Forecasting the Earning Capacity of Self-Employed Individuals
This article first appeared in the summer 1996 issue of the Expert Witness.
Financial experts encounter two major problems when attempting to forecast the earnings of self-employed individuals. First, although tax returns and financial statements are often available, these documents may not provide an accurate picture of the plaintiff's potential in any given year. This may be the case for one or more of the following reasons. The structure of the taxation system may allow self-employed individuals to claim some of their personal expenses as business expenses, thus reducing their taxable incomes. The owner-operator of a company may not receive payment for his product or service in the year he earned the income. The plaintiff may receive cash or payment-in-kind for his product or service and, therefore, not report that income. The plaintiff may be able to enter into an income-splitting arrangement with a spouse who is a co-owner of the company.
Resolution of these issues often requires the assistance of the plaintiff's accounting firm. (Further information about the problems which must be taken into account can be found on pages 10-11 of Christopher Bruce, Assessment of Personal Injury Damages, 2nd Edition, Butterworths, 1992.)
Second, even if the expert is able to determine that the net income reported by the owner-operator of the company represents his actual income in any particular year, it may still be difficult to project the self- employed plaintiff's future earning potential, had the accident not occurred. This is because the available documents often will not yield useful information about the cyclical and/or seasonal nature of the industry the company belongs to. In particular, the firm's financial data may not identify whether the industry was at a "peak" or a "trough" in business activity, nor whether the growth of the firm's business was consistent with overall trends in the industry or whether the firm was growing more (or less) rapidly than the industry as a whole.
Many of these problems can be dealt with through the use of Statistics Canada's Small Business Profiles. These publications contain data compiled on a biannual basis from tax returns submitted to Revenue Canada by businesses reporting gross revenues between $25,000 and $5,000,000. The Small Business Profiles present detailed operating ratios, financial ratios, balance sheet information and employment data for most industries by province and territory for the 1987, 1989, 1991 and 1993 taxation years. (Data for the 1995 taxation year will not be available until June of 1997.) More importantly, these profiles report the distribution of net profits, for both profitable and non-profitable businesses, in each industry.
As an example of a situation in which the Small Business Profiles can prove valuable, Economica was recently retained by the defendant to provide evidence concerning a plaintiff who had operated a small, specialized company in the construction industry. Although his business had been operating for less than two years at the time of his accident in late 1989, he had earned a substantial profit in the six months preceding the accident. Indeed, Small Business Profiles indicated that he was earning the average profit level of the firms in the top 25 percent of the industry. Based on this limited evidence, the plaintiff's expert projected that the plaintiff would have maintained the level of net income he had earned in that six month period for the remainder of his working life (almost 30 years).
What Economica was able to show, using the Small Business Profile for that industry, was that the annual profits of the top 25 percent of profitable companies in the same business as the plaintiff decreased by 76 percent between 1989 and 1993. Moreover, data from Statistics Canada showed that construction activity peaked in the plaintiff's province in 1988/89, and that at the time of the plaintiff's accident, the construction industry was on the verge of entering a slump from which it has yet to recover. (Activity decreased by 78.2 percent between 1989 and 1993, which corresponds directly with the decline in the net profits earned by companies providing the same service as the plaintiff.) Therefore, this information suggested that the plaintiff's net profit would have declined significantly from the profit level he was achieving at the time of his accident, and that he would not have been able to maintain his 1989 level of income throughout the remainder of his working career.