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Thursday, 16 August

The Hussle - Carillion's Accounting Tricks Revealed

Carilion

Carillion's accounting tricks and those who were culpable in allowing them have been revealed.

Peer review Royal Liverpool Hospital - Peer review is a check and balance whereby management’s contract appraisals on the estimate of the value and profit margin of a given contract are reviewed independently within the company. A November 2016 internal peer review of Carillion’s Royal Liverpool Hospital contract reported it was making a loss. Carillion’s management overrode that assessment and insisted on a healthy profit margin being assumed in the 2016 accounts. The difference between those two assessments was around £53 million, the same loss included for the hospital contract in the July 2017 profit warning.

 

Traded not certified

Carillion recognised considerable amounts of construction revenue that was 'traded not certified': revenue that clients had not yet signed off, such as for claims and variations and therefore it was inherently uncertain whether payment would be received. In December 2016, the company was recognising £294 million of traded not certified revenue, an increase of over £60 million since June 2014 and accounting for over 10% of total revenue from construction contracts.

 

The early payment facility (EPF)

Carillion’s early payment facility treatment helped hide its failure to generate enough cash to support the revenues it was recognising. Carillion had a target of 100% cash conversion: for cash inflows from operating activities to at least equal underlying profit from operations. It consistently reported that it was meeting this target. It could do this because the EPF classification allowed it, in cashflow statements, to present bank borrowing as cash inflow from operations, rather than as yet another loan.

 

Aggressive accounting

Carillion used aggressive accounting policies to present a rosy picture to the markets. Maintaining stated contract margins in the face of evidence that showed they were 'optimistic' and accounting for revenue for work that had not even been agreed, enabled it to maintain apparently healthy revenue flows. 'The only cash supporting its profits was that banked by denying money to suppliers', says a Work and Pensions and BEIS Committees report.

 

The Big Four

The report also says Carillion exposed the UK’s audit market as a 'cosy club incapable of providing the degree of independent challenge needed'.

The report recommends that the Government should refer the statutory audit market to the Competition and Markets Authority. Possible outcomes considered should include breaking up the audit arms of the Big Four, or splitting audit functions from non-audit services.

In its failure to question Carillion’s financial judgements and information, KMPG was 'complicit' in the company’s 'questionable' accounting practices, 'complacently signing off its directors’ increasingly fantastical figures' over its 19 year tenure as Carilion's auditor, says the report.

Deloitte was paid over £10 million by the company to act as its internal auditor but were either 'unable or unwilling' to identify the 'terminal failings' in Carillion’s risk management and financial controls, or 'too readily ignored them'.

Ernst & Young was paid £10.8 million for 'six months of failed turnaround advice'.

 

Conflicts of interest - report statements

The lack of competition in the audit market 'creates conflicts of interest at every turn', says the Committees' report, stating: 'KPMG were external auditors, Deloitte were internal auditors and Ernst and Young were tasked with turning the company around. PwC variously advised the company, its pension schemes and the Government on Carillion contracts, yet was still the least conflicted of the Four, and 'as the Official Receiver searched for a company to take on the job of Special Manager in the insolvency, the oligopoly had become a monopoly and PwC could name its price'.

KPMG's 'long and complacent' tenure of 'cursory' audits at Carillion was not an isolated failure: it was 'symptomatic of a market which works for the members of the oligopoly but fails the wider economy'.

As advisors to Government and Carillion before its collapse, and as Special Managers after, PwC benefited regardless of the fate of the company. Without measurable targets and transparent costs, PwC are continuing to gain from Carillion, effectively writing their own pay cheque, without adequate scrutiny.

 

The Regulators

The Committees say they have 'no confidence in our regulators'.

Financial Reporting Council and The Pensions Regulator were 'united in their feebleness and timidity', too 'passive and reactive' to make effective use of the powers they have. Any extra powers they may receive will have little impact without a change of culture and outlook in both. In TPR’s case, the Committees are 'far from convinced that its current leadership is equipped to effect that change'.

The FRC is too 'content with apportioning blame once disaster has struck' rather than proactively challenge companies and flag issues of concern to avert avoidable business failures in the first place.

The FRC was 'timid' in challenging Carillion on its 'inadequate and questionable' financial information and 'wholly ineffective' in taking its auditors to task.

The Committees have 'little faith' in the FRC’s ability to complete its investigations in a timely manner and say its mandate should be changed to ensure that all directors who exert influence over financial statements can be investigated and punished.

TPR 'clearly failed' in its statutory objectives to reduce the risk of schemes ending up in the PPF and to protect member's benefits: it had concerns about schemes for many years without taking action, even when Carillion’s trustees repeatedly asked it to intervene.

TPR only announced an investigation for possible recovery action after the company collapse, when there was next to nothing left to recover. The PPF expects a funding shortfall  - which will be absorbed by the PPF and its levy-payers - of around £800 million, the biggest single hit it will ever have taken. All the pensioners with schemes in the Fund will receive a reduced level of benefits.

 

Collapse inevitable

Successive Governments have nurtured a business environment and pursued a model of service delivery which made a collapse like Carillion’s almost inevitable - with the consequences clear in the taxpayer being left to foot so much of the bill for the clean-up operation.

Measures that Government has taken to improve the business environment, such as the Prompt Payment Code, have proved wholly ineffective and need revisiting.

The Government’s Crown Representative system - 'semi-professional and part-time' - provided little warning of the risks in a key strategic supplier and should be reviewed immediately.

When Special Managers are required for an insolvency, the companies must not be given a blank cheque. The Insolvency Service should set and regularly review spending and performance criteria and provide full transparency on costs incurred and expected future expense.

Picture: Carillion's accounting tricks and those who were culpable in allowing them have been revealed.

Article written by Brian Shillibeer

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