On average, the dollar has demonstrated significant weakness against the pound over the past three years. Comparing the spot rate in December 2005 to December 2006, the exchange rate declined by 14%. Not surprisingly, and particularly for US law firms with operations in the UK, these changes have presented significant operational challenges and some perception management challenges, especially when reporting results to legal publications in the UK and Europe.

Managing the operational challenge posed by sharply changing exchange rates is straightforward. Firms such as Covington & Burling purchase hedging instruments from financial institutions to minimise the exchange rate risks to the firm. If firms do not avail themselves of these types of financial products, they then absorb the full impact of the swings in exchange rates and the full impact of the affect of currency volatility on profits.

The most typical instrument for managing exchange rate risks is a forward foreign exchange contract (FXC). An FXC is a financial instrument which enables a wide range of institutions, including law firms, to arrange the future settlement of a foreign exchange (FX) transaction with a bank.

The contract results in the future purchase or sale of a foreign currency at a rate agreed today. Law firms generally employ these types of contracts in maturities of up to one year.

In an ideal world, pound sterling expenses would be completely covered by the firm's pound sterling revenues. In that case, the rapid changes in the dollar/pound exchange rate would not matter.

In the real world, this is seldom the case. For many US firms' London operations, hedging using FX instruments is a type of insurance policy. It provides a level of certainty as it manages the effect of the potential difference between the expenses incurred in pound sterling, such as rent, staff salaries and other London operating expenses, and the fee revenue received in both dollars and pounds.

The Law Firm Group at Citigroup Private Bank has built a thorough understanding of the FX risks to which the legal profession is exposed, working with law firms to identify the risks, determine where they should reside and design and execute a tailored FX risk strategy for a firm.

For better or worse, most US firms report their results to UK legal publications, which convert those results into pounds. Managing the perception issues that arise when reporting US dollar-based results that will be converted with very different exchange rates year to year has proven somewhat more tricky.

There are two issues to consider. First, the profitability of almost all US firms is analysed in dollars regardless of where the offices are located. Partner drawings and profits are paid in US dollars and the majority of fees are collected in dollars. Logically and understandably, the contributions of non-US offices, are almost always measured and analysed in the base currency of the firm.

To understand the year-over-year performance of the UK office of a firm that manages itself based on dollar revenues and profits, it is probably most useful to perform that analysis in US dollars. This approach will yield a more accurate analysis of the performance and contribution of the UK office of a US firm.

It is also worth noting that sometimes significant distortions occur when using spot rates. For example, the difference between using a spot rate in December and a spot rate in September of 2006 would have changed Covington's operating results by almost £1m – a 4% difference due only to the spot rate at a specific date.

There are benefits to using the dollar as the basis for the analysis of revenue growth, revenue per lawyer, profits per equity partner, and so on. The results will be more easily understood as well as more accurate.

Real changes in a firm's UK presence and impact will be easier to identify. By removing the issues created by currency fluctuation and 'spot' conversion, there will be an opportunity for legal publications and law firm managers to focus more on the impact of major client changes, new industries and practices, and lateral gains and losses.

John Waters is an executive director at Covington & Burling.