Carillion: FRC slated as toothless regulator and Big Four ‘too cosy'

In a lacerating report on the collapse of Carillion, the joint Parliamentary select committee has castigated the ‘parasitical relationship’ between the Big Four, accused the Financial Reporting Council (FRC) of ‘toothlessness’ and called for a major overhaul of the statutory audit market and the regulatory regime

The final report of the work and pensions and BEIS select committees says Carillion's business model represented ‘a relentless dash for cash, driven by acquisitions, rising debt and exploitation of suppliers’ , while its ‘at best questionable’ accounting practices ‘misrepresented the reality of the business’.

Rachel Reeves, chair of the BEIS committee, said: ‘The company’s delusional directors drove Carillion off a cliff and then tried to blame everyone but themselves. Their colossal failure as managers meant they effectively pressed the self-destruct button on the company.

‘However, the auditors should also be in the dock for this catastrophic crash. They are guilty of failing to tackle the crisis at Carillion, failing to insist the company paint a true picture of its crippling financial problems. The sorry saga of Carillion is further evidence that the Big Four accountancy firms are prioritising their own profits ahead of good governance at the companies they are supposed to be putting under the microscope.

‘KMPG, PwC, Deloitte and EY pocket millions of pounds for their lucrative audit work - even when they fail to warn about corporate disasters like Carillion.  It is a parasitical relationship which sees the auditors prosper, regardless of what happens to the companies, employees and investors who rely on their scrutiny. 

‘The collapse of Carillion exposed terrible failures of regulation. The government needs to stop dithering and act to ensure regulators are up to the job of intervening before companies fail, rather than trying to pick up the pieces when it is too late.’

The report calls for the government to refer the statutory audit market to the Competition and Markets Authority. The terms of reference of that review should explicitly include consideration of both breaking up the Big Four into more audit firms, and detaching audit arms from those providing other professional services.

Accounting tricks

The committee had previously released details of its criticisms of Carillion’s use of an ‘early payment facility’ with Santander as a way of improving its cashflow statements by presenting bank borrowing as cash inflow from operations, rather than as a loan.

The final report is critical of several other elements of Carillion’s approach to accounting, including the use of peer reviews as a way of independently assessing management estimates of the value and profit margin of a given contract. As an example, 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 £53m, the same loss included for the hospital contract in the July 2017 profit warning.

The report points out: ‘The Carillion board have maintained that the £845m provision made in 2017 was the unfortunate result of sudden deteriorations in key contracts between March and June that year. Such an argument might hold some sway if it was restricted to one or two main contracts. But their audit committee papers show that at least 18 different contracts had provisions made against them.’

Carillion recognised considerable amounts of construction revenue that was ‘traded not certified’, representing revenue that clients had not yet signed off, such as for claims and variations. In December 2016, this amounted to £294m, an increase of over £60m since June 2014, and accounting for over 10% of total revenue from construction contracts.

The report concludes that the outsourcer ‘used aggressive accounting policies to present a rosy picture to the markets,’ and is especially critical of Richard Adam, the finance director between 2007 and 2016, who is described as the ‘architect’ of this approach.

The report stated: ‘His voluntary departure at the end of 2016 was, for him, perfectly timed. He then sold all his Carillion shares for £776,000 just before the wheels began very publicly coming off and their value plummeted. These were the actions of a man who knew exactly where the company was heading once it was no longer propped up by his accounting tricks.’

Auditors

MPs accused KMPG of failing to question Carillion’s financial judgements and information and of ‘complacently signing off its directors’ increasingly fantastical figures’ over its 19 year tenure as Carilion's auditor, while ‘pocketing £29m in the process.’

The report stated: ‘In failing to exercise—and voice—professional scepticism towards Carillion’s aggressive accounting judgements, KPMG was complicit in them.’

MPs described the current state of the audit market for major companies as a ‘cosy club’, which is ‘neatly divvied up among the Big Four firms’, and said the lack of competition ‘creates conflicts of interest at every turn’.

Deloitte was paid over £10m as 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’, while EY was paid £10.8m for ‘six months of failed turnaround advice’.

PwC variously advised the company, its pension schemes and the government on Carillion contracts, but was still the least conflicted of the Four,  with the report noting that ‘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’.

‘Without measurable targets and transparent costs, PwC are continuing to gain from Carillion, effectively writing their own pay cheque, without adequate scrutiny.’

The report concluded: ‘KPMG’s long and complacent tenure auditing 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. Waiting for a more competitive market that promotes quality and trust in audits has failed. It is time for a radically different approach.’

Regulators

The committee takes aim at both the FRC and the Pensions Regulator (TPR), says it has ‘no confidence in our regulators’ and accusing the FRC and TPR of sharing ‘a passive, reactive mindset’ and being ‘too timid to make effective use of the powers they have’.

The report warns: ‘They do not seek to influence corporate decision-making with the realistic threat of intervention. The steps they are beginning to take now, and extra powers they may receive, will have little impact unless they are accompanied by a change of culture and outlook.’

MPs said the FRC should have followed up its identification of several failings in Carillion’s 2015 accounts with subsequent monitoring. Its limited intervention in July 2017 resulted only in securing ‘box-ticking’ disclosures  and failed to challenge Carillion on the ‘inadequate and questionable nature’ of the financial information it provided, while the FRC was ‘wholly ineffective in taking to task the auditors who had responsibility for ensuring their veracity.’

In the view of MPs, TPR ‘clearly failed’ in its statutory objectives to reduce the risk of schemes ending up in the Pension Protection Fund (PPF) and to protect members’ 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 of around £800m, the biggest single hit it will ever have taken. All the pensioners with schemes in the fund will receive a reduced level of benefits.

Recommendations

The committee’s report says Carillion is a test of the regulatory system and calls for a more active and interventionist approach in the forthcoming revision of the stewardship code, including a more visible role for the regulators, principally the FRC.

The report stated: ‘The Carillion collapse has exposed the toothlessness of the FRC and its reluctance to use aggressively the powers that it does have.

‘At present, the mindset of the FRC is to be content with apportioning blame once disaster has struck rather than to proactively challenge companies and flag issues of concern to avert avoidable business failures in the first place.

‘We believe that the government should provide the FRC with the necessary powers to be a much more aggressive and proactive regulator: one that can publicly question companies about dubious reporting, investigate allegations of poor practice from whistle-blowers and others, and can, through the judicious exercise of new powers, provide a sufficient deterrent against poor boardroom behaviour to drive up confidence in UK business standards over the long term.

‘Such an approach will require a significant shift in culture at the FRC itself.’

The report goes on to state: ‘While we welcome the swift announcement of investigations into the audit of Carillion and the conduct of the finance directors responsible for the accounts, we have little faith in the ability of the FRC to complete important investigations in a timely manner. We recommend changes to ensure that all directors who exert influence over financial statements can be investigated and punished as part of the same investigation, not just those with accounting qualifications.’

Select Committee Carillion report issued 16 May 2018

Report by Pat Sweet

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