NaN of http://www.copyright link/content/dam/images/1/m/g/9/q/l/image.related.afrArticleLead.620x350.gisk3h.png/1438786546414.jpg The credibility of Slater & Gordon chief executive Andrew Grech is at stake. Louie Douvis
The credibility of law firm Slater & Gordon now rests on its ability to convince the market that its due diligence on a $1.2 billion acquisition in the United Kingdom was bullet proof.
There is a sense of urgency to that task now that Quindell Plc has published accounts showing that the business Slater & Gordon purchased in May was losing money and had negative net tangible assets. One way a business can go from being worth $1.2 billion to nothing in the space of three months is if there is a more conservative treatment of the recognition of its revenue and expenses.
That's exactly what happened at Quindell. Under the guidance of a new board of directors, a new auditor in KPMG and with advice from another accounting firm PwC, Quindell has gone from one accounting extreme to another.
This would not be possible if Quindell was making and selling widgets. But because it is a professional services firm it can pick and choose how aggressively it recognises the revenue from thousands of personal injury legal cases.
The Quindell Professional Services Division sold to Slater & Gordon was particularly aggressive in its recognition of revenue from thousands of legacy hearing loss cases. This segment of the business was called NIHL.
Slater & Gordon's due diligence uncovered the games Quindell was playing with NIHL. It was so concerned it decided to remove all revenue and expenses related to NIHL in their entirety, to get a clear view of the core PSD performance.
It also said it had "better aligned non-NIHL Legal Services revenue recognition with Slater & Gordon's approach of using evidence based milestones and other accounting adjustments".
There are varying levels of conservatism in the accounting used by professional services firms.
But none would go as far as the new board of Quindell has done.
It not only abandoned the aggressive recognition of revenue from cases with minimal settlement experience, it went as far as to adopt cash accrual accounting.
That put an end to the Quindell double whammy of recognizing profits early and, as far as possible, deferring expenses to a later date.
Quindell's new board said: "Revenues and profits are now recognised, in the majority of cases, when liability is admitted by the at-fault insurer.
"Related costs are expensed as incurred, specifically marketing costs which had previously been deferred and expensed only as cases reported revenues and profits.
"Admission of liability is now generally considered to be at settlement of the case and is typically followed shortly thereafter by the invoicing and receipt of cash."
Of course, this conservatism virtually denies any opportunity to recognise the value of work in progress, which has been an important feature of Slater & Gordon's success.
In fact, it was a surge in work in progress at Quindell in the last few months of 2014 that prompted Slater & Gordon to upgrade its profit estimates for the Professional Services Division.
It annualised the case numbers for September to November 2014 and said that with 93,660 new cases and 77,831 settlements the pro-forma adjusted earnings were £86 million.
But when you included the 50 per cent earnout agreement in place with Quindell on 53,000 legacy NIHL files, the 2016 estimated earnings rose to £95 million.
That number would mean 41 per cent earnings accretion from the transaction, which was well up on the 30 per cent accretion embedded in the £86 million earnings estimate. Slater & Gordon's credibility and that of its chief executive Andrew Grech will stand or fall on the delivery of these numbers. Achieving the forecast numbers will be a testament to the quality of its due diligence on Quindell.
Other reputations will be riding on the back of Slater & Gordon's credibility test.
Investment banking advisers on the deal were global independent investment bank Greenhill.
Accounting firm EY reviewed the quality of Quindell's earnings and its revenue and acquisition cost recognition polices "to ensure they were aligned with Slater & Gordon's more conservative approach".
The other big names with their reputations on the line are Macquarie and Citi. They underwrote the $890 million rights issue, which was snapped up by investors and used to fund the bulk of the purchase price.
The remaining $375 million came from bank borrowings. Tony Boyd
Twitter: @TonyBoydAFR tony.boyd@copyright link.au
