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April 1994

Calculating fraud damage awards. (The CPA Consultant)

by Chang, Stanley Y.

    Abstract- Accountants play an important role in determining the amounts of judgments on and settlements of fraud-related legal disputes. As expert witnesses, accounting professionals may be called upon to assist in collecting evidence supporting charges of fraud. They may also be asked to estimate the amount of money that should be awarded to the fraud victims. The accountants' calculations may involve either the addition of the actual transactions of invested money and other relevant expenses, or the calculation of any applicable lost profits. There is no one legally prescribed method for calculating fraud damages. Accountants may use the before-and-after method, the benchmark or 'yardstick' method, or the hypothetical-sales or 'model' method.

Fraud Losses

A fraud loss occurs when a party loses money or other property to another party through false means. This could be as simple as a misrepresentation of facts, or as complicated as an international financial scheme. Normally, accountants become involved as expert witnesses in fraud cases in two ways. First, they may help gather evidence to prove that a fraud did indeed take place. Second, they may calculate how much money should be awarded to the victims of the fraud, the fraud damages. The authority that dictates how to calculate fraud damages, depending upon the circumstances, could be common law (court rulings), statutory (written laws passed by a legislature), or contractual (e.g., insurance policies). This discussion will concentrate on losses under common-law fraud damages assessment.

Governing Theory

Depending on the applicable state law, two theories have been used in assessing fraud damages: the benefit-of-the-bargain rule and the out-of- pocket-loss rule. The following example shows how the two theories operate.

The defendant sold the plaintiff a property with an alleged value of $1,000,000 for $925,000, when in essence, the property only had a market value of $800,000.

The fraud damages, under the benefit-of-the-bargain rule, will be calculated as $200,000--the difference between the misrepresented value, ($1,000,000) and the actual value received by the defrauded plaintiff, ($800,000). On the other hand, under the doctrine of out-of-pocket loss, the damages are $125,000, the difference between the properties exchanged ($925,000 and $800,000).

Under a benefit-of-the-bargain jurisdiction, the victim as plaintiff in a suit can claim not only the money he or she actually put into the transaction, but also the "profit" he would have made in addition to his or her original investment. Under the out-of-pocket-loss rule, however, he or she would, in theory, recover nothing beyond that investment.

Accordingly, when calculating damages in a benefit-of-the-bargain jurisdiction, the accountant would not only include money invested, but also any lost profits or extra costs, such as expenses of investigating the fraud. In an out-of-pocket-loss jurisdiction, the concern would normally be the money invested. Because the interpretation of these theories can be complex and there are some exceptions, obtain a lawyer's opinion before commencing calculation.

Working with Counsel

When calculating the loss, you will be working closely with legal counsel. As previously mentioned, the lawyer will tell you whether you need to calculate lost profits in addition to summing up the money invested by the plaintiff. He or she can also help identify the necessary assumptions for the case, assess the strength and applicability of the computation before its presentation at trial, and help you gather and verify information through interrogatories (written inquiries of the opposing side), document requests, and depositions (under-oath questioning sessions conducted in a lawyer's office).

For courtroom purposes, attorneys normally recommend simple mathematical techniques (e.g., simple averages as opposed to regression analysis). Complicated calculations and the use of obscure methodologies can invite unnecessary challenges and may fail to communicate to the jury the important aspects of a fraud damages computation.

Lost-Profits Calculations

Once you identify and properly evaluate the accounting and legal concerns related to your case, your calculations will usually fall into two categories:

1. Adding the actual transactions of money invested and any applicable extra costs; and

2. Calculating any applicable lost profits. Since the first category is normally straightforward, we will focus on lost-profits calculations.

The definition of lost profits may vary. It is commonly defined as the profits that the plaintiff would have made but for the fraud.

The computation of lost profits consists of five key elements: methods, damage period, definition of profit, growth rate, and discount rate. Each of which is discussed as follows.


No particular method is required under the law to calculate lost profits. The three methods below are commonly used to calculate lost profits. The expert accountant may choose one or a combination of methods depending on the requirements of the case.

Before-and-After Method. This method compares the profits before the fraud to those after. It first constructs an array of pre-fraud profits. Then, this array is compared to those of the fraud-affected periods. The damages will be a simple summation of discounted differences. Figure 1 illustrates this approach.

Benchmark (or "Yardstick") Method. This method compares the profits of the defrauded plaintiff to those of a similar business unaffected by the fraud. It is sometimes used when a new business is the defrauded subject. Since a new business has in sufficient historical data available for a before and after comparison, the profits history of a comparable business is used instead as the "benchmark," or "yardstick." This method also has been used in court cases involving franchises. Figure 2 illustrates how this approach may be used.

































Hypothetical-Sales (or "Model") Method. This method calculates lost profits in three steps:

1. Marketing evidence is gathered to show potential lost sales;

2. Lost sales are calculated; and

3. Costs and expenses are subtracted to obtain lost profits. The hypothetical sales method is normally used for new businesses with little or no track record. Because it is based on hypothetical sales, this method can be easily abused and produce unrealistic results. Nonetheless, there may be some instances where this is the method to use. An example of this approach is provided in Figure 3.

Damage Period

This is the number of years, or fiscal periods, affected by the fraud. While it may be more of a clear-cut case in a sale of property, it may not be in many other situations. Sometimes you need to do a detailed analysis on profit trends, production patterns, sales volume, etc. to establish a damage period for a lost-profits calculation.

Definition of Profit

It should be noted that income from operations, contribution margin, and gross profit have all been used as surrogates for profit. The determining factor for which measure to be used usually depends on the respective case. For example, a fraud affecting sales may make contribution margin more appropriate since the picture will not be distorted by items such as fixed costs. On the other hand, an inventory fraud may make the use of gross profit more suitable.

Contrary to what may seem intuitive to many accountants, net income is usually not used. U.S. tax law generally treats lost profit awards as taxable. Thus, while there can be exceptions, computations of lost profits are often performed on a pre-tax basis, which negates the use of net income.

Growth Rate

The use of a growth rate to incorporate the increase in earnings potential is acceptable under most circumstances. This rate can be positive, negative, or zero. It could be derived from the history of the business, or when that information is not available or not applicable, industry trends, inflation, or even that of a similar business undertaking.

Discount Rate

Since future periods are often involved in the calculation for lost profits, it is usually necessary to use a discount rate so that the present value of the damages can be calculated. In some jurisdictions, a statutory rate is provided for this purpose. In the absence of a statutory rate, the business's investment rate, its borrowing rate, or even a risk-free rate have commonly been used.

Paul R. Bjorklund, CPA, Shore & Azimov, CPAs, and Stanley Y. Chang, PhD, CPA, Arizona State University

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