Business Disruption and the Hunt for
Lost Profits

A fire that put a company out of business for nearly half a year prompted a financial investigation that revealed how far apart two estimates of lost profits can be

Andrew D. Pappas, CPA

In the spring of 2006, the Phoenix headquarters of Order-Up Distributing, a restaurant equipment and supply wholesaler, was destroyed by fire. The building was owned by a real estate investment company that rented the facility to Order-Up.

The fire claimed not only the building but also Order-Up’s inventory – to which management assigned a ballpark estimate of $1.5 million – and all of the company’s office equipment and records. While the company carried insurance on its inventory as well as a policy that covered lost profits, there was no insurance coverage for reconstructing Order-Up’s records. All of its documents and computer data had been kept on the premises, and there was no off-site storage or data backup.

Order-Up was shut down for five months, putting a temporary halt to a seven-year run of good business that had seen the company’s profits grow by an average of 25% per year. Even though it conducted no business during the five months following the fire, payment of salaries to key employees and some fixed expenses resulted in negative cash flow in addition to its lost profits.

Management filed a lost profits claim against the company’s business interruption insurance policy. The insurance company quickly offered a settlement based on prior financial statements it had been provided. Order-Up’s owner thought the offer was low. Through its law firm, Order-Up engaged Pappas & Company to reconstruct its accounting records and to determine lost profits.

Investigation. The scope of our work included an analysis of Order-Up’s:

• bank accounts,

• loan documents,

• sales tax reports,

• federal and state income tax returns, and

• prior years’ financial statements, files and working papers

Many of these documents were obtained from third parties, including various tax authorities and the company’s bank and accounting firm.

In addition, although not necessary, we contacted the company’s:

• suppliers, to verify the historic flow of goods;

• customers, to verify sales volumes; and

• payroll service, to confirm employee-related costs.

Complications. Our lost profits determination was complicated somewhat by the seasonal aspects of Order-Up’s business. Because many restaurants schedule their renovations and equipment replacement during the relatively slow summer months, to prepare for the winter tourist season, demand for Order-Up’s merchandise was at its peak during the time when the company was effectively out of business. In a typical year, as much as 50% of its annual sales were booked in June, July and August, and our analysis needed to reflect the fact that the company missed out on its prime sales period.

Key Findings. Through our review of the company’s tax documents, we learned that, for the year preceding the fire, it collected and paid sales taxes on $8.43 million of revenue from the sale of goods. But when we compared the 2005 sales tax reports to the company’s federal income tax return for the same period, we discovered that the company had under-reported its gross receipts by more than $350,000.

In addition, when we turned our attention to Order-Up’s payments to its employees, we found that the company was paying cash wages to illegal aliens and that it failed to issue a Form 1099 to any of its “independent contractors.”

And, before we were through, we found that Order-Up’s owner had been running many of his personal expenses through the company, including some expensive trips and the remodeling of the kitchen at his summer home.

All of these discoveries were critical to our investigation. The underreporting of sales to the IRS, misclassification of employees, and personal use of company cash and inventory had lowered the owner’s tax bill, but if we had based our lost profits analysis on the artificially depressed net income reported to the IRS, Order-Up would have had a significantly smaller claim than it ultimately submitted.

In arriving at our finding of lost income, we took into account the cyclical nature of the company’s business, as reflected on its sales tax reports. We also made adjustments for:

• the discrepancy between the sales reported on Order-Up’s sales tax reports and its federal income tax returns,

• the employee wages that should have been properly paid if Order-Up had not treated many of its workers as contractors,

• the value of the cash and inventory that the owner had appropriated for his personal use, and

• the negative cash flow actually incurred during the period of time that the company was shut down.

Also crucial was the company’s track record of consistent growth during the years preceding the fire. Past profit trends help indicate what future profits will be, as does the value of current contracts and orders (which we were able to confirm by communicating with Order-Up’s customers).

Happy Ending. While the owner was initially embarrassed by our discoveries of his monetary sleights-of-hand, in the end he was very pleased that the insurance company, after negotiating with Order-Up’s attorney, ultimately agreed to a settlement of the claim for lost profits that was $265,000 higher than had originally been offered.

Our client was happy, and we enjoyed the professional satisfaction of knowing that he benefited from our going the extra mile in our analysis. ●

While the preceding account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

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