Canada: Quantifying Recoverable Business Losses

Last Updated: December 1 2010
Article by Jim Muccilli

Every day, situations occur where recoverable business losses can arise. These include:

(a) Business interruption, due to fire, theft, product liability, etc.

(b) Breach of contract and/or fiduciary duty (including torts and negligence)

(c) Expropriation

(f) Patent or intellectual property infringement

(g) Predatory pricing and dumping

Quantifying such business losses for the purposes of recovery of the losses encompasses a very broad spectrum of analysis for an accounting expert. At the root of any analysis of losses is the concept of restoration. The objective is to quantify the difference between what could have been earned had a particular incident not occurred and what will likely be earned as a result.

Due to the many uncertainties involved in a loss scenario, very rarely can a loss be calculated definitively. Assumptions are typically necessary.

To gain an understanding of the possible losses, one needs to clearly understand the nature of the effected business. Factors that should be assessed at the outset include:

  • the industry within which the business operates,
  • competition,
  • key success factors,
  • lifecycle, and
  • financial position.

It is necessary to understand the revenue, cost, volume and profit relationships of the enterprise in order to determine how a loss of revenue and/or volume of production results in changes to various expenses. Some costs are fixed in the short-term while others are variable and can be avoided when sales drop. In such cases, it would not be appropriate to merely calculate the loss based on lost gross revenues.

There are several especially troublesome areas that exist that are often not considered adequately. Alternative business opportunities must be assessed on an ongoing basis. Take, for instance, a company that uses key staff and other resources to restore a division damaged during a flood. Those key staff members and resources could otherwise have been employed in various profitable pursuits, such as bidding on new projects. The cost of the incident may include the profits that were foregone due to missed opportunities.

The duration of the loss impacts how we define certain expenses and whether they should be considered in the calculation of losses. Some costs tend to be fixed in the short-run, but are not viewed as fixed in the longer term. For example, a building may be sold, capacity changed, operations can be relocated, leases re-negotiated, staff can be fired, etc.

An important consideration in the determination of business losses is whether an apparent short-term loss represents a permanent loss or whether such a result represents a postponement of revenue or income to a future period. Sales may not actually be lost in certain circumstances. For instance, where a customer may hold enough inventory for use when the supplier is not able to produce and the future orders are placed at a higher quantity level because the customer has to restore inventory levels.

The duration period of a loss calculation does not necessarily coincide with the period of interruption. In some cases, the effects of the loss may extend well beyond the closure period due to lost opportunities, damage to the reputation of the business, delay in mitigation efforts, such as the time required to replenish inventories, or the loss of competitive positioning.

In some cases, due to mitigating efforts such as increased advertising or recovery of postponed sales, excess profits may be earned by the business in a subsequent period.

Historic trends and historic data are useful and can help to corroborate the impact of economic shifts on any entities' operations. Although, for companies in a start-up phase or those in a declining phase of their lifecycle, historic data tends to be less useful.

Competitors' actions would be relevant whether they are due to a general change in competition or whether the change is a reaction by competitors to the business interruption that was experienced.

In extreme circumstances, competitors' reaction could lead to pricing policies and historic profitability being permanently changed.

Another important consideration relates to the capacity of the enterprise. What is the level of activity that the enterprise is capable of achieving and maintaining pre- and/or post-incident? For example, this issue is relevant in determining the inability of the business enterprise to secure or complete proposed or existent projects at the time of the interruption (e.g., were they constrained by lack of cash, space or restricted borrowing ability regardless?). Could the business enterprise have reasonably completed the ongoing projects, undertaken proposed projects and/or successfully pursued new opportunities had the interruption not occurred? Would the enterprise have even been able to handle its ongoing activities and any additional activities concurrently, without a resulting increase in fixed costs?

Many factors impact capacity, including the size of the company's premises, number and skill level of employees, regulatory or other external factors that may limit the size of operations of the enterprise, and anticipated changes in capacity that were contemplated prior to the incident.

Typically, advancing a claim for recovery of losses includes a duty in common-law to mitigate damages that may arise in both contract and tort. An accounting expert would generally consider the efforts and results of the attempts that were made by the claimant to mitigate damages. Efforts to mitigate may include execution of alternative contracts, hiring of replacement staff, replacement of inventory, enhanced promotion and advertising.

Jim Muccilli has worked in business valuation and litigation-related accounting for over 20 years. He brings with him vast knowledge in the areas of business valuation, loss quantification and forensic investigations.

Jim has qualified as an expert witness in a variety of financial matters. His practice demonstrates a broad range of expertise applied to shareholder disputes; purchase/sale transactions; Family Law Act matters; income tax and financial reporting compliance; breach of contract and breach of fiduciary duty.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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