See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/271505505

Teaching Notes: A Case Study on the Determination of Lost Profits for the
Forensic Accountant

Article · January 2012

CITATIONS READS

0 1,652

1 author:

James A. DiGabriele
Montclair State University
55 PUBLICATIONS   323 CITATIONS   

SEE PROFILE

Some of the authors of this publication are also working on these related projects:

Individual View project

The expectation differences among stakeholders in the financial valuation fitness of auditors View project

All content following this page was uploaded by James A. DiGabriele on 28 January 2015.

The user has requested enhancement of the downloaded file.

ISSUES IN ACCOUNTING EDUCATION - TEACHING NOTES American Accounting Association
Vol. 27, No. 3
2012
pp. 1–8

TEACHING NOTES

A Case Study on the Determination of Lost

Profits for the Forensic Accountant
James A. DiGabriele

ABSTRACT: This paper illustrates a teaching case study for use in a forensic
accounting course. The case study requires students to prepare and/or present their
findings for the valuation of lost profits in the framework of a business interruption.
Readers obtain requisite financial and qualitative information to complete a valuation of
lost profits due to a business interruption.
Keywords: forensic accounting; lost profits; business interruption; sales projection
method.

CASE PURPOSE/OBJECTIVES

 Expose students to a practical learning exercise in the determination of lost profits due to a
business interruption.
 Allow students to apply analytical judgment by investigating a fact pattern using problem-
solving capabilities in a new business environment.
 Disseminate income and expense behavioral patterns within the context of a business
interruption.
 Describe and discuss business interruption analysis.
 Utilize and understand the sales projection method.

METHODOLOGY

W
hen a business files an insurance claim for lost profits due to business interruption,
forensic accountants are frequently engaged by the insured to be certain the insurance
company (1) reimburses the claimant the maximum amount under its coverage and (2)
confirms the insured’s claim is reasonably calculated. In straightforward terms, the purpose of
business income coverage is to indemnify the insured for its net income or loss plus continuing

James A. DiGabriele is an Associate Professor at Montclair State University.

I thank Richard (Dick) Riley (associate editor) and two anonymous reviewers for their extremely helpful comments and
recommendations.
Please do not make the Teaching Notes available to students or post them on websites.

Published Online: August 2012

1
2 DiGabriele

(unavoidable) operating expenses during a period of interruption resulting from a covered loss. A
business interruption claim is fundamentally a claim for the lost profits a business suffers as the
result of an incident. This concept was derived from an older model where lost profits recovery was
based on gross earnings less discontinued expenses.
To quantify a loss of business income, an analysis of pre- and post-loss revenue, costs, and
operating expenses is required. A forensic accountant generally will provide his/her knowledge and
experience to the technical aspects of this process, including but not limited to accounting data to
quantify the claim, as well as policy terms. Specific policy terms such as waiting periods and
coinsurance are outside the scope of this case study and therefore will not be addressed. Here is a
partial list of particular examples of how a forensic accountant can assist:
 Request the relevant books and records needed to support a lost profits claim due to a
business interruption.
 Apply accounting knowledge of policy coverage to properly analyze, identify, and segregate
revenues, fixed and variable expenses to coincide with preparation of the loss of profits
claim.
 Offer productive exchanges between the claimant and insurance company on financial and
accounting issues that may be outside the scope of both parties represented. A productive
exchange in a potentially litigious environment regarding financial and accounting issues
aids in the ultimate resolution of the case. Claimants are often confounded with the theory of
business interruption and believe their loss is composed of lost sales. Forensic accountants in
this environment generally provide an invaluable service by cogently explaining to claimants
why the reimbursement from the insurance carrier is a combination of net income plus
expenses that continue. This type of productive exchange typically assists in the facilitation
of a settlement.
The principal theory of lost profits is that ‘‘but for’’ the damaging event, the claimant would
have experienced a historical rate or even growth of revenue or profits. In view of that approach,
four methods are generally used to calculate lost profits resulting from a business interruption:
before-and-after method, yardstick method, sales projection method, and market model. These
methods may be used alone or in combination to develop a lost profits analysis. The
before-and-after method determines the damages by comparing business operations before the
event causing the loss to the period after. The yardstick method uses industry benchmarks as a
proxy of what the loss would have been if the damaging event had not occurred. The sales
projection method uses historical company information to project the income that would have been
generated and the expenses that would have been incurred had the interruption not occurred. The
market model is centered on a claimant’s market share. This is a data-intense model used more
frequently in patent infringement damages.
This case illustrates a short-term loss, and therefore the use of the sales projection method is
more appropriate and practical.

TEACHING SUGGESTIONS AND PROPOSED SOLUTIONS

It is recommended that this assignment be completed by students within a group environment.
The case may be handed in then discussed, or each group can present its solution and methodology
to the class. The assignment can be divided into sections according to preference.
1. A precursor task of requesting the relevant books and records for the calculation of lost
profits can commence in the introductory phase of the case. The breadth of utilization could
be an in-class discussion regarding the scope of the information needed, or the students may
create a formal letter addressed to the claimant requesting the requisite information. An

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012
A Case Study on the Determination of Lost Profits for the Forensic Accountant 3

example list of pertinent items to include in a letter of request for a short-term calculation of
lost profits could be as follows:
a. Three years of business tax returns.
b. Three years of detailed general ledgers.
c. Payroll tax returns pre/post-loss periods.
d. Normal operating schedule.
e. Actual receipts during loss period.
The above list is optimal to perform the assignment. However, when applying to the case, it is
implied the forensic accountant has settled for a 2009 profit and loss statement and two years of
monthly sales for the same period. This establishes an opportunity to discuss unstructured
problem-solving skills.
2. Calculate the Business Interruption Value using Enclosure (a) as a guide. Expenses that are
‘‘fixed’’ continue during the loss period. Those expenses that are ‘‘variable’’ must be
examined to determine their behavior during the loss period. Professional judgment is
needed for each expense line item, deeming it either ‘‘fixed’’ or ‘‘variable’’; for variable
expenses, determine whether to disallow completely or pro-rate the expense. Provide
justification for all expenses continued/discontinued. Enclosure (d) will provide further
direction.
Enclosure (d) offers detailed explanations for expenses that either continue or are discontinued
during the loss period. Students should be able to understand the differences between the two
groups and the underlying methodology to restore a claimant to the position he/she would have
otherwise experienced if the damaging event had not occurred. Enclosure (a) presents the historical
behavior of expenses as a percentage of gross receipts. This is a common method to calculate a term
regarded as the Business Interruption Value. Theoretically, this quantity serves as the aggregate
substitute for net income (loss) plus continuing (unavoidable) expenses. The proposed solution
based upon the facts introduced in Enclosure (d) is illustrated as follows (The percentages in
Enclosure (a) do not sum exactly, due to rounding):

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012
4 DiGabriele

3. Calculate the gross receipts lost during the period of interruption to the business utilizing the
information provided in Enclosure (b). Several methods may be used to project income
during the period of interruption. ABC Pest Control did continue to operate at a limited
capacity and generated some income during the loss period. Please provide justification for
all assumptions and calculations.

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012
A Case Study on the Determination of Lost Profits for the Forensic Accountant 5

Since this case applies the sales projection method to extrapolate revenue during the loss
period, the following three scenarios may be considered in calculating lost gross receipts. However,
students’ using another variation is encouraged, assuming the methodology is sound. Emphasis
should be made concerning the reduction of lost revenue by actual receipts received during the loss
period. Suggested solutions could be:

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012
6 DiGabriele

4. Calculate the loss due to the business interruption based on the formula provided on
Enclosure (c).
This schedule represents the framework for the solution provided by the students based upon
the theory of lost profits in a business interruption scenario. The calculation is also guided by the
insurance policy in force. Enclosure (e) is included in the case to illustrate an actual loss of business
income section of an insurance policy. The proposed solutions can be illustrated (see below);
however, students may also apply alternate methodology to their calculations. Evaluating the
validity of students’ judgment in selecting a different approach is the perfect opportunity to engage
in a critical discussion on the topic.

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012
A Case Study on the Determination of Lost Profits for the Forensic Accountant 7

5. An additional assignment that can be integrated within the case framework effortlessly is the
use of invigilation. This technique compels close supervision of the claimant during the
period of restoration to avert the opportunity for an over recovery. Invigilation is generally
used in high-risk activities such as inventory with weak controls. Considering the claimant
is providing the financial information necessary to support the loss, the form of invigilation
that can be applied in this case is to closely monitor significant fluctuations in continuing
(unavoidable) expenses during the 30-day loss period. Introducing post-loss data points
(continuing [unavoidable] expenses during the loss period) for specific expenses engender
the opportunity to present investigative accounting techniques within the structure of this
assignment. A scenario could be where the claimant has submitted the succeeding expenses
for the loss period to the forensic accountant as continuing (unavoidable) during the loss
period: (1) Legal & Professional $732 and (2) Tolls and Parking $1,050. Although the
forensic accountant in this case is hired by the claimant, the analysis should remain free
from impartiality while implementing professional skepticism. Students should be attentive
to the high variability of the expenses when comparing to historical annualized behavior.
Instructors can use the following explanations as examples or variations of their own to
bolster the significance of invigilation in this setting.

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012
 8 DiGabriele

a. Legal & Professional expenses of $732 included a $500 retainer paid to the forensic
accountant to engage the services. This amount will be reimbursed to the claimant
under the professional fees clause of the policy. Removing this amount places ABC
Pest Control in the position the company would have otherwise have been in, had the
loss not occurred.
b. Tolls and Parking expenses of $1,050 included $650 of unpaid personal parking tickets.
Removing this amount places ABC Pest Control in the position the company would
have otherwise have been in, had the loss not occurred.
6. Applying the sales projection method to extrapolate revenue during the loss period. Three
years of sales data are provided for the forensic accountant to project revenue during the
loss period. For the period May 20, 2008, through June 19, 2008, the gross revenue is
conspicuously different from the subsequent comparative periods. It is important for
students to identify this as an anomaly in the data.
7. The written report will vary by students. The report outline could assist in the grading
process.

CONCLUSION
Case studies of this nature are particularly attractive to students because it gives them the
opportunity to apply their accounting skills in a diverse manner.
Critical thinking, logical reasoning, and deductive analysis are important requisites that are
innate components of this case. There are many options to reinforce these attributes such as
summarizing discussion questions.
Critical questions examine the validity of a particular methodology presented. Connective
questions challenge the students to connect their solutions to the theory of lost profits in a business
interruption. Comparative questions may also prove to be dynamic since it is unlikely that all
groups would present the same answer.

Issues in Accounting Education - Teaching Notes

Volume 27, No. 3, 2012

View publication stats