Cases litigated by law firms often have a long lifecycle, and fees are typically structured on a ‘no-win, no fee’ basis. This means that financial risk is taken on by the litigating law firm or specialist litigation funders, with the possibility of significant returns if litigation is successful.
However, law firms engaged in litigation may face numerous accounting and funding challenges, as recognition of revenue is likely to be deferred until late in the litigation lifecycle, due to accounting rules requiring a high degree of certainty before revenue is recognised. Set against the recognised costs and cash spend required to fund the litigation, uncertain and late-arriving cash in-flows can present a bleak picture in financial statements which do not reflect the underlying commercial position of the business.
So, what are the unique accounting considerations and judgements that litigators need to make in these cases?
The complexities of class action
Litigation funding was originally conceived as single case funding, where the claimant did not have the ability to fund the litigation. In these instances, a funder would finance the claimant, not the lawyer, on a non-recourse basis, with significant upside for the finder from the settlement secured if successful. The law firm receives the funding under an agreement with the claimant and funder.
As litigation has grown more complex, with law firms now sometimes acting for multiple claimants in group litigations (sometimes referred to as a class action or mass tort litigation), the nature of litigation funding has developed. Specialist litigation funders now operate in the market, entering into multi-million financing arrangements with law firms rather than claimants.
Litigation funders will typically fund a portfolio of claimants and cases, funding both staff costs and disbursements which can be very significant, taking those cases as their security. The litigation funders will often not only fund the action but will also support the law firm in marketing campaigns to generate caseloads. Consequently, returns are highly leveraged to reflect the risks involved, and the timing and amount of returns on the financing may be a function of the net proceeds received by the law firm upon successful resolution of litigation.
Accounting for non-recourse funding
Group litigation requires significant funding, and claimants will often not have the resources (or the desire) to fund the litigation themselves. Instead, financing is structured so that the claimants can litigate without personal financing risks, via ‘no win, no fee’ fees, including costs for the litigators time and a percentage of the awarded damages payable to the client.
This means that litigating law firms often enter into non-recourse funding agreements with the litigation funders, where repayment is only required if the litigation is successful.
Litigating law firms may view their non-recourse funding as commercially and economically no different from arrangements where funding is provided to the claimant. As a result, law firms often incorrectly account for non-recourse funding as consideration in a revenue arrangement, accounting for cash received from funders as revenue over time as legal services are rendered.
The law firm may then incorrectly account for payments to funders, upon successful resolution of litigations, as an expense in profit and loss.
If the funder is not a customer, this accounting would not be appropriate. The law firms’ customers are the claimants it acts for, and the funder is usually the lender. The fact that the funding is non-recourse does not affect this conclusion. The restriction on settlement, to the extent litigation is successful and the law firm receives net proceeds, does not negate the recognition of a financial liability.
The funding received is normally required to be credited to the balance sheet and accounted for as a financial liability.
Recognising debt liabilities
Calculating the value of the financial liability is likely to be very complex.
Measurement of debt will often involve having to forecast the timing and quantum of cash flow in the cases being litigated, calculating discount rates at each reporting date, and preparing probability weighted expected outcomes for cases. As returns are linked to the outcome of the litigation, debt is measured at fair value, with the carrying value of the debt likely increasing over time if a successful outcome becomes more likely.
Meanwhile the revenue still cannot be recognised until later in the case, when it is virtually certain there will not be a material reversal.
In summary, recognition of liabilities with much later recognition of income can result in the accounts of the firm presenting a bleak picture until the final outcome of cases is determined.
For a detailed analysis of the accounting considerations, please contact Andrew Baker.
*the views expressed are the author’s and not ICAEW’s