Revealing the bottom line

Although there are law firms that are changing the type of relationship they have with their auditor and are taking a more business-minded approach to their practices, many auditors believe this is not true across the whole community. Even those which are introducing changes could perhaps do more to meet the challenges posed by an increasingly financially-pressured legal market.

The very term 'audit' is misleading because of the special rules applying to law firms. There is no requirement in accordance with statute or under the Solicitors Accounting Rules for law firms to produce what most large companies would recognise as an audit.

Alistair Rose is a business assurance partner at Coopers & Lybrand and has over five years' experience of auditing law firms of all sizes. “Most law firms opt for limited financial review, where we look for major variances and reasonableness, because of this lack of requirement,” he says. “There are some who have what I would call a caveated audit, which is like an audit but with some major exclusions, including work in progress, which can in itself present a knotty problem. Those who may seek to incorporate will require a full audit.”

In the last three years Rose has seen a shift in law firms' attitude to their audit. He thinks that awareness of a competitive legal market and the concern with financial management and cash controls is largely a function of the recession.

“Law firms are recognising that they are businesses like any other, and although the structure may be different they are subject to the same pressures,” he says. “They are not the cosy old partnerships any more and they have to accept the realities of the harsh world.”

He continues by highlighting the forces that have brought the need for change: “Clients have a much more businesslike approach to the services they are being offered by lawyers, which means much more pressure on fees.”

The solution, says Rose, is to maximise the assistance and input that law firms receive from their professional service providers. This may go beyond the scope of a traditional law firm audit: “The message we have been giving for the last couple of years is that firms need to exercise discipline in areas like financial control and they need to tackle issues like manpower and and new technology. The successful firms are already doing this but there is a need to generate cash to invest. Small-to-mid-sized firms can get trapped in a circle where they cannot invest the cash to become more businesslike.”

An added pressure for fuller audits comes from banks and other lenders. “They want accounts to be made clearer and they generally want to know more,” warns Rose, ” especially in the light of several well-documented cases of partnerships suffering serious cash-flow problems, which have made them much warier of the risks of lending to law firms.”

One senior partner at an accountancy firm with close links to the legal market echoes many of these concerns. “A fundamental point that needs to be made clear is that most law firms are not audited. My view is that they should be. In general, law firms do not use accountants as much as they should do, and without independent opinions and annual reports, financial disciplines are not generally good.

“Some firms are run on strict commercial lines – this would include the top 10 – whose reputations attract a lot of work. It is the mid-ranking firms that can be squeezed by the competition from larger firms and niche players.

“There has been an evolution in the legal market. A personal example is that conveyancing fees are cheaper now than 15 years ago, when there was a standard fee which one would not dream of questioning.”

He feels that law firms have not met the challenge of these fundamental changes: “Generally accepted accounting standards are not in place within law firms – the exclusion of work in progress is an anachronism which can distort the reported value of the firm and can make economic judgement of a firm's position difficult.

“For firms that find they are in a precarious financial position, there can be two to three years' warning of a drop in reported profits. Firms need to involve their accountants more at a much earlier stage; even when faced with a dangerous financial problem, some firms will try to soldier on.”

Rose feels that the introduction of self-assessment may in one way increase the involvement of accountants in law firms. “There is potentially more work for accountants because it will introduce a need for increased discipline,” he says, “which will mean looking more to the professional service providers.”

But he acknowledges that in other areas some firms may not welcome the increased need for business-like disciplines. “It can be more difficult to impose these types of dictates upon a partnership structure,” he says, although qualifying this by pointing out that larger firms may find it easier.

He also makes a link with the size of firm and the use of a Big Six auditor: “The top 10 focus more on the Big Six, but there is a much wider spread of accountancy firms in the top 100 firms as compared with the the FTSE 100 firms, which again are very focused on the Big Six. This will change, though, as firms get bigger and look for more specialism and a greater understanding of the legal sector.”

This still leaves a number of law firms which could extract a lot more value from their accountants. “As they get bigger, law firms do expect more from their service providers, but there is still a reluctance to change in certain quarters.”

This reluctance to face a changing market environment is perhaps best summed up by the experience of an auditor from one of the Big Six firms. He has gone into and audited a number of top 50 law firms for the past two years and found the prevailing attitudes very different to those he experienced elsewhere. “The partners tend to be much more dismissive and less helpful than those in commercial business,” he says.

“They view us as a nuisance and even a waste of time. In many instances the finance department is chasing partners for billing, unpaid bills and timesheets, but they cannot chase too heavily because they are dealing with partners.

“I think the worst example was that of a partner who had not handed in his timesheets for over three months. That simply wouldn't happen in business.”