How Forensic Accountants Assist with Calculating Lost Profits

How Do You Prove Lost Profits?

Proving lost profits requires establishing three things: causation, foreseeability, and reasonable certainty. Each element addresses a different question: whether the loss was actually caused by the other party, whether it could have been anticipated, and whether the amount can be calculated with sufficient confidence rather than precision. A forensic accountant builds the financial evidence needed to satisfy all three when advising on or supporting a claim.

Was the Loss Caused by the Other Party?

Establishing causation requires that the lost profits can be tied directly to the disruption to operations. Lost profits can only be recovered if they can be clearly shown to be a direct result of another party’s wrongdoing. 

Proving causation can be difficult. Once a claimant is able to prove that another party has affected their profits, the burden typically passes over to the defendant, who will then have an opportunity to contend that there were other factors that contributed to the damages, either entirely, or partially.

Could the Loss Have Been Foreseen?

Foreseeability seeks to establish whether the lost profits were caused by an outside factor. It does not even seek to ascertain whether the loss itself was predictable, instead it establishes whether the particular loss and its effect on profits could have been expected when signing the initial contracts. 

If the effect on company profits could not be deemed as foreseeable when signing the contract on the services/employment/establishment etc. then it can be difficult to prove that the defendant is guilty of directly causing lost profits due to negligent action.

To establish whether lost profits were foreseeable, courts will look at the exact terms of any relevant contracts, as well as the industry standards, and any other circumstances besides. Foreseeability tends to be a matter of law.

How Certain Do the Figures Need to Be?

The rule of reasonable certainty dictates that lost profits can never be calculated to the penny, and therefore can never be totally accurate. For this reason, lost profit calculations do not need to be perfect as long as sufficient evidence exists to support a rational deduction with reasonable certainty. 

During this stage, it is fairly common for courts to expect a clear distinction between proof of profits without the disruption, and the amount of damages sustained. Generally the onus of expectation is more on providing evidence that proves expected profits would have taken place, rather than calculations regarding the value of profits lost.

How Forensic Accountants Determine Lost Profits in Six Steps

Forensic accountants calculate lost profits using a ‘but for’ analysis. This estimates how the business would have performed had the disruption not occurred. This involves six key steps, from establishing the business’s context through to reporting the final figure. Each case differs depending on the cause of loss, the length of the loss period, and the complexity of the financial data available.

The six key steps in how forensic accountants determine lost profits include

Step One: Contextualise the Business’s Situation

The first thing a forensic accountant will do when instructed to act on a loss of profit claim will be to attempt to understand the business. 

This means finding out as much information as possible about the operation, finances, industry standards, current market conditions, and any other market conditions relevant to the loss period. 

This context is vital before any figures can be calculated. 

Step Two: Identify the Total Loss Period

Another important aspect of the process is determining: 

• A) what caused the loss and
• B) how long it lasted. 

Once the cause (fraud, negligence, breach of contract, etc.) is identified, forensic accountants will examine the full extent of the period of loss. 

For a physical event, like a fire, this process is relatively straightforward. However, for ongoing issues like IP infringement or tortious interference, determining the loss period will require more detailed analysis of when the financial impact first appeared and when it was resolved. 

Step Three: Perform a Baseline Profit Analysis

Using historical financial records; income statements, balance sheets, cash flow statements, etc., the forensic accountant will construct a picture of what the business would have earned had the adverse event not occurred in the first place. 

This baseline accounts for growth trends, seasonality, and relevant market conditions

Step Four: Comparative Analysis

Once gathered, the baseline profit analysis is then compared against the company’s actual performance during the loss period. 

Revenue streams, expenditure patterns, and profit margins are examined in-depth to quantify the gap between expected and actual performance. This gap is what forms the basis of the loss calculation.

Step Five: Consider any Mitigating Factors

Any steps taken to reduce the loss, such as cost-cutting measures, insurance recoveries, alternative revenue streams, etc., are factored into the calculation. 

A business has a duty to mitigate its losses, and the forensic accountant ensures those mitigation efforts are properly accounted for without reducing the claim beyond what is fair.

Step Six: Report Findings

The culmination of this process entails the forensic accountant preparing a detailed report to document the methodology used, financial data relied upon, assumptions made, and the calculated loss figure. 

This report forms the evidential foundation for the claim — whether presented to an insurer, used as part of negotiations, or submitted as expert evidence in court.

Are Lost Profits Consequential Damages?

Lost profits can be consequential damages, though not always. It depends on how the loss arose. Consequential loss is loss that flows from a direct loss, rather than the direct loss itself. For example, if a breach of contract causes an immediate loss of income from a cancelled order, that’s a direct loss. If it then causes a knock-on loss of future business through reputational damage, that further loss is consequential.

The following factors determine whether lost profits are consequential damages or not:

• Indirect: Lost profits are not generally the direct outcome of an incident but will stem from the inability to conduct normal business as a result of an incident. 
• Foresight: In order for lost profits to be recoverable, they must be foreseeable. This means that the party responsible for the disruption, who would be expected to compensate the company affected, must be able to reasonably predict that their actions could result in lost profits. 
• Causation: There must be a clear causal link between the disruption and the profits lost. The affected party has to be able to demonstrate that the losses are a direct consequence of the disruption and not caused by other factors.
• Quantifiable: The lost profits have to be quantifiable to be deemed as valid. To this end, calculating lost profits amounts will require detailed financial analysis and projection to ensure the claimed amount would have been earned without issues. 

Whether lost profits are pursued as direct or consequential damages affects how the claim is pleaded and what must be proved to succeed. Direct losses are generally presumed to flow from the breach; consequential losses must be expressly claimed and shown to have been within the parties’ reasonable contemplation at the time the contract was made. This is another reason why early forensic accounting input can shape how a claim is framed, not just how it’s calculated.

How Forensic Accountants Prepare a Lost Profits Damages Calculation

The vital skill a forensic accountant possesses when calculating lost profits is thoroughness. Appointing a forensic accountant to assist you guarantees that no stone will be left unturned, no data will fall through the gaps, no fact will go unconsidered; nothing will be missed at all in pursuit of the right result. 

A forensic accountant will develop an appropriate plan of action for any lost profits claim — without one you could find your claim rebuffed as a result of something not considered. 

As part of the plan, a thorough internal review will take place, a forensic accountant will interview all relevant personnel, review all internal policy and paperwork, as well as conduct a thorough examination of all conclusions before the claim is submitted so as to spot any possible errors or figures that could be unpicked. 

A qualified forensic accountant also possesses the skills necessary to act as an expert in court should it be needed. A key part of the training and expertise of such a specialised accountant is their ability to present their findings in court; both accurately and in a relatable way.

A forensic accountant will be able to get their point across, including all relevant data and findings, while being able to present it in terms that everybody will be able to understand. 

What Are the Three Methods of Calculating Lost Profits?

Forensic accountants use three main methods to calculate lost profits: the before and after method, the benchmark method, and statistical forecasting. Which method applies depends on the type and extent of the damages, and how much reliable historical or comparable data is available.

Before and After Method

The before and after method requires the forensic accountant to demonstrate the firm’s profits prior to the inciting incident compared with the earnings following the event. This is used to simply and clearly show the losses incurred. 

In order for this method of calculating lost profits to work, the business in question must have a clear history of profits prior to the issue taking place. As a result, it is usually inappropriate for a case involving a new startup business. As part of the before and after method, outside factors that are not related to the damages that could have still harmed profits must be taken into account.

 

Example of the before and after method: An established manufacturer of computers experiences a breach of contract with a supplier responsible for providing a critical engine part. As this part can no longer be supplied for a large period, the manufacturer must halt production. This holds up the release date and significantly affects profits. A forensic accountant would chart the manufacturer’s historical data against actual profits during the disruption; the lost profit amount is the difference between the two lines.

Benchmark Methodology

The benchmark method requires experts to compare the experience of the affected firm with a ‘benchmark’ business in the industry. This company is one that the forensic accountant can reasonably compare to the damaged firm — there would be little use comparing a regional takeaway restaurant with Mcdonald’s. 

This method relies on the idea that the affected company could have achieved similar levels of profits of the unaffected but for the damaging event and barring any unforeseen external factors. Examples of the different ‘benchmarks’ a forensic accountant may look to when calculating lost profits include: 

• Revenue of a similar business within the same industry. 
• A separate and undamaged branch of the same business unaffected. 
• Projections for the impacted company compared to industry averages. 

Example of the benchmark method: A restaurant franchise hires an electrician to conduct work. A fault in the work results in a fire, meaning the restaurant is unable to open for a significant period. While insurance covers the equipment lost, it doesn’t account for expected profits. The forensic accountant could compare the alleged profits lost with those of another location under the same umbrella — with success depending on the similarity of the two businesses and expert testimony on the electrical work itself.

Statistical Forecasting

The statistical forecasting method is seen as the most complex and data driven of the primary methods of calculating lost profits. Statistical forecasting requires inputting data and assumptions made using the other methods into a modelling tool. This tool will yield predictive calculations regarding lost profits. Statistical forecasting is ideal for more complex cases, with multiple external factors to consider. However, it can be challenging to explain in easy to understand language when necessary. 

Fortunately, an experienced forensic accountant will have the expertise necessary to understand the best way of presenting this data as clearly, simply, and intuitively as possible for anyone to understand. 

Example of the statistical forecasting method: A supplier is taken to court for breach of contract. Despite the verdict landing in the supplier’s favour, significant reputational damage results in lost recurring clients and being passed over for jobs they’d likely have won previously. A forensic accountant would conduct before-and-after and benchmark analysis using historical and current data, then input this into a modelling tool to calculate the profits lost to reputational damage. They will also present the findings as expert witness evidence in court, if necessary.

Instruct a Lost Profits Forensic Accountant

If your business has suffered a loss of profits due to another party and you need a lost profits calculation to quantify the damage — whether for an insurance claim, a legal dispute, or expert witness evidence in court — Inquesta Forensic can provide the financial analysis your case requires.

Rob Miller ICAEW, MAE, CCI is a forensic accountant and expert witness based in Manchester, instructed by solicitors across England & Wales on commercial disputes, fraud, and business valuation matters.

Contact Rob Miller at rob.miller@inquestaforensic.co.uk, call 0161 243 0595, or fill in our contact form to request a callback.