Research Topic: Issues in Revenue Recognition

Slater and Gordon is a large law firm based in Melbourne, Australia. It is the first law firm being listed on Australian Securities Exchange. However, recently, the firm has frequently appeared in media headlines due to various controversial accounting issues. A serious problem with the firm is centered on the company's accounting policy in revenue recognition of 'work-in-progress' cases.

The following text is extracted from the article 'The Undoing of Slater and Gordon' by Melissa Fyfe published in the Age.

"The ... problem went to the heart of Slater & Gordon's profitability. Perhaps more accurately, to how much the market believed Slater & Gordon was profitable. Investors are looking for a company's "growth narrative"­ they want the key figures, the headline numbers, to be as big as possible and on an upward trajectory. Year after year, in his reassuring corporate­speak, Andrew Grech (CEO of the firm) presented to the market lovely fat figures for net profit after tax, earnings per share, and price­to­earnings ratios (the higher these were, the more law firms you could buy). But underpinning these figures was a concept called Work in Progress.

Slater & Gordon specialises in "no win, no fee" personal injury cases. This means it does not get paid until a case closes, something that typically takes 18 months to two years. If you sell cakes, you report your revenue when you sell a cake. But how does a law firm report revenue? Slater & Gordon decided to record revenue as cases progressed (Work in Progress), estimating the likelihood of success and how much work had been done. It recorded this as revenue, even though it was yet to get any ­ and, in some cases, would never get paid. In 2014, Slater & Gordon ­ which says it explained its methods to investors ­ declared $467 million of Work in Progress and, in 2015, $826 million...

Work in Progress is an accounting recipe used by many professional services firms ­ including the big accountancy companies ­ largely without incident. But as VGI's research pointed out, it is "trust me" accounting, and gives management huge discretion over the profit they record. VGI's research into Slater & Gordon threw up 10 red flags, including its Work in Progress accounting and its aggressive appetite for smaller law firms. VGI believed Slater & Gordon was buying the undervalued Work in Progress in these firms and pumping up its value on its own books, inflating revenue and profits. Each year, VGI concluded, Slater & Gordon needed to buy larger firms to meet the sharemarket's appetite for growth.

The VGI research suggested something even more troubling. Eighteen months to two years after the Work in Progress was declared, the matching cash was not coming through the door. Tynan and his eight­person research team did a run­of­the­mill check, pulling the balance sheets apart and trying to put them back together. But their  analysis found black holes in Slater & Gordon's accounts: about $80 million in 2013 and $90 million in 2014. In November 2014, two months before it became known that Slater & Gordon was interested in Quindell, VGI took a multimillion­dollar "short" position in the market, a punt on Slater & Gordon's share price falling. VGI was predicting the Australian firm's romance with the sharemarket was about to end.

Six days after Grech told Slater & Gordon's November 2015 annual general meeting that he saw no damaging legislative reform on the horizon, further reforms were announced. The UK government, as part of its ongoing crackdown on compensation culture, signalled changes designed to reduce whiplash fraud and deal lawyers out of small claims.

Shares fell by 50 per cent

On December 17, Slater & Gordon dumped its profit predictions, citing poor trading results. But no one expected the scale of the announcement which came on February 29 this year, with the firm declaring a $958 million net loss for the six months to December 2015...

Things weren't so good at home either. Slater & Gordon wrote down its Australian businesses by $52 million on lower­ than­expected cash flows. Investors wondered if the company would survive, and whether the banks would take it over. "Clearly today's results are very disappointing" Grech said in a statement to the Australian stock exchange.

Market watchers were so gobsmacked by Slater & Gordon's Icarus­like fall that they missed something significant in the February announcement. For months, at the insistence of ASIC, Slater & Gordon had been laboriously going through files and recalibrating its Work in Progress figures. This was sold in the statement to the market as simply an early adoption of a new accounting standard and, on the face of it, it was. But the new accounting standard forced Slater & Gordon to record only revenue that it could class as "highly probable", which triggered a huge write down in previous Work in Progress ­ from $467 million to $382 million in 2014, and $826 million to $694 million in 2015. The company admitted the new standard led to a discounting of Work in Progress by 15 to 20 per cent.

Slater & Gordon had been overstating its Work in Progress, which fed into its key revenue and profit figures, by up to 20 per cent (although a company spokeswoman says the "underlying value" of its services has not changed). With two class actions against Slater & Gordon already announced, ASIC made a carefully worded statement on February 29 saying that it neither "approved or disapproved" of Slater & Gordon's past Work in Progress accounting".

Source: The Age (Melbourne, Australia) ­ Online June 24, 2016 Friday 05:38.

Required

1. How did Slater and Gordon meet the capital market's expectation of the firm's growth as reported in 'the Undoing of Slater and Gordon'?

2. Why did the share price of Slater and Gordon fell so badly by 50% in late 2015?

3. Analyze how service revenue is recognized under IAS 18 Revenue and the new accounting standard IFRS 15 Revenue from contracts with customers

4. Did Slater and Gordon's accounting treatment for revenue recognition of 'work-in-progress' as reported in the Age (2016) meet the revenue recognition under the new accounting standard IFRS 15? Discuss

5. Review the annual financial reports of Slater and Gordon for the reporting years 2013, 2014 and 2015. Analyze how revenue was recognized in each of the reporting years, and explain why the firm's reported revenue dropped significantly in 2015?

6. Associate the above media report to relevant accounting research literature on factors influencing firms' accounting policy choice (e.g. Positive Accounting Theory), and explain why Slater and Gordon chose to be an early adopter of the new revenue standard IFRS 15?

7. In your opinion, was the sharp drop in the firm's revenue in 2015 resulted from the firm's early adoption of the new revenue standard IFRS 15 or from other factors? Explain.

8. In your opinion, are there any breaches of the fundamental principles of accounting ethics (as prescribed in APES 110 Code of Ethics for Professional Accountants) in the firm's accounting practices? Explain.

Attachment:- Research Assignment.rar