Alleged accounting errors cause Slater and Gordon's share price to plummet, ASIC to investigate

Slater and Gordon, a multinational law firm based in Australia, is a publicly traded law firm controlled by shareholders rather than lawyers. Following the acquisition of several United Kingdom law firms, it has become one of the largest consumer law firms in the UK in addition to the largest in Australia.

In June 2015, Slater and Gordon's share prices fell in response to an announcement that errors were discovered in the reporting of historical financial statements for its UK business. Share prices dropped almost 43 per cent in five days in late June.

The plummet began when it was announced that Slater and Gordon is undergoing investigation by the Australian Securities and Investments Commission (ASIC) in response to the accounting discrepancy and questions about its relationship with auditors Pitcher Partners. This drop is the equivalent of a $900 Million decline in share market value.

UBS analysts are questioning the accuracy of Slater and Gordon's financial statements and have expressed concern over the relationship between cash flow and revenue recognition. A major concern for shareholders is whether revelations from the audit will identify additional errors.

A Sydney-based fund management firm, VGI Partners is shorting Slater and Gordon stock, in an apparent expectation that additional problems are yet to be revealed. In a detailed presentation to The Australian Financial Review in April 2015, a VGI Partners fund manager identified a number of red flags with Slater and Gordon's accounts. VGI concluded that Slater's approximately 40 acquisitions represent an attempt to buy legal work in order to mask weak organic growth.

Slater's cash position has decreased at the same time as their impressive growth in accounting profits.

Douglas Tynan, a partner at VGI and a former accountant and auditor, told The Australian Financial Review, "Given it's only one of the many issues we have mentioned in our presentation, we would expect there to be more than one cockroach in the kitchen".

At the core of Slater and Gordon's accounting problem may be the way they do business. Slater and Gordon conduct no-win no-fee business and apply 'Work in Progress' (WIP) accounting. This means that revenues are recorded before they have been invoiced or payment received. As a result, profits increase as new law firms are acquired but real money is not coming in.

As additional acquisitions are made, even more funds must be raised from financiers and by market shares. VGI notes that Slater and Gordon's WIP balance has expanded from $300 million to almost $1 billion in merely 3 years. The 'arithmetic error' that was discovered in Slater and Gordon's cash flow statements involved tens of millions of dollars that were overstated in its cash receipts and cash payments. This was the result of double counting tax as well as incorrect client disbursements, and had a null effect on the net cash balance.

VGI Partners suggests that there could be a relationship between cash flow discrepancies and WIP accounting, as a higher balance in cash receipts would result in an overstatement in the degree to which WIP and receivables are being converted into cash. To counterbalance, VGI suggests that cash payments would need to be overstated by the same extent. VGI's criticism of Slater's acquisitions include its recent $1.2 Billion purchase of the professional services division (the legal arm) of UK group Quindell.

At the same time as the ASIC inquiry into Slaters, an investigation by the UK regulator, the Financial Conduct Authority, has been initiated into Quindell, the former parent company for Slater and Gordon UK operations.

Quindell is also receiving criticism for its aggressive accounting practices. In the April presentation, VGI partners questioned why Slater and Gordon rushed into the acquisition of Quindell given the latter's known financial reporting and cash flow issues.

The Australian Securities and Investments Commission discovered the UK accounting problems as part of a routine audit, which suggests to some that Pitcher Partners' accounting practices are less than stellar.

The accounting group Pitcher Partners audited another Australian company, ABC Learning's financial statements until 2007, but ABC went into receivership in 2008 even though its last statement was signed off showing a profit of $143 Million. This event did not garner confidence in the Pitcher Partners group.

One of the most aggressive class action law firms in the world, Slater and Gordon may themselves become the target of a class action suit from angry investors, some business analysts are already speculating.

When a journalist for Business Day in Australia approached Maurice Blackburn, the other major Australian class action firm, for their opinion on a potential class action, the company spokesman replied that it is too early to discuss the likelihood of developing a class action case but the situation will continue to be watched closely.

Whatever the outcome of the ASIC investigation, confidence in Slater and Gordon has fallen and the potential for a future drop in share prices understandably has investors anxious.