In the aftermath of the Worldcom scandal, construction share prices are being slashed over fears of accounting malpractice. But, asks Matthew Richards, are investors' concerns justified?
first Enron, then Worldcom … could your company be next? Construction firms' share prices are taking a hammering as jitters over accounting procedures rattle the sector.

Amey's share price has collapsed after successive restatements of accounts; the support services sector is being dragged down by accounting worries; and new accounting rules for PFI bid costs, coupled with more scrupulous accounting, are lining up some nasty surprises for contractors.

"Pencil in March and April next year as the time when people will be digging into the accounts of the major contractors," said the managing director of one such contractor. "New accounting rules mean profits will be less than before. I think chief executives will use this as an excuse to sneak out other bad news."

So far, shares in support service companies have suffered the most. Amey's fell 34% and WS Atkins' fell 17% last week – even worse than the overall 8% drop in the FTSE All-Share Index.

Giles Scott, head of corporate communications at Interserve, one of several contractors to relist on the stock market in the more glamorous support services sector, says: "The Worldcom scandal is the overriding factor; it sets the shape of the market as a whole. The support services sector is hit harder than average."

The biggest victim has been Amey, whose 92.5p price on Monday is down 78% from its January peak of 413.5p. Amey has been forced to stop treating PFI bid costs as assets rather than expenses – which is exactly what Worldcom had done with its telephone line maintenance costs. Bid costs and other written-off expenses meant that, when it reported its results in March, Amey posted an £18.3m loss for 2001, when the City had been expecting a profit of more than £50m. Its share price dropped again last week when Amey warned its cashflow would suffer from delays to the London Underground public-private partnership. Concerns over the high cost of PFI bids led Amey this week to announce it would be "more selective" in choosing projects to bid for.

In addition to bid costs, analysts are concerned about Amey's accounting for the Tramtrack Croydon PFI. The project owed Amey £14.1m in the support services company's 2000 accounts, but was unable to pay the debt. Amey swapped the debt for a 10% share in the company, which was recorded in the 2001 accounts as a £9.6m investment. Analysts believe Amey's share in the loss-making PFI is not worth that much.

Nobody knows how people make money in contracting. It’s impossible to reconcile order book, sales and earnings in any one year

Mark Hake, construction analyst, Merrill Lynch

Another example of aggressive accounting that makes analysts uncomfortable is Amey's treatment of expected income from property developer JJ Gallagher.

Amey carried out design work for Gallagher on Cambourne, a new town just outside Cambridge. Gallagher agreed to pay £20m for the work – £5m in 2001, £7m in 2004, and £8m in 2005. A City analyst told Building: "Amey tried to book all the revenue in 2001, but the accountants blew the whistle on it."

And if Amey has sneezed, other services firms are catching a cold. WS Atkins has delayed the announcement of its 2001/02 results until 25 July to give it time to implement a new financial system. One City analyst said: "Atkins has been known within the industry for some time to be losing people. The market is fearful that the new financial system will be so effective it will uncover some big losses." Amey's financial director was unavailable for comment.

In fact, the new financial system is basically a more efficient way of processing payroll and human resources data, and Atkins' financial director, Ric Piper, says it will have no impact on the firm's accounts. But the analyst's reaction illustrates how nervous the City has become, suspecting nasty surprises in the accounts even when there are probably none there.

Interserve's price has dropped by a third in the last two months. Giles Scott says: "To the uneducated, the closest thing we have to the bad accounting practices in the US is PFI, so there are some unwarranted concerns. We sit here, we know our figures are sound, but we still watch the share price going down. All logic says there's no reason for prices to drop any further, but markets aren't always susceptible to reason."

On top of comparisons with Worldcom and Enron, accountancy firms advising on PFIs have to contend with allegations of conflict of interest. Last month, public sector union Unison published a report that listed 45 PFIs and PPPs in which a top accountant advised both the public sector and a shortlisted bidder. PricewaterhouseCoopers was cited in 24 cases, KPMG in 17 and Deloitte & Touche and Ernst & Young in two cases each.

The criteria for winning PFIs have become opaque and bid costs are increasing. The private sector is being asked to shoulder too much risk

Richard Smee, head of construction, Ernst & Young

The embattled accountancy profession did try to head off some of the problems relating to PFI bids before the Enron scandal broke. A year ago, the Accounting Standards Board's Urgent Issues Task Force resolved to pass new rules on how to treat bid costs for major projects, principally PFIs. In May 2002 it published UITF 34, which requires all bid costs to be written off as expenses unless a company is "virtually certain" of winning the work it is bidding for. The new rules also prohibit companies from reclassifying bid costs as investment after they've won the bid.

Share prices can seriously suffer from these technical changes, as services firms are discovering to their cost. Last Wednesday (10 July) Carillion announced to the stock market that it was changing the way it reports results to comply with UITF 34. It said this would reduce its profit by £6m in 2002 and 2003 but increase its profit by a similar amount in subsequent years. It tried to sugar the pill by announcing £600m worth of new work at the same time. Nevertheless, its share price took a pounding, falling 10% following the announcement.

The long-term effects of UITF 34 could be even greater. Since it makes it impossible for firms to hide the large costs involved in bidding for PFIs, Ernst & Young's construction head Richard Smee says the bidding process will have to change to prevent the private sector losing interest.

He says: "UITF 34 is the straw that breaks the camel's back. The criteria for winning PFIs have become opaque, and bid costs are increasing. The private sector is being asked to shoulder too much risk."

The public sector is already subsidising bid costs for many major PFIs, for example by reimbursing a fixed percentage of all bidders' costs up to the preferred bidder stage. The flip side of this is that, since the state is spending more money subsidising bid costs, the success fees it pays to the winning bidders become smaller. If the trend continues, Smee predicts the barriers to entry to the PFI market could be lowered, encouraging new entrants.

In the meantime, the construction industry has to convince the City that it has nothing in common with the recently exposed villains of US capitalism. "Construction companies are becoming more conservative in their accounting," says ASB director Hans Nailor. But he adds: "There is no generally accepted definition of 'virtually certain' in UITF 34; the directors of a company decide the definition for themselves."