9 Conclusions: the aftermath

9 Conclusions

The aftermath

Preliminary conclusions concerning Carillion’s collapse and lessons to be learned

The issues raised by the failure of Carillion are not an isolated stand-alone issue. Some of the problems at Carillion are endemic as they are for some of the top companies in the UK. This perception speaks to a larger narrative about the state of reporting of the UK’s largest listed companies especially those with:

1 Low profit margins; 2 High debt and/or 3 Large intangible assets.

The accountancy profession’s shame

Carillion’s aggressive accounting was not exposed by its internal or external auditor. Only one person (Emma Mercer) was able to perceive a reality that eluded all the KPMG audit staff (and Deloitte staff acting as internal auditors). This is, we believe, a source of shame, not only for KPMG/Deloitte, but arguably for the whole British accountancy profession. The affair has provoked a storm of criticism levelled at accountants, much of which seems fully justified. Rachel Reeves (Chair of Parliament’s Business Select Committee) claimed that Carillion’s audit was “a colossal waste of time and money, fit only to provide false assurance to investors, workers and the public”.1 Peter Kyle (a member of the same committee) was even more scornful, commenting that he would not hire KPMG “to do an audit of the contents of my fridge”.2 The damage to the profession’s reputation and credibility has been enormous. This damage has been aggravated by KPMG UK chairman and Senior Partner Bill Michael’s “preposterous claim”3 that Carillion’s 2016 accounts presented a true and fair view. The general

110 Conclusions: the aftermath public would be entitled to wonder what meaning accountants give to the words ‘true and fair’ when, less than four months after the accounts were signed off, the company’s assets were shown to have been misstated by over £800 million, more than four times the profit reported for 2016.

Should we blame Carillion board rather than the Big Four and advisers?

The question of blame remains vexed. Iain Dey in the Sunday Times offers this argument:4

I struggle to see that Carillion would have been any less likely to go bust had there been more firms competing to audit its books.

Blame for the aggressive accounting methods deployed by Carillion, and the sneaky tricks to mask its shaky cash flow position, rests squarely on the shoulders of the company’s directors. . . . In Carillion’s case, the report found instances around contract accounting where the auditor (KPMG) does appear to have taken its eye off the ball. Does it necessarily follow that this failing was a result of the ‘cosy club’ operated by the Big Four, however?

It certainly was not in KPMG’s interest for Carillion to fail, nor was the subsequent negative public relations. Neither would be the subsequent reorganization of the audit markets, if that is an outcome. But neither was their work or scrutiny sufficient to mitigate themselves. Dey argues there is no correlation between collapses and audit firms. But that is wrong. This process has been incremental in several jumps of progress. Enron can never happen again (though there are echoes with Steinhoff), but another Carillion is a distinct possibility.

Consider the duty of the police. Each robbery may be unique, but the police are there to catch the robbers. If they are asleep, or are not conscientious in following clues, do you blame the robbers or the police? You probably blame both. As Dey argues, the external auditors are the external check to stop the board which was “[r]eckless, arrogant, naive and bizarrely unrepentant while cross-examined”.5 The auditors are there to protect the wider public, and the professional investors rely on their stamp. It should be one of approval we think.

If you are given several valuations including a high and a low one, do you always accept the highest one? Prudence would suggest further investigation and perhaps use a valuation (if not sure) somewhere in between. If the auditors did nothing to save the company thinking better times would come, then they failed the public and investors. However,

Conclusions: the aftermath 111 not to do your job deserves some blame. In the police analogy, to let the robbers walk right by is unforgivable. That is the basis of the complaint. The audit process, auditing rules, auditing quality and audit sector has had its rules and regulations tightened beyond all recognition. Yet, using the police analogy, if you open the triple coded and padlocked gate for the robbers and just wave them through, then you would expect the book to be thrown at the police. The same applies to the auditors, the FRC and the whole reporting process. It failed. The checks and the balances which should have worked, failed. Bill Michael’s defence letter to the SC6 shows that the system is, in our view and that of many others, broken. The external auditors are there to catch directors like the Carillion directors. And they failed. The signs, we think, were already there as far back as 2012 but certainly evident by 2014 and 2015. The 2016 accounts were, in our view, pure fantasy – see our re-evaluated income figures and net borrowing in Chapter 6.

However, we agree with Dey in one respect. We think there should be more severe forms of reprimand and penalties for directors (and not just those with accounting qualifications which can be sanctioned by the FRC). Penalties should exist for those who act in a manner which can be proven to be reckless, or incompetent, or not taking their fiduciary and stewardship functions diligently. That includes NEDs who are equally to blame, and yet remain in post at board level in the UK’s top companies. This is why the system is broken.

An audit failure

In our opinion, Carillion must be considered a case of audit failure. The investing public was misled by the 2016 accounts which did not present (in our view) ‘a true and fair view’ of the value of the company’s ongoing construction contracts. A few months later, KPMG agreed that the value of these contracts was £845 million lower; we reject as not credible KPMG’s claim that this fall in value had been caused by intervening events (during the period March to July 2017).

KPMG seem to believe that it fulfils its responsibility to the investing public as long as it discloses in the audit report the significant risks of material misstatement, and simply leaves it to the readers to decide for themselves the extent to which assets and profits may be misstated. We believe that this is a fundamental misunderstanding of the auditor’s function, which is to issue an opinion as to whether the accounts give a true and fair view. If, after assessing the risks of a material misstatement, the auditor comes to the opinion that there is a significant possibility of the accounts not giving a true and fair view, he or she should state so in

112 Conclusions: the aftermath the opinion. The responsibility for assessing the risk should not be passed to the reader. However, KPMG’s practice is roughly in line with the normal audit opinion given by all of the Big Four.

The response given in Bill Michael’s letter cannot necessarily be viewed as being at the extreme end of the spectrum. It might be considered as nothing more than the recital of the present standards somewhat strictly interpreted. We disagree. The problem is that the public wants more. They can probably have more – the liability regime may need to flex with it (signifying further changes to rules of the auditing process); and the audit market may need restructuring. The SC were particularly critical of the audit market.7

KPMG’s failure to stand up to management

How did KPMG come to make what we regard as such a large error in evaluating Carillion’s construction contracts in 2016? Bill Michael is correct that it is not the responsibility of the auditor to value assets: the auditor’s task is to report on the management’s valuation. But, in order to do that properly, the auditor has to make his or her own independent evaluation. We contend that KPMG did not do this; they accepted the management’s figures without an effective challenge, failed to stand up to Carillion’s management or were not sufficiently sceptical of Carillion’s valuations. Then they very quickly changed their minds before the first Trading Update/profits warning.

Why did KPMG fail to stand up to Carillion’s management? We believe that KPMG behaved in this way for essentially the same reasons that led Carillion’s Audit Committee to accept the management’s position, which we summarize here.

Assisting management We hypothesize that KPMG considered that one of its principal functions as auditor was to assist Carillion’s management in running the company – to make the company more efficient, more profitable and, above all, to help it survive. KPMG had been Carillion’s auditor since 1999 – a span of 18 years. Carillion’s last two chief financial officers had come from KPMG. KPMG’s audit staff ‘identified’ with Carillion; they wanted the company to survive and prosper. The result was that, where opinions differed, it was not 100% certain which side was right. KPMG tended to accept the management’s position. At the very least, this was with the aim of making life easier, if only in the short run. This tendency for the auditor to identify with the audited company is the reason why the EU

Conclusions: the aftermath 113 requires companies to change their auditors after 20 years; in practice, the rotation period length is much shorter. Carillion, having had the same auditor for 18 years, needed change.

Possible negative consequences It is possible that KPMG failed to stand up to Carillion’s management because the consequences of the auditor insisting on a correction or qualifying his or her report might have been grave. This would be the case in two areas, KPMG’s profits and the capital market.

1 KPMG’s profits: There would be a distinct possibility that Carillion’s management would be antagonized by KPMG’s action and decide not to reappoint the firm as auditor. Although, by law, the auditor is appointed by the shareholders, almost invariably the shareholders follow the management’s recommendation. Losing the Carillion audit would hit KPMG’s profits. Interestingly, this might be not so much the profit earned on actual audit work (for it is widely believed that these are very low) but the profits on non-audit work, such as consulting and or audit top-up work that fall within the 70% cap. In fact, in the case of Carillion, KPMG’s fees for non-audit work were comparatively trivial: £200,000 for taxation services compared to the audit fee of £1.4 million. But, although non-audit fees were not a problem in this particular case, they are a major problem for the accountancy profession as a whole. All of the Big Four earn considerably more from their non-audit work than they do from audits. The FRC, following the

Carillion fiasco, has suggested that each of the Big Four should be split up into an audit firm (that undertakes only audits and is forbidden to take on any other work) and a non-audit firm.8 The audit changes introduced a 70% cap on non-audit fees and also introduced a blacklist of work. So, the extent of the problem is now limited since 2016. One reviewer made the point that audit staff either work on

Channel 1 (Audit) or preferably, because it is more profitable, Channel 2 (Consultancy). But not on both. Though the audit work can bring in the consultancy work (up to the cap limit) and that makes the client work more profitable, taking into account audit and consultancy combined. This was not the case in BHS, where everything was mixed up and consultancy was the priority. 2 The capital market reaction: If the auditor were to state in the report that, in his or her opinion, there was a significant risk that the management had overstated the company’s assets, the result would be an

114 Conclusions: the aftermath immediate loss of confidence in the management’s trustworthiness on the part of the investing public, quite possibly leading to the company’s failure.

Rod thinks that the auditors would be better served by having robust discussions with management which can often result in a compromise acceptable to both parties and, if there is more transparency in the audit committee report, such discussion should be highlighted within that report.

In our opinion, the auditor should not let such considerations influence his or her decision on how and what to report. In reaching this opinion, we took into account the following considerations:

• In the case of Carillion, the effect would have been that the company would have collapsed 12 months or even earlier. The damage to the company would have been the same, but the damage to the auditor’s reputation and to the public’s trust in the audit profession would have been far less significant. • The overriding moral obligation of the auditor is to seek out and report the truth, no matter how damaging this may be to the firm and to the company being audited.

The cost of scandals – post Carillion

Post Carillion, everything has changed. No one has come out of this well: the FRC being toothless; the Big Four being useless; the directors only concerned with greed. The government is criticized for failing to monitor closely enough and awarding contracts to Carillion until close to the bitter end. Moreover, the government is ultimately responsible for the legal basis of reporting, auditing and watchdogs. The FRC, TPR and the Insolvency Service have all come under criticism and increased scrutiny. As the FT put it:

The UK parliamentary committees’ report on the collapse of Carillion is laced with moral condemnation. Individuals are described as reckless, contemptuous, cowardly, manipulative, hubristic, greedy, and on and on.9

As we have said, the optics are terrible and this is a pivotal time for the future of financial reporting and auditing. The FRC is under scrutiny by the Kingman Review and the Big Four, which may yet be broken up (or not) by the CMA.

The main cost of supporting the services of the collapsed Carillion goes to the government and taxpayers who may also have to pay for some

Conclusions: the aftermath 115 of PwC’s fees of administration. But the ultimate losers are the public: hospitals not finished or completed, roads not built, services interrupted. The role, functionality and cost of private public partnerships may forever be re-evaluated.

What now?

The recent cases, and especially Carillion, have led to disruption in financial and corporate reporting, the audit market and the process of auditing. The Carillion failure elicited a plethora of criticisms of the FRC from a cross section of sources.10

The announcement of the Kingman Review has seemingly spurred the FRC into action. In terms of publications, actions and activity, including investigations, the FRC certainly seems much more proactive from Spring 2018 onwards than ever before – see Box 9.1.

The government have accepted the Kingman Review and the new ARGA will replace the FRC. This new regulator will be an independent statutory authority. ARGA should be accountable to Parliament, have clarity of purpose and mission, new leadership, and new powers to keep pace with a changing market with an eye to the prevention of another Carillion. The Kingman Review made 83 basic recommendations – all of which are expected to be adopted by the government. Though for us some of these do not go far enough. That said, it will be much tougher and will have more sanctions over auditors and companies. It will have harsher penalties and the ability to investigate all company directors. ARGA will also be able to make changes to accounts, have a wider set of sanctions and can publish reports into a company’s conduct and management.

Box 9.1 Activities of FRC since Spring 2018

• Produced new policy and guidance documents. • Increased examination of annual and corporate reports. Its

Corporate Reporting Review function has Reviews of Corporate Reporting.11 • Announced the membership of its new Investor Advisory

Group. • Levied its first £10 million fine (on PwC in relation to BHS – reduced to £6.5 million). • Increased fines. According to Economia, the value of FRC fines handed out rose 23% to £17.96 million in 2017/18, up from £14.59 million in 2016/17.12

• Announced plans to enhance its monitoring of the six largest audit firms to avoid systematic deficiencies within firms’ networks, disruption in the provision of statutory audit services and instability in the financial sector. • Increased scrutiny of KPMG includes inspecting 25% more

KPMG audits over its 2018/19 cycle of work, and monitoring closely the implementation of the firm’s Audit Quality Plan. • Implemented a set of detailed actions due to the decline in

Audit Quality Review results.13

The Kingman Review only dealt with the FRC and its replacement, ARGA. The state and possible reorganization of the audit market sit with the CMA, which is now officially considering the possible breakup of the Big Four. The competition watchdog has also challenged the accounting profession and the Big Four to find ways to improve choice in the auditing market, which could save them from being broken up14 (see Volume 1, Disruption in the Audit Market, which examines and analyzes the audit market and evaluates possible solutions).

The CMA supported the additional regulatory scrutiny of audit committees. (We oppose this as we have found that the NEDs often do not have the time or the inclination to take their NED jobs seriously). The CMA liked the concept of dual audits. (We found evidence that audit quality fell and costs increased). The CMA wanted to bolster the mid-tier challenger firms to grow in size and perhaps sharing resources with the Big Four. (We have shown that this might take decades). Finally there was a peer group remedy. The CMA was not in favour of a market share cap or breaking up-the Big Four in any way. So the insufficient numbers problem relating to the Big Four remains.

The need for radical reform

In its role in the Carillion affair, it is abundantly clear that the accountancy profession failed society – not only the company’s investors, but its workers, its subcontractors, even members of the public whose welfare has been compromised by the company’s failure to deliver public works.

In order to ensure that the audit of a business does achieve what society expects, there needs to be a fundamental reassessment of the purpose of an audit. This would entail radical changes both to the law and auditing/ accountancy practice. At present, according to the law,15 an audit serves

Conclusions: the aftermath 117 the interests of the company’s current shareholders and no other party (not even a potential shareholder) has any right to demand that its interests be considered. In reality, the welfare of a far wider group can be harmed by an incompetent audit (as well a problematic management): investors in general (not simply current shareholders), employees, suppliers, subcontractors, the state and the general public. All these parties have a legitimate interest in being informed fully and truthfully about a company’s financial position and performance. The scope of audits is currently far too limited, both in the social groups to which it is addressed and in the information that it provides. The role of the auditor needs to be radically expanded with the aim of ensuring that the economic system functions efficiently and fairly. Hence there needs to be a thorough reappraisal of the auditor’s role. Two of the volumes in this series deal with these issues in detail: Volume 1, Disruption in the Audit Market, which covers scenarios and solutions for improving the audit market, and Volume 4, Disruption in Auditing, which explores changes to the process of auditing in order to improve quality and public perceptions. Readers may also be interested in John’s other publications with Routledge,16 which deal in depth with accountancy’s role and value in society.

The final outcome of the CMA and ARGA is going to present a significantly tougher environment. Bill Michael’s (Chairman of KPMG UK) claim that they stand by their audit opinion has resulted in a much tougher regime for all auditors of PIEs and most listed companies. Whatever happens from now on? We suspect that the changes to audit, company regulations, and the audit market is going to make Michael’s letter seem decidedly lame.

In fairness to KPMG, they have taken some action. The reward structure for partners is now linked to audit quality. KPMG has also banned consultancy work for their largest audit clients. Both actions may take some time to be fully implemented or to be effective. That said, it is the cultural message that is a start. Others of the Big Four will, or have followed. Is it enough? This question is answered in the next volume: Disruption in Financial Reporting.

However, with the Brydon report on auditing to come and a new powerful ARGA with real teeth monitoring all audits, and eventually some weak reorganizations and new controls on the Big Four arising from the CMA (perhaps), something has to change. The ICAEW is giving a series of seminars on auditing in 2019. However, the key message of all these prongs of attack on the current state of auditing is clear. These strands all support our views. All the regulators, any changes in laws and regulations are likely to take a fresh look at greater scepticism, greater independence, and the additional collection of more audit evidence. Any auditor trying to accept

118 Conclusions: the aftermath management estimates or accepting the top end of a range of values when only the top is supported by management, and the evidence tends to support a much lower figure, will not remain an auditor for long. This may be by 2020 or a little later. May be, just may be, this might prevent a Carillion beyond the point of no return when it was too late to save the company. Would it have saved Patisserie Valerie? (see www.fin-rep.org), Probably not. Other audit actions need to be taken. See Disruption in Auditing.

Could Carillion happen again? Definitely as of the date of publication, Interserve (with 68,000 employees [GT the auditors]), was a competitor with Carillion in the Government outsourcing and construction sector. In March 2019, the company went into a pre-pack sale (in effect administration and then immediate sale) to lenders - organized by EY the administrators. Surprisingly the company was brought down by the US hedge fund Coltrane Asset Management, and other shareholders rejecting management’s refinancing offer. Glyn Barker, the Chairman, (mentioned in Chapter 5), was behind the company’s rescue package. This pre-pack sale wipes out any shareholder value but the company may survive under new lender appointed management. However, the likelihood is that it will be broken up and sold in bits (as a distressed sale) with some parts of the company being closed. That said, Interserve sees their future differently.

Notes

1 Commons Select Committee, 2018, ‘Carillion Audits – Colossal Waste of Time and Money’, www.parliament.uk, 22 February. Available at: https://publica tions.parliament.uk/pa/cm201719/cmselect/cmworpen/769/769.pdf Accessed

July 2018. 2 Chapman, B., 2018, ‘Carillion Collapse: “I Wouldn’t Trust You to Audit the Contents of My Fridge”, MP Tells KPMG: “It Was Impossible to Get a True Sense of the

Assets, Liabilities and Cash Generation of the Business”, Business Committee Chair

Rachel Reeves Said’, The Independent, 22 February. Available at: www.indepen dent.co.uk/news/business/news/carillion-collapse-kpmg-deloitte-mps-worthlessaccounts-business-committee-rachel-reeves-a8223626.html Accessed July 2018. 3 Michael, W., 2018, ‘Letter from KPMG Chairman to the Chairs Relating to Carillion’, 2 February. The text of the letter may be viewed on the House of Commons website. Available at: www.parliament.uk/documents/commons-committees/ work-and-pensions/Correspondence/Letter-from-KPMG-Chairman-to-the-

Chairs-relating-to-Carillion-2-February-2018.pdf Accessed July 2018.

The full report on Carillion is: SC, 2018, House of Commons. Business, Energy and Industrial Strategy and Work and Pensions Committees. Carillion Second

Joint Report from the Business, Energy and Industrial Strategy and Work and

Pensions Committees of Session 2017–19. HC 769. Published on 16 May 2018 by authority of the House of Commons. Available at: https://publications.parliament.uk/pa/cm201719/cmselect/cmworpen/769/769.pdf Accessed July 2018. 4 Dey, I., 2018, ‘Iain Dey: Blame the Carillion Board, Not the Big Four’, The Sunday

Times, 20 May. Available at: www.thetimes.co.uk/article/iain-dey-blame-the-carillion-board-not-the-big-four-qh2xvdjst Accessed July 2018.

5 Ibid. 6 John Flower and others believe this. The letter can be found in: op. cit. Mitchell, 2018. 7 SC, 2018, page number of paragraph number given in text. House of Commons.

Business, Energy and Industrial Strategy and Work and Pensions Committees.

Carillion, Second Joint Report from the Business, Energy and Industrial Strategy and Work and Pensions Committees of Session 2017–19. HC 769. Published on 16 May 2018 by authority of the House of Commons. Available at: https:// publications.parliament.uk/pa/cm201719/cmselect/cmworpen/769/769.pdf

Accessed July 2018. 8 Marriage, M., 2018, ‘Probe Urged into Break-Up of Big Four Accountants: UK

Financial Reporting Council Wants Inquiry into Case for Creating Audit-Only

Firms’, Financial Times, 16 March. Available at: www.ft.com/content/911e8184283d-11e8-b27e-cc62a39d57a0 Accessed July 2018. 9 Editorial, 2018, ‘Unravelling a Web of Failures at UK Outsourcer Carillion:

Accountants with Little at Stake Were at the Root of the Company’s Collapse’,

Financial Times, 16 May. Available at: www.ft.com/content/37f63372-58f3-11e8b8b2-d6ceb45fa9d0 Accessed July 2018. 10 Kingman Review, 2018, ‘Independent Review of the Financial Reporting Council’, Review Secretariat Which Is Hosted by the Department for Business, Energy, and

Industrial Strategy, 6 June. Available at: https://assets.publishing.service.gov.uk/ government/uploads/system/uploads/attachment_data/file/717492/Indepen dent_Review_of_the_FRC_-_Call_for_Evidence_-_FINAL.pdf Accessed July 2018. 11 FRC, 2018, Corporate Reporting Review, CPR Reviews of Corporate Reporting, Company Names Published in June 2018, Financial Reporting Council,

June. Available at: www.frc.org.uk/accountants/corporate-reporting-review/ crr-reviews-of-corporate-reporting/company-names-published-in-june-2018

Accessed July 2018. 12 Doherty, R., 2018, ‘FRC Fines Increase Almost a Quarter This Year’, Economia, 17 July. Quotes taken from Economia and reproduced with kind permission of

ICAEW. https://economia.icaew.com/. © ICAEW 2018. Available at: https:// economia.icaew.com/en/news/july-2018/frc-fines-increase-almost-a-quarterthis-year Accessed July 2018. 13 FRC News, 2018, ‘Big Four Audit Quality Review Results Decline’, Financial

Reporting Council, 18 June. Available at: www.frc.org.uk/news/june-2018/bigfour-audit-quality-review-results-decline Accessed July 2018. 14 Kinder, T., 2018, ‘Big Four Are Told to Loosen Grip on Audits: Accountants Hold

Secret Talks to Avoid Break-Up’, The Times, 9 July. Available at: www.thetimes. co.uk/article/big-four-are-told-to-loosen-grip-on-audits-tw9cc58d8 Accessed

July 2018. 15 The current law on the liability of auditors is set out in the judgement of the

House of Lords in the leading case of Caparo Industries PLC v. Dickman, 1990

UKHL2. See: ACCA Factsheet, 2009, ‘Professional Liability of Accountants and

Auditors’, ACCA Global, January. Available at: www.accaglobal.com/content/ dam/acca/global/PDF-members/2012/2012p/Prof_liability.pdf Accessed July 2018. 16 Flower, J., 2017, The Social Function of Accounts: Reforming Accountancy to Serve Mankind, Routledge Studies in Accounting, Routledge, June.