|Taking a closer look at economic damage computations
An AICPA task force is studying damages calculations in an effort to help CPAs put more certainty into “reasonable certainty.”
August 14, 2013
Former Secretary of State and Chairman of the Joint Chiefs of Staff Gen. Colin Powell has a rule of thumb regarding tough decisions. If you make a decision before you have 40% of the facts, you are shooting from the hip. If you wait until after you have more than 70% of the facts, you wasted too much time accumulating information (and will likely miss an opportunity). The implication is that in most situations it is not possible to accumulate all of the facts, and, as such, the exercise of good and timely judgment is critical. This decision-making process can be referred to as the Powell Certainty Equation.
The Powell Certainty Equation is designed for the battlefield, which, of course, is easily distinguishable from the environment in which most CPAs practice. That being said, many practitioners involved in Forensic and Valuation Services (FVS) are retained in matters that require the expression of an opinion in court in a disputed matter. Anyone who has testified can tell you that these potentially combative situations seem somewhat analogous to a battlefield. And, given the stakes frequently involved in litigation, FVS practitioners also like to get as close to certain as possible before making critical decisions.
CPAs testifying as experts often have to perform economic damages computations—such as determining lost profits. Courts evaluating the admissibility of such testimony consider whether the amount of the loss was estimated with reasonable certainty. The key question is: How certain is reasonably certain? The AICPA Damages Task Force (DTF), which supports the AICPA Forensic and Litigation Services Committee, is studying this issue and hopes to release a practice aid on the subject sometime in 2014. The DTF, in partnership with the American Bar Association, has focused its research on three core challenges frequently confronted by CPAs performing damage computations.
Is the conduct linked to the loss?
First, before recovering an alleged loss, a plaintiff has the burden of demonstrating that the alleged wrongful conduct is actually linked to the loss. This linkage is called causation. But what is the damages expert’s role related to causation? Can the plaintiff’s damages expert simply assume the existence of the alleged causation? Or is the expert responsible for testing, or even demonstrating, causation?
A related question that frequently arises in this evaluation is whether the expert appropriately excluded the effect of other factors that may have contributed to the loss. For example, assume the plaintiff is a home improvement store that alleges that it has lost sales. Has the expert considered whether any portion of the decline was instead due to the global recession? A review of the case law to date indicates that there is not an absolute answer to these questions. But experts who are unaware of other factors potentially contributing to a reduction in the plaintiff’s income, such as the loss of intellectual property or the loss of key personnel, run the risk of being perceived as less credible.
To test or not to test?
A second question the DTF frequently encountered was this: To what extent does the expert have an obligation to independently test the data or representations provided by the client? For example, assume that the plaintiff is a record label. The plaintiff alleges that the defendant interfered with its relationship with an artist, which resulted in lower-than-expected album sales. The plaintiff’s CEO points the expert to what, in his view, is the best benchmark artist and album for what sales would have been absent the defendant’s harmful conduct. That particular album debuted at the top of the Billboard charts and remained there for many weeks. What analysis does the expert need to undertake, if any, before accepting such a representation?
What to do when there’s little history?
Another question being considered by the DTF is this: What additional analysis, if any, is required when the loss is alleged by a newly established business? Startup businesses often do not have sufficient historical data to enable a reliable forecast of future events. As a result, the expert is often required to make additional assumptions to compute the amount of loss. In many instances, courts will apply a heightened degree of scrutiny to such computations. The DTF hopes its analysis provides a tool to educate FVS practitioners regarding the ways in which courts are likely to scrutinize damages calculations in these scenarios.
So, has the DTF concluded that the courts apply the Powell Certainty Equation? It has not. But, the reality is that essentially all damages calculations require experts and courts alike to make assumptions about what would have happened, but did not, because of the defendant’s alleged conduct. For damages experts, the objective is to make those assumptions with as much information as possible balanced with an appropriate level of time spent doing so.
Every case is different, which means there is no one-size-fits-all solution. But the DTF anticipates that its research will benefit the FVS community by assisting practitioners in developing analyses that are consistent with commonly accepted approaches and methods. That should increase the odds that courts will be satisfied that the threshold of reasonable certainty has been achieved. When it is available, the new practice aid, along with all of the AICPA FVS practice aids, can be accessed by FVS Section members and Certified in Financial Forensics (CFF) and Accredited in Business Valuation (ABV) credential holders here.
Rate this article 5 (excellent) to 1 (poor). Send your responses here.
Greg Regan, CPA/CFF, CFE, is a partner in the Forensic Consulting Services Group in the San Francisco office of Hemming Morse LLP. He serves on the AICPA Forensic and Litigation Services Committee and is the current chair of the AICPA Damages Task Force.