Lost profits refer to any economic damages that are the result of some type of business disruption. These damages are estimates that are determined by a range of factors, including things like breach of contract, negligent acts, patent infringement, physical damage to business equipment or property, and liability brought about by an accident. As such, damages analyses are prepared by an accountant to ascertain lost profits, an element of the overall economic damages.
In litigation, a forensic accountant is typically brought in to lend their expertise in calculating lost profits. They do this for a variety of reasons, but the overall goal is to give an approximation for how well the business would likely have performed if no incident had occurred. These are sometimes referred to as “but for” estimates. Meaning that the plaintiff would have profited in this amount, but for the defendant’s actions.
The role of a forensic accountant in calculating lost profits is crucial. Combining the use of essential data, analytical procedures, and proven approaches, the forensic accountant will rely on several basic components. While there are a variety of ways in which to determine lost profits, most forensic accountants will use these elements in a formula:
- Lost revenues
- Avoided costs
- Extraordinary costs
- The duration of time in which damages took place
- Time value of money
The forensic accountant will obtain expense and income statements during the loss period in order to be able to better quantify lost profits. It is important to remember that while there are a number of generally accepted methods of calculating lost profits, each case is unique and therefore requires a different set of steps dependent on the facts at hand.
Calculating lost profits involves a number of general steps. An experienced forensic accountant will follow these guidelines loosely, understanding that adequately calculating lost profits means adjusting to best meet the current case. The following are the most common steps taken by a forensic accountant when calculating lost profits:
- Gathering Data and Information: through both research and conversations with the business owner as well as some employees, a forensic accountant will determine pertinent background information to lay the groundwork for the calculations. In addition, the forensic accountant will determine factors contributing to the “but for” projections. These factors include things like competition, economic trends, customer trends, and even seasonality trends.
- Timing: the next step is usually determining the time frame in which the sales were impacted. For example, in a breach of contract case the forensic accountant will look at the time left on the contract.
- Gross sales value of lost goods/services: this is determined by calculating the amount that a client or customer would have paid for goods/services. Gross sales value must be determined by subtracting any expenses that would have typically been incurred during the sale (i.e. shipping, packaging, promotional discounts, etc.).
- Any expenses saved: this refers to any saved cost or saved variable that existed due to the down time. From things like saving of product to saving on commissions or royalties, determining cost of goods sold is critical.
- Additional considerations: the expert forensic accountant must also take in consideration mitigation of damages, future lost profits to present value, and income tax treatment on damages.
Calculating lost profits is an extremely time-consuming, difficult process. Since it can be quite subjective, hiring an expert forensic accountant with notable experience is particularly important. Those seeking retribution for lost profits must consult with a qualified forensic accountant who is well-equipped to quantify lost profits with some degree of certainty.
At Ellrich, Neal, Smith & Stohlman, P.A, we provide litigation services in both federal and state courts in a wide variety of cases including brokerage fraud, shareholder disputes, class action litigation, personal injury, marital dissolution, contract claims, business damages, lost profits, business and contract disputes and criminal cases. Contact our Miami or Palm Beach Gardens office today to learn more!