Expert Accountants – When Should You Use One To Estimate Loss Of Earnings?
The answer in a nutshell is when professional experience is required to assist the Court to understand a party’s financial affairs.
Kemp & Kemp, excellent in many ways, used to deal only very briefly with loss of income for the self-employed, the member of a family business, and the senior executive whose pay and benefits depended on the performance of their company. Now things are different, as we shall see.
Loss of earnings – the complexities of a correct approach
For the conventional employee, the traditional way of calculating loss of earnings is to take payslips for say the last thirteen weeks before an accident, and assume that the average net pay would have continued but for that accident. That is wrong, because liability to income tax is assessed for a period of a year. The correct method is explained in Kemp at 9-016 as follows:
“It is submitted that in every case the true calculation is to ascertain the net amount which the claimant would have earned, but for the accident, in each tax year concerned, and to deduct from that the net amount which the claimant in fact earned (or is likely to earn) in that tax year.”
This is the method suggested by Lord Morton in West Suffolk County Council –v- W Rought Ltd [1957] AC 403, 414, 415. The worked examples in Kemp at 9-102 to 9-104 show just how far one would go wrong if the income lost through an accident were to be based on a small sample of past net weekly or monthly earnings.
Lord Morton’s suggested method – which is clearly the only correct one– deals properly with annual income tax rates and allowances. In simple cases this may not present a significant problem for the competent lawyer, but how many lawyers for example are versed in the necessary skills to deal with the complexities of IR35?
Lord Morton’s method also encourages the claimant’s lawyer to look at total pay for annual periods; for example, it may be that an employee has amounts of overtime which vary with the seasons. To take a very simple example, a labourer on an arable farm may work basic hours in winter, but extremely long hours on overtime at harvest time. His loss of earnings would be very much greater if he were to be injured and away from work for two months at harvest time than if he had had the same absence in the depth of winter.
Whilst such issues need careful thought, they rarely need the skills of an expert accountant. Indeed, under CPR 35.4 (1), a judge is hardly likely to consent to an expert accountant producing a report or giving expert evidence on such relatively straightforward matters.
The position with the self-employed is likely to be very different, hence this article. Its purpose is twofold: to give guidance on the situations where the expert accountant may be needed, and to draw attention to Chapter 5A in Kemp & Kemp, which describes briefly the world of the self-employed, and how an expert accountant may be used to interpret it.
Up to four years ago, Kemp & Kemp dealt very briefly with the self-employed. It used to say “There may, however, be many imponderables in the case of the self-employed”, and with that I heartily agree. But little guidance was given on how to address those imponderables.
That lack of guidance is something which I sought to address when I wrote Chapter 5A, and it may be helpful to the reader, in understanding the role of the expert accountant, if I were to explain how that chapter came to be written.
The origins of Chapter 5A, Kemp & Kemp
Some four years ago, I was engaged as expert for the claimant following an RTA. He was a very interesting person: a huge, powerful man; a workaholic, and a man whose activities before the accident were diverse. He was principally an arable farmer and plant hire contractor, but he did most of the physical work on the farm himself. He was the main operator for his heavy machinery for his own farm and as contractor for others. He also bought and sold building materials. He had constructed two science parks from derelict farm outbuildings, creating a rent roll for the future. He had converted a stable block into a home for his sister, and was in the process of converting a magnificent but derelict Grade II manor house into an impressive home for himself.
After the RTA he still had his business acumen, but was unable to implement it because his physical strength was much impaired. Whereas before the accident he could work 12-hour days for six days a week, medical evidence showed that he was now able to work only for a few hours before having to rest for a day or more.
What then was his loss, and how should the Court restore the status quo ante? The problem was how to follow Livingstone –v- Rawyards Coal Company [1880] 5 App Cas 25 at 39 where the Court said that the plaintiff:
“…should as nearly as possible get at that sum of money which will put the party who has been injured, or who has suffered, in the same position as he would have been in if he had not sustained the wrong for which he is now getting his compensation or reparation.”
I and my opposing expert took very different approaches to this challenge. She looked at the past accounts of the business, and recognised recurring earnings of about £5,000. That was correct, as far as it went; the annual accounts did show such low earnings. But that was only part of the picture. The reason earnings were so low was that the claimant had been neglecting his core business whilst engaged in other, very worthwhile, activities. He had spent his time on creating science parks for future rent income which did not yet show in the annual accounts or his tax returns, and on creating a home from a disused manor house, which should really be treated as a substantial DIY claim.
The approach I took was to stand back and think about what the claimant had really lost, and how it could be restored. He still had his farm, his hire plant, and a manor house to complete; and he would no doubt find other, equally challenging, projects in future. He still had his ambitions and plans, but he had lost the physical strength to carry them out himself.
So my solution was to “buy him a man”. I took the New Earnings Survey figure for a labourer and, with the cost of overtime and employer NI costs etc (reduced per Gourley for the tax relief he would have enjoyed on the business part of the labourer’s activities) I quantified the annual loss at some £25,000.
My opposing expert and I were far apart. What was to be done? I suggested the other expert should tour the claimant’s properties as I had done. We then had a meeting of experts, where she did not change her view that the annual loss was some £5,000.
The matter went to trial, we both gave evidence, and we both held to our views.
The Court adjourned, and the judge asked for closing submissions from counsel, to be provided to him in writing next morning.
Counsel for the claimant asked for my help, in identifying a precedent for the approach I had taken, but I was not aware of any.
That evening I made two telephone calls. The first was to Ben Nolan QC, with whom I had worked frequently on PI cases, and he said he was not aware of any such precedent, but he agreed with my approach. I then rang the late, dear David Kemp QC, who said very much the same thing. So I suggested to Mr Kemp that Kemp & Kemp needed a chapter on how to quantify losses for the self-employed, he readily agreed, I offered to write it, and Chapter 5A appeared shortly thereafter.
What then about the case in question? The judge agreed with my methodology and fixed the multiplicand at £25,000. Unfortunately, it was found that the claimant had a medical condition unrelated to the injuries – which emerged only in oral evidence from the medical experts during trial – which meant that he could not have continued working so hard for much more than another two years, so the judge awarded a multiplier of 2. £50,000 was less than the Part 36 offer, so the claimant won on multiplicand, lost on multiplier, and lost on costs.
And what about Chapter 5A? Kemp & Kemp is so highly regarded that counsel refer to it frequently, and one may say it is almost as good as a precedent where none exists. That being so, I had expected that it might attract some precedents on how self-employed earnings are quantified, so that other practitioners are not presented with the same problem I faced that night when counsel wanted a “red judge’s” precedent to support my approach, and I was unable to identify one.
In fact, I am aware of very little activity in that area, and no such precedents have appeared which might cause the chapter to be updated. So since it first appeared in March 2001, the chapter has remained unchanged.
Why is that? Was it so comprehensive that there is no more to be said on the subject? That can hardly be the case! Are there precedents worthy of inclusion which I have missed? If so, I would be very pleased to hear from you, so that they can be shared with all practitioners. Or is it, as I think most likely, that accountants generally agree the methodology, if not the result, of their quantification process, so that the Court is not left to decide on matters which accountants understand?
I suspect that this is the reason. Although I was called to give evidence very frequently in the days before CPR, it seems these days that such matters are dealt with at the meeting of experts. Even when the accountancy experts do not agree, the joint statement setting out reasons for their disagreement very often provides the Court with all they need to make a judgment, without the need for oral evidence from accountants.
That may please Lord Woolf in his desire to reduce the costs of litigation, but it has not been helpful in providing precedents for Chapter 5A!
Chapter 5A and the self employed
We started by looking at the erroneous way in which some solicitors have been known to quantify loss of net earnings for a straightforward wage-earner, and explaining why that method is most unlikely to give the correct result. To achieve the correct result requires an understanding of how tax is assessed.
The position with the self-employed is the same, a fortiori. For a wage-earner you do not look at payslips for the last 13 weeks and assume things will go on at that rate for a working lifetime. Similarly, for the self-employed you do not look at annual accounts for the last three years and assume the same. Life for the self-employed is seldom so simple.
The case I have described at length shows just how far wrong one can go without a deep understanding of the business – this business, of this type, in this unique setting, with these technical problems, with this competition, with these strategic strengths and weaknesses.
Taking another farming example, we were required to quantify the loss of earnings for a sheep farmer who could no longer do the heavy physical work on the farm following his RTA. His business accounts showed dire results – negligible profits or even losses – but he simply could not afford to sell the farm. It had been handed down to him, and sheep farming was so unprofitable that the farm had such a low value that for him to sell it at a huge loss was more than could be expected in mitigation. So again, we quantified the loss at the lump sum which would provide, per the Ogden tables, an annual sum to employ a farm labourer. Again, the status quo ante had been restored.
There are many other complications that are revealed only by an expert who takes the trouble to understand the business thoroughly.
The expert’s expertise
An expert accountant should, of necessity, have experience of a range of business types and sectors and will in many cases have a wealth of experience in dealing with people from a range of backgrounds. This enables the expert to draw from that experience and apply his knowledge to the case in hand with a view to understanding and drawing to the Court’s attention any relevant issues which need to be taken into account when making a judgment.
By way of example, you do not take the multiplicand as being the amount withdrawn from the business, because it is income which has been lost, and income is the net profit from the Trading and Profit & Loss Account, not the cash taken out.
A sole trader may have a net profit of £40,000 but drawings of only £18,000. So he has lived on £18,000 and chosen to re-invest £22,000 in the business. The loss of income is based on income of £40,000 (less tax etc per Gourley).
Conversely, a business may be facing hard times, where the net profit has fallen to say £2,000 but the proprietor is still taking out £18,000 to meet living expenses. The loss of income is based on £2,000 (less Gourley of probably nil), not on £18,000. Further, the amount withdrawn is unsustainable, and the £18,000 is being met by reduction in stock, or increase in bank borrowings or, surprisingly often, by capital introduced by the proprietor. It really is surprising how often one finds that a trader is introducing to the business legacies, personal loans, funds from remortgaging the home, and even child benefit, into a business which has no future. This does not create business income, it merely recycles private funds. It is not sensible, and it certainly does not provide an income on which a personal injury claim may be based.
The consequence to the personal injury claim is two-fold. Firstly, the multiplicand is only £2,000; and secondly, a business cannot exist for long where the proprietor is taking out each year much more than the net profit. So the accountant’s skill must be used to determine how long this can go on, before the business is forced to cease trading. The lifetime of the business is very much less than the remaining working lifetime of the proprietor, and the loss of future earnings should be based on a modest future lifetime for the business, plus expected annual earnings for the remainder of working lifetime for an appropriate career. Interestingly, as well as being closer to reality, that approach can often lead to an increase in the total future earnings claim. After all, how many people would be prepared to go to work for £2,000 a year, even if the minimum wage regulations would permit it?
Partnerships, family companies and executives
Matters can become much more complicated with partnerships, with family companies, and with executives whose remuneration package is based in part on the performance of their company.
It is a sad fact of life (and death) that highly paid people tend to travel more, and are at higher risk of being injured in an RTA or a rail crash. Ironically, rail companies such as GNER generally put first class carriages at the front of the train, so that the affairs of those who died in the Selby and similar rail disasters tend to be more complex. In fact I acted for the dependents of five highly paid men who were killed in the Selby rail disaster.
In situations like this, where claims involve large earnings, an expert accountant is often required to understand the employing company’s business, before and after the claimant was unable to work. This is especially so if the claimant had been a “rainmaker” for the company (hence benefiting from a package to give him a share of the company’s success which he was helping to create) and if the company’s actual results since his departure have worsened. This requires an expert accountant with a deep understanding of that company’s business, who can reach a robust opinion on what the results of that company would have been with the rainmaker’s help, and on what the claimant’s share of that success would have been. An annual bonus may be easy to predict, but where the package includes share options, much more experience and skill may be required.
To project the loss of a partner’s share of business profits requires little more than the same understanding of the business as is required for any loss of profits projection, plus an application of the precedents, principally Ward –v- Newalls Insulation Co Ltd [1998] PIQR Q41.
Matters are often more complex with the family business.
The ability to simplify
An expert will often have been involved in explaining complex issues to the owners of a family run business, and will be used to simplifying such issues so that they can be understood by the layman.
Consider the steps needed to quantify a director/shareholder’s loss:
- understand the business;
- project the company’s income, allowing for the loss of company income as a consequence of the claimant’s absence;
- establish the past distribution policy of the company;
- ascertain the share of that distribution which the claimant customarily received (which could include salary, benefits, pension contribution, fee and bonus, dividend, plus profits left in the company to increase the claimant’s share value) and
- apply that customary share to the profits which the company would have enjoyed but for the claimant’s absence.
This sounds complicated, but an experienced accountant has no difficulty in applying these principles, and an experienced expert accountant has no difficulty in explaining them in simple language to the informed layman – ie, to lawyers and the judge.
Understanding the business – the key concept of regression
An important issue, sometimes overlooked, is regression of trade. If an employed person has an absence from work for a number of months through injury, it is likely that they will be able to resume their employment without delay once they have recovered. There may be a loss of overtime for a while, but the Court can deal with that quite easily.
For the self-employed, the position is likely to be very different. If say the claimant had traded alone, and had been unable to attend their place of business for some months, some or all of the customers will have gone elsewhere. Once recovered, the claimant needs to rebuild the business, and this period of rebuilding is called regression. The period of absence may have caused a total loss of the business, or merely a period of gradually increasing profit until the business has reached the level of profit it would have enjoyed but for the claimant’s absence. These may sound difficult concepts, but again, an experienced expert accountant will have no difficulty in quantifying the loss in such circumstances, and in explaining them in simple terms in his report and in oral evidence.
To broaden the discussion briefly, because Chapter 5A comprises a simple summary of how businesses work, what business accounts reveal and may conceal, and how one may quantify business profit, it provides a good primer for those in other kinds of litigation. From the expert accountant’s point of view, an interruption to the business may have been caused by injury or death of the proprietor, or a fire at the premises, or a dispute between partners or directors. The expert accountant would apply the same principles in arriving at his opinion of the loss of profit, following a thorough understanding of this particular business in its unique setting.
So your commercial litigation colleagues may be interested to see this chapter, too.
Summary
- An expert accountant is seldom needed to quantify an employed claimant’s net earnings
- Be sure to calculate net earnings for complete tax years
- The self-employed’s affairs are likely to be much more complex
- You require an expert accountant who understands this particular business, and is able to explain his methodology in simple terms
- It is seldom possible to project future loss of self-employed earnings merely by a study of past trading accounts
- Net profit is not the same as withdrawals, and the claim must be based on the former
- There is a dearth of precedents on how loss of business profits are to be quantified, but precedents would be welcome so that they can be included in updates to Chapter 5A
- That chapter is of relevance to any litigation lawyer required to quantify loss of business profits, and not merely to personal injury practitioners
I trust this article will provide some pointers on when an expert accountant is needed, and when his involvement would be disproportionate. And further, in drawing attention to Chapter 5A, I look forward to receiving lots of news of precedents to confirm the methodology explained, and to provide the lawyer with some insight into the mysterious world of the self-employed claimant.
Chris Makin is a consultant at the national firm of Bentley Jennison, where he was latterly national head of litigation support. He has practised as a full-time forensic accountant for 18 years, after a long career in general practice. He is a fellow of the Institute of Chartered Accountants, of the Chartered Institute of Management and of the Academy of Experts, and a qualified commercial mediator. He is a frequent lecturer and contributor to legal textbooks and journals.
He has been involved in a vast range of cases. With his team he has produced over 600 expert reports, and has given oral expert evidence about 65 times.
Words with biog: 3,669
Contacts:
NC Makin FCA FCMI FAE QDR MCIArb
Chris Makin Mediator Ltd
Well Cottage
39 Water Royd Lane
Mirfield WF14 9SF
DX29648 Mirfield
01924 495888
07887 660072
