INTRODUCTION

You have been working for the forensic accounting department of a regional certified public accounting firm for several years. The work is rewarding and challenging everything you had hoped for in this field. You have recently been assigned to the commercial damages division of the department and now have some experience in appearing for deposition and in providing testimony in court in this area. You have done well so far, and the firm has recognized your abilities and views you as a valuable resource in these matters.

Your firm was recently engaged to represent Balboa Security Systems (plaintiff) in a commercial damages case. Due to your continued success in litigation matters, you were assigned this case and will serve as the expert witness for Balboa. The case involves allegedly defective security sensors purchased from a company called M&M Systems (defendant). As usual, both the plaintiff and defendant have wildly different positions on this matter. Even though liability has not yet been established, Balboas attorneys want you to estimate monetary damages.

Information you gathered based on your review of case documents and interviews with the attorneys and representatives of each party is presented below.

Background

Even when he was in high school, Bruce Berry enjoyed working with electronics. While his friends played video games, Bruce was repairing electronic gadgets for the surrounding neighborhood. Gifts of electronic toys, like the game console his parents bought him one year, were quickly dismantled to see how they worked. This fascination with all things electronic carried through high school and into college. As he progressed through college, Bruce began to contemplate turning his love of electronics into a potential career path. Bruce graduated with a degree in electrical engineering and went to work in the system security industry as an assistant designer.

One of his first positions after graduation was with a small security systems company. Bruce was attracted to the company, Bandini Security, Inc., because he believed the company was interested in exploring new technologies to improve the responsiveness, ease of use, and reliability of commercial and home security systems. However, it soon became clear that the company was reluctant to embrace new ideas, instead opting for small, incremental technological improvements so as not to disrupt its sales or market share. After eight years with Bandini, Bruce was very frustrated with this attitude toward technological improvements. Bruce felt his knowledge of the systems and the market was strong enough to make a move, so, in 1982, he started Balboa Security Systems. Bruce operated Balboa Security Systems as a sole proprietorship for the first few years. However, as the business grew, he was advised by his CPA to incorporate. Following that advice, Bruce incorporated the business in December of 1985.

In those early years, the Company generally had ten to fifteen employees who were kept busy with product sales, installations, and service calls. But Bruce was an engineer at heart and had little time for anything except product development. Because of this, product quality and innovation were excellent; however, his lack of interest in all other areas of the businessmarketing and product sales, installations, and repair serviceslimited the growth of the business. His CPA recognized the issues the company faced and introduced Bruce to Lyle Barker. Lyle had extensive marketing experience in the electronics industry, and, even more importantly, Bruce and Lyle hit it off from the beginning. Lyle joined Balboa in 1989. Lyles strong background in electronics marketing took the company to a new level through significantly increased sales. Lyle also reorganized the company to ensure timely installations. Due to Balboas success, Lyle became a shareholder in 1994, holding 35% of the shares. Bruce held the other 65%.

The Companys reputation for innovative design, quality products, and timely installation services drove expansion into new service areas. By 2003, the business had grown to over 100 employees and provided security system sales, design, and services to commercial businesses across the western United States.

Eroding Margins and a Solution

During 2010 through 2012, the companys gross margin began slipping. Balboas CFO, Sara Xu, analyzed the historical financial information and identified a primary cause of the slipping margin: the rising cost of security sensors. Each security system had one or more control panels and dozens, or even hundreds, of security sensors which monitored movement, heat changes, and other environmental factors. Sensor Systems, Inc. had been Balboas sole source of sensors since 1995. While the quality of the sensors was very good, these recent price increases were reducing the bottom line and the Company wanted to control this trend before it got worse.

The purchasing department was instructed to seek out alternative vendors. The selection process took several months and included a product testing phase. Based on these tests, and on what appeared to be a good fit with Balboa, M&M Systems was selected to become the sole supplier for security sensors. M&M had been in business for over 15 years and carried an excellent reputation. M&M offered a steep discount on pricing when compared to Sensor Systems; however, the sensors were sold with no right of return. Additionally, Balboa would clearly be M&Ms largest account. When asked about this, M&M assured Balboa they could handle the work and meet the volume requirements. Based on these assurances from M&M regarding the ability to meet Balboas demand for product, and after considering M&Ms reputation and the significant cost savings, Balboa confidently made the transition to M&M for sensors beginning in May of 2013.

A Problem Develops

One of the innovative features included in Balboas systems was an internal testing unit that allowed the customers to pre-scan for any likely system problems. This was one of the many product features that contributed to the financial success of the company.

Based on Balboas experience, approximately 1% to 2% of the sensors would either fail or register in the pre-test as potentially failing during the first year of operations. Balboa would make necessary repairs before any real problems developed.

It was business as usual through most of 2013. However, beginning in November of 2013, there was an unusually high number of sensor failures reported. The normally minimal cost of warranty repairs began increasing at an alarming rate and Balboa could not keep up with the growing demand for repairs. Even worse, word was getting out that the quality of Balboas systems was slipping. For the first time in years, Balboas sales declined from the prior year.

Identification of the Issue

Balboas repair teams quickly identified the M&M sensors as the cause of the increase in maintenance problems. The repair teams were replacing defective M&M sensors with new M&M sensors. However, they soon realized a second wave of repair calls came as the replacement sensors went bad.

Discussions with M&M

When the problems were first discovered, Balboa contacted M&M regarding the quality issues. M&M assured Balboa that any quality issue was temporary and there was no reason to be concerned. However, Balboa management didnt see any change in reliability or quality. Sensor failures continued and the negative impact on Balboas business increased each day. After repeated attempts to correct the situation and address the quality issues, Balboa management recognized a change had to be made. The last purchase from M&M was made in April of 2014. Unfortunately, by this time, significant damage was done. Balboas reputation was tarnished, sales were down, and repair costs continued to rise. In June of 2014, Balboa brought a lawsuit against M&M for damages.

Forensic Analysis

One Monday afternoon in late September of 2014 you were contacted by the partner in charge of forensic services at your CPA firm, Kylie Galvan. Kylie explained she received a call from attorney Laurel Zander earlier that day regarding the case. Kylie provided you with a brief overview of the case and felt you were up for the challenge.

After receiving the requested financial information, you toured the Balboa facility and interviewed key personnel regarding the case. Based on your tour, Balboas operations appeared well-organized and efficient; however, you did get the impression there had been more than the usual amount of labor turnover, especially in the installer department. You observed that the business clearly had capacity to increase annual sales by 20% to 25% without adding significantly to overhead costs.

Your review of economic conditions for the five years prior to the damage event and the forecast of future economic conditions indicates the economy is stable with continued growth expected. The securities industry is aligned with economic conditions; industry experts expect continued growth at a moderate pace for the five years following the event.

Key excerpts from your interviews with Balboa personnel:

Balboa Shipping Department Manager: We carefully pack all components for every job. We transport the components using the same vendors we have always used. If the job is local (within 200 miles) we use our own trucks. If the customer is out of our area, we use reputable transport service providers, the same ones we have used for many years. From what I hear, M&M claims we dont know what we are doing, which doesnt make any sense to me at all.

Balboa Installer Department Manager: Turnover has been a problem in my division. We have taken steps to rectify this issue, but turnover has resulted in inexperienced installers being used all too often. We tried to schedule all jobs with at least one experienced technician, but that wasnt always possible. I think we have the problem under control now.

Balboa Engineering Department Manager: Quality control is important to our business. We have been using the same quality control measures for over 10 years. Our approach has proven to be effective and efficient. No controls can compensate for poor quality sensors that fail after being in service for several months. We expect to incur continuing warranty repair costs on this for at least two more years.

Balboa Inventory Department Manager: We were stocked for sales of nearly $16 million for 2014 when this problem occurred. In addition to the $175,000 of questionable M&M sensors, we have consoles, cabling, connectors, all kinds of products on hand. Our warehouse is stacked from top to bottom. M&M refused to take back the unused sensors claiming they are fine of course, the litigation probably affected that decision. We cant afford to use the M&M products and we need the warehouse space. We found a business willing to give us ten cents on the dollar for the M&M sensors and we are in the process of closing that transaction right now.

Balboa Marketing Department Manager: Our analysis indicates sales will be negatively impacted for at least three years. We expect a decline in sales of 12% in 2015, 8% in 2016, and 4% in 2017. We have had to increase advertising expenditures to get a start on this. We are planning increased advertising over the next four years at 75% over historical averages for 2015 followed by 60%, 30% and 15% for each of the following years. Even with this additional cost, return to what we were before will be difficult.

Bruce Berry, Balboa CEO: In addition to the warranty replacement costs, our reputation has been seriously damaged. It will take years to rebuild, if it can be rebuilt at all.

Shortly after your visit to the Balboa offices you interviewed key personnel from M&M:

M&M Production Department Manager: The significant production volume necessary to keep Balboa stocked did put stress on our quality control systems, but we provided top quality sensors.

M&M Engineering Department Manager: Balboas installation process may be causing the problems. These sensors can be damaged by rough handling. We take great care to properly pack the sensors before they are shipped. I have no idea what happens to them once Balboa gets their hands on our product.

M&M CEO: We have been in business for over 15 years. I stand by our products. It is clear to me that Balboas growth has weakened their ability to do a good job. You cant operate a $14 or $15 million-dollar company like a mom & pop operation. They were an accident waiting to happen.

In thinking about the interviews, you recognize that many of the comments relate to liability rather than damages; however, this is often the nature of interviews. Your job is to find information that is useful for your damage calculations and leave establishment of liability to the court.

Assignment Guidance

Your assignment includes two deliverables: a preliminary research memo and a formal commercial damages report. Instructions for each is provided below.

Please read this case first, then answer this question

Question: Discuss the approaches available to the expert witness in calculating damages, including in which situations each approach would be most appropriate.