We consider the implications of the Work and Pensions and BEIS Committees’ report into Carillion, which highlights a lack of “meaningful competition” in the statutory audit market and recommends a reference to the Competition and Markets Authority.
In our article Conduct Risk and Corporate Governance - lessons from Carillion we consider some of the corporate conduct issues highlighted by the Work and Pensions and BEIS Committees’ report (BEIS report) into the collapse of Carillion.
Carillion’s senior management are not the only ones in the firing line, however; a number of Carillion’s professional advisors were criticised in the Committees’ report for failure to identify risks and/or to challenge the board in relation to the company’s practices. In particular, the report highlights a lack of “meaningful competition” in the statutory audit market and recommends a reference to the CMA with a view to considering breaking up the Big Four.
The BEIS report raises concerns about independence and audit quality, attributing Carillion’s collapse in part to a failure of auditors and other advisors to challenge Carillion’s management on the group’s liquidity, aggressive accounting policies and approach to financial reporting.
Auditors owe duties to the audited company in the interests of its shareholders, and must show scepticism, integrity, objectivity and independence. The audit report must state clearly whether, in the auditor's opinion, the annual accounts give a true and fair view and are free from material misstatement. This task must be approached with an “inquiring mind”; the auditor is not simply checking arithmetical accuracy. The Financial Reporting Council FRC’s guidance requires the auditor to obtain reasonable assurance (meaning a high level of assurance, but not a guarantee) about whether the financial statements as a whole are free from material misstatement. This should include:
- obtaining an understanding of internal controls relevant to the audit
- an evaluation of the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by the directors, and
- the exercise of professional judgement and maintenance of professional scepticism throughout the audit.
If the auditor concludes that a material uncertainty exists as to the entity’s ability to continue as a going concern the auditor is required to draw attention in the auditor’s report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify the auditor’s opinion.
Carillion’s external auditors, incumbent between 1999 and 2018, are criticised in the BEIS report for:
- failure to identify or challenge Carillion’s aggressive accounting practices, such as its approach to revenue accounting on specific contracts and to accounting for its early payment facility (EPF), which concealed its true financial position and level of borrowing, and weaknesses in the testing for impairments to goodwill; “the warning signs were there in highly questionable assumptions about construction contract revenue and the intangible asset of goodwill accumulated in historic acquisitions” which “were fundamental to the picture of corporate health presented in audited annual accounts”
- not at any time offering a qualified audit opinion on the accounts, despite having also audited an enhanced management review of key contracts in May 2017, going so far as to say that they merely signed off the figures put in front of them by the company’s directors, and
- failure to exercise professional scepticism
The BEIS report concludes that, in failing to challenge management, the auditors were effectively complicit, and should bear a share of responsibility for the consequences.
Other professional advisors
A number of other professional services firms who were advising Carillion are criticised in the BEIS report, again largely for failing to recognise warning signs and/or to challenge senior management on their approach. It is said that advisors appeared “unable to identify effectively to the board the risks associated with their business practices, unwilling to do so, or too readily ignored them”.
A small group of large accounting and professional services firms were, variously:
- Engaged as Carillion’s internal auditor, with responsibility for independently advising the board on risk management and financial controls - this firm was criticised for being either “unable or unwilling” to identify the “terminal failings” in Carillion’s risk management and financial controls, or for having “too readily ignored them”. The same firm also advised the remuneration committee and advised on takeover projects.
- Engaged to give advice and oversee a “business transformation” project after a profit warning in July 2017, described as having received over £10m in fees for six months of “failed turnaround advice””.
- Engaged to advise the company and its pension schemes.
- Engaged as advisors to the Government and Carillion before its collapse, and as Special Managers afterwards.
A “raft of City law firms” was also said to be advising.
There is an inherent conflict in an audit engagement; it is the company which retains and pays the auditor, but the auditor must remain objective when scrutinising the company’s reports. The BEIS report observes that “advisory firms are not incentivised to act as a check on recklessly run businesses”; when firms did give unwelcome advice to Carillion’s management, they were sidelined. The BEIS report notes that an auditor has little incentive to rock the boat, when its fees are paid by the company itself, during a potential tenure of up to 20 years.
The BEIS report expresses concern that a lack of competition in the audit market “creates conflicts of interest at every turn”. In order “to maintain lucrative working relationships, auditors had incentives to “accommodate executive management” in …unwarranted optimism”. In Carillion’s case, the “cursory approval of Carillion’s annual accounts” over a 19 year period “bore none of the hallmarks of competition”.
The BEIS report highlights a lack of “meaningful competition” in the statutory audit market, leading to conflicts of interest and a lack of independence, and suggests a reference to the CMA. It describes the “oligopoly” of the Big Four, recommending breaking the Big Four up to help increase competition and deal with conflicts of interest.
The dominance of the Big Four has already been subject to two official UK competition inquiries (2005 and 2011), and substantial barriers to effective competition were identified. The resulting “package of remedies” introduced in 2014 included a requirement for FTSE 350 companies to put their statutory audit out to tender at least every 10 years, and limiting the maximum tenure of an auditor to 20 years, as well as measures to strengthen the accountability of the auditor to the Audit Committee. These remedies have failed to reduce the dominance of the Big Four.
The BEIS report suggests a range of potential policy options designed to generate more competition in audit. These include:
- more regular rotation of auditors and competitive tendering for audit contracts
- breaking up the audit arms of the Big Four to create more firms and increase the chances of others being able to enter the market, and
- splitting audit functions from non-audit services, reducing both the likelihood of associated conflicts of interest and the potential for cross-subsidisation.
Suggested "soft" solutions include seeking to reduce the bias against using smaller, mid-tier, firms, and increasing the likelihood of switching between auditors.
Professional services firms, and their insurers, will be watching developments with interest.
Many of the criticisms levelled at professional services firms are not based on any technical assessment of their work, but appear largely impressionistic. Shortly after Carillion’s collapse, the FRC announced an inquiry into the 2014, 2015 and 2016 audits and it is this body which will determine whether those audits were performed to the required standard.
The Committees specifically invite the CMA to consider a break up of the Big Four, but given that each of the four is a large, complex, global organisation, such an outcome is likely to present a significant challenge for any single, national competition regulator. The other solution offered is to hive off audit services from others offered across all professional services firms, but this would not necessarily address the dominance of the Big Four. Further, greater price competition in the audit market would not by itself deal with the concerns expressed by the Committees about overly-cosy relationships between the auditor and management. Indeed, there is an argument that squeezing margins risks reducing the quality of audits. It is clear that this promises to be one of the more challenging market enquiries for the CMA.