Will we ever learn?

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In his latest UK200Group blog post, Jonathan Russell of member firm ReesRussell, discusses the news of Carillion's insolvency.

Jonathan Russell
The business news at the moment is full of the insolvency of Carillion PLC and it makes you wonder, potentially in hindsight, why did this happen? Those with very long memories will remember the travel firm Courtline and the accounting scandal which came from that, which in turn led to new accounting regulations. The question is will Carillion’s demise possibly lead to similar changes?

There have been substantial changes to accounting regulations in recent years and some have been quite difficult to comprehend, even to trained accountants. But what is the main issue that is emerging from Carillion?

We have a company which for 19 years had paid an increasing dividend to shareholders which can only be done out of distributable reserves – so in simple terms for all this time the accounts were showing a profit. The last accounts signed off by the directors and auditors, KPMG, were to 31 December 2016 and they were signed on 1st March 2017.

Yes, the company had a pension deficit, but it had an agreement with the trustees in place to address that – many companies who had final salary pension schemes have deficits because the funds required to secure these benefits, are now substantially higher than in the pre financial crash. Yes, people will point out that the bonus scheme for directors’ and any clawback was watered down and the directors were still getting substantial payments into their pension schemes, but we are not talking about the ‘excesses’ of some boardroom pay, and in comparison to the work force it was not a huge management team. OK the CFO retired as at 31 December 2016 and a new one was appointed and the CEO resigned on the first profit warning in July 2017.

The failure initially seemed to be a cash shortage not a profit problem – could this be the money spent on acquisitions or was it a problem caused by over-trading – a symptom often of rapid growth. I don’t believe that either of these were the root cause of the sudden demise but more a reason why the underlying problem was hidden within accounting cloak and mirrors.

Here is a statement from the 2016 accounts signed off in just March of last year:-

‘The three-year business plan includes information in relation to the Group's revenues, profits, cash flows, dividends, net debt, and other key financial and non-financial metrics. The business plan includes a level of cover to provide against trading risks and the resulting metrics are subject to sensitivity analysis to illustrate the impact of future deviations in the Group's liquidity position. The Board has tested the outputs from this plan against the potential impacts from the Group's key strategic risks both individually and in unison.
On the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.’

So, what could go wrong so quickly – obviously there are going to be investigations, but a simple explanation would seem to suggest that the accounts simply were wrong. So, what could be so wrong but didn’t lead to some earlier disclosure assuming fraud was not present? The issue would almost certainly be akin to the Courtline problem, an unreasonable assessment of when top take credit for profits and income maybe coupled with a recognition or lack of recognition of likely costs. Here we are talking about the valuation of long term contracts. Accounting standards have changed over the years and the simple interpretation of the current standards is that profit should be recognised over the course of the contract.

The problem is how do we recognise profit on a long-term contract? Take a simple example – you sell an annual maintenance contract on a piece of machinery. It could work all year without ever breaking down and cost you nothing, it could be breaking down every month or it could work perfectly for 364 days and then have a catastrophic failure on the last day of the contract. Right as a one-year agreement it is not even a long term contract but what should you do? If you have hundreds of similar contracts you may well know approximately how much you will make on average. But on more difficult and more individual contracts, especially those over many years the model is more difficult.

If the model is difficult then there is more room for variation and if you are wanting your business to look successful you will be inclined to use a model that brings profit forward rather than push it back and moves costs back rather than brings them forward. So quite quickly we can have a perfectly reasonable model that shows good profits but doesn’t deliver the cashflow. So, we then need to borrow against our ‘strong’ business because it will all come right in the end. Plus, we want more and more contract volume so that in turn shows more profits, and turnover can generate more borrowings.

The problem is – and I suspect this is the bottom line for Carillion – that if the profits are not made and you have already taken in anticipation them into accounts, we suddenly swing into losses which can only be hidden if you are signing up bigger and bigger contracts that you can drag in profits early. A corporate governance Ponzi scheme.

I am sure in a few years’ time when all the investigations finish and everyone who can be blamed has been, but no one found fundamentally culpable, we will have yet more changes to accounting regulations but in the interim remember the old adage – Turnover is vanity, profit is sanity but cash is king!

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