert’s conclusion. If the plaintiff must pay taxes, an after-tax assessment wouldn’t be equitable. Also realize that some parts of a damages award, such as return of capital, may be nontaxable and require an after-tax estimate.

Taxes also need to be handled properly when lost profits are discounted to present value. In other words, if damages need to be calculated on a pretax basis, the expert should use pretax discount rates. Mismatching after-tax discount rates to pretax cash flows would overstate damages, all else being equal.

In addition, it’s important to not assume that damages will occur into perpetuity. Economic damages generally occur over a finite period. They have a beginning and an end. Eventually most plaintiffs can overcome the effects of the defendant’s alleged wrongdoing.

For More Information

When calculating economic damages, there isn’t a one-size-fits-all approach. What’s right depends on the facts of your particular case. Contact the experts at Advent Valuation Advisors to develop an estimate that avoids potential pitfalls and can withstand scrutiny in court.

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Manufacturers More Susceptible to Fraud

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Manufacturing is among the industries most susceptible to fraud, with a median fraud-related loss of $198,000, according to the 2020 Report to the Nations. Photo by Laurel and Michael Evans on Unsplash

When fraud strikes manufacturers, the effects can be devastating. The median fraud loss in the manufacturing sector, one of the industries most affected by fraud, was $198,000, according to the 2020 Report to the Nations published by the Association of Certified Fraud Examiners (ACFE). That’s significantly higher than the median fraud loss for all industries ($150,000).

Here are some other key findings from the latest biennial ACFE report:

Common Fraud Schemes

Over the years, the ACFE has identified three methods of occupational fraud:

  1. Asset misappropriation. In these schemes, dishonest employees access and misuse assets for their personal gain. For example, they might steal company funds, inflate expense reports or engage in fake billing scams.
  2. Corruption. This is abuse of business privileges enabling an employee to gain a direct or indirect benefit. Examples include bribery and manipulation of conflicts of interest.
  3. Financial statement fraud. Here, the employee intentionally causes a misstatement or omission of material information in financial reports. For example, a fraudster might record fictitious revenues, understate expenses or inflate assets.

According to the 2020 Report to the Nations, asset misappropriation occurred in roughly 86 percent of the cases. Though misappropriation schemes are the most frequent fraud technique, they resulted in the lowest median loss ($100,000). Conversely, financial statement fraud took place less frequently (in 10 percent of cases), but it had the highest median loss ($954,000).

For manufacturers, the most common fraud schemes include:

  • Corruption (50 percent),
  • Billing schemes (23 percent),
  • Theft of non-cash assets, such as inventory or fixed assets, (23 percent), and
  • Inflated expense reimbursements (20 percent).

The total adds up to more than 100 percent because incidents may involve more than one type of fraud scheme.

The median loss from corruption crimes was $200,000. This could help explain why the median fraud loss for manufacturers was higher than the overall median for all industries.

Methods of Detection

More than 40 percent of the frauds in the 2020 report were unearthed by tips. About half of those tips came from employees. But customers and suppliers can also be valuable sources of fraud tips. Other common methods of detection include internal audit (15 percent of cases) and management review (12 percent of cases).

The ACFE concludes: “When fraud is detected proactively, it tends to be detected more quickly and thus causes lower losses, while passive detection results in lengthier schemes and increased financial harm to the victim. Anti-fraud controls such as account reconciliation, internal audit departments, involved management review, and active cultivation of tips are all tools that can lead to more effective detection of occupational fraud.”

While the median duration of a fraud is 14 months, averages differ based on the type of fraud. Usually, non-cash, cash on hand, skimming and corruption fraud is caught in less than 24 months. Billing, expense reimbursement, register disbursements, check and payment tampering, payroll and financial statement frauds typically take about two years before being discovered. Naturally, the longer fraud goes undetected, the larger the financial loss.

Profile of Perpetrators

The 2020 report shows that higher-ups are responsible for larger crimes. Although owners or executives perpetrated only 20 percent of the frauds in the study, the median loss in those cases amounted to $600,000 — much higher than losses caused by managers and mid-to-lower-level employees. This is attributed mainly to wide-ranging access to funds. Similarly, frauds committed by long-time employees resulted in greater losses than ones caused by relative newcomers.

Age and gender were also among the most significant factors. More than half of the perpetrators (53 percent) were between the ages of 30 and 45, but median losses trended higher for older fraudsters. Also, males committed 70 percent of the frauds and the median loss for male perpetrators ($150,000) was almost double the median for females ($80,000).

Methods of Prevention

Manufacturers are less likely to incur fraud losses if they learn how to identify potential fraud risk and adopt an effective system of internal controls for combatting fraud.
In particular, the ACFE recommends keeping an eye out for employees who engage in one or more of the following high-risk behaviors:

  • Living beyond their means (42 percent of cases),
  • Exhibiting financial difficulties (26 percent of cases),
  • Having unusually close association with a vendor or customer (19 percent of cases),
  • Displaying excessive control issues or an unwillingness to share duties (15 percent of cases),
  • Being unusually irritable, suspicious or defensive (13 percent of cases),
  • Reflecting shrewd or unscrupulous behavior (13 percent of cases), and
  • Being recently divorced or experiencing family problems (12 percent of cases).

In 45 percent of the cases in the 2020 report, the fraudster had a record of other work misconduct issues, such as bullying, absenteeism or tardiness. Furthermore, the report stated that lack of internal controls contributed to almost one-third of frauds. Be aware that annual financial statement audits aren’t specifically designed to detect fraud. Your management team is responsible for the internal controls it employs.

Smaller firms face different challenges in preventing fraud and implementing anti-fraud controls than larger entities. The most common anti-fraud controls — external audit of financial statements and code of conduct — were evident in 56 percent and 48 percent of small businesses with fewer than 100 employees, respectively, compared to 92 percent and 91 percent for larger companies.

Fortunately, fraud prevention measures don’t necessarily require you to spend an arm and a leg. For instance, a manufacturing firm might adopt a written code of conduct, require its managers to review procedures and institute anti-fraud training for all employees. In addition, you may rely on external consultants to perform independent fraud testing, when appropriate, to address these concerns.

Final Thoughts

In the current business environment, manufacturing firms must reevaluate internal controls, policies and operating procedures, training assessments and risk identification. Since the situation remains fluid, your company should be prepared to react quickly to minimize potential losses. If you suspect suspicious activity, a forensic accountant can help evaluate the situation.

Advent Valuation Advisors has extensive and varied experience in detecting fraud. Please contact us with any questions.

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