W10 Carillion Scandal Sem PDF

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IB3770 Advanced Financial Reporting Seminar - Week 10

Carillion – an example of a corporate collapse linked to accounting

Instructions In this seminar we will examine the collapse of Carillion, considering the accounting problem regrading goodwill and the wider implications for the organisation and its stakeholders. I have provided links to recommended sources of information to answer the following questions. In the seminar you will work in groups to share your findings. Goodwill ● How much goodwill was recognised on the acquisition of Eaga (renamed as Carillion Energy Services after the purchase)? - £321.4 million (NOPE) - £329.1 million ● What was management’s justification for the goodwill arising on acquisition (use the 2011 Annual Report, note 30 to the financial statements outlines details on the acquisition)? - The goodwill recognised on the acquisition of Carillion Energy Services represents the present value of future income streams expected to be generated from margin growth in the business acquired together with identifiable cost savings within the enlarged Group - Since CES is a leading provider of energy efficient solutions, the Group predicted several areas of growth such as o a strong position in a number of new and attractive markets o an enhanced ability to provide existing and new customers with integrated support services solutions - synergies in the enlarged Group would generate savings of £25 million per annum o elimination of duplication o the potential for significant cross-selling opportunities within the enlarged Group o at the time, govt was giving subsidies to companies which encouraged green and cleaner technology (EAGA were installing solar panels on rooftops) - wanted to diversify the Group’s business ● Were there any indicators in subsequent years that the goodwill could have been impaired? - Challenging economic environment because not long after the acquisition, the market for solar panels collapsed

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Rising debt EAGA was loss making every year Govt withdrew all their support and so EAGA ended up with close to zero contracts. Employees were all laid off, and the company became almost like a shell company Strange that they paid £298.4 for a net liability of £30.7 because EAGA had a lot of borrowings

● By 2016, how significant was goodwill in the company’s financial statements? (Use the 2016 Annual Report) -

1571.0 / 4433.1 x 100% = 35.4% of total assets Management are asserting that the goodwill is an asset which will generate economic benefit. But a number of months later, the company went bankrupt, so the future economic benefits were questionable

● Did the auditors comment on goodwill and impairment in their report for 2016? - Yes they did. They identified goodwill as a key audit matter. They acknowledged the significant size of goodwill as a proportion of the Group’s balance sheet. - They also listed out some of the procedures they adopted in assessing the value of goodwill o Considered the allocation of goodwill across CGUs o Considered the assumptions in determining the cash flows and growth assumptions o Challenged discount rates o Performed sensitivity analysis o Assessed disclosures about the sensitivity of the outcome of impairment assessments � Management commented on the following ▪ Sensitivity of discount rate; how much it would have to increase before impairment is required ▪ Sensitivity to cash flow forecasts; (but exact figure was not given, just merely stated ‘enough headroom’) ▪ Sensitivity to other assumptions - KPMG highlighted to shareholders that yes this is a risk, but ultimately they end up agreeing with the directors that goodwill doesn’t need to be impaired. But we don’t know how intensely KPMG challenged management, because the audit report doesn’t require that level of detail - FRC gave KPMG report in Aug 2020, reported on some audit failings (breaches of auditing standards). Not made public. KPMG given chance to contest the findings - Yes, the impairment review was carried out, but because the impairment test is such an area of judgement, it is … ● What do you think were the motives for not recognising impairment on goodwill? - So as to not cause further financial distress to the company, because if they had, investors, creditors and customers would be alarmed and withdraw their funds or money in Carillion. Recognising the impairment would have meant o There would be a loss before tax o Gearing levels would increase

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There was a huge pressure on the directors to pay dividends. So if there was a loss reported, they would not be able to do so. o Carillion was seen as a good investment because it was known for its dividends which increased almost yearly o If a company has a good track record for paying dividends, but they suddenly didn’t, it would send a very strong signal that the company is in financial distress Directors probably had their remuneration based on profit figures, so there may have been a self-interest Also, recognising goodwill impairment can indicate that the acquisition was over priced and this reflects badly on the management decision to buy and the negotiation of the deal.

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Other accounting issues ● What are the other examples of “aggressive accounting” which allegedly happened at Carillion? - Long-term contracting always rings alarm bells for readers of financial statements, because it offers companies discretion over when to report the income from a contract, with the risk that they will be tempted to report revenues earlier and costs later - Carillion included the reverse factoring creditor as an inflow of cash, and thus in the calculation of cash conversion. o Carillion reported operating profit of £145 million and operating cash flow of £115 million, which is a decent cash conversion ratio. But that operating cash flow was increased by the approximately £200 million increase in ‘other creditors’ during the year. Without that, operating cash flow would have been £85 million o The idea is that the higher the cash conversion ratio, the truer the profit. Because if companies are inflating their revenues, their overstated revenues are booked as increased receivables. These are deducted in calculating operating cash flow, so to catch the overstatement of revenues, analysts focus on ‘cash conversion’, which is the ratio of operating cash flow to operating profit. - It hid the true net debt it had, because debt worth 760.5 was recorded in ‘other creditors’. This was the liability that Carillion had to the bank which paid Carillion’s suppliers earlier. ● What caused the profit warning in July 2017 which ultimately led to the demise of the company? - profit warning is simply a statement by a company that earnings will be below what the market expects, so it is a reasonably common event -

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Loss before tax of £-1,165m was reported for the interim which was caused by sweeping impairments for cost overruns and other delivery issues, and for payment problems across several of Carillion’s major contracts

Wider implications ● What investigations have been launched in relation to Carillion and its advisors? - Investigation launched into the CEO, CFO and Chairman of Carillion’s BOD - Investigation launched into former directors as well - Investigation launched into auditor KPMG - Investigation launched into accounting treatment of various items in FS o Goodwill and revenue - Regulators such as FRC and the Pensions Regular were not strict enough in enforcement

● What are the wider implications of the collapse for Carillion’s stakeholders? -

Loss of jobs for direct employees as well as those in its supply chain Loss of pensions of £2.6b, which now has to be funded from the Pension Protection Fund Owed large sums to its creditors It was a strategic supplier to construction works for the UK Greater scrutiny for regulators and calls for review / reform Loss of confidence in audit profession Important contracts such as building hospitals have been suspended, delayed, cancelled etc, especially large impact because Carillion held many strategic contracts with the UK govt

IN SEMINAR Not saying that how they accounted for goodwill led to the company’s collapse When directors are under pressure, they are very tempted to engage in creative accounting. So goodwill and other accounting treatments are just illustrations of this. Not saying that anyone broke accounting rules, just an ethical dilemma. Rational -> it will keep the market happy, give the company time to recover. Motive -> It isn’t right, but there is powerful pressure which makes it understandable It is hard to say that management have breached accounting standards because there is no hard and fast rules. The whole issue of rules vs principles ● Easier for management to prepare ● Easier for auditors to audit ● Easier for regulators when assessing breaches Context They were trying to diversify, engage in prison services or providing meals to

Some useful sources of information:

I have posted the final annual report of Carillion for its 2016 year end into the seminar content area. I have also posted the 2011 annual report as it contains information specific to the acquisition of Eaga, which happened that year. You can also use the following sources of information to help prepare your seminar answers – both posted into the Seminar content area: ● Government report into collapse of Carillion (this is quite long! Just look at the exec summary at the start which is good for an overview) ● London Business School article...