How the Book of Wisdom Impacts Lost Profits

lost profits

By Matt Connors

Ex ante and ex post methodologies of calculating lost profits differ based on the analyst’s treatment of three components related to alleged wrongful conduct in a litigation dispute. The three components are:

1. The information subsequent to the unlawful act considered.
2. The measurement date of the economic damages.
3. How future damages are discounted. Discounting refers to calculating the present value of a future cash flow.

Cases and fact patterns can vary that make either the ex post or ex ante methodology more supportable. It is incumbent on the expert to be objective in determining which methodology is appropriate.

Ex Post Methodology
Using the ex post methodology, all lost profits are expressed as of the date of the expert’s analysis (commonly a proxy for the date of trial). The ex post methodology relies on all information known or knowable as of the date of analysis. This is sometimes referred to as using the book of wisdom because the analyst includes information and other factors that affect the company, the industry, the economy, etc. after the date of the alleged wrongful conduct. In addition, the AICPA Practice Aid 06-4, “Calculating Lost Profits,” recommends that, “There is no discounting of the historical lost profits that were incurred between the date of the breach and the date of trial.”

Critics of the ex post methodology point out that historic lost profits have not been risk adjusted if they are not discounted and, therefore, are treated as guaranteed. In fact, at times undiscounted historic lost profits have prejudgment interest added. Critics also cite that if a plaintiff is entitled to supposedly guaranteed historic lost profits, there is a disincentive to mitigate damages.

Ex Ante Methodology
Using the ex ante methodology, all lost profits are expressed as of the date of the alleged wrongful conduct. However, the analyst only considers information known or knowable as of the date of the alleged wrongful conduct and, therefore, could be criticized for disregarding events subsequent to the alleged wrongful conduct that could impact damages.

Since economic damages are typically discounted to the date of the alleged wrongful conduct using the ex ante methodology and the date of trial can be several years later, pre-judgment interest, if appropriate, may be applied to adjust time-of-incident damages to time-of-judgment damages. Because of the risk inherent in a company achieving future cash flows, the discount rate is meant to account for the uncertainty associated with the projected cash flow.

Proponents of the ex ante approach argue that it more properly accounts for risk because damages after the date of the alleged harm are discounted. It is further argued that the results of an ex ante approach can be independent of when trial occurs because, setting prejudgment interest aside, damages are expressed as of the date of the alleged harm. It is also argued that ex ante damages do not penalize a plaintiff for pursuing or failing to pursue mitigation.

Some analysts use a hybrid methodology that considers all information known or knowable up to the date of analysis, but discounts all economic damages to the date of the wrongful act.

Hypothetical Illustration
The impact of ex post damages compared to ex ante damages can be illustrated by considering Clearview, Inc., a manufacturer of glass doors. Clearview enjoyed positively trending sales due to the booming residential construction industry. However, Cascadia Glass, the glass supplier, breached an agreement with 10 years remaining due to increased costs of producing glass. Clearview lost the favorable pricing it negotiated with Cascadia Glass. As of the date of breach, damages would be equal to Clearview’s increased expected cost of acquiring replacement materials over the remaining life of the agreement.

However, during the course of litigation, the economy entered a downturn and Clearview’s sales began to suffer. In addition, Clearview lost a key customer that comprised 30 percent of sales and had not been able to replace the lost sales with other customers due to stifling economic conditions. To add to matters, Clearview became the defendant of a trademark infringement lawsuit that threatened the viability of the company if it did not prevail in the matter.

The ex ante methodology would disregard events not known or knowable as of the date of alleged harm and would likely project positively trending sales, but the ex post methodology would consider the book of wisdom and all information known or knowable through the date of the expert’s analysis. The measurement date of damages would differ and the discount rate would likely differ based on which methodology is applied.

It is the expert’s job to weigh the different methodologies and coordinate with counsel as to which is appropriate to arrive at a reasonable estimate of the plaintiff’s loss. Careful consideration of the appropriate methodology will result in the most supportable calculation.

Matt Connors is a managing member at Rocky Mountain Advisory, LLC and leads RMA’s business and intellectual property valuation practice. His expertise includes expert witness testimony in complex commercial litigation matters for business valuation, estimating economic damages, and forensic accounting investigations. He has extensive expertise in business valuation, preparing and rebutting lost profits calculations, investigating alleged fraud schemes, investigating departures from GAAP, performing Foreign Corrupt Practices Act investigations, and evaluating business solvency. He is a certified public accountant, accredited in business valuation and a certified fraud examiner. Connors can be reached at (801) 428-1605 or at mconnors@rockymountainadvisory.com. For more information, visit RMA at www.rockymountainadvisory.com.