Economic damage through contract and tort

A truck driver takes a short cut on a road closed to trucks, loses control and wrecks the power equipment that keeps a drinks factory's raw materials cold. The factory stops for a month. The factory's owners sue. The court will ask one question: how much money would put the factory back where it would have been if the accident had not happened?

A forensic accountant is hired to answer it. That answer, the amount of economic damage, is the heart of many civil claims.

This topic covers what economic damage is, why it is computed, the kinds of economic loss, the types of damages a court may award, tort, the "but-for" method of calculating damage and other methods, the limits of any calculation, the steps in a calculation, and two worked cases. The previous topic introduced forensic accounting, and the next covers computer forensics, fraud investigation and litigation support.

Key terms in plain English

Syllabus check

This topic is in syllabus area D, forensic accounting services (15% of marks). It covers:

• economic damage through contract and tort
• types of economic damage
• calculation of economic damage

CAMA 2020 and economic damage

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

What economic damage is

Economic damage is the financial loss or harm suffered by a person, organisation or economy as a result of financial crime or other economic offences. It is also the monetary loss or expense that results from a wrongful act, a breach of contract or other tortious conduct.

The main purpose of computing it in a forensic investigation is to compensate the injured person for the losses, aiming to restore that person to the financial position that would exist if the harmful act had not occurred.

A thorough, fully documented analysis of economic damage is often the key to a successful case, because it quantifies the loss caused by the alleged harmful act, so that the plaintiff can be put in the same economic position as if no harm had been done.

The court often gives guidance on the method to use, so the forensic accountant must apply the method that fits each case.

Gathering evidence for economic damage

• Internal evidence: data collected directly from witnesses and records, including subjective observations and objective performance data compiled over time. The investigator decides which information is most important to track. Good internal evidence makes it easier to find targeted external evidence.
• External evidence: data, statistical analysis and conclusions from scientific or independent studies. It helps to decide what approach is likely to be effective when a person or organisation loses money, and supports the internal evidence. Examples include market data, supplier quotations, price lists, independent engineers' reports and industry statistics.

Economic loss is financial loss, usually seen in the income statement or the statement of financial position of a business. It does not cover loss of income caused by physical or personal injury, although the effects of an injury can be a consequential economic loss.

Types of economic loss

Sources of economic damage

• Breach of contract: one party fails to do what it promised, causing harm to the other. For example a supplier fails to deliver raw material and production and revenue fall.
• Tortious interference and fraud: a tort is an act that causes financial harm to another person or organisation.
• Negligence: for example an accountant gives an inaccurate valuation and an investor loses money.
• Fraud: manipulation to make illegal gains, causing loss to another.
• Defamation: a false statement that harms a business's reputation, reduces customer trust and cuts revenue.

The damage may take the form of financial losses directly suffered, for example by embezzlement, theft or misappropriation; opportunity costs, the indirect costs of a missed opportunity or delayed investment; reputation damage, which may reduce revenue or business; and legal and regulatory costs, including fines and penalties.

Types of damages awarded

Compensatory damages are a monetary award to compensate for injuries or losses from another party's wrongful act or negligence, to restore the injured party to its position before the wrong. They divide into:

• Special damages: specific, quantifiable losses, such as property damage or product liability losses, lost income or wages from a breach of contract, and medical expenses from personal injury.
• General damages: non-quantifiable losses, such as loss of consortium, pain and suffering, emotional distress and loss of enjoyment of life.

Consequential damages are indirect. They compensate for losses that are a direct result of the defendant's wrongful act or negligence but are not immediately clear or directly related to the first harm. Examples are lost profit after a supplier's breach, business interruption caused by negligence, loss of reputation from defamation, and emotional stress.

Punitive damages, also called exemplary damages, go beyond compensation. They punish the defendant for wrongful conduct and deter similar conduct in future. They are awarded in cases of reckless and egregious behaviour, intentional torts such as battery and assault, and gross negligence.

Factors that decide whether and how much to award are the severity of the defendant's conduct, the defendant's intent or state of mind, the severity of the harm and the defendant's wealth.

Tort and economic damage

A tort is a wrongful act or omission that causes harm or injury to another person, their property or their rights. It is a civil wrong that carries legal liability and compensation for damages. Intentional torts are deliberate acts that cause harm, such as assault, battery or defamation. Negligence torts are careless or reckless acts, such as car accidents or medical malpractice.

The purposes of tort law are to compensate the victim, to deter others from similar wrongs and to hold individuals and organisations accountable. In a negligence claim the plaintiff must show a duty of care, a breach of that duty, causation and damage, and that the damage was not too remote.

Calculating economic damage

There is no single formula. In general, economic damage is the difference between the value of an asset or stream of cash flow at a point in time and its value "but for" the action or negligence of the accused party. Once causation is established, the expert finds the difference between the actual value and the but-for value.

For a mismanaged portfolio, the damage is the difference between its value and that of a similar portfolio properly managed. For defamation or wrongful termination, it is the difference between expected cash flows or earnings after the event and those that would have occurred without it. For theft of a trade secret, the injured party may recover its own loss and the profit the defendant made from the theft. Other methods are:

• Lost profit method: the plaintiff's actual profit compared with what it would have been without the defendant's act.
• Regression analysis: a statistical estimate of the relationship between the defendant's actions and the plaintiff's losses.
• Business valuation method: the difference in the value of the plaintiff's business before and after the defendant's act.
• Cost-benefit analysis: comparing the costs and benefits of the defendant's actions to find the economic damage.

Limitations in calculating economic damage

• Uncertainty of future losses: assumptions about matters outside the investigator's control, such as inflation, interest rates and discount rates.
• Limited availability of data, which makes accurate calculation hard.
• Complexity of financial data, especially with many parties, transactions or financial instruments.
• Estimates that may be subjective and biased.
• Causation: establishing a link between the defendant's action and the loss.

Steps in calculating economic damage

1. Identify the relevant data from relevant sources. For lost profit, income statement data.
2. Determine the relevant period over which the damage occurred.
3. Calculate the lost profit caused by the defendant's act.
4. Calculate other economic loss: property damage, medical expenses, lost opportunities.
5. Apply a discount rate to find the present value of future losses.
6. Consider mitigation: the injured party's efforts to reduce the damage must be taken into account. A plaintiff cannot claim for loss it could reasonably have avoided.

Present value is found by discounting each future loss: PV = loss ÷ (1 + r)ⁿ, where r is the discount rate and n the number of years. Past losses may be increased by interest to the date of the judgment, and the court may add costs.

Choosing the discount rate and the period

A future loss is worth less today than when it is suffered, so the expert discounts it. The rate should reflect the time value of money and the risk of the cash flows: a low rate for a secure stream, such as a contracted payment, and a higher rate for a risky one, such as a start-up's profit.

The expert tests the sensitivity of the result to the rate and gives a range. The period is the length of time over which the loss continues. For a destroyed machine it runs until a replacement could reasonably have been in place. For a lost contract it runs to the end of the contract or the time a replacement customer could have been won.

A claim for a period that is too long will be rejected as remote.

Wrongful dismissal: a short example

An executive on ₦40 million a year is dismissed in breach of a three-year contract with two years left. The expert estimates the loss as the pay for the remaining term, ₦80 million, less amounts earned or reasonably earnable elsewhere, and discounts the later payments.

If she finds a new post paying ₦25 million after six months, the loss is 20 million for the six months of unemployment plus 15 million a year for the next 1.5 years, which is ₦42.5 million before discounting. The court will also consider whether she tried hard to find work, which is mitigation.

Duty of care, causation and remoteness

Damages are limited by law. The plaintiff must show that the defendant owed a duty, that it was breached, that the breach caused the loss, and that the loss was not too remote. A loss is too remote if a reasonable person in the defendant's position could not have foreseen it as a possible result.

The forensic accountant does not decide these legal questions, but the work must separate losses that flow from the wrong from those that do not. In Kemdrinks, the loss of the raw material was foreseeable once the equipment stopped, but lost profit beyond the time it took to replace the equipment would be harder to claim.

Presenting the calculation to the court

The expert states the assumptions, the sources of each figure, the alternatives considered and the reasons for choosing one. A schedule of the loss by head of claim, with the effect of changing the main assumptions, helps the court. The expert says clearly what is fact, what is estimate and what is opinion, and avoids advocating for the client, because the expert's duty is to the court.

The next topics on litigation support and the expert report explain this duty.

Worked case: Kemdrinks plc

Kemdrinks makes soft drinks and stores its raw material, colatus, in a cold warehouse. Colatus goes bad within two days if the cooling stops. The equipment that cools the warehouse stands seven metres from the road, where the approved minimum is five metres. The road is for cars. Trucks are diverted to a longer route.

James Brown, an employee of JJP company, took a company truck along this road to answer an urgent customer call, lost control and wrecked the equipment. Kemdrinks stopped for 30 days and sued JJP. JJP's lawyers engaged a forensic accountant to find the likely economic damage.

The findings were:

• the truck was overdue for servicing
• the driver had told the transport manager about faulty brake pads and nothing was done
• the audited accounts of Kemdrinks showed a daily profit of ₦10.5 million
• the equipment cost ₦80 million from the German manufacturer
• inventory at the time was ₦75 million
• installation was quoted at ₦1.75 million by Kemdrinks' engineer and ₦1.075 million by an independent engineer
• freight was ₦330,000
• import duty and port charges for seven days were ₦108,000, but the equipment was held at the port for four days

Ordering and installation took 30 days.

Types of damage. Compensatory damages for the destroyed equipment. Consequential damages for the shut-down of operations, because the loss of cooling destroyed the raw material and stopped production, an indirect result of the accident.

Punitive damages are arguable because the driver chose a road that was closed to trucks, using it after ignoring the signal. The company knew the brakes were faulty and did not service the truck, which might be reckless conduct.

The court may influence the final package. The 28 days apply because colatus would deteriorate after two days. The independent quotation is used for installation as the lower and independent estimate, and port duties are limited to the four days the equipment was held.

Limitations that may affect the computation are the uncertainty about the future (assumptions such as inflation and discount rates), the limited availability of data, and the complexity of the financial data.

Worked case: Jotos plc, a theft claim

Jotos plc's finished goods warehouse, holding smart phones, was burgled on 30 October 2023, and a company lorry was used to carry the boxes away. CCTV recorded the robbers. The last inventory count was on 30 September 2023. The insurance policy covers the cost of inventory lost by burglary, and the company asked a firm to determine the amount to claim.

Planning matters. Meet management to understand the theft. Agree the objective: to find the amount of the loss and quantify the claim, and not to find the thieves, which would need other skills and would be outside the firm's competence. Clarify whether management has already computed the claim and wants it audited, or wants it computed from scratch, which affects the fee.

Agree timing and the deadline for the report, which decides staffing. Make sure that there is no unnecessary limit on scope and that all team members have access to the needed information. Find out whether the theft was reported to the police and whether the case may go to court, in which event the firm may be a witness and must reduce any advocacy threat to independence.

Consider whether any goods were recovered, and exclude them, and value any damaged goods at the lower of cost and net realisable value. Read the insurance policy to see what is covered and the conditions on security of the warehouse, and check that the date of the theft is within the policy period. Agree who will receive the report and put a restriction on its distribution.

Procedures. Watch the CCTV to find the quantity of goods removed and count the boxes if possible. Inspect the boxes remaining in the warehouse to find how many units each holds. Agree the cost of the stolen phones to the cost records. Count the boxes in the warehouse and reconcile to the latest inventory movements from the 30 September count.

Talk to the police to find out whether goods have been recovered or are likely to be. Get details of the stolen lorry, such as the licence plate, and agree it to the non-current asset register. The claim is then computed as the units stolen times cost, less recoveries.

Worked examples

1. The lost profit is the lost sales less costs saved: (5 − 3) × 20 = ₦40 million.
2. Claiming the full ₦100 million of sales would overstate the damage.

1. PV = 100/1.1 + 100/1.21 + 100/1.331 = 90.9 + 82.6 + 75.1 = ₦248.7 million.
2. This is the lump sum today.

1. The court may reduce the claim by the profit that could have been earned from the stall.
2. The forensic accountant states this in the report.

1. This is pure economic loss.
2. The measure is the difference in value with and without the fault.

How to score full marks

• State the aim: to restore the plaintiff to its but-for position.
• Name and apply the types of damages to the facts.
• Show the calculation line by line, with the stated assumption for each line.
• Add limitations: uncertainty, data, complexity, estimates, causation.

Common mistakes in the exam

• Double counting lost profit and the same costs.
• Forgetting mitigation and the discount rate.
• Confusing special and general damages.
• Claiming punitive damages without reckless or intentional conduct.

Quick revision

• But-for: actual value less but-for value.
• Compensatory (special, general), consequential, punitive.
• Methods: lost profit, regression, valuation, cost-benefit.
• Steps: data, period, lost profit, other losses, discount, mitigation.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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