Presentation to GSCPA Fraud and Forensic Accounting Conference - September 18, 2009

1. Lost Profits vs. Business
Valuation
Georgia Society of CPAs
Fraud & Forensic Accounting
Conference
September 18, 2009
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2. Resources/Skills
 Important to stay current
 Expert witnesses need to know
acceptable methodology
 Great use of CPA and forensic
accounting skills (skills not
possessed by pure finance people)
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3. Two damage claim possibilities, one
exception
1. If the business is completely
destroyed, the damage equals the
market value of business on the
date of the loss event.
2. If the business is not completely
destroyed, the damage equals the
lost profits due to the loss event.
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4. Two damage claim possibilities, one
exception
Exception:
This may occur if the business isn’t initially
completely destroyed and continues to
operate for a period of time before
closing.
In this case, the damage may be equal to
lost profits for a certain period of time
followed by the value of the business
from the date of the shutdown forward.
NO DOUBLE DIPPING
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5. Case Example: Valuation as Sanity
Check on Lost Profits
 Business struggled but wasn’t shut
down
 Claimed lost profits were extremely
high
 Business valuation highlighted the
overstated lost profits claim
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6. Reasoning behind the
litigation exception
The rules of the game don’t change for
litigation
 Estimates still must be developed using
sufficient competent evidence and
methods and techniques accepted by
knowledgeable practitioners
 Documentation needs may change since
the work product is subject to discovery
and cross-examination.
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7. Lost Profits
The goal is to put the plaintiff is the
same position as it would have been
“but-for” the defendant’s actions
that gave rise to the alleged
damages
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8. Lost Profits
Lost profit damages are typically
measured for a specific, limited,
time period (and not into
perpetuity).
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9. Lost Profits
General Approach
The loss is the difference between
the profits the business would have
earned during the loss period, less
what it actually earned during the
loss period
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10. Two ways to perform the calculation
 Using all of the company’s expenses
in both the “would have” and “did”
scenarios (usually only the variable
expenses and some other expenses
differ; fixed expenses continue
under either scenario).
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11. Two ways to perform the calculation
 Using only incremental revenues
less avoided costs
In either case, the result should be
the same – mixing these concepts
causes trouble
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12. Lost Profits
 If losses extend into the future,
they are present valued at the
appropriate discount rate, usually to
the date of the trial
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13. Business Valuation
Determine the business’s lost future
cash flows into perpetuity (what the
business would have produced,
using all revenues and expenses)
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14. Business Valuation
Discount lost future cash flows to
present value as of shutdown date
Question: Enterprise value or equity
value?
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15. Lost Profits
 Profits or cash flow?
 Does this matter? (In operating
businesses, is cash flow usually
higher or lower than earnings?)
 Do older lost profits court cases
contemplate cash flow?
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16. Lost Profits
Considerations related to loss period
determination include changes in:
 Competition
 Technology
 Regulation
 Economy
 Real-world events (9/11)
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17. Duty to Mitigate
A duty to mitigate is imposed on the
claimant. This could also apply to
business valuation, for example
related to salvage value.
The Eighth Circuit in 2007 noted:
“Calculating the value of an asset
at liquidation or disposition is a
necessary part of the discounted
cash flow analysis.”
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18. Mitigation issues
 Lost Profits
 Business Valuation – If a DCF shows
a negative “value” is the business
worth nothing?
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19. Case Example: Damages from
Failure to Deliver Fixed Assets
 Seller estimated the fixed assets
that would be included in the sale
 Purchaser was only able to find
90% of the income-producing fixed
assets that they expected.
 Economist hired by the purchaser
estimated lost profits of $750
thousand for the next twenty years.
 What is wrong with this picture?
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20. Lost Profits
Courts have been reluctant to award
lost profits damages over extended
periods due to the speculative
nature of the underlying projections
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21. Business Valuation
How are the cash flows used in the
income approach portion of a
business valuation determined?
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22. Business Valuation
Eighth Circuit also noted that “Delaware
courts and the financial community have
recognized the discounted cash flow
model as a preeminent valuation
methodology.”
Fifth Circuit in 2004 noted that lost asset
damages from a breached agreement
were “determined by considering what a
hypothetical buyer would pay for the
chance to earn future profits.”
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23. Case Example: Acquisition of a
Financing Company
 Accounting firm advised purchaser of a
financing company on the appropriate
accounting treatment for the purchase
price.
 Substantial amount was assigned to
goodwill by the accounting firm.
 In subsequent years the goodwill was
deemed to be unimpaired by DCF analysis
performed by the accounting firm even
though the Company lost $$$ millions.
 What is wrong with this picture?
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24. Do the Research
Understand near term future of
subject
 Company
 Industry
 Economy
 Other conditions
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25. Subsequent Events
Business Valuation – Generally, a
business valuation will not take
into account subsequent events
unless the facts were known or
knowable.
Lost Profits – A lost profits analyst
must take post-breach events into
consideration.
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26. Estimates at a tipping point
Would there be a difference between
an estimate of business value with
a valuation date of 8/31/08 and an
estimate of lost profits from an
event occurring on that date?
What happened to change the world
after that date?
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27. Income Taxes
Lost Profits
 Lost profit damages are usually
taxable income to the recipient
 Avoid double deduction for taxes
(once during the calculation and
second upon actual payment)
 Lost profits computation doesn’t
take into account income taxes
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28. Income Taxes
Business Valuation
 Lost business value is the price a
willing buyer would pay to a
willing seller
 Hypothetical buyer seeks a cash
return on a business investment
after payment of all business
expenses, including income taxes.
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29. Case Example: Valuing a
Healthcare Practice
Pass-through entity being sold to a
nonprofit entity
IRS and OIG for HHS require that business
valuation estimates treat the business as
though it was a tax-paying entity.
National valuation firm took projected
income, applied depreciation expense,
and calculated hypothetical tax burden on
the balance in order to estimate cash
flows.
What is wrong with this picture?
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30. Discount Rate
Lost Profits
Based on:
 Risk-free rate
 Risk assessment, or
 Plaintiff’s use of funds
Business Valuation
Based on:
 Risk assessment
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31. Prejudgment and post-judgment
interest
Lost Profits
 Both considered
Business Valuation
 Both considered
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32. Thank you for participating
James F. Hart
Managing Director, Lightfoot Group
jhart@lightfootgroup.com
Bill Black
William H. Black, PC
whb@billblackcpa.com
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