Beware of Forensic Accounting Issues When Calculating Lost Profits

By Theresa Greer, CVA, CFE – Manager, Valuation and Litigation Support Group

Estimating lost profits is not always straight forward. It is important to look behind a company’s financials for signs they might have been manipulated or falsified, especially during a down economy.

What Might Have Been

Lost profits calculations are intended to make a business “whole” again — not to provide a windfall from the loss. Put another way, the calculations estimate what the business would have earned “but for” the opposing party’s alleged wrongdoing or the catastrophic event that interrupted normal business operations.

Financial experts can help a business calculate not just lost sales, but also the avoided costs because of the lost sales. To determine avoided costs, the business’s expenditures generally must be split between:

Direct costs. Examples include raw materials and direct labor, which are often directly related to the production of a specific product or the offering of a service, and almost always vary proportionately with the volume of production.

Indirect costs. These include items such as overhead and indirect labor, which may be fixed or variable. Fixed costs, such as rent, are often the same regardless of the level of production (at least within a certain range). Variable costs, such as shipping expenses, depend on production or sales levels.

Experts typically subtract from lost sales the incremental cost of producing those sales. The incremental cost generally includes direct costs plus indirect costs that vary with the volume of production, both of which are avoided when sales are lost. However, because the business continues to incur fixed costs, despite the lost sales, subtracting those costs can distort the lost profits analysis, if not accounted for properly.

When the Numbers Don’t Add Up

Experts may turn to a company’s income statement or tax returns to help estimate lost sales and avoided costs. But how do you know that historical amounts are accurate? And do historical amounts reflect what’s expected to happen in the future? Experts cannot just accept management’s representations at face value. Instead, they must look at the numbers with professional skepticism.

Consider this hypothetical example: Company A was forced to shut down for six months in order to rebuild its headquarters due to a fire. It had to file a claim under its business interruption insurance policy for lost profits and other damages.

The insurance policy defined lost profits as “net profit before taxes, plus continuing normal operating expenses, including payroll.” Business interruption policies typically compensate the insured for certain payroll and other continuing expenses to relieve the business owner from the burden and expense associated with replacing key employees once operations are restored.

In this case, Company A submitted a claim for lost profits that included the continuing salaries of its six regional sales managers. The company also provided copies of payroll tax returns to substantiate the expense. After interviewing the sales managers, however, the forensic accountant who reviewed the claim became suspicious.

Further investigation revealed the payroll tax returns had never been filed and the taxes had not been paid. Inquiries with relevant government agencies also indicated all six employees were collecting unemployment benefits. As a result of the expert’s forensic skepticism, payroll costs were eliminated from the company’s lost profits and damages claim.

Why Qualitative Matters Count

Professional skepticism also requires experts to consider whether there’s opportunity, rationalization or pressure to commit fraud.  For example, an owner of a struggling business that would be difficult to sell might see an excessive lost profits recovery as his or her way to cash out of the business.

The existence of these three elements of opportunity, rationalization or pressure — known as the “fraud triangle” — does not always indicate an inflated estimate of lost profits. But it is important to be aware of the parties’ motives during challenging times, such as now, and consider their potential effect on the calculation.

Need help estimating your lost profits? Contact Doeren Mayhew’s advisors today.