Sorting Through Lost Income Claims
Calculations and concepts can be tricky even for experts
An individual or a business may have a compensable loss of income claim based on a variety of causes, such as fire, water damage, theft, vandalism, vehicle accident, faulty contractor work, or personal injury. The term “lost income” in these claims can mean business interruption, lost profits, or lost earnings.
To have a lost income claim, sales must be lost—not merely delayed—and then recouped within a reasonable period of time. This includes extra expenses incurred to avoid or minimize lost sales. The injured party has a legal duty to make reasonable efforts and work to mitigate their loss. Increased sales of other products may help to offset lost sales. In addition, subcontracting work that was normally done in-house prior to the peril is often a viable option to help reduce the loss.
Lost sales are determined by subtracting actual sales from projected sales. The net loss is calculated by subtracting the costs not incurred that correspond with lost sales. Extra expenses such as overtime worked over normal levels are included as part of the loss.
Projecting Lost Sales
Total sales should be projected based on expected sales during the loss period using a variety of methods while also taking into account historical growth trends and other relevant factors. Seasonality of the business needs to be considered. Jewelry sales, for example, typically vary significantly depending on the time of year.
For losses lasting more than one year, the cyclical nature of the industry should be analyzed. Other important factors may include the weather and changes in competition, technology, and the economy.
The nature of the business and extent of the loss are obviously significant, but reasonable and rational methods should be utilized when considering these factors. If only one wing of a motel or a limited number of apartments in an apartment complex become uninhabitable, for example, there may only be a limited amount of loss, or even no loss at all if vacant units are available and tenants transfer or guests use another room.
Non-Continuing Costs and Extra Expenses
Many operating costs continue at their normal rates during the property restoration period, but some may either vary or stop entirely. After lost revenue has been determined, related non-continuing/saved costs must be calculated and deducted from lost sales to arrive at net lost income. If a hamburger is not sold, a restaurant or grocery store does not incur the cost of the hamburger (it may have a compensable inventory loss for spoiled food under the separate business personal property portion of the policy). Other costs are also saved, such as supplies for things like wrappers, condiments, and packaging. Hourly wages and related payroll taxes and expenses may continue or be reduced. Saved operating expenses often include bank debit or credit card fees, calculated as a percentage of sales.
Depending on the nature of the peril and the length of the loss, historical fixed expenses—such as salaries, insurance, and employee hospitalization—may continue at their normal rates. Rent and utilities vary on a case-by-case basis. A forensic accountant should review all expense categories and details to the extent necessary to make a proper allocation.
Extra expenses include above-normal costs incurred to reduce the overall lost income. They may include a move to a temporary facility and its ongoing rent (less saved rent at the loss location), overtime premium, subcontracted work less saved costs, expedited freight, and other expenses.
Other Important Considerations
Lost income insurance policies are normally written using the “bottom-up” approach, defined as forecast net profit or loss plus continuing expenses. Most lost income calculations, in practice, use the “top-down” approach, projecting lost sales and deducting non-continuing expenses to calculate compensable lost profits. Both methods will yield the same results.
Lost income needs to be calculated using the accrual basis of accounting rather than the cash basis of accounting so that sales and receipts and expenses and disbursements are properly matched. A business often collects for its sales or services in the weeks or months after selling the goods or providing the service. A business also often pays for its purchases in the weeks or months after receiving the goods, so calculating the loss on a cash basis would lead to improper and unjust results. Payments for expenses incurred before the peril or after the loss are not owed.
Many health care service businesses bill their patients and insurance carriers much more than they expect to collect. Amounts paid to the business are limited to usual, customary, and reasonable charges or other agreed upon schedules or contracts. Patients often do not pay the share that they are billed due to financial constraints or other reasons. Projected lost billings must be reduced to likely net collections based on the historical records and trends of the business. This must be taken into account and the reported amounts revised accordingly.
Documenting Lost Income Claims
There are no hard and fast rules about what and how much documentation is needed for lost income claims because the information is dependent on the nature of the business, the type of loss, the length of the loss period, the time of year, the reliability or inconsistency of the data provided, and other factors.
The appropriate amount of data must be customized for each loss. Data requests should be specific, but not limiting, without being either overly broad or too detailed. Boxes of financial documentation or thousands of pages of electronically scanned data are generally not necessary for many lost earnings claims, but additional source documentation will be required for the analysis of potential fraudulent claims.
Commonly requested and required data may include:
A copy of the loss claim made and all supporting documentation used. This should go without saying, but the insured, claimant, or plaintiff is responsible for submitting and adequately supporting the loss claim. Detailed schedules showing what was claimed and how the loss was calculated should be obtained along with reasonable documentation. To be thorough, requests for the production of documents should ask for copies of all support used in the loss calculations and the outside experts consulted, whether relied upon or not used in their reports. Additional data may also be needed.
Tax returns. The data on tax returns often forms the bedrock of the loss calculation, as the amounts reported are deemed most reliable because they are filed with an outside party (the U.S. government). Complete copies of federal income tax returns for the business with all schedules and attachments should be obtained. Attachments should include copies of all wage and tax statements on form W-2s for individuals. Tax returns for up to three years prior to the date of the peril are used for comparison and analysis purposes. Older returns, beyond five years prior, are rarely needed.
For a small business operating as a sole proprietorship or one-owner limited liability company, the main form is IRS form 1040 Schedule C, Profit or Loss From Business. However, the entire 1040 should be obtained and reviewed to determine other possible related income and expenses, and to gain an understanding of the all owner’s income. When the business is operating as a partnership, C-corporation or, S-corporation, you also need to obtain the appropriate form 1065, 1120, or 1120S, in addition to the owner’s personal returns.
Be aware that the small business owner controls his wages and that the wages are most often based on the business’ profitability and cash flow. The income of both the individual and the partnership or incorporated business must be considered together as a whole to determine the actual loss sustained. The owners’ wages should be considered part of the net profit.
Financial data, including accounting and payroll records. Useful financial statements may include balance sheets, statements of cash flows, budgets, and projections. Loan applications, if applicable, are also good sources of data.
A detailed list of possibly relevant accounting records includes inventory records, sales journals or reports, invoices, cash register tapes, purchase journals, bank statements, cancelled checks, accounts receivable and accounts payable reports, and employee expense reports. This list also includes property records such as fixed asset depreciation schedules, deeds, mortgages, leases, options to purchase, rental agreements, insurance policies, licenses, sales and purchases contracts, and credit records and reports.
As noted previously, the data requested must be specifically tailored to the loss claim and limited to relevant documentation. A reason for each document requested may be useful when obtaining the necessary data.
Payroll reports from before, during, and after the end of the loss period are often needed, but take care to accurately identify these records—payroll journals, ledgers, and schedules. The specific names vary and some attorneys like to quibble about terminology.
Understand the difference between cash flow and operating expenses. For example, payment of loan principal is not a compensable expense, but the interest portion of the payment usually is. Loan amortization schedules should be obtained. Additional borrowing and the related expenses are not compensable, as they are considered a lack of adequate capital for the business.
Depreciation is a common area of misunderstanding. Fixed asset depreciation schedules are needed to calculate the saved depreciation expense for the loss calculation. If an asset is destroyed that was currently being depreciated, then that expense cannot continue and it stops. Insurance may cover the fair market value of the damaged asset. To continue its depreciation expense in the loss calculation will result in an overpayment of the loss.
Calculating lost income claims with a reasonable degree of accounting certainty is complicated and involves many concepts and specifics that the ordinary business person, accountant, or CPA does not typically encounter. Even if proper calculation methods are used, the process is prone to errors, and even experts’ findings are still dependent on the use of reasonable assumptions and estimates. To obtain fair results, assumptions must be deemed likely, not merely possible, and loss calculations must be based on accepted principles.