You are a consultant brought in to advise the Department of Business, Energy and Industrial Strategy (BEIS) on how executive compensation targets may have contributed to the collapse of Carillion. You have been tasked to write a report which:
Examines the link between executive remuneration and creative accounting in the existing accounting, corporate governance and financialization literature (40 marks)
Analyses the changing structure of executive remuneration at Carillion in its final 5 years of accounts and considers whether this contributed to Carillion’s ultimate collapse (40 marks)
Makes recommendations for the reform of remuneration practices in light of your answers to 1 & 2 (20 marks).
Q1 requires a review of the academic literature on ‘financialization’ and aggressive accounting practices. You also need to link this to executive compensation (remuneration), specifically in relation to financial misconduct/misrepresentation.
Q2 requires the use of accounting data and review of the remuneration reports, which can be accessed through the annual reports. You may also want to review the Work & Pensions Committee’s documents on Carillion’s Remuneration Committee and the BEIS/DWP report on Carillion’s collapse which also contain very useful commentary. Newspaper coverage, analyst reports and industry sources may all add texture to your findings
Q3 requires your own thoughts, with background reading on executive remuneration after financialization
MGT329: Case Studies In Accounting
& Consultancy
Dr Daniel Tischer
Lecture 1ª: Introduction
2
Contents
• What should you expect on MGT329?
• Which case are we studying?
• What skills will I need & what will I acquire?
• What is the course structure & how am I taught?
• What support is there?
• How am I assessed?
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What is MGT329 about?
• A case study course designed to provide deep, practical understanding of a firm and
sector
• Engages one ‘real world’ dilemma
• Cases and dilemmas are contemporary:
• The conditions of stability and instability in platform companies and other ‘Unicorn’ firms
• Creative accounting abuses: why firms do it and how to spot them.
• Does the pursuit of shareholder value lead to under-investment and short-termism?
• The role of financial innovation in financial crisis
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The course
• Case study method, three layers:
• One company, in-depth
• Related to a broader social/economic theme
• Framed by academic work/theory-building
• Provides a ‘real world’ example to develop research experience
• Find and interpret the data; consider wider implications; apply theory to explain
developments
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Why use a case study?
• Contemporary: the company & theme are in the news
• Relevant: wider significance of the case/applicable to other situations
• Interesting: different/competing perspectives
• Immersive: opportunity to delve into the detail
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What does the case study look like?
• Emphasis of deep knowledge of one company
• Single, in depth case study
• Located in historical context
• Time series product market and company data
• Newspaper and industry journal coverage
• Corporate strategy and corporate governance review
• Academic theory
• Up-close accounting, but no complex maths
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Which case/theme/literature & why?
• Company = Carillion, the outsourcing company
• Theme = financialization, executive remuneration & audit
reform
• White paper on audit reform (+ Kingman, Brydon, CMA)
• Literatures = fraud, audit failure, financialization, time
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What skills can you expect to acquire?
1. Corporate performance analysis (within a business environment)
2. ’Forensic’ accounting skills
3. Investigative skills – locating sources
4. Consultancy report-writing skills:
organise, synthesise, present and write up arguments w/
recommendations
5. Independent thought, critical thinking & scepticism
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Lectures
• Weeks 2-3: Case study and thematic social/economic issue.
• Background: Audit failure and audit reform
• Case study context: Outsourcing in the UK
• Carillion introduction, key accounting issues & collapse
• Weeks 4-7: Academic literature to frame the case.
• Financialization & Shareholder Value
• Accounting & Time
• History of Audit Failure & Fraud
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Lectures
• Weeks 8-11: Case evaluation & wider implications; conclusion.
• Aggressive Accounting & Executive Remuneration and Carillion
• Government White Paper & Capital Maintenance
• Capital Maintenance & Hollow Firms
• Conclusions
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Tutorials
• Week 2/3: Overview of case and theme.
• Week 4/5: Carillion’s accounting.
• Week 6*/7: Shareholder value & financialization.
• Week 8/9: The Influence of Executive Compensation and Firm
Performance on Financial Misrepresentation
• Week 10/11: Conclusion / assignment clinic
*due to strike action, students are permitted to attend the week 7 sessions
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Learning Outcomes (1)
• On successfully completing this module students will be able to:
• undertake and manage independent research work
• critically apply knowledge of financial reporting, management accounting and
corporate governance to a particular industry and company context
• evaluate corporate performance using financial and other information and
critically analyse relevant findings
• construct a reasoned argument, supported by evidence
• present an argument in a coherent manner
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Learning Outcomes (2)
• Through working on case studies students will be able to:
• demonstrate that the role of an accountant is embedded within a particular
social and cultural context
• discuss the function that accounting information fulfils in creating a reality
• compare and contrast the roles of accounting in different forms of corporate
governance.
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Assessment
• An individual written report of 4,000 words accounts for 100% of the
mark
• This report is to be submitted by (TBC).
• Late submission will incur a penalty.
• UoS plagiarism rules apply
• Style – more consultancy style, but will involve: a) accounting analysis b)
engagement with case themes c)some academic theory d)
recommendations
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Thank you!
• More line-by-line discussion of each lecture and tutorial in the
first introductory tutorial, week 2/4…
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Background: Audit Failure & Audit Reform
&
Context: Outsourcing in the UK
Dr Daniel Tischer
MGT329
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Content – part 1
1. Context of audit failure concerns in the UK
2. Three reports:
• Kingman Report
• Brydon Review
• CMA Review
3. White Paper
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Context of audit failure
• Historic cases:
• Co-operative Bank; Taveta/BHS; Ted Baker; Connaught
• High profile collapses from 2018:
• Carillion: 43k jobs w/w, collapsed w/liabilities of nearly £7 billion and just £29 million in cash
• Interserve: 60k jobs w/w, banks wrote off £800m of bad loans – bought by Mitie
• Patisserie Valerie: £94m ‘black hole’ outright fraud, faked invoices etc.
• Thomas Cook: goodwill accounting & use of ‘underlying’ profit figures
• Wirecard: fraud involving faked cash balances
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Persistence of Audit failures
• Fines issued by Financial Reporting Council
• Doubled in numbers: 28 (2019/20) to 62 (in 2021/22)
• Value of fines tripled: from £16.5m to £46.5m (discounted £11.3m to £34.6m)
• KPMG most fined company w/ £14.4m re Carillion
• Deloitte fined £2m for Mitie Group audit failure
• Grant Thornton fined £2.3m for Patisserie Valerie
• Fines + shift in FRC practice to amend audit behaviour
https://www.frc.org.uk/getattachment/7d1d58ef-18c0-4568-ab94524aec417197/FRC-Annual-Enforcement-Review_-July-2022.pdf
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FRC case openings and closures
https://www.frc.org.uk/getattachment/7d1d58ef-18c0-4568-ab94524aec417197/FRC-Annual-Enforcement-Review_-July-2022.pdf
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Is it about the construction / outsourcing sectors?
• PWC: Kier, Galliford Try & Babcock;
Deloitte: Mitie; & BDO: NMCN etc.
• Pressure to win contracts, but
underestimation of costs & complexity
• Downturns in profitability & low
margins
“balance sheet is a huge and opaque
blob, which is the contract value”
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BEIS/DWP Report on Carillion
“KPMG audited Carillion for 19 years, pocketing £29 million in the process. Not once during that time
did they qualify their audit opinion on the financial statements, instead signing off the figures put in
front of them by the company’s directors. Yet, had KPMG been prepared to challenge management, the
warning signs were there in highly questionable assumptions about construction contract revenue
and the intangible asset of goodwill accumulated in historic acquisitions. These assumptions were
fundamental to the picture of corporate health presented in audited annual accounts. In failing to
exercise—and voice—professional scepticism towards Carillion’s aggressive accounting judgements,
KPMG was complicit in them. It should take its own share of responsibility for the consequences.”
(BEIS/DWP 2018, para.124)
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Commentary on PwC & EY re: Thomas Cook
“It presents a picture of audit automatons that are incapable of drawing the most basic
of conclusions from a balance sheet, questioning what they add to the corporate
reporting process….
…How many more company failures, how many more egregious examples of
accounting do we need before your industry opens its eyes and recognises you’re
complicit in this and that you need to reform?”
(Rachel Reeves MP, cited in FT 22/10/19 and 4/11/19)
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Consequences
• Existential crisis about the quality of financial reporting; can the numbers be trusted
any more?
• Corporate culture: Willingness of companies to bend & break the rules
• Enablers in the Big 4 accountancy firms
• Failure of audit as the police officers of capital
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Main Concerns Raised
• Regulation is too weak (FRC & Pensions Regulator)
• Fines are too small (accommodated as a cost of doing business)
• Insufficient scepticism amongst auditors (culture of deference and proceduralism)
• Market concentration – absence of competition (Big 4 power)
• Conflicts of interest between audit & non-audit functions (audits are insufficiently
skeptical because firms seek more lucrative non-audit business)
• Conflicts of interest in company-pays model
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In Response…
• Three separate reports on audit failure and audit reform:
1. ‘Kingman report’ – review of regulation/the FRC
2. ‘Brydon report’ – quality & effectiveness of audit practice
3. Competition & Markets Authority Report or ‘CMA’ – audit services market
• Some overlapping criticisms and solutions
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Financial Reporting Council (FRC)
• Independent regulator in the UK and Ireland
• Roles:
• responsible for regulating auditors, accountants and actuaries
• setting the UK’s Corporate Governance and Stewardship Codes.
• Funding: voluntary levy on audit firms
• Impartiality questioned due to revolving door like staffing
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Kingman findings
• Main focus = the performance of the Financial Reporting Council;
• Conclusion: “a rather ramshackle house, … built on weak foundations”:
• Powers – the FRC’s powers “clearly deficient”; leadership had failed to make the case for greater powers
and to shape the debate around audit
• Sanctions and Enforcement – FRC had a range of sanctions available, but took ‘an excessively consensual
approach to its work’
• Independence – FRC lacks independence because it was not a statutory body; lacked direct regulatory
oversight over firms who voluntarily fund it; more like ‘a trade body than a regulator’.
• Appointments – flaws in its appointment processes; Board and Council “largely self-perpetuating”, and
reliant “on the alumni networks of the largest audit firms” with “inappropriately informal” recruitment
methods
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Kingman Recommendations
• 83 recommendations in total; a summary:
• Replace FRC (limited powers/voluntary levy) with ARGA (more interventionist/statutory funding)
• ARGA (Auditing, Reporting and Governance Authority) – new purpose, powers & leadership; expand remit
to ‘audit quality’
• Promote interests of consumers of financial statements – ‘duty of alert’ for auditors
• Consider whether reporting framework is of use
• Emphasise brevity & comprehensibility
• More interventionist: powers of review; force corrections & restatements
• ‘Skilled person review’ – an ARGA individual can inspect a firm, paid for by the firm
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Brydon Recommendations
• Limits of ‘expectations gap’ explanations; need to explore other gaps:
• Purpose: redefinition of audit purpose – a public interest function
• Separation: audit should be a stand-alone ‘corporate audit’ profession, outside accounting
• Culture: Need to be suspicious as well as skeptical
• Remit: extension of auditing beyond financial statements
• Role: Auditors should be more investigative; to try to find fraud & should have forensic accounting training
• Disclosure: Greater granularity about how estimates are made; resilience & public interest reports
• Accountability & engagement: Greater interaction with shareholders
• Wider reviews: companies act; reporting rules e.g. goodwill reporting
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CMA Findings (1)
• Problem of market concentration – no competition:
• only 4 firms auditing large companies (100% of the FTSE100; 97% of FTSE350 companies, 99% of
fees)
• Companies must change audit firms every 20 years, which removes one possible bidder.
• Firms are prevented from bidding – or choose not to bid – in audit tenders because auditing a
company limits the amount of available non-audit revenue from that company.
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CMA Findings (2)
• Accounting firms are increasingly less interested in audit
• Profitability: audit can represent as little as 15% of Big 4 revenue, and even less in terms of
profit.
• Conflicts of interest: profit-sharing gives audit partners an interest in the success of the nonaudit business
• Conflicting types of service: client-support vs skepticism & prudence
• ‘Marking your own homework’: auditors might review accounting practices of their colleagues.
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CMA Recommendations
1. Audit committee scrutiny – oversight of selection of auditors
2. Mandatory joint audit, including at least one non-Big Four firm, for most large
companies; peer reviews for the largest; measures to mitigate the effects of a Big
Four failure
3. Operational split between the audit and non-audit practices of the biggest firms
4. Five-year review of progress by the new regulator
• Others: remuneration deferral/clawback; liberalization of ownership rules;
requirements on tendering etc
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Government White Paper
• Kwasi Kwarteng, UK business
secretary:
• prioritises reforming the British audit
market
• May 2022:
• limited personal liability of directors (but
inclusion in UK CG Code which can be
opted out of (comply or explain)
• ‘shake up’ the Big Four accountancy firms
in the coming months.
• White paper released March 2021.
• Reduced companies included in PIE (public
interest entities)
• Intriguingly raised the matter of ‘capital
maintenance’
•
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Conclusions
• Audit failure has become more persistent
• Failure to spot corporate weaknesses during audit creates considerable
societal/economic costs
• Govt response seeks to
• give more enforcement powers to new body ARGA
• (operational) separation of audit in big firms to form standalone industry
• Strengthen professional audit culture
• Instil more competition in audit sector
• … but that may not stop firms from acting inappropriately and misrepresent
financial results
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Content – part 2
1. History Of Outsourcing
2. New Public Management & Public Private Partnerships
3. How The Tendering System Structures The Market
4. Austerity Budgets, Scandals & Corporate Failures
5. Pressure For Change
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Post-War settlement
• Post 1945 – nationalisations, formation of modern welfare state, expansion of
government
• From 1945-1970s, most functions of local government, central government and
public bodies were delivered by the public sector:
• front-line services including prisons, welfare, social care, waste collection etc, but also back
office activities – customer management, facilities management, maintenance
• 1970s slowdown/‘end of the long boom’ led some to argue that the public sector
had grown too large and trade unions too powerful; there were ‘too few producers’
(Bacon & Eltis 1976) ‘crowded out’ by the state.
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History of Outsourcing: Conservatives 1979-97
• Thatcher saw introducing competition as a way to introduce market discipline to lower
costs & boost efficiency, reduce the size of the public sector workforce and diminish Trade
Union power.
• Achieved through two main levers (outside deregulation)
• Sale/Privatization of state-owned monopolies (water, gas, electricity, airline etc)
• Outsourcing of tax-funded/tax-subsidized activities to private contractors for mundane services
like waste collection
• Outsourcing = delivery of services by private or other 3rd party providers to the public or
the government using fixed duration franchises & a process of competitive tendering
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History of Outsourcing: Conservatives 1979-97
• Demand had moved beyond ‘basic needs’ and needed refinement to meet
individual needs; greater say in design & deliver
• Critique of ‘professional cadres’ providing public services
• Compulsory competitive tendering (CCT).
• Required public-sector orgs to open up tendering to private companies to bid for contracts to
deliver public services (e.g. cleaning, transport, security, and catering) in competition with the
public sector’s own organisations
• Inject market competition into public-service provision; ‘modernize’; open up public services to
new providers and new ideas
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History of Outsourcing: New Labour 1997-2010
• Criticised implicit notion that private provision was always best
• Instead, they argued it was more about cost cutting than service provision:
‘Under Compulsory Competitive Tendering service quality has often been neglected and efficiency
gains have been uneven and uncertain, and it has proved inflexible in practice. There have been
significant costs for employees, often leading to high staff turnover and the demoralisation of those
expected to provide quality services. Compulsion has also bred antagonism, so that neither local
authorities nor private sector suppliers have been able to realise the benefits that flow from a healthy
partnership. All too often the process of competition has become an end in itself, distracting attention
from the services that are actually provided to local people. CCT will therefore be abolished’
Department of the Environment, Transport and the Regions (1998) Improving local services through best value: Consultation
Paper London, DETR
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Rise of New Public Management (NPM)
• Attempts to make public services more efficient by using private sector
management models.
• Experimentation with decentralized service delivery models, to give local agencies
more freedom in how they delivered programs or services.
• Emphasised financial control, value for money, efficiency, identifying and setting
targets and continuance monitoring of performance, handing over power to the
senior management executives.
• Performance assessed via audits, benchmarks and performance evaluations. Some
NPM reforms used private sector companies to deliver what were formerly public
services
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New Public Management (cont’d)
• In NPM, citizens are viewed as “customers” and public servants are viewed as public
managers.
• tried to realign the relationship between public service managers and their political
superiors by making a parallel relationship between the two.
• Under NPM, public managers had incentive-based motivation such as pay-forperformance, and clear performance targets set & assessed by using performance
evaluations.
• Managers also had greater discretion and freedom as to how they go about
achieving the goals set for them.
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Blair Years
• Move towards ‘Best Value’: less ‘competition’, more ‘partnerships’ in local provision
• Local Govt Act 1999: aim = improve ‘economy, efficiency & effectiveness’ of local services (3 ‘E’s).
• compared their service provision with that of other private and public providers; consulted with local
business and community; considered competition in provision; and challenged the reasons for, and
methods of, provision (the ‘4 Cs’).
• regime of audit and measurement of performance, Best Value Performance Reviews (BVPRs), Best Value
performance indicators (BVPIs), BV Performance Plans (BVPPs).
• government intervention in cases of Best Value failure, and reward in cases of success
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Public Private Partnerships
• Also concerns about levels of public debt (pre-dates Blair); need to reduce public
sector borrowing requirement
• Interest in long-term co-operative arrangements between public and private sector
entities
• Private sector: bundled building, operating & (up-front) financing to deliver public
services/products using a capital asset
• Public sector: provide a guaranteed stream of payments
• Notionally: risk sharing, innovation, lower operating & capital costs
• Private Finance Initiative (PFI) & ‘Value for Money’ (VfM)
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Tendering Process
• Govt invites bids for large projects that must be submitted within a finite period.
• Interested suppliers prepare a tender:
• Pricing, schedules, eligibility, comparative advantage, qualifications, competences, experience
• (Until recently) Governed by EU: ‘Most economically advantageous tender’ (MEAT).
• Interpretation of MEAT conditioned by ‘Treasury rules’ in the UK.
• What constitutes the ‘economically advantageous’ open to interpretation…
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Governance structures
• In UK outsourcing, the governance architecture links
• core executive agencies such as HM Treasury
• And a range of arms-length agencies such as the Financial Reporting Council and the Pensions
Regulator.
• The social and economic impact of the European directives on public procurement, enshrined in UK
law (Arrowsmith 2018), therefore depends on how those directives are interpreted and governed
within that architecture.
• This assemblage of EU directives and UK-based governance arrangements creates a variety of
contractual, accounting, corporate governance and supply chain practices that affect social and
economic life in the UK.
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Development 1: Growing Size & Complexity of Contracts
• Move away from discrete service contracts servicing one function like IT, towards
multi-service contracts
• Increasingly complex bundled packages of services to private contractors,
increasingly used to finance large infrastructure projects
• Growing imbrication of public/private sectors – the growth of the ‘franchise state’
• Contracting structures the market – favours large companies: forty largest suppliers
account for 25% of value of central govt contracting.
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Development 2: Favourable T&Cs
• A market must look like a market, hence the need to attract bidders
• Barriers to entry (and exit) must be low enough to attract bidders (semblance of competition
• State seeks VfM, but must promise some margin to attract bidders
• These tensions borne out in contract structures
• Favourable incentives to bid: low underperformance penalties, high margins, exit points built into the
contract
• Very conducive environment for money making
• Incentive = grow quickly & maximise number of entry points
• Pressure to scale up and diversify to become a bidding machine
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UK public sector procurement spending
• Cost of procurement have
risen significantly under New
Labour to approx. 60% of all
public spending
• Since then, it has stabilised
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Coalition, Cameron & May: Austerity 2010-19
• Much changed after a) 2008 Global Financial Crisis b) New Labour’s 2010 election
loss:
• Coalition government continued to extend the role of outsourcing: probation, healthcare and welfare.
• However, austerity sharply reduced overall spend on public services & external
suppliers:
• Outsourcing partly used as a tool to reduce spending; programme to curb the profits of some large
suppliers, (particularly IT)
• This compressed growth & margin
• High profile failures also meant more stringent contracts
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Impact on UK Revenues (Large Outsourcing Firms)
• Rise of outsourcing firms
disrupted by 2008 crisis
• Decline in revenue linked to
specific contract values
• Carillion lost its “revenue
leadership”
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Impact on Profit Margins (Large Outsourcing Firms)
• Profitability under pressure
• fall from ave >5%
• Carillion as outlier with stable
profit margin (why?)
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High profile failures
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Criticisms
• Critics of the UK’s outsourcing arrangements argue that
• it allows the private sector to exploit the information asymmetries and exert hold-up pressures
against the state (Hoffman et al., 2010; Jensen and Stonecash, 2005; LeGrand, 1999; Shaoul
1998);
• wield that power to exploit public/private sector wage gaps (Berlinski, 2008; Dube and Kaplan,
2010; Grimshaw et al 2015); erode working conditions (Domberger and Jensen 1997);
• reduce employment numbers and wages (Alonso et al 2013; Flecker and Hermann 2009);
• and diminish service quality (Hart et al, 1997; Quiggin, 2002), with a negative impact on
efficiency and social welfare.
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An Alternative View – What A Waste
• State and large contractors are bound in codependence – they are hybrid governing
institutions
• Leading to:
• Loss of state institutional resources and intelligence to deliver goods
• But this is also a highly unstable relation
• Carillion, Interserve, perhaps others?
• And it raises fundamental questions about risk, efficacy & accountability
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Pressure for Change
• ‘Change is needed’, according to BEIS & WPC (2018) report which highlights
1. multi-faceted and compounding failures of governance in UK outsourcing, and
2. reinforces earlier concerns about the systemic risks posed by government’s over-reliance on a small number of large
outsourcing companies (Public Administration and Constitutional Affairs Committee 2018; Public Accounts Committee
2018).
• These problems evoke Moran’s (2003) ‘crisis of the regulatory state’ – where the regulatory state is a
form of governance associated with the
1. rise of regulation as a distinct mode of governing (Hood et al, 2001),
2. the growth of audit as a central control device (Power, 1997) and
3. the reinvention of government as a quasi-enterprise association through processes like contracting-out (Cerny, 1997,
Osborne and Gaebler, 1992).
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The Market Is Now V Large
• The UK government spends approximately £292bn through commercial
relationships with external providers (Cabinet Office 2020, p.12)
• Over 3 times larger market than financial services in the UK
• Roughly £1 in £3 the govt spends goes to private providers.
• What is the future of public procurement post-Brexit?
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Post-Brexit ‘Principles of Procurement’
• Public good – procurement should support the delivery of strategic national priorities including
economic, social, ethical, environmental and public safety.
• Value for money – procurement should enable the optimal whole-life blend of economy, efficiency
and effectiveness that achieves the intended outcome of the business case.
• Transparency – openness that underpins accountability for public money, anticorruption, and the
effectiveness of procurements.
• Integrity – good management, prevention of misconduct, and control in order to prevent fraud and
corruption.
• Fair treatment of suppliers – decision-making by contracting authorities should be impartial and
without conflict of interest.
• Non-discrimination – decision-making by contracting authorities should not be discriminatory
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Conclusions
• The outsourcing market has grown significantly since the end of the 1970s
• Its growth, and the forms of contracting, have benefitted a small number of large,
diversified firms
• However, austerity budgets put pressure on margins and caused firms to seek
alternative, less certain avenues for profit making.
• The combination of competition, margin compression, uncertainty and public
awareness of scandal, put many large outsourcers in a difficult financial position.
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Carillion’s History & Accounts
Dr Daniel Tischer
MGT329
2
Contents – part 1
1. Background history of Carillion
2. Importance of acquisitions to Carillion’s growth model
3. Goodwill, shareholder value & remuneration
4. Impact of austerity
5. Carillion’s collapse
6. Conclusion
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Carillion – history
• Carillion formed through a demerger from Tarmac Group in 1999:
• building materials company (Tarmac)
• support & construction services (Carillion).
• 1st Goal – demerger
• To make profitability of each operation more transparent & increase focus.
• Based on a belief that Tarmac was subsidizing construction business
• Spin-off would enhance the value of Tarmac; making it easier to deal with construction
companies because it was no longer a competitor as well as a supplier.
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Carillion – history
• 2nd Goal – to give Carillion a separate identity, and to expand beyond construction
management
• To develop service sector strengths & specialise in growing markets: Private Finance Initiative
projects, facilities management, rail maintenance etc.
• Liberating Carillion to capitalise on new opportunities in UK market (rising public expenditures
and ’Best Value/VfM)
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Carillion – Executive Pay & Pension Concerns
• Initial concerns on pay:
• 1999 Shareholder meeting, Tarmac’s institutional investors protest increases of executive
compensation.
• The proposed compensation packages included £1.37 million in cash and pension adjustments
for Sir Neville Simms, Chairman of Tarmac, who became chairman of Carillion also queried.
• …and on pensions:
• transfer of pension rights from the well-funded Tarmac pension plan to an ‘allegedly
comparable’ Carillion plan without consultation with, or disclosure to, affected
employees/retirees.
• Exec pay & pensions became a defining feature of Carillion’s trajectory of growth &
their eventual demise
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Carillion’s Starting Financial Position
• Carillion began as relatively large company with healthy balance sheet:
• no debt (Tarmac retained all of the combined predecessor’s corporate debt),
• 14,000 employees,
• turnover of £1.8 billion and
• an estimated market capitalization of £200 million
• Carillion sought to take advantage of the market conditions, as described in lecture
2
• It grew inorganically to boost scale and to diversify
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Acquisition 1: Mowlem
• February 2006, Carillion acquired Mowlem plc (Mowlem), a construction company
• strengths in construction, particularly in the regional building and civil engineering markets
• Total acquisition cost = £350 million, of which £117m in cash, 2 million shares of
Carillion common stock, and the assumption of £122.5 million of Mowlem debt
• The transaction added £512 million of goodwill to the company’s balance sheet
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Acquisition 2: Alfred McAlpine
• February 2008, Carillion acquired Alfred McAlpine
• operations in facilities management infrastructure services, civil engineering and construction
• Acquisition price = £554.5 million, of which £381.5m shares, £171.7m cash
• Assumed £1.3 million in loan notes
• Recognised £615 million of goodwill
• Carillion’s net debt at end 2008 was £226.7 million, up from £44.9 million in 2007;
acquisitions the primary cause of the increase
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Acquisition 3: Eaga
• 2011, Carillion acquired Eaga plc, a provider of energy efficiency solutions
• aggregate purchase price of £306m million, comprised of £117.7 million of company common
stock and £180.7 million of cash.
• The transaction also involved recognition of goodwill by Carillion of £329.1 million.
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Carillion By 2016
• Carillion had grown substantially since its spin-off from Tarmac, generating £5.2
billion in total revenue that year.
• Carillion’s revenues were generated by three lines of business:
• Support services
• Project finance
• Construction services
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Support Services
Construction Services
• provision of maintenance, facilities
management and energy services for major
buildings and large property estates, for both
public and private sector customers
• infrastructure services for roads, railways and
utility networks
• notably telecommunications and power
transmission and distribution
• remote site accommodation services.
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• delivery of a wide range of buildings and
infrastructure
• focused on large contracts for long-term public
and private sector customers
Project Finance
• arranging the funding for Public Private
Partnership projects, to deliver public sector
buildings and infrastructure
• invest equity and for which they win
construction and long-term support services
contracts
12
Acquisitions, ‘goodwill’, & debt
• Carillion’s acquisitions led to significant increases in the company’s goodwill (excess
of purchase price over net asset value) and debt
• Goodwill is ‘forward-looking’ – its value reflects intangible things like brands, reputation etc; NPV
of discounted future cashflows that accrue to such things
• Carillion also became more indebted (we will discuss both later on)
• Balance sheet profile of the company changed: more debt financing assets of an
increasingly intangible nature
• Is this risky?
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Shareholder Value
• Carillion often boasted that it had increased dividends every year (dividends p/s
from £8 to £18.45 2006/2016) in order to woo investors
• In the eight years from 2009 to 2016, Carillion paid out £554 million in dividends
• But in the five years from 2012 to 2016, Carillion paid out £217 million more in
dividends than it generated in cash from operations.
• Was this sustainable?
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Remuneration structure
• Rising base salary
• Pension
• ‘Benefits’
• Annual bonus (cash and shares)
• LEAP (long term incentive plan)
• EPS (earnings per share) linked bonuses
• ‘Cash conversion’ bonuses
• NB Clawback provision (withdrawn 2016)
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Overview of
remuneration
structure (4
components):
• Increase in base
salary followed by…
• Introduction of Cash
conversion in 2012
for LEAP bonus
scheme
• + pensions & annual
bonus
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Impact of new remuneration structure
• Minor increase in base
• Reduction in bonus
• Larger increase in LEAP awards
• Do LEAP awards become structured in a way
to generate income for Execs more easily?
• …Possibly, as the deferred nature of them
(stock) requires longer-term commitment =
some trade off?
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Impact of Austerity
• As noted in lecture 2, austerity brought new challenges
• lower contract volumes/values @ aggregate, price sensitivity, state wanted less risk.
• Encouraged cannibalisation (failed Balfour Beattie merger, 2014)
• Aggressive tendering bids
• Diversification/globalization/cross-subsidy:
• support services = £2.7 billion of revenues for Carillion
• public-private partnership projects £313 million;
• Middle East construction £668 million
• construction services from outside the Middle East £1.5 billion (Canada & North Africa)
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Market concern grew through 2017
• (NB 2016 accounts issued March 2017)
• New finance director (Emma Mercer) noted an anomaly in how receivables
recorded – leading to a full contract review
• Subcontractor ‘creditor days’ were found to be 120 days (suggesting cashflow problems)
• Problems with a) Middle Eastern contracts b) PFI Liverpool Royal hospital contract
• Reports that hedge funds were ‘short’ the company
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Sept 2017 H1 Results
• Catastrophic results –operating losses and fair value impairments compounded:
• Contract impairment charge of £1,045 million, of which £845m were contract profit writedowns
• Also goodwill impairments
• Pre-tax loss for the period of £1,153 million
• These impairments cascaded through equity buffers
• Group = negative net assets/negative equity of £405 million.
• Carillion ‘technically’ insolvent
• Sought credit extensions, equity issue & govt assistance
• All failed & in Jan. 2018, entered liquidation proceedings
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Social & Economic Fallout
•
Carillion had around 43,000 employees, including 19,000 in the UK.
•
•
Carillion left a pension liability of around £2.6 billion.
•
•
Many more employed in its supply chains.
The 27,000 members of its defined benefit pension schemes were paid reduced pensions by the Pension Protection Fund, which faced its
largest ever hit.
Carillion owed around £2 billion to its 30,000 suppliers, sub-contractors and other short-term creditors. They
got little back from the liquidation.
•
According to the Institute for Government ‘A survey found that, on average, small businesses in Carillion’s supply chain were owed
£141,000; medium-sized firms (those with 50–250 employees) £236,000; and large firms £15m.
• Carillion was a major strategic supplier to the UK public sector; government committed £150 million of
taxpayers’ money to keeping essential services running.
•
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Liverpool Royal Hospital due for completion in 2017 is still not fully operational and costs grew from £117 million to over £300million to
complete
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Conclusion
• Speed of collapse shocked authorities – from going concern & healthy dividends
payments in accounts issued March 2017; to collapse in 10 months.
• Concern about audit failure – inadequate checks on management
• Also raised questions about power of the directors & how the firm apparatus was
used
• However arguably the more interesting question is about how accounting rules
were used to maintain healthy dividend payouts; and how accounts were
interpreted to trigger board bonuses.
• We will go more in depth on the accounts in our next lecture.
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Contents – part 2
1. Construction contract accounting/revenue recognition
2. Goodwill accounting/impairment testing
3. Cashflow categories: operations vs financing
4. What the market saw
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Carillion’s business
• Construction & various services
• Key point = these are often very long-term contracts with the state
• Major accounting question:
How do you account for contracts where payments can be very ‘lumpy’ and where
you may not be able to measure your total profit until completion?
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Do we account for contracts at the
beginning of contract?
Do we account for contracts at the
end of contract?
• No income may have yet been
received, no costs incurred
• all income may have been received &
all costs incurred
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Profit under accruals
• Under accrual accounting:
• P&L: revenue is recognised when it is earned, (but not necessarily received) and
expenses are recognised when they are billed (but not necessarily paid).
• Cashflow: recognises revenue and expenses only when money is received or
spent
• There can be significant differences between profit and cash…eg…
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Contracts (IAS11, now IFRS15) – what Carillion says
•
When the outcome of a construction contract can be estimated reliably, contract revenue and costs are recognised by reference to the degree
of completion of each contract, as measured by the proportion of total costs at the balance sheet date to the estimated total cost of the
contract.
•
Insurance claims, incentive payments, and variations arising from construction contracts are included in revenue where it is probable that they
will be recovered and are capable of being reliably measured.
•
When the outcome of a construction contract cannot be estimated reliably, contract revenue is recognised to the extent of contract costs
incurred where it is probable those costs will be recoverable.
•
The principal estimation technique used by the Group in attributing profit on contracts to a particular period is the preparation of forecasts on a
contract by contract basis. These focus on revenues and costs to complete and enable an assessment to be made of the final out-turn of each
contract. Consistent contract review procedures are in place in respect of contract forecasting.
•
When it is probable that total contract costs will exceed total contract revenue, the expected loss is recognised immediately. Contract costs are
recognised as expenses in the period in which they are incurred.
•
Where costs incurred plus recognised profits less recognised losses exceed progress billings, the balance is shown as amounts owed by
customers on construction contracts within trade and other receivables. Where progress billings exceed costs incurred plus recognised profits
less recognised losses, the balance is shown as amounts owed to customers on construction contracts within trade and other payables.’
(Carillion annual report, p.96)
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Carillion’s accrual accounting assumptions
• Accrual accounting is based on a range of assumptions
• Reliably estimation of contract outcome
• Forecast of costs/revenue on contract by contract basis
• Consistent contract review
• Loss recognition immediately
• So therefore, contract revenues/profits rely on estimation of total revenues/costs at
the beginning of the contract, and a truthful review if expected revenues/costs
change
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Total contract profit
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Accrual Accounting
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What kinds of risks may arise from this?
• The amount of revenue/profit recognised each year depends on estimates of total
contract costs – some discretion?
• Dislocation between ‘net profit’ and ‘cash’…
• If you want to distribute that profit (and Carillion clearly did) then you may have to
borrow
• What happens if there’s a crisis at the end of the contract – either a customer
refuses to pay because they are not satisfied the contract has been fulfilled; or
there is an unexpected problem which requires significant investment?
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Subjectivity & revenue recognition
• Changes to the estimated costs of the contract can give rise to material variances in
the amount of revenue and margin recognized in the accounts.
• Aggressive/Creative accounting would attempt to minimize estimates of total
contract costs to maximise upfront revenues and profits realized.
• Two kinds of review @ Carillion: Management & peer appraisals of contract costs.
• In 42% of cases, three times as many, management used higher margins than recommended by
the peer reviews
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Carillion: profit, cash, distributions
• At first glance Carillion’s
corporate performance looks
good
• Profits / cashflow is
positive(but fluctuates)
2012
2013
2016 restatement shows 2014
2015
that
2016
• Profits turn negative again TOTAL
• Cap of distributions
*2016 restated
• But profit still > distributions *TOTAL restated
• Profits > dividends > total
distributions
•
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Profit/
Net
Dividends Share
Total s/h
Loss After operating paid
buybacks Distrib’n
Tax
cashflow
166.2
-25.6
78.6
3
81.6
106.3
-78.4
75.7
0.3
76
127.5
123.8
76.7
0
76.7
139.4
73.3
80
0.4
80.4
129.5
73.3
82.7
1
83.7
668.9
166.4
393.7
4.7
398.4
71.6
-63.2
55.2
1
56.2
611
29.9
366.2
4.7
370.9
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Goodwill accounting – what Carillion says
•
In respect of acquisitions made prior to 1 January 2004, goodwill is included on the basis of its deemed cost,
which represents the amount recorded under previous Generally Accepted Accounting Practice. Goodwill
arising on acquisitions that have occurred since 1 January 2004 represents the difference between the fair value
of the cost of acquisition and the fair value of the identifiable assets, liabilities and contingent liabilities of an
acquired entity. Attributable costs associated with acquisitions are included within non-operating items in the
income statement in the period incurred.
•
Positive goodwill is recognised as an asset in the consolidated balance sheet and is subject to an annual
impairment review. Goodwill arising on the acquisition of subsidiaries is recognised separately as an intangible
asset in the consolidated balance sheet. Goodwill arising on the acquisition of joint ventures is included within
the carrying value of the investment. Negative goodwill is recognised in the income statement immediately.
•
Other intangible assets are stated at cost less accumulated amortisation and impairment losses. Amortisation is
based on the useful economic lives of the assets concerned, which are assessed annually
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Goodwill: Carillion’s accounting treatment of
acquisitions
•
1 Mowlem was bought in 2006, funded by
£117m in cash, 2 million shares of Carillion
common stock, and the assumption of
£122.5m of Mowlem debt.
•
2 Alfred McAlpine PLC was bought in 2008,
funded by £381.5m, £171.7m in cash,
assumption of and £1.3 million in loan notes.
•
3 Eaga was bought in 2011, funded by
£117.7m of company common stock and
£180.7m of cash.
•
4 This additional amount was booked to
account for customer contracts and lists,
which were separately reported to goodwill.
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Net Assets pre-acquisition
Net Assets valued at acquisition
Amount Paid
Goodwill recognised on acquisition
Other intangibles recognised on acquisition(4)
Total intangibles recognised on acquisition
Mowlem(1) Alfred McAlpine(2) Eaga(3)
-181
62.2
153.3
-80.5
-50.1
-30.7
350.3
564.9
298.4
430.8
615
329.1
119
90.3
29.4
549.8
705.3
358.5
Source: Company Annual Reports, various years
35
Impairment tests
• Since 2003-4 goodwill is subject to annual impairment assessments, not amortised
(under fair-value accounting)
• At Carillion, impairment assessment: value-in-use model/net present value of the
forecast earnings
• Calculated using assumptions re: discount rates, growth rates & cash flow forecasts.
• Object of assessment = ’cash-generating unit’ or ‘CGU’ not the individual
subsidiaries, operating segments or group as a whole.
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Cash Generating Unit
• CGU = ‘the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets’.
• Goodwill acquired in a business combination is allocated to the acquirer’s CGUs that are expected to
benefit from the business combination
• Estimate recoverable amount of CGU (IAS36)
• If recoverable amount > or = carrying amount, no impairment.
• If recoverable amount < carrying amount, allocate impairment loss to the CGU; impairment is expensed
through P&L.
• Subjectivity: CGUs can shield effects of impairment by bundling underperforming subsidiaries with
others…
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Figure 1: Profit (Loss) Before Tax of subsidiarised acquisitions: Carillion
JM Limited (previously Mowlem PLC), Carillion (AM) Limited (previously
Alfred McAlpine), Carillion Energy Services (previously Eaga)
300,000,000
200,000,000
100,000,000
01
/0
1/
20
16
01
/0
1/
20
15
01
/0
1/
20
14
01
/0
1/
20
13
01
/0
1/
20
12
01
/0
1/
20
11
01
/0
1/
20
10
01
/0
1/
20
09
01
/0
1/
20
08
01
/0
1/
20
07
01
/0
1/
20
06
0
-100,000,000
-200,000,000
-300,000,000
-400,000,000
Carilli on (AM) Limi ted
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Carilli on Energy Services
Carilli on JM Ltd
Source: Carillion JM Ltd, Carillion (AM) Ltd and Carillion Energy Services Accounts, various years
38
Cashflow
• Use of Early Payment Facility (EPF) - supply chain financing or ‘reverse factoring’
• Hidden debt: EPF structure meant Carillion had a financial liability to the banks that should have been
presented in the annual account as “borrowing”. Instead Carillion choose to present these as liabilities to
“other creditors”.
• “other creditors” excluded it from total debt. It was consequently not incorporated in a debt to earnings
ratio which was a key covenant test between Carillion and its lenders.
• EPF treatment also helped hide its failure to generate enough cash to support the revenues it was
recognising. By presenting money borrowed under the early payment facility as “other creditors”, it’s
classification within the cashflow can be seen as part of the company’s operating activity rather than a
financing activity.
• We will come back to this when we talk about executive remuneration
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What the market saw…
• A number of hedge funds saw weakness in Carillion’s business as early as 2015
• Many had gone ‘short’ (ie borrow shares, sell them and hope to buy them back at a
lower price, and return them)
• Around 18% of Carillion’s stock had been shorted
• It is estimated hedge funds made £200m profit from the collapse of Carillion.
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Key issues for hedge funds
1.
Failure of Balfour Beattie merger – spooked the market
2.
Issuance of a £150-170m convertible bond (a v expensive form of debt) in 2014/15; plus other more
esoteric loans later.
3.
Trade receivables, a total for revenues recognised but where payment is yet to arrive, were rising
even as sales declined.
4.
Treatment of some estimated costs associated with bidding for work as assets that can be
recovered, assuming probable success.
5.
Aggressive management of payment terms with suppliers (the reverse factoring) suggested a
company with substantial debts that might be struggling to generate cash flow.
6.
UBS analyst note about total debt, which included pension deficits
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Conclusion/Summary
• Aggressive revenue recognition: Carillion optimistically booked revenues by underestimating total
contract costs
• Lax goodwill impairment assessments: CGUs ‘shielded’ impairments on underperforming
acquisitions
• ‘Categorical arbitrage’ on cash: which reduced reported debt, boosted cash conversion & gave
apparent legitimacy to the profits booked.
• Three main results
• 1. profit ran ahead of cash
• 2. debt was needed to finance dividends
• 3. high risk of ‘impairment shocks’, which wiped out equity
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Financialisation and shareholder value
Dr Richard Goulding
MGT329
2
Contents - part 1
1. Shareholder distributions at Carillion
2. Financialization: Krippner and sources of accumulation
3. Lazonick and O’Sullivan: Downsize and distribute
4. Stockhammer: Financialization and the decline of investment
5. Froud et al.: Narrative and numbers
6. Conclusion
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Background
• Carillion (2017) ‘Making tomorrow a better place’: “the board has increased the dividend in each of
the 16 years since the formation of the Company in 1999”. The intention = “to increase the full-year
dividend broadly in line with the growth in underlying earnings per share”.
• The board, (most of whom were also shareholders) were expected to take into account these factors
when determining dividend payments:
• the level of available distributable reserves;
• future cash commitments and investment needs to sustain the long-term growth prospects of the business; and
• net profits, to provide “dividend cover”.
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BEIS/DWP findings
“The perception of Carillion as a healthy and successful company was in no small part
due to its directors’ determination to increase the dividend paid each year, come what
may. Amid a jutting mountain range of volatile financial performance charts, dividend
payments stand out as a generous, reliable and steady incline. In the company’s final
years, directors rewarded themselves and other shareholders by choosing to pay out
more in dividends than the company generated in cash, despite increased borrowing,
low levels of investment and a growing pension deficit. Active investors have
expressed surprise and disappointment that Carillion’s directors chose short-term
gains over the long-term sustainability of the company. We too can find no
justification for this reckless approach”. (para 21)
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Financialization
• The apparent prioritization of dividends raise questions about the role of
‘financialization’ in Carillion’s decision-making
• Financialization = a slightly blurry concept that captures a number of features &
processes (see Christophers 2015)
• Epstein (2005): ‘Financialization refers to the increasing importance of financial
markets, financial motives, financial institutions, and financial elites in the operation
of the economy and its governing institutions, both at the national and international
levels’
• But why have these priorities shifted (if they have at all?).
• Key text = van der Zwan (2014) – an excellent summary
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Van der Zwan (2014)
• Three strands of financialization:
• Financialization as a ‘regime of accumulation’ (structural): finance-led growth
regime, replacing Fordist model which focused on improving productivity in
industrial capital
• Financialization of the modern corporation (organizational): changing corporate
governance priorities/influence of agency theory
• Financialization of everyday life (cultural): individuals’ own interaction with
technology
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Core texts within the financialization literature
• Accumulation: What is financialization and how do we know it exists? (Krippner, 2005)
• The growth of financial sources of profit.
• Corporation: The effects of financialisation on corporate governance/firm behaviour
(Lazonick & O’Sullivan 2000)
• Downsize and distribute.
• Accumulation/corporation: the macro effects of financialization (Stockhammer 2004)
• Underinvestment and the slowdown of accumulation.
• Narrative and numbers: a cultural economy approach (Froud et al. 2006)
• Blends an analysis of corporate narratives with accounting strategies.
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A. Regime of accumulation
• An approach rooted in heterodox economics/political economy: PostKeynesian/Marxist approach which exists outside orthodox neo-classical economics
• Brings back the question of ‘capitalism’ as a political system, where mainstream
economics is largely silent
• Focus on ‘phases’ of capitalist development (esp. regulation school)
• Key focus = accumulation – investment will flow to assets with higher return;
capitalist elites ‘switching’ capital from production (productivity slowdown) to
finance (Harvey, 1989).
• Search for a set of generalisable relations to periodise capitalism.
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Greta Krippner (2005)
• Aim = to provide a definitive measure of financialization:
• Not employment or output/GDP based (which illustrates the shift from manuf to services)
• But accumulation-based (industry shares of corporate profit)
• Financialization = ‘a pattern of accumulation in which profits accrue primarily through financial
channels rather than through trade and commodity production’ (2005, p. 174)
• Findings:
• Growth of financial relative to nonfinancial profits & cashflow
• significant growth of FIRE income as a % of corporate profit.
• Growth of ‘portfolio income’ in non-financial firms (income from interest payments, dividends &
cap gains) relative to cash flow from productive activities
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Relevant issues for Carillion
• Carillion & ‘financialized regime of accumulation’ – link to dividends:
• Role of investors in pressuring company for more dividends?…
• Or board understanding that role was to increase returns to investors?
• Greater use of debt?
• Increased financial sources of profit at Carillion?
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B. Shareholder value and the firm
• Less focus on structural drivers; less sense of financialization as an external force that imposes on
firms
• More focus on managers as agents of financialization and role of theory in shaping organizational
practice and resource allocation.
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Lazonick and O’Sullivan (2000)
A history of US giant firm governance
• US firms pre-1980s operated a governance policy of ‘retain and reinvest’ (in physical &
human capital).
• Challenged in late 1970s due to
• growth of giant diversified corporation
• rise of new competitors.
• Result = poor profit performance & reform in corporate governance
• New governance policy of ‘downsize and distribute’, influenced by agency theory;
supported by growth of instit investors & facilitated by new regulatory/institutional
changes (junk bonds, deregulation etc)
• Outcome = production of new inequalities as snr managers cut employee numbers, wages
& investment to increase dividends & share buybacks
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Engelbert Stockhammer (2004)
• Explores the effects of financialization on the investment behaviour of non-financial
firms, esp. on the accumulation of physical capital
• Context: changing management priorities as hostile takeovers & share optionrewards meant management increasingly thought & acted like shareholders
• Assumption = a more financialized system is more concerned with increasing short
term capital gains & thus ‘starves’ investment for long term projects
• Findings = mixed, but some support for the hypothesis that higher dividend payout
& financial investment are correlated with a slowdown in productive investment &
accumulation.
• Paradox – pursuit of SV reduces capacity to generate SV over the long run.
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Relating back to Carillion
Expected outcomes:
• Evidence of zero sum conflicts: job/wage reduction, or cutting investment to
increase shareholder payouts
• Evidence of short-termism?
• Restructuring & growth of the market for corporate control
• Alignment of management and shareholder interests through bonus scheme:
shares/options
• Paradox – management remuneration growth (despite agency theory background).
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C. Critical social accountancy
• Froud et al. (2006): Giant firm strategy is not only about moves + results in product
market but also about a relation with the stock market which runs on narratives as
much as numbers.
• After financialisation, the relation with the capital market is increasingly important
and large corporations have to
• deliver the financial numbers which have a new importance as measures of
success
• also generate a narrative which shapes capital market expectations and
explanations
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Ideas reinforced by city insiders
Tony Golding (2001) Inside the City on “ what the fund manager wants”
• stock market preferences = for measurable/numbers based + for stories
(a) Good numbers, simple governance, pure plays, size
(b) ‘stories in a box’ (eg growth, turnaround etc) quality of management, having a
plan for keeping it going, activity
(c) the market develops its own stories & trades upon them
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Key definitions: narrative
• An ordering and constructive device which frames corporate and
industry purpose and achievement; sets parameters + defines the field
of the visible
• For CEOs, a vision and a promise going forward…but CEOs do not
control reception
• For outsiders, eg analysts and journos - a co-authored story which can
endorse modify or challenge company narratives or conventional
understandings of an industry
• Framing of targets, definition of success, interpretation of management
success or failure = a collective (and unstable) endeavour
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Conclusion
• Q2 explicitly asks for you to explain the drivers of Carillion’s collapse;
financialization could be interpreted as one of those drivers.
• But financialization = a fuzzy concept, so need to be explicit in how you use it (if you
use it) in your answer – are the problems structural or organisational?
• Does the evidence fit the claim? Or do you see different strengths and weaknesses
in the different financialization perspectives?
• Are there other explanations?
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24
Part 2: aggressive management and executive
remuneration
Contents
• Aggressive management
• Incentives to cheat?
• Carillion and supply chain finance
• Carillion’s use of early payment facilities
• Executive compensation
• Implications for financialisation
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‘Aggressive management’
Throughout forensic / critical works on Carillion’s accounts ‘aggressive management’ is raised a number
of times.
• There are a number of aggressive techniques used by Carillion
• Use of alternative performance measure - “underlying” measures re profit (exclusion of nonoperating items – 97)
• Revenue recognition (moved forward) – shorter (at point of sale, immediate, or based on
contract costs incurred over period w/ profit share attributable to that period)
• Payment term to creditors (moved backwards) – longer payment terms – forcing firms into
making use of early payment facility “cash conversion”
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Incentives to cheat?
• How does what happened at Carillion relate back to wider tendencies among firms?
• Academic studies find stock incentives have increased as a share of management
compensation (Kleymenova and Tuna, 2021).
• Harris and Bromiley (2006):
• Fraud more likely when management financial incentives are combined with poor
industry performance.
• Chen et al. (2021):
• Fraud driven by option incentives but can be mitigated by auditor efforts.
• Hajikazemi et al. (2018) (explicitly analyses Carillion):
• ‘Deviance’ becomes a ‘new normal’ in corporate behaviour when warning signs are
ignored over time.
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Supply Chain Finance - context
• Post-GFC supply & demand for finance was problematic
• SMEs were particularly affected (financing need estimated at £190bn by 2016
(~£45bn for smaller businesses)) and tended to use credit cards to bridge cash flow
/ working capital short falls
• Supply chain SMEs struggled to finance their operations as payment terms
deteriorated – big corps lengthened payment terms
• Govt could have legislated payment terms – e.g. 30days (preferred by suppliers) –
but instead it relied on its Prompt Payment Code (payment as agreed in contract)
arguing poor invoicing renders enforcement of specific period ‘unworkable’
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Supply Chain Finance: intentions and reality
• The idea is that schemes such as Supply Chain Finance (SCF) / Early
Payment Facility (EPF) / reverse factoring can improve cash flow in a
corporations supply chain
• Corp asks bank (credit provider) to repay SME early for services
rendered (minus a small fee)
• The problem was that it let to a (further) deterioration of standard
payment terms – Carillion increased its to 120 days following the EPF
announcement – which forced SME suppliers into utilising EPF
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Supply Chain Finance scheme
18/01/2024
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Example calculation of SCF
• Assumes deduction of payment to encourage
early payment (£2,000)
• Annualised figures are multiplied by a factor of
8.1 (for whatever reason, presumably based on 8
supply contracts which may be an average figure)
• Point is that the early payment (which is not
what Carillion did with its EPF) is costly for
suppliers and benefits corporates (i.e. those
contracting suppliers) based on an assumed
discount
• SCF, done correctly, is shown to be least costly to
suppliers
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https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_dat
a/file/32230/12-668-boosting-finance-options-for-business.pdf
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Carillion’s use of Early Payment Facilities
• Carillion uses the term EPF instead of SCF in its accounts – Why might this be relevant?
• EPF suggests early payment
• SCF suggests a form of financing
• Whilst SCF was meant to benefit SC SMEs receive prompt payment…
• …Carillion used it to shore up its own financing needs in two ways:
1.
It ‘forced’ SMEs to make use of its EPF by extending standard payment terms to 120 days – EPF
~45days
2.
Carillion used EPF scheme to the tune of £470m (Moody’s claims up to £498m was
misclassified) – borrowed from the banks which did not show up as a liability on its balance
sheet
https://committees.parliament.uk/committee/164/work-and-pensionscommittee/news/97957/carillion-used-its-suppliers-to-prop-up-failing-business-model/
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Accounting for the EPF
• Use of EPF argued to be a financial liability, so should be presented as “borrowing”
• Carillion presented EPF as liabilities (included in “other creditors”)
• Final figure approx. £472m
• FRC “encourages disclosure of complex supply chain arrangements”, which Carillion did not do
• Benefit of classifying EPF as other creditors:
• Excluded from total debt
• Not incorporated in debt to earnings ratio (relevant for covenants; e.g. EPF as liability would
have meant that Carillion would have breached its covenants much earlier)
• Hid Carillion’s failure to generate cash
https://publications.parliament.uk/pa/cm201719/cmselect/cmworpen/769/769.pdf
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Cash conversion (Moody’s)
• Moody’s claims that: “Carillion's approach to
its reverse factoring arrangement had two
key shortcomings: the scale of the liability to
banks was not evident from the balance
sheet, and a key source of the cash
generated by the business was not clear
from the cash flow statement[…]“
Group operating profit
Profit on disposal (PPE & IA)
Profit on disposal (PPP)
Operating profit
2013
124.4
2.3
-44.6
82.1
2014
175
0.3
-13.9
161.4
2015
183.4
-14.4
-37.7
131.3
2016
145.6
-6.4
-12.7
126.5
total
628.4
-18.2
-108.9
501.3
Cash generated from/(used in) operations
Deficit recovery payments to pension schemes
Cash generated from operations
-62.2
-39.2
-23
156
-46
202
120.3
-47.4
167.7
115.5
-46.6
162.1
329.6
-179.2
508.8
Cash conversion
-28%
125%
128%
128%
101%
Accounting for EPF as borrowing
Cash conversion accounting for EPF
(£72m) (£100m) (£150m) (£150m) (£472m)
-95
102
67.7
62.1
136.8
-116%
63%
52%
49%
27%
• 2013-16 OP (excluding disposal gains) =
£501m; cash generated from ops (before
pension deficit recovery payments) = £509m
→ high cash conversion >100%
• But £498m (revised down to £472m) of cash
was linked to the use of EPF – so taking this
into account the CC target was not met
https://www.moodys.com/research/Moodys-Carillions-collapse-exposes-flaws-in-theaccounting-for-supply–PR_380769
34
Why is all of this relevant?
• Cash conversion was an important component of its LEAP bonus scheme
(alongside EPS) & also annual bonus after 2016
• Much of the bonus structure was linked to “underlying” values (EPS, cash
conversion) or driven by net debt (note: the borrowings from EPF were not
included in that)
• Strong incentives for mgmt to use aggressive accounting to trigger bonus
payments
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REMCO
Source: Company Annual Reports, various years
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https://www.parliament.uk/globalassets/documents/commons-committees/work-andpensions/carillion/remco-executive-remuneration-update.pdf
36
Bonus payments
• Use of ‘underlying’ KPIs was used to
inflate performance to trigger bonus
payments
• Profit was down whilst underlying
profit was up
• EPS was down whilst underlying EPS
was up
• Basic dividend cover (1.6) was down
whilst underlying figure was stable
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Components of director remuneration
1.
Basic: Base salary, benefits & pensions
2.
Annual bonus (max. 100% of basic): 50% EPS (underlying); 25% personal targets; 25% ‘stretch’
personal targets
• Note in 2016 the 50% EPS was split into 30% EPS & 20% Cash conversion (but EPS target must be
met)
3.
LEAP bonus (long-term incentive plan – max. 150% of basic): 100 % EPS (underlying); 50% cash
conversions (underlying);
• Note equal contribution 50/50 EPS/CC; + 50% strategic metrics from 2014
• Malus (deferred) and clawback (cash) provisions apply but clawback provision turned out to be
toothless
• Clawback provision has been relaxed in 2016
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Annual bonus 2015/2016 for CEO/CFO
2015:
1. EPS – 35p – above threshold of
34.7%: 4.3%
2. Personal objectives: 22.5% /
21.25%
3. ‘stretch’: 21.25% / 21.25%
= 48% for CEO
2016:
1. EPS – below target; 0%
2. Cash conversion – above target but
linked to EPS; 0%
3. Personal: 15.625% / 6.25%
4. ‘stretch’: 21.5% / 24.17
• CEO: 50% cash; 50% deferred =
£293k; CFO: £215k
• Pg. 60
• CEO: 50% cash; 50% deferred =
£245k; CFO(outgoing): 100% cash =
£140k
• Pg. 68
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© The University of Sheffield
Source: Carillion JM Ltd, Carillion (AM) Ltd and Carillion Energy Services Accounts, various years
38
39
LEAP bonus award and thresholds
2015:
1. Granted 2013; vesting in 2016:
• EPS – under target: 0%
• Cash conversion – 99.6% (3-year average
2013-15): 23.7% (of salary)
• (did not have a strategic component in
2013)
2. LEAP awarded (face value):
• Performance period 2015-17; vests in 2018
• CEO: £916k; CFO: £690k
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2016:
1. Granted 2014; vesting in 2017:
• EPS – under target: 0%
• Cash conversion – 113.7%: 33.3% (of 150%
opportunity)
• Strategic metrics: 27.22% (of 150%
opportunity)
• CEO: £346k; CFO: £278k
2. LEAP awarded (face value):
• Performance period 2016-18; vests in 2019
• CEO: £915k; CFO: £690k
40
What the CEO earned…
• Importance of bonus payments in relation to accounting highlights importance of measures
such as
• Cash conversion (underlying) – important component re LEAP payment
• Revenue and profit recognition in relation to EPS (underlying)
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Key issues for financialization
1.
Carillion: a extreme example, or manifestation of underlying trends?
2.
Arguable ‘value skimming’ by senior executives (Froud et al. 2006).
3.
Value skimming exacerbated by shareholder value principles that linked executive pay to company
performance.
4.
Potential for ‘predatory value extraction’ (Lazonick, 2017) that hollows out firms and undermines
wages/productivity growth.
5.
Parallels to other corporate scandals such as Enron (Froud et al. 2004).
6.
Has this led to rent extraction by large outsourcing firms with consolidated market power?
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Conclusion/Summary
• Financialisation used to examine multiple phenomena, from regimes of accumulation to
organizational changes within the firm.
• What matters is not the existence of finance per se, but the role finance plays in relation to the
wider non-financial economy.
• In analysing corporate strategies such as shareholder value, what matters are not just the numbers,
but the narratives told through those numbers.
• Three main implications for Carillion
• 1. Executive pay linked to financial performance.
• 2. This created incentives to conceal the company’s underlying financial health.
• 3. While generating short term profits, this was a volatile strategy that ultimately broke the firm.
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Academic references
•
Chen D, Wang F and Xing C (2021) Journal of Management Science and Engineering, 6: 197-210.
•
Christophers B (2015) The limits to financialization. Dialogues in Human Geography, 5(2): 183-200.
•
Epstein G (ed.) (2005) Financialization in the world economy. Cheltenham: Edward Elgar.
•
Froud J, Johal S, Papazian V and Williams K (2004) The temptation of Houston: a case study of financialisation. Critical Perspectives on Accounting, 15: 885-909.
•
Froud J, Johal S, Leaver A and Williams K. (2006) Financialization and strategy: narrative and numbers. Abingdon: Routledge.
•
Hajikazemi S, Aaltonen K, Ahola T, Aarseth W and Andersen B (2020) Normalising deviance in construction project organizations: a case study on the collapse of
Carillion. Construction Management and Economics, 38(12): 1122-1138
•
Harvey D (1989) The condition of postmodernity. Oxford: Blackwell.
•
Harris J and Bromiley P (2006) Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation. Organization
Science, 18(3): 350-367.
•
Kleymenova A and Tuna I (2021) Regulation of Compensation and Systemic Risk: Evidence from the UK. Journal of Accounting Research, 59(3): 1123-1175.
•
Krippner G (2005) The financialization of the American economy. Socio-Economic Review, 3: 173-208.
•
Lazonick W and O’Sullivan M (2000) Maximizing shareholder value: a new ideology for corporate governance. Economy and Society, 29(1): 13-35.
•
Lazonick W (2017) The New Normal is “Maximizing Shareholder Value”: Predatory Value Extraction, Slowing Productivity, and the Vanishing American Middle Class.
International Review of Political Economy, 46: 217-226.
•
Stockhammer E (2004) Financialization and the slowdown of accumulation. Cambridge Journal of Economics, 28: 719-741.
•
Van der Zwan N (2014) Making sense of financialization. Socio-Economic Review, 12: 99-129.
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MGT329
Lecture 5: Accounting & Time: Implications
For Governance
Structure
1. The financialization of accounting
2. When the financialization of accounting meets
SV pressures
3. The context of firm behavior after the 2008
crisis
4. M&A, the growth of goodwill & ‘time-shifting’
profits
5. Revisiting Carillion
6. Conclusions
Financialization of financial
reporting standards and practice
• Financialization of accounting well covered in
the literature (Alvehus & Spicer 2012; Arnold
2009; 2012; Chiapello 2015; 2016; Cushen et
al 2013; Ezzamel et al 2008; Froud et al
2006; Haslam et al 2015; etc)
– Importance of financial economics as a cultural
authority in shaping accounting standards (Power
2010); role of accounting to ‘valorize its
constructs’ (Mennicken & Power 2015)
• This led to three shifts…
Historic cost to fair value
accounting
• Move from backward looking forms of
accounting & accountability issues to
forward looking predictions of future
economic states (Morgan 1988;
Ravenscroft & Williams 2009).
Transactional to speculative
valuation
• Power 2010
– growth of NPV measures increased subjective
and speculative character of accounting,
– prediction of future states is always uncertain
(Cheng 2012; Fiechter and Mayer 2010;
Huikku et al 2017; Power 2001; Roberts and
Jones 2009).
– Key issue of discretion & subjectivity.
Legal proof to theoretical
consistency
• Changing understanding of what it is to
make accounts ‘meaningful’ and reliable:
– consistency in theory and application,
– rather than legal processes.
– Key role for external actors – consultants,
auditors etc. as agents governing calculative
consistency
Financialized Tensions
• This shift introduced two tensions
– Tensions between
• subjectivism and discretion granted to management and
• the apparent objectivism of ‘the market’ – how managers
‘represent the market’ when reporting items on an NPV basis
– Tensions also between
• an accounting regime which hands management discretion
• in a corporate governance context where constraining
managerial discretion is viewed as paramount:
• Ie there is a tension between financialization of accounting
and financialization of corporate governance, as described by
Lazonick & O’Sullivan.
Conflicts of interest
• What happens when financialized accounting rules
meet financialized management incentives?
• Conflicts of interest: managers have both the incentive
and the means to make optimistic assumptions of
future states, to realise more distributable funds in the
present.
– Firms can pull forward income to maximise the
distributable capacity of the balance sheet
– Firms can push costs into the future eg avoiding goodwill
impairments.
• What are the checks and balances: is audit fit for
purpose/do the Big 4 abet this process?
Context: four developments
1. Secular stagnation, slow productivity growth, yet pressure to maintain
distributions
2. Liquid corporate debt mkt = M&A + more goodwill
◦ low interest rates & liquid corporate debt market => upward pressure
on corporate asset prices (12.4x a/e vs 11x 2007) & therefore
increasingly intangible balance sheets: since 2014, goodwill increased
approx. 25% for UK firms in Euro Stoxx 600
3. Loosening of audit practice: a new public interest issue & policy concern
◦ Kingman, CMA, Bryden, plus BEIS review, Luminate report, CAN etc
4. High profile company collapses who all fail similarly:
◦ Carillion, Interserve, Thomas Cook – sudden and unexpected
‘impairment shocks’, related to goodwill & other ‘fair valued’ items.
9
Firms are borrowing more against
earnings…
Firms are paying higher multiples
for corporate assets…
• Low return
environment (QE) +
• Plus difficulties in
primary markets, +
• Plus abundance of
cheap credit =
• …Firms are paying
higher multiples to
‘buy growth’
…and goodwill is therefore
growing
• Goodwill is rising
• More debt (contractual
obligation) financing
assets which are
speculative (based on
expectations)
• Rise in interest rates
increases both price of
debt and discount rate
• If firms are thinly
capitalized- what
happens?
Is this stable or unstable?
European goodwill impairments
(Euro m)
2016
2015
2014
2013
2012
2011
2010
Goodwill
added
Impairment
229000
28000
104000
37000
67000
29000
68000
50000
98000
66000
92000
77000
57000
15000
Source: Duff & Phelps, various years
Average
GWI per
Number of Market to
event
events
book
233
121 2.4x
254
146 2.5x
181
160 2.2x
309
162 2.2x
369
179 1.7x
510
151 1.4x
127
118 1.8x
Revisiting Carillion’s accounting
through the lens of time
– Re-temporalized revenue: booked revenues and costs based on
forecasts of total contract profitability and estimated stage in the
contract;
• Two on-site assessments; ‘Project Review Meeting’ & ‘Peer Review’;
PRM valuations 3x more likely to be higher than PR
• Realised time-shifted profit, in excess of net operating
cashflow.
– Impairment ‘shielding’: goodwill maximized, then not impaired,
despite weak performance of acquired subsidiaries (CGUs and
‘synergies’).
• Crucial for realization of positive distributable funds
– Backfilling cash: (reverse factoring) borrowing allowed realization
of operational rather than financing cashflow – boosted cash
conversion rate which triggered bonuses & lent legitimacy to profit
figures.
Contract profits & discretion
1. Contract profit? X
1
2
10
3
years
2. Contract profit
Total est rev
Total est cost
1
2
3
PRM & PR assessment
10
years
Carillion: profit, cash,
distributions
2012
2013
2014
2015
2016
*2016
restated
TOTAL
*TOTAL
restated
Profit/Los Net
s After Tax operating
cashflow
Dividends
paid
Share
buybacks
Total s/h
Distrib’n
166.2
106.3
127.5
139.4
129.5
71.6
-25.6
-78.4
123.8
73.3
73.3
-63.2
78.6
75.7
76.7
80
82.7
55.2
3
0.3
0
0.4
1
1
81.6
76
76.7
80.4
83.7
56.2
668.9
611
166.4
29.9
393.7
366.2
4.7
4.7
398.4
370.9
Goodwill: Summary of Carillion’s
accounting treatment of their three
largest acquisitions
Mowlem(1) Alfred McAlpine(2) Eaga(3)
Net Assets pre-acquisition
-181
62.2
153.3
Net Assets valued at acquisition
-80.5
-50.1
-30.7
Amount Paid
350.3
564.9
298.4
Goodwill recognised on acquisition
430.8
615
329.1
Other intangibles recognised on acquisition(4)
119
90.3
29.4
Total intangibles recognised on acquisition
549.8
705.3
358.5
Source: Company Annual Reports, various years
1 Mowlem was bought in 2006, funded by £117m in cash, 2 million shares of Carillion common stock, and the assumption of £122.5m of Mowlem debt.
2 Alfred McAlpine PLC was bought in 2008, funded by £381.5m, £171.7m in cash, assumption of and £1.3 million in loan notes.
3 Eaga was bought in 2011, funded by £117.7m of company common stock and £180.7m of cash.
4 This additional amount was booked to account for customer contracts and lists, which were separately reported to goodwill.
Group Consolidates Company & CGUs
Consolidated Group
Company
UK
Services
CGU
£1191.2m
goodwill
Canada
Services
CGU
£130m
goodwill
UK
Constructio
n CGU
£239.1m
goodwill
Canada
Constructio
n CGU
£10.7m
goodwill
Company Assets Are The Subsidiaries
Company
Fixed Asset Value of
subsidiary
undertakings
£2036.3m
Subsidiaries (n=330)
d
i
v
i
d
e
n
d
s
Carillion: Distributable reserves
Figure 2: Waterfall of assets and liabilities determining Carillion’s distributable reserves
Figure 1: Profit (Loss) Before Tax of subsidiarised acquisitions: Carillion JM
Limited (previously Mowlem PLC), Carillion (AM) Limited (previously Alfred
McAlpine), Carillion Energy Services (previously Eaga)
300,000,000
200,000,000
100,000,000
-100,000,000
-200,000,000
-300,000,000
-400,000,000
Carilli on (AM) Limi ted
Carilli on Energy Services
Carilli on JM Ltd
Source: Carillion JM Ltd, Carillion (AM) Ltd and Carillion Energy Services Accounts, various years
01
/0
1/
20
16
01
/0
1/
20
15
01
/0
1/
20
14
01
/0
1/
20
13
01
/0
1/
20
12
01
/0
1/
20
11
01
/0
1/
20
10
01
/0
1/
20
09
01
/0
1/
20
08
01
/0
1/
20
07
01
/0
1/
20
06
0
Other time-shifting devices
• The obvious ones: debt, securitization,
dividend recaps etc
• But also more oblique strategies:
– Growing difference in net asset positions of
group and parent, which allows parent to
distribute
– Liquidity transformation – non-distributable to
distributable reserves (Thomas Cook, Greene
King, etc)
Conclusion 1:
What is the purpose of the firm?
• Agency problems persist: central tension between SVled corp governance (designed to constrain
management discretion) and financialization of
accounting (which increases management discretion).
• Contemporary management increasingly seek
intertemporal interventions to maximise distributions in
the present
• This is not in shareholder interests in the long term, and
represents the growth of a different kind of agency
problem.
Corporation: a site of four
transformations
• Geographical and jurisdictional transformations, to
realize income or assets where it chooses;
• Temporal transformation, to move income through time
through contracts and accounting techniques;
• Identity transformation, to transfer and mask ownership
through the use of legal entities;
• Asset/Liability transformation, to convert
unrealised/undistributable profit into retained earnings
that can be paid out to shareholders.
• Or… ‘the firm is a portal; collateralized by a value chain
activity’
Conclusion 2:
The ‘grandfather paradox’
• The summonsing of a benign future in the present
affects perceptions of risk
• It changes strategic calculations in the present in a way
that makes the future summonsed much less likely to
occur.
• Grandfather paradox?: by paying out dividends against
aspirational profits, using debt secured against assets
whose value depends on the accuracy of the company’s
own forecasts, Carillion hollowed out the firm in the
present, made it less able to adjust to unanticipated
events and thus undermined its own forecasted future.
Audit Failure & Fraud
Dr Daniel Tischer
MGT329
2
2 items up front
• Deadline for assignment – 25th May 2023 at 12 noon
• Next week’s lecture will work through how to approach the
assignment re complexity of ExecRem and AggAcc
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3
Contents
1. Definitions of fraud
2. Types of fraud
3. Causes of fraud
4. Fraud cases
5. Is Carillion a fraud?
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What Is Fraud?
• Fraud definition = the deliberate use of deception or dishonesty for personal gain or
to disadvantage or cause loss (usually financial) to another person or party
• Applicable to both people and corporations
• Defined in statutory terms in the UK by two acts:
• Fraud Act (2006)
• Theft Act (1968)
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Fraud Act (2006)
The UK Fraud Act (2006) contains three main fraud offences:
• Fraud by false representation (section 2). A representation may be express or implied. It is
false if it is untrue or misleading and the person making it knows that this is, or may be, the
case.
• Fraud by failing to disclose information where there is a legal duty to disclose it (section 3).
• Fraud by abuse of position (section 4). Abuse of position applies where a person occupies a
position in which he/she is expected to safeguard, or not to act against, the financial
interests of another person. A person may abuse that position through an act or omission
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Theft Act (1968)
Offences under the Theft Act (1968) may also be charged; in particular:
• Theft (s1)
• False accounting (s17)
• False statements by company directors (section 19).
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Types of fraud: control fraud
• William Black, a former Federal regulator of banks
• Control fraud = using a corporation as both a ”weapon” and a “shield” to conduct
fraudulent activity.
• Key argument: CEOs uniquely placed to remove the checks and balances on fraud within a
company (eg through selective hiring and firing).
• These tactics can allows him/her/them to engage in accountancy fraud and embezzle money,
hide shortfalls or otherwise defraud investors, shareholders, or the public at large (“weapon”)
• CEO can also co-opt auditors to sign off on fraudulent accounting (“shield”)
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Control fraud ctd.
• A control fraud can obtain investments that have no readily ascertainable market
value, which are then sent to appraisers that assign unrealistically high values &
auditing firms that bless the fraudulent accounting statements.
• Some control frauds are reactive; ie they turn to fraud only after concluding that the business
will fail
• Others are opportunistic, they are attracted to a criminogenic environment where it is harder to
detect fraud
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‘Legal Fraud’
• Bethany McLean, broke the Enron story for Fortune magazine
• “Legal Fraud”
• Every action may have been in accordance with the laws and regulations but, taken together, the
actions fit into a pattern of “intent to deceive.”
• If a company makes a lot of enemies as it’s on its way up, you have to be a lot more skeptical
about that company than about an average company, because when the tide turns, it’s going to
turn viciously.
• The ethical failing may be more damaging the legal failing.
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Legal Fraud in the context of Carillion
• When we think about Carillion’s activities, we may consider actions taken
individually as perfectly ‘legal’ (although there are some questions as to the legality
of some of Carillion’s actions)
• However, taken together, i.e. putting various actions in relation to one another, we
may be able to argue an intent to deceive
• Carillion’s use of the EPF certainly is questionable
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‘Looting’
• Akerlof & Romer (1993):
• ‘an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot)
instead of to go for broke (to gamble on success)’
• Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to
pay themselves more than their firms are worth and then default on their debt obligation
• Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations; because net
worth is typically a small fraction of total assets, bankruptcy for profit can easily become a more attractive strategy for
the owners than maximizing true economic values.
• the normal economics of maximizing economic value is replaced by the ‘topsy-turvy economics of maximizing current
extractable value’, which tends to drive the firm’s economic net worth deeply negative. Once owners have decided that
they can extract more from a firm by maximizing their present take, any action that allows them to extract more
currently will be attractive
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Causes of fraud
• Drawing on Toms (2019)
• Leadership explanations
• Organisational explanations
• Legal structure/regulatory explanations
• Accounting explanations (briefly discuss)
• Institutional explanations
• Shareholder value explanations
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Leadership
• Focus on leadership
• Jones (2011/12), 18 scandals across six geographical locations from third millennium BC to the 1980s: cause
= poor management in some significant respect
• Gray et al. (2007) early speculative bubbles of 18thC, to contextualise unethical behaviour by leaders,
conflicts of interest and poor regulation
• Balleisen (2017) Misplaced behaviour by corporate leaders, in the form of hubris, status seeking, or acting
to cover mistakes= a common feature, creating an enduring policy dilemma between promoting
entrepreneurship and regulating against financial dissembling (p. 13).
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Jones 2011 Creative Accounting, Fraud and International Accounting Scandals
Jones 2012 Taking the Long View: Accounting Scandals over Time
Gray et al 2007 Financial Bubbles and Business Scandals in History
Balleisen 2017 Fraud
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Organisational explanations
• Marianne Jennings “Seven Signs of Ethical Collapse: Why good people at great
companies cross “bright lines” and behave unethically. These are:
• Pressure to maintain numbers
• Fear and silence
• Young ‘uns and a bigger-than-life CEO
• Weak board
• Conflicts (of interest)
• Innovation like no other
• Goodness in some areas atones for evil in others.
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Legal structure & regulatory explanations
• Other studies, highlight changes in corporate form & inadequacy of regulation:
• Taylor (2013) rise in fraud opportunity related to the emergence of the joint stock company and the lack of
funding for effective regulation.
• Robb (2002) growth of larger businesses, with more complex financial structures, facilitated by a laissez
faire ideology that limited regulatory intervention.
• Wilson (2014) financial crime was nonetheless recognised criminal category, requiring a specific response
(Wilson 2014) and regulation was accordingly fashioned by lawyers rather than accountants (Lee et al.
2009, p. 416). Consequently, the regulatory framework evolved as business problems arose, often in the
form of financial scandals.
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Taylor 2013 Boardroom Scandal: The Criminalization of Company Fraud in Nineteenth-Century Britain
Robb 2002 White-collar crime in Modern England
Wilson 2014 The origins of modern financial crime
Lee et al 2009 Scandals (in: Routledge Companion to Accounting History
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Accounting explanations
• Too much discretion & subjectivity (listen to Carson Block podcast)
• Changing role of large accounting firms
• Big 4 dominance of business advice over shareholder protection, leading to the marginalisation
of fraud detection and the emergence of the ‘audit expectation gap’ (Maltby 2009, pp. 234–235).
• Brooks (2018) suggests the expectation gap has a long history, compounded by conflict of
interest and over-concentration of accounting firms
Maltby 2009 Auditing (in: Routledge Companion to Accounting History)
Brooks 2018 Bean Counters
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Institutional explanations
Jim Chanos: “We are in the golden age of fraud…[The current environment is] a really fertile field for
people to play fast and loose with the truth, and for corporate wrongdoers to get away with it for a long
time”.
Institutional explanations:
• a 10-year bull market driven by central bank intervention;
• a level of retail participation in the markets reminiscent of the end of the dotcom boom;
• Trumpian “post-truth in politics, where my facts are your fake news
• Silicon Valley’s “fake it until you make it” culture, compounded by Fomo — the fear of missing out.
• All exacerbated by lax oversight. Financial regulators and law enforcement “are the financial archaeologists — they will
tell you after the company has collapsed what the problem was.”
• “A heady witch’s brew for trouble”.
https://www.ft.com/content/ccb46309-bba4-4fb7-b3fa-ecb17ea0e9cf
See Cabbioneta et al 2013 The influence of the institutional context on corporate illegality
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Three cases of fraud
• Polly Peck
• Parmalat
• Enron
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Polly Peck
•
Polly Peck = small UK-based textile company which expanded through acquisition in the 80s; collapsed in 1991
with debts of £1.3bn.
•
CEO, Asil Nadir, fled from the UK in 1993; returned 2010; convicted 2012 on 7 counts of theft from his own
company; sentenced to ten years in jail
•
•
From 1988, Asil Nadir used fake transactions to boost revenues and profits.
•
Looting: Up to £378m disappeared from the company in the form of loans, dubious transactions and the re-registration of Polly Peck’s
assets under Nadir’s name (Partridge 2019).
•
Loans mainly used to prop up Polly Peck’s share price or were stolen by Nadir.
•
Three accountants – Huseyin Erdal, Ahmet Ozdal and Firuz Fehmi – were found to have supplied audited figures to Stoy Hayward that “bore
no relationship to reality”.
•
Stoy Howard fined £75,000 and ordered to pay £250,000 in costs for failing to check the suitability of the company’s secondary auditors
Erdal & Co, and accepting unsubstantiated explanations about sums held in the company’s subsidiary in the Turkish Republic of Northern
Cyprus (Perry 2002).
Collusion with corrupt management practices: Erdal & Co were complicit in the fraud (Toms, 2017).
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Parmalat
•
Parmalat = an Italian company, specialising in dairy and foods.
•
Multi-faceted fraud involving multiple individuals. 2003 PWC investigation uncovered 14bn Euro black hole in its books,
company collapsed almost immediately. Primary auditor (1999-2003), Deloitte & Touche settled for $149m in 2007; primary
auditor until 1999/ secondary auditor from 1999-2003, Grant Thornton International expelled Italian affiliate; auditors
Mauricio Bianchi and Lorenzo Penca charged for aiding fraud
•
Overstatement of revenues through a double billing scheme: accounts sold on credit to a supermarket; invoices were duplicated (typically
in the name of the shipping company that delivered the milk) generating fake sales. The duplicate invoices inflated revenues and created
false receivables; the receivables were used as collateral which they pledged against new loans. The loans, then, boosted the cash position
of the company (Ferrarini & Giudici 2005).
•
Hiding losses using off balance sheet wholly-owned entities: uncollectible receivables were transferred from operating companies to
nominee entities like Cayman Islands subsidiary ‘Bonlat’. Fictitious trades/financial transactions were then constructed to offset losses of
operating subsidiaries and inflate assets & income.
•
Understating liabilities: recorded non-existent bond repurchases; sold ‘non-recourse’ receivables to remove liabilities; debt reported as
equity; debt not reported at all.
See Cabbioneta et al…
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