GAAP Accounting Gives Rise to Litigation Finance
Most firms do their best to avoid court and lawyers whenever possible. This is not an unreasonable attitude; after all lawyers and expert legal help are very expensive. This is even more true for major corporations, most of which spend a sizable amount every year on their legal department. This is the reality of the world we live in today; commercial disputes are part of the business environment and there is no way to avoid it, and litigation finance accounting plays an important role in that environment.
As such, organizations which perform best through adversity are those in which the financial executives and the Chief Financial Officer have learned to minimize the impact of litigation on an organization’s finances.
The first difficulty with litigation from an organization’s perspective is that its outcome is highly unpredictable. Additionally, it is also expensive, time consuming, requires internal and external resources, and demands substantial attention from a company’s management team. Finally, from the perspective of the financial department, litigation is almost a no-win scenario due to the accounting treatment required.
The unpredictable nature of litigation is such that it is very possible for a company to expend substantial time, resources, and effort from the company’s employees and still have an unexpected and very negative outcome. This situation is not unique as companies can see the same outcome when attempting to develop other physical or intellectual property. However, it is the accounting treatment which litigation receives that makes it so burdensome for companies.
A pending litigation claim with damages that a company has to spend resources to develop, could be considered an asset. However, unlike assets based on normal financial claims wherein the expenses required to develop them are capitalized and added to the value of the asset, legal expenses are taken direct from a company’s bottom line. This direct impact upon a company’s bottom line has the effect of immediately impacting a company’s perceived profitability. This problem is exacerbated by the fact that gains made from litigation are reported as non-operating income, and so are below the profit and loss line
This unfavorable accounting treatment leaves companies in a very difficult position when considering proposed legal claims. Even when a company has a valid legal claim against a party, pursuing that claim will lead to an immediate and ongoing decrease in the company’s net income. After an indeterminate amount of time, if the company is successful in pursuing litigation, and receives a judgment against the other party, they still have to collect that judgment. Then only if they are successful in that, do they see in increase in their non-operating income.
This leads to many companies foregoing the opportunity for litigation which might lead to recoveries and settling litigation wherein the company may bear little actual liability. Litigation finance can potentially solve these difficulties. Litigation financing allows companies to move the expenses of litigation off the balance sheet entirely while still pursuing legal action against parties who have caused the company injury. Further, since commercial litigation is generally provided on a non-recourse basis there is no risk that a loss in court will negatively impact the company.
It is seeking these types of opportunities which requires alternative thinking and take advantage of situation wherein costs are already expended and the only possible outcome is positive that separates average financial executive from the exceptional one.