CPAs often are engaged as experts to assist the trier of
fact in the quantification of lost profits, one type of economic damage. The calculation of lost profits can be required in litigation involving a breach of contract, business tort, patent or copyright infringement, or a breach of fiduciary duty.

In order for the lost profits calculation to be admissible, an expert must use acceptable calculation methods and appropriate assumptions based on the facts and evidence
of the case. Additionally, the underlying assumptions
should not be based on speculation thereby tainting the entire calculation.

Depending upon the facts of the case, a past and/or future lost profits calculation may be required. A calculation of past lost profit damages (for damages suffered before
the date of a trial) is required when the defendant’s alleged wrongful acts cause a plaintiff’s actual operating results
to be lower than they would have been absent the defendant’s acts.

Typically, the calculation of past lost profits compares the plaintiff’s actual historical operating results to a forecast of the plaintiff’s operating results assuming that the defendant’s acts had not occurred; the difference is the past lost profits damages.

Normally, the actual past operating results of the plaintiff are based on verifiable accounting records; however, the forecast of the plaintiff’s operating results, assuming that the defendant’s acts had not occurred, is based on a hypothetical situation (i.e., absent the defendant’s acts). As such, the forecast may not be readily verifiable and subject to a level of uncertainty.

The calculation of future lost profit damages (for
damages suffered after the date of the trial) is further complicated by the need to forecast not one, but two sets of operating results for the plaintiff. Future lost profit damages occur when the plaintiff’s expected future operating results are lower than they would have been without the defendant’s acts.

In this calculation, the expert is required to forecast the plaintiff’s future operating results given the current operating environment and to forecast the plaintiff’s future operating results assuming that the defendant’s acts had not occurred.

The forecasts used in past and future lost profits calculations are based on assumptions about past events that did not occur and future events that may or may not occur and, as such, are subject to a level of uncertainty. It is the responsibility of the expert to reduce the level of uncertainty through the application of principles and practices set forth in authoritative literature promulgated by the courts and leading economic damage experts.

Specific to the issue of speculation, in order for the lost profits calculation to be admissible, the expert must comply with the principles of reasonable certainty and best available evidence in the preparation of the underlying forecasts. The ultimate test is whether the item being forecast (revenue, volume, cost or profits) can be predicted with reasonable certainty. Forecasts that are based purely on speculation or the positive outcome of contingencies or possibilities are not acceptable.

Whereas all forecasts will contain uncertainties, the authoritative literature indicates that an expert has the responsibility to utilize the best available evidence. The authoritative literature sets forth a number of evidence sources that should be considered by the expert, including prior experience of the company, prior experience and trends of its industry and competitive factors.

In order to avoid being considered speculative, the lost profits calculation and its underlying assumptions should be: (1) based on facts and evidence set forth in the case; (2) based on a comprehensive evaluation of the facts and circumstances of the case and the gathering of sufficient, corroborating evidentiary matter; and (3) proximally related to the defendant’s acts.

Speculative characteristics of lost profits calculations

1. The assumptions to a lost profits calculation must be based on facts and evidence set forth in the case or they may be considered speculative.

All forecasts require the use of assumptions, but assumptions that are not grounded in evidence can be considered speculative. For example, an assumption that a company’s future market share will increase that is unsupported by historical growth trends, additional
products or the elimination of a major competitor could be considered speculative.

Other revenue assumptions that are often subject to challenge include product pricing trends, product volume and mix trends, and the duration of significant customer purchase orders. Cost assumptions that can be challenged include the duration and history of labor contracts, the terms of major supplier pricing and volume agreements, plant capacity and the way that operating costs fluctuate with changes in volume. For example, reliance on an internally prepared budget indicating significant cost savings in the future may be considered speculative if past budgeted cost reductions were not achieved or if the cost reductions are unsupported by current market data.

Forecasts involving an uncertain transaction (such as municipal approval of a special project) or a future unknown event (attracting investors at favorable rates of return) may be considered speculative. Additionally, forecasts that are predicated on the successful conclusion of negotiations that have not yet occurred (such as successful resolution of a customer pricing issue) may be considered speculative. Assumptions involving a risky business opportunity, an untested product, or entry into new or previously non-viable markets may cause speculation in the forecast.

In the past, forecasts involving new or start-up business ventures were considered speculative by their very nature and damages were not allowed. However, forecasts for new or start-up businesses are now acceptable if they are based on sufficient evidence and reasonable assumptions. Factors that affect the speculative nature of new or start-up businesses include the experience of the principles in similar undertakings, the maturity of the industry, the experience of others in the industry, and competitive forces in the industry itself.

2. Forecasts must be based on a comprehensive evaluation of the facts and circumstances of the case, and the development of reasoned assumptions.

The expert generally obtains the knowledge needed to prepare the lost profits forecasts by first analyzing the company’s historical operating results. Such analysis may include trend analysis of the company’s revenue, cost structure, profitability, and key financial ratios. In addition to the company’s historical financial and operating results, the expert should consider the company’s product mix, product life cycles, market share, competition, business plans, distribution channels, plant capacity, and
capital requirements.

The expert also should evaluate the industry in which the company operates, including industry growth trends, new product technologies, regulatory changes within the industry, and competitive and economic forces. Finally, the expert should consider the effects on the company of the local, regional and national economy and economic forecasts for the future.

Expert opinions or assumptions based solely on the expert’s past experience are no longer sufficient. Rather, the expert’s assumptions must be the result of a comprehensive evaluation of facts of the case, including company research, and based on evidence in the record. For example, lost profits calculations may be considered speculative if the expert simply relies on the testimony of the company’s owner as to key assumptions, or justifies such reliance based solely on his own knowledge and experience in the industry. Instead, wherever possible, the expert should obtain sufficient corroborating documentation for the owner’s testimony based on other facts and evidence presented in the case.

3. The damages claimed must be proximally related to the defendant’s acts.

Failure to determine how the defendant’s acts resulted in the damages claimed can result in a speculative lost profits calculation. For example, failing to prove the company’s sales decline was a result of the defendant’s acts could render the calculation speculative. Additionally, use of a forecast period that exceeds three to five years may be considered speculative because beyond that time the proximal link to the event that gave rise to the damages may be lost. A longer forecast period is generally not used unless the company holds special rights such as a long-term contract, a patent or a long-term exclusive marketing agreement.

In addition to establishing proximity, the expert must consider whether factors unrelated to the defendant’s acts had a significant effect on the historical operating results or the forecast. For example, consider a past lost profits calculation for a breach of a supply contract where the plaintiff’s profitability declined throughout the five-year damage period. The expert must eliminate outside factors, such as a national recession, competitive forces, technology changes or any other issue unrelated to the defendant’s acts that may have affected the profitability during the five-year period. Failure to do so could render the lost profits calculation speculative.

Additional factors
Two other factors are worth mentioning: the failure to adjust the calculation for future risk and the failure to perform reasonableness tests on the resultant lost
profits calculation.

Lost profits calculations generally are adjusted for the uncertainty (or risk) associated with the use of forecasts. The adjustment for uncertainty is normally reflected in the discount rate used to discount the forecasted lost profits to present value. Failure to apply an appropriate discount rate can result in a speculative lost profits calculation.

Experts are required to perform certain tests to validate the reasonableness of the damages claimed, often referred to as “sanity tests.” Individually, the assumptions that are required for a lost profits calculation could appear reasonable, but if collectively the resultant damages are not reasonable, the lost profits calculation may be considered speculative.

In summary, the forecasts used in past and future lost profits calculations are based on assumptions of hypothetical events and are subject to level of uncertainty. It is the responsibility of the expert to reduce the level of uncertainty through the application of principles and practices promulgated by the courts and leading economic damage experts.

The lost profits calculation and its underlying assumptions should be based on facts and evidence set forth in the case and a comprehensive evaluation of such evidence, including the operations of the company, its industry and the competitive and economic forces affecting it. Further, the assumptions to the lost profits calculation must be based on sufficient corroborating evidentiary matter including evidence that the damages claimed are proximally related
to the defendant’s acts. Failure to do so could render the lost profits calculation speculative and the expert’s testimony inadmissible.

About the Author
Patrick G. Dunleavy recently joined Virchow, Krause & Co. as a partner and firm-wide director of commercial litigation support services. Mr. Dunleavy recently spoke on “Basic Economic Damage Calculations: Business Claims,” at MACPA’s Litigation & Business Valuation Conference in Novi. He can be reached at 248.357.2400 X238 or by e-mail at pdunleavy@virchowkrause.com.