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Carillion - Early Warning Signals

February 6, 2018

The size and speed of the collapse of Carillion has predictably resulted in hard hitting questions from all parties - creditors, shareholders, regulators, politicians, etc. – as to how and why it happened and could it have been prevented. We believe the warning signs were clear, at least as far back as the 2016 annual report and accounts.

 

The attack dogs are now off the leash. The Financial Reporting Council (FRC) will investigate KPMG’s audit of the financial statements for the three years to December 2016 and additional audit work carried out during 2017. The FRC will ‘consider whether the auditor has breached any relevant requirements, in particular the ethical and technical standards for auditors. Several areas of KPMG’s work will be examined including the audit of the company’s use and disclosure of the going concern basis of accounting, estimates and recognition of revenue on significant contracts, and accounting for pensions’. The FRC enquiry will extend to the professional accountants on Carillion’s Board and look into the roles of the three Finance Directors Carillion had over 13 months. 

 

At the same time, the FCA has announced that it will investigate the timeliness and content of Carillion’s announcements from December 2016 regarding its financial situation. Meanwhile, the Insolvency Service has launched an investigation into the conduct of management across 16 Carillion companies and 169 directors across the group to establish whether there are cases to be brought for potential misconduct.  

 

It’s always easy to be wise after the event. However, we must ask ourselves whether, as a result of our analysis of companies and other organisations from a fraud risk perspective, we would have detected warning signals hinting at a possible future collapse of Carillion had we looked at the company prior to the event, and irrespective of whether there has been any misconduct or not. 

 

When we assess any company from a risk of fraud perspective, both from internal and external factors, our starting point is always to scrutinise publicly available data, particularly published financial statements. If we see something that concerns us, we raise a ‘red flag’ without hesitation. At least, investors and other parties then have a choice of either taking this on board and applying pressure on a company to effect necessary change, or not.  

 

In Carillion’s case, there is no shortage of ‘red flags’ that we would have raised, based on analysis of publicly available data, including the 2016 Accounts:  

 

Red Flag Number 1 

KPMG were Carillion’s external auditors for 19 years, which is too long in our opinion, implying too close a relationship between the auditor and its client and raising the question of independence. We believe that external auditors should be changed after no more than 10 years, and preferably five years.

 

Red Flag Number 2 

3 CFOs in the space of 13 months. The Chief Financial Officer who retired in December 2016 was formerly with KPMG, and was succeeded by a CFO who left after eight months. The most recent CFO was formerly with KPMG.  

 

Red Flag Number 3 

Several senior management departures in very quick succession including the CEO, two CFOs and one Non Executive Director.

 

Red Flag Number 4

The amount of goodwill at 31 December 2016, over £1.5bn (mostly arising from past acquisitions of ‘UK Services’), representing the largest single balance sheet item. The issue here is that, due to its significance in the balance sheet, any material impairment would have a significant impact on the reported results; hence, it could be argued that there was a disproportionate incentive to maintain the value of goodwill in the accounts, which alarms us. In the event, the Audit Committee ‘considered and critically reviewed the assumptions used in management’s impairment calculations and considered the views of the external auditor on this issue. This included a review of the sensitivity analysis undertaken by management and the external auditor. On the basis of this review, the Audit Committee agreed with management that no impairment to goodwill was necessary’ during 2016. Very wrong as it turned out. The huge value attributed to goodwill was worthless.

 

Red Flag Number 5 

Revenue recognition.  Given the nature of Carillion’s activities and its extensive portfolio of contracts, revenue recognition was a key area of judgement for management. As revenue is recognised based on the stage of completion of construction contracts by reference to the proportion of costs incurred to the balance sheet date compared with the estimated final costs of the contract at completion, revenues booked rely on estimates in relation to the final out-turn of costs on each contract.

 

The concern for us, again, is that changes to these estimates could give rise to material variances in the amount of revenue and margin recognised, therefore, it could be argued that there was a disproportionate incentive to recognise revenues, particularly in view of the overall deterioration of Carillion’s financial health during 2016. We would have looked for explanations for the increase in 2016 revenues, particularly in view of the sharp increase in receivables. 

 

Red Flag Number 6

The deterioration in Carillion’s financial health during 2016, which compounds the concerns raised in Red Flag Numbers 4 and 5. There is no hiding the fact that Carillion performed poorly in 2016. Post-tax profits declined, margins fell, net operating cash flows were stagnant and insufficient to cover the dividend, receivables rose sharply and net debt increased. In addition, the huge increase in pension liabilities resulted in a significant decline in net assets. The 2016 Accounts were signed off in March 2017, by which stage Carillion was effectively worthless.

 

Disclaimer

For the avoidance of doubt, this article makes no insinuation or inference of misconduct or fraudulent activity in the case of Carillion, its directors, employees or agents. We endeavour to make sure that the information contained in this article is accurate, but we cannot guarantee that it is accurate or complete. We make no warranty, express or implied, about the accuracy or reliability of the information above.

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