Introduction
The calculation of damages such as lost profits or lost business value requires knowledge of forensic accounting, financial economics, statistics, and economic modeling.
For example, the valuation of a business or lost profits needed to derive damages given that typically accrual accounting data is the primary source of performance involves the following key steps:
- Converting accounting performance to cash flow performance
- Valuing the future cash flows as of today using present value techniques with the appropriate discount rate or the weighted average cost of capital (discounted cash flows or DCF methodology)
- Incorporating other valuation methodologies such as market or transaction multiples as a check on and potential alternative to the DCF methodology
The accounting expert and economic damages experts may be able to perform some but not all of these key steps effectively, thus it may be necessary to either hire both experts or find the right expert with extensive knowledge in accounting, financial economics, and economic modeling.
The Accountant
A certified public accountant (CPA) or forensic accountant familiar with Generally accepted accounting principles (GAAP) should be able to convert accounting-based performance to cash flow-based performance needed for the DCF methodology. However, they are not necessarily well trained in all aspects of DCF type analyses or market multiples and sometimes rely on unreliable formulas that they do not thoroughly understand.
For example, in deriving the discount rate used to calculate the present value of future cash flows under the DCF method, an accountant may use a model that implies investors are well diversified but then arbitrarily add a non-diversifiable risk factor to the discount rate not considering the fact that adding such a factor to the model is not only unfounded but is in total contradiction to the model used to derive the discount rate in the first place.
The Economist
The economist is generally well versed in valuation modeling and all aspects of the models, but the economist may not have the requisite accounting background to convert accrual accounting data to cash flow performance both historically and for forecast future cash flows needed to derive the DCF valuation.
Such a gap in knowledge may leave one with a great valuation model but unreliable model inputs rendering the entire valuation or damages calculation unreliable.
Conclusion
One way to avoid these pitfalls is to use two experts, an accountant to derive the cash flows needed for the DCF and an economist to derive the other parameters of the valuation model such as the discount rate and market multiples.
Such an approach may be more costly but unless your expert is well versed in accounting, economic modeling, and financial economics such an approach may be what is needed.
Alternatively, only one expert is required if that expert has the dual accounting expertise and economic expertise necessary to accurately perform a damages calculation as per the steps described above.
DMA Economics Can Help
Dr. Donald M. May, managing partner of DMA Economics is both a CPA and Ph.D. economist versed in the intricacies of conversion of accrual accounting data to economic cash flow data and the modeling of such data to derive the most accurate valuation of damages.
Dr. May has the expertise and experience to rigorously derive and then value these cash flows using scientifically acceptable methodologies. Contact us today using the form on this page for more information on how our economic damages experts can help you.
