CPAs and the Search for Lost Profits
A multitude of disruptions can strike any business, causing catastrophic or partial losses and interruptions of revenues. Disasters occur in various guises, from fire and flood to fraud, theft, computer hacking and other malfeasance. The event may result in a one-time harm or may be reflected in an extended, ongoing loss of revenue.
A CPA may be called on to help evaluate various types of forensic claims, whether breach of contract, tort or insurance disputes. When commercial losses have occurred, accountants can provide expertise on these various fronts:
- Quantification of damages.
- Reconstruction of records.
- Dispute resolution.
- Expert testimony.
The measurement of lost profits in commercial situations varies greatly, depending on the industries involved and the wrongful acts alleged. Adding to the complexity, the law does not clearly spell out lost profit damages, which may also differ according to the particular event and jurisdiction.
Running through the computations
A very simplistic formula for lost profits boils down to the following elements:
- Defining the damage period.
- Measuring the lost revenues or sales from that time period.
- Subtracting any unspent costs such as sales commissions.
- Remembering that costs normally fixed in actual profits may become variable over a given level of revenues.
- Adding excess costs, such as a public relations crisis or the cleanup after a fire or a flood.
- Adding costs from efforts made to mitigate losses.
- Calculating lost profits in present value terms.
One of the most important measurements is the determination of the damage period, which may include the entire time required for the injured firm to fully adjust to its loss of business and for its profits to recover. The exact loss period itself is often a bone of contention between parties.
As always, the longer it is projected into the future, the dimmer is the clarity of any forecast, and a court will be less likely to award damages in the absence of certainty. Generally, lost profits cannot be overly speculative. Even estimates must be established with a reasonable degree of economic certainty.
Revenues or sales will also need to be measured on the basis of relevant factors. Since sales normally express the relationship between volumes sold and unit price, a CPA will typically estimate that aspect of lost profits by examining the firm's historical rate of revenue growth as well as future expectations for prices and volumes to be sold.
Models and methodologies
There are three common valuation methods for calculating lost profits:
- But for: What would the profits have normally been "but for" the damaging event? How much is the firm worse off due to the wrongful conduct? The capacity to make profits is as important here as any particular set of transactions.
- Before and after: Lost revenue is calculated and multiplied by an incremental profit margin.
- Yardstick (or benchmark): How do the injured firm's results compare with those of similar companies in terms of size, product lines and markets in the same time period?
Determining lost profits is a complicated exercise, so you should be sure to consult an experienced CPA for help with the process.