Forensic accountants are often asked to verify the amount of lost profits or business income loss sustained as the direct and proximate result of a “triggering event”, such as a natural catastrophe (e.g. fire, storm, etc.), theft, vehicle collision, a breach of contract, etc. For example, a forest fire may cause direct physical damage to a business's property, resulting either permanent or temporary closure. This may in turn result in economic loss (e.g. business income loss) to the affected business during the relevant period. A business’s operations may also be disrupted by a breach of contract, fraud, or other tort, which may result in a loss of business income. Assuming liability has been established for a loss, this article focuses on key issues that are inherent in performing an analysis of business income loss. Each case is unique, and the evaluation of potential lost profits must be based on the facts presented and circumstances of the case.
The "But-For" Method
One common method of calculating economic damages in these types of cases is the “before and after” method or the “but-for” method. The but-for method requires the forensic accountant to make a projection of the revenues, expenses, and resulting net profit that would likely have been earned during a specified period of time if the triggering event had not occurred. The but-for projections are then compared to the actual results achieved by the business during that same period to identify the difference between the but-for projections and the actual results. This difference may represent the potential amount of business income loss damages sustained due to the triggering event.
The but-for projections and the actual results may seem to be a mathematical process. However, this inference would be faulty, on the basis that it disregards the nuances associated with the analysis. When comparing projected but-for revenues, expenses, and net income, to the business’s actual results of operations, care must be taken to analyze whether the measured differences are as a result of the triggering event. There are various types of differences, which may not be related to the triggering event. Take, for example, a scenario in which, just before to the triggering event, management negotiates the terms of new lease agreement, resulting in increased rent expense. In this situation, actual rent totaling $45,000 expense may exceed historical trends totaling $15,000 per month (e.g. before new lease agreement), which, mathematically, may imply extra rent expense (e.g. actual expense is greater than the “old” historical trend) without further explanation.
However, based on the hypothetical scenario, the measured difference between the but-for projection and actual would have nothing to do with the triggering event. Such an occurrence may only become apparent when analyzing the cause of the differences. In this case, the accountant seeks information and documentation regarding the change in rent. Based on the facts, the forensic accountant would then change the projection basis to an amount or level commensurate with the anticipated increase in rent expense (e.g. $15,000 per month under new lease agreement).
The key point in this simplified example is that a proper analysis does not merely take the difference between projected and actual as being the potential business income loss due to the triggering event. Rather, the forensic accountant should analyze the differences in revenues and expenses for purposes of developing some basis for concluding that such differences are the result of the triggering event.
The but-for method of calculating business income loss damages requires projections to be made, which are estimates. Those projections must be supported by documentation and data to render the projections probable, not speculative. This means that the forensic accountant cannot guess, or speculate, when making the projections. One way to avoid speculation is to make use of the actual historical results of the business’s operations and build projections that reflect a combination of the business’s historical results and trends coupled with the expected impact of both internal and external current factors and circumstances (e.g. outside of the triggering event).
Examples of internal factors that may impact the projections include, but are not limited to, the addition of a new product line, loss of a key customer, loss or gain of a key employee(s), or a gain or loss of a significant client or contract just prior to the triggering event. These internal factors may result in either an increase or a decrease in the projections, relative to the historical trends. External factors, for example, might include recent changes in an essential technology, a new competitor has entered in the marketplace, or changes in the industry.
Note that in all of the above-included examples, a key issue is the timing of the factors relative to the triggering event. For example, if a key customer was lost a full year prior to the triggering event, the impact of that lost customer would be fully included in the historical trend, which would be included in the but-for projection. However, if the customer was lost only a month prior to the triggering event, the full impact of the loss would not be included in the historical trend, which may require an adjustment to the but-for projection basis. As another example, a business may increase the incremental unit price of a service or goods sold two or three months prior to the triggering event. The relative price increase would need to be incorporated in the but-for projection, in order to estimate, with reasonable certainty, the business’s revenue had the triggering event not happened.
There may be instances when the but-for projections differ from the historical trends. The key to using projections, which differ from historical trends, is identifying and supporting the basis for the difference. Historical results of operations for a business are typically recorded fact and so should be a primary, but certainly not the only, factor in developing the projection basis. However, almost any projection must include some amount of estimate and clearly state assumptions. Even if the projection is entirely based on the historical trends, there is an implicit assumption that the trends will persist into the future. If the but-for projections differ significantly from the business’s historical trends, the forensic accountant must adequately support the assumed basis and provide explanation regarding the appropriateness of the differences.
The but-for method for determining potential economic damages is a generally accepted method. This method must be supported with sufficient relevant documentation. It must be applied with thoughtful consideration of all the above-discussed factors, for purposes of creating critical projections and in analyzing the potential business income loss.