Lost Profits – Part 2: Calculation of Lost Revenues

This is the second post in a three part series discussing the calculation of lost profits in a hypothetical scenario seeking economic damages for the alleged violation of a non-competition covenant.  As noted in the prior post, the three part series will utilize the following fact pattern:

  • The Best Animal Hospital, Inc. is a veterinary clinic located in Atlanta, Georgia.  The company was established on January 1, 2000 by Bob and Jill.
  • Bob and Jill each own 100 shares of The Best Animal Hospital, Inc.’s stock, representing 100% of the outstanding shares of the company.
  • Bob and Jill signed a Shareholder Agreement on January 1, 2000, which contained a five-mile non-competition covenant for a period of one year subsequent to termination.
  • On December 31, 2013, Bob and Jill parted ways, and Jill purchased Bob’s 100 shares.
  • On January 1, 2014, Bob opened Bob’s Animal Hospital, Inc. which is located within five miles of The Best Animal Hospital, Inc.
  • Jill filed a lawsuit on January 1, 2015, for the alleged violation of the Shareholder Agreement, specifically the non-competition covenant.
  • John, a seasoned forensic accountant, was engaged by legal counsel for The Best Animal Hospital, Inc. as a financial expert regarding lost profits.

Generally, one of the initial steps in determining lost profits, if any, is the calculation of lost revenues.   The AICPA practice aid for calculating lost profits identifies and describes several methods for calculating lost revenues including the following:

  • Before-and-after method
  • Yardstick method
  • An approach based on the terms of the underlying contract
  • An accounting of the defendant’s profits

This post will focus on the calculation of lost revenues utilizing the Before-and-after method.  As noted in the AICPA practice aid for calculating lost profits “this method compares the plaintiff’s performance before the event or action causing the lost profits to the plaintiff’s performance after that event or action.  The underlying theory is that ‘but for’ the defendant’s action, the plaintiff would have experienced the same level of revenues and profits after the event or action as if the plaintiff did before that event or action.”  What follows is a hypothetical forensic accounting analysis performed by John at the request of The Best Animal Hospital, Inc.’s legal counsel regarding the alleged lost revenues of the animal hospital.

Calculation of Lost Revenues

As noted in the initial post of this series, The Best Animal Hospital, Inc. alleged that Bob caused losses to the business as a result of setting up his business nearby.  In order to evaluate this claim, counsel requested that John quantify the amount of lost revenue, if any, for The Best Animal Hospital.  To perform this analysis, John obtained copies of The Best Animal Hospital’s internal financial statements and tax returns for the period from 2010 through 2014.  John first compared the internal profit and loss statements to the revenue and expense figures contained in the tax returns.  John did not note any differences in the revenue and expenses between the internal financial statements and the tax returns.  The Best Animal Hospital Inc.’s revenue by year was as follows:

      2010 2011 2012 2013 2014
$1.40 Million $1.50 Million $1.58 Million $1.64 Million $1.26 Million

Subsequent to comparing the internal financial statements to the tax returns, John analyzed The Best Animal Hospital, Inc.’s revenue by year from 2010 through 2013 and calculated the following annual growth rates:

2011 2012 2013
7.14% 5.33% 3.80%

John obtained industry growth rates from several veterinary trade association annual reports and noted that The Best Animal Hospital, Inc. had experienced revenue growth exceeding the industry standard for all of the periods prior to the opening of Bob’s Animal Hospital in 2014.  John discussed the growth rates with Jill and Jill’s practice manager, Christine.  During the course of the interview, Jill indicated to John that the city in which The Best Animal Hospital, Inc. was located had experienced significant population growth, which Jill indicated started in approximately 2010.  Jill further noted that the city had incorporated in 2010.  Subsequent to the interview with Jill and Christine, John confirmed the details provided by Jill via economic research and a site visit to the new city hall.

Noting that the growth rates experienced by The Best Animal Hospital, Inc. showed a downward trend, John projected 2014 “But For” revenue utilizing a weighted average of the 2011, 2012 and 2013 growth rates.  John’s calculated weighted average growth rate based on The Best Animal Hospital, Inc.’s historical revenue was 4.42%.  Despite the fact that this growth rate exceeds the 2013 growth rate, based on the facts and circumstances and John’s professional experience, he determined the calculated growth rate of 4.42% is appropriate.

Utilizing the weighted average growth rate and 2013 actual revenue, John calculated “But For” 2014 revenue of approximately $1.71 million.  John compared the “But For” 2014 revenue of The Best Animal Hospital, Inc. to the actual 2014 revenue of approximately $1.26 million resulting in a calculated lost revenue figure of approximately $450 thousand.

In conclusion, the calculation of lost revenue often requires the forensic accountant to obtain an understanding of additional facts and circumstances beyond just an analysis of the financial transactions.  In the final post of this series, we will explore identifying saved costs. In the meantime, if you have any questions or need assistance in a complex damages matter, please contact Tyler Wright at 770-635-1701 or Karen Fortune at 770-635-1699.  Initial consultations are offered free of charge.

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IAG Forensics

IAG Forensics & Valuation is a CPA firm that specializes in forensic accounting, fraud investigation, business valuation and litigation support.

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