Case law, industry publications, and a host of other sources all say economic damages have to be estimated to a reasonable degree of certainty. Once a calculation is prepared, you review it for mathematical accuracy and determine whether the calculation itself is reasonable. This seems straightforward, but there is some confusion as to what is considered “reasonable.” This column looks at what is (and what is not) meant by reasonable certainty.
Fact of Damage
Oftentimes, CPAs can be extremely focused on the numbers, losing sight of whether damage actually occurred. In fact, the level of scrutiny applied by the courts to the fact of damage is higher than that to the amount of damage. There must be a causal link between the action of the defendant and the damages claimed – they must be proximately caused. AICPA Practice Aid 06-4, Calculating Lost Profits, defines proximate cause as “an act from which an injury results as a natural, direct, uninterrupted consequence, and without which the injury would not have occurred.” [Editor's Note: Practice Aid 06-4 has since been superseded by a new practice aid titled simply Calculating Lost
Profits.] Once an action has been determined to have occurred and that action results in economic harm, then a CPA can go about attempting to measure it. In attempting to find reasonable certainty, the fact of damage must come first.
Factors to consider when ensuring that economic damage estimates are calculated to reasonable certainty are the documents and information relied upon. The AICPA Practice Aid on reasonable certainty explains that “as the quality of the evidence improves, so does the court’s confidence in the level of certainty associated with the damages calculation.”1 Sometimes we accept a case and later find out that certain documents were never produced, or the documents we would like to have do not exist.
The expert should use the “best available” documents and information upon which to base his or her opinions and prepare an estimate of damages. Estimates of loss based upon independently audited financial statements are going to be viewed as more reliable, and thus reasonable, than estimates prepared using handwritten or other less formal documents because of the level of care demonstrated. The most prudent thing a CPA can do is to rely on the best available information; neglecting to do so will almost assure that your estimates will be challenged as not reasonably certain.
Amount of Damage
After the fact of damage is established and the best available information has been gathered, a CPA can move on to determining the amount of damage. This is where most CPAs spend the bulk of their time and effort, but, according to Robert L. Dunn in his book Recovery of Damages for Lost Profits, “While proof of the fact of damages must be certain, proof of the amount may be an estimate, uncertain, or inexact.”2
The amount of damage must be determined using sound financial and economic principles, supportable assumptions, and an appropriate methodology. Failing to include any one of these can destroy any hope of reaching an estimate with reasonable certainty. However, once the fact of damages has been demonstrated and the best available evidence has been considered, the courts generally grant more discretion in estimating an amount.3
Yes, the amount of damage requires less certainty, but if the principles, assumptions, or economic models are not based upon the facts of the case, documents provided, or accepted methodologies, it will be difficult to demonstrate that the estimate was prepared with reasonable certainty.
While there is case law and economic damage theory that provides guidance, there is no officially sanctioned universal definition of reasonable certainty. So, when faced with the prospect of preparing an estimate to which you may have to testify, remember the primary factors common to all estimates:
- Damages must have occurred and be linked to the action of the defendant.
- An expert must rely on the best available evidence to prepare estimates.
- Prepared estimates must be based on sound principles, assumptions, and methodologies, but damage amounts don’t have to be exact, they have to be reasonable.
If you spend the time to measure and weigh the factors in this column, then you should be able to rest easy that your estimates were prepared with reasonable certainty.
1 AICPA Forensic and Valuation Services Practice Aid, Attaining Reasonable Certainty in Economic Damages Calculations, page 9.
2 Robert L. Dunn, Recovery of Damages for Lost Profits, vol. 1, section 1.8.
3 Ameristar Jet Charter Inc. v. Dodson International Parts Inc., Supreme Court of Missouri (2005).
Jeffrey T. Willoughby, CPA, CFF, CFE, is a director with Forensic Resolutions Inc. located in Philadelphia and Westmont, N.J. He can be reached at email@example.com.