I prepared this guest post from Professor Atul K. Shah that asks questions about the audit of Carillion last night. I have just heard that the Financial Reporting Council has just announced that it will be reviewing this audit. The issues any such review will raise will drive to the heart of the fitness of the UK audit and reporting system:
A company with rising dividends suddenly goes bust six months after their audit. KPMG had given it a clean bill of health on 1st March 2017, with no qualifications, and stated that the financial statements gave a ‘true and fair view'. They confirmed that those accounts had been prepared in accordance with the law. They said they had nothing to report on the disclosures of principal risks. They agreed with the assumption that Carillion was a going concern.
But they were wrong: it wasn't.
The role of the audit is to verify the accuracy of the disclosures a company makes in its financial statements and the reliability of reported financial data and notes to the accounts. In the case of construction companies, there are two commonly known high-risk issues: liquidity, which requires a critical assessment of cash flows, and the timeliness of the recognition of income. Any auditor of companies in this sector should know that these issues have to be the principal focus of the audit, and that they must be verified microscopically for to determine the presence, or not, of material risks.
In the case of Carillion what we learned in June 2017 was that there were an additional £1bn of previously unanticipated contract losses. As a result a profits warning was issued three months after the completion of the audit. Within another six months, Carillion was bankrupt. The obvious question that gives rise to was whether the audit to which KPMG lent its name was properly undertaken.
These are just some questions that common sense suggests it would be appropriate for KPMG to answer with regard to what they knew on 1st March 2017 when signing off Carillion's financial statements with a clean bill of health:
- What was known about the risks of those big construction contracts at the time of signing the audit opinion? The trade receivables figure of £1.7bn should have raised huge queries, given that this is ten times the Operating Profit of the business, and if unrecovered, even partially, could cause serious problems;
- Current liabilities in the financial statements were £2bn and were higher than trade receivables. This was, surely, a danger sign? In this situation where it seemed more money was due by the company than it could reasonably expect to recover in the short term what checks were made of creditors and how did this impact on the assessment of likely cash flows?
- Intangible assets were stated to have a worth of £1.7bn on the last financial statements. These have now proved to be worthless, but when the accounts were signed off they represented 70% of total assets. Why was no warning given on such a large figure on the balance sheet, given the business problems that were already apparent to many, including the hedge funds that were already shorting the shares of the company?
- Profit margins were wafer thin over years (less than 5%) but this is not like food retail where such margins can be tolerated because that is a safe, dependable, business. It is, instead, a high risk construction business. How did KPMG verify the business' sustainability at such low margins?
- The recognition and timing of contract income is a hugely risky area for audit, and requires a very careful review of contracts, repayments and assumptions. What evidence do the audit files contain to support the decisions taken?
- The dividend was increased by 1% in spite of the huge problems the company appeared to be facing, and despite a very tight cash flow. What questions were raised about this with the Board of Directors? Given the huge pension deficit of £440mn, giving a comprehensive loss of £205mn in 2016, why was this dividend paid at all, given that distributable reserves need to take account of all losses, realised and unrealised? What calculations were undertaken to prove that it was legal? Auditors have a specific duty to check this issue.
- To what extent were loan covenants breached, and how was this audited?
- Post-balance sheet events need to be audited to ensure any new information does not affect the basis for the audit opinion. What work was done on this? What changed between March 1 and the date of the profit warning? Why couldn't the change of circumstance have been anticipated when the audit was underway?
- To what extent did KPMG's consulting work on the multi-billion pound High Speed Rail project (HS2) influence the audit opinion? How were conflicts of interest created by this project addressed in the course of the audit?
Sometime, someone is going to have to answer these questions. And for the sake of all involved the sooner the better might be a reasonable request.
Atul K. Shah is Professor of Accounting and Finance at University of Suffolk. Twitter @atulkshah He is author of Reinventing Accounting and Finance Education
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‘A company with rising dividends suddenly goes bust six months after their audit. KPMG had given it a clean bill of health on 1st March 2017, with no qualifications, and stated that the financial statements gave a ‘true and fair view’.’ etc.
For a minute there I had deja vu. I thought you were talking about ENRON. It all looks frighteningly similar.
BY all accounts KPMG deserves to go the same way as Arthur Andersen. That would be justice in my view.
Enron parallels keep popping up with increasing frequency where the Big 4 are concerned. This is another prime example.
Turning the big 4 into the big 3 sounds like a bad idea
It is
At that point total reform of audit is required
I was thinking sequentially and hoping that a poor audit for KPMG in this situation would leave behind more rigorous for arrangements for the others via reform.
The Finance module I did during my MBA left me thoroughly convinced that something is severely wrong with standard company accounting.
You are right re company accounting: it is profoundly flawed and a group of us, including Atul and me, argue it is also likely to not comply with UK company law at present
That is reflected in an article by Jonathan Ford in he FT today: he interviewed Atul for it
“Turning the big 4 into the big 3 sounds like a bad idea”
Should we have kept Arthur Andersen in existence on that logic?
Hi Richard,
Apologies if you’ve covered this before…
I guess there’s a difference between principle and reality, but to what extent are auditors accountable for their audit process and results?
In this case, if investigation shows that KPMG were at fault in some way, what actual penalties would they face, and who would perform such an investigation?
Thanks,
Jon
They can be fined, individuals can be barred from work and the firm can be barred from auditing temporarily or for good
Expect a slap on the knuckles
The FRC is riddled with ex Big 4 people who will look after their own, I fear
I think the most serious questions relate to the 70% of intangible assets, given that the bulk of that was goodwill. In the light of the other queries raised here you would expect that goodwill to be written down by the auditors (‘impaired’ is the term I believe).
On Jan. 21st in response to this post:
http://www.taxresearch.org.uk/Blog/2018/01/21/mays-suggested-reforms-on-directors-responsibilities-are-a-sham/
I made the comment below which you followed with a brief reply:
“Marco Fante says:
January 21 2018 at 6:36 pm
… Should these pension schemes be compelled to have some form of compulsory insurance or re-insurance perhaps? Remembering that the the term ‘moral hazard’ originated in the insurance industry, the insurer in this case could possibly provide the necessary discipline and oversight. No one else seems to be doing that.
Richard Murphy says:
January 21 2018 at 7:36 pm
That’s an interesting idea
Who would provide it though?”
As this issue remains unresolved I think the idea may be worth exploring. In essence it reflects the idea of procedural justice as articulated by the philospher, John Rawls:
“Perfect procedural justice has two characteristics: (1) an independent criterion for what constitutes a fair or just outcome of the procedure, and (2) a procedure that guarantees that the fair outcome will be achieved.” https://en.wikipedia.org/wiki/Procedural_justice
In his essay ‘Distributive Justice’ Rawls uses the metaphor of a cake to explain “fair division”. The last person to take a slice of the cake is first given the task of dividing it. The procedure ensures an even division and eliminates a conflict of interest.
The point is one of eliminating conflicts of interest rather than policing them. In the case of my compulsory insurance idea, the insurance company would see that the pension fund was soundly managed not because it was right and proper but because it is in their interest.
As to who would provide it. The only existing form of compulsory insurance that I can think of offhand is compulsory 3rd party motor vehicle, which is a bit off topic but the principles are similar. In this case it is not the policy holder (the company) but the pensioners (a 3rd party) that are being insured.
There seems to be no shortage of compulsory 3rd party insurers available despite the fact that the insurers cannot monitor the behaviour of drivers. They could, however, monitor the performance and management of a pension fund, quite easily, by establishing eligibility criteria and strict reporting standards. If the criteria and standards were strong, the risk for the insurer would be low and the insurance accordingly cheap.
As to the eligibility criteria, I would imagine that the first priority for insurers would be to insist that the fund was not operated by the employer but run at arm’s length by a separate, independent and reputable company with its own operating standards to comply with. That would eliminate the most obvious problem for starters.
At any rate I think this idea might have some legs to it, generally if not specifically.
For those who may be interested:
http://www.csus.edu/indiv/c/chalmersk/econ184sp09/johnrawls.pdf
https://plato.stanford.edu/entries/justice-distributive/#Scope
Marco
Fascinating, but my concern is that the matters insured are quite different.
My insurance company had to settle a very third parry motor claim against me recently. I had made a genuine error and it happened on an icy day. I may have committed the mistake but men’s rea was most most certainly absent, as it usually is in most motor claims.
But would that be true of pension funds? Isn’t the risk of moral hazard enormous and only increased by insurance? I think the mens rea to commit fraud is high, and to commit it on the insurer would be substantial.
Richard