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Revenue Recognition

Revenue Recognition : Capitalization Structure

Revenue Recognition : Capitalization Structure

Question:

Discuss about the Revenue Recognition for Capitalization Structure.

Answer:

Introduction:

The Salter & Gordon was one of the first law firms to be listed in Australian stock exchange. It was one of the largest Australian law firms and has a brand that is recognized by three out of four persons. The investors had high expectation on the profitability of the firm and were always interested that the key bottom line figures are as high as possible. The firm also every year after year presented the figures that showed high net profit after tax, price to earnings ratio and earnings per share figures (Legg and Nehme 2016). These profit figures were high due to accounting treatment of work in progress by the law firm. The cases usually continued for more than one year as a result law firm followed a policy of recognizing revenue as the case progressed.  The estimated profits from the ongoing cases were recorded in work in progress figures of the firm that inflated the profit figure of the company. The company specialized in personal injury cases where the firm did not charged fees if it does not win the case.  Therefore, the work in progress figures includes profits are not yet received and there exists a possibility that the profit may not be received (Muzio et al. 2016). The expectation of the capital market of high growth was meet by the firm by inclusion of unrecognized revenue in the work in progress figures and thereby inflating profits.

The investors always had high expectations from the firm but the share price of the company fell due to multiple reasons. The research conducted by the hedge fund group VGI showed that the work in progress figures of Salter & Gordon was overvalued. The firm acquired smaller firms and then showed their work in progress at inflated value. This policy of over valuing the work in progress inflated the profit and revenue of the firm (Laugesen 2013). The research conducted by the VGI group also showed that the company did not receive the declared work in progress amount in the eighteen months to two years time. The VGI group in its analysis of the firm’s balance sheet found that there was a loophole of about $80 millions in 2013, and$90 million in 2014. It expected that the share price of the company would fall so it took short position in the market. The Australian security and Investment Commission (ASIC) initiated an investigation on the accounts of 2014 and 2015 of the firm (Barton et al. 2015). The findings of the research of VGI group, the short position it took on the share price of the law firm and the investigation undertaken by the ASIC was all jointly responsible for the fall of share price by 50% in 2015.

 

The Australian Accounting Standard Board has issued AASB 118 that deals primarily with the recognition of revenue in accounting. This Accounting standard is applicable for all the entities that are required to prepare the financial statements in accordance with the corporation act. In Para 1 of the AASB 118 it is provided that this standard will be applicable for revenues that are arising from transactions and events that are related to the selling of goods, rendering of services and the use of the assets of the company by others (Markle 2013). The revenue is defined in the Para 7 of the AASB 118 as the gross inflow of the economic benefits by the entity in the ordinary course of its activity.  In Para 9 it is provided that the measurement of the revenue should be based on the fair value of the consideration that is received or receivable. The rules regarding recognition of revenue from rendering of services is provided in Para 20 of the AASB 118. In this Para, it is stated that in case of rendering of services if the outcome of a transaction can be reliably estimated then in such cases revenue should be recognized at the end of the reporting period based on the stages of completion (Phi and Finney 2015). The outcome of the transaction is said to be reliably estimated if the amount of revenue can be measured, it is probable that the economic benefit will flow to the entity; the stages of completion of the transaction can be measured, the cost associated with the providing the services can be measured. From the above it can be concluded that as per AASB 118 the Revenue is recognized when it is probable that the entity will receive the future economic benefit and the benefits can be measured reliably.

The Australian Accounting standard Board has issued AASB 15 Revenue from contract with customers and it is applicable to an entity that is required to prepare the financial report in accordance with the corporation act.  The AASB 15 is the new accounting standard for recognizing revenue and its measurement.  This standard provides a five-step approach for revenue recognition and measurement. The first step is to identify the contract with the customer and the second step is to separate the performance obligation of both the parties in the contract (Rhode 2013). The third step for recognizing the revenue is to establish the transaction price of the contract. In the fourth stage the transaction price are allocated for separate performance obligations. The last stage is to recognize the revenue when the separate performance obligations are satisfied. From the above it can be concluded that the revenue under AASB 15 should be recognized when there is a commercial contract between the parties and each parties recognizes its rights. In such cases, the revenue is recognized if it is probable that entity will collect the consideration (Candler 2016).  On analysis of both the standard AASB 118 and AASB 15, it can be seen that definition and criteria is for recognizing revenue is more detailed in the new AASB 15 than in AASB 118. The new standard has offered significant improvement in the measurement and recognition of revenue. It has also helped to improve the comparability of the financial statements of companies. The main improvements and objectives of the AASB 15 are as follows:

  • To provide a single revenue recognition model for both the transfer of goods and services;
  • To remove weakness and inconsistencies in the existing revenue recognition standards;
  • To simply the process of preparation of financial statement;
  • To increase the disclosure requirement about the revenue;

The Salter and Gordon specialized in the cases of personal injury. It offered to its clients “no win, no fees” service. This means the firm company will only receive fees at the end if the case if it wins the case otherwise the firm will receive no fees. The firm while calculating its Work in progress included the fees that are not yet realized in the revenue based on the progress of the case and the estimated result (Adams 2013). This work in progress calculation of the Salter and Gordon is evaluated by using all the five stages in the revenue recognition model under AASB 15.

In Para 9 of the AASB 15 it is provided that there are certain criteria’s that are required to be followed before an entity can account for a contract with the customer. These criteria’s are given below:

  • The contract is approved by the parties and they are also committed in performing the contract;
  •  The rights of each parties can be identified by the entity for goods and services transferred;
  • The payment terms regarding the goods and services transferred can be identified by the entity;
  • There is a commercial substance in the contract;
  • The entity will be entitled to receive consideration for the goods and services it transfers to the customers and it is probable that this will be collected.

In addition to this as per this accounting standard, a contract is not recognized if it is wholly unperformed. Further, if the parties in the contract have unilateral right to terminate contract then the contract is not recognized. In the case of Slater and Gordon, there is a contract between the firm and the customer that explicitly provides that in cases of personal injury if the firm does not win the case then it will not receive fees (Akdogan and Ozturk 2015).  In the Para 9 of the standard mentioned above it is clearly stated that the contract should not be recognized if it is not probable that consideration for the services and goods will be collected. In case of personal injury, Slater and Gordon may or may not receive the fees it is based on the outcome of the case. As there is no probability that the fees will be received so the first step of revenue, recognition is not satisfied therefore the fees should not be recognized as revenue. In Para 46 of the AASB 15 it is stated that if the performance obligations under the contract are satisfied then the entity should recognize revenue (AASB 2015). In the case of Slater and Gordon the performance obligation is to win the case as the firm has not yet own the case so the revenue that yet has not been received should not be recognized as per the Para 46 of AASB 15.

Based on the above analysis it can be concluded that the accounting treatment for the work in progress of the firm is not appropriate, as the revenue that is yet no probable to be received has been recognized as income under work in progress.

The Slater and Gordon is one of the biggest law firms of Australia that is listed in Australian stock exchange. On analysis of the financial report shows, that the firm derives its revenue by providing legal service related to personal injuries, personal legal services and business & specialized litigation (Mollik and Berapi 2014). The Annual financial report of 2013 showed that the revenue of the firm is AUD $ 297.6 million and it has increased by 36.7% from the last financial year of 2012. The revenue increase in 2013 is mainly due to the increase of 8% revenue in the personal injuries. In 2014, the annual financial report showed that the revenue of the firm during the year is AUD $ 418.5 million. The revenue of the firm has increased by 40.4% from the financial year of 2013.  This revenue figure included the work in progress related to the acquisition of the Fenton’s. The business successfully achieved its revenue target due to good performance of the core Slater and Gordon business of personal injury law. The almost 77% of the revenue of the firm comes from the personal injury law. The reason for such good revenue figures is due to strong performance of the Fenton’s (Bodle et al. 2016). In 2015, the analysis of the annual financial report showed that the net profit after tax of the firm increased by 22.8% that is AUD $ 83.8 million. The revenue was generated by providing legal services to the multiple clients. The most of the revenue was generated from the personal injury law cases. This cases was performed on the condition that if firm wins the case on favor of the client then fees will be received otherwise the firm will receive no fees. The revenue from the personal injury law cases was recognized in the revenue in percentage completion method in accordance with the AASB 118. This process of recognizing revenue gave rise to a corresponding asset of work in progress that is shown in the asset side of the balance sheet (De George et al. 2012). The difference in work in progress is included in the calculation of Revenue. The work in progress is calculated or measured based on the percentage completion, probability of the success and estimated fees of the case. Therefore, the revenue of the firm included amount that is not yet realized and is not assured that the revenue would be realized. The operating cash flow of the firm during the financial year 2015 was AUD $ 40.8 million and it was less than the operating cash flow of 2014. The less operating cash flow is mainly due to implementation of the management system in UK that caused delay in billing. The cash from the personal injury law cases is not received in the year the revenue is recognized but generally in later year. It is one of the primary reasons that the cash flow from the operation of the firm is low (Kraal et al. 2015). On the above analysis of the financial statement of 2013, 2014 and 2015 shows that the increase in revenue is 36.7%, 40.4% and 22.8% respectively. It can be seen that there is a decline in the percentage increase of revenue and it is mainly due to the treatment of work in progress.

The revenue is recognized by an entity when it provides services or sells goods to the customers in the normal course of business. The amount of the revenue that is recognized is dependent on the consideration that the customer has agreed to pay (Pacter 2014).  The information related to the revenue is critical in evaluating the financial performance of the company. It is important for the investors to have information regarding the amount of revenue earned by the entity and the nature of the revenue so that they can make appropriate decision. It is also important for the shareholders and investors that the revenue derives by the entity are comparable to the similar entity so that performance of the entity could be compared (Aghimien and Bashnini 2013). The Slater and Gordon should adopt this new standard so that the revenue measurement policy of the firm becomes comparable with the other firms.

The other reason that makes it necessary for adopting the new standard by Slater and Gordon is that there are problems in the existing revenue recognition standards. The existing standard relating to the revenue recognition has led to the inconsistencies in the revenue reported mainly in cases of revenue recognition for long-term contract. In order to overcome this problem of inconsistencies in revenue recognition it is important that a new standard in place of existing standard should be adopted (Loyeung et al. 2016).  The Australian Accounting Standard Board adopted a new standard AASB 15 to replace the existing standard of AASB 118. The new standard of AASB 15 aims to overcome the weaknesses of the previous standard by providing more consistencies in revenue recognition and by improving the disclosure requirements. This new standard also provides a framework for addressing the revenue related issues in a more robust way (Bugeja and Loyeung 2016).  This application of new standard simplifies the process of revenue recognition by reducing the number of requirements that the entity is required to follow. This new standard will also enhance the comparability of the financial information provided in the financial statement of the entity and provide a more improved disclosure requirement. The advantages of the new standard forced the Slater and Gordon to be an early adopter of the standard. The annual financial report of 2015 in note to financial statement it is provided that the new standard of AASB 5 is operational from 1 January 2017 and the firm at the end of 2015 is evaluating the consequences and affect the new standard will have on the financial result of the company (Cameron and O’Leary 2015).

The analysis of the financial result of 2015 showed that the Salter and Gordon performed reasonably well in that year with an increase in net profit of 22.7% during the year. The firm did not adopt the new accounting standard for revenue recognition AASB15 during the financial year 2015. The firm adopted the new standard for revenue recognition AASB 15 early in the financial year 2016. Due to adoption of AASB 15, the balance in the work in progress on 1 July 2015 is 16% lower. This standard required that the revenue from the no win no fee of the personal injury law cases should only be recognized when it is probable that the reversal of revenue recognized will not occur (Tweedie et al. 2013). As a result, the company performed significant data analysis to estimate the average fees and to determine the probability of success. This new standard was retrospectively applied from 1July 2014. This change in accounting policy resulted in the valuation of Work in progress 15 to 20% lower as a result the revenue has also decreased in for the financial year 2016 and also the revenue of the financial year 2015 declined as the standard was applied retrospectively from 1 July 2014 which affected the result of financial year 2015.

The accounting profession is distinguished for its commitment to act on the behalf of the public interest. It is the responsibility of an accountant not only to satisfy the needs of the client but also to act for the public interest (Martinov-Bennie and Mladenovic 2015). In order to satisfy this need a member of the accounting profession is required to comply with the code of ethics. The code of ethics has three parts first part is the identification of the threat to compliance with the accounting standard. The second part of the code of ethics is to evaluate the significance of the threat and the last part is to apply the safeguards to minimize the threat. Therefore, the most important part of the code of ethics is to identify the fundamental principles. The fundamental principles that should be complied is given below:

Integrity: The accountant should be honest and straight forward and should also maintain professional and business relationship with the client;

Objectivity: The decisions of the accountant should not be influenced with the biases and conflict of interest;

Professional competence and due care: The accountant should maintain the professional knowledge and skill so that clients could receive the best services;

Confidentiality: The professional should maintain the confidentiality of clients information;

Profession Behavior: The professional should comply with all the rules and regulations that are required to be followed;

In the case of Slater and Gordon, the treatment of work in progress in the accounts was questionable. The work in progress included the profits that were not recorded not yet realized and there was a possibility that the revenue may not be realized. This treatment of work in progress showed that the fundamental principles of professional competence and due care was breached (Horngren et al. 2012). The principle of professional behavior was also breached.  This principles was breached because if the profession knowledge and due care were applied then the “no win no fees” revenue should not have been recorded in the working progress because the general principle of the revenue recognition is that only those revenue should be recorded that is probable that it will be received.

 

Reference

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Barton, B.H., Lockett, H. and Lockett, C., 2015. Middle Income Access to Justice. University of Toronto Law Journal, 65(4), pp.434-444.

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