I’ve decided to create a 3-part series on Carillion and the hidden goings-on in the accounting world. This is part 2, where I look at some of the questionable accounting. You can read Part 1, on the insolvency process here. You can read Part 3, on the ongoing investigations and aftermath here.
I loathe hyperbole. As I explained in the first part of this series on insolvency, a lot of the time that hyperbole is nonsense. So when I started hearing people describe Carillion as like a Ponzi scheme, I was thinking: “here we go again“.
A big difference this time is that one of those saying it is former Auditor General Sir John Bourn. That made me stop and think. When somebody of that calibre says it, you should probably take it seriously.
Having reflected on those comments for a week or so, I think they are right. Carillion had many characteristics of a Ponzi scheme.
What is a Ponzi scheme?
Ponzi schemes are named after Charles Ponzi, who used the technique in the 1920s. A Ponzi scheme is a fraud where a business seeks funds from new investors and pays those funds as profits to earlier investors. The fraudster tricks the old investors into believing that the profits are from sales or trading returns, not disclosing their true origin. Investors are misled as to the true nature of the alleged ‘profits’.
Ponzi schemes can keep running as long as: investors do not demand repayment of their funds, continue to believe that their non-existent assets will continue to generate ‘profits’ and there are new investors willing to contribute new funds.
Carillion was primarily a construction and services contractor. As a forensic accountant, a big red flashing light appears. This is because the most notorious financial frauds and scandals are perpetrated by recognising non-existent revenues. Construction and services contracts are the most tricky when it comes to determining when and how to recognise revenue. (So much so, the international accounting standards body is once again updating the standards on revenue recognition).
The big problem is this: the contractor pays lots of cash out upfront and gets most of the cash backloaded. It’s easiest to see this graphically:
When the orange line is above the blue line, the contract is making a cash loss. You can see that for most of the project, it is making a cash loss. It’s only at the end that a cash profit is made. This is quite common, where the contractor is paid in increments when it reaches a milestone. [update: for those after a bit more detail have a look at the end of the post]
The accounting standard relating to construction contracts is IAS 11 (for general revenues it is IAS 18). Both will be replaced by a new standard, IFRS 15 this year. Basically, it says, if the outcome of the contract can be estimated reliably, revenue and costs should be recognised in proportion to the stage of completion.
If the outcome cannot be estimated reliably, no profit should be recognised. Instead, contract revenue should be recognised only to the extent that contract costs incurred are expected to be recoverable and contract costs should be expensed as incurred.
However, the stage of completion of a contract can be determined in a variety of ways. Such as, including the proportion by costs incurred compared to estimated total contract costs or completion of a physical proportion of the contract work.
Importantly, an expected loss on a construction contract should be recognised as an expense as soon as such loss is probable.
As you can see from the standard, quite a bit of judgement is involved. In the judgement lies the grey areas. In the grey areas lies dodgy accounting.
Carillion was a relatively young company. It started in 1999, a spin-off of the old Tarmac Group. From the outset, Carillion’s approach was to take on debt and buy up competitors. Over time, it made increasingly big bets buying out a number of competitors including Mowlem, McAlpine, part of John Liang and even tried and failed to merge with Balfour Beatty.
Despite the rapid acquisitions, following the financial crisis the company struggled to grow profits. Struggling to grow revenues from acquisitions alone, it resorted to taking on more projects to grow profits.
But as we saw above, those projects start off with cash outflows. Generally speaking, the bigger the project (think the big PPP stuff with the government) the bigger the outflow. So Carillion turned it’s hand to getting short projects in to get the cash to fund the big projects. The trouble was, those short projects had wafer-thin margins – making very little profit. So Carillion needed more and more of them.
In other words, Carillion was bringing in projects so it could service the old ones. It became a cycle and somewhat reminiscent of a Ponzi scheme.
How things turned bad
These projects are complicated and often go wrong. Especially when you have little profit margin to play with. So many firms have big cash-buffers to help if this happens. They also retain deep pools of knowledge and expertise that it can use to ride out rough patches and know when to cut their losses.
Unfortunately for Carillion, it had huge debts from its acquisition spree. More concerning, Carillion just wasn’t very good at building things.
At this point, with very little cash in the bank and projects going wrong, a company should cut its losses to stop the bleeding before its too late. Carillion, however, doubled down.
The “Early Repayment Facility”
Its first step was to find cash in more creative ways. Despite being a signatory to the Prompt Payment Code, it used ethically questionable practices to delay payment to suppliers (querying invoices, delaying issuing purchase orders or just flat out not paying for supplies).
It went one further and arguably abused a government scheme called the Supply Chain Finance Scheme.
The scheme, created in 2012, was designed to help SMEs that got burnt during the financial crisis by banks refusing to offer credit. SMEs could use their invoices to get the money from their bank rather than wait for the company to pay them. In turn, the bank would collect the money from the company when it was eventually paid.
Carillion flipped this on its head. It said to its suppliers, if you want your money early then you can use the scheme. They renamed it the “Early Payment Facility”.
However, a few months later it cynically pushed out its credit terms (sometimes up to 120 days). In other words, it wasn’t an early repayment at all. Worse still, many suppliers would have to pay a fee to access that early payment, leaving them with a difficult choice of losing money but getting cash or waiting for longer and longer to get hands on the money it was due.
In effect, Carillion was borrowing from its suppliers to plug its cash and funding gap. Carillion was quite open about this, boasting that the scheme: “Gives Carillion greater flexibility in terms of managing its own working capital.” But in the accounts, there was no mention of the Early Repayment Facility.
A gap in the accounting standards
That’s because, in my opinion, it falls in between a gap in the accounting standards.
Carillion was in effect borrowing cash from its banks secured on supplier invoices. This is, by most people’s reckoning, a debt. But the accounting standards are vague on these transactions (sometimes called Reverse-Factoring). It essentially boils down to a judgement call about whether the link to the original payable has been broken. If it has, it’s a debt liability. If not, then it stays as a payable. It’s a judgement call that depends on the exact wording of the legal agreements.
This is important because if you keep it as a payable your debt levels look much lower. Carillion decided the link to the payables was still there – this wasn’t a debt. This should have been a high-risk area for the auditors because of the large amount of subjectivity.
One of my major projects was where there were bad debts on a factoring facility and the argument was that the accounting by the company was wrong. The answer was, according to the accounting standards: “it depends on the legal documents”.
As far as I can tell from the accounts, KPMG (the auditors) didn’t consider this a high-risk despite the very large sums of money at play (roughly £500m). If Carillion had recognised these amounts as debts, then it may have broken it’s borrowing covenants and the banks could have recalled their loans putting Carillion out of business.
But the major problem was that Carillion resorted to aggressively recognising revenue on contracts.
If you recall from above, you could either recognise revenue on a percentage basis (only if you could reliably estimate it) or you couldn’t recognise any profit, only the recoverable costs.
As I mentioned before, Carillion was doing a poor job at delivering projects, usually over budget and behind schedule. Where there is doubt that you can deliver the project to contract, you should stop booking profit and only book the money you’ve actually brought in. If it’s probable you might incur some losses, those should be recognised immediately as well.
But Carillion continued to book revenue as if everything was fine and dandy. Trouble is, once you go down this route there is no going back. It’s like Cortez scuttling his ships. The more you book aggressive revenues the bigger the gap becomes between your actual revenue and the forecasts. This is exactly what happened at Carillion when a new finance director came in and said: “hold on this isn’t right!”. In 2017, Carillion wrote off around £800m of revenue (the difference between the stage of completion accounting and the actual money it could bring in).
From my review of the 2015 and 2016 accounts, I would consider that Carillion was potentially insolvent in 2016 (and possibly 2015 as well). This view is shared by, among others, Frances Coppola, a finance and economics journalist. During 2015 and 2016, hedge fund managers smelt something was up and it became the most shorted stock on the London Stock Exchange.
This is because Carillion had a wafer-thin amount of cash, had mountains of debt (excluding even, the payables possibly that were mis-classified), and because its net assets were almost entirely propped up by Goodwill (an intangible asset that is not immediately realisable, unlike cash or hard assets like property, though usually at a discount).
Goodwill is the extra money paid by the acquirer above the asset value of the company being taken over. It can be thought of as representing things such as brands, patents and reputation. In Carillion’s case, it represented the forecast profits from its the subsidiaries, joint ventures and “special purpose companies” that it used to run projects. As those profits evaporated so should have the goodwill.
Put bluntly, the goodwill accounting in Carillion’s accounts made no sense. Carillion was due to pay ‘contingent consideration’, extra money, to the sellers of some of the businesses it acquired. However, because they were missing profit targets it was slashing these amounts. At the same time, it was saying that goodwill would only reduce in value if the discount rate (the time value of money) went up to 20% – i.e. money in 5 years time is worth only 40% of money today. But this would mean almost all of the extra profits from the acquisition had to come within 5 years. This was a big sign that these profits (like Carillion’s own) were overestimated.
In 2017, Carillion tried to undo the damage with enormous write-offs. Including nearly £800m in overstated revenues. But it was too late, the company was already short on cash and had nothing left in the bank. Likewise, because almost all its assets were goodwill, it had nothing to sell either. Carillion quickly went from people thinking it was insolvent to being insolvent (more on that in part 3).
A lesson for all businesses
There is a lesson here for all businesses. It was one of the first I was ever taught as an accountant:
Most businesses go bust, not because they fail, but because they do too much business.
It’s called overtrading (that link made me laugh, Carillion followed the bullet points in that link point-by-point). What happens is that you sell too much stuff, and you run out of cash to complete those sales.
Carillion was the quintessential overtrader following bad projects with more bad projects. Rather than stopping before the damage was permanent, it followed a Ponzi-like business practice that made salvage impossible.
It’s quite inexplicable that experienced directors could act with such incompetence. However, there are questions about whether there was something more insidious going on. I’ll be looking into that in the next and final part.
All the best,
Young FI Guy
(p.s. a personal thank you to Frances Coppola, who was an inspiration for me writing this post).
[update: some industry bods kindly shared this post on twitter and there were some interesting comments.
This post was designed to be accessible to those with no knowledge of accounting or contracting. So I’ve kept it as simple as possible. That said, for those after a little more detail it’s worth talking a bit more about the contracting subcontracting relationship (something helpfully mentioned by commenters on twitter). Here it goes.
Generally speaking the contracting industry can be broken down into a hierarchy of three (or more) ‘Tiers’. At the top is Tier 1, the contractor engaged by the ultimate customer. For major projects, this will be a national contracting firm like Carillion. Tier 2 is a subcontractor engaged by the contractor to deliver major parts of the work. These are often local contracting firms, specialists and consultants. Tier 3 are the subcontractors engaged by Tier 2 subbys. These will do specific jobs or services in the project ranging from electrical installations through to cleaning toilets.
Even though each tier will have contracts with one another, a lot of the industry still works on trust. That said, there are also specialist ‘supply chain management’ firms that can also act as the ‘grease between the wheels’.
Generally speaking, as you flow down the chain, the subcontractor will rely more on cash to fund works. The Tier 3 contractors will pay for material and labour in cash or short (monthly) credit terms. In turn, the Tier 2 contractors will pay Tier 3 contractors on longer credit terms. And so on, up the chain.
In effect, this means that subcontractors are net lenders of finance to build projects and contractors net borrowers. The contractors ‘borrow’ by having services rendered for them before getting paid, only paying out when work reaches the relevant milestone. In other words, they borrow from their suppliers.
So what happened with Carillion? Well as I noted in the main piece, Carillion aggressively tendered for projects. Taking on projects with very late payment or thin margins. Unfortunately, some major projects became severely delayed or not built up to standard.
You might think that’s the subcontractors’ fault. After all, they are the ones doing the job, right? To some extent, there are bad subbys out there. But it’s important to understand that it’s not just about doing the right job. You have to do the right job at the right time. It is the responsibility of the contractor, like Carillion, to ensure everything is working in order.
As we saw in the main piece, as things started to go pair-shaped, and the cash stopped flowing in, Carillion would delay and delay paying subcontractors. In effect, they had to borrow more and more from suppliers to keep the lights on.
There’s only so far you can push things though. From speaking to people and reading around, Carillion became notorious in the industry (though by no means the only one) for sharp business practices. Over time, a great deal of goodwill was lost between Carillion and its subcontractors.
Eventually, Carillion has tapped out their suppliers as far as they could and only cold hard cash could keep the business afloat. As we saw in the main article, that’s when the business came crashing down.
Frances Coppola on the Early Repayment Facility: https://www.forbes.com/sites/francescoppola/2018/01/30/how-carillion-used-a-u-k-government-scheme-to-rip-off-its-suppliers/#7ab7a7c252dc
FRC letter to the Work and Pensions committee on Reverse Factoring: https://www.parliament.uk/documents/commons-committees/work-and-pensions/Carillion%20report/Letter-from-FRC-to-Chairs-21-March-2018.pdf
Carillion 2016 Accounts: http://www.annualreports.co.uk/Click/12208
- The references relating to my point on Goodwill are Note 11 (Intangible Assets), p110 and Note 29 (Acquisitions and disposals), p129.