A little over a year after major UK contractor, Carillion, went spectacularly bust, we thought it would be opportune to consider the criticisms of poor governance by the board and failings by the auditors, and look at the solutions subsequently proposed for audit regulation and audit practice. We can then consider what difference they might have made had they been in operation in the years prior to the collapse.
What happened at Carillion?
Carillion was created in 1999 as a demerger from the long-established construction company, Tarmac, to focus on contracting services in what was then seen as a rapidly expanding market and, particularly, the opportunities arising from the Private Finance Initiative from the government to outsource public services. Over the next few years it grew rapidly by acquisition of some other former UK construction industry leaders such as Mowlem and McAlpine, and ventured overseas, for instance buying companies in Canada.
The rapid growth impressed analysts, as revenues grew from £2bn in 2000 to £5bn in 2016. However, there were some fundamental weaknesses which were eventually going to contribute to the collapse of the slightly ramshackle structure which was being assembled. These included:
- the acquisitions were being funded primarily by debt, giving rise to a growing interest charge which demanded reliable performance by the acquired businesses
- contracts in the outsourcing field were highly competitive and won on wafer-thin margins
- hence there was no room for poor estimating or poor management, and Carillion appears to have had both of these in large measure
- in at least one case, the purchase of energy efficiency business, ERGA, in 2011 for £305m, almost from day one, the justification for the acquisition was invalidated by the change in government policy which progressively cut the subsidies on which ERGA’s business model was founded. Over the next five years ERGA’s losses exceeded the amount Carillion paid for it.
The result of building a business through assembling a set of poorly performing operations with razor thin margins at best, funded by debt, was the requirement to keep finding new sources of cash. The approach taken was later described as a type of Ponzi scheme, in which the new businesses acquired would generate initial cash flow which would cover the losses made on earlier non-performing contracts. The end result was probably inevitable without someone arresting the process and stopping new contract signings while sorting out the legacy of loss-making ones, and simultaneously raising funds to bridge the turn-round process. Sadly, unlike some of its peers, no-one bit the bullet at Carillion.
The end came after the company had declared profits before tax of £142m on revenues of £5.2bn for 2016 in unqualified accounts signed off by KPMG. Six months after the year-end the directors had to declare write-offs of £845m, and the CEO resigned. There followed three profit warnings, and Carillion collapsed into compulsory liquidation the following January with cash balances of £29m and liabilities of £7bn.
Where did the governance go wrong?
If we take the leading accountants’ approach to corporate governance, we would have to say that, assuming KPMG were doing their job properly as external auditors, Carillion apparently ticked all the boxes as regards compliance with the regulations applying to a listed company and with the UK’s Corporate Governance Code. KPMG signed off their accounts for 2016 and the earlier years without any qualification regarding compliance.
However, Carillion went bust within a little over twelve months from the last audited year end, so “compliance” doesn’t appear to have been much use in assessing the quality of their corporate governance.
For many years, recognising the limitations of relying on compliance, we have therefore defined corporate governance holistically, and that is how we’ll summarise the failings here, by reference to our Five Golden Rules of good corporate governance.
An ethical approach
The board paid regular dividends to shareholders in order to maintain the image of a successful company though its finances were clearly inadequate. This imperilled the business, and hence the well-being of its 40,000 employees and hundreds of suppliers. Similarly, in the year before collapse, it awarded significant bonuses to its senior staff who were instrumental in creating this disaster, and, worse, not long before the final collapse, the directors had removed a “malus” clause in the remuneration contracts which would have clawed back earlier bonuses in the event of a subsequent liquidation.
Score: 3/10
Congruence of interests in the company’s goal
Here we see Carillion chasing after government outsourcing contracts, frantically agreeing hopelessly optimistic performance targets to get the business. However, the government had rather different objectives, which included shifting responsibility for the performance from their own departments to the supplier, and moving the financial obligations from the Treasury to the private sector. The contracts were drawn up very aggressively in the knowledge that the competing firms were desperate to get the work. Mutuality of interest was weak, and when things went wrong, government was quick to lay the blame on the contractor, though a large part of the performance commitment and much of the financial requirement then came back to haunt them.
Score: 4/10
Strategic management quality
The strategic decision made by Tarmac was to hive off part of their business into a new vehicle to focus on outsourcing by government departments. The management of Carillion then set themselves the goal of building scale rapidly, and did this by debt-funded acquisitions over the following years until it had been built into the second largest operator in the field. So scale was achieved, but the profitability in the target market was very slim, and the resources acquired to deliver were plainly inadequate, evidenced by poorly run acquisitions and insufficient finance. Moreover, lessons weren’t learned, and the flawed strategy was pursued to destruction.
Score: 5/10
Organisation appropriately structured and resourced
There seems to have been little integration of the acquired businesses, which appear to have been simply bolted on. This may be an unfair criticism, but remarks made by the Insolvency Service about the difficulty of determining who were the directors on the various boards at any given point in time suggests a serious lack of central control. Moreover, the fact that there were huge amounts of uninvoiced work and disputed invoices, presumably across the whole network of subsidiary companies, points to ineffective management controls generally. The apparent ignorance of the board as to the true, underlying state of affairs points to a serious failing both in information systems and controls, but also in the supineness of the directors in not challenging the information they were given.
Score: 3/10
Accountability and transparency
The 2016 Report and Accounts summarised the outlook with the words: “High quality order book and strong pipeline of contract opportunities”. The summary stated an “order book pipeline of £41.6bn” and “net borrowings of £218m” together with, as mentioned above, a figure for profit before tax of “£146m”. But what it certainly didn’t highlight was that due to the extreme financial pressure, Carillion had taken advantage of a government scheme through which suppliers to companies like Carillion could get paid promptly, for a modest fee, through a separate bank scheme. This took these trade creditors off Carillion’s books and put the liabilities into a different part of the balance sheet, thereby flattering the short-term liquidity position.
Furthermore, the goodwill in the balance sheet had grown to huge proportions as the company made its acquisitions, and its valuation, in reality, was very small. For instance, ERGA, mentioned above, was taken into Carillion’s books at a valuation of £329m against a purchase price of £306m, and even after the losses mentioned above, the goodwill was left unimpaired. It took a newly appointed CFO of one of the group companies to challenge Carillion’s “sloppy” accounting practices, in early 2017. And despite the initial rebuttal, this “whistleblower” had pulled the thread which caused the concealment to start unravelling. A few months later Carillion announced its huge write-off.
Score: 1/10
What were the criticisms of auditors?
The criticisms of the Big Four accountants firms, all of which were involved with Carillion in different ways, can be grouped into two broad categories: professional ethics and professional competence.
The work performed and some of the advisory fees charged were
- KPMG: external audit and £157K work on a potential rights issue, which never happened
- Deloitte: internal audit and £554K over three years for a market-sizing exercise for a new product
- EY: £11m in 2017-8 for a cost-cutting initiative
- PwC: liquidation adviser and adviser to the pension fund.
KPMG’s role as external auditor from 1999 onward needs no explanation, but Deloitte’s role in internal audit apparently included advice on risk management and financial control, for which they charged £51m over ten years
PwC was challenged on the ethical question of, effectively, advising on how much was owed to its own client. The others were accused, less fairly, of feeding voraciously, like vultures, on the sucker which was Carillion.
Regarding professionalism, it is arguable that EY’s exercise was essential, but too late, even if it was more than the company could afford at the time. Similarly, KPMG’s help in an unsuccessful exercise to try and raise vital funds can clearly be justified. But the performances of KPMG and Deloitte in their roles of external and internal auditor can surely only be described by an independent onlooker as dire.
KPMG’s defence is effectively the “safe harbour” one, that they followed all the required steps and it was management’s business judgement that was to blame for the sudden collapse. The challenge to this view is the one that has been debated around the issue of the so-called expectation gap regarding the purpose of audit, but Deloitte must surely have a more difficult case to answer.
Professionally, KPMG signed off 2016 accounts, which included the encouraging statements mentioned above, shortly after which Carillion was shown to have little in the way of realisable assets (fixed assets amounting to less than 5% of the total assets in the liquidation) and huge, largely valueless goodwill, securing equally huge borrowing. Additionally, there was a £500m pension deficit, when over the period 2012 – 2106 Carillion paid out £376m in dividends while generating only £159m of operational cash flow. Indeed, the business was later described as having little real capital value but consisting essentially of simply hiring out labour and recharging expenses. And this business was valued at £1.6bn at the end of 2016, down from £2.4bn six months earlier, further down to £1.2bn six months later, and to zero just over six months after that. So it halved in market value over twelve months, during which time the audit was conducted, and was dead twelve months after a clean audit
And over this period the risk management and financial control systems which Deloitte had been advising on proved their true worth
No wonder observers were critical of the professional competence of the Big Four, to the extent that an MP on the Parliamentary Committee grilling one of the KPMG partners concerned memorably said that he wouldn’t hire him to do an audit of the contents of his fridge
What are the new proposals?
Since Carillion blew up, the UK Parliament has been attacking the audit profession, or more particularly, the Big Four. In the view of MPs there is a cosy oligopoly which is detrimental to standards, and where audit is used as a loss-leader to help sell lucrative consultancy and advisory work. And all the big client audit work is shared out among the Big Four, to the exclusion of the worthy smaller firms.
To precipitate change, they prompted reviews of the audit profession and its regulator, and commissioned the competition authority to look at the issue of the Big Four oligopoly. In response, the audit profession has accepted the need for some kind of changes and pointed to the work being done by its own research and standards review organisations (we were rather critical about the audit profession’s efforts to address the expectations gap last year). In summary, the main initiatives have been:
Kingman Review of Audit Regulation: which recommended that the regulator, the Financial Reporting Council (FRC), was out of date in its remit and should be replaced by a new body, the Audit, Reporting and Governance Authority (ARGA), which would have a wider remit and all the extra powers of a statutory body. And maybe consider a UK version of the US’s SarBox.
Competition and Markets Authority (CMA): issued proposals which include splitting up the Big Four, ring-fencing the audit side of the firms, joint audits and a cap on market share.
Project Flora, headed by Donald Brydon: currently examining the quality and standards of audit and what can be done to meet public expectations.
Meanwhile, the FRC is trying, belatedly, to show its teeth, and in response to the “going concern” issue, is issuing its own more stringent provisions that go far beyond the current international standard ISA 570, which auditors will now be required to meet
What difference would the new proposals have made to Carillion’s governance and the interests of its stakeholders?
Looking at our short summary of Carillion’s nineteen year business life and the issues that led to its downfall, do we think the changes outlined above would have made a significant difference to the eventual outcome?
The chief factors that doomed Carillion were a marginal business model, ineffective operational management, delusional accounting, and dangerous over-gearing which led inexorably to the cash shortages which killed it. The public presentation of the company’s performance fooled some analysts (referred to by the KPMG partner as providing support for his judgements) but not all (it was one of the most shorted companies towards the end). So would separation of the audit into a separate firm have improved KPMG’s audit? Would bringing a smaller firm into a joint audit have made a difference? Would a new more powerful regulator with a wider remit to include the Corporate Governance Code have spotted the flaws in the audit process?
The answer to the first two questions is surely no, as the perceived purpose of the audit would be no different, and hence the practice would still adhere to existing principles, which, for instance, would permit demonstrably flawed valuation of goodwill. And creating a bigger regulatory bureaucracy with the remit to include the Corporate Governance Code would surely deliver yet more extensive box-ticking. It’s possible that Donald Brydon will redefine the purpose of the audit to bring it closer in line with common sense, but less likely that he will add the rider that the practice should include an independent survey of the key stakeholders to cast a light on the reality or otherwise of the company’s internally generated information flows.
We outlined our views regarding the future of audit in our earlier articles. Official opinion has been moving our way in recent years regarding the need to account to all the key stakeholders, not just the shareholders, and on a wider range of matters than simply financial performance. Sadly, one of the key elements – independent survey – hasn’t yet appeared in recommended practice. So, in the words of Christopher Booker, this looks like another example of a sledgehammer to miss a nut, albeit a rather big nut.
Earlier posts on audit:
- Don’t rely on compliance
- Reliance on Compliance threatens the Audit Profession
- Holistic Corporate Governance can save the Audit Profession
