By Adrian Grant
No one appears to have foreseen the collapse of British constructiíon services company Carillion in early 2018.
Despite issuing three profit warnings in five months in 2017, investors, senior credit analysts and auditors all failed to spot the accounting techniques employed by the company to make Carillion seem healthier than it was.
Worryingly, one of those techniques was to use supply-chain finance – a relatively new and useful way for healthy businesses to maximize working capital – to mask the true scale of the company’s financial problems.
Carillion’s collapse wrought widespread havoc. It employed 43,000 people globally, with some 20,000 in the UK. It left about 30,000 small firms, including subcontractors, unpaid, forcing many to make their own lay-offs.
Construction activity in the UK fell in the aftermath, and the country saw a 20% surge in insolvencies at UK building firms. It left an £800 million pension deficit and will cost taxpayers an estimated £180 million.
The UK government has since launched investigations into the accounting practices of the big four auditors – Deloitte, EY, KPMG and PwC – as well as the UK’s accounting watchdog itself.
In December, the UK’s Competition and Markets Authority recommended sweeping changes to the structure of the audit industry. Carillion’s demise even catalyzed the end of UK private finance initiatives, used extensively by the government since the 1990s.
However, Carillion is only one of the most recent cases of aggressive accounting gone wrong. Why is this?
Financial statements are meant to reflect a company’s true financial position, but what is true in accounting is, in fact, highly subjective
Some blame the agency model of business. Under this model, companies are operated by professional managers who often have little ownership interest. This skews incentives and can lead to individuals preparing financial statements in a manner consistent with their own personal gain, rather than in the interests of transparency.
Like Enron and WorldCom, Carillion will undoubtedly serve as a textbook case of big-ticket accounting failures for future business students.
And like those failures, Carillion’s case is rife with sordid details: executives padding out their own pay instead of attending to the pension deficit; shareholders stripping dividends even as cash flow and profitability were tenuous (Carillion paid £376 million in dividends over a five-year period in which it made only £159 million in net cash from operations); and incompetence, or even negligence, on the part of the company’s management and auditors.
The May 2018 parliamentary select committee report* on Carillion’s collapse highlights the all-too common issues: dubious revenue; delaying costs; over-estimating profits and over-valuing assets.
With Carillion’s business model being an “unsustainable dash for cash”, according to the report, “the mystery is not that it collapsed, but how it kept going for so long”. A lack of coherent strategy, prioritizing shareholder dividends over financial health, a “rotten” corporate culture and a negligent board – to read the report is to see all too clearly that Carillion was doomed to fail. But only with the benefit of hindsight.
So why were Carillion’s dubious accounting methods so hard to spot at the time?
Papering over the cracks
The causes of Carillion’s downfall may be familiar, but the mechanism it used to paper over the cracks is unique to supply-chain finance, a scheme that allows businesses to optimize their cash flows.
Going beyond the numbers
Financial statements are meant to reflect a company’s true financial position, but what is true in accounting is, in fact, highly subjective. Assessing revenue and profits from individual contracts is difficult and often controversial, so a comprehensive and intelligent analysis involves going beyond the numbers.
Directors – the people responsible for writing and reviewing financial statements – are more likely to construct aggressive presentations when their businesses are facing difficulties. So on top of more intelligent scrutiny of the financials, analysts need to form a more thorough understanding of management and its integrity.
Analysts far too often cut and paste profiles of senior management from corporate websites with little real analysis. Better understanding of management’s talents, incentives and behaviours can be all-important to spotting misleading financial statements before they become a problem.
Building on Carillion
In cases such as Carillion, the techniques may differ but the result is depressingly familiar: aggressive accounting, potentially morphing into fraudulent accounting, then demise.
Yet it is possible to spot suspicious accounting techniques and prevent future collapses.
Euromoney Learning’s in-depth guide Deconstructing Carillion will help you understand not only how Carillion used supply-chain finance to present an overly optimistic view of its contract revenue and profitability, but also highlight other ways to spot aggressive accounting techniques and potential fraud, before they bring down a company.
* Carillion, Second Joint Report from the Business, Energy and Industrial Strategy and Work and Pensions Committees of Session 2017-19, HC709, published under authority of House of Commons May 16, 2018
** Paragraph 91, page 43 of the select committee report
About the author: Adrian Grant
With more than 30 years’ experience in banking and financial services, Adrian specializes in delivering practical and interactive training programmes in the areas of credit, origination, corporate restructuring, financial analysis, and loan workout up to an advanced level.
Before becoming a trainer and consultant, he worked as a regional director for the National Australia Bank Group’s corporate and institutional banking division.