Colin Garvie, assistant professor at Edinburgh Business School, doesn’t mince his words when discussing the collapse of Carillion. He describes the outsourcing giant that imploded in mid-January 2018 as “amongst a select group of private contractors being awarded countless lucrative public sector service contracts. How could the UK government have awarded large and vital public service contracts to Carillion so soon after the company had issued a stark profits warning?”
There are also question marks as to why no one in government appeared to take notice that Carillion was at one time the most shorted stock on the London Stock Exchange. “The signs of impending collapse were there, yet no heed appears to have been taken,” says Prof Garvie. “To prevent a similar repetition, clearer and more robust rules on procurement and effective contract monitoring systems will surely have to emerge, and quickly.”
“It would appear from what has been reported to date that the non-executive directors (NEDs) asked insufficiently probing questions on the financials. Why not? For example, did the NEDs fully probe the reported drop in profits yet contemporaneous rise in dividends? Alarm bells should have rung. “Lesson learned – the criteria (experience, competence, remuneration, independence to name but a few) used for appointing NEDs requires overhaul. Is legal regulation required?” he ponders.
“Maybe more alarming from an investor’s viewpoint is why the auditor did not pick up on the danger signals. For example, Carillion’s largest single reported asset by value was goodwill, generated when Carillion acquired its various subsidiaries and the value of which should have reflected an assessment of the anticipated value of future cash flows to be generated from these acquired companies,” says Prof Garvie. “In light of the subsequent liquidation of Carillion, this rings a bit hollow perhaps. Why did the auditor not insist on recognising impairment in the value of this goodwill that would have reduced both the asset value and profits?
“In my opinion, more robust and transparent accounting standards are required on reporting the value of intangible assets like goodwill and better audit procedures are required to test the value of these assets. A set of financial statements, with an unqualified audit opinion, should be able to give investors some comfort as to the performance of their investments. Far from it as things turned out in Carillion,” he adds.
“This is simply a repetition of supposed lessons learned from past similar accounting scandals and subsequent collapses. Action is required, and immediately. Nobody seems to disagree. Indeed, some initiatives have already been taken (such as a call for a shake-up of the audit market, although nobody seems to have concrete suggestions as to how this might happen), yet if history is anything to go by, nothing meaningful will actually be actioned. The next Carillion is, I fear, simply a matter of time,” he adds.
The failings of Big Four firms in relation to Carillion and other recent corporate collapses set in train a push for re-evaluating the role of the accountancy sector. In February, Liberal Democrats leader Vince Cable told Financial Director: “I would want the competition authorities to look at the industry with a view to whether there should be a structural remedy- that could involve divestment or breaking up some of the firms,” he said.
In the final report of their inquiry into the spectacular collapse of Carillion last May, the Work and Pensions and BEIS Committees concluded that Government “lacked the decisiveness or bravery” to address the failures in corporate regulation that allowed Carillion to become a “giant and unsustainable corporate time bomb”.
It says the committees called on Government to carry out an “ambitious and wide-ranging set of reforms” to “reset our systems of corporate accountability”. “The mystery is not that it collapsed, but that it lasted so long,” it added.
It is Carillion’s board who are both “responsible and culpable for the company’s failure” presiding over a “rotten corporate culture” that led to the company’s devastating and hugely costly failure, said the report. Despite clear accountability, the directors presented themselves in Parliament as “self-pitying victims of a maelstrom of coincidental and unforeseeable mishaps”, said the damning report.
Carillion’s rise and spectacular fall was a story of “recklessness, hubris and greed”, its business model “a relentless dash for cash, driven by acquisitions, rising debt and exploitation of suppliers” with at best questionable accounting practices that “misrepresented the reality of the business”, it added.
Frank Field MP, Chair of the Work and Pensions Committee, said: “Same old story. Same old greed. A board of directors too busy stuffing their mouths with gold to show any concern for the welfare of their workforce or their pensioners. They rightly face investigation of their fitness to run a company again.
“This is a disgraceful example of how much of our capitalism is allowed to operate, waved through by a cosy club of auditors, conflicted at every turn. Government urgently needs to come to Parliament with radical reforms to our creaking system of corporate accountability. British industry is too important to be left in the hands of the likes of the shysters at the top of Carillion.”
Rachel Reeves MP, Chair of the BEIS Committee, said: “Carillion’s collapse was a disaster for all those who lost their jobs and the small businesses, contractors and suppliers left fighting for survival. 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 Competition and Markets Authority (CMA) must now look at the break-up of the Big Four accountancy firms to help increase competition and deal with conflicts of interest.
“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.”
Call to action
Following similar expressions from shadow chancellor John McDonnell and business secretary Greg Clark, the Competition and Markets Authority (CMA) eventually announced by the end of the year it was investigating the sector. In addition, accountancy regulator the Financial Reporting Council’s (FRC) shortcomings were addressed in the Kingman review, which pressed for its powers to be increased.
The CMA has published an update paper outlining serious competition concerns and proposing changes to legislation to improve the audit sector for the benefit of savers and investors alike. It is now putting these proposals out for public consultation.
In October, the CMA identified a number of reasons why it believes audit quality is falling short. It said companies choose their own auditors, choice is too limited, with the Big Four audit firms conducting 97% of the audits of the biggest companies and auditors’ focus on quality appears diluted by the fact that at least 75% of the revenue of the Big Four comes from other services like consulting.
In order to address these concerns, the CMA is proposing legislation to separate audit from consulting services, introduce measures to substantially increase the accountability of those chairing audit committees in firms, and impose a ‘joint audit’ regime giving firms outside the Big Four a role in auditing the UK’s biggest companies.
CMA Chairman Andrew Tyrie said: “Addressing the deep-seated problems in the audit market is now long overdue. Most people will never read an auditor’s opinion on a company’s accounts. But tens of millions of people depend on robust and high-quality audits. If a company’s books aren’t properly examined, people’s jobs, pensions or savings can be at risk.”
The CMA will now consult on a number of proposals for robust reform. These intractable problems may take some years to sort out. If it turns out that the proposals are not far-reaching enough, the CMA will persist until the problems are addressed.
CMA Chief Executive Andrea Coscelli also commented at the time: “We have moved fast to come up with a comprehensive package of proposals for legislation, which we will now consult on. Successful reform of the audit market will require legislation, in combination with planned improvements to regulation as recommended by Sir John Kingman.
But a new poll by ICSA: The Governance Institute and recruitment specialist The Core Partnership reveals that just 9% of company secretaries surveyed think that the audit process has improved since the collapse of Carillion. Over half (51%) feel that it has failed to advance with many believing that the industry has learned little from the collapse.
According to Peter Swabey, Policy and Research Director at ICSA: ‘Generally companies feel that it is too early to tell if things have improved to any great extent. What is clear from the results of our poll is that there is very little confidence that proposed changes to the audit regime will lead to improvements in the audit process. On a scale of one to ten, with ten being very confident and one not at all, the average response was a lowly four.’
Some of the concerns voiced about the current state of the audit process were that auditors have become lazier, there is an issue with management pushing audit firms on fees which reduces their ability to resource audits an there is still too close a relationship between management and auditors. It added that audit is not taken seriously by the big four firms and there is gap between what auditors are required to do and what the public think they do is large and needs to be addressed.
When questioned about the best way for the big four accountancy firms to reform, 45% called for audit and advisory businesses to be split within the big four, with one respondent warning that “Splitting audit and consultancy firms could materially impact the quality of the pipeline to the audit firms as consultancy firms will look more attractive and can generate fees from a more diversified base. It could also result in a significant increase in audit fees as the firms seek to retain talent.”
Many respondents highlighted increased regulation and monitoring as necessary for reform, with responses including that audit firms need to raise their standards to ensure audits are conducted properly and there needs to be tighter registration and regulations, and there is a conflicting interest in providing the audit opinion and seeking reappointment as the auditor.
“While there is much good work already done that should not be overlooked, it will take time to establish a step change in independence, rigorous challenge and culture. Even then, we need to have shared expectations of what audit is for and what it can achieve. Audited accounts can only provide a level of assurance, they do not mean a company cannot fail,” concludes Peter Swabey.