May 2021
Businesses may suffer a loss of profits through breach of contract or tort (e.g. negligent installation of machinery), or as a result of events such as floods. In these situations, lawyers may need to obtain advice and possibly an expert report expressing an opinion on the quantum of the losses.
Essentially, a loss of profits claim is a claim for the contribution to profitability which the business might have expected had it not been for the incident in question.
External and Internal Factors
Forensic accountants will consider the circumstances of a loss which is the subject of a claim, reviewing external factors such as the business environment and internal factors such as management, cost structures and plans for the business.
Reviewing external factors involves putting the claim into the context of the claimant’s general financial position. It will be important to consider sales in the claimant’s business sector at the relevant time and whether there were features of the sector which might have had an impact on profitability. Forensic accountants will be able to extract useful information from a company’s internal sources, including financial statements, management accounts and sales data.
What to ask Forensic Accountants to do
Forensic accountants instructed by solicitors acting for a claimant will build up the quantum of the claim, which for a standard business will comprise loss of gross profits (i.e. turnover less cost of sales) and/or extra costs of working less costs saved.
Forensic accountants instructed by a defendant’s solicitors will normally review the assumptions and calculations on which the claim is based. They will raise the following types of questions:
- Could the claimant have handled any increase in turnover, or were there staffing or other constraints which would have limited sales in any event?
- Were there factors which affected the claimant’s business sector (e.g. the impact of new regulations, changes in distribution patterns or changes in fashion)?
- Did the claimant take all available steps to mitigate the loss, for example by subcontracting production or reallocating work within the business?
Potential Issues
It is important to address the “remoteness” of the loss, as the Courts are likely to take the view that the longer the period a loss is claimed for, the more likely it is that profits will be affected by factors other than the matter which is the subject of the claim. A claim for the loss in value of a business (as opposed to loss of profits) may be appropriate where a business has ceased trading or has been sold.
Expert accountants will need to check that there is no double counting in a claim – for example between extra costs of working and calculation of lost profits. Similarly, if a claimant’s business is reinstated in a way which improves its facilities and/or methods of working, this betterment must be excluded. Claims for damages sometimes include the cost of managerial time in dealing with the problem which is the subject for claim. This is only likely to be sustainable if it can be proved that management attention was diverted from more profitable activity. A further potential problem area may be the availability of accounting records, especially if the incident which is the subject of the claim took place some time ago.
Although it is common practice for experts to disregard taxation in their calculations, they should state the fact that they have done so in their reports.
Conclusions
Forensic accountants are trained to analyse business situations and to extract information from accounting records. They can investigate the circumstances of a loss, analyse the effect on quantum, and advise on the strengths and weaknesses of a claim. For these reasons, it is often constructive to ask a forensic accountant for a view on the financial aspects of a loss of profits case at an early stage.
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