How do you measure damages? Lost income or lost cash flow? The choice of method can make a big difference in the final amount.

HOW DO YOU MEASURE DAMAGES? LOST INCOME OR LOST CASH FLOW?

The choice of method can make a big difference in the final amount.

In the burgeoning field of litigation services, one common role played by the CPA is as an expert on damages. As a general rule, attorneys are unfamiliar with the different ways to compute damages and normally leave it up to the expert to decide how damages should be computed.

Moreover, the law itself gives little guidance to CPAs on the proper way to compute damages. Damage statutes usually don't prescribe an exclusive way of doing it. Statutes authorizing the award of damages often use this kind of language: "Damages are to be awarded in an amount which will make the plaintiff whole" or "damages are to be awarded in the amount of the benefit of the bargain."

So how should an accountant choose between calculating damages as lost income or lost cash flow to the plaintiff? This article explains the difference between the two methods and the factors to be considered when making a decision about which approach to use.

TYPES OF DAMAGES

The first consideration is typically the type of damages that are being computed. Damages may be in the form of out-of-pocket losses or lost profits.

Out-of-pocket losses are generally computed on a cash basis. Damages are the total amount of cash paid less any cash received. However, there are certain situations in federal class action securities litigation in which out-of-pocket damages are computed as the difference between what a security was purchased or sold for and what it was actually worth on that transaction date. This difference is attributable to the alleged fraud or misrepresentation that affected the security's price. In these circumstances, the computation of out-of-pocket loss is not a simple cash basis computation but requires sophisticated econometric techniques to determine the value of the securities in question.

For computing lost profits, there's less guidance on which approach to use. The choice is really up to the expert CPA. Either the income or the cash flow approach is valid and will be acceptable to the court. There's no common practice among CPAs and often a CPA will use the approach he or she is most comfortable with. However, here are some factors to consider when deciding on which approach to use.

HOW MUCH IS BEING CLAIMED?

One factor to consider is the amount of damages being claimed. Why should that make a difference? A large number of capital items may have to be purchased to reach the incremental level of sales or services estimated in the damage claim. Since capital items aren't expensed on the income statement but, instead are depreciated over their useful lives, there can be a difference in the estimate of damages depending on the approach used. A simple example will explain this problem.

Exhibit 1 A comparison of the cash basis and income basis damages methods illustrates the results of using the cash basis and the income basis approaches to damages. It shows the amount of cash or income that would have been generated if the legal violation had not occurred. The top portion of the exhibit shows the calculation of cash basis damages over the three-year damage period. In year one of the damage period, capital items totaling $9,000 would have to be purchased in order to achieve the incremental revenue estimated in the damage claim. Therefore, under the cash basis damages method there's a loss of $3,000 in the first year. Under the income basis damages method, there's a profit of $3,000.

Looking at the total three-year period, the problem seems to resolve itself because the timing differences between the two approaches even out; both methods arrive at the same amount of damages--$12,000. However, there still are two problems.

SHORTENING THE TIME FRAME

The first problem is explained by exhibit 2 A comparison of the cash basis and income basis damages methods. This exhibit is identical to exhibit 1 except there's no third year. In this example, the capital improvements necessary are the same as the first example--$9,000. The economic life of these capital improvements is the same as well--three years. The difference is that now the damage period is only two years rather than three years in length.

Notice the difference in the total column. Now, under the cash basis damages method, damages total $4,000. The income basis damages method computes damages at $7,000. Obviously, the difference is the amount of the net book value of the capital improvement. The asset was put on the books at $9,000 in year one. By the end of year two, there was $6,000 of depreciation taken resulting in a net book value of $3,000. Subtracting the value of the asset remaining on the plaintiff's balance sheet from the computation of damages using the income method results in an adjusted damage figure of $4,000 ($7,000 -- $3,000).

I have used only one example of the many types of differences between a cash flow statement and an income statement. Any accrual item will lead to a difference between the cash flow and income statements for a particular plaintiff. These include

* Accounts receivable.

* Accounts payable.

* Accrued salaries or bonuses.

* Accrued interest on a loan that requires no interest payments until maturity.

ENORMOUS COMPLEXITY

Obviously, if the CPA were to attempt to model the plaintiff's entire financial performance assuming the legal violation had not occurred, all the balance sheet effects of the incremental business would have to be considered.

It's been my experience that many damage studies ignore the complexity of modeling how the plaintiff's balance sheet would change as a result of estimating the amount of cash flow or income lost. It's often more difficult and speculative to estimate some of the working capital changes than the revenue and expense items related to the plaintiff's incremental business.

Unless all these complexities are estimated, there might be a difference between the cash flow method and the income method of computing damages. Financial Accounting Standards Board Statement no. 95, Statement of Cash Flows, should help the damage expert because the differences between cash flow statements and income statements will be available for the plaintiff for the periods before, during and after the damage period.

Financing assumptions. My simple example of the difference between the purchase of the capital items and their depreciation on the plaintiff's projected income statements also can be affected by how the purchases are financed. If the capital items are financed by borrowing all the money, under a complete analysis of cash flow there's no net cash outflow in year one except whatever interest and principal repayments would occur in that year. In fact, under this assumption, the income basis damages might be lower than the cash flow damages by the end of the damage period--if balance sheet changes are ignored.

CALCULATING PRESENT VALUE

The second major problem resulting from the differences between the cash flow approach and an income approach is the calculation of prejudgment interest on the damage amount or the discounting of future damages back to the date of judgment. Exhibit 3 Difference in present value of damages between cash basis damages and income basis damages illustrates the second problem, using the damage study in exhibit 1. In this illustration, I assume damages are prospective and the date of judgment is year zero. The exhibit shows the differences in the estimates of damages if the $12,000 of damages is brought back to a present value as of the end of year zero.

It's assumed in discounting the yearly damage amounts that they're lost equally during the year, so a middle-of-the-year assumption is made as to loss for each year. Therefore, year one damages are discounted for one half of a year to the end of year zero. Year two damages are discounted for one-and-a-half years and year three damages are discounted for two-and-a-half years. The discount rate is assumed to be 10% for all years.

Using these assumptions, there's a $756 difference in the present value of damage estimates between the cash basis and income basis approaches of calculating damages. Looking at year one under the cash basis approach, it's clear the large negative cash outflow that results from the incremental capital improvement is given a lot of weight in the discounting process because it's necessary to make this expenditure before any of the incremental income can be earned. Because this negative cash outflow is discounted for only one half of a year, it has a large negative present value. Under the income basis approach, this expense is spread out over the three-year damage period (the capital expenditure is depreciated), causing these costs to have a lower present value due to the longer period of discounting--with a resulting higher present value of total damages.

Normally, CPAs can expect a higher present value of future damages under an income approach rather than a cash flow approach if the only difference between the approaches is the depreciation or amortization of capitalized items. This assumes that the capital expenditure is made with cash and is not borrowed.

A number of other balance sheet changes also would tend to give a higher present value to the income approach over the cash flow approach. Examples include

* Increases in accounts payable.

* Increases in prepaid expenses.

* Accruals of interest income.

Conversely, some differences between the cash flow and income approaches might cause the present value of the cash basis approach to be higher than the income basis approach. If as the incremental business is estimated, it's also estimated that accounts payable would increase, this would cause the income basis approach to have a lower present value. The reason is because the expense is incurred earlier in the future period on the income statements than on the cash flow statements. Other examples include accrual of interest expense, salaries or bonuses.

PREJUDGMENT INTEREST

The same problem with the timing differences between the recognition of revenues and expenses using the cash flow and income methods also arises when calculating prejudgment interest. Using the same $12,000 of damages outlined in exhibits 1 and 3, I computed the difference in damage estimates, assuming the end of year three is the date of judgment and that prejudgment interest is awarded at a rate of 10% per year compounded. This calculation is shown in exhibit 4 Difference in future value of damages between cash basis damages and income basis damages, using the same midyear convention shown in exhibit 3.

The difference between the cash basis and income basis damage approaches is even larger here. Now it's $1,007 instead of $756. This is because under the cash basis approach, the large negative cash outflow in year one earns negative interest for a full two-and-a-half years rather than being spread out over the two-and-a-half-year period under the income approach.

CPAs should not conclude the income approach always will result in a higher estimate of damages than the cash flow approach because of the different timing assumptions between these methods. In fact, just the opposite might occur depending on the assumptions made as to how the incremental business would be financed and what balance sheet changes would occur along with the changes in the income statement. The point here is there might be differences. The CPA damage expert should be aware of this possibility and account for any differences in the estimate of damages.

A PREFERENCE FOR THE CASH BASIS

Generalizations about litigation service engagements are difficult because of the unique factual situations that arise. However, in my experience, the longer the damage period, the more I prefer the cash basis approach to damages because the estimates of present value and prejudgment interest are better when they're based on cash receipts and expenditures. Although discounting future earnings rather than cash flow is common, it lacks the theoretical justification of discounting cash flow.

EXHIBIT 2

A comparison of the cash basis and income basis damages methods (Two-year damage period)

                                   Year       Year
Cash basis damages                 one        two      Total
Incremental operating cash flow   $6,000     $7,000   $13,000
Incremental capital improvement    (9,000)             (9,000)
Cash basis damages                ($3,000)   $7,000   $4,000

Income basis damages

Incremental operating cash flow   $6,000     $7,000   $13,000
Incremental depreciation           (3,000)   (3,000)   (6,000)
Income basis damages              $3,000     $4,000   $ 7,000

[Exhibits 1, 3 and 4 Omitted]

MICHAEL J. WAGNER, CPA, JD, is a partner of Price Waterhouse in Los Angeles, California. He is a member of the American Institute of CPAs MAS practice standards and administration subcommittee and the auditing standards board litigation service task force. A coauthor with Peter B. Frank of the AICPA MAS Technical Consulting Practice Aid no. 7, Litigation Services, he is a member of the California Society of CPAs.