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Easing litigation’s accounting impact with outside finance

October 23, 2019

Corporate balance sheets rarely face as much scrutiny as they do during tax season. Nevertheless, among companies involved in pending legal matters, the accounting treatment of litigation is often overlooked—and companies may be losing value as a result.

Litigation claims are not popular in the world of corporate accounting. Without external financing, litigation can permanently impair financial performance because of accounting rules regarding the treatment of litigation expenses and awards. Legal costs are immediately recorded as expenses, which means they hit company profits, often in substantial and long-lasting ways. Worse, large recoveries are often recorded “below the line” as non-recurring items. Thus, the accounting impact of pursuing a successful claim can perversely be to reduce earnings and make the company look less profitable.

Companies with pending litigation thus face a dilemma. In the past, companies had to choose between either bearing the cost of the matter (both in terms of paying mounting legal costs now, and dealing with the impact on earnings later), or else not pursue the claim at all. But increasing numbers of companies are turning to a third option: Litigation finance.

Litigation finance generally refers to using the asset value of a litigation claim as the basis for a financing transaction. Companies may secure financing for single matters or portfolios or groups of claims. External financing moves the costs associated with paying for litigation off balance sheets, which removes the hit to corporate profits—and represents both a powerful financing tool as well as a desirable tax planning opportunity.

As the saying goes, taxes may be one of life’s certainties, but litigation is far from it: Everything from how long a matter will take to resolve to how much it will cost is up in the air. Litigation finance helps manage the impact of litigation on balance sheets and risk profiles, which can be hugely powerful for publicly traded companies concerned with the negative impact of litigation on earnings before income taxes.