Overview of Damages and Accounting Basics

Introduction

In this chapter, we set out an overview of how damages are calculated in international arbitration, and we include an explanation of some of the fundamentals of accounting on which the damages calculation is necessarily based. Unlike law, which may fundamentally differ between jurisdictions, accounting and damages are based on accounting and economic concepts that are common to all jurisdictions – although any damages calculation for any particular arbitration dispute will need to be rooted in the legal principles of the law that governs that arbitration.

Accounting basics

Double-entry bookkeeping

A fundamental building block of accountancy is the principle of double-entry bookkeeping. This means that every accounting transaction that is recorded in a set of company accounts is effectively entered twice; this helps ensure that the accounts include all the company’s transactions and are free from input errors (although the accounts may still include errors or fraud, where the transactions have been recorded wrongly). For example, if a company is recording all the payments from a set of bank statements in its accounts, it will record all these payments as debits to various accounts, such as purchases of raw materials or purchases of machinery, and it will also record all the payments as credits to the bank account (i.e., reductions in the bank balance – for an accountant, a credit to the bank account is a reduction, while a debit is an increase).

The development of computerised enterprise systems means that double-entry is often hidden from view but it remains the key structure in accounting and explains why balance sheets balance and the components of a set of financial statements reconcile with each other. Despite the ever-increasing sophistication of accounting systems, the basic process for recording financial transactions remains a double-entry journal posting to ledger accounts that are then grouped and summarised for financial reporting and monitoring purposes.

A company normally prepares its accounts annually by extracting a trial balance from its accounting system and turning this into a set of financial statements. The trial balance lists the total value of items debited or credited to each particular accounting category in the year; so, for example, it will include the total of purchases of raw materials, the total of salaries and other employee benefits, the total of entertaining costs, the total of purchases of fixed assets and so forth.

Financial statements

From the trial balance, a company prepares its financial statements, which comprise a profit and loss account, a balance sheet, a cash flow statement and explanatory notes. The profit and loss account records the company’s income and expenses, together with certain accounting adjustments, such as depreciation, to arrive at the profit or loss after tax for the year. The cash flow statement also records the company’s transactions for the year, but on the basis of the money flowing into and out of the company, showing, for example, how the company has financed its purchases by way of loans or net reduction in its bank balances. The balance sheet summarises the state of the company at the end of the year, showing its assets and liabilities, with double-entry bookkeeping recording the overall balance as accumulated profit or loss. Changes to financial reporting standards can affect what is recorded in a company’s financial statements. Following the introduction of International Financial Reporting Standard (IFRS) 16, for example, right of use assets, such as operating leases, are now reflected in the balance sheet, whereas previously these assets were reflected only as an annual lease charge in the profit and loss account. Financial statements also include a large number notes, which include details of the accounting policies adopted by the company and more detailed explanations of many of the summary items included in the profit and loss account and balance sheet. Disclosure notes can reveal key areas of risk for a business that do not meet the threshold for inclusion in the accounts, such as contingent liabilities.

An important page in the financial statements is the audit report. Most large companies have to have their accounts audited by a qualified firm of auditors, who review all the company’s accounting transactions and financial statements on a sample basis, and conclude on whether the financial statements show a true and fair view of the company’s transactions in the year, and that they comply with accounting standards and include all the disclosures the financial statements are required to include. Audit reports are prepared on a formulaic basis, whereby the auditors note any exceptions from a ‘clean’ audit report; consequently, lawyers and other users of financial statements are well advised to carefully consider the implications of a qualified audit report on the financial statements of any company they are reviewing.

International Financial Reporting Standards

To ensure adherence to accounting principles and to ensure reasonable consistency between different companies, accountants have developed standard ways of accounting for specific items. Thus, large international companies are often obliged to prepare their accounts in accordance with IFRS,^[2] which set out standard ways of accounting for particular transactions, such as revenue, fixed assets and depreciation.

In this short introduction, we do not comment on how every type of transaction is accounted for under IFRS, but we briefly comment on a few types of transactions that often arise in international arbitration cases:

• The accruals concept: Accountants record income and expenses on the basis of the accounting period that is affected by the income or expense. For example, for a company with a calendar-year accounting period, a payment of 12 months’ rent in September will be recorded as four months in the period up to December and eight months in the following period.
• Revenue: Sales are generally recorded at the value received by the company, but IFRS include a number of detailed rules, for example, in relation to recording transactions at ‘fair value’, recording revenue on long-term contracts and recording transactions in the correct period.
• Depreciation. This is a very important accounting concept whereby tangible (e.g., land, buildings, machinery) and intangible (e.g., intellectual property, patents, goodwill) assets are recorded at cost or ‘fair value’ in the balance sheet, but are then depreciated over their useful lives. For example, if a piece of machinery has an estimated life of 10 years, depreciation at 10 per cent of its value is charged as a cost in the profit and loss account each year.
• Impairment. Companies are required to test their cash-generating units to ensure that they remain worth at least the value at which they are recorded in the financial statements. Thus, for example, if a company has overpaid for an asset, it should then record an impairment provision against the cost of the asset.
• Contingent liabilities. Companies are required to recognise a liability when it is likely that they will be required to make a payment in respect of the item in the future. When there is less likelihood of having to make a payment or it is not possible to calculate the amount of such a future payment, the company records a contingent liability in the notes to the accounts, but does not record the amount as an expense.
• Related-party transactions. Companies are required to list transactions with related parties in their financial statements. The related-party note can be a useful place to understand the relationship between entities that appear to be under common ownership.

Flexibility, consistency and estimates

Preparers of financial statements often face a choice of ways of applying accounting policies; for example, the depreciation rate. Indeed, one of the challenging areas of interpreting accounting information is that one is often choosing between two or more reasonable treatments. Within this flexibility, there is the need for preparers to be consistent in their treatment from year to year.

The very nature of business means that preparers are faced with uncertainty, meaning that estimates must be made. The word ‘reasonable’ is a key adjective in accounting; the use of judgement is a key task.

Within all this, one must not forget the ‘dark side’ of accounting: the aggressive accounting policies in areas such as income recognition, provisions and impairment – indeed, all areas where one is faced with choice, has to use judgement and can push reasonableness to the limits and beyond.

It is worth bearing all of this in mind in relation to damages claims, because accounts are the building blocks of quantum.

Basic principles of damages – loss of profit

If an entity has suffered damage but still continues in operation, the goal of a damages award is to put the claimant back in the position in which it would have been had the company not suffered the damage; for example, if a contract had not been breached. On this basis, forensic accountants, valuers and economists have developed the ‘but for’ principle as the basis for calculating damages, whereby damages are based on the difference between what would have happened ‘but for’ the breach of contract or other intervening event and what actually happened.

The second limb is normally relatively straightforward; for example, the profit the claimant actually made. What is more difficult is calculating what would have happened if the contract had not been breached (i.e., the but-for situation).

The but-for situation needs to be realistic, and one needs to remember that the calculation can only ever be an estimate – because nobody can ever actually know with complete certainty what would have happened in an alternative universe in which the breach of contract, or treaty, never occurred. The but-for situation also needs to be possible (e.g., it takes into account the production capacity of the company’s factory). The graph, below, illustrates the basic calculation of economic damages:

The degree of damage suffered by a claimant in a commercial arbitration is likely to be based on the profits that it would have earned had the breach of contract not occurred, but that it did not actually earn. Although in theory one can simply estimate the profits in a but-for situation, the calculation is likely to be more accurate if the loss of profit is broken down into its constituent parts, which are:

• loss of gross revenue;
• gross profit margin, as a percentage;
• variable overheads; and
• fixed overheads.

The damages expert tends to estimate the loss of future revenue of a business as a separate exercise – this is often the parameter that drives profitability, and it may also be the most difficult and subjective number to estimate. However many companies’ gross profit margins remain reasonably constant as a percentage of sales, and this constant margin may be reflected in the company’s budgets – so in many cases it may be fairly uncontroversial to assume that the gross profit margin in the future will be the same as in the past.

Overhead costs are those a company incurs that are not directly related to producing its output for sale. When calculating overheads, it is important to distinguish between variable overheads that are linked to sales (such as transport and distribution costs) and fixed overheads that remain the same regardless of the level of sales (such as general and administrative costs). Variable costs need to be deducted in calculating the future loss of profits, whereas fixed costs may not change at all whether the company is selling anything or not, and so they are generally not deducted in a loss of profits calculation.

Estimating what would have happened in the future ‘but for’

The most important part of a damages calculation is estimating what would have happened had the breach not occurred. There are three commonly used ways of doing this:

• The company’s own forecast. If the company had its own forecast of the future profits it expected to make, this may be the best data to use to estimate what would have happened but for the breach. However, before relying on a forecast, one needs to consider the purpose for which it was prepared, and how accurate it is likely to be. If the forecast was prepared for the company’s bank, which had carried out due diligence and lent the claimant money based on this forecast, and if the company’s actual results during the past five years have always been within 5 per cent of its forecasts, one could feel reasonably confident in relying on the forecast. If, however, the company’s forecast was limited to a single sheet of paper prepared by the directors after the breach of contract occurred, and it had never actually achieved its budget in the past, one would not feel confident in relying on the forecast without first determining whether serious adjustments must be made to it.
• Extrapolating from the past to the future. When a company has been operating for many years, and has a track record of always achieving a certain level of sales and profit, and where profits have grown consistently at, say, 5 per cent per year, the best estimate of future profits may be an extrapolation of past profits. This may be based on professional judgement, or it may be based on a statistical regression line, which estimates the future based on the past.
• Comparison with what actually happened to a similar company or store. If one can find a similar company operating in the same field, and one can see that the claimant’s results have been closely correlated with the results of that company in the past, the best way of estimating what would have happened may be to consider what actually happened to the comparator company.

Frequently arising issues

Having set out the basic principles of how damages are calculated, some issues that frequently arise in arbitration include the following:

• Lack of trading history: The claimant may have no history of trading. Many claims arise very early on in the life cycle of a project, for example, because one party terminated the contract while a factory was still being built and before it started trading. If the future cash flows can be estimated reasonably reliably, damages can be calculated on the basis of the net present value model, following which the value of a project is equal to the cash flows expected over the project’s life, discounted by an appropriate discount rate.^[3] However, if the future profits cannot be estimated reliably, the only fair basis for damages may be the amount of costs the claimant has actually incurred.^[4]
• How long should one claim for? If the company has been driven out of business and has gone into liquidation, normal practice is for the claim to be based on the ‘valuation’ model discussed below. However, if the claim is based on the company using the damages recovered from the respondent to recapitalise its business and start trading again, key questions include how long that will take and what resources it will require for the company to restore its business to its previous level of operations.
• The use of hindsight: A key legal question is whether one should take account of hindsight in calculating damages. This may depend on the jurisdiction of the claim – for example, the traditional position in English law was that damages for breach of contract were evaluated at the date of the claim, but this has been modified by the case of Golden Strait Corporation v. Nippon Yusen Kubishika Kaisha (known as the Golden Victory),^[5] in which the House of Lords held that achieving an accurate assessment of damages based on the losses that had actually happened was more important than considerations of contractual certainty and finality. In other jurisdictions, the use of hindsight in calculating damages is the default position.
• Sunk costs: Generally, costs that have already been incurred at the date of the loss cannot be claimed in addition to lost future profits. This is because profits can only be generated if the factory that will be used to generate them already exists, and so it would be double-counting to claim for both loss of profits and the cost of building the factory.
• Overhead recovery rates: An issue that often arises is the definition of what exactly is a cost. For example, the cost of employees may be measured as the amount actually paid to them (including overtime, pension, etc.) divided by the number of hours they work, or as the hourly ‘charge-out rate’ (which may be equal to direct salary cost multiplied by a factor of 3 or 4, to take account of the general and administrative and other fixed cost overheads of the company) or the rate that is charged by a service company in the group.
• Management time: Again, the principles here may vary between jurisdictions but, generally, the rule is that one can claim damages for lost management time only if the claimant can demonstrate that this management time would otherwise have been spent on generating profits on other projects. This is because management time is a fixed cost that would have been incurred whether or not the event causing the loss had occurred.
• Compensation for loss of an opportunity or return on investment: A claim may include an element of loss that is premised on the assumption that had the claimant not suffered damage, it would have invested monies in a particular project or opportunity, yielding a certain return. Generally, compensating a claimant in this manner rewards a claimant with a return, which is a function of a commercial risk to which it was not exposed. It can also result in claimants cherry-picking a high return investment out of a portfolio composed of both profitable and loss-making ventures, and assumes that such an opportunity was available to the claimant at the time.
• The date adopted for the quantification of damages: Damages are usually assessed at the date of breach but claims may also be calculated at a hypothetical date of a future award. The adoption of the latter approach can raise issues around the use of hindsight, and the risk attached to the cash flows in question.

The chapter on assessing damages for breach of contract discusses the valuation of damages for breach of contract in greater detail.

Basic principles of damages – valuation

If the asset has been expropriated or the company has gone into liquidation, the normal way of calculating damages is the ‘valuation’ basis. This is because the actual value of the asset or company tends to be zero, while the but-for value tends to be the value of the company immediately before the event of expropriation. Consequently, this approach is commonly used to quantify damages in investment treaty expropriation cases.

On this basis, the loss is calculated in accordance with the normal ways of estimating ‘fair market value’, which are as follows:

• The income (or discounted cash flow (DCF)) approach. This approach is commonly used because it can be applied to any company or project that has reliable projections of future income. The approach involves estimating the future cash flows from the company or the project, and then discounting these back to a net present value by applying a suitable discount rate. The big challenges in applying this approach in practice are calculating reliable cash flows into the future and calculating the discount rate. This approach is discussed in further detail in the chapters on income approach and the discounted cash flow methodology and on determining the weighted average cost of capital. The concept of the net present value is this – a dollar today is worth more in economic terms than a dollar in a year’s time. Indeed, if I have a dollar today and place it in a bank account, even with the current low interest rate, I will still have more than a dollar in a year’s time. This simple insight is the basis for discounting. The key, of course – and one can see this when one considers how interest rates have changed during the past decade – is what is a suitable rate at which to discount.
• The market (or earnings) approach. This approach values a company by multiplying its annual earnings by a factor based on multiples applicable to other similar quoted companies. This is the method more commonly used for valuing companies being bought and sold in the real world. It is often used as a check on a valuation given by the income approach. This approach is discussed in further detail in the chapter on market or comparables approach. A company may also be valued on the basis of comparable transactions in similar companies or of the company itself.
• The net assets approach. This approach values a company on the basis of the value of its assets. The value of its assets (e.g., its machinery) is based on the resale value of those assets, which in practice may be based on their cost, their second-hand value or their replacement cost, adjusted for depreciation during the period in which they have been operating. As this approach does not take any account of the ability of the assets to generate profits in the future, it tends to give a lower value than the income and the market approaches, and it tends to be used in situations when the company itself has gone into liquidation and will never operate again. It is also used in start-up situations when there is insufficient certainty about future cash flows to use the income approach, and so tribunals value the company on the basis of the costs incurred to date on building the plant. This approach is discussed in further detail in the chapter on valuation approaches.

Other issues

Tax

If the goal of a damages award is to place the claimant in the same post-tax position as it would have been in if the relevant breach or expropriation had not occurred, the damages calculation must take account of tax. Thus, both the actual and the but-for calculations should be carried out on a post-tax basis. If the tax rates have changed considerably over time, or if damages awards are taxed on a different basis from income, or if dividends from a project would have been subject to withholding tax, but a damages award is not, the impact of tax may be considerable. Consequently, care must be taken to make sure that tax has been treated consistently in the damages calculation.

Currency

The choice of currency in which a claim is made may have a very considerable effect on the size of the claim, particularly in developing economies or economies with hyperinflation. Again, legal principles may vary between jurisdictions, but the general principle is that the claimant should be compensated for what it has lost. Thus, damages should generally be calculated in the currency in which the loss of profit or the increased costs have been suffered. A claimant generally also has a right to be compensated in a freely convertible currency – so, even if the damages are calculated in a local currency, the tribunal may wish to translate the award into US dollars or euros at the rate of exchange on the date of the award.

Interest

As some awards are rendered many years after the date of the breach or expropriation, an award for interest is often a very sizeable element of an award. The purpose of pre-award interest is to compensate the claimant for not having had its money over the period from the date of the breach to the date of the award, and consequently, it is often based on the claimant’s marginal borrowing rate, to compensate the claimant for the additional cost it incurred in borrowing money. Other bases for calculating interest include the rate the claimant could have earned from putting the money in a deposit account, the risk-free rate and the respondent’s borrowing rate, which are discussed in greater detail in the chapter on interest, which also considers the appropriate interest rate for post-award interest. As indicated above, a claimant may also claim on this basis for a loss of an opportunity forgone because it was deprived of funds available for investment.

Finally, by way of introduction, the tribunal needs to decide whether to award interest on a simple or a compound basis; although the simple basis used to be the default basis in some jurisdictions, and still is in certain countries, it is generally acknowledged today that the compound basis (which results in a higher award) more accurately compensates claimants for what they would actually have done with the money if they had had it earlier.

It is also important that the interest rate used is based on the currency of the claim, as it makes no economic sense for the award to be in a hard currency, with a high interest rate based on a soft currency that is expected to depreciate.

Data management and modelling

The final topic we consider in this chapter is the use of modelling and statistics in damages awards.

Models

As discussed earlier, the but-for and DCF approaches to damages generally require the damages expert to prepare a model of what would have happened in the future. This may be a simple one-page spreadsheet or it may be a 100-page interlinked corporate finance workbook forecasting the future profit and loss account and balance sheet of the company, showing when all the borrowings would have been repaid, etc. Such complex models are commonly prepared by banks and project finance initiative transactions, so that the company and banks can understand when the project is anticipated to produce income and how borrowings will be repaid.

A model that was prepared at the time and was relied on by a bank for lending money to a company is likely to be more reliable than a model that was prepared by the company solely for an arbitration, and that may be biased in favour of the claimant.

There is a major risk that models include errors. Consequently, it is vital that models are prepared in a systematic way, and that they are systematically checked by an independent third party. For example, the Institute of Chartered Accountants in England and Wales has prepared a helpful booklet entitled ‘Twenty principles for good spreadsheet practice’.

It can also be helpful, where matters of disagreement between experts are clearly delineated, for both experts to agree on the use of a joint financial model, where sensitivities can be run clearly indicating the output of different assumptions on the damages calculation.

Sampling

Where there is a large population of data, it may not be possible or cost-efficient to review or to test every item in the population, and the most efficient way of considering the validity of the data may be to use a sampling methodology. If the data population includes 10 large items comprising 90 per cent of the data, a valid sampling methodology may be to review those 10 items as part of a judgement sample. However, where the population includes thousands of similar small items, the only statistically reliable method may be to select a sample of the items and test these. To rely on the output of the sample of items tested, the sample should be selected in a statistically valid way, such as by cumulative monetary sampling, which selects items on the basis of every so many dollars, and thus includes the possibility of selecting all the items in the population, but biased towards larger items; if a sample is selected in this way, any errors found can also be extrapolated across the entire population to give an estimated error rate in the entire population.

Statistics

Statistics can be a useful tool to use in damages quantification. Two of the most commonly used statistical tools are the following:

• Regression analysis. In graphical terms, regression analysis is plotting certain points on a graph, such as historic profits during the previous 10 years, and then using the past to forecast future profits, by drawing a straight line into the future. This approach has the advantage that the output can be shown to have a statistical basis, rather than simply being based on the damages expert’s judgement, and a coefficient of correlation can be calculated, indicating how reliable the particular regression analysis is. More complicated regression tools can also be used.
• Seasonal adjustment. If there is a seasonal pattern to a company’s sales, seasonal adjustment may be needed to estimate future profits.

Finally, there are other more sophisticated statistical tools that can also be used to improve the reliability of damages calculations. Many of these have yet to gain traction with decision makers and experts. However, with low-cost add-ins increasingly available for spreadsheets, the humble laptop has a powerful means of crunching vast amounts of data in stochastic approaches that attempt to model more accurately the effects of uncertainty. One can expect to see more use of stochastic approaches in damages, such as the Monte Carlo method.

Conclusion

Damages calculations are rooted in a claimant’s financial accounts, and the accounting principles on which these are based need to be understood to arrive at a reliable quantification of loss. The basic approach to calculating damages is to compare the claimant’s actual position with the position it would have been in but for the intervening event causing the loss; this requires an analysis of revenue, gross profit margin, variable and fixed costs, and projections of the future. If a claimant has lost all its business, such as in an expropriation, the normal method of valuation is the fair market value of the business immediately before the expropriation, which is normally calculated using the income, market or assets approach.

Notes