“Loss of Profits” or “Loss of Value:” Which Measure of Loss is Appropriate?
Karl D. Weisheit
The question of which measure of loss is appropriate, “Loss of Profits” or “Loss of Value,” has plagued many a lawyer. Loss of Profits has been the go to measure of a loss for many years, though Loss of Value has become more popular in recent years. This begs the question, “Which measure of loss is more appropriate?”
The answer (an expert’s disclaimer), of course, is, “It depends.” It depends on the jurisdiction and the facts and circumstances of the loss. Now that I have gotten the disclaimer out of the way, the real answer, in general, starts with another question, “Does the loss affect the target business temporarily or permanently?” If the loss is expected to affect the target business on a temporary basis, Loss of Profits is typically used as the measure of loss. If the loss is expected to affect the target business on a permanent basis, Loss of Value is typically used as the measure of loss. Additionally, if the target business suffers a partial or total destruction, a Loss of Value calculation would typically be in order. (Exceptions do exist to this premise, particularly in contract situations, such as insurance agreements, where the insurance policy may dictate a Loss of Profits calculation even in a business destruction situation.)
And, sometimes these two methods are used together if there is a situation where you have a Loss of Profits for a temporary period of time followed by a Loss of Value for a permanent period of time.
Loss of Profits is typically determined by calculating the difference between the income stream that would have been earned “but for” the loss event and the income stream actually earned. Loss of Value is typically determined by calculating the difference between the values of the target business immediately prior to the loss event and immediately subsequent to the loss event.
In each measure of loss case, the analyst must determine which income stream to utilize in calculating the loss. Loss of Profits is often calculated utilizing net income (or profits) as the lost income stream, whereas Loss of Value calculations are typically calculated using some form of cash flows. The facts and circumstances surrounding the loss will determine the income stream to utilize.
When calculating Loss of Profits or Loss of Value, analysts typically perform projections utilizing income and expenses in the target business. Those income and expense projections are typically the same whether calculating Loss of Profits or Loss of Value.
One of the major differences between a Loss of Profits calculation and a Loss of Value calculation is that the Loss of Profits calculation, depending on the jurisdiction, is normally calculated utilizing information related to the target business that is known or knowable (often called the “Body of Knowledge”) up to the date of trial. Whereas a Loss of Value calculation, because it is a value calculation immediately prior and subsequent to the loss event, is normally calculated without the benefit of hindsight or the actual performance of the target business subsequent to the loss event.
Another difference between the calculations of Loss of Profits and Loss of Value may be in the discount rate utilized. In a Loss of Profits calculation where the period of loss is expected to extend beyond the date of trial, Loss of Profits expected to be incurred subsequent to the date of trial are usually discounted to present value as of the date of trial. In a Loss of Value calculation, income and expense projections are usually discounted to present value as of the date of the valuation. The discount rate utilized in calculations for Loss of Profits and Loss of Value may be the same or different depending on the type of income stream utilized in each of the calculations.
Different utilizations of income streams, discount rates, and the Body of Knowledge, can create significant differences in the measurement of the loss.
Many factors go into the “Loss of Profits” versus “Loss of Value” measure of loss decision. Consult your favorite financial damages expert to help you make the decision on which one, or both, is the right one for you to pursue in your specific case in order to calculate financial losses to a reasonable degree of certainty.
Karl D. Weisheit, CPA, CFF, CVA is a forensic accounting expert at HSNO in Dallas, Texas. He can be reached directly at (972) 980-5095 or at email@example.com.