The combined committee report from the House of Commons on the failure of Carillion provides some 'interesting' reading this morning. The findings on the company itself are summarised in this one paragraph:
Carillion's business model was an unsustainable dash for cash. The mystery is not that it collapsed, but how it kept going for so long. Carillion's acquisitions lacked a coherent strategy beyond removing competitors from the market, yet failed to generate higher margins. Purchases were funded through rising debt and stored up pensions problems for the future. Similarly, expansions into overseas markets were driven by optimism rather than any strategic expertise. Carillion's directors blamed a few rogue contracts in alien business environments, such as with Msheireb Properties in Qatar, for the company's demise. But if they had had their way, they would have won 13 contracts in that country. The truth is that, in acquisitions, debt and international expansion, Carillion became increasingly reckless in the pursuit of growth. In doing so, it had scant regard for long-term sustainability or the impact on employees, pensioners and suppliers.
My concern is with the systemic issues, and that means the auditors and their regulators. Of KPMG the committees say:
KPMG audited Carillion for 19 years, pocketing £29 million in the process. Not once during that time did they qualify their audit opinion on the financial statements, instead signing off the figures put in front of them by the company's directors. Yet, had KPMG been prepared to challenge management, the warning signs were there in highly questionable assumptions about construction contract revenue and the intangible asset of goodwill accumulated in historic acquisitions. These assumptions were fundamental to the picture of corporate health presented in audited annual accounts. In failing to exercise–and voice–professional scepticism towards Carillion's aggressive accounting judgements, KPMG was complicit in them. It should take its own share of responsibility for the consequences.
Deloitte acted as internal auditors. The report is little kinder to them:
Deloitte were responsible for advising Carillion's board on risk management and financial controls, failings in the business that proved terminal. Deloitte were either unable to identify effectively to the board the risks associated with their business practices, unwilling to do so, or too readily ignored them. (Paragraph 125)
The Financial Reporting Council regulates both firms. Of their role the committees say:
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.
I added the emphasis: it is an opinion I have long held. The committee added:
The FRC was far too passive in relation to Carillion's financial reporting. It should have followed up its identification of several failings in Carillion's 2015 accounts with subsequent monitoring. Its limited intervention in July 2017 clearly failed to deter the company in persisting with its over-optimistic presentation of financial information. The FRC was instead happy to walk away after securing box-ticking disclosures of information. It was timid in challenging Carillion on the inadequate and questionable nature of the financial information it provided and wholly ineffective in taking to task the auditors who had responsibility for ensuring their veracity.
What's to conclude?
First, mates can't regulate mates.
Second, no one can audit for 29 years in a row and be objective.
Third, the audit market has failed.
Fourth, without decent auditors and non-execs (the Committees say Carillion had just one who served with credit) capitalism as we know it is just a gravy train for those acting in their own self-interest.
Fifth, it's not clear where those people of the required ethical standing are to come from, but we have to try.
What is clear is that the failings are systemic.
The Big 4 have failed.
The FRC has failed.
Our markets are at risk as a result.
Nothing less than reform will do. And saying so is not to challenge markets: it is to support them. It is the status quo that threatens market viability. That is why it must be swept away, and nothing less will do. The corruption of markets has to end starting with complete reform of accounting.
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I forget the figure that was quoted at the time of the Carillion crash, but the element of ‘goodwill’ seemed to be very large and to have been something which was suddenly not bankable.
Is there a rational process for assessing a figure for ‘goodwill’ other than including a figure which matches the discrepancy in the balance sheets between fact and fiction ?
It is supposedly the discounted value of the future extra cash flows arising from the sum paid for the acquisition of an asset not represented by tangible assets
Orm how long is a piece of string?
“It is supposedly the discounted value of the future extra cash flows arising from the sum paid for the acquisition of an asset not represented by tangible assets”
I’ll take that as confirmation of my natural suspicion.
I would
What do the accounting regulatory bodies say about companies taking “aggressive” accounting positions? Has prudence ceased to be an important accounting concept?
On goodwill, I am not an accountant so no doubt you will correct me if I don’t understand the treatment properly, but isn’t goodwill arising on an acquisition simply the difference between two numbers: the price the buyer agrees to pay, and the valuation of the assets acquired? The buyer should know the first number with some certainty, and the second should come from the target’s historic accounts (although there is some scope for pushing valuations of illiquid assets up or down, of course).
Where does the discounted value of future extra cash flows come into it? Impairment?
Prudence long ago disappeared from accounting
Again, so did simplistic good will accounting
Initially your suggestion is right – but impairment exists from day 1
At best you set a parameter on values with your suggestion
I am not an accountant, so perhaps you can excuse me for being simplistic.
You say prudence has gone, but I am just looking at the general principles listed in Section 2 of FRS102, and in particular paragraph 2.9, and then also paragraph 10 of IAS8. The word is used in the accounting standards, and many people think the concept is still important: are you saying it is just not observed in practice?
If you impair goodwill, don’t you write it down on the balance sheet and so end up with less of it, and take a charge against the P&L ? So the “simple” goodwill arising on the acquisition is the maximum amount, and impairment only reduces that. You don’t write it up in value. If that is right, I am struggling to see a comparison with discounted cashflow (necessary to consider impairment) could inflate the value of acquired goodwill. In the case of Carillion, didn’t they just buy stuff for more than it was worth, and then fail to properly impair it?
Please accept my apologies for the delay in replying: this was simply due to pressure of time.
Notionally you are right: the principle of prudence does, supposedly, still get a mention. The reality is otherwise. Take a simple example. When prudence pervaded it was necessary that losses be anticipated i.e. profits were never booked before they were around but if it was obvious that a loss might arise in the future as a result of the current action then that loss would be taken at the point that it could be recognised. If the precise amount of loss was unknown then reasonably estimated some would be taken instead.
Under IFRS audits went out the window: what happened instead was that losses were only recognised when they actually crystallised i.e. when the customer did not pay, for example, even notably the apparent first some time (under, say, a mortgage agreement) the default was inevitable. It has taken enormous effort to restore a prudent approach here. But even now that is happening it does not restore the general principle that sound judgement based upon the simple explanation I have offered be used on all occassions: instead we have a rule based apprapch that effectively over-rules this too often and prudence is but a memory.
Excellent and timely Richard – devastating critique by MPs and bold of them to do so. Accounting and Auditing lie at the heart of fair economics, but have become subverted by this collusion between power elites and I agree this has to come to a stop. Well done for all the great and bold campaigning you and Prof Prem Sikka and Tax Justice Network have done over the years.
And you…
Yep my experience of internal audits completed by Deloitte is that they are feeble and of little value.
I fully agree. The case could not be more clear cut. But I fear in pursuing this case you’ll be ploughing a lonely furrow. The Torirs and their allies will stay shtum or quietly seek to prevent any change. Moderate and centrist Labour MPs are compromised by the extent to which Labour while in government relied so much on these polished chancers. (And it’s not just the Big 4. There are armies of well-rewarded professional functionaries and flunkies servicing and supporting the status quo).
What’s even worse is that the current Labour high command has a visceral hatred of anything to do with markets. They don’t understand them or understand why well-governed efficiently functioning markets can generate significant benefits – but that continuous vigilance is required. All they know is tax, spend and nationalise with national control and direction from the centre (the hoary old soviet “democratic centralisation”) – leavened by some half-cocked, hare-brained efforts of local “democratisation”.
Not views I entirely share: you overstate your case
Paul Hunt says:
“Labour high command has a visceral hatred of anything to do with markets. They don’t understand them or understand why well-governed efficiently functioning markets can generate significant benefits …”
They have a bit of a downer on well rotted Unicorn dung for rose fertiliser too. 🙂
Paul Hunt says:
” The Tories and their allies will stay shtum or quietly seek to prevent any change. ”
That may just depend how many get stung, when the failure of Audit to properly represent listed companies health costs them significant chunks of their wealth.
It could easily be very expensive, and orthodox minded financial advisers are going to get clobbered too. They will hide behind their standard caveats about risk when the excrement hits the extractor.
Regulation in Britain never works. The standard history of regulation in Britian is for the Regulator, sooner or later, to become the prisoner of the industry or industries it regulates. The precedents are endless; the FSA, the Department of Agriculture & Fisheries are just two major illustrations.
It is time that the underlying question was asked – why does regulation so often fail in Britain? Could it be that regulation in Britain has often been the easy option; a political fudge; and perhaps not even intended to work?
We have real difficulty in Britain looking in the mirror and seeing what is there, rather than what we want to see.
I think accountancy did work – at least much better than it does now
The issue is a failure of ethics
I will expand in a post
John S Warren says:
” The standard history of regulation in Britain is for the Regulator, sooner or later, to become the prisoner of the industry or industries it regulates. ”
I’m afraid it’s built in. The received wisdom is that only industry insiders have the knowledge and experience to be regulators.
“…and perhaps not even intended to work?”
Well, yes. There is that about it too.
Richard, to what degree are other accountancy firms culpable in this? I assume that the Big 4 are not alone in these business practices, and that it’s more a question of scale?
There are only four big firms
And they dominate the professional bodies
And their recent alumni dominate the regulators
I terms of scale they are it on this issue
It is a four horse race – and not really that, to be candid, since they don’t really compete
You say KPMG were auditors for 19 years then say 29 years later on. Either is too long but I think one is a typo.
Parliament says both….
I was having a discussion about this with my son this morning. It seems that the contradiction of having an entity pay for a service which will (potentially) result in the people that commissioned that service having their reward reduced or even terminated it too great. The pressure in this system is all towards compliant and meek auditors. The solutions our combined brain power came up with were either a state-run audit function (maybe a bit too “soviet”: ) ) or a tax levied on companies to pay for the audit function and the selection of auditors for companies being performed by a public body. The reward incentive could then be turned on its head and the system could reward tough/awkward auditors that uncover inconvenient facts.
I incline to the latter
Writing a key-note presentation on this issue for delivery next week right now
It will be published here, soon
how does this help if the public body has the same audit firms to choose from?
We have to split the firms: state aid may be needed to create new firms to achieve this social goal.
Also, the participants in the market would have to evolve to suit the new incentives. New entrants could be rewarded for the required uncompromising audits. If the existing participants did not evolve then they would eventually be given no audit work and would cease to exist (as auditors anyway).
Perhaps accountancy firms should decide ex-ante, whether they are to be audit firms, or as now, continue to be allowed to aspire to be ‘a one-stop shop for everything’ (save research in quantum-mechanics, and preparing the lunchtime sandwiches). The alternative way to regulate auditors could be an well resourced and statute-enabled independent audit-auditor with extensive investigative powers, funded directly by limited liability businesses.
The latter is my choice
The Bank of England does not figure in these criticisms of regulators. I have been told by directors of a smallish building society and a large co-op that they are forced by Bank of England regulations to use one of the big four.
True
They are
Eric Walker says:
“…a smallish building society and a large co-op that they are forced by Bank of England regulations to use one of the big four…..”
Effectively it’s the ‘closed shop’ Tories claim to so despise (unless it is in their own control.)
I’ll keep it short, and avoid one of my political moans. Just to say you have been proved correct again Richard, about both the Big 4, and the FRC.
Congratulations, and please keep up the good (and very Hard, no doubt) work.
This is happening more and more often
But we have to deliver the follow on policy