Professional Standards and Guidance

The American Institute of Certified Public Accountants (AICPA) created the “Forensic and Valuation Services” (FVS) Section. This section, in concert with the efforts of the greater AICPA organization, has created several practice aids, special reports, and other publications to support the certified public accountants’ efforts with regard to litigation support and valuation engagements. However, the AICPA makes clear that a “practice aid” does not establish standards, preferred practices, methods, or approaches, nor is it to be used as a substitute for professional judgment. Other approaches, methodologies, procedures, and presentations may be appropriate in a particular matter because of the widely varying nature of the litigation services, as well as specific or unique facts about each client and engagement. Professionals involved in litigation support services are encouraged to consult with counsel about laws and local court requirements that may affect the general guidance contained in the practice aids.

As of this writing, AICPA special reports, practice aids, and other publications that address the concerns, issues, methodologies, and other aspects of litigation support, forensic accounting services, and valuations include the following:

• A CPA’s Guide to Family Law Services
• Assets Acquired to Be Used in Research and Development Activities
• Attaining Reasonable Certainty in Economic Damages Calculations
• Forensic and Valuation Services Practice Management Toolkit
• Business Valuations for Estate and Gift Tax Purposes
• Calculating Intellectual Property Infringement Damages
• Discount Rates, Risk, and Uncertainty in Economic Damages
• Engagement Letters for Litigation Services
• Forensic Accounting—Fraud Investigations
• Forensic and Valuation Services: Calculating Lost Profits
• Forensic and Valuation Services: Engagement Letters
• Forensic & Valuation Services: Related Standards
• FVS (Forensic and Valuation Services) Consulting Digest
• FVS (Forensic and Valuation Services) Eye On Fraud
• Introduction to Civil Litigation
• Measuring Damages Involving Individuals
• Mergers and Acquisitions Disputes
• Providing Bankruptcy and Reorganization Services, Volume 1—Litigation and Dispute Resolution in Bankruptcy
• Providing Bankruptcy and Reorganization Services, Volume 2—Valuation in Bankruptcy
• Serving as an Expert Witness or Consultant
• Testing Goodwill for Impairment
• Valuation of Privately-Held-Company Equity Securities Issued as Compensation
• VS (Valuation Services) Section 100 Toolkit

In the area of fraud examination, the Association of Certified Fraud Examiners (ACFE) offers the Fraud Examiners Manual, a virtual encyclopedia of information that addresses four major topics:

• Financial Transactions and Fraud Schemes
• Law
• Investigation
• Fraud Prevention and Deterrence

Further, the ACFE publishes Fraud Magazine and a wide range of antifraud resources that can be useful to the antifraud professional.

In the area of valuations, in addition to efforts by the AICPA, the National Association of Certified Valuators and Analysts (NACVA) provides textbook-like materials for education and training as well as courses and an examination that supports their Certified Valuation Analysts (CVA) credential.

The Journal of Forensic Economics, as well as several books on “forensic economics,” provide useful information on personal injury and wrongful death claims that often require the valuation of lost wages, fringe benefits, household services, and other losses.

Although these publications and their content are categorized as nonauthoritative, they provide useful information to practicing professionals. As fledgling fraud examiners and forensic accountants continue to develop their knowledge, skills, and abilities, these and other publications can be included in the professionals’ libraries and maintained among their important resources.

Engagement Issues and Professional Responsibility

Fraud examination, forensic accounting, and litigation support activities can expose the traditional professional to more risk than consulting engagements and, possibly, to more liability than traditional auditors. For example, professionals may be asked to evaluate business practices and transaction activities and are normally engaged by one side or the other—looking for “defense” of their client’s choices, decisions, and judgments while taking a critical view of the other side’s similar actions.

Professionals and their firms’ names may appear in the media and may even be accused of using less than professional approaches, turning a “blind eye” to their clients’ practices and activities; ignoring or not giving proper disclosure to important assumptions that constitute part of the engagement; as well as other professional shortcomings. Prior to entering into any litigation support, forensic accounting, or fraud examination activity, professionals are encouraged to consider the implications to their business reputation, professional stature, and possibly threats or personal harm or injury that may be attributable to their participation in the disputed issues. As with all engagements, professionals need to ensure that they currently have or can obtain the necessary skills, training, experience, and other resources required to participate in the resolution of the issues at hand.

An engagement letter is recommended for such work. If a written engagement letter is not provided, the scope of the engagement and other relevant information may be obtained as part of an oral arrangement. If the engagement is agreed upon through verbal discussions, the practicing professional should clearly note the discussion in memo format, paying particular attention to the wording used by the client or the client’s attorney.

The written engagement letter should describe the nature and extent of professional services to be provided. If the practicing professional is generating the engagement letter, the specialist should outline the degree of responsibility assumed and any limitations on liability. Importantly, any verbal or written understandings should not describe the expected outcomes of the work to be performed, make any guarantees regarding expected findings or results, and should not commit the practicing professional in any way to a particular position, opinion, or any aspect of the case that is grounded in judgment. That is the responsibility of the judge, jury, or other trier-of-fact. The engagement letter should make clear that the procedures and analyses to be performed in connection with the engagement do not constitute an audit, review, or attestation engagement as described in authoritative literature promulgated by the AICPA or PCAOB. It should also indicate that the engagement constitutes consulting services and is subject to applicable standards.

Practicing professionals, because of the nature of their independence and objectivity, generally, should not accept contingent fee arrangements. Instead, compensation should be based on hours worked and time spent on the engagements. The practicing professional may seek to obtain a retainer in advance. This simply helps ensure that the client has the ability to pay for the services rendered. If not paid in a timely manner, he or she may seek to suspend the engagement until money has been collected. Further, the professional may withhold the sharing of work product until the fees have been paid. But unpaid fees provide an opportunity for the opposite side and its counsel to attack the professional’s independence, judgment, and credibility. Opposing counsel may suggest that the arrangement is of a contingent fee engagement and that fees only be paid upon a favorable resolution for the client, even if this is untrue.

Fraud examination, litigation support, and forensic accounting activities can be staffed like any other engagement. Assistants and other professionals may be used to accomplish duties such as clerical tasks and sophisticated analyses; to conduct and document interviews; and to gather, compile, and analyze important books and records—financial, nonfinancial, and qualitative. However, the engaged professional is responsible for supervising the work performed by others, properly training assistants, and, ultimately, taking responsibility for all conclusions, judgments, decisions, and opinions.

Thus, although testifying professionals need not complete the work themselves, they are expected to be able to describe the nature, extent, and timing of all work performed. They must also be able to defend their conclusions, the outcomes, and their professional opinions. Given the adversarial nature of fraud examination, litigation support, and forensic accounting engagements, practicing professionals should expect their work product to be scrutinized closely, and they should be prepared to describe and defend all choices made.

Like the fraud examiner, the testifying expert should have no opinion concerning the ultimate outcome of the litigation. For practical reasons, the practicing professional is not an attorney, so he or she may not entirely understand or contemplate subtle nuances of the law. Similarly, forensic professionals may be working directly, indirectly, or tangentially with other experts whose areas of expertise may be unfamiliar to them. Thus, forensic accountants need to be careful of their reliance on the work of others. From a more professional perspective, the ultimate decision maker is the trier-of-fact—the judge, jury, or other person or body, saddled with the responsibility for deciding the case based on its merits from the evidence offered. The fraud examiner can have no opinion about the guilt or innocence of alleged fraudsters. Similarly, the fraud examiner or forensic accountant should have no opinion concerning the ultimate outcome of the dispute. This position is consistent with practitioners remaining unbiased and performing their work with impartiality. Thus, they do not act as advocates for a client or their allegations, assertions, or positions in a dispute.

Professional standards for expert witnessing do not require independence, as described in the AICPA, ACFE, NACVA, or other similar codes of conduct. However, depending on the nature of potential conflicts of interest and other issues of independence, opposing counsel may raise concerns over this to question a practicing professional’s credibility and objectivity. Further, although professional standards may not require independence, laws and regulations, such as the Sarbanes–Oxley Act of 2002, may preclude some CPAs from performing litigation support and other similar consulting services under certain circumstances. General standards require professional competence, due professional care, proper engagement planning and supervision, and the collection and analysis of sufficient relevant data to support (provide a reasonable basis for) the conclusions and opinions offered.

Types of Consulting and Litigation Support Activities

Fraud examiners and forensic accountants can be engaged as consultants and experts to provide a wide array of services. First, not every engagement is related to litigation. But fraud examination and forensic accounting professionals get involved in many different aspects of issues that may someday be the subject of litigation. First, fraud examination is a methodology for resolving fraud allegations—from inception to disposition, including obtaining evidence, interviewing, writing reports, and testifying. However, fraud examiners, as designated by the ACFE, also assist in fraud prevention, deterrence, detection, investigation, and remediation. Thus they may be engaged to consult regarding indications or allegations of fraud, but also in any number of other areas. Similarly, CPAs may provide consulting services that are concerned with fraud but are not necessarily fraud examination services, auditing, or litigation support services. These might include the following¹:

• Assessing the risk of fraud, noncompliance and illegal acts
• Evaluating the adequacy of internal control systems
• Substantive testing of transactions during an examination or a 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

In litigation advisory services, accountants use their knowledge, skills, abilities, experience, training, and education to support legal actions; such activities are normally carried out by forensic accountants and fraud examiners acting as consultants, expert witnesses, masters, and special masters. Even though forensic accountants may provide litigation support services in criminal cases, the majority of them are in the area of civil litigation.²

Experts and expert witnesses are professionals who have been offered as such by parties to the litigation. However, the ultimate decision to qualify a witness as an expert is at the judge’s discretion, and the jury is the ultimate arbiter of credibility. Experts in the litigation advisory services context are expected to provide testimony, before a trier-of-fact, that includes their findings, conclusions, and opinions. Testimony may be provided in any number of venues, including federal, state, or local courts, depositions, regulatory hearings, arbitration, and mediation. Generally, the entire work product of the designated expert is discoverable by the other party. Work product includes not only the expert’s report and main analyses but also all notes, work papers, evidentiary materials collected as part of the case, supporting analyses, research, documents, and data reviewed or relied upon by the expert as part of their engagement. Drafts of reports, handwritten notes, and marginalia are all considered part of the expert witnesses’ work product. Thus, experts need to maintain careful vigilance over all aspects of their work and the impact that it can have on the parties to the litigation. That said, because the professional is not an advocate for one side or the other, the notes, marginalia, and draft reports should not typically be risky; however, they can give insight into how the professional developed conclusions and opinions, uncover any bias in performing the work and other procedures, and shed light on preliminary, but ultimately discarded, theories of the case that opposing counsel may find valuable to their side of the case.

Tools and Techniques: General Discussion

The term forensic is generally defined as used in or suitable to courts of law or public debate. When applied to fraud examination or forensic accounting, forensic has evolved to include procedures to gather evidence systematically, using investigative techniques such that the results derived from the procedures can be presented in a court of law or similar setting (arbitration, mediation, regulatory hearing, or other setting) where disputes are heard and resolved. Some of the various professional environments applicable to forensic engagements and fraud examination specifically associated with financial issues and disputes include accounting as well as the following:

• Auditing
• Fraud examination
• Law
• Sociology
• Psychology
• Criminal justice
• Intelligence
• Cyber security
• Computer forensics
• Computer data extraction and analysis, data mining, big data, data analytics
• Forensic sciences

In addition, most engagements are grounded in a specific industry, competitive environment, and/or business operational settings. Thus, the typical fraud examination, forensic accounting, or litigation support engagement usually requires the development of at least some knowledge of the business models, operational procedures, and other aspects unique to the organization and industry under examination. The purpose of the engagement is to utilize the various methodologies appropriate to the issue at hand, combined with research and investigative skills, to collect, analyze, and evaluate evidence and then to interpret it and communicate the outcomes. Not all engagements in this area constitute litigation support, because, as a practical matter, most engagements do not result in courtroom testimony. Nevertheless, all engagements require investigative tools and techniques to develop the most accurate and supportable conclusions and opinions. Therefore, the examination needs to be organized and structured to assist in the evaluation and interpretation of the evidence.

AICPA Practice Aid 07-1 describes seven forensic investigative techniques and compares and contrasts them with similar evidence gathering activities of auditors:

Legal Framework for Damages

Generally, to successfully pursue a claim for legal damages, the allegedly injured party must prove two points:

• Liability: That the other party was responsible for all or part of the damages claimed
• Damages: That the injured party suffered certain losses as the result of the actions or lack of actions of the offending party

To prove that damages were sustained, the injured party also needs to prove three additional elements. First, that the accused party was the direct or proximate cause of the damages, by either causing or contributing to them as a result of their conduct. Second, the amount must be calculable to a reasonable degree of certainty. Third, the accused parties should have been reasonably able to foresee that damages were likely to accrue as a result of their conduct. Note that such conduct may include action or inaction either may lead to large damage awards.

Generally, damages result from a tort or breach of contract. With a tort, the action itself leads to direct harm. In breach of contract, the relationship between the parties was previously defined in an agreement, and the courts are asked to interpret that contract. Some cases involve millions of dollars and may hinge on a single word or phrase found within a contract of hundreds of pages. Some clauses that seem clear at the inception of a contract are later interpreted differently by the parties. In those cases where the parties cannot reach agreement, the courts are asked to settle the matter. Further, no contract can anticipate every contingency. Those aspects of the relationship between the parties that are not specified in the contract are subject to negotiation; if the parties cannot negotiate a reasonable basis for moving forward, they may choose to litigate the matter and let the courts decide.

Torts, on the other hand, occur when a party has been injured, even though the parties to the suit do not have a contractual relationship. Torts may include theft, fraud, infringement of trademarks, copyrights, trade secrets or other intellectual property, professional malpractice, defamation, or negligence.

Causality is central to the issue of damages. Even if the damages sustained by a plaintiff are substantial but the impact of the defendant’s actions cannot clearly and conclusively be associated with them, the plaintiff may not prevail in the action. The plaintiff’s goal is to connect the plaintiff’s conduct with the damages sustained. Plaintiffs may use graphics, such as timelines, or statistical methods to demonstrate the alleged causality between the defendant’s conduct and their harm.

Types of Commercial Damages

Successful plaintiffs may be awarded different types of damages:

• Compensatory
• Economic loss or restitution
  • Lost wages
  • Incremental or incidental expenses
  • Lost profits
  • Lost value
• Reliance
• Punitive
• Special

Compensatory damages are those amounts designed to compensate the injured party for some specific loss. Economic loss or restitution damages compensate for a specific loss and recognize that the damages carry into future periods. Reliance damages put the injured parties back where they would have been if the cause of action had not happened. Punitive damages are monetary awards that have the intention of punishing the defendant sufficiently to act as a financial deterrent, to discourage similar actions in the future. Finally, courts may award special damages to plaintiff or defendants.

The Loss Period

One of the first steps in measuring commercial damages is determining the loss period. For a breach of contract claim, it is generally the remaining term of the contract. However, exceptions are sometimes warranted. In some cases, a period other than the contract term is more appropriate:

1. If the contract term is very long, courts may be reluctant to enforce it because of issues of uncertainty, especially in industries where contracts are altered prior to the completion of the full term.
2. In other cases, the damages may extend beyond the contract term because the parties have a history of extending or renewing prior contracts.

Thus, although the contract period may appear to be the logical choice, the facts and circumstances may indicate that a different measurement period is more appropriate.

The measurement period for commercial damages related to torts can be more difficult because, unlike breach of contract claims, a preliminary starting point is not available. With torts, the loss period starts when the tort begins and ends when business returns to normal—either when revenues rebound or expenses decline to appropriate levels. The damage period for a tort can be considered closed, open, or infinite. It can be infinite when the damaged company has effectively been put out of business. In such cases, business operations and performance obviously can never return to normal. A closed period, on the other hand, is when there is a loss in sales or additional expenses during a time frame that can be reasonably defined, which has ended prior to the calculation of damages. An open period of damages indicates that, at the time of the forensic work, the damage period still exists and is expected to continue into the future.

Economic Framework for Damages

Commercial damages do not occur in a vacuum. The amount of loss may be affected by the general economy, the conditions of the industry, the damaged entity’s competitive environment, and other specific issues. In some cases, the damage assessment may be restricted to the organization without detailed, formal evaluation given to the economy, industry, and competition because their impact is judged negligible. Therefore, even if not formally documented, this may be an inherent assumption behind the work of the antifraud professional or forensic accountant.

The impact of the overall economy on the entity under study and on the particular types and amounts of damages being sought is the first step in documenting losses as a result of commercial liability—tort or breach of contract. The global and national economies are cyclical, usually either expanding or contracting. For the United States, one of the most prominent indicators of the national economy is the gross domestic product (GDP). The more GDP generated, the better the economy is. Although very large firms are often affected by global or national economic trends, smaller firms can also be affected by regional economic conditions. If need be, economic performance can be further localized by evaluating a state, city, county, town, or even, in some cases, at the neighborhood level. Although data on the global, national, and, in some cases, the regional economy tend to be gathered with regularity and made available to the public, economic indicators by state, city, county, town, or neighborhood vary considerably by the amount of data available and how long it takes to have these data collected, summarized, analyzed, and released to the public. Nevertheless, the fraud examiner and forensic accountant should give consideration to the appropriate economic conditions and available data as a starting point for any damage analysis.

Once the appropriate overall economic data have been identified, and the impact, if any, on the damage claim has been assessed, the next level of consideration is the industry—the number of organizations that offer similar products or services and possibly compete with one another for customers and market share. An industry assessment is based on the number of competitors, the degree of concentration, and the extent of vertical integration. Competition, combined with the overall economic conditions, often explains at least some portion of the organization’s performance and, thus, may be an integral part of the damages analysis. When the overall industry is growing and performing well, the average organization tends to perform in a similar manner. The condition of the industry and its growth can be assessed on numerous levels—sales and revenues, shipments to customers, employment levels, and other financial and nonfinancial dimensions.

The U.S. Department of Commerce tracks numerous statistics based on SIC (standard industrial classification) code. Further, companies such as First Research, Moody’s, Value-Line, and others provide periodic industrial performance metrics. Like the overall economic data, the applicability of the industry data to a firm-specific damage claim cannot be arbitrarily assumed. The firm subject to damages analysis may be on the fringes of the industry and have very little in common with it. At the other end of the spectrum, the industry may have few participants, and the company under study may be the largest participant and overall driver of industry performance. Thus, even though the company and industry data are highly correlated, industry analysis may yield little value.

Notwithstanding the appropriate means by which industry data should be incorporated into damage analysis, the industry should be examined for the damage period or left out for appropriate reasons. Related to the overall industry, when appropriate, the performance of the entity under study to its key competitors may be an important part. The damaged organization can be compared along the dimensions of economies of scale—critical supplier and customer relations, technological advantages and shortcomings, life cycle of the company and its products—that help the fraud examiner or forensic accountant to understand the organization’s situation.

Once the economic and industry data have been gathered and evaluated for applicability and assessed for impact on firm performance, the next step is to compare them to those of the firm under consideration. As a starting point, financial statement data should be gathered, including balance sheets to assess financial condition; income statements to assess operational performance; and cash flow statements to determine the sources and uses of cash; and the ability of the company to generate cash flows from operations, invest in the future of the organization, and examine choices for financing (obtaining debt and equity capitals and paying returns on that capital in the form of dividends and principal repayments).

Optimally, the financial statements should be collected on a monthly basis, but, in many cases, quarterly and annual financial data will suffice. In addition to financial statements, another important source can be tax returns. They not only show the taxable income and other information provided to the Internal Revenue Service, but the return also has an annual balance sheet and a reconciliation of book to tax income. Another important source of data to assess commercial damage amounts is subsidiary, regional, divisional, product line, and other financial statement data breakdowns. In many cases, the alleged liability (the cause of the damages) affects only a portion of the business, and such internal breakdowns allow for a more fine-tuned analysis and estimation of damages.

Finally, nonfinancial data are often very important for developing and evaluating the reasonableness of damage claims. Although it is not always available, the ability to break the financial statement numbers into prices and quantities can be valuable. In some cases, nonfinancial data (volumes or quantities) may allow the data to be broken into prices and quantities. Then, each element can be considered independently and in concert with an effort to develop and evaluate damages.

Other important considerations can be the historical performance and financial conditions; rates of growth (historical and projected); sales data; and sales by product-line, key customers, regions, and divisions. Fraud and forensic accounting professionals understand that, for financial statements, the account balances and the accounting for specific transactions and groups of transactions—such as accounts receivable—are often affected by the numerous discretionary choices made by accountants or management. Executives and managers make choices about the applicability of specific, generally accepted accounting principles; the discretionary aspects of applying them; the necessity of using estimated and other judgments to determine the amounts reflected in the books and records; and the impact of unusual, one-time (nonrecurring) transactions.

These discretionary aspects are available so that financial managers and executives can make choices that best reflect the overall economic performance of the business. These can also be used for less than desirable goals, such as managing earnings and hitting one-time performance goals and objectives. Unfortunately, they also may present the opportunity for collusion and management override of internal controls—to record fictitious journal entries; develop unsupportable accounting judgments and estimates; and record unusual, one-time events that do not reflect the economics of the underlying transactions. Such manipulations may be systemic and embedded in the processes that have an impact on regularly recorded transaction amounts.

Using the financial and nonfinancial data collected, one of the most common firm-specific assessments is ratio analysis. Ratios may be categorized as liquidity, profitability, efficiency, or capital structure ratios. The categories, specified in AICPA Practice Aid 06-3, Analyzing Financial Ratios, include the following:

• Liquidity ratios
  • Current ratio
  • Quick ratio
  • Working capital
  • Inventory to working capital
  • Current assets turnover
  • Inventory to current liabilities
• Profitability ratios
  • Gross profit percentages
  • Operating profit percentages
  • Net income before taxes (NIBT) percentage
  • Net income after taxes (NIAT) percentage
  • Return on equity
  • Return on assets
• Efficiency ratios
  • Accounts receivable turnover
  • Accounts receivable collection period
  • Inventory turnover
  • Inventory to days in inventory
  • Operating cycle
  • Accounts payable turnover
  • Accounts payable days outstanding
  • Asset turnover
  • Net revenue to working capital turnover
  • Net fixed assets to stockholder’s equity
• Capital structure ratios
  • Debt to equity
  • Current debt to equity
  • Operating funds to current portion of long-term debt
  • Times interest earned
  • Long-term debt to equity

In addition, the growth in sales and revenues, accounts receivable, inventory, and accounts payable should approximately align with one another. If not, one should investigate the reasons.

Finally, an assessment of cash flows can also be useful. First, operating cash flows should be positive (i.e., meaning that the company is generating cash flows from operations). Maybe more importantly, cash flows from operations should generally be greater than operating income because of the add-back of depreciation and other noncash expenses to income (assuming that the indirect method is used to create the statement of cash flows). Normally, cash flows from investing transactions should be negative, indicating that the company is investing in its future. Whether these dollars have been targeted to the appropriate long-term assets is a qualitative assessment that must be made. But it does not negate the expectation that investing cash flows be negative (for companies in growth and development stages).

Finally, financing cash flows can have either a positive or negative sign. Financing cash flows being positive suggests that equity and/or debt investors believe in the future of the company, and it also may indicate that the company will be expanding. Likewise, negative financing cash flows can be associated with dividend payments and debt repayments. Qualitative assessments are required to determine whether the financing cash flows reflect preliminary signs of positive or deteriorating financial condition. Each of these assessments can be compared to industry norms, those of key competitors, and those of the organization over time.

Quantifying Lost Revenues and Increased Expenses

The accepted concept for measuring lost revenues, excess expenses, and/or lost profits is to project these incremental changes over a loss period. Essentially, the lost revenues are those that the damaged entity could have expected except for the actions of the adversarial party. Similarly, incremental expenses are those additional expenses incurred as a result of the actions of the adversarial party. A number of methods can be used to develop incremental lost sales or excess expenses; some of those are discussed in the following paragraphs. Notwithstanding the choice of methodology, the forensic accountant has two competing goals: a high degree of accuracy and simplicity.

The value of simplicity is that proving the foundations for the claim is relatively straightforward and it is likely that the other side—the judge and the jury—will be able to understand the method and calculations. However, a risk in using simplified methods is that they may be subject to attack, because they may oversimplify the estimate of damages and, thus, not meet the threshold of being provable with a reasonable degree of scientific certainty. More sophisticated methodologies may be more complete and accurate, but they risk being complicated and difficult to communicate or for the untrained to understand.

Even if the trier-of-fact or other parties understand the methodologies and their inherent subtleties, they may not give the method the credibility it deserves, which could affect the outcome of the court action. The forensic accountant is left with the goal of trying to measure the damages in the most accurate, yet simple method, recognizing the threshold of a reasonable degree of scientific certainty.

Some of the decisions that need to be made include:

• The base amount of revenues or expenses, usually based on historical experience or reliable projections
• The choice of revenue or expense growth rates, recognizing that influences outside the control of the company (e.g., inflation, seasonality, prior forecasting accuracy for the industry, competition, or the organization under examination) have at least some impact on expected rates over time
• Whether historical rates of growth are applicable to the damage period
• Whether relatively straightforward calculations (using a spreadsheet tool, such as Excel) are reasonable or whether more sophisticated methods, such as regression, statistical, or econometric methods, are better suited.

Regardless of what choices are made, every method and calculation inherently incorporates certain assumptions and relies on the judgment of the professional. Ultimately, the decisions need to be described and outlined in oral or written reports and defended during a deposition or in court. As such, the professionals need to ask themselves: “Do the outcomes make sense?” Sometimes, damage estimates appear perfectly reasonable and defensible on the surface, but, when examined more closely, they do not hold up under detailed scrutiny of the evidence.

For example, consider the damage claim where a supplier—one of many, to a reseller—makes a damage claim that asserts they were not given credit for units supplied by them to the reseller, and the undercredited units total more than the company sold in its entirely. The damage claim makes no sense, because it claims more units than the company sold, not recognizing that the allegedly damaged supplier provided no more than 5% of the total units available for sale. When carefully examined, the damage claim fails in light of a complete examination of the evidence; even though a forensic professional may have used sound methods and seemingly reasonable assumptions but failed to take a step back to look at the bigger picture from different angles and perspectives. With revenues, the forensic accountant must consider whether the organization has the infrastructure (operating capacity, fixed assets in place, a competent work force, intellectual horsepower, etc.) to meet the demands of the customers. If additional investment in infrastructure is required, incremental costs need to be deducted from projected lost sales.

Nonfinancial information, data obtained from independent third parties, evidence from nonaccounting, operational systems can all be informative in estimating lost sales, incremental expenses, and lost profits. These sources often provide relevant quantities or volume of activities, the “q” in the price times quantities calculation. Prices, while inherently financial, also permit the calculation of quantities or volume associated with revenue or expense amounts. Like other aspects of forensic accounting and fraud examination, a more granular examination of quantities and prices may permit a more thorough analysis of the revenue and expense amounts. The information regarding prices and quantities during the relevant period needs to be established to be credible. For example, invigilation considers activity before, during, and after an alleged act. The correlation between quantities and/or prices needs to be established for the “before” and “after” periods in order to have relevance for the “during” period. That said, nonfinancial evidence can be valuable and integral when using the following methods.

Some of the methods that can be used to develop estimates of lost sales, incremental expenses, and lost profits include:

Determining Lost Profits

Although the liability claim alleged by the plaintiff against the defendant is often centered on lost revenues and/or incremental expenses, the actual amount of damages is a function of lost profits. Thus, any incremental lost revenues or incurred expenses require additional evaluation that considers the impact on “bottom-line” net income or some appropriate derivation (e.g., cash flows) for at least a couple of reasons. First, from a practical perspective, in order to generate incremental revenues, most companies incur at least some incremental expenses. In order for the best estimate to be developed, incremental costs, expenses, and infrastructure (capacity) need to be subtracted from the incremental revenues. Second, the damaged party has a duty to mitigate its damages. As such, this obligation may result in incremental revenues from other sources, for example. Conversely, the generation of other sources of revenue or reduction of some expenses might mitigate losses.

For example, assume that a farmer loses a contract to provide corn to a distributor, and, as a result of market oversupply, no other distributors are willing to buy corn from the farmer. Assume also that the field is in a condition to grow a substitute crop—such as soybeans. As such, the farmer is obligated to do so, even if the soybean contract is less profitable than that for corn. In this circumstance, the best estimate of damages assumes lost profits related to the loss of corn sales, reduced by the benefits of reasonable steps (e.g., the planting of soybeans) to mitigate the losses, whether or not such steps were actually taken.

One might assume that gross profit is a good starting point for determining incremental profits. However, the portion of gross profit attributed to the cost of goods sold may include some fixed costs, particularly if the damaged party is a manufacturer, and the assumption that all cost of goods sold is a variable (incremental) cost may be erroneous. Further, in addition to variable/incremental costs incorporated in gross profit, other expenses related to selling and distributing may also be incremental.

For example, many companies generate incremental sales through advertising and marketing campaigns. Likewise, salespersons often receive commissions based on actual sales and hitting various levels of sales volume. Other costs, such as incremental labor, shipping, administration, and miscellaneous expenses, may be incurred to generate the incremental sales. There may also be cases where incremental revenues have zero associated incremental costs. An example of this is where the company was not given proper credit for sales by a distributor, but the company had, in fact, provided those incremental goods and services and thus had incurred incremental costs. In such a case, the damage claim is the amount of sales that were not credited to the plaintiff and excludes associated variable costs.

The definition of lost profits needs to be explored as well. Most commercial damage claims assume lost profits—incremental revenues less incremental expenses—and other costs required to generate the lost sales. However, AICPA Practice Aid No. 7, “Litigation Services,” indicates that losses can be characterized using a number of metrics, including lost profits, lost value, lost cash flows, net revenue, and incremental costs. The forensic accountant needs to evaluate which of these metrics or some other is best suited to measure the damages applicable to the case, facts, and circumstances at hand.

Determining Incremental Costs

Although incremental revenues can be determined using the methodologies discussed previously, properly isolating incremental costs and expenses can be trickier. Incremental costs are defined as those incurred as a result of the plaintiff’s action or inaction that would otherwise not be incurred (a type of damages) and those additional costs required in order to realize the projections of incremental lost revenues. First, as discussed previously, incremental costs associated with revenues may include infrastructure requirements, in order for the plaintiff to have the capacity necessary. Thus, some incremental costs are not those normally considered expenses associated with GAAP. Second, as a starting point, in order to isolate incremental expenses, the antifraud professional or forensic accountant needs to be able to identify the type of cost.

At the most basic level, cost behavior can be described as fixed or variable. Fixed costs are those that do not change with the level of output (e.g., sales). In contrast, variable costs are those that move directly with output, such as sales. A few concepts need to be further discussed. First, when analyzing fixed costs, many make the mistake of assuming that fixed costs exist at zero output. The assumption is that, when the producing unit is completely inactive or shut down, fixed costs exist. Although that assessment of fixed costs is valid, most organizations do not operate at zero output levels. More organizations operate in some range of volume called the “relevant range.”

Cost behavior should not be evaluated at zero production levels unless the levels are part of the relevant range. Zero production levels may be appropriate if one organization, the plaintiff, was put out of business by the defendant. In such a case, the relevant range may be zero units. However, assuming that the company produced 100,000 units but expected to produce (and sell) 110,000 units “but for” the actions of the defendant, the relevant range may be between 100,000 and 110,000 units. It is the behavior of costs in this range, fixed and variable, that are appropriate for analytical purposes.

Further, some costs exhibit semi-fixed, semi-variable, or mixed behavior. Take for example the output of one unit of labor (e.g., one incremental employee or one shift of workers). That unit has an ability or potential to produce some level of output, such as 20,000 tons of coal per day. If this unit is currently producing only 7,500 tons, the cost is fixed until the unit produces an incremental 12,500 tons per day. Once the incremental output reaches 20,000 tons of coal per day, in order to reach beyond those 20,000 units, incremental costs must be incurred. Those costs could include overtime, additional labor, or more shifts. Thus, for example, if the relevant range for consideration in a damage claim is 5,000 to 30,000 incremental units, this cost behaves in a semi-variable manner—because the relevant range spans the range where incremental costs are required = 20,000 unit. The cost is fixed for some time (up to 30,000 units); once the output unit crosses the threshold of 30,000 units/day, the variable nature of the cost kicks in, and additional expense must be incurred.

A second example is related to computer servers. Each can house and process only so much data for any given period of time. Until the computer server reaches capacity, no incremental costs are required, and the cost is fixed. However, once it reaches capacity, another computer server must be added, and the cost becomes variable or incremental and relevant to the damage estimate. In a similar manner, the computer server might require periodic software patches, maintenance, and updates. These aspects are variable. Unfortunately, in the world in which we operate, most costs tend to be mixed, semi-variable, or semi-fixed; thus, careful analysis of cost behavior is required.

The fixed and variable nature of cost behavior may also change with time; a cost that is initially fixed may become variable, and vice versa. For example, an organization may own computer equipment for some time and then switch to a leasing arrangement where the costs are associated directly with volume of use. Thus, the forensic accountant needs to analyze costs carefully in his or her effort to identify incremental increases.

Other concerns that must be considered include the following:

• Allocated costs. Not all costs can be directly associated with the activities that drive it. Other costs, such as administration and management, are often indirectly associated with units of output. In many cases, to derive a sense of profitability by product, by product line, by segment, by division, etc., the organization allocates those costs not specifically identifiable with the units of output. These must be carefully analyzed to ensure that the basis is reasonable and defendable and that the true incremental costs have been isolated and allocated. Costs at the unit level can easily be evaluated as to their incremental nature, but those occurring at the batch level, production level, facility level, or back-office administrative level are far more difficult to isolate.
• Accounting estimates. A significant number of GAAP expenses require estimates. Examples include bad debts, warranty costs, returns, and allowances, etc. In addition, at period end, in order to determine profitability, accountants attempt to get revenues in the appropriate period based on the revenue recognition principle, and they try to match expenses against revenues using the matching principle. Getting revenues and expenses in the right period also requires assumptions and estimates by the accountant. These judgments can have a significant impact on incremental revenue and expense calculation and should be carefully studied.

The methods for determining cost behavior include the following:

• Account analysis
• High to low method
• Graphics
• Statistical (regression, survey, and sampling)
• Engineering

When using the account analysis method, the forensic accountant examines general ledger accounts, financial statements, and/or tax returns, often each line item, or other identifiable categories of costs from the books and records to understand the types included and the behavior exhibited by that account or cost category. This method is relatively inexpensive, requires interaction between the professional and entity representatives, and can be defended with experience, analysis and judgment.

The high to low method is a little more analytical in its approach, yet it is simple and easy to use and often serves as a starting point for more detailed analysis. The basic formula is y = a + bx, where

• a is the fixed cost
• b is the variable cost or slope of the cost
• x is the independent variable or unit of output
• y is the dependent or incremental cost
• b is determined as follows:

For example, assume the following facts:

• b = ($12,500 – $9,500 = $3, 000)/(1,000–600 = 400) = $7.50
• a = y − bx
• = $12,500–($7.50 * 1,000)
• = $5,000

Proof:

• High level: Total variable costs = $7.50 * 1,000 = $7,500
• High level: Fixed costs = $12,500 − $7,500 = $5,000
• Low level: Total variable costs = $7.50 * 750 = $4,500
• Low level: Fixed costs = $9,500 − $4,500 = $5,000

A third methodology includes developing and examining graphs of the data that include costs and volumes. This analysis is useful when lots of data points and a clear association between costs and volume exist. For many real-world applications, one or both of those attributes is not available in enough quantity to discern a pattern.

A fourth methodology assumes a statistical approach. Like graphs, statistical methods require a large number of data points. Statistically, number, survey, experimental data can be evaluated. They require more sophistication to use them properly, and they require more skill to communicate and defend the results effectively.

Finally, engineering studies can be conducted to isolate cost–volume relationships. The average fraud examiner or forensic accountant is generally not qualified to complete this type of work. However, such scientifically based engineering approaches can form the inputs for additional analysis by fraud examiners and forensic accountants. Engineering-type studies typically require a fair amount of time and are more expensive than other methods for isolating incremental costs.

Variable Cost Application

The following example applies the previous discussion related to marginal, incremental, or variable costs for ABC Company. The company is in the natural gas industry and produces dekatherms of natural gas. In the following chart, four years of data is provided related to the production of 4,322,700 dekatherms of natural gas.

Related to production, the company tracks four expense categories: labor and benefits, royalties, overhead, and materials. A company representative was asked to estimate the variable cost per dekatherm. According to the representative, 90% of labor is variable. The representative took the total for the four years, multiplied by 90%, divided by the dekatherms, and came up with $6.50 of variable cost per dekatherm. The same approach was used to estimate the variable costs of royalty (100% variable, $0.35 per dekatherm) and materials (75% variable, $2.91 per dekatherm). Overhead was considered to be 0% variable, 100% fixed. Combining these amounts, the company representative estimated that total variable costs associated with the production of a dekatherm of natural gas to be $9.76 ($6.50 + 0.35 + $2.91).

Using the tools associated with fixed, variable and incremental costs, we can test these assertions.

With regard to labor, if 90% is variable, then 10% is fixed; so, if we take 90% times these individual yearly amounts, this gives us an annual dollar estimate of total variable costs. Then, we would divide that number by the dekatherms per period, and calculate the variable cost of labor per period per dekatherm, approximately equal to $6.50. It is unlikely that each amount will be exactly $6.50. However, we can determine if the estimate is relatively close.

For labor, we can see in the above chart that periodic variable cost estimates range from $6.14 all the way up to $7.08. That may be too wide of a range to conclude that $6.50 is a reasonable estimate of variable cost per unit. In addition, we clearly see a pattern that’s increasing over time.

For royalty, the estimate of $0.35 per dekatherm is nearly perfect. First, we multiply the royalty by 100%, then divide it into the dekatherms, and we get approximately $0.35 in all years.

For overhead, mathematically the estimate is going to calculate to zero, but that doesn’t mean that it’s correct; this technique to test the assertions for overhead doesn’t provide a good sense of accuracy; so, we’ll have to do something different to test the assertion that overhead is zero percent variable.

For materials, multiplying the cost for the individual years by 75%, dividing by the number of dekatherms, and we obtain a range of $1.77 all the way up to $3.51, a patterns that decreases over time.

The overall conclusion here is that only one of the four categories appears to be estimated in a reasonably accurate manner using the approach offered by the company representative.

Continuing with this example, we incorporate three techniques to estimate the variable cost per unit: graphical approach, high–low method, and the regression approach. It should be noted that with such a limited number of observations, the reliability of the approach may be limited. More granular data, such as monthly, daily or shift amounts versus annual totals might yield a better result.

Now, the first approach is to graphic the data. Because we only have four observations of cost by year, the trend is difficult to see here, but you can see that they both trend up. Now, the second technique is to utilize the high and low method. So, the high was in the last full year, as we pick up both the dekatherms and the labor amounts; the low was in the first year so again, we incorporate the dekatherm and the labor amounts. We calculate the difference in both and we divide the labor difference by the dekatherm difference—it calculates to $4.20 variable cost per unit. The third technique is that we can use regression. The regression intercept has $3,273; the slope (the beta coefficient) is $4.20, an estimate of the variable cost per unit.

Now it’s important to retest the assertion. The annual estimates are 4.20 (2018), 4.18 (2017), 4.20 (2016), 4.20 (2015), 4.19 (4-year total); overall, this range is pretty tight and the estimate of $4.20 of variable cost per unit of labor appears reasonable.

We use this 3-technique approach for each of the other expense categories: royalties, overhead, and materials. In the updated chart below, in the far two right columns, revised cost per dekatherm is presented: $4.20 (labor), $0.35 (royalty), $1.81 (overhead), and $10.54 (materials). Added together, the revised total variable cost per dekatherm is $16.90.

As an alternative to test the total derived through the addition of the four cost categories, the 3-technique approach is used to estimate the variable cost per unit on total expenses. Per the following chart, the amount is $16.94 variable cost per dekatherm, an amount reasonably close to the $16.90 presented above.

It should be noted that the company representative estimated $9.76 as the cost per unit. Rather, an empirical examination of the data suggests that variable costs per dekatherm are in the range of $16.90 to $16.94, a cost that is more than 73% higher than what was originally estimated. Conceptually, the techniques applied produce a better estimate than was developed originally.

The Time Value of Money

The use of money is not free. Similarly, money that is earned (e.g., profits or positive cash flows) may be used to earn additional money or distributed to shareholders. When money could have been collected, principles associated with the time value of money must be considered in the analysis. It may affect two different aspects of claims for damages. First, prejudgment interest is used to denote lost profits that could or would have been earned prior to the date that the legal issue is resolved. The second aspect related to the time value of money is associated with profits that will be earned with a reasonable degree of scientific certainty in the future—after the legal dispute is over. In both cases, the issue considers the risks involved in achieving the calculated results.

First, prejudgment interest is associated with claims made for lost incremental profits before the matter can be resolved between the parties. It is therefore common for courts to award prejudgment interest. The amount is often set by the courts or statutorily by legislation. For example, some states award prejudgment interest of 4% annually, starting when the breach of contract or tortuous interference first occurred and ending when the dispute is resolved. In other cases, professionals are asked to offer testimony and evidence on an appropriate rate. Typically, the minimum is the risk-free rate on U.S. Treasury bills.

Above the risk-free rate are various risk-based rates of interest. For example, some suggest that what one could have earned on debt instruments (either contracted by an party to the litigation or traded in the public domain) compensate for some risk but do not fully compensate the plaintiff for the lost opportunity cost to invest in assets for which the risks are higher and the corresponding expected return is also higher. In such cases, one might argue that the damaged organization should be awarded prejudgment interest equal to its weighted average cost of capital (WACC). The methodology for calculating this is discussed in more detail later, and this topic is given extensive coverage in most finance textbooks.

Another aspect related to the time value of money are those amounts that would only be realized in future periods, after the dispute has been resolved between the parties. Essentially, the time value of money suggests that $1 dollar in my pocket today is worth more than $1 dollar that I receive at some future date because, over time, I could earn interest on the money I received today. Conversely, if I must wait for that $1 dollar until some future period, but I can accept a cash payment today, I should be willing to accept less today because I do not have to wait for that money and can put the cash to use immediately. Thus, $1 dollar to be received in the future is worth something less than $1 dollar received today.

In venture capital investment deals, for example, discounted interest rates are used to convert future profits into today’s dollars for valuation purposes. Venture capital interest rates in excess of 25% to 30% are not uncommon for some high-risk investments. Further, an organization’s cost of equity capital can exceed 20%. Although courts have provided no overall guidance for estimating the appropriate interest (discount) rate, prior court rulings have indicated that they are most likely (but not always) to assess rates that are far less than those required to complete venture capital deals or fund an organization’s equity. The following list of cases was provided in AICPA Practice Aid 06-4, “Calculating Lost Profits.”

The cost of equity can be developed using a number of approaches. The build-up approach assumes that the starting point for the cost of equity capital is the risk-free rate. To that base, adjustments are made for systematic risk associated with an equity investment premium, size, and industry. The industry adjustment can be positive or negative. An adjustment for unsystematic risk, positive or negative, is also common using the build-up method. Unsystematic risk is usually associated with a number of company-specific factors, including the organization’s financial condition, the quality and depth of management, the company’s products and/or services and customer base, the competitive environment, and other factors affecting projected cash flows. Other methodologies that are beyond the scope of this text include the capital asset pricing model (CAPM), arbitrage pricing theory, the Fama-French three-factor model, and the weighted average cost of capital (WACC).

Communicating and Defending the Results of Commercial Damage Estimates

Regardless of the choices made and the underlying assumptions, the “tire hits the road” for antifraud professionals or forensic accountant when they communicate and defend their work. This process tends to be iterative, in the sense that issues may arise at various points as the court action proceeds, and these issues may require antifraud professionals or forensic accountants to revisit their work and evaluate it from new perspectives, based on data and testimony. Beyond completing the assignment at the highest levels of competence and quality, communicating and defending one’s work are some of the most important aspects of consulting, litigation support, and being an expert witness. The venues where the forensic accountant can expect to be evaluated, scrutinized, challenged, etc. include the following:

• Periodic meetings with attorneys for whom you have been engaged
• Prejudgment testimony related to summary judgment
• Meetings with counsel where they determine, strategically, how to proceed with the case
• The written report
• Deposition testimony
• Regulatory or administrative hearings
• Alternate dispute resolution forums such as mediation or arbitration
• Trial testimony
  • Direct examination
  • Cross examination
  • Redirect examination
  • Recross

In addition to communicating and defending one’s own work, the forensic accountant is often asked to critique the work of the expert engaged by the opposing side. At all times, the professional needs to maintain his or her independence and objectivity and be sure not to become an advocate in the process or for its outcomes.

Communications—whether oral or written—that are related to work performed should reflect the professional’s neutral and objective position. They should avoid conclusions concerning the ultimate resolution of the dispute or the likely appropriate findings of the judge or jury. The trier-of-fact has the ultimate decision, and the forensic accountant should avoid usurping that responsibility. That said, the experts are expected to have opinions, conclusions, findings, and interpretations. It’s a fine line between having professional, defendable opinions, conclusions, and findings related to one’s expertise and presenting those that are better left to others because of their expertise, assignment, or responsibility under the law.

Reports created by fraud examiners and forensic accountants can take on many formats, including that of a letter, memorandum, affidavit, declaration, or summary, which usually provide an overall view of the main opinions, describe the bases for them, and include at least some charts, graphs, tables, or exhibits that summarize some of the important analyses. A reservation should be included similar to the following: “Should additional information become available, facts become known, or additional inquiry arises, I reserve the right to modify or supplement the analysis as necessary.” Attached to the report may be detailed schedules, exhibits, copies of specific pieces of evidence, and other important work product necessary for the reader to understand its contents. Reports, including example reports for fraud/financial crimes, litigation support, valuations and lost employment compensation, are presented in more detail in the following chapter.

Commercial Damages Application

Genuine Coal Corporation had been mining for Western USA Mineral Rights, Inc. since 2009. During the period 2009–2018, Genuine had two contracts to mine two separate tracts of coal for Western. A “Coal Expert Report” was provided that related to the mining aspects of the case. The coal mining expert concluded that the tracts of coal were contiguous, mined in the same seam of coal, and pre-mining engineering studies indicated that the geological characteristics of the tracts were indistinguishable. The first tract was mined during the period 2009–2013 and Genuine was paid for 7,500,000 clean tons of coal averaging $20 per ton, the contract price. The second tract was mined during the years 2014–2018; Genuine was paid for 5,000,000 clean tons of coal averaging $20 per ton, the contract price. In 2018, Genuine bid on a third contiguous tract of land at $21 per clean ton; however, Western awarded the mining to a Genuine competitor for $20 per ton. At that point, Genuine filed suit against Western, alleging three issues (Complaint Civil No. 18-254):

1. The bidding process was unfair and Genuine was entitled to the third contract with Western.
2. During the second contract, pre-mining engineering studies consisted of “core” drilling. This core drilling indicated that approximately 50.6% of the core was coal. In contrast, during the second contract, Genuine was only paid for clean coal percentage averaging 44.6%. As such, Genuine was underpaid by 6% of the clean coal. Thus, instead of mining and being paid for 5,000,000 clean tons, Genuine alleges that during the period 2014–2018, the company should have been paid for 5,673,000 clean tons.
3. As a result of the under-payment and the failure to receive the third contract, Genuine is in a precarious financial position at the end of 2018 and may be forced to seek bankruptcy protection.

To support their lawsuit and claim for damages, Genuine provided the following financial data with regard to its 2018 income statement and balance sheet, as well as its annual projected earnings for the 2014–2018 period.

During deposition testimony, plaintiff’s Mortar and Pestle contended that Genuine’s 2018 net losses of ($875,000), its negative retained earnings of ($1,338,500), especially in comparison to its projection profits of $12,500,000 ($2.5M times 5 years), is consistent with the bad behavior of Western, its tortious interference, and its failure to pay for 673,000 tons of coal. As such, Genuine claims to be entitled to damages of $13,460,000, calculated as $20 per ton selling price times 673,000 tons for which Western did not pay. Because Genuine already incurred the costs to mine the incremental 673,000 tons of coal, it asserted that no incremental costs would be incurred. Rather, Genuine has sued for payment for the incremental tons of 673,000 tons of coals at the contractual selling price of $20 per ton.

Your firm has been hired by Western to examine Genuine’s claim for damages. As part of discovery, Western subpoenaed annual income statements and balance sheets for the periods 2009–2013 and 2014–2018. The following is a summary of the income statements for that period:

The following is a summary of the balance sheets for that period:

As the expert, you also requested the detailed general ledger for the period 2009–2018, as well as an intermediary accounting document referred to as the “journal posting report” that summarizes each transaction and bridges from the underlying transaction evidence (e.g., invoice) into the accounting general ledger for cash deposits and disbursements and payroll. A review of the general and related journal postings report for the relevant period indicated several new expense categories and new vendors beginning in 2014 as follows:

Deposition testimony, a review of the Secretary of State’s records and subpoenaed “purchase and sale” contracts, revealed that these new vendors were part of a “purchase and sale transaction” from Genuine’s owner, Mortar, from the inception of the company through 2013 to new owner, Pestle, on January 1, 2014. These vendors did not exist prior to 2014 and the vendors in place in 2013 continued to provide services during the 2014–2018 period in a manner consistent with, and supportive of, the mining operations during that pre-2014 and post-2014 periods. Deposition testimony could not substantiate the business purpose for these expenses and despite a subpoena, no invoices to support these transactions were provided by Genuine. One of the contact documents contained one sentence with language that stated that the objective of the purchase and sale agreement was because Genuine planned to “cease its mining operations.”

A review of related parties also identified “Mountain Finance, LLC,” a company controlled by former owner, Mortar. This company lent approximately $1.5 million to Genuine, has a security arrangement on the assets of Genuine and, therefore, will be paid before unsecured creditors including the employee benefit obligation.

The impact of these related-party activities is analyzed in Exhibits 2a as follows:

As noted in this analysis, the unsubstantiated disbursements to related-party vendors totaled $13,500,000 for the period 2014–2018. When this amount is added back to the losses incurred by Genuine, the company would have earned approximately $12,250,000 during the period 2014–2018. The annual amounts, as well as per ton estimates, are also provided. Finally, in the following chart, the investment in property, plant, and equipment, as well as the corresponding equipment rental expenses, are examined by year. As noted in the chart, Genuine was not replacing fixed assets, nor renting equipment to sustain the long-term operations of the business.

Finally, the coal mining expert concluded that the approach used to determine clean tons by Western was consistent with industry practices and to some extent is a function of the mining practices of the coal miner. Further, clean tons are estimated on a continuous basis, at least daily, whereas core drilling prior to mining was based on a sample of 20 drill sites. As such, 20 core drillings do not justify disregarding daily testing over a period of 5 years. As such, the coal mining expert concluded that clean tons paid at 45.6% is reasonable. As a result, the following conclusions appear to be grounded in the evidence.

1. Genuine earned just shy of $12,250,000, recovering 5 million tons of clean coal, approximately $2.45 per ton, from mining operations between 2014 and 2018. The sales price for clean coal during this period was $20 per ton (per long-term base coal contract).
2. Despite these positive earnings, Genuine reported “book” and “tax” losses of ($1,250,000) or ($0.25) per ton on its 2014–2018 tax returns. The “book” losses agree to amounts reported on internal financial statements for all years.
3. The reason for the disparity between reported earnings and estimated actual earnings is expenses (disbursements) to related party companies, related to either former owner, Mortar, and/or new owner, Pestle. Positive cash inflow before related party transactions totaled approximately $13.5 million, approximately $2.70 per ton. Alternatively stated:
   • Related parties billed Genuine for operating expenses in excess of $13.5 million.
   • The differential ($1,500,000) was loaned back to Genuine by another related party, Mountain Finance, LLC.
   • Outstanding debt to Mountain Finance, LLC which is owned and controlled by former owner, Mortar, totaled $1.5 million by December 31, 2018. This amount was secured by the assets of Genuine.
   • Despite discovery requests and deposition inquiries, no invoices for the disbursements by Genuine to related parties were provided by the plaintiff (Genuine).
   • Further, these vendors did not exist prior to 2014.
   • Additionally, the vendors that had been providing services to Genuine during the 2009–2013, in general, period continued to do so at level correlated with the amount of coal mined by Genuine.
   • No business purpose for the expenditures by Genuine to its related party vendors could be established by discovery interrogatories, requests for production of documents nor deposition testimony.
4. Genuine’s reported losses and excess liabilities would likely give uninformed readers of the financial statements the impression of a failing company.
5. Genuine’s transfer of cash flow to related party companies created an environment where Genuine did not replace aging equipment.
6. The decline in tons produced, deteriorating financial condition and lack of investment in mining equipment is consistent with Genuine’s cancellation of a coal supply agreement dated December 31, 2017 that that included language that stated that Genuine determined to “discontinue its plans to pursue further mining/coal reserve activities.”
7. Genuine’s transfer of cash flow to related-party companies, it’s decline in assets, its debt to Mountain Finance, LLC. is such that Genuine will be unable to satisfy its pension and health-care benefits obligations to retired employees and other unsecured creditors.

Overall, given that over a period of years, Genuine’s clean ton production was declining and significant cash flow was being disbursed for the benefit of related-parties and replaced with a loan to another related-party, Genuine’s operations were such that the company was bound to result in poor financial condition. Such a sustained pattern of business operations and financial performance would necessarily result in a company that was no longer financially viable and would be unable to meet their remaining financial obligations. A report sample related to this examination and its findings are presented in the following chapter.

Overall Engagement Considerations

Forensic accounting professionals should undertake valuation engagements where they can reasonably expect to complete the work with professional competence, recognizing that valuations require specialized knowledge, skills, and abilities. In assessing what is necessary to complete a valuation engagement with professional competence, one should consider the ability to identify, gather, and analyze the relevant data; apply the appropriate valuation methodologies; and incorporate critical thinking, objectivity, and professional judgment in the decision-making process that will ultimately determine the amount of value.

Like a commercial damages case, the valuation engagement usually requires an assessment of economic and industry conditions and the competitive environment on the assets subject to valuation. All work that incorporates judgment inherently requires identifying assumptions on the part of the practicing professional. Further, those engaged to complete a valuation always face the trade-offs of simplified methodologies and ease of understanding versus theoretically more complex valuation methods. No matter how sophisticated the method, the outcomes are affected by assumptions and other conditions that limit the ability to develop the perfect valuation estimate. The professional should be aware of these inherent limitations and the impact of assumptions and limiting conditions on the value estimate.

The work of the forensic accountant with regard to valuations should be impartial, intellectually honest, and free from conflicts of interest. Generally, notwithstanding the implications of Sarbanes–Oxley related to public company engagements, the professional need not be independent; however, any issues that may result in challenges to his or her work related to independence should be disclosed. Although not a limiting factor, the expert needs to understand the nature of the client’s expectations and planned use for the valuation services outcomes. If the client imposes any scope restrictions, those should be disclosed so that readers of the valuation report understand the context in which the valuation was developed. If the work of other specialists is incorporated into the services performed, that should be disclosed as well.

The Types of Valuation Engagements

AICPA Statement on Standards for Valuation Services No. 1 describes two types of engagements: valuation and calculation. The valuation engagement, even when considered beyond the scope of AICPA members, assumes that the forensic accountant will analyze the value of the asset/organization under examination, consider, choose, and apply the appropriate valuation tools, techniques, approaches, and methods and that the work will be appropriately documented. Valuation engagements are ongoing, iterative processes whereby data and information are continually gathered, updated, incorporated, and analyzed. Essentially, professionals are expected to utilize their experience, training, and expertise to select and apply the most appropriate methods and approaches until a determination of value has been issued.

With a calculation engagement, the client outlines the asset(s), valuation methods, and other aspects of the engagement. The service provider agrees in advance on the approaches, methods, tools, and techniques to be used and the extent of work to be performed. Given that understanding, the professional proceeds to apply the agreed-upon procedures. In either case, the amount of value can be expressed as a single amount or within a range. However, the nature of the engagement should be disclosed, so that readers can understand the context in which the amount or range was developed.

In some situations, the forensic accountant may be asked to consider the impact of certain hypothetical conditions on the valuation of an asset or entity. The request may be made, for example, as part of a commercial damages case where the plaintiff was put out of business or permanently impaired as a result of the alleged actions or inactions of the defendant. Such hypothetical scenarios should be disclosed as part of the report. Valuations are also commonly prepared in estate and tax planning activities.

Valuations can be developed to address a number of issues. For example, they may help facilitate asset transfers by helping to determine value for the following:

• Asset liquidations
• Employee stock ownership plans
• Management buyouts
• Mergers and acquisitions
• Minority shareholder transactions
• Purchase and sale agreements
• Purchase price allocations
• Recapitalizations
• Stock sales

Valuations may also be used to help resolve disputes among parties to a transaction and litigation

• Bankruptcy
• Divorce
• Lost profits and long-term value

Valuations are heavily utilized in tax situations:

• Casualty losses
• Charitable contributions
• Estate and gift taxes
• Gains and losses on sales of assets (e.g., home, business, stocks, bonds)
• Purchase price allocations

By identifying the type of valuation and associated issues, the forensic accountant better understands its specific purpose, the parties who make decisions based on the valuation work, and the types of assets involved. The date of valuation is a critical aspect of the engagement because, like a balance sheet, it represents a specific date in time.

Measures of Value

A number of measures of value have been developed over the years. Each has situations where they are reasonable measurement methodologies, and each has strengths and weaknesses. Some of those are as follows:

• Book value represents an asset’s balance sheet value, derived by subtracting accumulated depreciation from historical (acquisition) cost. For capital-intensive, slow, and moderate-growth organizations, book value may approximate market value. However, for fast-growing, high technology firms—those dependent on intellectual property and service firms—book value does not usually approximate market value.
• Liquidation value represents the amount of cash likely to be received by owners of an asset, assuming that pressure exists that will require the sales transaction to be completed quickly. Liquidations can occur in an orderly fashion or are sometimes “forced.” An orderly liquidation permits time to prepare the assets properly to derive a higher value and to locate buyers who can better utilize the available asset. Thus, an orderly liquidation tends to generate more cash than a forced one. However, because of time constraints, both liquidation values are likely to fall short of market amounts where the seller has time to find buyers that can best utilize the asset. Book and liquidation values can often be used to determine the floor for the asset’s worth.
• Market value is used to describe the price of an asset, assuming that a willing buyer and willing seller can come to terms under normal market conditions. Fair market value is usually correlated with market value. It is used to describe the estimated purchase price at which a willing buyer and a willing seller would transfer the asset. Fair market value, like market value, assumes that each party is knowledgeable and can evaluate the risks and rewards associated with the transaction. Its determination often involves the expertise of a valuation professional and can be used as the starting point for negotiations from which a sale can be completed. Market value and fair market value place an amount on the entire asset(s), without regard to ownership and control rights and their marketability. Thus, the term fair market value assumes that one person has a 100% controlling interest in the asset. Other considerations include fair value when the asset holder has ownership and/or control rights of less than 50% (a minority interest). A minority interest, by definition, does not have a controlling interest in the asset and therefore may have limited marketability, which may reduce its market value.
• Investment value assumes a specific buyer or class of buyers. This may dictate the type of use that the buyers have for the assets and thus may create a price that is something other than market value or fair market value. Other conditions attached to an asset may have an impact on its worth. For example, a minority interest may have selling rights only if the owner with controlling interest approves. Deed or zoning restrictions may come attached to a piece of real estate. In a divorce, state law is likely to affect the value of assets to be distributed. Any conditions that limit the flexibility and choices of the asset owner are likely to lower its overall value.

Determining Market, Fair Market, and Fair Value

Essentially, two considerations ultimately determine the market and fair market value of an asset: the future income stream that can be derived and the difference between that and the income stream from alternative investment options. Generally, a minimum income option for any investor is considered to be the risk-free interest rate on government bonds. This return is virtually guaranteed. As such, any risky investment or purchase of an asset requires an expected higher return. Ultimately, the value of an asset has to be associated with its income potential over the short and long term, recognizing that, over the life of an asset, income is correlated with its net cash flows.

Traditionally, three methods have been used to determine fair market values. Given fair market value, the impact of ownership and control rights, marketability considerations, and other issues related to use and alternative uses can be factored into the valuation estimate. The common method is discounted/capitalized income or cash flows.³ In addition, market comparables valuation models and asset and liability market valuations can be used as substitutes, when appropriate, or as checks as to the reasonableness of the discounted/capitalized method.

Discounted Earnings and Cash Flows

The discounted earnings or cash flows method (DCF) requires an estimate of future earnings or cash flows, a sense of the duration of those, and the derivation of an appropriate risk-adjusted discount rate. Assuming constant cash flows, value is a relatively straightforward formula:

where CF is the constant periodic cash flow to be received in the future at time t, i is the risk-adjusted discount (interest) rate, and n is the number of years the cash flow stream is expected to be received. Because the cash flow stream will not be received with certainty, the risk-adjusted discount rate is used to incorporate the uncertainty into the calculation. Further, in this model, dividends can be substituted as long as they are equal to the firm’s estimated free cash flow. Substituting earnings for cash flows is also functionally equivalent to assuming that those retained are reinvested and assumed to earn the risk-adjusted discount rate. Because cash flow projections are difficult to estimate, it is normally for some period, say five years, and then a terminal value must be estimated for the relatively uncertain amounts to be received in year six and beyond. The adjusted formula is as follows:

V represents the terminal value at the end of year five, which can be estimated assuming constant growth after year five and incorporating a model such as the Gordon Growth Model (GGM). It assumes that the current value of a constantly growing income (dividend) stream is equal to the dividend divided by the growth adjusted net discount rate. Mathematically, the GGM is expresses as follows:

where P is the price of the company’s equity at time 0, D is the dividend in time period 1, k is the cost of equity capital, and g is the expected growth rate of future cash flows. Note that, if expected growth exceeds the cost of equity capital, this equation becomes nonsensical. As a practical matter, in some cases, the book value of equity using the projected balance at the end of year five is assumed to be the terminal value. In other cases, the year-five earnings are divided by the risk-adjusted discount rate.

The most important and challenging factor is the projection of cash flows, which are influenced by the company’s historical performance and its prospects for performance in future periods.

Capitalized Earnings

The capitalized returns method is generally used when an entity’s future operations are not expected to change significantly from its current normalized operations. To apply this method, an entity’s current operations, either earnings or cash flow, are divided or multiplied by a capitalization rate to estimate value. An entity’s capitalization rate is generally derived from its discount rate and can be stated as either a divisor or multiplier.

Estimating the Risk-Adjusted Discount/Capitalization Rate

Risk and return are positively related. This means that, as risk increases for an investment, the return is expected to also rise. Mathematically, one can assume that the expected earnings are the sum of the risk-free return, plus an upward adjustment for inflation, plus the specific risks associated with the asset. Those can be derived from the overall economy or industry and the asset. Generally, at least four methodologies can be used to develop the risk-adjusted discount rate and its related cash flows (income): CAPM, the bond-equity additive method, the build-up method, and the weighted average cost of capital.

CAPM, the capital asset pricing model, is probably the most well-known methodology for estimating the expected risk-adjusted discount rate for equity. CAPM posits that the return required by an investor is the sum of the risk-free rate of return, plus an adjustment for the relative risk of the asset compared to the overall market rate. This model for estimating the risk-adjusted rate of return requires public market data for the company, the overall market, and the use of statistical estimation software. Although accounting-based data can be substituted for market-based data for privately held companies, those techniques add to the complexity of the overall estimation. The standard CAPM equation is as follows:

where R_M is the rate of return on the overall market. The estimate of i can be derived by using regression to estimate B (beta) over time and then applying the parameters for any estimation period. Historically, the rates of return of various market categories between 1926 and 1996 are as follows⁴:

The weighted average cost of capital (WACC) is another method traditionally used to estimate the risk-adjusted discount rate. The formula is as follows:

where K_D is the expected return on debt financing, K_E is the expected return on equity financing, MV_D and MV_E are the market value of debt and equity financing, respectively. CAPM can be used to estimate K_E, whereas Copeland, Koller, and Murrin⁵ provide detailed guidance on developing K_D and K_E. The WACC can be used as an estimate of i, the risk-adjusted discount rate.

The bond plus equity method is derived as follows:

where R_b is the interest rate on firm bonds, and the equity premium is the rate of return on the market (R_M) less the risk-free rate of return (R_risk-free); i is then used as the risk-adjusted discount rate.

The build-up method, described in the Ibbotson Associates, Stocks, Bonds, Bills, and Inflation Annual Yearbook, is similar but more sophisticated than the bond plus equity method and can be derived as follows:

One consideration that applies often to smaller organizations is leverage. Particularly with smaller, closely held enterprises, professionals are likely to encounter significant variations in the amount of debt (leverage) relative to equity. Some small businesses have no equity investment and have used creditors as essentially the only source of financing. In other cases, the venture was considered so risky that the balance sheet is financed almost exclusively with equity, with the exception of some short-term liabilities such as accounts payable and accruals. A methodology for dealing with differences in leverage is the Hamada adjustment. To incorporate this adjustment, the following data or their surrogates are required:

The Hamada adjustment can be used to modify the traditional CAPM model as follows:

Use i as the discount rate.

The capitalization rate is the discount rate, adjusted for growth (i.e., i – g = capitalization rate).

Forecasting Income and Cash Flows

One of the most challenging issues associated with the discounted income and cash flows model is projecting income and cash flows into the future. At a minimum, data should be considered in the following areas⁶:

1. The nature of the business
2. The general economic and industry outlook
3. The book value of equity (derived from the balance sheet)
4. The earnings (operating) capacity of the company
5. Dividend-paying capacity
6. Goodwill and other intangible assets
7. Previous sales of company securities
8. The market prices of comparable companies

Notice that these considerations are similar to those discussed when developing and critiquing estimates of damages. Various economic, industry, competitive, and company-specific factors are likely to have an impact on the projection of cash flows. These need to be considered either implicitly or explicitly in the analyses used to project future income, cash flows, and dividends. Other information that may affect the valuation includes the number, type, and age of organizational facilities; the management team; the classes of debt or equity and their associated rights, products, services; relative geographical reach (e.g., local, statewide, United States, North America, global, etc.), industry markets and conditions; key customers, suppliers, and competitors; business risks; strategic planning and planned changes in strategy or its operational execution; and the impact of government and regulators.

Most income and cash flow projections are grounded in historical financial performance. For an organization, it’s difficult to know where it is going if it does not know where it’s been. As such, a starting point for the projection of future cash flows is the historical financial statements: income statements, balance sheets, statements of cash flows, and the tax returns. Three to five years of historical financial statements are preferable. Even though tax returns are only available on an annual basis, public and internal balance sheets are usually available at least quarterly, and internal income statements are usually available monthly. The additional data points from monthly financial data often provide invaluable information and a solid basis for trend analysis.

Keep in mind that, if professionals are armed with beginning and ending period balance sheets and an income statement for the period, a reasonably good estimate of cash flows (operating, investing, and financing) can be developed. They may provide a significantly different picture than that suggested by the income statement, so the time used to create the statement of cash flows is usually justified. Texts and other authoritative guidance in this area often refer to free cash flows, but this definition often varies. At the most simplistic understanding, free cash flows are those that an owner could consume without injuring or reducing the value of the organization. When developing a valuation using this concept, the professional needs to ensure that free cash flows is defined so that users of the report can properly interpret valuation outcomes.

For smaller (nonpublic), closely held businesses, owners may combine personal financial transactions with those of the organization. Through inquiry, inspection, and analysis, the forensic accountant needs to determine whether such transactions exist and consider appropriate adjustments, if any. In other cases, an owner may be providing sweat equity management services, meaning that the compensation for those services may be below market values or nonexistent. It may be proper therefore to add expenses to the projections. Another area of concern is with related parties. For example, suppliers or merchandise coming from a company owned or operated by a close family member may not be at “arm’s length.” Those transactions may be at, below, or above those that would be charged by an unrelated, independent third party.

Beyond the historical financial statements to be gathered, the fraud examiner or forensic accountant should attempt to gather the following:

• Forecasts of projected (future) financial results
• Articles on industry-related valuation issues
• Relevant client information from inquiries, interviews, and deposition transcripts, if available

From this historical information, the professional should calculate various ratios and interpret their meaning, particularly the impact of projected income and cash flows:

• Common-size financial statements
• Liquidity ratios
• Profitability ratios
• Efficiency ratios
• Capital structure ratios
• Long-term debt to equity

In addition, the professional should examine revenues for past trends, growth rates, variability in individual annual results, overall observed results, and the identification of appropriate questions for company management. Once a satisfactory understanding has been gained of revenues as a basis for projecting future revenues, gross profits and gross margins should be examined: both the components of goods sold and their calculations (and underlying inventory flow and valuation assumptions). Once satisfied, the valuation professional should turn to operating expenses, operating profits, other income and expense items, pretax profitability, EBITDA (earnings before interest, taxes, depreciation, and amortization), taxes, and net income. Particular attention should be paid to nonrecurring, one-time, and unusual transactions and their impact on operating performance. Because such items are nonrecurring, they generally should be excluded from projections of future operating performance, unless expected to occur in future periods. Once the analysis of the income statement has been completed, a similar one should be made of the balance sheet, the statement of cash flows, and the tax returns, where particular attention should be paid to the reconciliation of book to taxable income.

Beyond studying the organization’s internal performance, the following should also be considered:

• Company’s economics and business model
• Management’s strengths and weaknesses and the impact on an investor’s perception of risk
• Trends and what they say about the possible future
• Key elements of company strategy
• Industry forecasts, as a basis for comparing a company’s performance to industry peers
• Key competitors
• Internal and external forces that affect the business
• Risk, future threats, and opportunities

Notice that much of this work entails an initial analysis, followed by applied judgment. Armed with these analyses and various judgments, the fraud examiner or forensic accountant can start to make projections of future periods, usually for approximately five years. Finally, using net present value methods discussed in the calculation of economic damages section, projected future earnings and cash flows (including an estimate of terminal value) can be discounted back to the present value.

Asset Valuation Models

The asset valuation model starts with the assumption that the organization’s balance sheet does a reasonably good job of identifying the company’s assets and liabilities. Using a detailed listing, the market value of each asset or liability can be estimated. Appraisers can be used to value the assets. Net present value techniques can be used to approximate the market value of liabilities based on current interest rates and projected cash flows. Although this method makes a reasonable attempt to convert the traditional, historically cost-based balance sheet to one that incorporates market values, it has at least two shortcomings. First, it does not account for the sometimes significant benefits associated with asset synergy—where the value of the whole is greater, sometimes significantly greater, than the sum of the parts.

In addition, many companies have significant intangible assets, and the market-based balance sheet fails to account for those. Some include patents, trademarks, research, and development; they can be estimated by analyzing historical benefits. However, other intangibles, such as organizational know-how; knowledge; and a productive, efficient, and effective workforce, do not lend themselves to analytical valuation with a reasonable level of confidence. Also, contingent and unknown liabilities may be significantly understated, which overvalues the actual market-based book value. Thus, if an attempt is made, the professional needs to consider adjustments that are not on the face of the balance sheet, but about which information is known. At least, list those intangible assets and potential liabilities for cases in which no reasonable estimate of value is available, so that users of the valuation can determine for themselves what consideration, if any, they should be given.

Market and Accounting-Based Comparables Models

The use of comparable data from similar companies, the industry, and competitors are often referred to as methods involving benchmarks, guidelines, and rules of thumb. Transaction methods are categories as “comparables” methods. Such approaches are not valuation methods per se, in the sense that they do not make a detailed assessment of the underlying assets as a basis for current value. Inherently, these methods assume that the valuation associated with a comparable asset (sometimes with adjustments) is applicable to the company. Generally, such approaches are useful as a reasonableness check on the results of other analyses but can be used as a stand-alone method. Some of the comparables based on key competitors, the industry, or other attributes that suggest similarity, include comparable revenue or income levels, the use of price-earnings (P/E) ratios, price-to-revenue models, and the use of market-to-book ratios for similar companies.

Valuation Discounts and Premiums

Many small businesses have majority and minority owners with various control rights. Finally, asset ownership interests have differing marketability or liquidity attributes. Some rights may have restrictions on sales; others may require that the ownership interest be sold in blocks. Each of these may have an impact on the valuation. Based on court cases, the following were observed with the value of various valuation discounts⁷: Summary of Discounts: 1970–1994

Mergerstat Review reports that median premiums for control purchases for the years 1986–1995 are in the range of 29–35%.

Other Ownership Interests Subject to Valuation

Other ownership-type interests that are subject to review include valuing debt, preferred stock, convertible debt, stock, warrants, options, and intangible assets. Each of these presents additional issues that require consideration.

Conclusion of Value

Once the valuation work is complete, the professional needs to set out a conclusion of value. It may be in the form of a number or specified range. In arriving at the conclusion, the expert should reconcile and correlate the results from selected methodologies and/or alternative assumptions. Furthermore, the expert should consider the reliability of the valuation outcome as a result of deriving differing numbers using a variety of approaches and underlying assumptions. The valuation professional has a choice of relying primarily on one method, and using the others as reasonableness checks, or relying on multiple methods that incorporate a reconciling approach to determine the value or specified range.

Valuation Application

Your firm has been hired to performed a valuation engagement, as that term is defined in the Professional Standards of the National Association of Certified Valuators and Analysts (NACVA) and Statement on Standards for Valuation Services (SSVS) of the Association of International Certified Professional Accountants, of a 40.0% ownership interest in Rosewood Florist Shop, LLC (hereinafter, the “Company”) as of December 31, 2018, on a noncontrolling, nonmarketable basis. This valuation is to be performed for United States gift tax compliance and reporting and conducted in accordance with professional standards. The estimate of value that results from a valuation engagement should be expressed as a conclusion of value.

Rosewood Florist Shop, LLC is a Florist company headquartered in Morgantown, West Virginia. Ms. Rosewood started the company in 1983 and now has gross sales of approximately $24 million and employs about 210 people. In 1986, Rosewood Florist had annual sales of $100,000 and only five employees. The employee turnover rate is very low by industry standards, which implies a high degree of employee satisfaction and a relative constant level of florist work. There is an adequate supply of labor in the area when occasional help is needed, and the compensation for these individuals is average for the area.

Rosewood offers a wide range of services, including retail sales, weddings, corporate, and special events, has contracts with numerous area businesses to provide all plant and florist needs and some maintenance contracts. A 0.5% decline was noted in florist revenues from 2017 to 2018. Ms. Rosewood suggested that the decline was associated with retail sales. New competitors and cheaper retail options from Wal-Mart, Kroger, Giant Eagle, and other national chains have reduced the need for walk-in retail sales. Delivery retail sales have also seen a decline as edible eats and other delivered gifts have entered the market. The comparison of revenue by service from 2017 to 2018 shows growth in weddings and corporate and special events, while business contracts and maintenance were relatively flat. Ms. Rosewood indicated that these trends are likely to continue. Her assessment is consistent with industry trends.

Nearly all of Rosewood Florist’s customers are located in Morgantown, Fairmont, and Bridgeport/Clarksburg, West Virginia, and most of the company’s customers are located within 75 miles of Morgantown, West Virginia metropolitan area. However, Rosewood Florist does have two large accounts in Pittsburgh, Pennsylvania (approximately 90 miles north of Morgantown). The clients are the Pittsburgh Steelers and Pittsburgh Penguins and are responsible for about $400,000–$500,000 in revenue per year. Ms. Rosewood has known the Steeler and Penguin owners for more than a decade, attends almost all home games and occasionally sits in the owners’ box.

Rosewood Florist obtains a significant amount of revenue from a relatively small number of customer accounts. In recent years, the company had 20 to 25 customer accounts that each generated more than $250,000 of annual revenue. Discussions with Ms. Rosewood and review of accounting revenue summary schedule pulled up on the Rosewood computer monitor indicate that no customer is responsible for revenue of more than $250,000. The listing of large customers viewed on the Rosewood computer monitor suggests that the 20–25 large customers pretty evenly span a range of $100,000–$250,000. The 25 customers average $175,000 each; given that average, the 25 customers account for $4,375,000 of revenue or about 18% of total revenue. A comparison of these top customers over time suggests some turnover; however, turnover has declined in more recent years because Rosewood Florist’s “one-stop” shop approach makes companies less inclined to defect.

Sales are somewhat cyclical with most floral revenue occurring in the 9-month period from August through April, matching the changes in Morgantown demographics associated with West Virginia University that occur in the fall, winter, and spring seasons. Because Morgantown and surrounding areas are a major portion of their metropolitan statistical area, the seasonality tends to be light. With a stronger emphasis on contract business, seasonality has been less of an issue in recent years.

A web search suggests that Morgantown, West Virginia, has more than 20 florists in the region. However, many of those are small “mom and pop” shops. According to Ms. Rosewood and her sales representatives, Rosewood faces three major competitors:

• Sunshine Florist Services (4250 118th Ave N, Morgantown, WV, 26508)
• Max and Wilma Plants and Florist Services (123 W. Seneca Ave, Morgantown, WV 26501)
• Gardens, Plants and More, Inc. aka GPM (202 S 22nd St, Morgantown, WV 26505).

Rosewood ranks second in market share estimated at 10%, while the largest, Sunshine, is estimated to have 10–15% of the market; the other two, Max and GPM, are estimated at 8–9% each. Each of these three competitors has significant facilities, comparable to Rosewood and with comparable service offerings. The next 6 competitors, all smaller than Rosewood, are estimated to have between 5% and 6% of the market with services offerings that capture customers with similar needs to those of Rosewood.

According to Ms. Rosewood, Rosewood Florist has state-of-the-art florist, delivery, and operations services. Rosewood made capital expenditures in 2015–2017 when it moved into its new facility at the Westover Building. This also corresponded with a new website, app-based ordering, and state-of-the-art contract/ordering electronic systems. This assessment was confirmed through a walking tour with the operations manager and discussions with the sales representatives and operations management. This allows Rosewood to be price competitive while offering services that are comparable to that of their competition. However, the technology of the florist business is somewhat dynamic and is expected to require continued capital expenditure, though not as high as the upgrade required when the company moved facilities. However, state-of-the-art technologies offered by key competitors suggest that Rosewood may not be able to obtain a price advantage over its competition nor lower production costs.

The operation has some current liabilities and no long-term financing. The company’s banking relationship is excellent—they have a $1.50 million credit line at their bank, which they rarely need to utilize. Financial statements for Rosewood Florist Shop, LLC are prepared annually on an accrual basis and are reviewed by an outside CPA. The financial statements are compiled by the outside CPA and are available two weeks after the end of each month. Tax planning is done annually.

Rosewood has a manager of accounting and finance who supervises the entire accounting department and is responsible for accounts receivables. The company also employs one accounts payable clerk and a payroll clerk. The administrative assistant to the manager of accounting and finance completes bank and other account reconciliations monthly and those reconciliations along with the accounting activity are provided to the CPA firm that compiles the financial statements monthly, prepares annual financial statements on an accrual basis, reviews transactions, and completes the tax return. While separation of duties is not optimal, Ms. Rosewood is a stickler for detail and tends to carefully review the financials and bank statements monthly. In addition, Ms. Rosewood holds a weekly accounts receivables meeting with the controller, 16 sales representatives and the VP of operations. Cash balances have been growing, and accounts receivable and payable have remained roughly in line with revenue changes.

Management below the owner level is capable. They are able to perform their duties without extensive supervision or control. The owners (Linda and Daniel) worked 100% of the time in the business. Linda Rosewood (age 64) is the president of Rosewood Florist and Daniel Rosewood (age 60) was the office manager. Each owner was paid $10,000 per month. It is expected that an adequate replacement for Daniel can be found at an annual salary of $65,000–$75,000. Linda’s salary is at the market rate for the area. The company’s other key employees include Eric Forest (VP of Operations and Delivery), Kurt Davidson (VP of Weddings and Special Events), Dan Richardson (Manager of the Retail Department), Sam Erickson (Manager of Accounting and Finance), and Tammie Samuelson (Manager of the Contracts and Maintenance). Rosewood Florist currently has 16 sales people, all of whom are located in Morgantown. In the future, Rosewood Florist anticipates that salespeople will be added in other geographic areas. However, no definitive plans for geographic expansion existed as of December 31, 2018.

The company leases real estate from Linda & Daniel Family Limited Partnership, which is owned by the company’s principal shareholders, Linda and Daniel Rosewood. The lease agreement includes Rosewood Florist’s Morgantown facility and an additional property known as the Westover Building. The lease payment is $41,167 per month. This is the only related-party transaction in which the company is involved. Rosewood Florist subleases approximately one-half of the space in the Westover Building to another company.

Discussion with Ms. Rosewood and the sales representatives is optimistic that Rosewood’s market share is solid and that the company is well positioned for the future. An economic and industry analysis and outlook and its application to the Rosewood valuation engagement is presented in the report and not repeated here to economize on space.

Rosewood’s historical balance sheet assets are as follows:

Rosewood’s historical balance sheet liabilities and stockholder’s equity are as follows:

Additional relevant balance sheet details are discussed in the report and not repeated here.

Rosewood’s historical income statements are as follows:

Additional relevant income statement balances are discussed in the report and not repeated here. Also, a financial examination of historical reporting over time and in comparison to the industry is presented in the report and not repeated here.

It is commonly accepted that most financial statements, even if prepared using GAAP or using a Tax Basis of Accounting (TBA), often present a picture that is different from economic reality. As a result, the analyst will generally prepare economic or “normalized” financial statements. Normalized financial statements will allow the analyst to better compare the subject company’s financial performance and position to similar companies or industry averages. It also allows the analyst to better measure true economic income, assets and liabilities.

The main objective for recasting or adjusting the financial statements of a closely held company can be stated as follows: “To adjust the financial statements or income tax returns of a business to more closely reflect its true economic financial position and results of operations on a historical and current basis.” Balance sheet adjustments are made to reflect the current market values of both assets and liabilities. Income statement adjustments are made to reflect the true economic results of operation similar to what a prospective buyer might require to have reasonable knowledge of the relevant facts. Normalizing adjustments are hypothetical and are not intended to present restated historical results or forecasts of the future in accordance with AICPA guidelines.

Normalizing adjustments to the Rosewood’s balance sheets and income statements are discussed below.

Balance Sheet Adjustments

Valuation Calculations

As presented in the written report in the following chapter, the adjusted net asset and market approach/guideline transactions methods (BizComps, IBA Data, and Pratt’s Stats) were used to estimate the value of Rosewood. These methods were not deemed to be representative of the value of Rosewood and are not presented herein. Rosewood does not prepare long-term financial projections, so the income method, discounted cash flows, was not able to be applied to the facts and circumstances of the company. Rather, the capitalization of adjusted net earnings method under the income approach was used to determine the fair market value of the subject interest. This method includes determining the adjusted net earnings available to the equity owners of the Company, developing an appropriate capitalization rate, and implementing the capitalization process.

The benefit stream to be capitalized is that which an investor would expect the enterprise to realize in the future. The historical weight-adjusted normalized pretax earnings were calculated to be $1,740,630. Estimated ongoing tax adjustments were made resulting in an amount consistent with the after-tax capitalization rate used in the calculation. Cash flow adjustments were then made; $100,000 for working capital and $100,000 for recurring capital expenditures, resulting in an ongoing adjusted net cash flow of $581,500.

The rate used to capitalize the expected economic income is the expected rate of return that a buyer requires to make a particular investment. Most of the information for estimating the expected rate of return, or capitalization rate, comes from the investment markets. A build-up method was used to estimate the capitalization rate.

The risk-free rate (Rf) is of 2.50 is based on the annual yield of a 20-year United States Treasury bond as of the valuation date, December 31, 2018, as published by the Federal Reserve in their Statistical Release.

The equity risk premium (6.6%) and the risk premium for small size (6.0%) and is calculated as the average rate of return on common equity securities over the average income return earned on long-term Treasury bonds over the same period and ranked by five different measurements of size as found in the 2018 Ibbotson SBBI Valuation Yearbook. The total ERP plus risk premium used is 12.6% (6.6% + 6.0%).

The company-specific risk premium (RPu) is a subjective measurement of the unsystematic risk associated with the subject company. This risk premium is based on factors such as industry risk, volatility of returns, leverage, size smaller than the smallest size premium group, and other company-specific factors. Some of the factors influencing the company-specific risk premium include the following:

• Size. Investments in small companies typically carry a greater expected rate of return.

  Rosewood is on the lower end of the size spectrum.

• Access to Capital Markets. Small, closely held firms generally have more difficulty raising money.

  Rosewood has an unused line of credit and no long-term financing.

• Breadth of Customer Base. Dependence on specific customers who can easily choose a competitor is a significant risk.

  While no single customer accounts for more than 3% of revenue, Rosewood’s largest twenty-five customers account for about 40% of 2018 revenue.

• Geographic Location. Certain regions of the county or metropolitan areas under-perform.

  The West Virginia economy and Morgantown in particular seem to offer improving economic conditions, thought conditions that trail the nation.

• Key Executive Dependency. Smaller companies that rely on certain executives, particularly if these executives are older, may be vulnerable.

  The company is dependent on a few key management personnel.

• Limited Product Line. Single focus closely held companies are more risky.

  The company has little diversification, earning all revenues from the Florist industry that is currently impacted with technological innovation.

• Litigation/Regulating Risk. Many profitable, otherwise healthy companies have been significantly affected overnight by lawsuits and legislation.

  No litigation has been identified.

• Volatility of the Industry. Certain industries are subject to cycles or serve competitive pressures.

  The industry is changing due to the impact of technology and trends in florist services.

Rosewood has been operated by experienced leadership and has been financially conservative. There have been no major issues, such as environmental or labor problems, in the Company’s history nor does management foresee any arising in the future. Company-specific risk for an entity like this should be relatively low. Based on these factors and our analysis of the financial and operational characteristics of the Company, a company-specific risk premium of 6.0% was considered reasonable.

The build-up method resulted in a net cash flow discount rate of 21.1%. From this amount, the estimated long-term sustainable growth rate must be subtracted in order to determine the capitalization rate. The long-term, sustainable growth amount of 2.5% was determined based on the forecast for the foreseeable future based on the estimated growth in inflation and revenue opportunities afforded Rosewood through its early transition to digital florist. Subtracting the 2.5% long-term sustainable growth rate from the discount rate of 21.1% resulted in a capitalization rate for next year of 18.6%. To determine the appropriate capitalization rate to apply to the historical earnings, the 18.6% was adjusted by dividing it by 1 plus the long-term sustainable growth rate of 2.5%, calculating a capitalization rate of 18.1%, which is appropriate for the historical income benefit stream. As shown below, this capitalization rate was then applied to the adjusted net cash flows of the Company to estimate the fair market value of Rosewood.

Losses: Personal Injury

The primary circumstance with court actions and related loss claims is that the injured person survived the incident and subsequently lost income. The expertise needed to investigate these types of cases and develop proof of losses includes that of the forensic financial specialist (accountant, financier, or economist). These experts estimate the reduced earnings and other forms of support as a result of the injury. In addition to earning losses, depending on the nature of the injury, the party may suffer some permanent injury and thus his or her earnings capacity may be reduced for indefinite periods. Moreover, the person’s injury may be such that he or she needs to incur future costs for medicines, medical treatments, home health care, and other costs. If this is anticipated, the fraud examiner or forensic accountant may need to rely on the expertise of a specialist from the medical field, who can affirm the need for future medical care, outline the types of treatments that may be necessary, and help the financial professional locate data on the associated costs. If the person requires permanent health maintenance or special living arrangements, these concerns are probably beyond the medical expert and require someone who deals with after-care needs to estimate the costs of future living arrangements. The reports and testimony of the medical, life-care, and other experts should be incorporated into the work of the anti-fraud professional or forensic accountant.

Another form of expertise that may be needed could include human resources and labor relations professionals. They understand the vocational aspects of the injured party and his or her possible career paths. The human resources professional needs to consider the person’s past work history and job opportunities and incorporate the information from the medical experts into the determination of potential career paths. They must also consider the possibility of permanent disability, which may be assessed from at least two perspectives. First, a permanently disabled person may never again be productively able to enter the workforce. A second possibility may involve a permanently diminished capacity to work at a level previously achieved, although gainful under-employment at reduced earnings is still possible.

An injured person may suffer up to five types of losses, both past and future, that need to be considered:

1. Loss of earnings
2. Loss of employment benefits associated with the earnings
3. Losses associated with the ability to perform “nonmarket services” (personal labor to the household that may need to be contracted to outsiders)
4. Medical costs
5. Life-care costs

Earnings losses include those associated with time off work and may also involve reductions in earnings capacity as a result of the nature of the injury. When a person loses his or her employment earnings, there are fringe benefits to consider: medical, dental, disability, unemployment, and life insurance; employer retirement plan contributions; Social Security and Medicare/Medicaid contributions; clothing allowances; and an employer-provided automobile for personal purposes. An injury to a person may also result in the need for incremental expenditures because of the inability of the person to complete usual household chores. For example, a person or the family may need to contract for home repairs, cooking, laundry, cleaning, childcare, lawn maintenance, and other duties that had been performed by the injured party. For these types of nonmarket services, no money changed hands in the past; however, now workers must be hired for the household. Finally, there may be the need for redesigned living quarters, special tools and equipment, or special diets.

Losses: Wrongful Death and Survival Cases

The unfortunate death of a person where another party may be held accountable can result in two general types of cases: wrongful death and survival actions. The type of case depends on the laws of the state in which the “death with associated liability” occurred. In jurisdictions with wrongful death statutes, the primary right of recovery resides with the survivors. In a survival action (even though the person didn’t survive), the estate of the deceased has the primary right of recovery. These actions proceed in a manner similar to those of a permanent disability. Once recovery has been awarded to the estate, the assets are transferred to the survivors through the settling of the estate. Thus, survival actions are akin to thinking “what if” the person survived the injury instead of dying. The resulting issue is important, because the losses are different when considered from the perspective of the “survivor” and those of the surviving family (as in wrongful death).

The decedent or his or her surviving family (in a wrongful death suit) may have suffered the following types of losses, both past and future, that need to be considered:

1. Loss of earnings
2. Loss of employment benefits associated with the earnings
3. Losses associated with the ability to perform “nonmarket services” (personal service contributions to the household that may need to be contracted to outsiders)

When his or her losses are compared to the list of losses to an injured person, the decedent has no need for medical or life-care costs; thus, categories 4 and 5, described in the previous section, do not apply to wrongful death and survival actions. However, much of the discussion with regard to earnings, both current and future, employment benefits, and costs associated with nonmarket services, which now must be contracted out or performed by a surviving member of the household, do apply. In the discussion that follows, generally, injuries (temporary or permanent) are considered first and then the changes, assuming wrongful death and survival actions are addressed.

Analysis of Earnings Losses

The estimate of earnings losses requires the evaluation of five examination areas:

1. Determining the basis for earnings losses: expected earnings versus diminished earnings capacity
2. Analysis of employment history and related past earnings
3. Projection of probable career paths: before and after the loss
4. Determining the proper earnings for each projected career path
   1. Base earnings: before and after the earnings loss (injury or death)
   2. Earnings increases
   3. Application of present value
5. Consideration of other factors on earnings losses
   1. age and experience
   2. probable duration in the workforce
   3. probable periods of unemployment

First, the professional must determine whether to project either expected earnings or lost earnings capacity for the decedent. Expected earnings are an estimate of the amount an injured party would (could) have earned but for his or her wrongful death. Earnings capacity refers to the ability to produce future earnings. It assumes that some choices about earnings duration and type of work are made by the injured party and have an impact on the amount of likely earnings losses. Earnings capacity is a broader standard that considers the potential for the individual to generate earnings, notwithstanding the fact that the injured party may not have chosen to perform the work necessary in order to generate those earnings. These attributes may be reasonably understandable to some, yet confusing to others. An example may help clarify the differences.

Assume that an unmarried man, age fifty, with no children, has the necessary retirement funds accumulated such that he planned to retire and move to warmer climates at age fifty-five. However, prior to the planned retirement (age fifty-five), he is injured (died) at fifty years old. Given this scenario, his expected earnings period is five years, starting at age fifty and ending, as a result of the planned retirement, at age fifty-five. However, notwithstanding the impact of the injury, his profession might have allowed him to have earning capacity through age seventy or even longer. Generally, the legal standard for the jurisdiction determines either expected earnings or earnings capacity. In that regard, the professional needs to work closely with legal counsel in order to identify the proper basis for projections. In some cases, the expert needs to develop loss estimates for both expected earnings and earnings capacity.

Once the basis for projections has been determined, data should be collected on the injured party’s employment and earnings history. If, for some reason, the records are incomplete or not available, the earnings history of a comparable uninjured person may be obtained. A further alternative is to identify and use descriptive statistical data (e.g., U.S. Department of Labor Statistics) that include averages for groups of persons who have similar duties and responsibilities. In order to develop lost earnings, the professional can rely on W-2 statements, pay stubs, tax returns, and data from the Social Security administration, as well as a résumé for the individual. Because many people do not maintain a current résumé, a professional may need to ask for assistance in preparing a listing of employers, positions, titles, duties, and responsibilities. The expert would also seek information on the injured person’s educational history and any special training or on-the-job skills.

Generally, assuming that the information is available, the injured party’s own experiences are given superior weight. However, recent employment changes—unrelated to the injury—may suggest that other comparables may be a better basis. For example, assume that a medical doctor recently completed his or her residency requirements and had moved into a chosen area of specialization. Under those conditions, past earnings may no longer serve as a reasonable basis for future projections. As another example, assume that the injured person had recently obtained a promotion to a new position with higher earnings. Under that scenario, the majority of the historical data would be at the lower pre-promotion levels and would no longer carry as much relevance for future projections.

The third consideration is that of the prior career path, the projected career path, and the possibility of multiple career paths. This is a particularly challenging area, because both expected earnings and earnings capacity may be affected, so there is a need to incorporate individual preferences into the analysis. The expert also needs to consider the market for the type of work and responsibilities associated with the decedent’s chosen and desired career paths. For example, some professional services firms have mandatory retirement at age sixty. Thus, a principal in one of those firms would only have earnings capacity in that firm through that age. However, depending on the nature of the professional services, noncompete commitments, etc., and the individual’s expertise, the injured person may have earning capacity in outside services firms after retirement.

The consideration of career path requires the incorporation of judgment and uncertainty into the estimate of lost expected earnings or capacity. To develop a likely career path, the financial expert may need to rely on the work of others with human resources expertise. Another alternative is averages developed by economists related to the impact of age, education, region, sex, race, and other demographic characteristics on earnings history. To apply these criteria, the use of a human resources specialist is often warranted, an expert who may suggest several likely long-term professional career paths. In such cases, the fraud examiner or forensic accountant needs to develop multiple estimates based on the various assumptions suggested. The determination of earnings related to career path after injury is challenging and often entails using hypothetical input from human resource professionals or direction provided by the attorney.

The first three areas of consideration—expected earnings versus earning capacity, prior employment and related earnings, and projected career path(s)—serve as the foundation for projecting lost earnings into future periods. During this phase, the fraud examiner or forensic accountant projects earnings (expected or capacity) based on the probability of each potential career track. Notwithstanding recent changes in career path, the last full year of employment often serves as a defendable foundation or basis for projecting future earnings. In some cases, a range of years can be averaged to derive a starting place. If so, prior years’ wages should most likely be adjusted for cost-of-living increases before averaging. For employees paid by the hour, for cases in which the hours tend to fluctuate, separate the total earnings into hours and wage rate. Each of these attributes can then be evaluated with the goal of developing a defendable basis.

From the data on historical employment and past earnings, determine their applicability to the facts and circumstances at the time of the injury and the period after the injury that requires projection. From a technical perspective, the fraud examiner or forensic accountant needs to develop two amounts: (a) one that assumes that the preinjury earnings history would have continued into post-injury periods and (b) a projection of the probable (actual) employment income that would be earned in the post-injury period. The difference between the two amounts represents losses to the injured party. Incorporate recent actual events, such as promotions, education, or other changes, that may have an impact on the projected earnings, either positively or negatively.

Notwithstanding these issues, the analysis of expected earnings and earnings capacity should incorporate judgment by the professional. For instance, mandatory retirement ages may be in place in the profession that has physical requirements, such as athletic skills or beauty. Assume that a professional football player may say he plans to retire at the age of forty-five, but a quick review of historical statistics suggests that the probability is highly unlikely. Finally, the jurisdiction in which the case is being heard may determine whether expected earnings or earnings capacity is the proper basis. State laws and prior case law may make one or the other the chosen standard.

Given an assessment of past earnings and their impact on future earnings, the next consideration is increases in projecting earnings. A related issue is the discount rate to use for the projection, recognizing that most injury settlements are likely to be paid in lump sum in current dollars. In Jones and Laughlin vs. Pfeifer, the Supreme Court allowed three options for projecting earnings and the appropriate discount rate:

1. Case-by-case method
2. Below-market discount method
3. Total-offset method

When using the case-by-case method, wages and discount rates are projected in nominal terms (including estimated increases for inflation). Using this method, the “actual” dollars that would have been earned in the past or into the future are estimated. They are made on a year-by-year basis and include projections of earnings increases. Future earnings are then discounted back to the present, using discount rates based on projections for interest rates (recognizing that anticipated inflation is an inherent attribute of interest rates). Incorporating earnings, earnings increases, and discount rates have the effect of compensating for the impact of inflation where purchasing power would otherwise decrease.

With the below-market discount method, earnings and discount rates are projected where the impact of inflation has been removed. By working in real dollars, the projections ensure that the purchasing power associated with the earnings remains approximately constant. Further, the earnings projections are more pure, in the sense that they reflect the benefits of experience, increased responsibility, etc., that are often recognized as a worker ages and becomes more productive. Further, because real discount rates have been adjusted downward for inflationary pressures, they tend to be lower than nominal discount rates. The term below-market refers explicitly to the fact that real discount (interest) rates will fall below those of nominal rates, recognizing that market rates of interest incorporate inflation and are more in line with nominal rates. Using real rates, there are two options: the real interest rate, which is the rate of return on borrowed money net of any premium for inflation, and net discount, which is calculated as the difference between the nominal rate of interest and the wage inflation rate.

To illustrate these two methods (case-by-case and below-market discount methods), assume that Pete is disabled on 1/1/2018 and that the disability is judged permanent. Further assume that Pete’s salary indicated that he’d earn $40,000 in 2018. Earnings increases are expected to be approximately 3.5%, and a nominal discount rate of 6% per year is considered reasonable. Because Pete is near his fifty-sixth birthday, he is expected to lose ten years of earnings (for this illustration, assume that the hypothetical jurisdiction requires expected earnings to be the proper basis of consideration). Both the 3.5% projected earnings increases and the 6% discount rate are nominal, in that they anticipate inflation. Assume further that, instead of using nominal rates for earnings and discount rate projections, the attorney prefers the use of real rates. Given Pete’s chosen profession, age, and experience, it is further assumed that the only basis for his wage increase is inflation. Thus, the real wage rate increase is zero and his annual 3.5% projected earnings increase represents inflation. However, it is not only the projected increases in wages that are in nominal terms. The professional also needs to remove inflation from the discount rate, decreasing that estimate. For simplicity, assume that the real discount rate is 2.1453%. Thus, the real discount rate is 2.1453%, and the inflationary impact on the nominal discount rate is 3.8547% (the two amounts total 6%). The outcomes of those approaches appear in the following table.

From these results, focusing on the nominal approach, we can see that the total loss using the nominal approach is $469,256, but, after discounting back to the present value, the actual projected loss is $360,110. Switching to the net discount rate in the right-most three columns, the real wage loss is $400,000 (ten years times $40,000 in real-dollar wages), but the discounted present value is $360,112. Note that the outcomes of the two approaches are approximately equal. This stems from the fact that inflation adjustments were made to both the wage increase rate and the discount rate (or, in the case of the nominal approach, which inherently incorporates inflation in the wage increase rate and discount rate).

The third method for dealing with wage increases and inflationary pressures on the discount rate is the total-offset method. This simplifying assumption is that the wage increase rate is equal to (i.e., offset by) the discount rate. The same fact scenario previously discussed is recalculated in the following table.

In the left-side columns, total-offset approach #1, the projected wage increase is assumed to be offset by the discount rate. In the total-offset approach #2 example, the nominal discount rate previously discussed is assumed to be offset by the wage increase. In both cases, the net present value of the projected loss is $400,000. Thus, the simplest way to approach the total-offset method is to take current year wages and multiply that amount by the number of loss years. In the example given, $40,000 earnings times ten years of losses equals $400,000.

Related to projecting future wage rate increases and changes in the future discount rates, some argue that the past can be used to project the future. Others claim that the future is too unpredictable for past rates to be a good indicator of future rates. The practical reality is that it is a matter of debate that never ends. However, at a minimum, the practicing professional should examine prior history to see what has happened to wages for the type of individual whose future earnings will be affected. In addition, to the extent that projections arise for future wages and related increases, those should be examined as well.

A further issue related to the appropriate discount rate requires discussion. As noted in the damages and valuation sections of this text, discount rates—when associated with business ventures and incorporated in court cases—can be relatively low compared to those observed for early-stage investment capital. In fact, in early-stage investment capital, discount rates can become quite high, such as in the market for angel-type investments and for venture capital. However, with loss wage engagements, the discount rates are generally low, lower than even those considered appropriate when a business has been damaged. The discount rates appropriate for wages and the ability to earn wages in the future should be analogous to those of relatively safe investments, not risky businesses or angel/venture capital investments. Generally, U.S. Government Securities is considered a high quality, safe investment, and the discount rates selected should reflect that standard. Alternatively stated, the discount rate should not incorporate premiums that are appropriate for investors who are willing to accept some risk that the return may be zero or that they may even lose their investment. Not to be confused, the risk-free rate does not eliminate the risk of inflation. It includes some adjustment for inflationary risk. However, the U.S. Treasury Inflation-Indexed Securities (TIIS bonds) are essentially risk-free, and they eliminate the risk of inflation as well.

The fifth area of consideration accounts for other factors that may have an impact on the analysis. Some of those may be age, experience, projected duration in the workforce, possible periods of unemployment, and life expectancy. As discussed previously, pressure for wages to increase is generated either from inflation or from productivity gains. The impact of inflation is generally unrelated to productivity gains, but some productivity gains may be associated with age and experience. The professional must keep these issues in mind as he or she develops projections. Although one may not always be able to disentangle the impact of inflation versus productivity, it is important to understand the foundation of the factors as a basis for wage rate increases.

If employment before the injured party enters the workforce on a full-time basis is ignored, the typical pattern for wage and experience for noncollege graduates starts around eighteen years of age, with relatively low-paying jobs. According to Ireland et al., the period of low pay continues until around age twenty-six, by which time the employee has gained some experience and confidence and has been able to establish a track record with the employer. With age, maturity, and experience, the employee’s wages generally go through a period of rapid growth. Toward the end of the employee’s work life, increases are usually lower than those of the average workers, and overall wages may even decline. The pattern for workers with college educations parallels that of the noncollege workers, with the exceptions of the age of entry into the workforce and of wage increases for older workers. For educated workers, wages for the fifty-five- to sixty-four-year-old age group tend to be lower than those of the forty-five- to fifty-four-year age group. Because, for the average worker, age and experience are very highly correlated, the practicing professional usually cannot disentangle the effects.

In cases where the individual cannot continue in the same field, his or her age or experience makes a difference in starting salaries and projected annual increases in a new field. The antifraud or forensic accounting professional can make assumptions with someone who has human resources experience; however, this does not provide the benefit of long-term statistical support, because such information is not captured in the U.S. census data.

Another complication is life expectancy. In order to earn income, the individual needs to be alive and employed. Thus, estimates of lost expected earnings and earnings capacity need to take into account the probability of being alive. At least two systems have been created to account for this. The first is the Statistical Work Life Expectancy (SWLE) method. Work life is defined as the period during a person’s life when he or she participates in the workforce, either by being gainfully employed or by seeking employment. The U.S. Department of Labor provides work life estimates with the Effects of Race and Education tables.

The second system is the Life Probability, Participant Probability, and Employment Probability, or LPE system. Life probability is the likelihood that the person will survive through the year in question; participant probability is the chance that the individual will participate in the labor force in any particular year; finally, employment probability is the odds that the employee will be employed in any given year (i.e., not be unemployed). The (Department of) Vital Statistics of the United States maintains data on life probabilities; the U.S. Department of Labor has data related to the final two probabilities. The LPE system is the conditional probability that a person will be alive, a labor market participant, and employed in a future year.

Both the SWLE and LPE approaches have strengths and weaknesses the professional needs to be aware of those and, possibly, make adjustments when preliminary results appear misleading and when those issues can be associated with the shortcomings in the underlying statistical data. Some of the areas of concern for the probabilities include homemakers, single-career women, consideration of periods of unemployment, and some issues concerning the timing of when a person is more likely to be in the workforce.

Considering that the professional needs to estimate two streams of expected earnings or earnings capacity—that of the worker preinjury and that of the worker post-injury—a permanent disability is likely to have an impact on post-injury participation in the workforce. According to Ireland et al., from the Bureau of Census and Social Security administration data, workforce participation rates for disabled workers are lower than for those similar but nondisabled employees. Given the likely impact of disability on the injured person’s ability to participate in the workforce and the challenge of determining how that may affect participation, the professional should consider input from a qualified expert. Life and employment probability is considered in the detailed example presented later in the chapter.

Another area of concern for wages is associated with taxes. The objective is that the injured party comes out whole. As a result, a study of federal, state, and local taxes is necessary. Earnings, if received in the future, would be taxable when received. But, in some cases, lost earnings awards are not taxable. How the settlement is characterized may also have tax implications. Historical earnings had an amount associated with the tax liability. In cases where lost wages would not be subject to taxes, such as those covered by disability insurance where the premium was paid by the individual, taxes can be removed from the lost wages amount. In other cases, the lost wage award is taxable, because the award represents expected wages that would have been earned in future periods but for the injury. In those situations, the issue is the marginal tax rates. The tax on a single lump sum may be considerably higher than if the person earned those amounts in future years in lower tax brackets. The estimate of lost earnings needs to address this.

A related issue is the discount rate. Some government bonds generate interest tax free; others do not. So the expert should be careful when the discount rate explicitly considers the impact of taxable interest because of the type of investment. The simplest solution is to incorporate Aaa-rated municipal bonds as discount rates. Because earnings on these investments are tax free, the rate explicitly deals with the taxability of interest. If other investments are chosen to proxy for the risk-free rate of interest, an adjustment for taxes can be taken into account.

With regard to a survival action (where the decedent was assumed to have lived into the future), the standard of loss is that of the decedent. The calculation is generally the same as a total disability. Thus, the estimate of actual future earnings would be zero, and the total amount of expected future earnings or lost earnings capacity would be the amount of the loss. The lost earnings would be awarded to the estate, which would distribute the assets to the survivors based on wills and applicable state laws. With wrongful death, where the amount of loss is to the survivors, the total of lost earnings is normally too high. The argument is that the deceased person would have enjoyed at least some of those lost earnings him- or herself and that what the deceased individual enjoyed, the others could not. The challenge is determining how much of the total lost earnings would have been enjoyed by the deceased versus the amount enjoyed by the survivors. One clarification is necessary: Expected earnings are all that could be lost to the survivors. Only the deceased could have pursued any lost earnings capacity.

Analysis of Lost Employment Benefits Associated with Lost Earnings

Generally, not all employment benefits are lost when an injury or permanent disability occurs. The standard applies to those benefits the injured party has lost. Discretionary employee benefits are those paid by that employer that are not government-mandated and include automobiles, bonuses, and other award plans (e.g., contest awards, trips, etc.), dental disability, medical, vision care, and life insurance; education; employee discounts, meals, employee uniforms, health and entertainment facilities; paid sick, vacation, and family leave; and prescription drug, retirement, and stock option purchase plans. The amount to include in the loss calculation is not the cost to the employer, but the value to the employee. It is the use of those benefits that determines the amount of the employee loss. A few complications arise.

For example, how should benefits be reflected that were available but not used? In some cases, such as a fitness facility, the person may have not used it before but now needs that benefit as a result of the injury and changes in lifestyle. Even if the injury does not necessitate the use of a previously unused benefit, it does not necessarily mean that the employee would never have elected to use it at some future date. For example, as people age, they often become more concerned about their overall fitness and may select the use of a facility when that option had not been used in prior years. The minimum seems to be that it would have been likely the employee might have elected that benefit in the future. In some cases, such as where disability insurance is utilized; the argument can be made that the particular benefit has been activated and that no future loss is possible.

Going back to the issue of loss to the employee versus the cost to the employer, it needs to be considered that an employer may have access to group discounts and other options that allow him or her to pay less than a worker seeking a benefit as an individual. For example, health insurance tends to be lower under employer group rates than for individual policies. Because it is the benefit to the employee that counts, the cost to the employee to obtain that benefit in the marketplace as an individual is the proper standard. Finally, given the need to project expected employment after injury, compared to what could (would) have been but for the injury, consider the types of benefits available with post-injury employment versus pre-injury employment and career path.

With regard to benefits mandated by government laws and regulations, additional analysis is required. Generally, mandated employment benefits are provided in four separate areas: Medicare, Social Security, unemployment, and workers compensation. Medicare payments are a type of tax, and a person’s eligibility is not affected by amounts contributed or not contributed. The 1.45% mandated amount for Medicare is usually not counted as a lost job-related benefit. Social Security is 6.2% of earnings up to certain maximum income levels. The U.S. Social Security administration maintains a record of earnings upon which the tax is paid by individuals. Social Security benefits are then paid based on the highest thirty-five years of wages. Thus, the elimination of employer payments into Social Security would likely have an impact on the employee’s Social Security benefits later in life. However, determining the impact is challenging, because the amounts paid from Social Security are not analogous to amounts paid in.

A detailed analysis of the changes to Social Security contributions and resulting payouts is necessary to determine losses associated with Social Security benefits. Of the 6.2%, 5.35% is related to retirement income, and 0.85% is associated with disability insurance. If the injured party becomes eligible for disability, that person is likely to derive greater benefits from prior contributions than any loss of future benefits. Unemployment benefits can be estimated for workers who face joblessness with some regularity. Because workers’ compensation is designed to support workers during times of unemployment as a result of on-the-job injuries, the injured worker tends to lose no benefits when receiving lost earnings from other sources. As can be seen, employment benefits need to be carefully examined to ensure that the injured party is not made worse off as a result of the injury.

Assuming a survival action where the deceased is assumed to have lived, the analysis of lost benefits correlates highly with that of a permanent disability loss. However, in wrongful death cases, where the basis of evaluation is losses to the survivors, the analysis is more challenging. Each type of benefit—discretionary and mandated—needs to be examined to determine whether the survivors suffered losses because they would have received incremental benefits (because the deceased would have passed at least a portion of the benefit along to them). In a number of areas, the surviving spouse, children, and other beneficiaries would have received little or no benefits. For example, assuming that the deceased would not have drawn Social Security until age sixty-five, in all likelihood, the children would have grown by then and would have received little or no portion of those benefits. However, had the person been an older parent and the children not reached the age of eighteen, a portion of lost benefits would have been allocated to the underage children.

A similar case can be made for retirement plan contributions made by the employer. Assuming that the children had grown prior to distributions from the plan, they would have received little benefits. However, to the extent that the contributions would have created excess amounts in the retirement that would have been inherited by the children, a case can be made that the children suffered losses. Similarly, the surviving spouse often suffers from lower Social Security benefits because of the decedent’s passing. Because the standard of loss is to that of the surviving spouse, an allocation needs to be made of lost benefits between the persons. However, if the major “bread winner” is lost in a wrongful death case, an argument might be made that the surviving spouse’s quality of life and retirement income levels would be negatively affected. Life insurance that was previously paid by the employer, which was activated and paid off at the time of death, is arguably not a lost benefit because it had been received. The fundamental premise in a wrongful death examination is that the loss must be sustained by the survivors. Each benefit must be carefully assessed to determine whether it was lost to the decedent or to the survivor, and if the loss is to the survivor, determine the amount involved.

Analysis of Lost Nonmarket Services

As discussed previously, persons not only generate earnings and related fringe benefits but they also perform services—primarily around the living quarters and for parents, children, and others who may not reside with the injured person but who are dependent on the injured party for delivery of these services. Such services may include the following:

1. Auto maintenance and repair
2. Childcare
3. Cleaning
4. Cooking
5. Periodic home improvements
6. Home repairs and maintenance
7. Laundry
8. Lawn mowing, care, and maintenance
9. Painting
10. Plumbing
11. Sewing
12. Shopping
13. Teaching and other contributions to education
14. Transportation (to doctors, grocery stores, pharmacy, sporting events, etc.)

A number of approaches can be used to estimate these costs. First, the actual costs to develop and utilize substitute services in the marketplace can be used. Obtained on a piecemeal basis, such services may be expensive, but that may be the only option for some survivors when a provider is no longer able to deliver the service.

A second option is to accumulate the number of hours associated with these activities on a weekly basis and then multiply those hours by a reasonable rate to pay for those services in the marketplace. Some estimates suggest that the full-time male year-round worker contributes an average of seven hours of unskilled labor around the household and that the number of hours decreases as the need for skilled labor arises. For married full-time female workers, the estimate of household hours contributed can be two to three times the number for men. The wages applied to the different areas of household production can be based on the skills required and the availability of labor in the marketplace to perform those services. Further, the coordination and organization of household work are often considered skilled labor.

In the absence of actual hours worked each week, month, or year, an option is to develop a “per hour,” “per week,” or “per month” estimate and apply a reasonable wage rate. The amounts can serve as benchmarks for the trier-of-fact, and the judge or jury can decide how much time those services would have been provided into the future. For example, assume that a full-time working mother suffered an injury and that she worked approximately fifteen hours per week in the evenings and on weekends performing cooking, cleaning, and laundry for the family. Further assume that the going wage rate for these services is $8.00. Then, on average, the mother’s weekly contribution was $120. This benchmark could be provided to the trier-of-fact. If it is determined that she would have provided these or similar services for the next twenty-five years, the value of her contribution, before discounting, is $156,000 ($120/week × 52 weeks × 25 years).

A couple of issues arise. First, the injured person may have provided these services well into retirement. Second, even if the injured person had not suffered the injury, he or she would not have provided these services for the remainder of life. These issues must be incorporated into the estimate of nonmarket services provided. For example, childcare may only last until the children graduate from high school. Another issue arises when the injured party provides services to others outside his or her primary household. Some examples include services provided to older parents or to children who have left the household but still depend on the parents. Presume an injured father may have provided automobile repair and other household fix-it services to his children who reside locally. These are valuable to those receiving them and can be included in the estimate of losses for nonmarket services. Finally, in a few cases, the injured person can still contribute some services, but not to the level that was provided before the injury. In those situations, the professional needs to place a value on the difference between the “before” and “after” amount of services. Also, issues of inflation and present value apply to household services, as they did to earning and fringe benefits.

In a death case, there is no possibility of the deceased providing any level of services after the injury. Thus, one complicating factor is eliminated. For survival actions where the deceased is assumed to have lived, the analysis for an injured person as described previously still applies. Regarding wrongful death cases, the analysis is more challenging, because the loss is not to the deceased, but to the survivors. In all likelihood, the deceased would have enjoyed at least some portion of the nonmarket services provided. As an example, the survivors may now have to do household chores, such as cooking and laundry, themselves, but the amount of those services would likely be reduced, because nothing would be required for the deceased. Thus, the amount of cooking and the size of meals would be reduced, the types of meals may change, and fewer loads of laundry are likely required. These factors may also be considered.

On the opposite side, expenses may actually increase, because the costs to the survivors increase. Consider the case where a grandmother was providing daycare services for her grandchildren. Upon her death, the child’s parents may now be required to pay for expensive daycare services. As another example, consider the child who is providing services to elderly parents. Upon death, they may now need to enter a senior care facility or pay for home care services not previously required. In such cases, the overall costs to the survivors may rise dramatically.

Analysis of Medical and Life-Care Costs

In some cases, with short-term, long-term, and permanent injury, ongoing medical and life-care costs are necessitated to restore bodily and lifestyle functionality, reduce pain, and induce comfort. Such expenditures are not necessary in cases of death but are more common in personal injury cases. Injured persons may require 24/7 nursing services, personal trainers, personal attendants for bathing and personal hygiene, etc. Medical, prescription drug, and other life-care costs may be required. In some situations, special equipment may be necessary to allow the person improved mobility and other bodily tasks.

The development of costs associated with these types of needs may be predicated on the work of other professionals from the medical, personal training, physical therapy, and life-care fields and/or research by the professional. They need to identify requirements in a number of areas:

1. The types of needs the injured person will have
2. How long those needs are likely to continue
3. Changes in those needs over time
4. How often those needs will be required
5. Special equipment required
6. The types of professionals who will need to provide services

Once the listing is complete, estimates of the costs can be developed. Given the significant increase in health care and related costs in recent years, the rate of inflation for these specific services is likely to be greater than anticipated inflation projections for the overall economy. A challenge is that medical, health care, and life-care solutions are rapidly changing, and it will probably not be possible for a professional to anticipate or project the required services for the remainder of an injured person’s lifetime, assuming that it is likely that the person will require such services.

One approach to developing an estimate for life-care costs is to seek out bids for a life-care annuity. Quotes from service providers can be obtained, assuming that the circumstances and types of needs are consistent with the services offered by companies offering life-care annuities. Such financial instruments essentially guarantee services and lock in long-term pricing, which alleviates some of the ambiguity, required estimates, and other challenges associated with the development of life-care costs, medical care, and healthcare needs of the injured party.

Injured Children, Homemakers, and Retired Persons

Three categories—injured children, homemakers, and retired persons—create other challenges. Generally speaking, most have limited earnings and possibly no W-2s. Children create a special problem because they have their whole lives ahead of them. Further, the child will have made very few, if any, decisions that would determine his or her future. Although demographic characteristics of the parents may provide some statistical averages, there is some uncertainty. The U.S. Census Bureau provides some statistics based on educational assumptions. And, in certain cases, those can be documented. For example, the injured child’s parents may have started an IRS-qualified 529 savings account for the child’s education and may have made a number of contributions. Such evidence would lend credibility to the assertion that the child would have gone to college. Of course, the best-laid plans of parents are not always borne out by the children. In addition, the lack of college savings and other planning activities does not indicate that the child would not have pursued higher education.

Homemakers have primary responsibility for the home and, often, childcare as well. They may even be employed part-time or full-time and also provide necessary household and childcare services. For those employed at some level, the projection of lost earnings is relatively straightforward. For those not in the labor force, the professional cannot project lost wages but needs to estimate the cost of the various home and childcare services that now need to be contracted with outside parties.

With retired persons, the issue is not expected earnings—it is earnings capacity, combined with the probability that the retiree will ever enter the work force again. Like the part-time and full-time employed homemaker, assuming that the retiree is employed and has some proof of wages, the calculations for expected earnings and earnings capacity become more straightforward.

Personal Injury and Lost Compensation Application

Your firm has been hired to offer its professional opinion with respect to the value of economic damages sustained by Alex Jones (hereinafter “Jones”) resulting from a permanent disability. The damages may consist of loss of wages and fringe benefits, retirement benefit, and loss of household services. The analysis may also consider mitigating wages and pension benefits. On November 16, 2017, Jones suffered a personal injury. At the time of injury, Jones was a maintenance worker for Mononghia School District.

Jones was born on May 16, 1977. He was approximately 40.5 years old at the time of his injury. Jones is currently married to Deena Jones. They have one child, a son, born on March 14, 2002, currently 16 years of age. Jones suffered an injury on the job on November 16, 2017. He was unable to work after that date; he was paid through November 16, 2017. According to the Jones, he would have retired upon reaching 62 years of age on May 16, 2039. According to Social Security’s On-Line Actuarial Life Table, Jones’ statistical life expectancy in 2018 is an additional 37 years to age 78.50 (November 16, 2055).

Projected gross wages represent wages Jones would have earned in the absence of his injury. Projected gross wages for years 2017 through 5/16/2020 are calculated based on an agreement between The Board of Education Mononghia County School District and Mononghia County School District Custodial and Maintenance Organization. Jones’ future wages from 5/17/2020 through his planned retirement date of 5/16/2039 are projected forward by 1.50%, which is the average annual increase from 2016 to 2017 school year to the 2017–2018 school year. As part of Jones’ compensation package, he was offered overtime. His average overtime from 2015 through 2017 was approximately 20% of his salary.

Related to Jones’ fringe benefits, he would no longer receive employer Medicare nor social security contributions. As part of Jones’ compensation package, he was offered health-care insurance, 100% paid for by his employer; pay stubs indicate that Mr. Jones received this employer-paid benefit. Post-injury, Mr. Jones’ most likely source of healthcare benefits is the Affordable Care Act (ACA, also known as Obamacare). According to Jones’ pay-stubs, his annual union dues were $225, or 0.50% of his annual salary.

Mononghia School District automatically enrolls all employees in a defined benefit pension plan. The district plan requires a 5% contribution by employees. Typical employees risk possible periods of unemployment. According to the Bureau of Labor Statistics, the average unemployment rate for Government Workers as of April 2017 is 1.8%.

Dr. Job’s vocational expert report states that if Jones is successfully rehabilitated, his future earnings potential is approximately $21,000 per year with full employment. Job states that Jones would be limited to entry-level positions and minimum wage rates.

The following chart summarizes many of these assumptions and model inputs:

Calculation of loss of earnings and fringe benefits subsequent to Jones’ loss of income date (11/16/2017) to his planned retirement date (5/16/2039) is summarized in the following schedule:

The above charts were based on the following assumptions where the letter (e.g., “a”) aligns with the column in the chart:

1. Projected Gross Wages: Projected gross wages represent wages Jones would have earned in the absence of his injury. Projected gross wages for years 2017 through 5/16/2020 are calculated based on an agreement between The Board of Education Mononghia County School District and Mononghia County School District Custodial and Maintenance Organization. Jones’s future wages from 5/17/2020 through his planned retirement date of 5/16/2039 are projected forward by 1.50%, which is the average annual increase from the 2016–2017 school year to the 2017–2018 school year.
2. Overtime: As part of Jones’s compensation package, he was offered overtime. His average overtime from 2015 through 2017 was approximately 20% of his salary.
3. FICA Benefits: As part of Jones’s lost fringe benefits, he would no longer receive employer Medicare nor social security contributions. These lost benefits are added to wages and overtime.
4. Healthcare: As part of Jones’s compensation package, he was offered healthcare insurance, 100% paid for by his employer; pay stubs indicate that Mr. Jones received this employer-paid benefit. Post-injury, Mr. Jones’ most likely source of healthcare benefits is Obamacare. Healthcare.gov was use to estimate the cost of healthcare for Mr. Jones, his wife, and son.
5. Union Dues: According to Jones’s pay-stubs, his annual union dues were $225, or 0.50% of his annual salary. Projected wages were reduced by union dues Jones would have paid had he remained employed as a maintenance worker with Mononghia School District.
6. Required Pension Contribution: Mononghia School District automatically enrolls all employees in a defined benefit pension plan. The lost benefits associated with this plan are considered in a separate section. The district plan requires a 5% contribution by employees. Because the benefit is added to Mr. Jones damages in a separate section, the cost of participation is subtracted from income.
7. Taxes: Ignored in compliance with West Virginia Supreme Courts decisions.⁹
8. Risk of Unemployment: Jones’s earning reduction rate for possible periods of unemployment is estimated to be 1.8%¹⁰ of his earnings from November 17, 2017, through May 16, 2039 based on the average unemployment rate for government workers as of April 2017.
9. Mitigating Income: The calculation has been reduced by mitigating wages, in accordance with a report from a vocational expert. Dr. Jobs’ vocational expert report states that if Jones is successfully rehabilitated, his future earnings potential is approximately $21,000 per year with full employment.¹¹ Jobs states that Jones would be limited to entry-level positions and minimum wage rates. The aforementioned has been projected forward by 1.50%,¹² which is the 5-year average national growth rate for all occupations from the period of 2013–2017. Wages have been mitigated beginning on November 17, 2018, as suggested by Dr. Jobs in his report date June 6, 2018.
10. Economic Income Benefit: The total loss of income subsequent to Jones’s loss of income date (11/16/2017) through his planned retirement date (5/16/2039) before discount.
11. Number Alive: Derived from the National Vital Statistics Reports, Vol. 66, No. 4, August 14, 2017, Table 14. The amount represents the number of persons from 100,000 who survived to the age. The first number is 95,641, for a non-Hispanic white male, age 41–42.
12. Probability of Surviving: The National Vital Statistics Reports provide the basis to estimate the probability that a person will be alive up through 100 years of age. Using (k) as a base, the probability of survival is estimated in column (l). An alternative is to assume a 100% probability of life through life expectancy estimated by the social security administration and/or National Vital Statistics reports and 0% probability thereafter. For example, Mr. Jones at age 40 has a life expectancy of 37.5 years, or expected quietus of 78.5 years of age. An alternative to the probabilities in column (l) is to assume 100% up to 78.5 years of age and 0% probability of life thereafter.
13. Discount Factor: Total lost income is discounted to present value, to provide a lump sum representing the future loss. Generally, the discount rate represents the rate at which a person can invest a lump sum with no risk of loss. Interest bearing United States Treasury investments are commonly referred to as risk-free investment. The most recent yield available to date on United States 20-year Treasury Note (approximate time from the future value to present value date of 5/16/19, which is on or around our report date) is 2.75%.¹³
14. The column represented the total lost income after considering the probability of survival and discounting to the present value.

According to Jones, he plans to retire at age 62 with 30 years of service to the Mononghia School District. Under the Defined Benefit Retirement System, members vest with 5 or more years of service. Bylaws require members to contribute 5% of wages from any and all sources: wages and overtime. Plan members may retire at any age with 5 or more years of service. Maximum annual pension is calculated as follows:

Pension percentage is as follows: less than 20 years of service, the retiree receives 2.00%t per year for all years of service, and for 30 or more years of service, retirees receive 2.50% for all years of service. Final average salary is based on the highest averages wages earned during any three consecutive years (36 months), inclusive of overtime. The retirement benefit is subject to an annual COLA (cost of living adjustment). The COLA over the 5-year period 2013–2017 averaged 1.50%.

Mitigating and projected pension are summarized as follows:

Prior to the injury, Jones was responsible for performing specific household services: inside housework, household maintenance, pet care, lawn and outside maintenance, and automobile maintenance. The estimated weekly hours appear to be reasonable based on a review of the American Time use Survey of household activities. These services and the estimated percentage that Jones indicate that he will be able to perform post-injury are summarized in the table below. The value of household services that Jones is no longer able to perform is based the median wage for such services from the BLS occupational employment statistics for the appropriate job code.

The calculation of the annual cost to replace household services that can no longer be performed due to the injury sustained by Jones is as follows:

The 2017 annual household service amount is projected forward by 1.50%,¹⁴ the estimated 5-year average annual wage growth rate for all occupations. The future loss is discounted by 2.75% to present value,¹⁵ the calculation is summarized as follows:

Based upon the above analyses, the estimate of Jones’s economic damages is summarized as follows:

A report sample related to this forensic economic examination is presented in the following chapter.

We have eight types of assignments for instructors to choose from:

1. Critical Thinking
2. Review Questions
3. Multiple Choice Questions
4. Fraud Casebook
5. Brief Cases
6. Major Case Investigation (MCI)
7. IDEA Exercises
8. Tableau Exercises

1. CT-1 Take Me Out to the Ball Game. In baseball, how many outs are there in an inning?
2. CT-2Parker Brothers. CT-2Parker Brothers. A man pushed his car. He stopped when he reached a hotel at which point he knew he was bankrupt. What was he doing?

Short Answer Questions

Discussion Questions

1. Estimate of Fixed and Variable Costs: Overhead

Following the example in the book, assume that the company represented that overhead was 100% fixed and zero percent variable. The following data are applicable to these assertions. Techniques 1 (graphics) and 3 (regression) are provided.

Assignments:

1. Estimate the fixed and variable portions using the high–low method.
2. Test the assertion. Using the updated data from techniques 1 and 3 as well as your estimates when applying technique 2, estimate the fixed, variable and variable per dekatherm in the lower matrix.
3. Draw two conclsusions:
   1. Was the company representation accurate?
   2. What is a defensible estimate of variable cost per dekatherm?

2. Damages from lost employment—Permanent disability

Megan Alexander was injuried in an auto accident on December 31, 2019. She has been deemed by medical and vocational experts to be completely disabled from her ability to complete any kind of employment function. As of the date of her injury, she was earning an annual salary of $100,000 and was scheduled to receive a raise of 2.50%, starting on Janaury 1, 2020. The total healthcare cost paid by the employer is $12,000 in 2019 and is expected to rise 4%, starting January 1, 2020.

The insurance company has agreed to compensate her for lost wages and benefits for the year 2020, with one payment each year on the final day of the year (December 31). Her company encourages retirement no later than a person’s 65th birthday and Megan planned to retire on her 65th birthday, January 1, 2045. There are no lost pension benefits nor lost household services.

The settlement agreement requires that the insurance company place the present value of lost wages and benefits into a trust for distribution at the end of the year.

Other important facts and information are as follows: