Canada: Facts vs. Assumptions - Experts Need To Know The Difference

Last Updated: January 18 2013
Article by Kim Jezior

Chartered Business Valuators (and other financial experts) are often retained to provide their professional opinion as to the quantum of a financial gain or loss in the context of litigation or a dispute. One or more experts are generally retained by each of the opposing parties and as a result, at least two differing opinions are often presented to the Court. In most cases, the differences in opinion often arise as a result of the assumptions underlying the experts' analysis.

Quantifying the financial impact of an event that did not (or will not) occur, by its very nature, requires the adoption of certain assumptions. However, drawing conclusions of fact and making unreasonable or unsupportable assumptions may result in an expert's report being granted little weight by the Court and therefore being of limited use. It is essential that Counsel and their client understand the differences between the facts that the expert relied upon and the assumptions that the expert made (or was asked to make), including the impact that these assumptions have on the expert's overall findings and opinion. This understanding is also critical for purposes of assessing the client's litigation position and strategy as well as possible settlement offers.

FACTS vs. ASSUMPTIONS - WHAT IS THE DIFFERENCE?

The difference between a fact and an assumption may not be obvious. A fact is something that has occurred or is actually the case. The usual test for a statement of fact is verifiability; that is, whether it can be proven.

An assumption, on the other hand, is a belief without proof. We, as a society, have grown accustomed to assumptions being presented to us as facts. Advertisers routinely present assumptions as facts as a means of influencing our purchasing decisions; political candidates present assumptions as facts in order to garner public support; friends and colleagues often present assumptions as facts in order to obtain our approval or agreement.

There are times when we need to act on certain assumptions without checking for the proof (or support) behind them. However, when it comes to the credibility, reliability and acceptance of an expert report for purposes of litigation it is essential that the key assumptions underlying the expert's opinion be clearly disclosed and, where possible, supported by consideration of the relevant facts.

Standard No. 310 issued by The Canadian Institute of Chartered Business Valuators ("CICBV") requires that expert reports disclose the "assumptions used and the procedures followed to determine the reasonableness and appropriateness of key assumptions". In applying Standard No. 310, the CICBV suggests that the Chartered Business Valuator classify the key assumptions as follows:

i) Category 1 - Those assumptions that the Expert is directed to take, that are not within his/her area of expertise;

ii) Category 2 - Those assumptions made by the Expert, within his/her areas of expertise and based on a scope of work executed by him/her; and

iii) Category 3 - Those assumptions that the Expert is directed to take on matters that are within his/her area of expertise, but where the Expert was not provided the opportunity to execute a scope of work appropriate to add assurance to the assumption.

Categorizing the assumptions in this manner allows for a better comparison between expert reports and may assist in reducing the number of issues to be addressed during settlement discussions or litigation proceedings.

COMMON TYPES OF ASSUMPTIONS – A CASE STUDY

Whether the case pertains to allegations of beach of contract, personal injury or lost business value, assumptions are an integral component of an expert report. The following case study highlights some of the major areas where assumptions are required, as well as the steps that can be taken to ensure that the assumptions adopted by the financial expert are reasonable, supportable and consistent.

The Case

A U.S. based manufacturer of sporting equipment and athletic attire terminated its contractual relationship with a Canadian distributor prior to the contract's expiration date. The distributor sued alleging a breach of the contract and claiming loss of profits in excess of $2 million. For purposes of quantifying the incremental profits that would have been earned by the distributor "but for" the early termination, the expert must make certain assumptions relating to:

a) the period of the loss (i.e. a "reasonable" notice period);

b) expected net future sales volumes, selling prices and gross margins;

c) incremental costs that would have been incurred by the distributor to earn the lost revenues and margins being claimed; and

d) the net proceeds realized from the distributor's mitigation efforts.

Given the need to make these types of assumptions, what is it that distinguishes an expert report that will stand up to rigorous cross-examination from a report that will be given little consideration by the Court? To further explore this question, we have considered the three categories of assumptions outlined above in relation to the case study.

Period of Loss - Category 1

In order to provide an opinion regarding loss of profits, the expert must make a reasonable assumption(s) as to the period of loss. The period of loss is generally a legal matter that will ultimately be determined by the Court. While this assumption is outside the expertise of the financial expert, in our experience, providing an analysis that considers alternative loss periods is most helpful to Counsel and to the Court. In this case, the Plaintiff claimed losses for a period of 2 years, which the Defendant alleged was excessive. The Defendant suggested that 6 months was more reasonable. The Defendant's expert quantified the loss of profits to the distributor based on three alternative loss periods (6 months, 12 months and 2 years) – the loss periods selected were based on the case facts and Counsel's instructions. The Plaintiff's expert's report considered only one loss period of two years, therefore limiting the usefulness and comparability of that report.

Quantification of Net Incremental Profits – Category 2

The expert must make certain assumption(s) as to the revenues that would have been generated during the loss period, net of incremental costs, in order to quantify loss of profits. The assumptions that are made by the expert that are within his/her areas of expertise are based on a scope of work executed by him/her. Where historical financial records exist, it is important that the expert understand the historical results – what happened and why, in order to project what would have likely happened during the loss period "but for" the triggering event (i.e. the alleged breach of contract). Absent a fundamental change in the operations of the business or industry, historical experience is often the best indicator of future experience. However, the expert must also consider and address potential differences between the historical actual results and the likely results. For example, in this case, the Plaintiff's expert adopted management's revenue forecast of 8% annual growth, based on historical growth rates. However, management had been advised prior to the termination that certain product lines were likely going to be discontinued by the manufacturer (during the period of loss). The Defendant's expert adjusted the expected sales volumes to reflect this likely decline from historic levels. In order to assess the historical results and management's projection of future results, the Defendant's expert relied upon the following sources of information:

  • Historical monthly, quarterly and annual financial statements;
  • Forecasts, budgets, and plans;
  • Correspondence between the manufacturer and the distributor; and
  • Independent market analysis.

Proceeds from Mitigation (Category 2/Category 3)

Litigants are required by law to take reasonable steps to mitigate or reduce their losses. In this case, the distributor sought out and secured an unrelated product line subsequent to the termination. The Plaintiff's expert was asked to assume that the Plaintiff would have secured this product line absent the termination and as a result concluded that there were no net proceeds from mitigation. This assumption was not supported by an analysis of the case facts. The Defendant's expert considered the Plaintiff's previous efforts to secure additional product lines (there were none) as well as the warehouse and personnel capacity of the Plaintiff. Based on his analysis, the Defendant's expert concluded that absent the termination, it would not have been possible for the distributor to service the original contract as well as the new product lines without securing additional warehouse space and hiring additional personnel and as a result concluded that there were net proceeds from mitigation.

Internal Consistency – Category 2/Category 3

The most common mistake that financial experts make when adopting assumptions is that of internal consistency. For example, in this case, management projected an 8% annual increase in sales volumes with no increase in overhead costs or capital expenditures. In order assess management's projection, the following types of questions should be considered by the experts:

a) Do the historical actual growth rates support the projected growth rate? If not, what is the basis for making an assumption of 8% growth?

b) Does the business have sufficient warehouse space and staffing levels to service the projected increase in sales? If there are potential capacity issues, would the business have incurred incremental costs to rent additional space and hire additional staff?

c) Has the risk related to achieving the sales forecast been adequately reflected in the discount rate that was adopted by the expert to calculate the present value of the future losses?

THE BIG PICTURE

Assumptions are an integral component of a financial expert's report (and opinion). Clearly disclosing the assumptions that were relied upon, including those that were provided by Counsel, and setting out the underlying supporting facts (including those that differ from the assumptions that were adopted), will assist the Court in assessing opposing views and ultimately determining the damages award.

Lastly, remember

"The least questioned assumptions are often the most questionable." Paul Broca

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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