As more CPAs get involved in the expanding field of litigation consulting, they find that many of their skills carry over and some do not. (This was discussed by Ray Sloane in his article, "Litigation Consulting--A Practitioner's Guide" in the April 1990 issue of The CPA Journal.) Many accountants can help their clients in the area of calculating damages or evaluating damage claims prepared by others. In the October 1990 issue of The CPA Journal, Vincent Love and Steven Reiss laid out some general guidelines for the CPA to follow in calculating damages in litigation engagements. This article applies some of those guidelines to a hypothetical litigation engagements. This article applies some of those guidelines to a hypothetical litigation case called Happy Landings. Even though Happy Landings is a fictional case, it is a composite of many actual incidents I have experienced, combined into one situation. The CPA expert represented here works for the defendant's counsel, though the same approach and principles would apply to work done for plaintiff's counsel.

THE FACTS OF HAPPY

LANDINGS

Happy Landings is a local travel agency and earns its revenues by commissions from carriers for ticketing passengers. The standard commission for airlines is 10% of the ticketed price and airline ticketing makes up roughly 75% of the agency's business. Most bookings are for travel along the northeast corridor of the United States. About 20% of business is cruise and excursion bookings for individuals and groups (about 50 per month). The commissions on these cruises and special packages vary, but usually range between 10% and 15% of the total package billing.

Rob East, the president of Happy Landings, has carefully built the agency over the last five years, adding resources as needed. During that time he has established an enviable reputation with the local business community for a high level of personalized service. This service is primarily dependent on a unique reservation system that drastically reduces the number of keystrokes required to process a booking and flags errors before the reservation is issued. The system also provides detailed statements to help clients with their own billing and accounting for trips. The program has been painstakingly created from scratch, beginning when East started the business five years ago.

The technology has begun paying off: several local businesses use Happy Landings exclusively, requiring that all travel be booked through the agency. The agency moved into new space just over a year ago.

The agency is online to all the major reservation systems and pays a flat $7,500 per month charge for the computer service plus a fee of 95 cents each time an agent accesses the files. The agents are paid a salary of $2,000 per month, and benefits cost the agency roughly 20% more on top of cash compensation. The agency leases its office space, most of its furnishings, telephones, and computer hardware and software. A recent monthly income statement is presented in Exhibit 1.

Recently, one of East's former top agents opened a competing business using essentially the same methods and operations as Happy Landings. East has learned that the new agency, Us Too, also has an innovative order entry system and an extensive customer database of "travel profiles" on essentially the same business customers as Happy Landings. The database appears to contain virtually identical data fields as the program at Happy Landings.

Even though the former agent had signed a non-compete agreement while at Happy Landings, the new agency has been soliciting business aggressively from most of Happy Landings' best clients, offering cut rates to the airlines and incentives to the travelers in an attempt to build market share.

Happy Landings brought suit against Us Too, alleging theft of proprietary information, but has been unsuccessful in its attempt to have the court impose a temporary restraining order. The suit asked for $2.5 million in damages.

The former agent has counterclaimed, alleging harassment and interference with business relationships, claiming that his system was developed independently, and the database was built on publicly available information and his own promotional mailings. Based on the counterclaim, Us Too is asking for unspecified actual and punitive damages. An analysis of the claim by a CPA should address the guidelines in the article by Love and Reiss mentioned above.

APPLY DAMAGE PRINCIPLES

East must prove that his business has been damaged (or will be) as a result of the actions of Us Too. He must meet the standards of causation, certainty and remoteness to be awarded damages. Essentially, they constitute the legally recognized minimum standard of proof for assessing responsibility.

Did the actions of Us Too take business away from Happy Landings? Are there any other reasons why East's business is off? Is it off? Can he reasonably forecast how his business will be damaged in the future?

Many CPAs, unfamiliar with the litigation environment, can easily assume the role of advocate if they are not careful. I continue to be impressed by the irony of how normally skeptical auditors so readily accept ideas and numbers given them by counsel. All amounts are subject to challenge, especially when provided by a party to the suit.

A set of interrogatories filed by defendant's counsel produces the following detail of Happy Landings' damage calculation:

Number of customers stolen 1,500

Average annual trips per

customerx10

Annualcustomertripsstolen15,000

Averagefeeearnedpertripx$27.50

Annualfeeslost$412,500

Averagecustomer"life"6years

Totaldamagesclaimed=$2,062,500

Interestondamages+437,500

Totaldamagesclaimed=$2,500,000

The principle of certainty requires that the calculations be reasonable, though not necessarily exact. All of the claimed damages in this case are for future losses. Such amounts are inherently speculative and must have some supportable foundation. The preliminary calculation has not given any basis for the damages claimed and they may be entirely arbitrary.

Know the Numbers

The calculation also shows losses calculated at gross, not considering any expenses required to produce the revenue. A CPA can be very valuable to defendant's counsel here in determining what kinds of costs should be charged against the claimed lost revenues. Two alternative defendant calculations are shown in Exhibit 2.

Putting forward alternative calculations is a risky proposition because it can appear as an admission of guilt. Only defendant's counsel should decide if defendant's expert should prepare and present alternative calculations or simply show where plaintiff's calculations are incorrect.

It is very tempting for CPAs to view a

EXHIBIT1

HAPPYLANDINGS

INCOMESTATEMENT

NOVEMBER1990

Revenues

AirlineCommissionRevenue$68,350

OtherRevenue10,980

TotalRevenue79,330

Expenses

Salaries12,500

Benefits2,650

EquipmentandFurnitureRental4,000

SiteLease10,000

Computer16,000

PhoneLease10,000

Interest1,300

Utilities2,050

Taxes4,200

Supplies1,800

Other1,700

TotalExpenses66,200

NetIncome$13,130

case like this as simply a cost accounting issue. Before the number crunching starts, however, the expert must understand more than costs. (Cost issues can become critical to a case, however. In William Inglis and Sons Baking Co. v. ITT Continental Baking Company, Inc., (668 F. 2d, 1014), an anti-trust case, the trial hinged on the issue of what were fixed, variable, avoidable, and marginal costs in baking and selling a loaf of bread.)

The expert must also consider the mathematical accuracy; are the numbers a faithful representation of the actual business? Has anything been accelerated or deferred? Are there any improper costs or unentered revenues?

Clarify Language to Emphasize

Future and Interest Factor

The calculation done by the plaintiff (or his expert) in the preceding set of interrogatories filed by defendant's counsel, includes an allowance for interest on past losses. Because no losses have actually been suffered yet, this is a very favorable approach to the calculation. It cannot, however, be supported logically. For example, in New York, interest rates on historical (past) losses are set by law and would be calculated by a clerk of the court if an award is ever made. These rates will depend on the type of injury, the parties, and the length of time. As easy as it is for the defendants to exclude this item from the plaintiff's calculation, it may actually have done more harm to the plaintiff by including it, because it shows how "greedy" and overreaching the calculation is.

Know the Law, the Case and the

Business

The expert must understand the law as it applies to the case. Unless the plaintiff can prove that the customer data: 1) is proprietary; 2) was stolen; and 3) the plaintiff suffered a loss as a result, then there is no basis for damages. The expert can begin by showing the flaws in the plaintiff's calculation, but such an exercise may still be premature.

A preliminary review of the initial calculation shows several weaknesses. The expert must be careful to consider more than cost issues, including an analysis of the business as a whole and the environment it operates in. Very rarely is one person able to understand all aspects of the plaintiff's business or the factors affecting possible future losses. Experienced litigation support practitioners realize the value of both brainstorming before they start the number exercises, and getting reliable input.

For example, a closer look at Happy Landings' operations show that the vacation and cruise bookings are very lucrative,

EXHIBIT2

HAPPYLANDINGS

ALTERNATIVE DEFENDANT DAMAGE CALCULATIONS Marginal, Direct Costs Only

AverageTicketFee$27.50

AccessFeeperTicket(.95)

AgentSalary(1)(5.65)

Supplies(2)(.72)

DirectContributionperTicket$20.18

Fully Allocated Cost

Direct Contribution per Ticket (above) $20.18

Allocated Costs (3)

SiteLease(4.00)

ComputerLease(4)(6.40)

PhoneLease(4.00)

EquipmentRental(1.60)

Utilities(.82)

Interest(.52)

Taxes(1.68)

Other(.68)

NetIncomeperTicket$0.48

(1) Assumes cost of agent is $2,400 per month ($2,000 plus 20%), and the agent is writing an average of 425 tickets per month.

(2) Calculated as $1,800 / 2,500 tickets = $.72 per ticket.

(3) Monthly costs per Exhibit 1 divided by 2,500 ticket per month.

(4) The cost is the sum of the $7,500 fixed fee for the online service and $8,500 for software. These individual amounts (and the specific phone amount) would have to be determined in discovery, but would not have changed the overall calculation. grossing approximately $200 per ticketing, more than seven times the typical fees for business booking. Even though Happy Landings only writes about 50 excursion bookings per month (2% of all tickets), they account for over 70% of the net income. At an average booking cost of $1,600, Happy Landings earns approximately $200 (12.5%) with direct (or marginal) costs of roughly $7 (as described in the Alternative Defendant Damage Calculations); the contribution is about $193 per booking. The contribution times the number of tickets equals $9,600, or 73% of November's net income. It may also be possible that some of the Airline Commission Revenue is for vacations, making the business travel contribution to net income even smaller.

The defendant will argue that the business clients were only marginally profitable on a fully allocated cost basis and that Happy Landings was actually making most of its money on special bookings.

The plaintiff will argue that the time spent by agents on the excursion bookings is much higher and that these bookings only come because the business clients look to Happy Landings for vacation arrangements as well as their business travel. These issues might be true and could be explored if time permitted. Resolving these issues would depend on the quality of records, the memories of the agents, and even their predispositions in the case.

The expert cannot know everything affecting the business, so part of his or her strategy might include consulting someone with an economics background or someone familiar with the industry.

The calculations implicitly contain assumptions about volumes, costs, efficiencies, capacities, historical and forecasted growth in sales and market, among other factors. This input gives the expert a larger economic backdrop against which he or she performs the calculations.

This information addresses questions of growth potential (apparently limited), barriers to entry (few), competitors (many), conditions of the market (fair to poor), and price sensitivity (apparently high). If, for example, business was down for all agencies in the metropolitan area, plaintiffs may be attempting to lay blame on the defendants for the real causes of their stalled growth. This information would provide support to any calculations put forward by the damages expert. It is also possible that East has brought suit to stifle competition.

Get the Right Documents

So far, we have seen little actual financial information from the plaintiffs. Except for the plaintiff's initial damage claim, the balance of the calculations are based on assumptions, observations, discussions, and unsupported representations. Experts should expect a very unpleasant experience in cross examination or deposition if they have not given themselves some independent basis for their calculations. Exhibit 3 lists a few of the places the expert should consider looking for information about Happy Landings' business and the case. Because Happy Landings is a small business, East probably only has to report to taxing authorities and a lender, limiting available documents.

Keep an Open Mind

Brainstorming, acting as your own worst enemy, and thinking strategically are not activities CPAs usually engage in, but they are critical in litigation service engagements. Only by stepping back from the data can the expert determine that the business travel was almost a loss leader for the vacation bookings. At some point the calculations done by both sides will be challenged, so the expert must anticipate weaknesses and mitigating factors in his or her calculations. At a minimum, the expert should expect questions such as: "Do you allocate all costs to every engagement you perform? What costs have you allocated to this engagement? Have you allocated any overhead items to this engagement?"

The attorneys and their experts should also consider external issues, such as seasonal variations, local economic conditions, changes in technology, competitors, etc. For example, even though Happy Landings' normal business is 75% airline/business travel, the November income statement shows it to account for more than 85% of total revenues, probably because there are fewer cruises and vacation bookings in November. The defendant may argue that November's results are well above the average month's results. If there is a large seasonal fluctuation, relying on November's results alone to calculate damages could distort any long-term loss actually suffered by Happy Landings and estimated by the damage calculation.

The expert should typically expect some interesting revelations when the finances of a closely held business are analyzed. As a closely held business, it is possible that personal expenses have been intermingled with business expenses. The plaintiff in his circumstance might have to choose, for example, between admitting that "Other" expenses are the lease on his wife's Mercedes--with no business purpose served--or having those costs allocated into the remedy calculation, hurting any potential award.

Unless the expert is intimately familiar with the respective reservation systems and databases, he or she should talk to other experts. They could tell him or her whether they are the same type of program, whether the defendant could have

EXHIBIT 3

IMPORTANT DOCUMENTS

TO CONSIDER

Legal/Strategic Complete copy of the latest version of the complaint and the answer Copies of any other experts' depositions or reports A copy of the non-compete agreement Examples of the databases in question including the program formats and representative customer files

Financial/Business Tax returns and workpapers Loan files (from the lender) Applications for loans denied (also from lenders) Source Documents Original invoices Payroll data Inventory data or analysis Work in process reports Business plans Budgets prepared before the suit was filed Sales analyses (especially by types of customers) Regulatory filings Cash flow reports

Industry/Economic Industry data Trade groups and publications Government Local economic data Universities and chambers of commerce developed the system independently (reverse engineering), if there was anything East could have considered proprietary about the data files, etc.

There may be separate financial issues such as ownership versus leasing, or the treatment of internally-developed (expensed) software, that the attorney has not considered or has not discussed with the expert. These may be worth exploring.

Be Reasonable and Professional

Protect yourself: in the heat of litigation, the attorney may ask you to do certain things or make calculations you cannot support in concept or in fact. Do not make or support any calculations or assertions you cannot put forward in good conscience. Even though you are retained by counsel, you are put forward to the court as an expert whose opinion can be relied on. Protect your reputation. Mitigating factors may not often come from the attorney. You must be aware of the environment you are working in and the nature of the players.

Presenting the Damages in Trial

or Deposition

The discussion of costs, breakeven and contribution, for example, can be greatly enhanced by simple graphs that tell much more than words. Graph 1 shows the relationship of the number of tickets issued--business and cruise. Graph 2 shows the relative contribution of the two lines of business in an entirely different picture.

The real test of the expert's ability comes in presenting and defending his or her position to a judge or jury. Much of this cost accounting may seem basic to a group of accountants, but juries are often composed of people who may have difficulty balancing their own checkbooks.

The primary rule for testimnoy, as mentioned by Love and Reiss, "keep it short and simple." Even though the expert's position may be based on detailed analysis and several sources of information, the message expressed to the judge of jury does not have to be complicated. For example, phrases like "read my lips" and "I have a dream" convey in simple terms a deeper message--and are easily remembered.

Juries like analogies, but recent research shows they can backfire if not prepared carefully. The American Bar Association recently completed a study on jury comprehension. Their findings are found in an ABA publication called, Jury Comprehension in Complex Cases: Report of the Special Committee on Jury Comprehension of the ABA Section of Litigation.

The expert must communicate the findings to the judge or jury in terms they will understand.

PRINCIPLES FOR FUTURE

GUIDANCE

The preceding discussion focused on a few aspects of an unrealistically simple case. The alleged theft of the database is a legal issue but is critical to the calculation of lost profits (if any). Economic and other considerations would also impact the calculations and should be considered by the CPA expert. From the defendant's perspective--and with limited information--we have seen the facts in a certain way. An expert for the plaintiff in possession of different information could have a different view. An expert must beware of claiming to have the "right answer" even when the information appears very straightforward. Remember these principles:

* Maintain a healthy skepticism;

* Consider the assumptions supporting any calculations;

* Play devil's advocate by evaluating the weaknesses and assumptions in your work;

* Consider the business as a whole, not just a limited area (such as costs);

* Consult with other experts, if necessary, to round out your understanding;

* Be ready to support and defend your work;

* Don't take positions that fail to meet your professional standards; and

* Present testimony in easy-to-understand terms.

Articles like this can only begin to treat all the issues involved in even "simple" litigation consulting engagements. Anyone who ever learned how to be a competent professional in the fields of taxation, consulting, or auditing can contribute valuable skills to ligitation services if they follow the guidelines.

Terry Lloyd, CPA , is a manager in the office of the National Director of Litigation Services for Ernst & Young and a member of the NYSSCPA and the AICPA. Mr. Lloyd has been an author and contributing author to texts published by the Practicising Law Institute and the New York State Bar Association.