Red flags abound for Shine Justice but “no win no fee” law firm no respond, nor PwC

An investigation into Shine Justice has found accounting irregularities and a large gap between the law firm’s cash flow and the far shinier accounting numbers it presents to the market. Michael West reports.

Shine Justice sounds like something from the Marvel Universe. Indeed the firm’s branding and moniker “Right Wrong” suggest a team of legal super-heroes fighting valiantly for the underdog. However, an investment report obtained by Michael West Media discovered an array of “red flags” in the group’s statutory financial disclosures, wrongs which need to be put right, .

Being a law firm, Shine’s directors and executives would understand that the Corporations Act requires them to comply with Australian Accounting Standards (AASB). Auditor PwC would also be aware of this. Questions were put to Shine and PwC for this story but there was no response. An offer to meet to discuss the red flags covered by the investment report was also ignored.

Rise and fall

In May 2013, Shine Corporate Ltd listed on the ASX after a capital raising at $1 per share. In July 2014, Shine completed a 1 for 10 rights issue at $1.90 per share.  Things were looking up for investors as the share price climbed above $2 peaking above $3.20 during 2015. Then on January 29, 2016 the stock fell 73% in one day to $0.62 after reappearing from a ten-day trading halt. The culprit? Sudden bad news about the firm overestimating its work-in-progress (WIP) – and its revenues and profits – by $17.5 million.

Alas, the share price of Shine, which switched its name Shine Corporate in favour of borrowing the word “Justice” from the justice system in which in operates, has not reached heights of $2 or $3 since. Since late 2016, the share price has traded in a range of around $0.50 to $1.40. It was trading today at $1, which makes it look fairly cheap. But is it cheap for a reason?

While the stock is back to where it started on listing, it has managed to distribute some $0.369 in unfranked dividends over the course of its ten years trading on the ASX. Nonetheless, those that still hold Shine shares acquired in the 2013 float and the 2014 rights issue could be forgiven for feeling underwhelmed or nervous about their investment. In contrast to Shine, the ASX 200 index is up around 42% over the last 10 years. 

Class action suer gets class action sued

On 27 September 2017, Shine was notified that a class action was being brought against it on behalf of those shareholders that had purchased Shine shares at their lofty levels during 27 August 2014 to 29 January 2016. 

Damian Scattini, a partner from Quinn Emmanuel Urquhart & Sullivan was running this class action against Shine on behalf of affected shareholders. He was reported to have said of Shine: “It is ironic that a law firm which claims to specialise in class actions would mislead its own investors”. 

The allegations in the statement of claim against Shine included that it had misled investors in a series of representations in its financial reports for 2014 and 2015.

In May 2019, Shine announced that the shareholder class action had been settled on confidential terms without any admission of liability. Shine claimed the settlement would have no impact on the group’s earnings, cash position or balance sheet.

While the ironic shareholder class action against Shine was settled in 2019, it seems there are a range of issues in Shine’s accounting and disclosure practices for revenue recognition, cash flows and intangibles. Has Shine been up to its old tricks that led to the ASX earnings update, lawsuit and share price debacle on 29 January 2016?

Accounting and disclosure red flags

Shine is currently in acquisition mode, looking to buy legal practices, perhaps offering its shares as well as cash. 

There are eight red flags that indicate investing in Shine at current prices may result in a personal financial injury. The red flags are discussed in the remainder of this report as follows.

• Shine’s low PE ratio,
• earnings unmatched by taxable profits and operating cash flows,
• dubious accruals look like earnings management,
• dubious quality of sales and net income,
• questionable work-in-progress,
• questionable operating cash flow disclosures,
• accounting for intangible assets,
• revenue recognition.

Shine’s low PE ratio

Shine is currently trading on price earnings ratio of 5.8. It has the lowest PE ratio of its peers chosen by the same sub-industry and market capitalisation. Slater & Gordon Limited, another law firm listed on the ASX, is currently trading at a PE multiple of 51.6.

Investors in Shine may take comfort from the fact that Shine’s earnings have been audited by PwC (from 2020) and Ernst & Young (until 2019). But the audits of Big 4 firms are cold comfort if the share price tanks, or a company fails.

As the audit profession is wont to say when called to defend its rubber-stamping of accounts when things turn awry, we can only be guided by what a company’s directors have told us.

On the one hand, investors may view Shine as a strong buy because it has an attractive PE ratio, increasing dividend, increasing assets, and (supposedly) increasing cash flow. On the other hand, Shine’s relatively low PE ratio signals the market is not convinced about the quality of Shine’s earnings or the market lacks belief that Shine’s earnings will grow or are sustainable.

It appears the market doesn’t trust the Shine value proposition. It demonstrates a suspicion that Shine may less a value proposition than a value trap.

Earnings not matched by taxable profits and operating cash flows

Table 1 presents selected financial performance measures of Shine over the 10-year period to 30 June 2022 and is based on information in the audited annual financial reports. If the market has a problem with the quality of Shine’s earnings, then Table 1 indicates why this could be the case.

Table 1: Shine’s financial performance and accruals

It is apparent from Table 1 that Shine’s accounting profits significantly exceed its taxable profits. In total, Shine has managed to record $306 million of accounting profits before tax but $8.4 million of taxable losses before tax. It is unclear why there should be such a large discrepancy between these two measures over a 10-year window.

It is also apparent that Shine’s accounting profits significantly exceed its net cash from operating activities. In total, accounting profits before tax exceed net cash flow from operating activities (with negligible income tax) by $119.2 [$306.3m – $187.1m]. 

The gap between profits and net operating cashflow will be significantly greater than $119.2 million if Shine has been classifying cash outflows in investing activities that should be included in operating activities.

Shine’s ASX announcement on 9 September 2022 states that cash is expected to be positively impacted in FY 2023 because of the reimbursement of work in progress from the vaginal mesh class actions, but they don’t say by how much. It is unlikely that the positive impact to net cash flows from operating activities will be $119. 2million.

Has Shine Lawyers left the ASX in the dark over its Johnson & Johnson pelvic mesh fee-fest?

 

Shine’s accruals consistent with earnings management

Table 1 also shows Shine’s accruals over the 10-year period to 30 June 2022 calculated as profit after tax less net cash flow from operating activities.

Accruals are the extent to which accounting adjustments result in an increase or decrease over operating cash flows to arrive at profit after tax. Accruals tend to be negative (decrease) because of the financial effects of non-cash adjustments such as depreciation and amortisation but it is not always the case.  

Switching from significantly negative to significantly positive accruals can be a warning sign that a company is under financial pressure and earnings are being managed. Shine’s accruals for 2022 are positive $20.6 million whereas for 2021 they are negative $23.5 million.  

The last time before 2022 that Shine accruals were significantly positive was for the years 2013–2015. The relevance of these years is important. Shine’s infamous ASX announcement of 29 January 2016 involved overestimated revenues (and profits) of $17.5 million across 2013–2015. Does this augur for more bad news about earnings on the horizon given the significant positive accruals again for 2022?

Poor quality of sales and net income

Table 2 shows the quality of Shine’s sales and net income (profits) relative to cash flow over the 10-year period to 30 June 2022. These two ratios indicate the extent to sales and profits are backed by cash flow and, in the long run, should approach 100%.

Shine’s quality of sales is 87% over the 10-year period, which means there is a significant deficiency (13%) in cash receipts to sales revenue over this long window. Sales revenue is not consistently realised in cash receipts. Only in 2021 did the cash receipts from customers (net of GST) exceed the revenue being recognised.

The quality of sales for 2022 is 82%, that is, down on recent years and back around to level of the 2013–2015 period where Shine had overestimated its revenues.

Shine’s quality of net income (profit) is also 87% over the 10-year period. The quality of net income for 2022 is only 34%, that is, back to the low levels of the 2013-2015 period where Shine had overestimated its revenues.

It is possible that the cash proceeds from the vaginal mesh class actions will provide 2023 figures for quality of sales and quality of net income significantly higher than 100%.  

Table 2 suggests that there can a be a significant time lag between Shine’s recognition of revenue/profit and cash realisation.  It appears that Shine’s business model may be riskier than suggested by its 2013 Prospectus.  The cash realisation of Shine’s recorded revenues/profits over the 10 years to 30 June 2022 appears to be contingent on the successful outcome of longer dated cases.

Dubious work-in-progress

There are three indicators that Shine’s work-in-progress (WIP) may be materially overstated as of 30 June 2022. These indicators are as follows:

(a) a decreasing ratio for cash receipts from customers to lagged WIP;

(b) a decreasing (increasing) proportion of current (non-current) WIP to total WIP; and

(c) a decreasing ratio for bad and doubtful debts expense relative to sales revenue.

Table 3 presents the ratio of Shine’s cash receipts from customers as a proportion of WIP and Unbilled Disbursements assets at the end of each previous year, that is, the beginning of each current year. This ratio measures Shine’ success at cash realisation for work-on-hand at the beginning of each year.

It is apparent from Table 3 that Shine’s cash receipts from customers as a proportion of WIP and Unbilled Disbursements assets at the beginning of each year is in decline. This ratio is 81% for 2013 but is down to 48% for 2022. Table 3 also shows a decreasing trend in the ratio across the 10-year period to 30 June 2022.

There are at least two possible explanations for the declining ratio of cash receipts from customers to lagged WIP. 

One explanation is that Shine is experiencing increasing delays on the cash realisation of its WIP and Unbilled Disbursement assets because legal matters are taking longer to settle. Another possible explanation is that Shine’s WIP and Unbilled Disbursement assets are bloated because they increasingly include amounts that are stale.

Table 4 presents Shine’s work-in-progress (WIP) classified as current and non-current for each year 2013 to 2022 together with the ratio of sales to WIP.

It is apparent from Table 4 that Shine’s total work-in-progress has grown significantly over the 10 years to 30 June 2022. Total WIP is up $216.2m (186%) from $116.3m to $332.5m. The growth in WIP is consistent with a growing business and that would be good news for investors except the character of the WIP has also changed.

The current and non-current columns in Table 4 show that Shine now relies much more heavily on recovering non-current WIP. In 2013, non-current WIP is $27.4m or 24% of the total WIP of $116.3m. In 2022, non-current WIP is $150.9m or 45% of the total WIP of $332.5m. 

Table 4 also shows that sales to WIP has decreased significantly since 2013, which means Shine is recognising less revenue per average dollar of WIP. In 2013, Shine recognised $1.01 of sales on the average WIP balance for the year. In 2022, only $0.67 of sales is being recorded on the average balance of WIP for the year. One possible explanation for this phenomenon is that WIP is turning over more slowly because of the increasing proportion of non-current WIP.

The move towards proportionately more non-current WIP may reflect Shine’s increasing reliance on new practice areas over its traditional personal injury legal services. Nonetheless, the recoverability of non-current assets and WIP staleness presents much more of an issue for Shine than when it first listed.

Table 5 shows the ratio of Shine’s effective bad and doubtful debts expense to sales revenue for each year across 2013 to 2022.

It is apparent from Table 5 that Shine’s ratio of bad and doubtful debts expense to Sales is relatively lower in 2021 and 2022 when compared to previous years. 

Shine should have an increasing rather than decreasing ratio of effective bad and doubtful debts expense to sales for two reasons. Firstly, the slowing cash realisation of WIP and Unbilled Disbursement assets shown in Table 3. Secondly, the slower turnover of WIP shown in Table 4.

Shine’s operating cash flow disclosures

There are at least two dubious practices relating to Shine’s cash flow disclosures, according to the investment analysis of the company.

The first concerns the classification of certain cash outflows within investing activities that seem to belong in operating activities. 

Payments for the acquisition of files from third party legal practices are classified by Shine in the investing activities section of its statements of cash flows for 2022 ($0.5m), 2017 ($5.9m) and 2016 ($2.3m). 

On the face of it, cash outflows for case files are equivalent to the purchase of work-in-progress and should be classified in operating activities because this involves Shine’s principal revenue-producing activity (refer paragraph 6 of AASB 107 Statement of Cash Flows).

Shine’s reasoning for classifying the purchase of case files from third party legal practices in investing activities is that a similar approach applies to business combinations (refer page 59 of the 2017 annual report). Shine’s reasoning is not in accordance with accounting standards and is unconvincing.

The company also appears to have further cash outflows classified in investing activities that may belong in the operating activities relating to intangible assets that have the character of internally generated goodwill.

The second dubious cash flow disclosure practice of Shine is its promotion of an alternative measure of operating cash flow performance that includes cash flows from financing activities. 

Table 6 shows the differences between Shine’s preferred measure of GOCF and the accounting standards measure of NOCF for each year of 2020, 2021 and 2022.

In recent years, Shine has reported its financial results using an unaudited non-accounting-standards measure it calls Gross Operating Cash Flow (GOCF). The Shine Chairman’s address to the 2022 annual general meeting referred to GOCF of $30.7 million as a “solid outcome”. The Chairman did not refer to the much lower net operating cash flow (NOCF) of $10.6 million disclosed in the audited financial statements. 

Most of the difference between GOCF and NOCF for 2022 is net cashflows from disbursement funding of $15.2 million, which relates to financing activities. Accordingly, Shine has effectively increased its obligations, or debts, from funding arrangements and then passed this off as a solid outcome for the results of cash from its operating activities. 

Financial results are less likely to be solid outcomes if they are achieved by including items that are not in accordance with accounting standards.

Prior to 2020, it appears that Shine incorrectly included net disbursement funding in its net operating cash flows by default. In light of this, it is likely that the net operating cash flow reported in Shine’s audited financial statements has been significantly overstated in the years prior to 2020. 

likely that the net operating cash flow reported in Shine’s audited financial statements has been significantly overstated

In the 2018 year, for example, Shine reports net cash flows from operating activities of $18.7 million, but this appears to include cash received from third party funders (a financing cash flow) in excess of $20 million. In other words, Shine seems to have reported positive net operating cash flows for 2018 when in fact they were negative. 

Shine also seems to have made an inappropriate disclosure in its 2022 financial report using GOCF. Page 140 of Shine’s 2022 annual report refers to an event after the reporting period in respect of the settlement of the Boston Scientific Class Action for $105 million and states that “the settlement is expected to have a positive impact on the Group’s Gross Operating Cash Flow”. 

Shine’s events after reporting date disclosure does not appear to comply with accounting standards because COGF is not a financial effect included in accounting standards (refer paragraph 21 of AASB 110 Events After the Reporting Period). GOCF includes net cashflows from disbursement funding, which means the disclosure at page 140 does not describe the real financial effect of the event, that is, the financial effect on net cash flows from operating activities. 

Page 7 of Shine’s 2022 annual report makes it clear that GOCF has not been audited, which means the disclosure at page 140 of the financial report has not been audited. In the audit report at page 160, PwC claim to have audited the notes to the financial statements. The PwC audit is incomplete if they have not audited the GOCF disclosure in the notes at page 140. 

PwC’s failure to audit GOCF may belie the fact that describing this measure as “operating” misleading because it includes a financing cash flow.

Questionable accounting for intangible assets

Table 7 shows the costs capitalised by Shine as intangible assets across the 10-year period to 30 June 2022. There appear to be some irregularities in the way Shine has been going about it especially for the intangible assets described as Transformation Project.

The financial effect of Shine inappropriately capitalising costs as a Transformation Project asset would be that certain costs are not included in net operating cash flow or EBITDA resulting in these financial results being overstated. As shown in Table 7, the financial year FY17 is the most likely candidate for such a phenomenon.

Transformation Project costs of $13.1 million were incurred to 30 June 2019. In the 2013 Prospectus, the Transformation Project is described as the T2 project with the objective of improving efficiencies in case selection and management (refer page 7 of the Prospectus). Shine’s capitalisation of Transformation Project costs of $13.1 million does not align with the representations made in 2013 Prospectus for three reasons. 

Firstly, $13.1 million is around 2.5 times the Prospectus forecast amount of “about $5.2 million” for the design and development of the new case management system over the forecast period (refer page 55 of the Prospectus). 

Secondly, the minuscule outlays of $0.6m for 2013 and $Nil for 2014 are a small fraction of the $5.5 million in capital allowance for the T2 Project set out in the forecasted statements of cash flows for FY13 and FY14 (refer page 33 of the Prospectus).

Thirdly, Shine’s delayed capitalisation of $6.1 million of Transformation Project costs for FY17 appears to be opportunistic because this is the year after FY16, that is, the year after Shine had downgraded its earnings and suffered a severe market reaction.  In the Prospectus, Shine indicated that any delays, cost overruns or integration issues with the T2 Project could have an adverse effect on “operations and profitability” (refer page 7 of the Prospectus).

In contrast, the financial effect of the T2 Project delays and cost overruns appear to have been a positive effect on intangible assets and EBITDA.

Internally generated goodwill

Shine’s capitalisation of Transformation Project costs also appears to be contrary to accounting standards because it confuses intangible resources with intangible assets. Entities frequently incur expenditure on the enhancement of intangible resources including the design and implementation of new processes or systems, but this does not mean all such expenditures qualify for recognition as an intangible asset. 

A transformation project or business improvement project is not of itself an intangible asset because the project cannot be separated from the entity itself, which means the project lacks the key criteria of identifiability. Many of the costs of transforming  business systems and processes will relate to internally generated goodwill and must be recognised as an expense when incurred (refer paragraphs 9–11 of AASB 138 Intangible Assets). 

Shine appears to have belatedly come to the realisation that Transformation Project costs ought not be capitalised as an intangible asset.  As shown in Table 7, the capitalisation of Transformation Project costs ceases in FY20 and is replaced by the capitalisation of costs for IT Development and Computer Software, which certainly are separate intangible assets. 

Change of auditors

Shine appears to have changed its accounting policy on Transformation Project Costs only after it changed auditors from Ernst & Young to PwC for the FY20 financial report. Shine could have educated itself about Transformation Project costs much earlier if it had read the correct formulation for intangible asset disclosures in the financial statements of Slater & Gordon.

Another dubious intangible asset shown in Table 7 is non-contractual client relationships of $3.3 million recognised in the FY17 year. 

Page 98 of Shine’s 2017 annual report states the intangible asset for non-contractual client relationships arose when Shine acquired 100% of voting shares in Claims Consolidated Pty Ltd for $6.4 million. Apparently, it was “the premium paid to access profits expected to be obtained”. 

Shine’s description here sure sounds like goodwill not a separate intangible asset.  Shine also claimed that the acquisition of the shares in Claims Consolidated Pty Ltd was an asset acquisition under AASB 116 Property, Plant and Equipment.  Shine ought to know that acquiring 100% of the voting shares in a company Is not an acquisition of an item of property plant and equipment.

The irregular nature of Shine’s disclosures for the acquisition of 100% of the voting shares in Claims Consolidated Pty Ltd suggests that the true details of this acquisition have not been disclosed. One possible explanation is that Shine acquired WIP in a business combination and when this WIP was realised by Shine its profits were overstated because the WIP had a carrying amount of $Nil.

Irregular revenue recognition

Table 8 presents the revenues of both Shine Justice and Slater & Gordon disaggregated by contract type for each year 2019–2022.

As shown on Table 8, the no-win-no-fee model dominates the business models of both Shine and Slater & Gordon. No-win-no-fee contracts are 90% [=46% + 44%] of Shine’s business for 2022 and 92% [=86% + 6%] of Slater & Gordons business. 

The problem with a no-win-no-fee arrangement is that it also potentially means no-profit. The current required accounting approach to this uncertainty is that revenue for services performed be recognised only to the extent that it is highly probable that the amount will not be subject to reversal when the uncertainty is resolved (refer paragraphs 56–57 of AASB 15 Revenue from Contracts with Customers).  

There are four clear problems that stand out with Shine’s recognition of revenue for variable consideration on no-win-no-fee contracts with customers.

The first problem is that the amount of consideration for no-win-no-fee business is highly susceptible to factors outside of Shine’s control especially judgments or actions of third parties including the Court.

The second problem is that the period for uncertainty about the amount of consideration appears to be increasing based on the change in Shine’s non-current WIP relative to current WIP (refer section 8 of this report)

The third problem is that Shine’s experience with contracts in new practice areas appears to be much more limited than its experience with personal injury claims making revenue recognition inherently more unreliable.

Changing shapes

As shown in Table 8, the composition of Shine’s no-win-no-fee business has changed significantly in recent years. Personal Injury (PI) no-win-no fee was 67% of Shine’s business for 2019 but this is down to 46% for 2022.  New Practice Areas (NPA) no-win-no-fee has grown from 20% for 2019 to 44% for 2022. In contrast, Slater & Gordon was still recognising 86% of its revenue for 2022 on personal injury contracts.   

The fourth problem is that Shine has a track record of being overly optimistic on revenue recognition as indicated by the dramatic ASX earnings downgrade announcement of 29 January 2016.

It should be said that law firms generally book their WIP as revenue but the difference between a Mallesons or a Freehills and Shine is that the former do a lot of work for government and large institutions, income which is reliable. They also charge for services rather than operate on contingency.

Editor’s Note: both Shine Justice and PwC were provided with detailed questions for this story. They declined to be respond. The author of the Shine investment report on which this story is based preferred to remain anonymous.

Update 8 March, 2023: Response received from Shine Justice CEO, Simon Morrison

Editor’s Note: MWM and the author of the report stand by the story and extend a standing invitation to meet with Shine executives and auditors PwC to discuss the issues raised.