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28 August 2003
First, an apology. This piece really should have been written a long time ago. Years of reporting law firms' revenues and profits have generated at least anecdotal evidence that there is an element of tinkering around the edges when it comes to reporting results. In the cases of Norton Rose and Finers Stephens Innocent, both of which have in the past admitted to overstating revenues, it is more than anecdotal.
But with so many firms now converting to limited-liability partnership (LLP) status and the concomitant requirement for publicly disclosed and audited accounts, the level of freedom that firms have with reporting their figures is decreasing all the time.
As Giles Pugh of Professional Services Consulting (PSC) puts it: "No firm will want to report numbers that, when the accounts are published at Companies House, are shown to be wrong."
That said, the number of firms caught out overstating their results is dwarfed by the number of those suspected of manipulating their figures over the years. And, the firms may argue, why not? There is absolutely no legal imperative for a non-LLP law firm to either report its figures at all or to prepare its accounts in an industry standard, uniform way.
Consultant Alan Hodgart says: "A firm's management accounts don't have to match its tax accounts. It's an internal document, not an externally regulated one."
In the past few years there has been what amounts to a competition among firms to see which of them can go public with the most outlandish increase in average profit per equity partner (PEP).
Shoosmiths sent shockwaves through the market in 2005 when it reported a 47 per cent rise in PEP. This year it is Pinsent Masons that has seized the crown, reporting a staggering 70 per cent increase in PEP to £400,000, although a stream of other firms - Lewis Silkin (40 per cent), Stephenson Harwood (45 per cent), Cripps Harries Hall (50 per cent) - have reported market-busting PEP increases.
The legal press is, at least to some extent, culpable in this game. Every year the race to report results gets more fierce, encouraging firms to release figures. The early profit figures that now tend to emerge in May are estimates. They have to be: it is simply not possible for a firm to know precisely what the distributable profit will be so soon after the year-end.
For example, a firm may have good information on its overhead costs but will not have finalised its work in progress valuation. As Pinsent Masons managing partner David Ryan says: "Two weeks after year-end, no firm will have finalised accounts. Our reported results were a calculated estimate based on the information we had at the time from the firm's monthly management account. We prepare our year-end accounts to plc standards and I'm confident that the final PEP figure will be £400,000."
But the problem with this is that, once the figures have been published, they tend to stick. If a firm is not obliged to report accurate figures, it is unlikely to go public with a lower figure once it has made the headlines for having had a good year.
So what are the most common ways of making yourself look better than you are? The simplest is the technique increasingly seen at firms across the UK: shrink the number of equity partners sharing in the pot - the fewer there are, the better the PEP.
"Whenever equity partners leave the partnership, promote associates to salaried partner level," says management consultant Tony Williams of Jomati. "That reduces the number of equity partners and tightens the equity."
"It can add another £20,000 or £25,000 per partner, as the partners that leave tend to be at the top end of the equity, so proportionately there's a lot more going into the pot for fewer partners," adds Williams.
But reducing the number of equity partners is not an accounting manipulation as such - it is a structural fact. For more creative examples of how firms can make their figures look better, or in some cases worse, it is necessary to dig deeper.
All firms will have provisions in their accounts for a variety of contingencies. Property-related costs are among the biggest. A firm might receive money from its landlord to give up a break clause, or it could be offered a rent-free period by its landlord. If the market is going well, a firm might take the view that it does not need the slush fund.
Instead of averaging out the cash over the period, the firm could take the saved money and give it to the partners. It might be unfair on other generations of partners and it would have a major distorting effect on the PEP, but legally there is nothing to stop a firm from doing it.
Changing the provisioning policy on unbillable disbursements and bad debts also provides scope to change PEP. This includes photocopying and other administration-related jobs, but also travel, an increasingly large cost for globalising law firms.
Another area of judgement is determining what expenditure should be capitalised or treated as a revenue item. Capitalising a major purchase can be a good way to smooth out profit over a period of years. If a firm buys a new IT system, for example, rather than bring it into the accounts in one year, it could depreciate it over several years, and so reduce the hit on profit in the first year.
Then there is headcount. When calculating profit per partner, the denominator could be the average or year-end number of partners, it might be calculated on a full-time equivalent basis, or adjustments may be made for partners who operate in other jurisdictions.
And this year there will also be the FRS5 uplift, although some firms will already have brought it in. The impact on PEP here can be huge. According to one consultant, there is a firm in the bottom half of the top 100 where its profit on paper will be 25 per cent higher this year, simply because of the FRS5 adjustment.
A word of warning: the ability to manipulate results goes both ways. "Some firms may say their figures are looking too good so they put in provisions," says Smith & Williamson director Colin Ives. "It could be a firm where the profits vary a lot. They might put in provisions to smooth out the good and bad years."
In other words, be sceptical.
Top tips for making your figures look better or worse