Topic: Issues in Revenue Recognition
Subject:Issues in contemporary accounting
Law is one of the few professions that are sponsored by a state with a historical expectation of addressing publics’ and clients’ interests first. The profession is also charged with fiduciary and accountancy duties. From that perspective, law firms were not viewed as organizations with prevailing commercial logics. However, times have kept changing with various law firms rebranding themselves with commercial outlooks. Instead of continued provision of safeguard services to the public, large firms in the corporate world are designed to fuel global capitalism activities. Different values and structures have therefore been promoted by the focus on financial performance with regards to revenues and profitability metrics. This has not only seen corporate firms grow in size but also pulling a rising number of shareholder societies and a profession where there is capitalization of everything (APESB, 2010).
This paper analyses one of such firms, Slater and Gordon law firm, which made headlines in various media publications after its float under the management of its CEO, Andrew Grech.
1. Slater and Gordon in the capital market
Slater and Gordon ceased from operating as a partnership and instead got incorporated in 2001. The firm’s internal business intention informed the move so as to coincide with national provisions that would facilitate its operation nationally. The company developed aggressive strategies to ensure its growth through increasing its working capital as well as expanding its capital funding. The strategy would best be supported through issuance of Initial Public Offering (IPO). Some of the advantages included the perception that IPOs would provide a higher valuation potential and offering shares would be enhanced especially when considering future mergers. In 2007, the company attracted immense interest on its 35 million shares it offered in the year 2007. Over- subscription of the IPO saw about 35 percent of the law firm under external shareholders ownership, with the rest of 65 percent under company’s employees’ ownership (Fyfe, 2016).
This law firm knew that investors were craving for growth in their fortunes and therefore it made sure that the investors’ thirst for earnings growth was taken care of by buying smaller law firms in the country. The currency to facilitate this was from the rising prices on the shares. When the stock market placed a high value on the firm’s shares, then Slater and Gordon would have the stock issued to absorb other small law firms which were of lesser value creating accretion of earnings. When Australia could not offer more firms for sale, the company entered the UK market purchasing seven law firms by 2007 (Taub & Sondhi, 2011).
Investment in the small law firms that Slater and Gordon purchased kept its shares performance at the pick in the stock market. The firm was also able to win investors from esteemed institutions who would take very huge stakes in the firm’s vision of having dominance in the UK market and having the personal injury law corporatized (Savage, Cerf, & Barra, 2013).
2. The falling of shares
Slater and Gordon law firm had done so well in its accretive acquisitions to raise investors’ earnings and increasing capital fund for acquisition of new firms without them generating income. However, the firm seems to have followed a route that only few had returned. In 2014, a major warning came after unraveling of a law roll-up of Quindell law firm in the UK stock market. Quindell’s downfall was signaled after it became clear that there were little chances of the firm winning the many cases they were dealing with. Their work would never turn in to cash since a client they represented would not pay if they never won a case. Slater and Gordon on the contrary saw an opportunity in the wounded Quindell rather than a warning. Just like it had done to other small law firms, Slater and Gordon decided to purchase Quindell’s division of professional services in an attempt to quench its thirst for expansion in the UK. The price tag under which Slater and Gordon firm purchased Quindell was way too much higher than their aggressive end(Fyfe, 2016).
Investors’ attention was also drawn by Bank of America Merrill Lynch’s report that contentiously questioned the price tag under which Slater and Gordon acquired Quindell. The report also made suggestions that law firm’s earnings in Australia were no longer rising. Shareholders’ attention was further intensified by intentions of the Australian Securities and Investment Commission (ASIC) in getting to the bottom of the matter. Despite the firm’s assurance to its shareholders and explanation on the merits of Quindell’s acquisition, the news that Quindell firm was going to be under investigation made investors in the Slater and Gordon firm get spooked triggering the firm’s stock to slide by 17 percent. The stock price later fell by 25 percent after ASIC questioned the firm’s accounting process (APESB, 2010).
VGI Partners later revealed that based on the red flags raised from accounting errors, the firm’s stock was being short. The claims that the firm was somehow buckling just to create assurance to the shareholders were added weight by the accounting errors that VGI Partners noticed in the firm’s practices (Rankin, 2012).
3. IAS 18 and IFRS 15
There are standards applied when accounting for revenue as well as dealing with customer contracts. IAS 18 address issues regarding revenue accounting while IFRS 15 deals with revenue involving customer contracts (Buschhüter & Striegel, 2011). Under IAS 18, the standards apply on revenues that arise from goods sold or services rendered and interests yielded from an entity’s assets. Revenue is recognized by IFSR 15 through five steps that include:
a. Identification of customers’ contracts- A contract in its definition is an agreement that is entered between parties but with enforceable obligations as well as rights. IFRS provides accounting requirements for such an account that is combined with a contract.
b. Identification of contract obligation with regards to performance- In the contract, there is inclusion of promises of services or goods transfer to customers. The promise becomes the performance obligation and should therefore be separately accounted for according to IFRS 15 if at all those services and goods are distinct in characteristics.
c. Determination of the price of transactions–This could be a fixed amount which the customer considers though it may have variable considerations to be paid in other forms instead of cash. The transaction price as provided by IFRS 15, require adjustments depending on effects of moneys’ value time effects if the transaction has a significant component of finance (Mazhambe, 2014).
d. Transaction price allocation to obligation with regards to performance- This should be done by an entity on a relative stand-alone basis when it comes to the selling prices of services and goods in the contract’s promise. In a situation where that particular selling price cannot be observed, an entity is required to estimate it.
e. Revenue recognition when performance obligation is delivered by an entity- When a customer receives the contract’s promise, he or she obtains control over the services or goods in the promise and that is when revenue is recognized by the entity in the contract. The revenue amount must be that which has been stipulated in the performance obligation. There are times when performance obligations are not met at a particular point in time but rather over time. In such a case, the contract’s entity will have its revenue recognized over time as well. An entity in such a contract is therefore required to come up with an appropriate progress measurement method for ensuring that performance obligation is completely satisfied(Buschhüter & Striegel, 2011).
Revenue recognition timing under IAS 18 from sales is primarily based on rewards and risks transfer while in IFRS 15, the focus is mainly on the moment goods and services under the contract are under customer’s control (Mazhambe, 2014). Both the IAS 18 and IFRS 15 standards offer guidance that is very detailed in revenue reporting, requiring entities to ensure that the standards are considered during assessment of accounting policies extent with regard to revenues (Buschhüter & Striegel, 2011).
4. Slater and Gordon law firm’s revenue treatment with regard to IFRS 15
Before recognition of revenue from a transaction by an entity, the flow of economic benefit to the entity must be probable. IFRS 15 standards result for revenue recognition where the contract’s portion of the set price is considerably at risk. Slater and Gordon law firm happened to overstate their work in progress and failed in turning the work into profit. Instead, the work in progress was recognized as revenue before the services had been delivered. Though IFRS 15 standards provide that revenue should be recognized by an entity at a point when performance has been satisfied, for situations where is to be recognized over time, then there must be establishment of appropriate progress measurement method for ensuring that performance obligation is completely satisfied (International Accounting Standards Board, & IFRS Foundation, 2016).
Slater and Gordon’s work in progress was marred with uncertainties of success since the firm could only get payments after their clients won the cases. For this reason, the firm adopted the IFRS 15 standards which would require recognition of work in progress as revenue only if it was certain that there would be no occurrence of revenue reversal of that which had already been recognized. The firm’s over reliance on the work in progress resulted to problems in cash flow since it had an obligation of carrying legal work costs as well as disbursements until the cases were completed. It was also unable to have the work in progress converted into cash. Slater and Gordon failed to observe due diligence whole assessing Quindell Company and therefore missed to note the aggressive practices of accounts that Quindell had before handing over its cases to Slater. Acquisition of Quindell led to increase in the firm’s debt as well as increased need for consistence revenue (Fyfe, 2016).
Litigation financers’ model of business is very different from that of Slater and Gordon law firm. While they bear litigation costs till the cases are completed, those costs are never treated as revenue. Instead, they get valued on basis of cash or damage awards’ expected size from the cases they fund. The profits realized from a case do also not get linked to the funded costs but instead, they get a significant amount as percentage of case damage. These financers are also wary of risks associated with concentration unlike Slater and Gordon who mainly gave focus to lower value claims of personal injury that were high in volume making the firm susceptible to many risks such as competition (“Reports and Presentations | Slater and Gordon,” n.d.).
5. Financial reports review for Slater and Gordon law firm
The Slater and Gordon law firm had been preparing financial reports for every financial year since it was founded. However, its performance between years 2013 and 2015 became an issue of discussion in the country. At the close of the year 2013, the company reported total revenues of A$ 298m as compared to year 2014 where it reported A$ 418m (Fyfe, 2016).
The law firm had made several acquisitions since 2007 which saw its revenue get boosted as well as its market shares. Between the year 2007 and 2013, the price of the firm’s shares had fluctuated up with a range of A$1.35 to A$2.50. A dramatic rise was experienced between 2013 and 2014 where the shares shot from A$2.20 to A$4.72. By the close of year 2014, the shares price was A$6.40 and by early 2015 they had shot to A$7.78 (“Reports and Presentations | Slater and Gordon,” n.d.).
The firm’s financial report for the year ending on June 2013 showed that there was a revenue lift of A$79.9m with A$70.5 being delivered from the UK businesses. There was a drop of A$36m for the cash delivered from the customers in 2013 report and a A$32.5m drop for the year 2014. After revenue reconciliation, there was a variance of A$49m in 2013 and A$59m in 2014. The same variance effect was similar to cash payments offsetting overstatement of the cash received (“Reports and Presentations | Slater and Gordon,” n.d.).
Slater and Gordon experienced a huge drop in revenues due to decline in volume of personal injury claims than were more than claim values both in the UK and Australia. Overstatement of unpaid services as work in progress and treating it as revenue contributed to the drop since profits were not being generated from the cases in progress. The investors’ warning about the overpriced Quindell acquisition as well as Slater’s accounts investigation by ASC led to the drop of the firm’s shares in the market as well as their prices (Fyfe, 2016).
6. What influences accounting policies for firms
Several studies have tried to investigate what determinants influence the choices of IFRS accounting policies in companies. Such studies are based on positive accounting theory as well as comparative international accounting where various causes are listed. Accounting literature identifies three major determinants that include, company related, industry related and country related determinants(“Reports and Presentations | Slater and Gordon,” n.d.).
a. Company related determinants
These determinants include the size of the company, its type of auditor and the company’s capital structure.
1. Company size: The size of the company is measured in terms of its total revenue and assets, the number of employees in it, , its operating income and company value as well as the number of shareholders in that company. There is therefore a relationship that is positive between the level of company’s disclosure and its size.
2. Auditor type: There is a great association between the auditor and financial information’s quality of a company. The auditor is viewed as an advisor when it comes to financial statements under IFRS as well as a constraint.
3. Company’s capital structure: The debt ratio of a company can influence its choice of accounting policies (International Accounting Standards Board, & IFRS Foundation, 2016).
b. Industries related determinants
For companies that operate under a certain industry, they are likely to have similar business models as compared to those that operate under different industries. Those companies and firms that prepare accounts using different choices of accounting from those of their competitors within the same industry can be penalized by the market. A particular industry therefore becomes a determinant that is very important when there is comparison of financial statements (“Reports and Presentations | Slater and Gordon,” n.d.).
c. Country related determinant
Different countries have various features that may influence choices in accounting policies. For instance, economics and political systems differ from one country to another. Legal systems are also different between states when focusing on tax authorities, shareholders and creditors. Religion is also a major factor since some religions in countries have unique ways of conducting businesses for instance banking systems under Islam. Rules on financial reporting and their relationship with those of tax vary from one country to another.
A country’s culture can influence the choice of accounting policies through its influence on accountants’ behaviors as well as their accounting practices. Various accountants will possess different values depending on the country’s culture. Such values include uniformity, secrecy, conservatism and professionalism. Language difference among countries results to translation challenges. Companies whose financial statements are in different languages would be difficult to compare (“Reports and Presentations | Slater and Gordon,” n.d.).
Slater and Gordon chose to adopt the IFRS 15 standards so as to have the firm’s revenue captured and recognized after the cases in various acquisitions’ were determined. Companies and firms were required to comply with the standards as well and therefore Slater and Gordon had no option other than complying. The firm’s uncollected revenue from its work in progress, under the IFRS 15 standards would allow it to have the revenue collected over time (Fyfe, 2016).
7. The drop of revenues in the year 2015
Other factors other than adoption of IFRS 15 significantly contributed to the drop of Slater and Gordon revenues. The firm’s downfall is seen to have been attributed by acquisition of Quindell’s division of professional services at a very high price and its accounting on work in progress as well as goodwill. There was over reliance on work in progress as the biggest asset in the firm’s balance sheet and worse of it all, it is was unable to have the work in progress converted into cash (EY, 2015).Slater and Gordon law firm happened to overstate their work in progress and failed in turning the work into profit. Instead, the work in progress was recognized as revenue before the services had been delivered. Despite IFRS 15 standards provision that revenue should be recognized by an entity at a point when performance has been satisfied, for situations where is to be recognized over time, then there must be establishment of appropriate progress measurement method for ensuring that performance obligation is completely satisfied.Slater and Gordon failed to observe due diligence whole assessing Quindell Company and therefore missed to note the aggressive practices of accounts that Quindell had before handing over its cases to Slater. Acquisition of Quindell led to increase in the firm’s debt as well as increased need for consistence revenue (Fyfe, 2016).
Underperformance of the firm’s businesses in the UK also contributed greatly to the fall of its revenue since there were several business shake ups in the UK at that time. The UK government raised a concern on the handling of claims regarding road accident. The government went ahead to implement proposals that limited the rights of UK residents whose claims on personal injuries were of low value. Most of the firm’s newly acquired law firms in the UK had a significant number of cases that would be considered as of low value. Therefore, the firms’ performances in the UK were affected by the government’s proposals resulting to Gordon and Slater’s drop in revenues particularly from the UK market. There was also a significant reduction in resolutions of low value cases but on the other hand the high legal costs were not addressed by the law firm. The firm still maintained a huge number of employees in the newly acquired law firms, especially in the UK, yet enough income was not being generated to meet the firm’s operations costs resulting to reduction of its revenues.
The firm had altered its accounts in the year 2014 and 2015 as well. It also had its earning guidance dropped together with some of the accounting standards. These changes may have significantly played a role in the sharp drop of its shares. Its latest financial reports contained figures that painted more of its troubles than that of acquiring Quindell. Slater and Gordon ignored the warning shot by Gotham City about Quindell before buying it and then it became too late to address the issue (Savage, Cerf, & Barra, 2013).
8. Accounting ethics
Concerns were expressed over how revenue recognition related with cash flow in Slater and Gordon’s reports. It is an obligation of every member under section 110 of Code of Ethics for Professional Accountants to have integrity and express it by being honest and truthful in any business dealings. This is what led to the company’s short of its stock by the investigating company, VGI Partners. The investigating company found out that Slater and Gordon was trying to cover their weak growth by purchasing legal work from other smaller law firms. The ethics also requires that members should not associate themselves with reports and communications that are misleading (Fyfe, 2016).
The alleged arithmetic error discovered in the firm’s statements showed that millions of dollars had been overstated in both cash payments and receipts. All this resulted from having the tax double counted, customers’ disbursements were also incorrect yet net cash balances had not been affected. Slater and Gordon rushed the process of acquiring Quindell while well aware of Quindell’s cash flow and its reporting issues. The firm’s financial reports were therefore misleading to both the investors and shareholders since they created a false picture of the firm as one that was making profits (Fyfe, 2016).
This paper has managed to analyze Slater and Gordon law firm highlighting the firm’s operations with regard to financial matters and compliance with standards that regulate customer contracts as well as revenues. The firm’s performance has surfaced how errors in financial reports and inadequate observation of due diligence when entering into a business contract can result into a business mess.The paper has also shown how some of the business accounting malpractices can be contrary to the code of ethics that govern professional accounting.
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