With the recent demise of Manches, we examine the auditors and the complex task of determining a firm’s health
Who audits the UK 200? For the first time The Lawyer has answered that question, offering a glimpse into one of the most competitive and potentially fraught professional services sectors out there.
And a timely glimpse it is too. While auditors have rarely been painted with liberal use of the exciting brush, the demise of Manches last month has highlighted the current challenges they face when assessing the robustness of firms across the UK market.
“Auditors look at businesses as going concerns,” outlines Nexia Smith & Williamson’s head of professional practices Giles Murphy. “They assess the ability of a business to function for the following 12 months. And what the last year or two has shown in spades is that the partnership model is fragile.”
We wanted to shine a light not only on the market share of the leading auditors and their role in assessing the current health of the UK legal market, but also the peculiarities of auditing law firms, a growing number of which are facing potentially life-threatening difficulties.
The Lawyer examined the accounts for all of the 162 firms in this year’s UK 200 that have LLP accounts available. All of these are therefore statutorily required to file year-end accounts and submit their finances to the pinpoint gaze of an auditor.
The LLPs show who audits the top 200 and also who does not. Merely undertaking this exercise threw up some interesting findings.
The most obvious is the extent to which Deloitte dominates the top end of the UK 200. While the largest firm in the UK 200 – DLA Piper – is audited by PwC (the auditor tends to dominate the US legal market along with Ernst & Young), 20 of the UK top 30 are clients of Deloitte.
In contrast, PwC has a total of just four, with the remainder of the top 30 audited by Nexia Smith & Williamson (two), BDO (one), Grant Thornton (one) and Baker Tilly (one). Mathematicians will spot that this makes a total of 29 firms – Slaughter and May is the sole non-LLP in the top 30 and does not file accounts at Companies House. It is understood to have a relationship with top 20 firm Kingston Smith but would not confirm whether it was audited by the firm.
In total, Deloitte has 40 clients in this year’s UK 200, 26 ahead of BDO in second place. And 36 of those 40 are in this year’s top 100. Deloitte also has a stranglehold on the UK magic circle, with Allen & Overy being the sole PwC client (its other two in the top 30 are Eversheds and Simmons & Simmons).
In short, Deloitte owns the top end of the UK legal market. (See Deloittes’ Dominance, below.)
Once outside the top 30 it becomes a different story. A scattergun smattering of 47 accountancy firms in total audited this year’s top 200. Of those, 32 had just a single client including Ernst & Young and its sole audit client, Newcastle’s £11m Watson Burton.
There is no place for either KPMG or Ernst & Young in the upper reaches of this year’s table, with the former’s highest-ranked client coming in at 34 (Parabis) and the latter having no clients in the top 100 at all, with only Watson Burton in 168th place turning to it for auditing services.
While auditing law firms as limited liability (rather than general) partnerships is still a relatively recent task for the UK’s leading audit shops, with the number of firms that have converted to LLP status having mushroomed over the past decade the most pertinent challenge for auditors is the growing number of legal practice failures.
“Auditors need to opine on whether the law firm will be solvent for 12 months from the date of the accounts being approved,” says Murphy. “This has always been the case, but pre-recession this was perhaps more of a theoretical risk, whereas now the regular announcements of law firm failures have put this firmly in focus.”
One issue here from an audit point of view is that of whether or not firms are good at retaining cash for a rainy day. Typically, in many firms, if there is any spare cash in the business, partners tend to want it for themselves.
“And the problem the auditors face is how do they trust the partners and believe what they’re being told?” adds Murphy. “It often comes down to the strength and quality of the relationships.”
Most law firms are ‘thinly capitalised’ in that they operate a full distribution policy, meaning they pay out ‘spare’ cash balances to partners as soon as is reasonably practical. It means that if the business activity takes a turn for the worse, there is very little for the firm to fall back on.
As Murphy points out, one big peculiarity is that auditors are reporting to partners, people who work in the business but also own it. Auditors need to bear in mind that there may be conflict of interests.
The business might be running out of money and the partners say ‘cut drawings’, but in reality, will they? What’s good for the business could be bad for them personally.
“What worries me is when the management is not brave enough to deal with the partners and insist on taking a step like cutting drawings when it’s obvious the firm is not earning as much as it did the previous year,” says BDO’s head of professional services (tax) Colin Ives. “Sometimes partners need to take a haircut. The trouble with monthly drawings is that this is the benchmark for partners’ standard of living and that’s going to have to change.”
Ives says there are currently fewer firms facing this issue because there is a bit of a “feel good factor” across much of the sector right now, with activity levels and half-year revenues generally up, but over the years there has certainly been a number of firms where a cut in partner drawings has been, or should have been, on the table.
“US firms are typically very good at [enforcing] it because they account on a cash basis and drawings reflect this,” adds Ives. “If there’s no cash, there are no or reduced draws. In one firm I know, the month the firm threatened a partner drawings cut the partners ensured it was the highest month in terms of bills collections they’d ever had. These are the behaviours you have to influence as a law firm manager.”
Auditing the auditors
So what exactly does an auditor, when casting his or her eyes over a law firm’s finances, do? Or to flip that, when faced with a firm that bears the hallmarks of a potential collapse, as was certainly the case with Manches and others before it (Halliwells, Cobbetts or Challinors, for example), what is an auditor not required to do?
At year-end the question is, is it a going concern? It’s not the role of the auditor to speculate on what might or might not happen in the longer term.
“You’re looking for an auditor view of a going concern at a particular time, not an auditor comment on a firm’s ongoing prospects,” says Ives. “It can become quite difficult. It’s only when there is a crystallising event [such as a large group of partners leaving or the decision of a firm to shut up shop] that you find WIP [work in progress] is difficult to bill or debtors difficult to collect.”
The growing number of firms converting to LLP status has added another aspect to the position in that the ring-fencing of liabilities has made firms more prone to collapse while at the same time providing a degree of comfort for partners.
“In the early 1990s if you had a firm in difficulties and the partners started leaving, the managing partner would have said ‘you do realise you’ve just put my own and your house in the bankruptcy court’? The partners would all have an interest in finding a solution such as a merger,” recalls Ives. “In an LLP everyone has the ability to walk away, they just have to accept that whatever money they had in the business has been lost and understand the potential for claw-back of drawings for the last two years.”
So you might lose, say, £250,000 but as a partner you’re not going to go bankrupt and you can continue to be a solicitor earning a good income.
“These days it’s easier to walk away and that’s why you’re seeing more spectacular law firm crashes,” adds Ives.
So, precisely, what does an auditor do when they assess the chances of a law firm making it through another year?
“Law firms are different from corporates because they’re selling time and experience, not the cost of manufacturing and selling on,” says Baker Tilly’s head of London and south professional practices Rowan Williams. “So, as an auditor, it’s much more of a subjective thing. But it’s very similar to the accounting profession, so it should be something we understand well. Interestingly, it doesn’t always seem to be.”
Firms are free to appoint anyone who has an audit licence to do the job. “And it can catch them out,” adds Williams, “as there is a whole different set of legislation and governance. For example, there are rules around revenue recognition – what you can recognise and shouldn’t. If a firm is working on something with a conditional fee agreement, for example, there might be a lot of time on the clock but you won’t know the final outcome until there is some event. There is no right or wrong answer, but you can get it very wrong if you allow a firm to recognise revenue that it shouldn’t. I’m not aware that this has actually happened but we’re consulted a lot about what should and shouldn’t be recognised.”
BDO’s Ives agrees with Williams that the complexities of recognising revenue depend on the type of work a firm is doing.
“WIP is normally calculated by the time charged by the lawyers on their time sheets,” says Ives. “So if you’ve put down 10 hours in the last week of the year but you haven’t billed it yet, the accounting rules say you need to recognise this at the lower of cost or net realisable value. This is governed by the generally accepted accounting rules (GAAP). Discounts may apply in some situations and cost will be less than the normal charge rate. In most cases it is pretty reliable guidance.
“It becomes more complex if there are CFAs (conditional fee agreements) involved because there is no guarantee of the firm getting the contingent element of the fee and therefore it is normally booked as zero. If your firm is handling, for example, a high volume of road traffic claims there will be an expectation of some value coming in and some element of value should be attached to the incomplete work. The auditor has to be satisfied that applying GAAP any income recognised is not overstated but a fair reflection of what will be realised. But there is obviously scope for some variations of what that figure should be. The auditor will need to consider what is the right methodology of recognising the income on a consistent basis.”
Another accountant comments that it is possible a firm may tell the auditor that it needs the right result. This might mean talking the value down or could mean talking it up; that is fine as long as the auditor is satisfied that it complies with GAAP. “There is certainly scope for pressure on the auditors. The bigger firms will say that’ll never happen but smaller firms might acknowledge that it does.”
Finance fit for purpose
Often this is where the quality – and occasionally lack of quality – of the finance function within firms comes in. Certainly it can be challenging for those working in the finance team. Have they got sufficient voice within the practice? How much is the debt book value being challenged? Do they have a seat on the board?
Firms often get into trouble when they have finance professionals who can’t stand up to dominant partners. Warning signs include frequent changes of finance director.
“That could be someone trying to change things and not succeeding or someone who’s just not good enough,” says Ives.
Another big challenge for the financial function within a law firm is how quickly they can get partners to turn activity (chargeable time) into cash.
“The longer this period, the bigger the strain on the firm’s finances,” says Murphy. “Ultimately, it may be the case that a significant element of this activity will not be recoverable (which sometimes only becomes apparent when under scrutiny from the auditor).”
Unlike a corporate, a law firm is a collective, a collaboration of professionals where, in theory at least, there is less of a hierarchy. Certainly in the UK 200 when you get down to the lower levels of say 100 to 200 there is generally still more of a collaborative approach.
“That can make it slower and occasionally character building [for the auditor],” says Williams. “Lawyers are trained to have their opinion and they very much like to give it.”
That said, the auditors The Lawyer spoke to say that the end product generally at law firms is improving considerably.
“Over the past couple of years firms have increasingly been bringing in skilled people, recognising that they’re very important,” says Williams. “Previously, because they weren’t fee-earners they were less well regarded. Firms are now hiring the right people with the right skills.”
Ives agrees with Williams on this, adding, “often firms become too big for their legacy finance teams because they have expanded too quickly; it’s no longer fit for purpose. But we’re now starting to see better quality people in more of the legal firms.”
Another factor is that when firms are going through a recession they tend to look much closer at what they’re spending.
“You want to keep fees as low as possible and one way to do that is to have the right people on board. The option of borrowing more money from the banks is not there,” adds Williams. “So law firm management is becoming far more reliant on good information and people internally.”
The auditor will need to talk to the partners in various departments to build up a picture of current and future revenue.
“You can’t just take the opinion of one partner,” continues Williams. “And the thing about law firms is that they are rarely just one business, it’s a collection of businesses – things like employment, personal injury and corporate – and they’re all very different. If you’re going to do an effective audit you’ll need to get under the skin of that. And you need to trust and understand that.
“If you look at the way partners are remunerated it’s often based on the performance of their team and themselves, so they won’t want to tell you their work is valueless. It’s not necessarily an attempt by them to pull the wool over your eyes, but as an auditor that’s where your commercial judgement comes in.”
The cost to law firms of doing an annual audit, which is generally measured in hundreds of thousands of pounds for a large firm, is very much a ‘piece of string’ question.
“It depends on time and complexity of what’s involved,” says Williams. “Law firms vary so much in size, and the fee often also depends on the quality of information provided for audit. If a firm provides really good audit evidence and financials with draft statutory accounts, and full back information for all of the items in those accounts, plus good models for how they value revenue and WIP, and really well thought-out 12 months’ financial forecasts to establish good working capital, then the audit process could be a lot cheaper for a large firm than for a smaller firm that doesn’t or can’t provide all of this data.”
There are other challenges facing those auditors that specifically target law firms and which can add a few noughts to the final bill.
“The legal services market is going through a period of change unprecedented in recent times,” says Deloitte professional services practice partner Jeremy Black. “Firms are becoming increasingly complex organisations, both as a result of expansion in the UK and internationally and through changes in the way they deliver legal services.
“These changes increase the complexity of their businesses and the inherent risks. From an audit perspective, it is becoming increasingly important to be able to service firms in a wide range of local markets across the globe.”
Where a firm is operating from a number of jurisdictions, the audit can become more complex. In order to ensure sufficient coverage, it may well be necessary for work to be performed in the overseas jurisdictions.
“Depending on the international structure there can also be local tax or reporting requirements, with reports needing to be signed off by locally qualified accountants,” adds Black.
These factors can add significantly to the costs of audits, which typically are based on the amount of time required to perform the work.
“The time is dependent on a number of factors that include the size of the firm, the firm’s structure and its geographical spread,” says Black. “Local reporting or other regulatory requirements are also a significant driver.”
What this all adds up to is a complex process coupled with a relationship between a law firm and its auditor that is one of huge trust.
“The audit firm will obtain insight into the detailed inner workings of the law firm,” confirms Murphy. “Using this knowledge and their sector expertise, a good audit firm is well placed to act as the trusted adviser to the management and partners of the firm.”
In times like these, that is worth it’s weight in gold.
Hammonds’ two-partner auditor
Back in 2004 and 2005, legacy Hammonds was regularly making The Lawyer’s front page for all the wrong reasons. New managing partner Peter Crossley was facing an uphill struggle to wrestle the firm’s finances into shape, with partner drawings slashed after a prediction that profits would slide by 25 per cent and a fee write-off of £1.6m.
Amid the flow of stories about partners leaving the firm, one article stands out. In February 2005, we reported that a tender of service providers had resulted in the termination of a decades-long relationship between Hammonds and its auditors, two-partner Bradford firm Fletcher Greenwood & Co.
Instead of Fletcher Greenwood, the firm turned to Pricewater-houseCoopers (PwC). PwC are still retained by Squire Sanders’ UK LLP, the successor practice
to Hammonds following the 2008 merger between the two firms.
Hammonds was at the time an international outfit with turnover of £130m – a figure matched in 2011/12 by Squire Sanders in the UK – which would still put it squarely in the UK’s top 25 firms. As we report today, this is a market dominated by Deloitte and other major accountancy firms, with the resource to dig into the complex accounts of global LLPs.
Crossley told The Lawyer back in 2005 that the firm had decided it needed more “focused help”. A review of past accounts by PwC unearthed a revenue shortfall of £8m for the 2003/04 financial year, to be recouped from future profits – which, coming on top of a call for the repayment of overdrawings for the 2004/05 year, led to a dispute with several former partners which lasted until 2009.
The decision to dump Fletcher Greenwood was one of several vital decisions made by Crossley in the first years of his tenure at Hammonds, which ultimately led to the firm being in a position to merge with Squire Sanders & Dempsey in January 2011.
And Fletcher Greenwood? Well, the firm is still going, but it has no UK 200 law firms on its books these days.
Why does Deloitte dominate the UK legal audit market? The story stretches back to the mists of the 1970s and 1980s, when the accountancy firm of Spicer & Oppenheim dominated the legal market in a similar fashion to the way Deloitte does now. That was until 1 August 1990, when it merged with Touche Ross & Co, itself later acquired by Deloitte. At that point, Deloitte nabbed itself a huge chunk of the UK law firm audit market.
“Deloitte has also not been shy about introducing some of its partners to law firms as potential in-house talent, locking in these clients by sending them one of their own,” says one rival. “It’s a challenge for us, so we have to work on those relationships. That means if we hear people are moving, we work on them to move to us. But we recognise they’ll always likely be loyal to their former home.”
And why is Ernst & Young so absent?
“They used to have more but they lost some of their market share,” claims the source. “They keep making attempts to get into the market but it’s a very, very small world advising professional services firms and maybe £250,000 for an audit isn’t much for them? Deloitte has obviously got a dominant position. KPMG and E&Y have a focus on it, and they look at it at times, but you’ve really got to understand the market and they just don’t.”
Clearly, Deloitte does.