Why are CFOs so often allergic to lawyers in general and litigators in particular?
Some of the reasons are obvious—among them, the high cost of litigation and its inherent lack of predictability. Another is less obvious but, arguably, more important—and that is how legal fees and litigation claims are treated as an accounting and financial statement matter.
When a company is owed money by someone, that almost always creates a balance sheet asset—a “receivable.” Money spent to collect that receivable is often added to its asset value, or “capitalized,” rather than flowing through the P&L and reducing profits. This makes sense for receivables, and many assets work similarly. If I have a clever idea for a new business, the money I spend pursuing it will also be capitalized. Instead of hitting the P&L, it will create an asset on the balance sheet.
Sadly, for reasons understood only by green eye-shaded members of the accounting profession, litigation does not follow these rules. Indeed, litigation claims receive precisely the opposite accounting treatment.
To start, as a company pursues a litigation claim, the money it spends doing so is not capitalized. Rather, it is immediately expensed, flowing through the P&L and reducing operating profits. Moreover, those expenses just vanish into thin air, as opposed to creating a balance sheet asset. Indeed, a pending litigation claim—despite having legal status as an asset, or a “chose in action”—is affirmatively not an asset for accounting purposes. It is found nowhere on financial statements or even in the notes.
To add insult to injury, when a significant litigation claim succeeds, the associated income from the claim is often not treated as operating income on the P&L. Instead, it’s put “below the line” as a non-operating or one-off item because, in the accountants’ view, litigating claims is not the core business of the company.
This is bad on many levels.
Obviously, companies want to maximize their profits and minimize their expenses. Being hit with expenses as a litigation matter proceeds and then not later recognizing the income from the win is about as far away from corporate happiness as it is possible to be.
Moreover, investors and stock market analysts are by nature superficial. They must be, in order to cover multiple complex companies. They want to look at the balance sheet and see the company’s assets. When an asset isn’t there, they don’t credit it. Litigation claims don’t show up on the balance sheet, so they are not credited by the market for their potential value. This accounting result makes no sense—companies show receivables on the balance sheet even when their collection is highly uncertain and deeply risky. Litigation claims are just the same, but the accounting rules make them invisible. That hurts companies with large, high quality claims.
Not only does a company fail to create a litigation asset when it brings a claim, when it pays for lawyers directly it actually reduces its total asset value because the cash paid to the lawyers flows out of the cash account on the balance sheet… into oblivion.
Litigation finance helps companies manage the adverse accounting impact of bringing litigation. Using litigation finance turns the accounting issues on their head:
- When a litigation financier pays the costs of proceeding, those costs do not flow through the company’s P&L, preserving the company’s profitability from its operations
- Working with an outside funder also enables the company to husband its cash to use for other purposes—and to avoid it flowing out of the company’s coffers and thus reducing its asset value
- When the company wins its claim, the very first time its financial statements are impacted by being a litigant is when it has a positive cash and income event
Needless to say, this yields a far happier accounting outcome for companies.
CFOs may remain dubious of lawyers in general and litigators in particular, but litigation finance provides a tool that can solve the otherwise intractable accounting woes of spending on litigation.