Auditing is under scrutiny as perhaps never before. The January 2018 collapse of Carillion, the UK’s second-largest construction company, is just the latest in a long line of corporate failures raising very serious concerns about this most vital of professions.

Carillion boasted almost 500 government contracts – from building hospitals, roads and bridges to the provision of school meals and rubbish collection. In April 2017, the outsourcing giant unveiled accounts showing annual profits of £178 million, which drove a bumper shareholder dividend and executive bonuses.

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The real culprits behind Carillion's collapse

By Liam Halligan

In July, only a few months later, Carillion’s rosy financial outlook had been utterly transformed. The company issued an £845 million profits warning, the largest the City had seen in a generation, wiping out combined profits since 2012. And by the turn of the year, despite another £1.9 billion of government contracts, Carillion had imploded – forced into compulsory liquidation.

The Official Receiver found Carillion had a staggering £6.9 billion of gross liabilities. Some 30,000 suppliers and sub-contractors, many of them small and medium-sized firms, are now shouldering £1.2 billion in unpaid bills. Carillion’s £800 million-plus pension deficit is the largest ever to be absorbed by the Pension Protection Fund, to be subsidised by levies on other workplace pension schemes.

The accounts published in April 2017 that unravelled so quickly were overseen by KPMG – Carillion’s external auditor for the entire 19 years of the construction firm’s existence.

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The Carillion meltdown follows recent audit controversies involving Tesco and the software company Quindell, among others, similarly relating to profit over-statement and “aggressive accounting”. It’s not just a UK phenomenon. The International Forum of Independent Audit Regulators found that no less than 40% of the audits it inspected last year around the world were sub-standard. All those with serious deficiencies were by KPMG, PwC, EY or Deloitte. These ‘Big Four’ auditors generated combined global revenues of $134 billion last year, directly employing 945,000 people.

They are now under fire in many countries – having been involved in tawdry episodes from the Petrobras scandal in Brazil to the Gupta affair in South Africa. Auditing is in crisis and must be reformed. And the UK, as the world’s financial services superpower, needs to take the lead.

Previous changes to accounting standards, following earlier scandals, mean big auditors are now just box-tickers, able to avoid nuanced judgement. Conflicts of interest remain endemic, between firms, their clients and regulators. Even in advanced country jurisdictions, regulatory oversight is weak and feebly enforced. That’s because the Big Four have been allowed to establish themselves as a hugely powerful, practically untouchable oligopoly – auditing an astonishing 97% of FTSE 350 UK-listed companies and 99% of S&P-500 in the US.

The auditing profession – with its too-big-to-fail and increasingly too-big-to-regulate structure – is at the heart of our crony capitalist crisis. Reforming audit sounds obscure, but is a vital part of re-building public confidence in Western liberal capitalism.

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By Liam Halligan

Listed companies must employ auditors by law. With four companies so overwhelmingly dominant, the resulting lack of competition promotes malpractice. Since the Enron scandal, and the demise of Arthur Andersen – the fifth member of what was, until 2002, the Big Five – the authorities have been petrified of heavily sanctioning the rest, fearing an even more dominant Big Three. This explains the regulators’ light touch approach – and why, after the systemic misreporting ahead of the 2008 financial crisis, the Big Four faced so little sanction.

The current audit industry structure seriously undermines the public interest. The Big Four are too profit-driven and compliant towards the managers of client firms, resulting in low-quality reporting – a disservice to investors, tax authorities and the broader public. “It is crazy there are just four top-bracket auditors,” Sir John Bourn, the UK’s longest ever serving Auditor General, told me. “The system simply doesn’t work and hasn’t for a very long time”.

During the decade before Carillion collapsed, the Big Four received a combined £51 million to advise and assist the company. They all deny wrongdoing and say they acted in good faith. Yet after a Parliamentary report said the Big Four were a “cosy club incapable of providing the required degree of independent challenge”, the Financial Reporting Council, the UK’s main official corporate government watchdog, is now investigating KPMG’s work at Carillion.

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Carillion has become a byword for financial misreporting, and public anger towards the profession has been further fuelled by revelations that Big Four firms working at Carillion got their bills paid before the company went bust, in contrast to thousands of regular contractors. And, of course, with the Official Receiver now overseeing Carillion, some of the very large audit firms are being paid large amounts of public money to dismantle the debt-soaked mess.

A complete overhaul is needed – here are five reforms to fix the industry.

1. Tackling Market Structure

An investigation by the UK Competition Commission resulted in the introduction of a nominally stricter audit industry regime in 2013. But the proposals were piecemeal and, after extensive auditor lobbying, heavily diluted. They have almost entirely failed – and in some cases been counter-productive.

Mandatory auditor rotation was recently introduced – but only every 20 years. Since then, the industry has become even more concentrated. In 2013, the Big Four audited all but 16 of of the UK’s 350 largest listed companies. Last year, it was all but nine.

In March, Britain’s fifth-biggest auditor, Grant Thornton, announced it would no longer tender for audits of FTSE-350 companies, complaining the grip of the top players remained so strong with its network of alumni in the Finance Departments of listed firms, that retendered contracts were all kept within the Big Four.

The time for tinkering is over. The Competition and Markets Authority – the successor to the Competition Commission – must urgently re-investigate the audit industry, with a view to breaking up the leading players. Only a wholesale, forced restructuring will spread highly experienced and influential individuals across a larger number of firms, so generating more competition.

2. A Cap on Market Share

The Financial Reporting Council (FRC) has singularly failed to tackle lax auditing. But rather than being disbanded, it should be strengthened, with its mandate extended to implementing a cap on market share. The Big Four should be required to reduce its combined coverage from 97% to 60% of FTSE-350 firms over the next five years, then 40% over ten.

‘Shared audits’ would count towards that reduction in market share, but only for a five-year period at each listed company, and only as long as Big Four companies gave smaller rivals access to their technology platforms.

Rotation is also crucial – not just re-tendering, but a change of auditor. This should happen every five years, rather than every 20 years as at present.

3. Separate Audit and Consulting

As well as market share, it is vital to address conflicts of interest. The Big Four provide extensive and highly lucrative consulting services to the same group of companies they audit – generating two-thirds to three-quarters of their fees from consulting. After Enron collapsed, under US regulatory pressure, three of the Big Four split from their consulting arms, but they have since rebuilt that part of their business.

There are widespread fears independent audit work is compromised by the prospect of securing large consulting contracts from the same clients. And with senior staff at the Big Four increasingly focused on consulting, ever more complex audit work is pushed onto junior, less-experienced staff.

Auditors should be forced to divest their consulting arms, with regulators being granted powers to insist on ‘audit-only’ firms. The FRC previously opposed this idea. Since the Carillion collapse, the watchdog has said such a move should “be considered”.

4. More Active Investors and Listing Authorities

Investors must be more demanding of audits. There are signs this is happening. Standard Life Aberdeen, one of the UK’s largest institutional investors, recently publicly stated that the “Big Four let profits affect audit views”. The company has held meetings with the boards of FTSE-100 and FTSE-250 companies, trying to convince them to appoint auditors outside the Big Four.

Should it be listed companies that choose who audits them, or shareholders and other investors? If auditors were hired by shareholders they could be robust, judging governance and even management quality without fear of losing clients.

The idea of auditors working for stock exchanges and other listing authorities should also be explored. Any companies wanting to list its shares on an exchange would be scrutinised by that exchange’s appointed auditor, with audit costs included in the price of listing. The exchange could employ a range of auditors, rotating them at will. It could even offer lower audit fees to companies found to have the best internal controls and standards, incentivising good behaviour and recognising that they will cost less to audit anyway.

5. Less Complex Rules – Back to First Principles

“If you look at the rules for the preparation and auditing of financial statements, you are overwhelmed by their size and complexity,” says Former UK Auditor General Sir John Bourn. “This complexity is really getting in the way of proper audit and genuine transparency – and sometimes, out of that complexity, you get deliberate obfuscation”.

Over recent decades, rather than holding themselves and clients to the highest standards, the Big Four have introduced overly complicated disclosures and procedures. As such, ‘tick box’ formulas have been used, rather than principled rules, to help large clients get away with ‘aggressive accounting’ to mutual benefit, with leading auditors using their enormous influence to avoid liability.

They’ve been helped not only by ever more complex rules, but also a gradual move away from historical cost accounting and towards the notion that accounts should present information that is “useful to users”. As such, company managers have been able to bring forward anticipated profits and unrealised gains, presenting them as current surpluses. Such practices are widely seen to have taken place at Carillion – where ever increasing reported profits drove a rising share price, along with dividends and executive bonuses, even amidst negative net cash. That’s why Sir John Bourn later described Carillion as “a Ponzi scheme”.

UK company law says accounts must present a “true and fair value” of the underlying business. It strikes me there is a tension between such company law based on “factual verification” and rules introduced stealthily over many years, relating to “useful to users” principles, that rely instead on “faithful representation”. This gradual rule change has been deeply damaging – a gateway to abuse. It should be entirely reversed.

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The Big Four constitute a formidable lobby. Across the UK, Europe and the world, many audit professionals are doing very well for themselves and want things to stay as there are. I’m often told I don’t know what I’m talking about and the situation is too complex for me to understand.

Well, as an economist, who also covers politics for living, what I do know is that the auditing profession, as it is currently conducting itself, is helping to provoke rising popular discontent with capitalism. This is an extremely dangerous trend and must urgently be reversed.

The Big Four deny wrongdoing, insist they acted in good faith and, are appalled by the idea they could be broken up. They claim auditing is a unique market requiring companies of huge scale due to global demands and say that forced restructuring would be unduly disruptive.

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But there are plenty of international law firms, competing vigorously for business. And, while the break-up of Standard Oil, AT&T and other highly dominant companies throughout history has been disruptive, this restructuring sparked more competition, encouraging broader innovation and investment and ultimately adding to national wealth and the public good.

The reform of audit should begin in the UK. London is the hub for the world’s largest firms, the policy debate here has been on-going over many years. Catalysed by Carillion, there is now a growing clamour for change among politicians, regulators, and the industry itself – albeit largely outside the Big Four.

So the threat of a major restructuring should now be placed on the table. And if the Big Four want to avoid that outcome, they must accept market caps, compulsory rotation and other new measures, demonstrating a very clear and immediate determination to reform – in the interests of themselves and the broader public.

The collapse of Carillion exposed a vast firm – responsible for hundreds of government contracts and benefiting each year from hundreds of millions of pounds of public money – that had mistreated its sub-contractors, neglected its pension schemes and systemically cooked the books.

The day after Carillion imploded, I argued in an essay for UnHerd that the nature of the collapse “threatens to upend British politics, and could have policy implications that are felt far beyond these shores”. Having spent the last few months investigating the company for an upcoming Channel 4 Dispatches documentary, I would go further. Carillion is, quite simply, the single-most shocking business story I’ve covered in over 20 years as a national print and television journalist.

When Carillion went bust, it had almost 500 contracts with HM government – including the construction of hospitals, roads and other key pieces of infrastructure. The company went down owing an astonishing £1.2 billion to sub-contractors – many of them small- and medium-sized family-owned businesses – that are unlikely ever to be paid.

Carillion also left behind a record £800 million pension deficit, the biggest ever shortfall to be absorbed by the Pension Protection Fund (PPF). That means many of the 27,000 scheme members will now receive inferior occupational pensions, subsidised by those paying in to other private UK workplace pension schemes.

When the state finally ordered that Carillion be dismantled, the company had total liabilities, according to the Official Receiver, of almost £7 billion – the largest trade insolvency in UK history.

Founded in 1999, Wolverhampton-based Carillion was formed from fabled British names like Tarmac, McAlpine and Mowlem. It emerged as the flagship among a select group of huge private sector outsourcing companies that, particularly under the New Labour governments of Tony Blair and then Gordon Brown, were awarded countless lucrative contracts to deliver all manner of public sector projects and services. Now this once lauded company lies in ruins, having folded under the weight of debts so heavy, and contracts so toxic, that the Official Receiver dismissed any notion of administration and a possible rescue plan.

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Yet this is a story about far more than the failure of one company – although, with 43,000 employees worldwide, and responsibility for multiple public-sector projects Carillion was an extremely important company.

It’s a story about whether the British public can have faith in private firms delivering public services, and about jaw-dropping failures at the heart of our business and political establishments. Above all, it’s a story about how UK capitalism works – and fails to work.

How can a company issue a rosy set of audited accounts and pay-out the highest dividend in its history, as Carillion did in the spring of 2017, and then, just weeks later, issue a £845 million profits warning – the largest the City has seen in a generation? Why did ministers and the civil service, with Carillion’s share price enduring a near-instantaneous 70% drop, and just weeks after that profits warning, then hand the same outfit eight new contracts, delivering vital public services, worth over £2 billion?

Capitalism involves and indeed requires the occasional corporate failure, of course. But the scale of Carillion’s mismanagement, the hidden losses, the ever-rising shareholder and executive pay-outs as the pension deficit grew – all of it kept afloat with taxpayers’ money – points to an astonishing lack of both private and public oversight.

One of several recent Parliamentary investigations into Carillion concluded that MPs have “no confidence in our regulators”. The Financial Reporting Council (FRC), responsible for auditors and accountants, was “timid” in challenging Carillion on its “inadequate and questionable” financial information and “wholly ineffective” in taking its auditors to task, according to a joint report from the Work and Pensions select committee and the Business, Energy and Industry select committee.

The FRC was “content with apportioning blame once disaster has struck,” concluded MPs, “rather than proactively challenge companies and flag issues of concern to avert avoidable business failures in the first place”.

The Pensions Regulator (TPR), said MPs, meanwhile “clearly failed” in its statutory objectives to reduce the risk of schemes ending up in the PPF and to protect member’s benefits. The regulator “had concerns about the schemes for many years without taking action, even when Carillion’s trustees repeatedly asked it to intervene”.

Taken together, the FRC and TPR – the two leading corporate regulators in a country that prides itself on commercial savvy and business oversight – were, according to MPs, “united in their feebleness and timidity”, too “passive and reactive” to make effective use of their powers, with “any extra powers they may receive having little impact without a change of culture and outlook in both”.

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And the government, for its part, “lacked the decisiveness or bravery” to address the failures in corporate regulation that allowed Carillion to become a “giant and unsustainable corporate time bomb”. As Parliamentary reports go, the language of this joint committee – co-chaired by Frank Field and Rachel Reeves, two Labour MPs widely-respected for their financial nous – could hardly have been stronger or more urgent.

And Carillion’s collapse “could happen again”, according to another Parliamentary investigation chaired by Tory MP Bernard Jenkin, “as the government has not yet learned how to outsource work effectively”. Public services are deteriorating as the government prioritises costs above all else in outsourcing decisions, said MPs on Jenkin’s Public Administration and Constitutional Affairs Committee (PACAC). The public sector has become “too reliant on a small handful of big businesses”, which are effectively “too big to fail” as they run “vast swathes of public services with little effective competition”.

Successive governments have “accepted bids below what it costs to provide the service, so contracts have had to be renegotiated”, said the PACAC, calling on ministers “to use this moment as an opportunity to learn how to effectively manage its contracts and relationship with the market”.

Certainly, my Dispatches investigation unearthed a pattern whereby Carillion repeatedly booked and declared profits on contracts that were unrealistically high – using those profit announcements to then justify generous dividends and senior executive bonuses. The company, at the same time, relentlessly chased and was often awarded new government contracts, often at unrealistic prices, to get fresh money in the door, and thereby keep existing and often struggling projects going.

By using aggressive accounting techniques and amassing debts that were kept out of the headline figures with the use of obscure trade financing schemes and endemic sub-contractor late-payment, Carillion kept the plates spinning for years – running a company which more than one interviewee in my upcoming film, including a very senior former civil servant, describe as “a Ponzi scheme”.

The UK’s public-sector procurement is a mess. As the only buyer in major markets, the government “has huge power to set prices, standards of quality and to determine the behaviour of participants,” according to the PACAC. Yet ministers and civil servants focus heavily on awarding, rather than managing contracts. Across Whitehall, the noble and hugely important pursuit of continuing commercial checks and contractual oversight is marginalised and starved of resources. There’s an indulgent and counter-productive emphasis, instead, on politicking, strategising and the promotion of headline-grabbing gimmicks.

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Parliamentarians, the National Audit Office and some other public servants have been trying hard – issuing warnings a-plenty over many years, not only about Carillion, but also the broader failings related to how billions of pounds of taxpayers’ cash are spent on outsourced public services. And, since Carillion’s collapse seven months ago, a succession of cogent and powerfully argued Parliamentary reports have appeared, full of good ideas. All these documents, before and after Carillion’s implosion, have generated far too little media attention and scant ministerial response.

My Channel Four film goes further, featuring fresh and important testimony from insiders across Westminster, Whitehall, the City, the construction industry and Carillion itself. The UK’s public-sector procurement chaos is a long-standing, cross-party problem. This is about delivering decent public services, and securing some semblance of value for taxpayers – goals that are widely shared across the political spectrum.

The UK public’s trust in business is at its lowest ebb since 2012. Only 43% of the adult population now “trusts business”, according to the latest Edelman Trust Barometer. That should be no surprise. Along with Carillion, we’ve seen the failure of BHS in 2016, shortly after Sir Philip Green sold the retailer with a £600 million pension deficit. Then there’s been the seemingly endless string of financial scandals, from Libor-rate rigging to PPI mis-selling, to the persistent tax avoidance strategies employed by the world’s largest technology firms.

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And all this follow, of course, the 2008 financial crisis itself – an episode sparked by the reckless and, in some cases, fraudulent activity of white-collar professionals across the world’s leading financial capitals, not least the City of London. Ten years on, despite the tens of thousands of ordinary businesses destroyed and millions of lives upended, there’s been no major public enquiry, very few court cases and little in the way of any kind of public reckoning

Carillion’s directors and auditors deny any wrongdoing. They say they’ve always acted entirely within the law. Yet capitalism is in danger of becoming a four-letter word. And that’s disastrous – capitalism and broader private enterprise, if they are to flourish and spread wealth, must be built on public consent.

Carillion, and episodes like it, dent and seriously damage such consent. That’s why we need clearer rules, stronger and more vigilant regulators and ministers with the courage and presence of mind to back them. It’s also why we need journalists and broadcasters who pursue such stories – taking economics and business coverage beyond punch-and-judy political headlines and venturing deep into the analytical undergrowth.

“How to Lose Seven Billion Pounds”, Channel 4 Dispatches, Wednesday 22^nd August, 10.30pm

“I was absolutely astonished when I discovered there was a proposal to put into law the ability of shareholders to stop these excessive payments… I thought this was a power shareholders had always had”

That’s what Jacob Rees-Mogg said when I asked him about fat cat pay packages. “What is the point of owning the business,” he continued, “if you can’t even vote down the remuneration committee’s answers?” It’s a good question, but I think it misses the point.

Last year, the British Prime Minister referred to excessive executive pay as the “unacceptable face of capitalism”. Her manifesto, a few months earlier, had pledged to change that by legislating “to make executive pay packages subject to strict annual votes by shareholders”.

It’s easy to see why legislating to change behaviour – by giving the owners of capital the absolute right to vote against, for example, executive pay packages – looks attractive. Certainly, the current non-binding “say on pay” requirements – of which the UK was an early adopter, with the US following suit in 2011 –  are a damp-squib.

Research by Stanford Graduate School of Business found that, overall, “granting shareholders the right to vote on executive compensation contracts has a fairly limited impact on pay”, which helps explain why pay levels haven’t been shifted in countries that have adopted it.[1. David Larcker and Brian Tayan, ‘Say on Pay research spotlight’, Stanford Graduate School of Business, 2016]

There is the odd case – like that of the construction company Crest Nicholson –where, despite shareholders voting against a pay package, the “advisory” nature of the vote has allowed the business to push ahead regardless. But, more commonly, where a majority of shareholders has voted no, action has been taken. The real problem is that shareholders are too often asleep at the wheel, and executives disinclined to moderate their behaviour.

So, while it’s disappointing that the Prime Minster has backtracked on her manifesto promise, the real question is: why do capitalists need legislation to make them do the right thing?

The writing is on the wall, capitalists need to read it

My colleague. Henry Olson. has pointed out that the experts who were blindsided by Brexit, Trump and the wider rise of populism across the West could have foreseen the upheaval. The data was there, they just weren’t reading it. Capitalists should take note.

• Polling this month found less than half of Americans, 48%, trust business; in the UK it’s even lower at 43% – and on both sides of the Atlantic, that’s a decrease from 2017.[2. .‘Global Trust Index’, Edelman, 2018]
• Last year, YouGov polling for UnHerd found that three quarters of Britons and more than 60% of Americans believe big businesses have dodged taxes, damaged the environment or bought special favours from politicians.
• In 2016, just 24% of people in the UK and 38% of people in America trust business leaders to tell the truth.[3. .‘Trust in business leaders’, Ipsos Global Trends, 2016]

That’s pretty damning evidence that the people – those pesky individuals who sent political shockwaves reverberating through the West – are unhappy with corporate behaviour. In Britain, only those aged 65 or above are more likely to describe themselves as capitalist than socialist.[4. .‘British people keener on socialism than capitalism’, YouGov, 23 February 2016]

A hard-left Corbyn government, or socialist-styled Bernie Sanders administration, is no empty threat, it’s a very real possibility. Corbyn was a whisker away from winning last year’s UK general election, and many people, including Donald Trump’s own pollster, believe that Sanders could have won in 2016 had he been the Democratic candidate. The alternative to shareholders and executives putting their own house in order – or, to you and me, acting with integrity – is someone else doing it for them… and with a heavily anti-business bias.

Shareholders need to act

Rebuilding trust in business is, of course, going to take more than curtailing excessive executive pay – as important as that is – and at the start of 2018 we’re seeing encouraging signs that investors might just be getting it.

Larry Fink, the head of the world’s biggest fund manager BlackRock, used his annual New Year letter to CEOs to demand better behaviour.

“To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate. Without a sense of purpose, no company, either public or private, can achieve its full potential.”

BlackRock’s responsibility to its investors, Fink states, “goes beyond casting proxy votes at annual meetings”, it requires active engagement with companies. Warm words will not make the difference, but in beefing up their “investment stewardship’” team BlackRock is putting its money where its mouth is.

Another encouraging example is the shareholder resolutions filed at Facebook and Twitter this month by $200 billion New York State Common Retirement Fund and activist investor Arjuna Capital. The resolutions are aimed at forcing the tech giants to tackle abuse of their platforms. The shareholders want a detailed examination of the scope of abuse – including sexual harassment, hate speech and fake news – and an assessment of how the platforms are responding.

They also want the report to assess the financial and operational risk of “content management controversies”; which is a question other investors are likely to be interested in.

The collapse of UK facilities management and construction company, Carillion, shone the spotlight once again on fat cat corporates and their inadequate investor oversight. The Prime Minister is back on her soapbox, writing in The Guardian that: “for the first time, businesses will have to demonstrate that they have taken into account the long-term consequences of their decisions”. There’s no detail, and the Prime Minister’s track record is hardly encouraging, but it sounds ominous.

It’s time for the capitalists to get a grip and start rebuilding trust in business. That means active engagement with the companies they invest in, collective action and, ultimately, a willingness to act with their feet. The alternative, after all, is a whole lot worse.