13 July 2022 Mini Series: The Business of Law Firms - Profit

Mini Series: The Business of Law Firms - Profit​

Overview

This article is the third in a series on the Business of Law Firms.

Last time, we considered why profit might be calculated in different ways and then looked at two measures of profit: operating profit and profit before taxes and partner remuneration.

Today, we will look at the third way law firms measure profit: profit before tax with partners’ remuneration charged as an expense.

Accounts: Measuring Profit

Continuing with Clifford Chance’s accounts, we have copied its most recent consolidated income statement below.


This rather long-winded description is essentially revenue brought in after:

• all core expenses (operating costs) are accounted for;
• all non-core expenses (net finance costs) are accounted for; and
• money paid to partners classified as an expense is accounted for.

We looked at the relevance of the first two adjustments in the last article of the series. The question now is two-fold:

1. what is partners’ remuneration charged as an expense; and
2. why is it relevant?

As always, our first port of call should be to look at the notes in the accounts. Note 9 (p 32) states that of the £30m listed as expenses, £11m went to partners that do not share in the profits and £13m is a “charge” for annuities paid to partners.

To the uninitiated, this description is not particularly illuminating.

Starting with the £11m figure: the traditional law firm model was one where all new partners would have to “buy-in” to the partnership by contributing a large sum of cash. In exchange, they would be entitled to a share of the profits because they were “equity partners”. However, most large firms now have a two-tier system, with more junior partners having no equity rights in the partnership. Instead, they are paid a fixed salary and may be entitled to an additional bonus. Importantly, they do not have any rights to share in the profits (nor are they liable for the firm’s losses).

Clifford Chance’s accounts do not give us any more information because information on partner compensation structures is highly confidential. However, we may assume that much of that £11m has gone to junior, non-equity partner compensation.

The £19m charge for annuities is a different kind of expense.

Annuities in general refer to contractual agreements made between one party (the law firm) to another party (a firm partner) where a partner pays the firm a lump-sum payment upfront, which is then paid back to the partner over time (at a premium). Annuities are commonly used to pay back retired partners their share of the equity. But they are also used to structure large contentious settlements, such as if Clifford Chance was owed £100m in legal fees following the winning of a large lawsuit.

But why is this given its own separate accounting treatment?

The simple answer is that — while technically this money comes from the firm’s profits (all other expenses having been accounted for) and it is money paid to partners — from a tax perspective, the firm is entitled to treat it as an expense. This means that the firm can write this figure off its bottom-line profits and reduce its overall tax burden.

Additionally, it can provide limited insight into the partner compensation structures used by different law firms.

Finally, we should note that other law firms may list this figure after taxed profits but before bottom-line profit.