Quindell - Understanding Accural Accounting.

I'm not an accountant and I'm long Quindell - all disclaimers out of the way!

Today I'm going to have a brief look at the issues people seem to have regarding the accruals in the H1 results that were published last week.


What is accrual accounting?


- Accural accounting is pretty much the standard form of accounting for most reasonably sized businesses (according to a friend of mine who is an accountant) across the whole of Europe.


- It's used because it gives a better current picture of a business than cash accounting does - cash accounting only recognises transactions when there is an exchange of cash.


How does it work?


-  For example, if my imaginary company sells a computer to someone that's paying by credit card, the revenue from that sale will only be recognised by the cash accounting methods when the cash is received.


The accrual method however states that the chance of receiving that money is very high if not certain and as such recognises that revenue from the point of which the sale was made.


- In short, this often method means that sales revenue can be instantly recognised even if the cash hasn't been collected.


The case with Quindell:


- The first point to make is that accrual accounting in the legal services industry in the UK has been (as far as my friend told me) mandatory, so I struggle to understand why people are complaining about so much about something Quindell is obliged to follow.


- In the case of Quindell the accrual accounting method uses figures that would be the equivalent of working on a legal case and billing hours that you're pretty certain you're going to get paid for, even though an invoice hasn't been sent to the other party yet.


- Going into more detail, for a lot of the claims that Quindell takes on it pays out a cash fee. Quindell can't then bill the insurance company until the case is done and dusted (settled). Now, because claims take around six months to settle, at the end of Quindell's financial year, they will have booked a lot of costs (paying to get the work), but no matching revenue to illustrate why these costs are booked, because the bill would be raised in a future year. Consequently, the accrual accounting system gives a much better idea of what's going on.


- One of the reasons why the accrual accounting method is the best to use in the case of Quindell is that if income was not accrued, the tax man would likely accuse the company of understating profit and therefore tax. 


- Secondly, when auditing the 2013 accounts, KPMG would look at the 2012 income accruals and assess the cash conversion rate to satisfy themselves that the basis for calculating the accruals was sound. They would then look at the 2013 income accruals and satisfy themselves that they were calculated on the same basis. 


The importance of this system:


- Basically, this method of accounting means that you can have very large and most importantly more representative revenue and profit growth than you otherwise would under the cash accounting method, but it doesn't impact upon your cash-flow, because you can't update your cash flow until that money has gone from party A to party B.


- The real beauty of this method in my opinion is that because it's so much more representative of the full picture than cash accounting is, you can have a good look at the accrued income and use it to help with personal cash flow projections. Now, not being FCA authorised, it would be unwise for me to make any good guesses on this front, but I would encourage people to have a good look and do some maths - the picture is rosy!


Doubters:


- I really struggle to workout why some people don't like this method of accounting. Yes, it doesn't directly effect cash flow or show an instant cash flow increasing effect, but it does show what's going on in the business as a whole far better than the cash accounting method does. Remember that cash flow is only part of the picture for a company and if the accrued accounting method wasn't used you would have a serious issue in valuing most companies on the AIM.


- Moreover, this is an accounting method that is used by almost every company that's listed in the UK and Europe, so I think that claiming that there's an issue with it is ridiculous.


- Further to my previous point, is a more generic point about Rob Terry, which is that in the UK we seem to be very bad at not forgiving. Yes, The Inovation Group (TIG) was a bit of a pigs ear, but frankly most business men will mess up at some point. Look at Carl Icahn, who blew up in his first career as a stock broker, but came back to be one of the greatest investors of the current time.


In the case of Rob Terry, I think we need to be more American in attitude (not something I often say) and accept that being an entrepreneur is one of the only paths in life where you can have as many chances as you like at being successful.


To conclude, I don't really understand why people have had an issue with the accrued income in the H1 results, but I hope this helps to explain what they actually are.