Carillion: Questions to be answered

For all our Carillion coverage, go to www.building.co.uk/carillion-collapse

Next week former Carillion chief executive Richard Howson, and his long-time right-hand man and former financial director Richard Adam, alongside other former and current senior directors, will appear before a committee of MPs that look to be baying for blood over the collapse of the £5bn turnover contractor. Howson and Adam have been vilified in the press since the 43,000-strong contractor went under last month leaving just £29m of cash in the bank, a £900m debt mountain and thousands of pensioners facing the loss of a large chunk of their retirement income. 

To say they have questions to answer is akin to saying the Sahara can get quite hot in summer. And it is not only MPs on both the business and work and pensions select committees that are hungry for information. There are now three other separate inquiries going on into the business, one by the Official Receiver – which has been fast-tracked at the insistence of business secretary Greg Clark – another by the financial services regulator, the Financial Conduct Authority, into the timeliness of Carillion’s stock exchange announcements. And on Monday the Financial Reporting Council, the UK’s accountancy watchdog, said it would launch an investigation into KPMG’s audit of Carillion’s financial results between 2014 and 2016 as well as the work it carried out during 2017. 

The most obvious question the industry and investors are asking is how could a company worth £1bn less than a year ago, with revenue of more than £5bn, fall so quickly? In last year’s report and accounts the company was boasting of a “high-quality order book and strong pipeline of contract opportunities”, a “rigorous approach to selecting the contracts for which we bid” and a “strong and experienced leadership team”. Both MPs and the various regulators looking into the business will be asking how its reported financial position then was consistent with the mess it ended up in. So, where will they be looking? 

Carillion has the hallmarks of another corporate governance failure with directors asleep at the wheel while the business went off a cliff

Rachel Reeves MP

Balance sheet 

After Carillion issued its infamous £845m profit warning last July, it became clear that it was the firm’s weak balance sheet that led to its downfall – leaving it searching to refinance while its bankers and shareholders realised there were vanishingly few real assets against which to secure their money. Rachel Reeves MP, chair of the Business, Energy and Industrial Strategy (BEIS) Committee, wants to know how the situation was allowed to get so bad, saying in a statement: “Carillion has the hallmarks of another corporate governance failure with directors asleep at the wheel while the business went off a cliff […] How is it that so many warning signs were ignored by the company and the government?”

The firm fell into net debt in 2011 with the purchase of Eaga, a disastrous £400m venture that left it on the back foot chasing work while seemingly encountering problems getting paid. 

However, Carillion did publicly report its steadily worsening position from the profit warning onwards. And while Carillion from 2012 onwards used a supply chain finance scheme that allowed it to hold on to suppliers’ cash to boost its stated cash position, it publicly announced this, and its “real” cash position could be derived from published information. 

When asked if Carillion’s presentation of its balance sheet and cash position were in line with normal practices Kevin Cammack, analyst at Cenkos, says: “To my belief it’s not actually done anything illegal. You can actually argue that by and large it’s been quite open.” 

The ongoing investigations are yet to determine what exactly was behind the abrupt and serious worsening of its financial position last year and no findings have been made against Carillion or its directors. So enormous was the July profit warning that many, such as Kier chief executive Haydn Mursell, suspect this deterioration could not have occurred in the six months since the last published accounts and must reflect problems with a longer gestation. He told Building last week: “You would assume that sort of thing would have come out earlier, because you can’t build up that scale [of profit warning] that quickly.” 

Directors may believe that if they can just get the next contract it’ll solve all their problems, and will argue they’re acting in good faith

Theresa Mohammed, Trowers & Hamlins

Revenue assumptions 

Carillion’s rivals had long been unsettled by it consistently reporting – until 2016 – an underlying pre-tax profit margin of more than 4%, around twice as profitable as most of its listed peers. Kier’s Mursell says: “Every company can have a year where they produce impressive results, but it’s different to do that every year. If you look at that, and things like cash generation, particularly if they haven’t got any assets that underpin debt, you then start to have more concerns.” 

So how could this have been happening? Many suspect Carillion was aggressive in its interpretation of accounting rules, which allow contractors significant flexibility in reporting profit and revenue. Accounting rules are flexible in that while some contractors make conservative assumptions on profit until work has progressed on a job, others record higher profit margins from the start.

Still, KPMG, Carillion’s auditor in its last accounts, said in the report and accounts that recognition of revenue on contracts posed the biggest risk to the accuracy of the accounts. It said, before declaring itself satisfied with Carillion’s approach: “There is […] a high degree of judgment in: assessing the level of the cost contingencies to recognise; appropriately recognising variations and claims; and estimating the revenue recognised by the group based on the projected final out-turn on contracts.” 

So far KPMG has defended its auditing of Carillion, claiming it acted “appropriately and responsibly”.

But one former managing director of a listed construction company alleges that Carillion bid for projects at lower margins and then in its accounts it made overly optimistic assumptions that it could make more profit. “So, from day one they were presuming 8% profit on a job bid at 3%,” he says, adding that the extra profit was assumed to come from driving efficiencies and pressuring the supply chain.

One former subcontractor to Carillion has told Building that on two major jobs his business worked on, Carillion’s winning bid vastly underestimated the cost of specialist packages – which in both cases ended up costing double its assumption. 

If Carillion’s jobs were, as they progressed, turning out to have higher costs than assumed, it should have revised its view of them and written back some of the profit already taken. One question is whether, rather than writing the profit down, Carillion assumed the money was still to come in, writing up the missing cash as a “receivable” in its accounts (technically an asset on the firm’s balance sheet). A receivable is a way of a company accounting for money that it is expecting to receive from those it trades with. 

Every company can have a year where they produce impressive results, but it’s different to do that every year. If you look at that, and things like cash generation, you then start to have more concerns

Haydn Mursell, Kier

This growth in “receivables”, in fact, was another sign to investors of the trouble Carillion was in. In its last published accounts, total receivables had ballooned to £1.7bn, of which money owed on construction contracts was more than £600m – almost 12% of its total turnover. This was way above its competitors. At Kier, for example, the same figure was just 3.3% of turnover, while at Balfour Beatty – which, lest we forget, has had its own problems – the figure was 4.4%. 

Ultimately these receivables were not backed by cash coming in, so mounted up year on year, as admitted by interim chief executive Keith Cochrane last August, who said: “Historically, underlying earnings have not been cash-backed.”  

Many feel that Carillion was overly optimistic in its accounting assumptions about the profit it could bring in on jobs. For example, one former manager at a joint venture partner with Carillion, who declined to be named, describes his experience working on a large infrastructure job. The job encountered significant problems and delays, and the client agreed to pay the 20% cost overrun, leaving the joint venture breaking even. However, to his surprise, his opposite number at Carillion refused to settle at this price, telling him that Carillion had already made an accounting assumption of a further 10% profit margin on top. The JV partner took this to mean his Carillion counterpart was reluctant to take a writedown on the job in its accounts. Ultimately Carillion had to settle at a 5% margin. 

As investigations are ongoing there are no findings that any rules were broken. Even if Carillion’s assumptions are ultimately proved wrong, it does not mean Carillion broke the rules – as long as judgments were reasonable at the time. Certainly, in notes to its accounts Carillion said it made “forecasts on a contract by contract basis” and that “consistent contract review procedures” checked these forecasts. It added that “when it is probable that total contract costs will exceed total contract revenue, the expected loss is recognised immediately”. 

Out of time 

Whatever had been going on, a new group finance director, Zafar Khan – appointed in January 2017 following the retirement of predecessor Richard Adam – undertook a balance sheet review with the help of KPMG that started to reveal the extent of the problems at the group. 

But it was not until July that the firm reported the conclusions of the balance sheet review. The timing of this announcement to the stock exchange may come under the scrutiny of the FCA investigation. The FCA is investigating the “timeliness and content of announcements made by Carillion between 7 December 2016 and 10 July 2017”,

but even here the rules include a large degree of judgment as to when announcements have to be made. Under UK Listing Authority rules, firms have to make announcements when they hold information which they can reasonably expect to affect their share price – but there is no specific threshold for the size of problem that must be notified. 

Questions will be asked particularly since both Carillion’s joint venture partners on one of its biggest problem projects – the £750m Aberdeen Western Peripheral Route bypass – had reported major writedowns on it by January 2017. Meanwhile, delays to the Royal Liverpool and Midland Metropolitan hospital jobs were admitted in March and May 2017 respectively. 

As mentioned at the beginning of this article, a number of former and current senior management of Carillion are being questioned by the joint select committee inquiry next week. The select committee is expected to ask a wide range of questions about what led to the collapse of Carillion and the role that certain directors played in that. Committee inquiry co-chair Reeves has said: “As a committee, we will […] want to explore the executive pay arrangements at Carillion, the potential cost to the taxpayer of the insolvency, and the role of both directors and non-executive directors in the company’s collapse.” 

Generally speaking, in terms of directors’ obligations and the possible consequences of any misconduct on their part, under the Companies Act, directors must exercise “reasonable care, skill and diligence” for the benefit of the members and shareholders of the company. However, even those who breach these rules have not necessarily behaved criminally, though they may be liable for fines or disqualification from being a company director. To be guilty of a crime, directors have to have been knowingly dishonest, as under the Theft Act 1968, which includes the criminal offence of “making a false statement as to the affairs of the company with the intent of deceiving shareholders or creditors”. 

However, even then directors may argue that they believed they could save the company, and therefore that their actions were in the best interests of shareholders. Theresa Mohammed, partner at law firm Trowers & Hamlins, says: “There is a high threshold to get in trouble. Directors may believe that if they can just get the next contract it’ll solve all their problems, and will argue they’re acting in good faith for the benefit of their members.” 

There is no suggestion that in this case any of Carillion’s directors breached any rules or laws as it is far too early to know exactly what was known and when by the directors at Carillion. Hopefully at next week’s select committee hearing, we will start to get some answers. 

For all our Carillion coverage, go to www.building.co.uk/carillion-collapse