At the very last minute the Insolvency Service, acting for the UK Government, has just abandoned disqualification proceedings against five former non-executive directors of Carillion, which collapsed in 2018. This is a massive relief, not just to those individuals, but to the whole non-exec community as it would have put full responsibility on all non-execs and audit committees to detect and stop hidden executive misconduct. Three ex-Carillion executive directors have already been disqualified, but non-execs are now becoming increasingly at risk from prosecution.
Do not think that the cessation of this prosecution against Carillion directors will be the end of attempts to make other non-executive directors legally liable for scandals.
The case against the non-execs was that;
- They should have known the true financial position and not knowing meant that they allowed executive misconduct. They are therefore unfit to be directors.
- The non-execs missed (unspecified) “warning signs” that should have alerted them and therefore they are responsible for publishing misleading accounts.
This prosecution is of course typical of government and regulators. Whenever there is a scandal, they blame individuals and try to prosecute them. It’s easy for someone with 20:20 hindsight just to claim that they should have known. Leaving aside individual conduct, the reality is that financial reporting is a process, and we need to learn from these failures to avoid them happening again. It’s a basic tenet of a secure process that it can be robust against individuals’ errors and failings.
Rather than point fingers at the non-execs, we should be focussing on what went wrong and ensuring that non-execs in the future would be more likely at least to spot that something was very wrong. All non-execs should read this, as even those not serving on an audit committee bear the same legal responsibility.
The Financial Reporting Council (FRC) has also now fined KPMG £21m for its failures in auditing Carillion. The FRC published its two decisions against the auditors that sheds some light on how the audit committee might have been able to spot problems. I have used this to suggest what non-execs and Audit Committees can do and ask that might help avoid getting into a similar situation.
The specific findings against the auditors centred on long-term contracts, net debt, unusual or one-off contracts, pension’s liability, goodwill, overseas contracts and the audit process.
Long-term contracts
These are always problematic and higher risk items. Despite this, according to the FRC, the auditors performed detailed audit testing on only a few contracts and very limited work on others. The auditors therefore had very little evidence of some £1.5bn of accrued revenue. They;
- Didn’t evaluate the design of the controls on long term contracts;
- Didn’t check whether those controls were operating;
- Didn’t test those controls adequately nor confirm they were actually working;
- Didn’t obtain adequate assurance on claims and variations against those contracts;
- Didn’t properly challenge management’s forecasts for those contracts, even when there was little evidence to support them and despite inconsistencies and other evidence available;
- Didn’t challenge those inconsistencies and ambiguities in the advance booking of contract revenue;
- Didn’t take seriously enough allegations from a customer that one contract’s records had been falsified, even though another team from the same auditor had performed work that supported that claim, and;
- Didn’t properly evaluate the risk that some contracts were likely to be loss-making or at least ‘high risk’ and thus £600m revenue was potentially overstated.
This suggests some things that non-execs should be doing to try to detect these sort of risks.
Audit Committees should;
- Treat long-term contracts as very high risk and plan thoughtful risk management around this.
- Not rely solely on external auditors and assume that management is telling you the whole story. Challenge, seek confirmatory data and demand explanations.
- Ensure that they understand the controls around long term contracts.
- Use internal audit to look into the long-term contract management process and to test controls.
- Ask the auditors to review and test contract controls and confirm that they are working.
- Insist on seeing a list of claims and variations against significant contracts.
- Ask if there have been any claims from customers/suppliers about fraud or false reporting on contracts.
- Ask both management and the auditors what evidence each has used to verify contract revenue accruals.
- Check that the auditors are not auditing work by a different team from their own audit firm.
- Demand to see full cash and profit forecasts for significant contracts and challenge them. Any low profit or potentially loss-making contracts should be reviewed carefully and discussed with the auditors to ensure correct treatment.
- Ensure that company whistleblowing procedures are operating correctly and allow customers and suppliers to participate.
Net Debt
Full and accurate reporting of the net debt position is crucial to understanding a company’s liquidity and financial health. Carillion’s auditors were criticised for failing to challenge, understand and audit properly a number of material aspects;
- Carillion had a large reverse factoring facility, where its banks paid suppliers early and Carillion later reimbursed the banks. It looks as if this was treated as working capital rather than debt and so understated Carillion’s net debt. Given that at one point this was worth £472m, this was a considerable adjustment that was not, in nature, cash available from supplier credit terms, but from borrowing from banks.
- There were large movements in cash in 2016 that ‘suggested manipulation of borrowing at the year-end’ (FRC). Although not quantified, the report seems to believe that these were both artificial and material.
Audit Committees should;
- Keep a very careful eye on all factoring and reverse factoring deals;
- Challenge why they are being set up and what terms are required of both your company and any other participant;
- Committees should understand whether these amounts are treated as working capital or debt;
- Look at the working capital and cash numbers with and without the factoring. Is it making a material difference to these key numbers? Is this potentially giving a misleading view of the cash position?
- Ask the auditors to explain the reason why the factoring is being treated as it is and check that this reasoning is valid and based on the committee’s understanding of what is really happening.
- Review the wording in results announcements and annual reports to satisfy themselves that the factoring is being fully and comprehensively explained. Do not rely on what management and auditors decide is the minimum required disclosure. The minimum disclosure is exactly that, whereas boards should disclose more if needed to explain what is really happening.
- Many companies will ‘dress’ their year-end balance sheets. Sometimes it’s a fairly ‘harmless’ case of asking customers to pay a few days early or delaying payments a week, but;
- Ask management if they have dressed the period-end balance sheet and if so by how much.
- Look at the final period of the year and first few periods of the next year. Do profit and cash flow look strong towards the end of the year and poor early in the next year? This may have an innocent explanation (eg seasonality), perhaps shown by both profit and cash rising together at the same time, or with a standard working capital lag. However, if there seems to be a disconnect, non-execs should take a closer interest.
- Be wary where the company has a large profit or cash movement booked in the final period of the year. At best this makes the year-end nerve wracking, at worst it suggests some form of (possibly perfectly legal) management going on.
- Look at the movement in net debt not the change in cash and cash equivalents when looking at the cash flow statement. The latter is like deciding if you are becoming better off just by counting the cash in your wallet and ignoring your savings accounts and your mortgage. Tell the CFO to prepare the cash flow statement for the board so that it adds down to movement in net debt, not cash equivalent (when they tell you that this is not consistent with IAS7, explain that it does not mandate what you present in board papers).
Unusual or one-off contracts
There were a number of contracts, coyly described by the FRC as ‘one-off’ that had a material effect on revenue, profit and cash at the year-end. One, in particular, had a new supplier to whom Carillion assigned ‘certain intellectual property rights’ in return for Carillion getting £27m cash. The new supplier also paid another £14m to compensate for supplanting the previous supplier. The combined £41m was all booked to 2013 profit. Carillion then had to pay back £41m over the life of the contract for unspecified ‘Other Charges’, and in the event that Carillion terminated this new agreement early, total payments to the new provider would still be topped up to £40m. As the FRC says; ‘The most likely explanation for the transactions was that all the elements were linked in substance’. In any case, the £41m was not earned, and should not have been credited to the one year.
Audit Committees should;
- Ask management if there are any one-off or unusual contracts and get an explanation. Are there any contracts not in the normal course of trade?
- Are there are any contracts with unusual cash flows, such as upfront payments or very delayed final payments?
- Are there any new or long-term contracts that have unusual features, such as compensation being paid, sale of intangibles or having a significant exit fee?
- Are any reporting disclosures being made about such contracts? Are they comprehensive?
- Are there any unusual linkages between different contracts?
Defined Contribution Pensions Liability
Carillion’s auditors accepted management’s assumptions about the pension liability even though it knew they were ‘at the extreme weak limit’. Moving the assumptions to the mid-range would have increased the liability by £200m.
Audit Committees should;
- Take pension liabilities very seriously and listen to the views of the auditor’s actuarial experts.
- If auditors think pension assumptions are optimistic, non-execs should think about whether the extra cost compared to a mid-position would have a material impact on the overall financial position and at least make sure that disclosure reflects this.
Goodwill
You can’t see or touch goodwill and it often becomes an accounting calculation rather than a real attempt to value an intangible asset. Most non-execs glaze over at the goodwill discussion, but they shouldn’t as the underlying principle is fairly simple and the numbers can be huge. This means that when something goes wrong, or an assumption is changed, the goodwill written off can be huge. Carillion had £1.5bn goodwill, representing its biggest single asset and a third of all assets. Nevertheless the auditors didn’t assess it appropriately nor gather sufficient evidence to justify its retention.
Audit Committees should;
- Stay awake during the discussion on goodwill impairment and challenge the assumptions. Never mind the arcane discussion about discount rates and the future cash flows, does it feel reasonable? Where did it arise and is that still as valuable as it was? Would anyone else buy this goodwill?
Overseas contracts
Carillion’s auditors did limited work and had insufficient evidence on large overseas contracts, notably a £600m Qatar contract which had £100m of unagreed variations and claims.
Audit Committees should;
- Challenge auditors on their overseas work and seek assurance that work abroad is as good as work at home. There will be some countries where the audit teams are weaker and need more supervision.
- Be aware that some countries have less strict ethical standards and suffer political pressures as well as customs and practices that would not be acceptable in the home country.
- However, they should not assume that the home country has less fraud and malpractice than foreign ones. There is plenty in the US and Europe.
Audit process
Carillion’s auditors deviated from the normal audit process. In particular, there was no effective process to ensure that all the substantive work was done before the audit was signed off. Some aspects were completed six weeks after the audit was signed off, a fact that was not properly recorded.
Audit Committees should;
- Ask the auditor what work has yet to be completed as part of the audit and record their answer carefully. Make sure to follow up to ensure that all work is completed.
- Be very wary where subsidiary accounts have not been signed off for a year or more and ask probing questions why not.
Summary
Non-execs must develop a heightened vigilance and scrutiny of financial results, even if they are not on the Audit Committee. There is a growing risk that non-execs will be held to account by government and regulators, or worse, by unforgiving and uninformed social media. The non-execs’ secret weapon is asking probing questions, such as these here. Asking questions won’t guarantee financial propriety, but it will reduce the risk of publishing false or misleading results. At the very least, it will show that non-execs did their job and acted diligently. That alone may avoid public humiliation…or even prosecution.
There are more lessons from Carillion’s collapse elsewhere on my blog here: ‘What can we learn?’ and ‘A salutary reminder on due diligence’.
Many more cautionary tales and practical advice for non-executive directors are in my book: “Behind Closed Doors. The Boardroom: How to Get In, Get On and Make a Difference” available from Amazon and my website.