By Andrew Baker, partner at leading audit, tax and consulting firm RSM UK

Law firms engaged in litigation may face numerous accounting and funding challenges, particularly in the case of Group Litigation or Class Actions

Litigation cases are often characterised by a long lifecycle, with fees typically structured on a ‘no win, no fee’ basis. Financial risk is taken on by the litigating law firm or specialist litigation funders, with the possibility of significant returns if litigation is successful. 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.

These uncertain and late-arriving cash inflows can present a bleak picture in financial statements when placed against the recognised costs and cash spend required to fund the litigation. However, this often does not reflect the underlying commercial position of the business.

As the landscape of litigation evolves, litigating law firms need to consider unique accounting considerations and judgements to ensure compliance with accounting standards.

The evolving landscape of litigation funding

Litigation funding, for claimants  who do not have the ability or desire to fund the litigation, originated as single-case funding. A funder would finance the claimant, not the lawyer, on a non-recourse basis, with a successful outcome providing significant upside for the funder from the settlement secured. In these circumstances, the law firm generally receives the funding under an agreement with the claimant and the funder as payment for its services and recognises revenue as it provides its services.

As litigation has grown more complex, with law firms sometimes acting for multiple claimants in Group Litigations (also known as Class Actions or Mass Tort Litigation), and with Group Litigation requiring significant funding, the nature of litigation funding has developed. Specialist litigation funders now operate in the market, entering  multi-million-pound financing arrangements with law firms, rather than claimants. Funding can be provided on a recourse basis or a non-recourse basis, where repayment of funds by the law firm is only required if the litigation is successful.

In these cases, litigation funders will typically fund a portfolio of claimants and cases, funding both staff costs and disbursements, which can be significant, and taking those cases as their security. The litigation funders will also often support the law firm in marketing campaigns to generate caseloads alongside funding the action. Returns are often 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 when the litigation is successful.

As a result, claimants, who will often not have the resources (or desire) to fund the litigation themselves, can litigate without personal financial risk. The law firm’s fees with the claimants are generally structured on a ‘no win, no fee’ basis and cover time costs, plus a percentage of the awarded damages payable to the claimant.

The complexities of non-recourse funding

Litigating law firms may view their non-recourse funding as, commercially and economically, no different from arrangements where funding is provided to the claimant. This can lead to law firms incorrectly accounting 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 the litigation, as an expense in profit and loss.

This accounting is not appropriate when the funder is not a customer.  The law firm’s 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 fact that repayment is contingent on the litigation succeeding and net proceeds being received does not negate the recognition of a financial liability.

In summary, funding received by law firms from litigation funders is normally required to be credited to the balance sheet and accounted for as a financial liability.

Measuring the liability at fair value

Due to the nature of returns on litigation funding, the debt will often have to be recognised and measured at fair value under accounting standards. Calculating the fair value of debt can be a very complex process.

Measurement of debt at fair value often involves having to forecast the timing and quantum of cash flows in the cases being litigated, calculating discount rates at each reporting date, and preparing probability weighted expected outcomes for cases.

Because the returns are linked to the outcome of the litigation, the fair value of the debt (and therefore the carrying value of the debt in the accounts) will likely increase over time as cases progress and the likelihood of success increases. As returns for non-recourse finance are often multiples of the sum advanced, the liability recognised can be a significant multiple of the original debt advanced.

Meanwhile, revenue is not recognised on a ‘fair value basis’. Instead, revenue contingent on future events (success of cases) cannot be recognised until it is highly probable there will not be a subsequent reversal. Therefore, revenue is generally recognised much later in the litigation lifecycle, and later than the fair value losses on the funding debt are recognised.

Overall, this recognition of liabilities with much later recognition of revenue can result in the law firm’s accounts presenting a  distorted picture until the outcome of cases is determined.