Recent developments in class action cases in Canada have opened the door to gain-based claims. Although this approach has yet to be accepted at the trial level, it appears to be on its way. From an accounting perspective, here’s what legal counsel might want to consider when faced with this new development:
As class action lawyers are well aware, several recent cases, especially Serhan Estate v. Johnson & Johnson, have allowed plaintiffs to obtain certification without the traditional onus of having to establish proof of loss.
In this celebrated and controversial matter, the proposed plaintiff was a diabetic who had used SureStep, a home monitoring system to determine glucose readings by means of a small meter and testing strips manufactured by the Johnson & Johnson Family of Companies.
The monitor was determined to have provided inaccurate readings. Although no diabetic appeared to have suffered any known health effects, a class action launched in Ontario was certified in 2004 by Ontario Superior Court Justice Maurice Cullity under the doctrine of waiver of tort and upheld two years later by the Divisional Court.
At the crux of the claim was the contention that Johnson & Johnson should not be allowed to retain any profits generated from knowingly having sold a defective product. An aggregate award based on the profits gained from the sale of the product, it was argued, could be assessed and distributed among the plaintiffs.
Underlying this determination, which we understand has arisen in several other class action cases, is also the understanding that, depending on the circumstances, even if the class of plaintiffs could prove a loss had occurred, it would be far too difficult and expensive to calculate the loss that may have been suffered by each of them.
In matters involving consumer products, for example, where countless thousands or even millions of purchases might have transpired, an alternative approach would be to calculate the defendant’s unwarranted profits and divide them among the plaintiff class or apply them to a remedial course of action.
Whether the gain-based remedy in class actions is accepted at the trial level will likely be determined in the near future. In the meantime, it seems beneficial to highlight some of the key accounting issues counsel might have to contend with when confronted with a gain-based claim that requires an accounting of the defendant’s profits. Determining the profit earned by the defendant from the product in question is rarely a simple matter.
From an accounting perspective, profit earned from a specific product is considered to be the difference between the incremental revenue earned from the sale of that product less the incremental costs and other reasonably attributable costs related to the product.
Profit as reported by a company’s financial accounting system, and as disclosed in financial statements prepared in accordance with GAAP (Generally Accepted Accounting Principles), is seldom the right starting point to calculate the profit in a gain-based claim because they usually have limited applicability in an accounting for profits matter.
For example, a GAAP-based profit-and-loss statement typically encompasses the financial results of the entire company’s products, services, offices, and geographic regions. It rarely discloses the level of detail necessary to determine the profit earned on an individual product. Unless the company makes only one product or sells one service there’s a lot of work to do before identifying the profits that relate to the class action claim.
Determining the revenue that relates to the sale of a specific product may not be as straightforward. Revenue might extend beyond the sale of the subject product of the class action. “Convoyed” products or services, which are sold in conjunction with the subject product, might be considered relevant for purposes of calculating profits.
Other cash inflows associated with the sale of the product may also be relevant such as government subsidies, tax credits, research grants, and other incentives that would not have otherwise been obtained if it were not for the sale of the subject product.
GAAP-prepared financial statements typically include a variety of estimates, accruals, cost allocations, and non-cash expenses that are not necessarily relevant when assessing the profits in question. Careful deciphering of the relevant costs and expenses is required. Needless to say, the more costs or expenses deemed to be applicable the smaller the reported profit in question - and vice versa.
What are the relevant “costs” that should be considered? When it comes to accounting for profits in a litigation context, one of the most important battles is usually fought over the question of whether profits should be determined using an incremental-cost or full-cost method.
The incremental-cost approach is naturally favoured by plaintiffs, who likely argue that the only allowable costs are those that relate directly to the product or service in question. Defendants, not surprisingly, tend to lean towards the full-cost approach, claiming as many allocable costs as possible.
Depending on what costs are ultimately considered relevant, the difference in the reported profit can be significant. For an accounting expert to advise counsel on what costs can reasonably be offset against revenues, he or she must acquire an in-depth understanding of the business sector where the product or service was sold.
This should not be done in a generic fashion or by applying a type of checklist approach. Each case will be different and the nuances of how the business actually works need to be determined and understood from as many perspectives as possible.
Research and development costs for a pharmaceutical product, for example, can be substantial. The deductibility of R&D costs may depend on their contribution to the revenue generated by the subject product, which needs to be assessed on a case-by-case basis.
For example, under GAAP, costs incurred in the preproduction stage of a product are typically expensed in the period in which they are incurred, which might be years before the revenue from the product is realized. It may be necessary to match the expensed research amounts from one accounting period to the revenue generated in a later period from the subject product to calculate profit.
Likewise with marketing costs. In a marketing campaign related to 10 products, what portion of the marketing costs can be reasonably allocated to one product? The costs associated with designing and executing a company’s marketing and advertising campaign may not be directly tied to any specific product or the overall volume of product sold. Therefore, it is more difficult to relate such costs with a specific product.
Is a CEO’s salary an allocable cost? It can be argued that the CEO’s salary is a fixed cost that would have to be paid by the company regardless of the sale of the subject product. A counter-argument might be made that the salary of a director of R&D when he is responsible primarily or exclusively for the sale of the subject product is a deductible cost. And so on.
There is also the issue of “bundling” to consider. A large manufacturer of appliances might sell a washer and dryer combination, or a fridge and stove. If one of the paired appliances is defective and a class action suit results, the calculation of unwarranted profits might need to factor in a determination of how many of the non-defective appliance were sold as a result of being paired with the faulty one. And, how much, if any, of the resulting profits apply to the suit.
In addition to the accounting for profits discussion, there is also the issue of the return earned by the defendant on the profits (“profit on profit”) over the relevant period in question.
This article has noted only some of the many factors to consider when determining profit in a gain-based claim. As it seems that the gain-based approach is currently being accepted at the certification stage of some class action suits, legal counsel should be aware that it is here at least for the time being and the underlying accounting concepts supporting the calculation of profit/gain need to be understood.
Larry Andrade, CA, CBV, and Enzo Carlucci, CA, CBV, are partners in the forensic and investigative accounting practice at Cole & Partners. Their web site is www.coleandpartners.com.
