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Understanding business accounts – what to look out for

Posted on 25th September 2018 by Chris Makin

Lawyers are good with words, and accountants are good with figures.  What a pity they don’t talk the same language!  Now meet an accountant who is good with words – I have to be, as an experienced expert witness – which means that I must be weak with figures.  True?  Not really!  It’s a pity that so many people, some lawyers included, are frightened of figures because the principles really are quite simple; they have to be, for me to understand them!  Many accountants like to keep the mystique of business accounts to themselves, but I am happy to share.

An understanding of business accounts is important in so many aspects of the lawyer’s work:

  • A self-employed man is seriously handicapped after an operation went wrong; what would he have earned but for his disabilities?
  • A company director is killed in an RTA; but for his death, how much of his earnings would his dependents have received?
  • A couple seeks a clean break divorce. The husband has a limited company; what is it worth, and what cash could be withdrawn to assist in the settlement?
  • A factory burns down. What would the future profits have been?
  • A factory burns down, and a false claim is suspected. Was the business really earning as much as claimed?
  • The directors of a company can’t get on, and a Section 994 claim is made. How much should the Court order that the unfairly prejudiced shareholder receives for his shares?

…and so on.  In all these situations and more, you the lawyer need to know what the past business accounts show, how reliable they are, and how they may be used as a basis for projecting future profits.

How do you begin?  Well, you could, of course, instruct an accountant to advise on every case where business accounts are involved; but in these days of stringent costs, that can’t happen.  So how do you gain an understanding of which cases do need an expert accountant’s help, and which you, as a wordsmith but perhaps not a figure-smith, can handle yourself?

The first thing is to get a simple guide to business and company accounts.  I can help.  For some years up to the death of David Kemp QC, I had a short chapter (9 pages) in Kemp & Kemp which gave this guidance.  After Mr. Kemp’s death, the work was re-written, and my simple guide is subsumed in the work of others.  So it is out of print, but still highly relevant to lawyers dealing with all the kinds of cases I list above, and not just personal injury.  I would be happy to send a copy, without charge, to whoever asks for it.

The second is to have a friendly relationship with a forensic accountant who will perform an initial review of any case, and give his views, without charge if not appointed.  I do this frequently; I don’t sulk if not appointed, and I tell you if I consider that an expert accountant is not needed.  It’s good business for both of us: I am appointed only on worthwhile cases, and you have the assurance that someone who understands business accounts, and their relevance to your case, has considered them.  If nothing else, it saves negligence claims!

Thirdly, let us have a very brief look at what to watch out for.  Once you have my Kemp & Kemp chapter you will be half-way there.  But I will finish with some quick tips on what to look out for in limited company accounts:

  • The audit report: does it use standard wording for a “clean” report, or is the auditor trying to tell you something?
  • A qualified audit report (no “true and fair view” or a true and fair view “except”) is serious. Beware of what the auditor clearly is trying to tell you!
  • If there is no audit report, it may simply be because the company is too small to require one. But then there can be no assurance that a qualified accountant has looked at the books independently.
  • Even then, good accountants would not put their name to accounts which they knew to be wrong, so speak to someone who knows the good or bad reputation of the accountant.
  • Look at the Profit & Loss Account. Are dividends being paid even if a loss is suffered?  Does that lead one to believe that matters are not so bad as the directors would have one believe?
  • Look at the Balance Sheet, and remember that the total (Shareholders’ Funds) is not the worth of the business. If that comes as a surprise, I will explain if you give me a ring when you have a spare half hour!
  • Is Net Current Assets a positive or a negative figure? If the latter, is there fear that the company will not be able to pay its debts as they fall due?
  • Accounts obtained by a search from Companies House are almost always virtually useless, since the vast majority of companies are “small”, and allowed to file accounts consisting of a balance sheet, a couple of notes, and virtually nothing else.
  • Ensure that you receive a copy of the detailed trading accounts, usually headed “Trading and Profit & Loss Account for Management Information only”. These do not form part of the statutory accounts, but they are essential to an understanding of the business.  I insist on seeing these for several years, and I always start by charting them in Excel, to see whether turnover is going up or down, the rate of gross profit, whether expenses have any “quirks”, and so on.  Seek explanations.
  • Consultancy fees are usually interesting. What assistance was given?  Was it to someone close to the directors?  Was it at a market rate, or just a tax dodge?  Will the benefit of the consultancy be reflected in future profits?
  • Directors’ remuneration: has it varied much? With a family company, the proprietors will take out salary, fees, benefits in kind, pension contributions, dividends, in a tax-efficient way.  The salary will seldom be at a commercial rate.
  • Depreciation: have the rates changed? Is there a suspicion that this is to increase (insurance claim) or reduce (divorce) profits?
  • Fixed assets: after depreciation, are they shown at a realistic value? Remember that fixed assets are to be shown at historic cost (unless revalued) less depreciation, which can give a false indication of the value of the company.  Is freehold property undervalued?

There is much more, but in this short article, I trust I have provided something of value so that you can decide with your many types of cases when a forensic accountant is needed, and when not to waste his time.  But as a final point, if you wish to send me your key documents for a free initial review without obligation, that would never be a waste of time!


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