Switching to limited liability partnership status confers different requirements on law firms. Steve Gale discusses important factors firms need to consider

When law firms first considered the move to limited liability partnership (LLP) status, one of the barriers cited was, somewhat euphemistically, 'disclosure'. In reality this was the disclosure of partners' remuneration. Other aspects of disclosure were either just accepted or, possibly, not contemplated at all.

One of those 'other aspects' is now coming to the fore i.e. the annual accounts may reveal uncertainty over whether the firm is a going concern. Not only that, but the disclosure may be out of the firm's control as the auditors have the potential to include it in their audit report.

So what can firms do to make sure that there is not a problem?

What is the going concern basis?

There is a presumption built into accounting standards and company law reporting, that statutory accounts should be prepared on the going concern basis, unless that basis is not appropriate.

Essentially, the going concern basis is that a firm will have sufficient resources available to enable it to meet its debts and obligations as they fall due for the foreseeable future. In the UK, the 'foreseeable future' means a period of at least 12 months from the date that the annual accounts are approved.

It is important to emphasise, therefore, that the going concern basis is not about profitability; it is about having sufficient cash.

Over the last six to 12 months the vast majority of law firms have seen a downturn in activity in one or more of their departments or business streams. Accordingly, firms have been taking well-publicised steps to ensure that their cost base is commensurate with activity levels.

As part of the process of preparing the annual LLP accounts, they will now need to ensure that they are considering adequately whether they will continue to have sufficient cash resources to enable them to continue as a going concern.

Why is this important to LLP members?

Under company law, as applied to LLPs, it is the duty of the members of the LLP to prepare annual financial statements and to approve them. For many firms, the responsibility for the preparation of the accounts will be delegated to a smaller group of members e.g. the management board, and even when it comes to the approval process, many firms will effectively have this power delegated, for example, to the equity members.

Accordingly, those members not involved in either process are trusting their fellow members to ensure that appropriate steps are taken which includes the consideration and assessment of the going concern basis.

Primarily, the members should be satisfied on two counts: firstly, that there are reasonable grounds for concluding that the firm is likely to avoid an insolvent liquidation for a period of at least 12 months from the date they approve the statutory accounts; and secondly, the statutory accounts contain adequate and appropriate disclosure where that conclusion is subject to significant uncertainties in the future.

It is that second aspect which may cause members most concern, as there is the fear that such disclosure could lead to a self-fulfilling prophecy.

The process that a firm will need to go through in arriving at their conclusions will depend on the individual circumstances facing the firm. Those with significant cash balances and a core of stable, recurring work will probably require less analysis than one with significant borrowings, little recurring work and exposure to sectors most badly hit by the current economic conditions.

What procedures should firms undertake?

Firms should discuss this issue with their auditors at an early stage. After all, the auditors will need to be satisfied with the approach that the members have taken in considering whether the going concern basis is appropriate. If they don't concur or they don't believe that disclosures in the accounts are adequate, then they will have little option but to make reference in their audit report to the uncertainty as to whether the firm is a going concern.

Notwithstanding those discussions, firms should consider preparing projections and forecasts for a period of at least 12 months from the expected date of approving the statutory accounts. Many firms will prepare forecast profit and loss accounts, but neglect to consider the likely timing of cash flows. This is essential, as some of the biggest effects on the cash position are caused by items that don't appear in the profit and loss account, e.g. partners' tax payments.

When preparing projections and forecasts, firms should make sure that the key assumptions and estimates that underpin them are considered, agreed and documented. Forecasts by their nature are uncertain; they should be 'stress-tested' by means of flexing the assumptions for sensitivity and probability.

It is also useful to consider some 'what if' scenarios. What would be the impact if the firm's biggest billing partner suddenly left? How significant is the firm's biggest client and what would the effect be if that client moved? What would need to happen if the firm could not obtain an increase in bank facilities?

For those firms with bank financing, there are other important issues to consider. For example, if facilities are due to expire within the projection period, what is the likelihood that they can be renewed at a sufficient level? Also, do the projections indicate that financial covenants in existing facilities will come under pressure or be breached? Either way, keeping an open dialogue with the bank and other providers of finance is important.

Ensuring that the firm is a going concern should not actually be limited to a once-a-year exercise for the statutory accounts. Members of an LLP are subject to the wrongful trading provisions of company and insolvency law in much the same manner as directors of limited companies; it should become part and parcel of the management and governance of the practice. If it is, then it should become less of an issue dealing with the auditors.

Steve Gale is an audit partner in the professional practices group at Horwath Clark Whitehill.