In the unpredictable business operations landscape, unforeseen events and disruptions can significantly impact a company's bottom line. Whether it be a natural disaster (hurricane, fire, tornado, etc.), supply chain disruption, equipment failure or any other unforeseen circumstance, the resulting business interruption can lead to substantial financial losses in the form of lost profits. In such challenging times, it becomes crucial for businesses to have a clear understanding of how lost profits are calculated and apply effective strategies to recover the same to ensure financial stability and continuity.
Calculating lost profits is a complicated process requiring careful application of established industry-accepted methodologies to the unique operating conditions, sales, expenses and cash flows of the impacted entity. Typically, a forensic accountant is engaged on behalf of the business (claimant) to calculate its lost profits, submit the loss amount to the insurance company and work with the insurance company’s forensic accountant to negotiate the final payment of the loss.
A qualified forensic accountant can provide the necessary knowledge and experience to quantify lost profits clearly and concisely in a manner that the insurance companies can understand and accept. While there should be certainty as to both the occurrence that caused the damage and the extent of said damage, effectively calculating the amount of loss is not simply based on mathematical precision.
Understanding the Impacts of Business Interruption Insurance
Companies typically maintain business interruption insurance coverage associated with a property and casualty insurance policy. In case of a loss event, it is important to identify the covered cause of loss associated with the business interruption resulting in lost profits. In other words, before business interruption insurance coverage can be triggered, there must be damage to the property insured under the policy that is attributable to the loss profits claimed.
Insurance companies typically require that losses be calculated only to within a reasonable degree of certainty and in accordance with the terms of the applicable insurance policy. In many policies, the loss that will be reimbursed by the insurance company is typically defined as the “actual loss of business income you sustain” due to the necessary suspension of your “operations” during the period of “restoration.”
Business income is often defined as “net income that would have been earned or incurred, plus continuing normal operating expenses incurred, including payroll.” The business income amount may be subject to a specified coverage limit or time period in the policy. Therefore, it is important to carefully study the terms of the insurance policy prior to calculating and submitting insured losses, including all provisions set forth and summarized on the declarations page of the policy.
If a business experiences loss profits due to a business interruption without business interruption insurance, the parties involved (e.g., the business and the party responsible for the interruption) can negotiate a settlement, provided there's evidence of the interruption's cause.
When there is no business interruption insurance coverage, nor the potential for negotiation between the parties, litigation may ensue. In these cases, familiarity with the laws governing the pursuit and recovery of business interruption losses is important. Qualified legal counsel should be engaged to accurately explore and pursue available legal remedies.
While calculating lost profits does not require mathematical precision, there must be competent evidence and a reasonable basis to support the calculation.
Calculating Lost Sales (or Revenues) and the Period of Loss
The calculation of lost profits often begins with determining lost sales, which are the difference between the impacted entity’s actual and “but-for” sales (i.e., sales that would have been earned if not for the interruption) during the period of loss.
The period of loss is typically defined in the insurance policy as the “period of restoration,” which, depending on the policy terms, may begin immediately at the time of the physical loss or damage or after a certain waiting period.
The period of restoration also ends in accordance with the policy language, which typically states that it ends on the earlier of the date when the property at the described premises should be repaired, rebuilt or replaced with reasonable speed and similar quality or when the business resumes operations, whichever comes first. In some cases, there is a maximum period stated for the period of restoration. Thus, the policy language should be carefully analyzed to determine the specific applicable period of restoration in each loss situation.
While the forensic accountant’s role in determining lost profits does not involve proving causation, the forensic accountant should understand how the insured event caused the claimant’s lost profits and the extent to which other circumstances may have contributed to or caused the lost profits.
There are several methods to calculate but-for sales, including the following:
- Before-and-After Method
- Yardstick Method
- Market Share Method
- Specific Contract Method
Before-and-After Method
The before-and-after method is best suited to circumstances where the claimant has an established history of operations with little volatility. When applying the before-and-after method, but-for sales of the business are often estimated based on the actual sales during a specified time-period before the damaging action or event.
When using actual historical sales prior to the period of loss to determine but for sales, the forensic accountant should consider how those sales were trending before the incident. The practitioner must also consider changes in economic conditions, company management and objectives, and other factors that may impact these projections.
Yardstick Method
The yardstick method of estimating but-for sales entails using another business location of the claimant that is similar to the claimant’s impacted location, or a comparable company’s sales during the period of loss, as a proxy for but-for sales.
When using the yardstick method, it is critical for the practitioner to confirm that the unaffected location of the claimant, or the comparable company, is similar enough to the impacted business in terms of the type of goods or services sold, the length of time in business, and the economic conditions in which it operates, to serve as an appropriate “yardstick” for the impacted business.
Market Share Method
In circumstances where neither the before-and-after method nor the yardstick method is applicable, the market share method may be acceptable. The market share approach can be used when sales in the market are available for the business. This entails determining the market share percentage of the business before the period of loss and applying this percentage to the actual sales in the market during the period of loss.
Regardless of the method employed, credit should be given and the losses reduced for any actual sales resulting from the partial operations of the business occurring during the period of loss.
Calculating Saved Expenses and Lost Profits
Once lost sales have been determined, the practitioner should calculate the claimant’s lost profits by reducing the lost sales by the expenses that the claimant did not incur and therefore saved because of the loss event and the interruption of business operations.
Saved expenses are also referred to as variable expenses, which correspond consistently with increases and decreases in sales. Examples of saved expenses include:
- Cost of Goods Sold
- Packaging Expenses
- Delivery Expenses
- Sales Discounts
- Sales Commissions
- Royalty Expenses
- Percentage Rents
- Credit Card Fees on Sales
- Certain Payroll Costs Saved During the Period of Loss
Extra Expenses and Other Provisions in the Policy
Another coverage provision typically included in business interruption insurance policies is extra expense coverage. Extra expenses are typically defined in policies as the “necessary expenses you incur during the ‘period of restoration’ that you would not have incurred if there had been no direct physical loss or damage to the property caused by or resulting from a Covered Cause of Loss.” These extra expenses should be compiled by the forensic accountant and submitted to the insurance company for reimbursement.
Other coverage provisions include those pertaining to civil authority, utility services or dependent property, wherein losses associated with mandatory evacuations, utility service interruptions or other property losses may be reimbursed. Given these and other policy nuances, a careful review of the specific policy language is critical to a thorough and complete loss calculation in a business interruption insurance claim.
Finally, an insurance policy may also include coverage for “claim preparation” or “loss data expense.” These provisions typically permit policyholders to hire experts, including accountants, auditors or consultants, to assist with claim submission and documentation, with the insurer covering the costs in full or in part.
Serving As Your Guide Forward
Calculating and recovering lost profits from business interruptions is a complex process that should be undertaken by experienced forensic accountants.
Cherry Bekaert’s Forensic Dispute Advisory Services team has years of experience in calculating and recovering lost profits for companies ranging in size from local businesses to multinational, publicly traded Fortune 100 companies.
As business interruption events arise, having professionals who provide transparent and credible analysis that will withstand the scrutiny of the insurance company (and if necessary courts, arbitrators, mediators and opposing counsel) is critical to a successful claim resolution. Cherry Bekaert’s Forensic and Dispute Advisory Services team brings together accounting, consulting and forensic experience to provide the insight and clarity required to meet the challenges of business interruptions and other corporate disputes with confidence.
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