Law firms using litigation funding – particularly non recourse and portfolio arrangements – face complex accounting challenges under UK and International Accounting Standards.

A litigating law firm’s revenue is generally structured on a no win no fee basis, resulting in revenue recognition being deferred until late in the litigation lifecycle when outcomes are more certain. Litigation funding received by law firms is typically significant and accounted for as debt rather than revenue. This means a law firm’s accounts can look poor on paper, even when the business itself is in a strong position.

Here, we look at the key accounting issues and explain how law firms should account for litigation funding.

What is litigation funding and how does it work for law firms?

Litigation funding was originally designed to support claimants who could not afford to fund legal action themselves. In early models, a funder would finance the claimant on a non-recourse basis, receiving a share of any settlement if the case were successful. The law firm typically received their fee out of the funding, under an agreement with the claimant and the funder.

As litigation has become more complex – particularly in group litigation (class actions or mass tort cases) – funding arrangements have evolved. Specialist litigation funders now operate in the market, entering into multi-million financing arrangements with law firms rather than individual claimants.

These arrangements often fund:

• Staff costs
• Disbursements
• Marketing activity to generate caseloads.

Claimants usually then enter into fee arrangements with the law firm on a ‘no win, no fee’ basis. The fees include costs for the litigators’ time and a percentage of the awarded damages payable to the client, so that the claimant can litigate without personal financial risk.

Returns on the litigation funding are typically linked to the net proceeds received by the law firm when litigation is successfully resolved. The funding is often on a non-recourse basis where repayment is only required if the litigation is successful.

How should law firms account for non-recourse litigation funding?

Some law firms may view their non-recourse funding as commercially and economically similar to arrangements where funding is provided directly to the claimant. This can lead to incorrect accounting, where law firms recognise funding received as revenue over time as legal services are delivered, and account for payments to funders as an expense in profit and loss upon successful resolutions of litigations.

This approach isn’t appropriate under UK and International Accounting Standards.

Why is litigation funding treated as a financial liability?

The key accounting judgement is whether the litigation funder is a customer or a lender. In most arrangements:

• The claimant is the law firm’s customer.
• The funder is the lender.

Where the funder is a lender and not a customer, the funding cannot be accounted for as revenue. Instead, the funding is accounted for as a financial liability (debt). This reflects the underlying contractual arrangement and the substance, being the provision of financing rather than an executory contract for the provision of any goods or services.

If funding is non-recourse, such that repayment is contingent on the future success of litigation, it is still considered a financial liability under UK and International Accounting Standards. Because the parties enter the financing arrangement on an arm’s length basis, the financial liability is normally recognised at the transaction price (the cash received), as adjusted for transaction costs if required.

As a result, funding received is credited to the balance sheet as a financial liability (debt).

How are litigation funding liabilities measured in practice?

After initial measurement of the financial liability (debt), the next key accounting judgement is how the debt should be measured subsequently.

Since returns are linked to litigation outcomes, the liability is usually measured subsequently at fair value. As the likelihood of a successful outcome increases, the fair value (and therefore the carrying value) of the liability may also increase over time.

Calculating the fair value of the debt can be very complex, typically requiring the law firm to:

• Forecast the timing and amount of future cash flows.
• Apply discount rates at each reporting date.
• Prepare probability-weighted expected outcomes for cases.

Why do litigation funding and ‘no win, no fee’ arrangements distort financial statements?

Under UK and International Accounting Standards, ‘no win, no fee’ arrangements are accounted for as variable consideration. Although the law firm renders its services over time, variable consideration cannot be recognised until it is highly probable that there will not ultimately be a significant reversal of the revenue.

The deferring of revenue recognition to late in the litigation lifecycle creates a timing mismatch whereby:

• Funding liabilities and costs are recognised early.
• Revenue is recognised much later.

As a result, a law firm’s financial statements can present a bleak picture that does not reflect the underlying commercial position of the business, especially for law firms engaged in group litigation and class actions.

How RSM can help law firms with accounting for litigation funding

RSM works with law firms involved in complex and funded litigation to support:

• Technical accounting analysis and advice
• Accounting policy decisions
• Valuation of non recourse funding
• Audit readiness.

Our specialists help firms navigate judgement heavy areas while ensuring compliance with UK and International Accounting Standards and transparent financial reporting.

For more information on accounting considerations for complex and funded litigation, please contact Andrew Baker.

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