A Unified Approach Economic Damages
Derk G. Rasmussen & Joseph L. Leauanae
This
article proposes a unified approach for defining and quantifying economic damages suffered by
operating entities. For purposes of this treatise, economic damages refer to any temporary and/or
permanent impairment caused by one or more parties and sustained by an operating entity. The authors
identified a need for this article after encountering numerous variations of economic damage
calculations, in litigation settings, that were seemingly inconsistent with damage theory.
What
is a Unified Approach?
The
authors’ unified approach to calculating economic damages entails the analysis and synthesis of
three distinct but interrelated components:
1.
Historical lost profits
2.
Future lost profits
3.
Causation
When
determining economic damages, it is imperative that experts understand the ultimate purpose of their
calculations. The components identified above must all be considered and unified into a final value
for economic damages. The damage calculation will be deficient if these components are not analyzed
or integrated correctly.
The
ultimate consideration when calculating economic damages is that the components identified above are
not mutually exclusive. In fact, there is an integral relationship in every case between causation,
historical lost profits, and future lost profits. Unfortunately, it has been the authors’
experience that experts in many cases fail to fully consider the relationship between these
components.
An
effective application of the unified approach to calculating economic damages will rely upon the
amalgamation of forensic accounting, economics, finance, and business valuation techniques.
Why
Should a Unified Approach be Used?
Apart
from the fact that a uniform approach would eliminate many of the theoretical inconsistencies that
are often apparent in these types of calculations, the application of a unified approach is also
helpful because it specifically structures economic damages into components that are easier to
substantiate and defend. As in most litigated situations, the clearer and better defined the
calculations presented by the expert, the easier it will be for the expert to defend or at least
explain the methodologies employed and the assumptions made.
If
a unified approach is not used, opposing experts may be more successful in attacking economic damage
calculations because of the greater likelihood that the methodologies employed will not be based on
generally accepted damage theory.
A
well-constructed case that appropriately applies a unified approach will inevitably focus arguments
more towards specific disagreements between the parties regarding the underlying assumptions of the
damage calculation and away from disagreements as to how the damage calculation was constructed.
Timelines
in Economic Damage Calculations
In
order to ensure consistency between the facts of each case and the damage calculations being
performed, it is imperative that experts fully understand the important chronological points that
are used in economic damage calculations: the event date and the trial date.
The
event date refers to the historical date on which the injurious event is alleged to have occurred.
For example, in a matter involving the breach of a contract, the event date refers to the date on
which the damaging party breached the contract.
The
trial date refers to the anticipated date of trial, which is often the same as the valuation date,
the date generally designated at which to present value economic damages.
Components
of Damage Models
Although
circumstances differ between cases, a solid calculation of economic damages consistently depends
upon an accurate assessment of the following metrics: actual performance, but-for performance, and
the present value of past and future losses.
Actual
Performance
Actual
performance refers to the financial performance exhibited by the damaged party during the period
from the event date through the trial date. When assessing the actual financial performance of the
damaged party, particular attention must be directed towards the following:
1) Reconstructing
accounting records
a)
What financial records are available to calculate actual financial performance?
b)
How reliable is this information?
2) Identifying normal
operating costs versus extraordinary expenses
a)
What was the normal level of expenses during the period of actual performance?
b)
How do these expenses compare to the expenses in periods prior to the event date?
c)
What assurances did the expert have that the operating costs listed in the accounting records do not
include personal, inflated, or extraordinary expenses?
3) Analyzing
mitigation issues and their impact on actual performance
a)
What might the damaged party have done to minimize the damage caused by the injurious event?
b)
To what extent, if any, did the damaged party undertake these mitigating actions?
c)
If the damaged party could have mitigated a portion of the economic damages, and if the damaged
party, for whatever reason, did not undertake actions to mitigate damages, then it may be necessary
to reduce the calculated losses.
But-For
Performance
But-for
performance refers to the financial performance that the damaged party would have exhibited had it
not been for the injurious event. Depending on the applicable damage model, discussed later in this
article, but-for performance should generally be characterized as pre-trial and post-trial.
Pre-trial but-for performance refers to the financial performance that would have been achieved by
the damaged party, during the period from the event date through the trial date, but-for the
injurious event. Post-trial but-for performance refers to the financial performance that would have
been achieved subsequent to the trial date, either into perpetuity or for a fixed period of time,
but-for the injurious event. When assessing the but-for financial performance of the damaged party,
particular attention must be directed towards the following:
1) Determining market
size
a)
Within what type of market or industry did the damaged party operate?
b)
How large is/was the industry in which the damaged party operated?
c)
How reasonable is this assessment and how was it determined?
2) Assessing market
penetration
a)
How much of the total market could the damaged party have captured?
b)
How reasonable is this determination?
3) Projecting lost
sales
a)
What level and quality of sales could the damaged party have achieved?
b)
What information is available to make this determination?
c)
Did or could the damaged party have had the infrastructure to achieve the level of projected sales?
d)
Is there sufficient working capital or did the damaged party have access to sufficient working
capital, to fund the level of projected sales?
4) Identifying fixed
versus variable versus capital costs
a)
What costs would have been incurred to achieve projected but-for sales?
b)
How reasonable is/was the expectation that these costs could be incurred and covered?
5) Projecting
operating cash flows
a)
How much cash could the damaged party have generated?
b)
Absent the injurious event, would the damaged party have had sufficient cash flow to maintain and
fund the projected but-for sales growth and service anticipated debt?
6) Analyzing the
interplay between anticipated growth, fixed, variable, and capital costs, and working capital
requirements
a)
How reasonable are the individual projections of growth when considered in terms of overall growth?
b)
Do the individual projections appropriately interrelate?
7) Verifying that
historical but-for performance is consistent with future but-for performance
a)
The assumptions used to project pre-trial but-for performance should be similar if not the same as
those assumptions used to project post-trial but-for performance.
b)
This does not necessarily mean that pre-trial and post-trial performance should be linear but,
rather, that the logical conclusions observed in post-trial projections should relate in some
meaningful way to the pre-trial projections.
Present
Valuing Past and Future Losses
The
actual and but-for performance discussed above is measured in past or future dollars. For example,
if the current year is 2005 and the projected but-for profits extend through the year 2010, then the
projected profits for 2006 through 2010 must be adjusted to account for inflation and for the risk
that the projected level of profits may not be achieved. Correspondingly, historical but-for profits
must also be adjusted to account for inflation. This simple example illustrates the crux of
financial analysis as it pertains to deriving a value as of the trial date: both the time value of
money and the various aspects of risk must be carefully examined before any conclusion of economic
damages can be considered supportable. When assessing the present value of past and future losses
incurred by the damaged party, particular attention must be directed towards the following:
1) Appropriately
applying business valuation methodology
a)
There are various methods by which to appraise business interests. These methods are also applicable
to the determination of lost business value, whether in terms of a claim for diminution of business
value or to determine the value of an entire business for a claim of business destruction.
b)
It is imperative that experts apply the appropriate business valuation method to the business entity
or partial business interest being valued.
c)
The value of most operating companies is generally appraised by considering two core factors: the
future economic benefit that the operating entity is expected to achieve and the risks inherent in
achieving that future economic benefit. It is important that experts fully evaluate both of these
factors and that these factors be considered in concert, since they share a symbiotic relationship.
2) Determining the
standard of value
a)
The specific factors of the case must be evaluated in order to determine the standard of value that
should be used when appraising any lost or destroyed business value.
b)
There may be significant errors in economic damage assertions relating to diminished or destroyed
business value if experts do not use the appropriate standard of value. The applicable law
governing the case will usually dictate the appropriate standard of value.
3) Analyzing the risk
factors used to derive discount rates
a)
The riskier the investment or projected economic benefit, the higher the discount rate.
b)
Does the discount rate adequately capture the risk inherent in achieving projected sales?
c)
If there are multiple projected streams of income, is each stream of projected income adequately
evaluated and discounted appropriately?
4) Applying business
valuation discounts and premiums
a)
In addition to the discount rate it may also be necessary to evaluate discounts and premiums that
are specific to business valuation, such as premiums/discounts for control and discounts for lack of
marketability.
b)
Experts must be well versed in both the objective and subjective issues that provide guidance in
determining the applicability and derivation of these discounts and premiums.
Damage
Calculation Models
Under
a unified approach there are three variations on the economic damages sustained by an operating
entity: a temporary decline in profits, a permanent decline in profits, and a permanent decline in
profits followed by the destruction of the business. Each of these models is evaluated below.
Temporary
decline in profits
 In
this model, the injurious event causes the damaged party to earn smaller profits than they would
otherwise have earned but-for the injurious event. In the situation shown in Figure 1, the damaged
party partially recovers from the effects of the injurious event prior to the trial date and is
expected to fully recover at some point subsequent to the trial date. Since this scenario has part
of the loss occurring before the trial date and part of the loss occurring subsequent to the trial
date, the differential between but-for and actual that exists prior to the trial date is future
valued forward to the trial date, while the differential between but-for and actual that is expected
subsequent to the trial date is present valued back to the trial date.
Permanent
decline in profits
In
the situation shown in Figure 2, the damaged party never fully recovers from the effects of the
injurious event but is expected to continue operating into perpetuity. Since this scenario has part
of the loss occurring before the trial date and part of the loss occurring subsequent to the trial
date, the differential that exists prior to the trial date is future valued forward to the trial
date while the permanent differential expected to exist subsequent to the trial date is reduced to a
value representative of the permanent diminution in the value of the damaged party. In general, this
should be done by calculating the differential between post-trial projected but-for profits and
post-trial projected actual profits, and then discounting or present valuing that differential back
to the trial date using a net discount rate, which in turn should be calculated based on the
difference between the risk of achieving the projected but-for profits and the risk of achieving the
projected actual profits. Since the calculation of post-trial economic damages seeks to value the
permanent decline in business value, the expert must pay particular attention to factors such as the
discount rates applicable to projected but-for and actual future profits and the appropriateness of
business valuation discounts and premiums.
 Permanent
decline in profits and destruction
of business
In
the situation shown in Figure 3, the damaged party never fully recovers but rather goes out of
business prior to the trial date. Since this scenario has part of the loss occurring before the
trial date and part of the loss occurring subsequent to the trial date, the differential that exists
prior to the trial date is future valued forward to the trial date while the differential that
exists subsequent to the trial date (which is essentially but-for profits since actual profits are
effectively zero) should be converted into a value for the destroyed business as of the trial date.
In general, this should be done by calculating the post-trial projected but-for profits and then
discounting or present valuing that stream of income back to the trial date using a discount rate
that reflects the risks inherent in achieving the projected but-for profits. Since the calculation
of post-trial economic damages seeks to value the destroyed business, the expert must pay particular
attention to factors such as the discount rates applicable to projected but-for future profits and
the appropriateness of business valuation discounts and premiums.
Core
Skills Required
The
ability to identify the components of a well-constructed unified approach to economic damages will
only be helpful if the expert also has the requisite skills, training, and expertise to quantify and
put those components together. Since a number of organizations purport to offer certification and
training in the skill sets listed below, and because this article is not an evaluation of said
organizations1, the authors have elected to bypass the issue of credentials. However, specific
skills that should be considered requisite to a thorough evaluation of economic damages would
include investigative accounting economic and finance, and business valuation.
Causation
The
connection between the injurious event and the economic damages incurred by the damaged party is
commonly referred to as the causal link. Proving that the damaging party and the injurious event
were the proximate cause of the economic damages to the damaged party is known as proving causation.
Causation
should be considered a determination based on degrees of responsibility, which the damaged party is
responsible for establishing. The damaged party must prove that the injurious event was caused by
the damaging party but must do so while minimizing the amount of contributory negligence for which
the damaged party might be responsible. For example, if the damaged party contributed in some part
to either causing the injurious event or exacerbating the detrimental effects caused by the
injurious event, whether directly or indirectly, the amount of economic damages that the damaged
party may be entitled to could be subject to downward adjustment.
In
proving causation, the damaged party must also prove that the economic damages they suffered were
not caused, in whole or in part, by intervening factors either wholly or partially separate from the
injurious event. For example, if a damaged party claims that the predatory practices of a competitor
drove the damaged party out of business, they must prove in the process of establishing causation
that they did not go out of business for reasons unrelated to any predatory behavior ascribed to
that competitor.
Causation
can be established either directly or indirectly. Establishing a direct causal link means that the
damaged party is able to prove that they were damaged as a direct result of the injurious event.
Establishing an indirect causal link typically involves eliminating all of the intervening factors
or alternative rationalizations as to why the damaged party suffered economic losses. Although a
direct causal link provides the most definitive evidence that the injurious event precipitated the
economic damages to the damaged party, such a causal link is often difficult to prove, particularly
in complex cases where there are a myriad of intervening factors that provide alternative reasons,
completely unrelated to the injurious event, for the damages suffered by the damaged party. These
intervening factors often include claims such as poor cash flows, mismanagement, increased
competition, and industry trends. For this reason, the damaging party typically attempts to force
the damaged party to prove a direct causal link.
While
an indirect causal link does not directly tie the injurious event to the damages suffered by the
damaged party, such a causal link can be used to show that the damaged party was impacted by the
injurious event despite the lack of a direct connection to that event. Such an example might include
instances where a manufacturing company with a single large customer is economically damaged when
its single largest customer is put out of business as a direct result of an injurious event.
Damage
calculations and causation issues must be addressed simultaneously. They should not be developed
independently, since doing so may lead to a theoretical disconnect in associating the appropriate
level of economic damages to the injurious event. In all cases, economic damages must flow from the
injurious event, which inevitably points to the fact that causation should be the starting point for
all of the economic damages models under the unified approach.
Summary
and Conclusion
While
there may not be any one particular way to estimate the economic damages suffered by an operating
entity, the authors’ experiences have led them to observe that there are quite a large number of
wrong ways to perform such calculations. If experts take the time to learn, understand, and
comprehend the unified approach proposed in this article, we believe that the issues contested at
trial can be significantly reduced to testimony regarding the variables and assumptions used by the
individual experts, which in our opinion is much more productive than arguing the merits of two
disparate economic damage calculations, particularly when both may be inadequate.
Derk
G. Rasmussen, CPA, ABV, CFE, ASA. Derk G. Rasmussen has over 21 years of extensive experience in
providing litigation support services, including expert witness testimony, forensic/investigative
accounting, economic loss calculations, and business valuations. Mr. Rasmussen holds the CPA
designation and is a member of the American Institute of Certified Public Accountants and the Utah
Association of Certified Public Accountants. Mr. Rasmussen is also a Certified Fraud Examiner
(CFE) and a member of the Association of Certified Fraud Examiners. He is an Accredited Senior
Appraiser of the American Society of Appraisers and has earned the Accredited in Business Valuation
(ABV) designation from the American Institute of Certified Public Accountants. Mr. Rasmussen
earned a Bachelor of Science degree in Accounting and a Bachelor of Science degree in Finance from
the University of Utah, and a Master of Business Administration degree from Utah State University.
Mr. Rasmussen is also the author of various Continuing Legal Education (CLE) courses and various
published articles in his field of expertise. Mr. Rasmussen may be reached by e-mail at
derk@sagefa.com.
Joseph
L. Leauanae, CPA, CITP, ABV, ASA, CFE. Joseph L. Leauanae has over 8 years of professional
experience including providing litigation support services, including expert witness testimony,
forensic/investigative accounting, economic loss calculations, and business valuation services.
Mr. Leauanae holds the CPA designation, and is a member of the American Institute of Certified
Public Accountants, the Utah Association of Certified Public Accountants, and the Nevada Society of
Certified Public Accountants. Mr. Leauanae is also a Certified Fraud Examiner (CFE) and a
member of the Association of Certified Fraud Examiners. He is an Accredited Senior Appraiser
of the American Society of Appraisers and has earned the Accredited in Business Valuation (ABV)
designation from the American Institute of Certified Public Accountants (AICPA). Mr. Leauanae
has also earned the Certified Information Technology Professional (CITP) designation from the AICPA.
Mr. Leauanae also serves as a member of the AICPA’s Business Valuation and Forensic &
Litigation Services’ Editorial Advisory Board. Mr. Leauanae earned a Bachelor of Science
degree in Accounting and a Master of Business Administration degree, both from the University of
Utah. Mr. Leauanae is also the author of various Continuing Legal Education (CLE) courses and
various published articles in his field of expertise. Mr. Leauanae may be reached by e-mail at
joe@sagefa.com.
1 For a lengthy discussion of the factors that should be considered
when selecting an expert witness, including an evaluation of useful certifications, please refer to
Expert Witness Qualifications and Selection, an article published by the authors in the Journal of
Financial Crime (December 2004)
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