Chapter 15

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					                Chapter 15


Consulting, Litigation Support
   and Expert Witnesses:
  Damages, Valuations and
    Other Engagements
  Critical Thinking Exercise




How many outs are there in an inning?
 Professional Standards and Guidance
• AICPA’s Forensic and Valuation Services
  Section
  – Litigation support and valuation engagements
  – “Practice aid”
  – Special reports
  – Other publications
 Engagement Issues and Professional
          Responsibility

• Consider the implications
• CPAs need to ensure they have or can obtain
  necessary skills, training, and experience
• Engagement letter
  – Nature and extent of professional services to be
    provided
  – Outline degree of responsibility assumed
• No opinion about guilt or innocence
   Types of Consulting and Litigation
           Support Activities
• Assessing the risk of fraud and illegal acts’
• Evaluating the adequacy of internal control systems
• Substantive testing of transactions during an attest
  or general consulting engagement
• Designing and implementing internal control policies
  and procedures
• Proactive fraud auditing when fraud is not suspected
• Preparing company codes of business ethics and
  conduct
• Consulting about employee bonding
• Developing corporate compliance programs
Tools and Techniques – General Discussion
• AICPA Practice Aid 07-1
  1. Public Domain Reviews and Background
     Investigations
  2. Interviews of Knowledgeable Persons
  3. Confidential Sources of Information and
     Evidence
  4. Laboratory Analysis of Physical and Electronic
     Evidence
  5. Physical and Electronic Surveillance
  6. Undercover Operations
  7. Analysis of Financial Transactions
      Commercial Damages
• Estimating damages on a case-by-case basis
• Understanding and appropriate use of proper
  accounting methods
• Understanding how accounting information is
  used to create the required components of
  the damages estimate
• Accurate, timely, and professional advice will
  help attorney formulate effective strategies
   Legal Framework for Damages
• To pursue legal damages, injured part must prove
  2 points
  – Liability: That the other party was liable for all or part
    of the damages claimed
  – Damages: That the injured party suffered damages as
    the results of the actions or lack of actions of
    offending party
• To prove damages were sustained, injured party
  must prove 3 additional elements
  – Accused party was the direct or proximate cause of
    the damages
  – Amount must be calculable to a reasonable degree of
    certainty
  – Accused parties should have been reasonably able to
    foresee that damages were likely to accrue
   Types of Commercial Damages
• Compensatory
• Economic loss or restitution
  – Lost wages
  – Incremental or incidental expenses
  – Lost profits
  – Lost Value
• Reliance
• Punitive
• Special
           The Loss Period
• One of the first steps to measuring commercial
  damages is to determine the loss period
• For breach of contract, it is generally the
  remaining term of contract
  – If the contract term is very long, courts may be
    reluctant to enforce it because of issues of
    uncertainty
  – The damages may extend beyond the contract term
    because the parties have a history of extending or
    renewing prior contracts
Economic Framework for Damages
• Amount of loss may be affected by the
  economy or conditions of the industry
• Give consideration to the appropriate
  economic conditions as a starting point
• Next level of consideration is the industry
• Performance of entity compared to
  competitors
• Gather financial statement data, breakdowns,
  non-financial data, and tax returns
• Consider historical performance
• Assessment of cash flows
    Quantifying Lost Revenues and
        Increased Expenses
• Decisions that need to be made
  – Base amount of revenues or expenses
  – Choose revenue or expense growth rates
  – Are historical rates of growth applicable to the
    damage period?
  – Use straightforward method or more
    sophisticated method
• Methods used to develop estimates of lost
  sales and incremental expenses
  – The Before and After Method
  – The Benchmark (“Yardstick”) Method
             Determining Lost Profits

• Consider impact on “bottom-line” net income
• Incremental costs subtracted from
  incremental revenues
• Damaged party must mitigate its damages
• AICPA practice Aid No. 7 “Litigation Services”
  – Losses characterized as lost profits, lost value, lost
    cash flows, net revenue and incremental costs
  Determining Incremental Costs
• Incurred as a result of plaintiff’s action or
  inaction that would otherwise not be incurred
• Infrastructure requirements in order for the
  plaintiff to have the capacity necessary
• Cost Behavior
  – Fixed
  – Variable
• Relevant range
• Allocated costs
• Accounting estimates
  Determining Incremental Costs



• Methods for determining cost behavior
  – Account analysis
  – High-low method
  – Graphics
  – Statistical (regression, survey and sampling)
  – Engineering
      The Time Value of Money
• Lost incremental profits before the matter can
  be resolved between the parties
  – Pre-judgment interest
• Amounts that would only be realized in future
  periods after the dispute has been resolved
• AICPA Practice Aid 06-4 “Calculating Lost
  Profits”
• Cost of equity
   Communicating and Defending the
Results of Commercial Damage Estimates
• “Tire-hits-the-road”
• Venues to be evaluated, scrutinized or challenged
   – Periodic meetings with attorneys for whom you have been
     engaged
   – Pre-judgment testimony related to summary judgment
   – Meetings with counsel where they determine how to
     proceed with the case
   – The written report
   – Deposition testimony
   – Regulatory or administrative hearings
   – Alternate dispute resolution forums
   – Trial testimony
• Critique opposing side expert
• Neutral and objective position
                 Valuations
• Value business, business ownership interest,
  security, or intangible asset
• Statement on Standards for Valuation Services
  No.1
  – Overall engagement considerations
  – Development of the valuation
  – Valuation report and appendices
• Organization certificates
           Overall Engagement
             Considerations
• Assessment of economic and industry
  conditions
• Ability to identify, gather and analyze relevant
  data
• Simplified versus complex valuation methods
  – Limitations
  – Assumptions
• Understand nature of client’s expectations
  and planned use for valuation services
  outcomes
  Type of Valuation Engagements
• Two types of engagements
  – Valuation
     • Data and information are continually gathered,
       updated, incorporated and analyzed
     • Use most appropriate methods and approaches
  – Calculation
     • Outline assets, valuation methods and other aspects of
       the engagement
     • Service provider agrees in advance
     • Professional proceeds to apply agreed-upon procedures
        Measures of Value

• Book value
  – Balance sheet value
• Liquidation value
  – Cash likely received by owner under pressure to
    sell item quickly
• Market value
  – Willing buyer and seller come to terms under
    normal market conditions
 Determining Market, Fair Market and
             Fair Value
• Two considerations that determine market
  and fair market value of an asset
  – Future income stream
  – Difference between future income stream and
    alternative investment options
• Three methods used to determine fair market
  values
  – Discounted earnings and cash flows
  – Market comparables valuation
  – Asset and liability market valuation
Discounted Earnings and Cash Flows

                          n       t
                            CF
              Value             t
                      t 1 (1 i)

                     5
                        CF t        V5
          Value             t         5
                  t 1 (1 i)     (1 i)
     
                        D1
                 P0 
                    k  g
    Estimating the Risk-adjusted
           Discount Rate
Four methods to develop risk adjusted
discount rate and its related cash flows
– CAPM
– Weighted average cost of capital (WACC)
– Bond-equity additive method
– Build-up method
Forecasting Income and Cash Flows
• Consider data in the following areas
  –   Nature of the business
  –   General economic and industry outlook
  –   Book value of equity
  –   Earnings capacity of the company
  –   Dividend paying capacity
  –   Goodwill and other intangible assets
  –   Previous sales of company securities
  –   Market prices of comparable companies
  –   Number, type and age of organizational facilities
  –   Classes of debt or equity and their associated rights
  –   Industry markets and conditions
  –   Business risks
Forecasting Income and Cash Flows
• Grounded in historical financial performance
• Free cash flows
• Related parties
  – “Arm’s length”
• Attempt to gather the following
  – Forecasts of projected financial results
  – Articles on industry-related valuation issues
  – Relevant client information
• Calculate applicable ratios and analyze trends
        Asset Valuation Models
• Assumes balance sheet reasonably identifies
  company’s assets and liabilities
• Appraisers value assets
• Net present value techniques estimate
  liabilities
• Two shortcomings
  – Does not account for benefits associated with
    asset synergy
  – Fails to account for significant intangible assets
     Market and Accounting-based
         Comparable Models

• Benchmarks, guidelines and rules of thumb
• Useful as a reasonableness check on results of
  other analyses
• Should not be used as stand-alone method
  unless other method is not possible
• Address shortcomings if used as stand-alone
  method
Valuation Discounts and Premiums




• Majority and minority owners with various
  control rights
• Asset ownership interests have differing
  marketability or liquidity attributes
    Other Ownership Interests Subject to
                Valuation
•   Valuing debt
•   Preferred stock
•   Convertible debt
•   Stock
•   Warrants
•   Options
•   Intangible assets
          Conclusion of Value
• Number or specific range
• Reconcile and correlate results from more
  than one methodology or assumption
• Consider reliability of the valuation outcome
• Valuation professional has 2 choices
  – Primarily rely on 1 method using other methods
    as reasonableness checks
  – Rely on multiple methods to determine the value
    or specified range
       The Valuation Report
Accredited Senior Appraiser’s (ASA’s)
Principles of Appraisal Practice
– Description of the property
– Objectives of the appraisal work
– Statement of contingent and limiting conditions
– Description and explanation of appraisal method
– Statement of appraiser’s disinterestedness
– Appraiser’s responsibility to communicate each
  analysis, opinion and conclusion
– Mandatory recertification statement
– Signatures and inclusion of dissenting opinions
              The Valuation Report
• Uniform Standards of the Professional Appraisal Practice
  (USPAP)
   –   Identify and describe business enterprise, assets or equity
   –   State purpose and intended use of appraisal
   –   Define the value to be estimated
   –   Set forth the effective date of the appraisal and report
   –   Describe the extent of the appraisal process employed
   –   All assumptions and limiting conditions that affect analyses
       opinions and conclusions
   –   The information considered, appraisal procedures followed and
       reasoning that supports the analyses, opinions and conclusions
   –   Any additional information that may be appropriate to show
       compliance
   –   Rationale for the valuation methods and procedures used
   –   A certification in accordance with Standards Rule 10-3
Personal Injury, Wrongful Death and
          Survival Actions
• Three types of damages that may ensue
  – Losses to the individual
  – Losses to survivors
  – Losses to the estates of decedents
• More technical than analytical
• Guidelines are relatively straight forward do
  to their common nature
• Inflation is a major challenge
         Losses: Personal Injury
• Injured person survived and subsequently lost
  income
• Experts estimate reduced earnings and other
  forms of support as a result of the injury
• May incur future costs or earnings capacity may
  be reduced as part of a permanent injury
• Injured person may suffer 5 types of losses
  – Loss of earnings
  – Loss of employment benefits
  – Losses associated with ability to perform “non-market
    services”
  – Medical costs
  – Life care costs
           Losses: Wrongful Death
             and Survival Cases
• Death of a person where another party may be
  held accountable can result in two types of cases
  – Wrongful death
     • Primary right of recovery resides with survivors
  – Survival actions
     • Estate of deceased has primary right of recovery
     • “What if”
• No need for medical or life-care costs
      Analysis of Earnings Losses
• Investigation of five areas
   – Determining the basis for earnings losses
   – Analysis of employment history and related past
     earnings
   – Projection of probable career paths
   – Determining the proper earnings for each projected
     career path
   – Consideration of other factors on earnings losses
• Three methods for projecting earnings
   – Case-by-case method
   – Below-market discount method
   – Total offset method
 Analysis of Lost Employment Benefits
    Associated with Lost Earnings
• Generally, not all employment benefits are
  lost when an injury occurs
• Applicable standard are those benefits the
  injured party has lost
  – Value to employee not cost to employer
• Additional analysis is required for benefits
  mandated by government laws and
  regulations
Analysis of Lost “Non-Market Services”
• Approaches used to estimate costs
  – Actual cost to develop and utilize substitute
    services
  – Accumulate hours associated with activities and
    multiply by reasonable rate
• Issues with “non-market services”
  – Injured person may have provided services well
    into retirement
  – Injured party may not have provided services for
    remainder of life
Analysis of Medical and Life Care Costs
• Identify requirements in the following areas
  – Types of needs the injured person will have
  – How long those needs are likely to continue
  – Changes in those needs over time
  – How often those needs will require services
  – Special equipment required
  – Types of professionals who will need to provide
    services
• Once listing is complete, estimates of costs
  can be developed
• Seek out bids for a life care annuity
 Injured Children, Homemakers and
          Retired Persons
• Generally have limited earnings and no W-2’s
• Children
  – Have made few decisions that would determine his or
    her future
  – U.S. Bureau provides statistics based on educational
    assumptions
• Homemakers
  – Estimate cost of home services that will need to be
    contracted with outside parties
• Retired persons
  – Earning capacity
  – Will retiree ever enter work force again?

				
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