Slater & Gordon: oops, we double counted the cash | FT Alphaville

Slater & Gordon: oops, we double counted the cash

Slater & Gordon is the Australian law group which has bought almost all of Quindell, the London-listed basket of businesses balanced atop a law firm. On Friday we asked them about the difficulty of reconciling some lines on the cash flow statement to other part of the accounts. On Monday the group issued a statement to the Australian Stock Exchange restating historic cash flow statements.

The company and its auditor have begun a detailed analysis of financial information to be provided to the Australian Securities and Investments Commission, and discovered “a consolidation error… in the reporting of historical UK cashflows”. Accounting firm E&Y has been appointed to oversee the responses to ASIC queries.

Also on Monday, Quindell announced it wouldn’t publish 2014 financial statements by the end of June deadline, and its shares remain suspended. Historic figures will also be restated following a review by PWC. Investors might ask, what is the problem with law firm accounting?

The Slater & Gordon announcement follows news last week that ASIC was looking at the ability of Melbourne auditor, Pitcher Partners, to oversee a much enlarged UK business. Pitcher notified the company on Friday ASIC intended to make direct inquiries.

As for the restatements, Slater & Gordon said it would be usual to deal with these in a note to the 2015 accounts, and has published a draft of the proposed restatement. Details of that, and what we we asked about below, but first the share price:

We’ve previously looked at how Slater & Gordon got big by rolling up more than 50 other legal outfits, as well as what some might consider the surprisingly low amounts of cash it holds at any moment in time.

Intrigued by the cash situation, we compared cash collected from customers to revenues over the years. Expecting the cash total to trail well behind fees reported, as lawyers working on a contingency basis can be paid long after much of the work is recorded, we were in for a surprise: over eight years cash received very nearly matches revenues reported, A$1,450m to A$1,487m.

However Slater & Gordon also lists more than A$700m of “work in progress” and receivables on its balance sheet, fee revenues recorded but where the cash is yet to be collected. We could reconcile most, but not all, of the difference.

Here are the totals, financial year by year:

Not all of the cash received from customers goes through the revenue line on the income statement. If you buy a company which has work in progress or receivables on its balance sheet already, these should bring in cash unrelated to any revenues you will later report. Slater & Gordon acquired WIP and receivables in those 8 years of A$370m, with more than half acquired in the 2014 financial year.

Australia’s general sales tax is 10 per cent, so 9 per cent (10 as a percentage of 110) of Australian cash collected is taxes. From 2012 the group also had UK fee revenues where VAT at 20 per cent, meaning 17 per cent of UK cash goes to the exchequer. Assuming the cash split is similar to the geographic breakdown for fees, we can estimate cash sales tax at about A$150m.

Over eight years the balance sheet total for work in progress rose by A$600m. So cash taxes, acquired WIP and receivables, and the uncollected revenues accounts for most of the rise: 150 + 370 + 37 = 557.

What we’ll call the unexplained variance in our estimate is A$43m.

We then did the reconciliation another way, on a year by year basis.

To do this start with revenues on the income statement. Add the starting total for WIP and receivables, any WIP and receivables acquired during the year, then deduct closing WIP and receivables. We should be left with an estimate for cash collected.

As above, the difference between our estimate and the reported number tends to be similar to our estimate for cash taxes collected from 2007 to 2012. It is much larger in 2013 and 2014, the first full years in which Slater & Gordon had UK operations.

We had a conversation about the above with Wayne Brown, finance director, and Andrew Grech, managing director, in May.

On the difference last year, Mr Brown said “I think its mostly in the gross-up of the GST and the AST.” He estimated the sales taxes were about A$60m, and that differences in exchange rates accounted for about another $10m.

We asked about the remaining variance, about A$20m or so between cash received in 2014 and our estimate above. Mr Grech said “I think we’ve given you the best answer we can”.

He said, “In many businesses the way they grow future revenues is through the capex line. The way we invest is through the operating cash flow, and we’re investing in next year and the year after’s cash flow.” He said that educating investors about this process has been one of the challenges, but that Slater & Gordon’s understood the way a professional services firm grows and accounts. The deal to buy most of Quindell has bought a new set of shareholders on to the register who also need to be educated about the way the accounts work.”

He also said, “I guess, being honest, the process isn’t assisted very much by people who are short the stock and are trying to sow seeds of doubt for their own short term processes. I think a lot of the confusion being created, I might say quite deliberately to help the shorts, in the process of making money for adding no value is essentially just that. The confusion of principals which are actually quite straight forward.

We repeated the reconciliation exercise with the “payments to suppliers and employees” line of the cash flow statement, and changes in payables and provisions. this also produced a variance, of about A$80m in the 2013 and 2014 financial years.

Mr Brown said this was again the effect of sales tax and exchange rates. Some might find this odd, given that there is no sales tax paid on salaries, the principal cost for a law firm. We went back to the company on Friday to clarify, and ask if they had resolved the question of the remaining $20m or so from last year.

On Monday, the company announced it had “identified two errors in the method used to report receipts from customers and payments to suppliers and employees by the UK business.” The cause? A spreadsheet error:

From the initial date of acquisition of Russell Jones and Walker LLP in the year ended 30 June 2012 until the period ending 31 December 2013, the UK business reported receipts from customers on a ‘gross’ rather than a ‘net’ basis. This effect was wholly offset by the same amount being added to the calculation of total payments to suppliers and employees. The amounts represented customer disbursements and related Value Added Tax (VAT). Net cash derived from operating activities in all periods was unaffected and remains as reported.

In the 30 June 2014 and 31 December 2014 financial statements UK VAT is included twice in receipts from customers. This effect was wholly offset by the same amount being added to the calculation of total payments to suppliers and employees. The cause of this was an arithmetic error in the consolidation spreadsheet model operated in the Company’s UK business at that time. Net cash derived from operating activities in all periods was unaffected and remains as reported

Here is the reconciliation table:

The cash received from customers line drops by A$36m for 2013, and $32.5m for 2014. One aspect to consider: it might seem odd for the number to be so similar for both years, given the UK contributed about a quarter of sales in 2013, and about 44 per cent of a larger total in 2014.

Arithmetically, here’s what happens to our revenue reconciliation table:

Some might also find it interesting that the same effect is seen in the cash payments, perfectly offsetting the cash received overstatement. As mentioned above, costs should almost entirely be salaries and rent, on which sales taxes are not charged or paid.

The company said, “given that there is a process underway with ASIC and that we have engaged EY to assist us with that engagement, we will not comment any further at the moment.”

Note too the remaining variance when comparing the cash “payments to employees and suppliers” and our estimate for cash payments to suppliers based on reconciling the income statement figure and balance sheet movements: the restatement explains A$33m of the A$82m variance.

More broadly, the ASIC investigation has just begun. Investors are yet to see reliable accounts for the company Slater & Gordon has effectively acquired, Quindell, which is also the subject of a regulatory investigation by the Financial Conduct Authority in the UK. Regulators may, of course, find nothing of concern.

Law firm financial statements have been called “trust me accounting”, due to the high level of work in progress recorded as revenue long before cash arrives. We have obtained a copy of a presentation raising questions about aspects of the accounting treatment by VGI Partners, a Sydney and New York based asset manager which looks after A$600m for rich individuals and family offices.

Douglas Tynan, a partner at VGI, said “today’s admission of a so-called ‘accounting error’ from the company throws into question the integrity of the carrying value of the Work-in-Progress balance and thus profitability of the entire business”. VGI has been short the company’s stock since late 2014.

The company has in the past emphasised the rigour of its approach to work in progress accounting, and will no doubt seek to address such questions when presenting results for the financial year which ends on Tuesday. More scrutiny of Slater & Gordon, which has A$550m of debt since acquiring most of Quindell, and a market capitalisation of A$1.3bn, seems likely.

Related Links:
More cockroaches in Slater & Gordon’s kitchen – Australian Financial Review