Navigating the Challenges of Lost Profits Analysis in Economic Damages Cases

Lost profits claims are among the most complex—and often contentious—components of economic damages litigation. Attorneys rely heavily on forensic accountants to quantify damages that are defensible, grounded in sound methodology, and capable of withstanding rigorous scrutiny from opposing experts and the court. However, the path from alleged harm to an evidence-based damages calculation is far from straightforward. Each assignment carries its own mix of factual uncertainty, data limitations, and methodological pitfalls.

Below are some of the most significant challenges forensic accountants face when assessing lost profits in litigation, along with best practices to help ensure reliable and credible results.

1. Establishing Causation vs. Correlation

One of the most fundamental hurdles in lost profits cases is distinguishing the impact of the alleged wrongful act from other factors that may have influenced financial performance. Courts expect that damages experts demonstrate a clear, causal link between the defendant’s actions and the plaintiff’s lost profits.

Key Challenges

• External market forces: Economic downturns, supply chain issues, regulatory changes, or industry-wide shifts may independently affect sales and profitability.
• Company-specific variables: Management decisions, pricing changes, internal inefficiencies, or unrelated operational disruptions may confound the analysis.

Best Practices

• Conduct a but-for analysis that isolates the impact of the alleged harmful event.
• Evaluate industry benchmarks, competitor performance, and macroeconomic data to contextualize the plaintiff’s historical performance.

2. Reliance on Imperfect or Incomplete Data

A common challenge for forensic accountants is the quality, availability, and reliability of the data provided. Lost profits calculations depend heavily on accurate historical financials, operating records, sales data, and industry metrics. In some cases, these records are incomplete or inaccurate—or simply never existed.

Key Challenges

• Missing historical sales or cost data.
• Poorly maintained accounting systems.
• Lack of documentation supporting key assumptions.
• Overly optimistic or speculative projections prepared by management.

Best Practices

• Perform data reasonableness checks to validate the reliability of information.
• Leverage third-party sources (industry databases, government statistics, market reports) to corroborate internal data.
• Clearly disclose data limitations and explain how they impact the certainty of your conclusions.

3. Determining the Appropriate “But-For” Revenue Stream

Lost profits analyses typically begin with estimating the revenue the business would have earned absent the wrongful act. This requires developing a but-for scenario that reflects realistic, supportable expectations—without drifting into conjecture.

Key Challenges

• Volatile revenue streams or cyclical business models.
• New or rapidly growing companies with limited operating history.
• Disputes involving start-ups, early-stage ventures, or product launches.
• Economically unsustainable past trends (e.g., unusually high growth periods).

Best Practices

• Use multiple approaches (historical trends, customer attrition, market share analysis) to triangulate a reliable estimate.
• Avoid simple extrapolations when historical trends are not representative of future expectations.
• Incorporate capacity constraints, pricing changes, and market conditions into the but-for scenario.

4. Capturing Incremental Costs and Avoiding Overstatement of Damages

Lost profits calculations require not only estimating lost revenue but also adjusting for costs that would have been incurred to generate that revenue. Misclassifying fixed versus variable costs is a frequent source of error and dispute.

Key Challenges

• Incorrectly treating fixed costs as variable, or vice versa.
• Difficulty determining the incremental cost structure of multi-product companies.
• Overlooking avoided costs or alternative revenue streams.

Best Practices

• Perform a detailed cost structure analysis to determine true incremental profitability.
• Consider contribution margin rather than gross profit when possible.
• Review cost accounting records, budgets, and interviews with management to validate cost behavior.

5. Forecasting the Duration of the Loss Period

The length of the loss period can significantly influence the damages amount. Determining a reasonable duration often requires careful judgment supported by facts and evidence.

Key Challenges

• Disputes about how quickly the business could mitigate damages.
• Identifying when operations or market conditions returned to normal.
• Evaluating long-term damage claims versus short-term disruptions.

Best Practices

• Support the loss period with contemporaneous documentation (emails, production logs, customer communications).
• Analyze customer churn, re-acquisition timelines, and sales cycles.
• In cases of permanent loss of business opportunity, carefully evaluate longevity, market share, and competitive factors.

Conclusion

Lost profits analyses require a disciplined balance of financial expertise, investigative rigor, and professional skepticism. Each case presents its own mix of uncertainties, analytical challenges, and factual disputes. Forensic accountants play a critical role in guiding the trier of fact through these complexities by presenting clear, well-supported opinions rooted in reliable data and sound economic principles.

A carefully executed lost profits analysis not only withstands scrutiny—it strengthens the overall credibility of the case.