Chapter 15

Consulting, Litigation Support and Expert Witnesses:

Damages, Valuations and Other Engagements

Critical Thinking Exercise

How many outs are there in an inning?

Professional Standards and Guidance• AICPA’s Forensic and Valuation Services

Section– Litigation support and valuation engagements– “Practice aid”– Special reports– Other publications

Engagement Issues and Professional Responsibility

• Consider the implications• CPAs need to ensure they have or can obtain

necessary skills, training, and experience• Engagement letter– Nature and extent of professional services to be

provided– Outline degree of responsibility assumed

• No opinion about guilt or innocence

Types of Consulting and Litigation Support Activities

• Assessing the risk of fraud and illegal acts’• Evaluating the adequacy of internal control systems• Substantive testing of transactions during an attest

or general consulting engagement• Designing and implementing internal control policies

and procedures• Proactive fraud auditing when fraud is not suspected• Preparing company codes of business ethics and

conduct• Consulting about employee bonding• Developing corporate compliance programs

Tools and Techniques – General Discussion

• AICPA Practice Aid 07-11. Public Domain Reviews and Background

Investigations2. Interviews of Knowledgeable Persons3. Confidential Sources of Information and

Evidence4. Laboratory Analysis of Physical and Electronic

Evidence5. Physical and Electronic Surveillance6. Undercover Operations7. Analysis of Financial Transactions

Commercial Damages• Estimating damages on a case-by-case basis• Understanding and appropriate use of proper

accounting methods• Understanding how accounting information is

used to create the required components of the damages estimate

• Accurate, timely, and professional advice will help attorney formulate effective strategies

Legal Framework for Damages• To pursue legal damages, injured part must prove

2 points– Liability: That the other party was liable for all or part

of the damages claimed– Damages: That the injured party suffered damages as

the results of the actions or lack of actions of offending party

• To prove damages were sustained, injured party must prove 3 additional elements– Accused party was the direct or proximate cause of

the damages– Amount must be calculable to a reasonable degree of

certainty– Accused parties should have been reasonably able to

foresee that damages were likely to accrue

Types of Commercial Damages• Compensatory• Economic loss or restitution– Lost wages– Incremental or incidental expenses– Lost profits– Lost Value

• Reliance• Punitive• Special

The Loss Period• One of the first steps to measuring commercial

damages is to determine the loss period• For breach of contract, it is generally the

remaining term of contract– If the contract term is very long, courts may be

reluctant to enforce it because of issues of uncertainty

– The damages may extend beyond the contract term because the parties have a history of extending or renewing prior contracts

Economic Framework for Damages• Amount of loss may be affected by the

economy or conditions of the industry• Give consideration to the appropriate

economic conditions as a starting point• Next level of consideration is the industry• Performance of entity compared to

competitors• Gather financial statement data, breakdowns,

non-financial data, and tax returns• Consider historical performance• Assessment of cash flows

Quantifying Lost Revenues and Increased Expenses

• Decisions that need to be made– Base amount of revenues or expenses– Choose revenue or expense growth rates– Are historical rates of growth applicable to the

damage period?– Use straightforward method or more

sophisticated method

• Methods used to develop estimates of lost sales and incremental expenses– The Before and After Method– The Benchmark (“Yardstick”) Method

Determining Lost Profits

• Consider impact on “bottom-line” net income• Incremental costs subtracted from

incremental revenues• Damaged party must mitigate its damages• AICPA practice Aid No. 7 “Litigation Services”– Losses characterized as lost profits, lost value, lost

cash flows, net revenue and incremental costs

Determining Incremental Costs• Incurred as a result of plaintiff’s action or

inaction that would otherwise not be incurred• Infrastructure requirements in order for the

plaintiff to have the capacity necessary• Cost Behavior– Fixed– Variable

• Relevant range• Allocated costs• Accounting estimates

Determining Incremental Costs

• Methods for determining cost behavior– Account analysis– High-low method– Graphics– Statistical (regression, survey and sampling)– Engineering

The Time Value of Money

• Lost incremental profits before the matter can be resolved between the parties– Pre-judgment interest

• Amounts that would only be realized in future periods after the dispute has been resolved

• AICPA Practice Aid 06-4 “Calculating Lost Profits”

• Cost of equity

Communicating and Defending the Results of Commercial Damage Estimates• “Tire-hits-the-road”• Venues to be evaluated, scrutinized or challenged– Periodic meetings with attorneys for whom you have been

engaged– Pre-judgment testimony related to summary judgment– Meetings with counsel where they determine how to

proceed with the case– The written report– Deposition testimony– Regulatory or administrative hearings– Alternate dispute resolution forums– Trial testimony

• Critique opposing side expert• Neutral and objective position

Valuations• Value business, business ownership interest,

security, or intangible asset• Statement on Standards for Valuation Services

No.1– Overall engagement considerations– Development of the valuation– Valuation report and appendices

• Organization certificates

Overall Engagement Considerations

• Assessment of economic and industry conditions

• Ability to identify, gather and analyze relevant data

• Simplified versus complex valuation methods– Limitations– Assumptions

• Understand nature of client’s expectations and planned use for valuation services outcomes

Type of Valuation Engagements• Two types of engagements– Valuation• Data and information are continually gathered,

updated, incorporated and analyzed• Use most appropriate methods and approaches

– Calculation• Outline assets, valuation methods and other aspects of

the engagement• Service provider agrees in advance• Professional proceeds to apply agreed-upon

procedures

Measures of Value

• Book value– Balance sheet value

• Liquidation value– Cash likely received by owner under pressure to

sell item quickly

• Market value– Willing buyer and seller come to terms under

normal market conditions

Determining Market, Fair Market and Fair Value

• Two considerations that determine market and fair market value of an asset– Future income stream– Difference between future income stream and

alternative investment options

• Three methods used to determine fair market values– Discounted earnings and cash flows– Market comparables valuation– Asset and liability market valuation

Discounted Earnings and Cash Flows

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Estimating the Risk-adjusted Discount Rate

Four methods to develop risk adjusted discount rate and its related cash flows– CAPM– Weighted average cost of capital (WACC)– Bond-equity additive method– Build-up method

Forecasting Income and Cash Flows

• Consider data in the following areas– Nature of the business– General economic and industry outlook– Book value of equity– Earnings capacity of the company– Dividend paying capacity– Goodwill and other intangible assets– Previous sales of company securities– Market prices of comparable companies– Number, type and age of organizational facilities– Classes of debt or equity and their associated rights– Industry markets and conditions– Business risks

Forecasting Income and Cash Flows

• Grounded in historical financial performance• Free cash flows• Related parties– “Arm’s length”

• Attempt to gather the following– Forecasts of projected financial results– Articles on industry-related valuation issues– Relevant client information

• Calculate applicable ratios and analyze trends

Asset Valuation Models• Assumes balance sheet reasonably identifies

company’s assets and liabilities• Appraisers value assets• Net present value techniques estimate

liabilities• Two shortcomings– Does not account for benefits associated with

asset synergy– Fails to account for significant intangible assets

Market and Accounting-based Comparable Models

• Benchmarks, guidelines and rules of thumb• Useful as a reasonableness check on results of

other analyses• Should not be used as stand-alone method

unless other method is not possible• Address shortcomings if used as stand-alone

method

Valuation Discounts and Premiums

• Majority and minority owners with various control rights

• Asset ownership interests have differing marketability or liquidity attributes

Other Ownership Interests Subject to Valuation

• Valuing debt• Preferred stock• Convertible debt• Stock• Warrants• Options• Intangible assets

Conclusion of Value• Number or specific range• Reconcile and correlate results from more

than one methodology or assumption• Consider reliability of the valuation outcome• Valuation professional has 2 choices– Primarily rely on 1 method using other methods as

reasonableness checks– Rely on multiple methods to determine the value

or specified range

The Valuation ReportAccredited Senior Appraiser’s (ASA’s) Principles of Appraisal Practice– Description of the property– Objectives of the appraisal work– Statement of contingent and limiting conditions– Description and explanation of appraisal method– Statement of appraiser’s disinterestedness– Appraiser’s responsibility to communicate each

analysis, opinion and conclusion– Mandatory recertification statement– Signatures and inclusion of dissenting opinions

The Valuation Report• Uniform Standards of the Professional Appraisal Practice

(USPAP)– Identify and describe business enterprise, assets or equity– State purpose and intended use of appraisal– Define the value to be estimated– Set forth the effective date of the appraisal and report– Describe the extent of the appraisal process employed– All assumptions and limiting conditions that affect analyses

opinions and conclusions– The information considered, appraisal procedures followed and

reasoning that supports the analyses, opinions and conclusions– Any additional information that may be appropriate to show

compliance– Rationale for the valuation methods and procedures used– A certification in accordance with Standards Rule 10-3

Personal Injury, Wrongful Death and Survival Actions

• Three types of damages that may ensue– Losses to the individual– Losses to survivors– Losses to the estates of decedents

• More technical than analytical• Guidelines are relatively straight forward do

to their common nature• Inflation is a major challenge

Losses: Personal Injury• Injured person survived and subsequently lost

income• Experts estimate reduced earnings and other

forms of support as a result of the injury• May incur future costs or earnings capacity may

be reduced as part of a permanent injury• Injured person may suffer 5 types of losses– Loss of earnings– Loss of employment benefits– Losses associated with ability to perform “non-market

services”– Medical costs– Life care costs

Losses: Wrongful Death and Survival Cases

• Death of a person where another party may be held accountable can result in two types of cases– Wrongful death• Primary right of recovery resides with survivors

– Survival actions• Estate of deceased has primary right of recovery• “What if”

• No need for medical or life-care costs

Analysis of Earnings Losses• Investigation of five areas– Determining the basis for earnings losses– Analysis of employment history and related past

earnings– Projection of probable career paths– Determining the proper earnings for each projected

career path– Consideration of other factors on earnings losses

• Three methods for projecting earnings– Case-by-case method– Below-market discount method– Total offset method

Analysis of Lost Employment Benefits Associated with Lost Earnings

• Generally, not all employment benefits are lost when an injury occurs

• Applicable standard are those benefits the injured party has lost– Value to employee not cost to employer

• Additional analysis is required for benefits mandated by government laws and regulations

Analysis of Lost “Non-Market Services”• Approaches used to estimate costs– Actual cost to develop and utilize substitute

services– Accumulate hours associated with activities and

multiply by reasonable rate

• Issues with “non-market services”– Injured person may have provided services well

into retirement– Injured party may not have provided services for

remainder of life

Analysis of Medical and Life Care Costs• Identify requirements in the following areas– Types of needs the injured person will have– How long those needs are likely to continue– Changes in those needs over time– How often those needs will require services– Special equipment required– Types of professionals who will need to provide

services• Once listing is complete, estimates of costs

can be developed• Seek out bids for a life care annuity

Injured Children, Homemakers and Retired Persons

• Generally have limited earnings and no W-2’s• Children– Have made few decisions that would determine his or

her future– U.S. Bureau provides statistics based on educational

assumptions• Homemakers– Estimate cost of home services that will need to be

contracted with outside parties• Retired persons– Earning capacity– Will retiree ever enter work force again?