Category Archives: Corporate Governance

Sexing up the statistics. Who needs facts?

Female CEOs

Want Higher Profits? Hire a Female CEO, CFO” The article headline caught my eye. Aren’t we all looking for a magic ingredient that can guarantee financial success? I think that women are disadvantaged and undervalued in business. And this doesn’t have to be the case. The last CEO I appointed was a woman – in a male-dominated industry – and the last board I chaired had a majority of female directors. So, I read this article with great anticipation.

The article is based on a research report1 by S&P Global, entitled even more eye-catchingly: “When Women Lead, Firms Win”. This is shown by the statistic that: “In the 24 months post appointment, female CEOs saw a 20% increase in stock price momentum…”

So, your investment strategy should be to buy stocks with newly appointed female managers! Ah no, the report rebukes you for drawing this obvious conclusion; “…we admonish the reader to interpret the results as a descriptive analysis, relevant from a governance standpoint, but not providing evidence of a predictive trading signal.” Maybe they don’t quite have the confidence in their own research?

The study goes on to suggest that one driver of female-led out-performance is that females are held to a higher standard than males, so like-for-like female executives are better: “…females in C-suite positions are consequently more talented.”

Naturally, I wanted this all to be true. But something about the scale of the claim and the certainty didn’t ring true. I wondered if the statistics were that definitive? Had those headlines been sexed up?

The research study

The study2 is a large one, based on the Russell 3000, a benchmark for the whole US stock market, over the last 17 years and encompassing over 5,800 new executive appointments, of whom 90% were male. It looks for changes in company performance in the two years3 post a female executive appointment4.

In summary, the results seem to show that;

  1. The sex of a newly appointed CEO does not have any effect on the market capitalisation of a business.
  2. New female CEO’s have a better record than males in improving the valuation5 of a company over their first two years.
  3. There is no significant difference by sex for new CEOs in levels of capital expenditure, profitability6, or 12 month share price momentum. However, new female CEO’s companies have greater share price momentum over 6 months.
  4. Companies with new female CEOs appear to reduce the level of their balance sheet accruals compared to those with new male CEOs (However, given that female CEOs on average inherit significantly higher accruals than their male equivalents, this is quite likely to be a case of reversion to the mean).
  5. Companies with new female CEOs increased leverage more than those with new male CEOs7.

What conclusions does the research make?

Sadly, the research makes the most basic of statistical errors. Correlation does not imply causation8. The fact that two sets of data appear to move together does not prove that one causes the other. This is particularly pertinent where both different results are cherry-picked to highlight those that fit the argument, and there is not a robust hypothesis tested to explain the mechanism involved.

The research’s headline claim is that female CEOs deliver a 20% increase in share price momentum. However, this is only true looking at the 6 month momentum. Even then, this result is statistically ‘significant’ at only the 90% level, well below the standard test of a 95% chance of it not a being random event. The 12 month momentum shows improvement of less than half the 20%, and is not significant at any level.

The next major claim in this research is that new female CEOs improve their company valuation (ie reduce the book/market value ratio) over their first two years versus those of new male CEOs. However, the research finds no evidence of a significant gender-related improvement in market capitalisation, share price momentum or profitability, and so it’s not clear where this rating improvement derives from. One answer could be in the finding that new female CEOs increase leverage, which can assist in improving company valuations, whilst raising financing risk.

Confusingly, the graph of average residual returns in the research appears to show that new female CEOs companies are generally under-performing against equivalent males. This finding, whilst unlikely to be statistically significant, seems to undermine the central conclusion.

Ave res returns graph

So where did those headlines come from?

Contrary to the article headline, the research does not claim that female CEOs deliver higher profits. However, the research itself is also guilty of wish-fulfilment and outcome-seeking. There is no evidence that “When women lead, firms win”. In fact, the predominant evidence is that the sex of a new CEO is not a significant factor in company success. This is as you would expect. If sex were a dominant factor, life would be so much easier for Nomination Committees. Business – as with everything in life – is so complex that no one factor about a person is likely to have an overwhelming predictive effect on a company’s performance.

The research’s major claim is that new female CEOs see a 20% increase in stock price momentum. However, the report’s own data doesn’t support this conclusion9, nor would this be a robust long-term performance indicator in the absence of any improvement in either profitability or market capitalisation10.

Is it still possible that the average new female CEO is better than their male equivalent?

It is certainly possible than new female executives are better than equivalent males, and it is possible that female CEOs drive superior company performance. It is possible that the data on financial performance is so noisy that it would not be evident statistically. However, at this stage, there is no robust evidence for this.

It is also possible that females are discriminated against so that they have to be superior in ability or experience to male equivalents in order to get promoted to senior roles. The research uses a crude analysis11 of executive biographies to conclude that females are ‘more talented’ than male equivalents. The research here fails to distinguish between ability and experience. There is no reason to believe that females are innately better executives than males, but they may well suffer discrimination. As a result, women may find they need more experience or more talent, compared to a male candidate, to get the top job. Also, in having and caring for children they may well end up with less management experience than similarly aged male executives. All of this suggests that females deserve some positive discrimination in appointing them with less experience than their male equivalents might have.


This is one of many pieces of research12 that appear to be aimed at proving that females outperform males in senior roles. Studies like this should be invaluable sources of understanding about how business works, how prejudice harms decision-making and how business can create value. However, wish-fulfilment, the selective use and hyping of inconclusive statistics helps no-one, merely pandering to media and political prejudice against business.

I think females are discriminated against and constitute vast under-utilised talent. The fact that we can’t prove it doesn’t mean it isn’t true. We need to work hard to counter prejudice and promote women.  We don’t need sexed up headlines to tell us that this is the right thing to do.


Simon Laffin



2 The statistics are difficult to interpret, particularly how exactly the performance measures are calculated and presented, with little explanation or definition provided. I have interpreted them to the best of my ability in their absence.

3 Two years appears to be a random time frame.

4 The research also looks at new CFO performance, but for simplicity I have focussed on the CEO analysis. If sex were a significant indicator of executive success, you would expect to see that primarily in CEO performance.

5 Defined by market capitalisation divided by accounting book value

6 Defined as Gross profit or EBITDA as % of book assets

7 Interestingly, this is counter to many commentators’ claims that females are more risk-averse and would be more conservative in running companies, particularly in financial services.

8 See for example for more explanation:

9 The research claims that; “These results are economically and statistically significant.” However, this would only be true if the research had started out with a hypothesis that female CEOs improved stock price momentum and then found that the data supported that. In fact, it looks as if the researcher selected seven measures of performance and alighted on the only two that gave him the answer he was looking for. It has two measure of stock price momentum and he has selected the one with a result that fits its conclusion. Test of statistical significance are based upon the likelihood of something happening against a random event. If you choose a measure because you like its outcome, you cannot rank it against a random event, precisely because you selected it. Statistical significance doesn’t work on a ‘pick and mix’ basis.

10 The research does not provide a hypothesis as to how share price momentum is boosted despite there being no improvement in either market capitalisation or profitability.

11 It looked for words in biographies of male executives in companies with ‘positive excess returns’ and then judged the quality of female CEOs by counting the occurrence of these same words in their biographies.

12 The research claims; “The analysis presented herein is one of the most comprehensive examinations, by breadth and time horizon, of gender diversity, to-date.”

Response to consultation on Market Study on Statutory Audit Services

CMA report coverI am responding to the request from the Government for views on the recommendations by the Competition and Markets Authority on the market for Statutory Audit Services. This submission is made in a purely personal capacity.

Over the last 25 years, I have been chairman or director of ten different companies, from small privately owned to FTSE100, participating in over 200 audit committee meetings. I have never worked for an auditing firm, big or small. I am now a non-executive director/Chairman of the Audit Committee at Watkins Jones plc and Chairman of the Audit Committee of Dentsu Aegis Network, as well as a private investor.

Introductory Comments

There needs to be a clearer understanding that audit is a regulated statutory service. As such companies and stakeholders should rely on the regulator to ensure high quality standards. Failings in the quality of audits are primarily the responsibility of the audit firms and their regulator, not company audit committees. Audit committees should be responding to issues that they see in the conduct of their own audits, and should be allowed to select their auditor based on their own criteria. If shareholders are unhappy with this, then they have the power to influence boards and ultimately vote directors out if necessary.

The CMA Report is heavily UK-centric, failing to take full account that the Big 4 have international arms and associates and that most FTSE350 companies are international. It does however recognise that the dominance of the big 4 firms is an issue that must be tackled globally, or at least on a European basis. It is not tenable to argue that the global oligopoly of the Big 4 can be successfully challenged by measures that affect UK-based firms only.

The CMA report provides no analysis as to why the market has become so concentrated (although its predecessor body contributed significantly by allowing the merger of Coopers & Lybrand and Price Waterhouse in 1998). As a result, the report sheds no light on what will happen if the joint audit proposal is implemented, diverting significantly more revenue to non-big 4 players. How will they react? Will this artificial subsidy turn the non-big 4 into real challengers? The answer is that no-one knows. This is a poor basis for a major change to affect virtually all our 350 largest companies. The CMA should have recommended that this proposal be trialled first to learn what happens rather than rush to rollout a significant untried policy measure.

The most effective and fastest way to increase competition in this market would be to increase competition within the big four by ensuring that each of the big four can always compete for an individual audit. This is not currently the case as often a company already uses one or more of the big 4 to provide tax, advisory or internal audit services. The CMA recommendation to require some form of split between the audit and non-audit services of the big 4 is therefore the strongest recommendation and the one most likely to provide more choice in the short term. The government should also lobby internationally for other countries to require a similar split.

Arguably, the best opportunity for non-big four firms to increase their competition against the big 4 would be by investing in their non-audit work. Developing a strong tax practice or due diligence team is likely to be easier than trying to compete for audit work, particularly as the latter tends to require a strong international network.

Detailed responses to questions posed by the Government

  1. Do you agree that the new regulator should be given broad powers to mandate standards for the appointment and oversight of auditors, to monitor compliance and take remedial action? What should those powers look like and how do you think those powers would sit with the proposals in Sir John Kingman’s review of the Financial Reporting Council?

The CMA has not provided any guidance as to what form the ‘standards’ for the appointment and oversight of auditors would be, and therefore there is no basis for this being new powers for a regulator. UK corporate governance hinges on boards, and particularly non-executive directors, exercising their fiduciary duty to operate the company on behalf of members and other stakeholders. There is no evidence in the report of widespread failure by boards to do this. Nor is there any analysis of why individual auditing failures have emerged. Regulation of statutory audit is not the role of boards, who have in fact been let down by the failure of the regulators themselves to do their job. It is therefore somewhat ironic to have regulators trying to increase their own powers to regulate boards with regard to audit quality.

  1. What comments do you have on the ways the regulator should exercise these new powers?

These new powers are not justified by any evidence and so should not be conferred on a regulator.

  1. How should the regulator engage shareholders in monitoring compliance and taking remedial action?

Shareholders should be engaging with boards directly themselves.

  1. What would be the most cost-effective option for enabling greater regulatory oversight of audit committees? Please provide evidence where possible.

The case has not been made for greater regulatory oversight other than by shareholders themselves engaging with individual companies.

  1. Do you agree with the CMA’s joint audit proposal as developed since its interim study in December?

The CMA’s joint audit proposal does not have an evidential basis. Joint audits are voluntarily used by a few companies, but are mandatory only in France. The actual evidence shows very mixed results. For example the Lesage, Ratzinger-Sakel, Kettunen study, ‘Struggle over joint audit: on behalf of public interest?’ concludes that;

“we do not observe a higher quality associated with joint audit, neither on the Danish sample (main analysis) nor on the matched FRA/GER [France/Germany] sample.”

The CMA admits that the effect on quality ‘should be at worst neutral.’ (Final Summary Report. P10). This is hardly a ringing endorsement for a major proposal to improve audit competition and quality.

The CMA’s main objective is to increase revenue for non-big Four firms. It is akin to them mandating that shoppers must purchase half their groceries from an independent convenience store, rather than a supermarket. This proposal would by definition lead to the non-big four firms getting more audits, but is by way of a large subsidy to them rather than through increased competition. There is no guarantee – and no evidence identified – that this will improve the quality of non-big four audits, as opposed to swell their partners’ incomes.

This proposal would be a very substantial change to UK audits and incur considerable extra costs. An incumbent big Four firm is very unlikely to reduce its fees in order to fund a smaller competitor duplicating some of its work. Companies will have two sets of auditors reviewing the same accounts, slowing the process and consuming management time. It would take a long time for the non-big 4 to grow their headcount to cope with even 30% of the audit work of the FTSE 350. The CMA interestingly has made no attempt to model out how much this work would be, how long it would take for the non-big 4 to be in a position to resource this, nor whether such pace of expansion required is feasible.

The CMA has failed to show any evidence that this proposal is likely to be either successful or proportionate. In the absence of this evidential basis, the most that should be proposed is a trial for certain companies or sectors to see if joint audits do have the benefits claimed. This should be followed by a very gradual roll-out if it deemed successful. This would also give more time for the non-big 4 to resource up.

  1. Do you agree with the CMA’s proposed exemptions to the joint audit proposals? How should the regulator decide whether a company should qualify for the proposed exemption for complex companies?

Whilst I believe that the joint audit proposal is a costly and disproportionate measure, I do not see the argument to exempt complex companies. This measure would be most cost/benefit effective if applied precisely to the largest companies and largest audits, as they would transfer most revenue to non-big 4 companies per audit affected. The more complex the audit, the more the learning should be transferred to smaller firms.

  1. Do you agree that challenger firms currently have capacity to provide joint audit services to the FTSE350? If a staged approach were needed, how should the regulator make it work most effectively? If not immediately, how quickly could challenger firms build sufficient capacity for joint audit to be practised across the whole of the FTSE350?

Obviously non-big 4 firms would need both to recruit new staff and to improve the overall quality of the staff that they currently have. Inevitably this would require large scale recruitment by them from big four firms. It might well mean that non-big four firms would also have to resign from smaller audits in order to resource the new audits gained. The main results are likely to be inflation in pay for auditors and partners, with a modest growth in non-big 4 headcount. Audit quality is likely to suffer as big four firms lose staff and non-big 4 firms struggle to upscale. Accordingly, the Government would be taking a major risk in mandating a large scale roll out of this proposal.

As suggested above, a pilot scheme involving a relatively small set of large companies would be the optimum next step to see if the remedy works without causing widespread disruption.

  1. Do you agree with the CMA’s recommendation that the liability regime would not need to be amended if the joint audit proposal were implemented?

If both firms were jointly and severally liable, they would need to review each others’ work. It seems unlikely that they could place reliance on the other’s review. This would reinforce the duplication of effort and increased costs of this proposal.

  1. Do you have any suggestions for how a joint audit could be carried out most efficiently?

A joint audit is inherently inefficient, particularly when its main purpose is to give more work to smaller players in the market.

  1. The academic literature cited in the CMA’s report suggests the joint audit proposal would lead to an increased cost of 25-50%. Do you agree with this estimate?

This sounds plausible.

  1. Do you agree with the CMA’s assessment of the alternatives to joint audit, including shared audit?

No comment.

  1. How strongly will the CMA’s proposals improve competition in the wider audit market, and are there any additional measures needed to ensure that those impacts are maximised?

The CMA’s proposals will cause significant dislocation in the audit industry as non-big 4 firms try to grow to meet the increased number of audits required, poaching staff from the big 4. Overall audit quality is likely to therefore decrease, not helped by the inefficiency of having two auditors.

  1. Do you agree with the CMA’s proposals for peer review? How should the regulator select which companies to review?

The CMA argues that there should be a non-big 4 peer review for audits that are too complex for a non-big 4 firm to jointly auditor. This seems illogical, especially as the inexperienced non-big 4 firm will have no liability for the outcome. How different is this from a regulator’s Audit Quality Review (AQR)? What value would the peer review have? The peer reviews would report only to the regulator, but if they are not shared with either the auditor or the Audit Committee, how can the regulator get a balanced view of the value of said peer review?

  1. Are any further measures needed to ensure that the statutory audit market remains open to wider competition in the long term?

It is likely that forcing a split between audit and other services would be the most effective and low risk measure to improve competition. This would enable companies to have a fuller choice between the big 4, reducing the times that one or more is ruled out through a conflict of interests.

  1. What factors do you think the regulator should take into account when considering action in the case of a distressed statutory audit practice?

As the CMA recommends, the regulator should take a close interest in the viability of the big 4 and act early in the unlikely event that one appears to be failing.

  1. What powers of intervention do you think the regulator should have in those circumstances, and what should be their duties in exercising them?

No comment.

  1. Do you agree with the CMA’s analysis of the impacts on audit quality that arise from the tensions it identifies between audit and non-audit services?

I have not seen any evidence that audit quality is affected by ‘tension’ between audit and non-audit services. There are in fact benefits from the cross-fertilisation between audit and non-audit in sharing knowledge and career development. However, the overwhelming argument is to split them organisationally to increase effective choice for audit clients.

  1. What are your views on the manner and design of the operational split recommended by the CMA? What are your views on the overall market impact of such measures?

The proposals for an operational split seem sensible.

  1. Are there alternative or additional measures which would meet these concerns more effectively or produce a better market outcome?

No comment.

  1. Do you agree with the CMA’s proposal to keep a full structural separation in reserve as a future measure?


  1. What implementation considerations should Government take into account when considering the operational split recommendations? Please provide reasoning and evidence where possible.

No comment.

  1. Do you agree with the CMA’s other possible measures? How would these suggestions interact with the main recommendations? How would these additional proposals impact on the market?

Limiting notice periods and non-compete clauses for big 4 firms seems sensible. The other proposals appear somewhat peripheral. Moving audits to a fixed term of seven years would be unnecessarily intrusive, but there could be a requirement for a tender every seven years. This however should not be expected to have an impact on big 4 market share.

  1. Do you agree with the CMA’s suggestions regarding renumeration deferral and clawback?

Having the opportunity to clawback auditor remuneration for serious failings discovered later seems sensible and in line with modern corporate governance.

  1. How would a deferral and clawback mechanism work under a Limited Liability Partnership structure?

No comment.

  1. Do you agree that liberalising the ownership rules for audit firms would reduce barriers for challengers and entrants to the market?

It is difficult to be sure how this would work in practice, but it would be worth trialling for a few smaller firms to see how it works.

  1. Do you agree with the CMA’s suggestions regarding technology licensing?

It might work, but you might find a low take up by smaller firms.

  1. Do you agree with the CMA’s suggestions to provide additional information for shareholders? Do you have any observations on the impact of the Public Company Accounting Oversight Board’s database on the US audit market?

This seems harmless, but I’m not sure that there will be significant benefit.

  1. Do you agree with the CMA’s suggestions regarding notice periods and non- compete clauses? Do you agree that the regulator should consider whether Big Four firms should be required to limit notice periods to 6 months?


  1. Do you agree with the CMA’s suggestions regarding tendering and rotation periods?

Moving audits to a fixed term of seven years would be disproportionate, but the requirement for a tender could be set at seven years. This however should not be expected to have an impact on big 4 market share.

  1. Do you have other proposals for measures to increase competition and choice in the audit market that the CMA has not considered? Please specify whether these would be alternatives or additional to some or all of the CMA’s proposals, and whether these could be taken forward prior to primary legislation.

The Big 4 could be required to initiate a certain level of secondments of staff into non-big 4 players, in order to boost the latter’s capabilities.

  1. What actions could audit firms take on a voluntary basis to address some or all of the CMA’s concerns?

They could initiate an operational split between audit and non-audit services. They could also have a code of conduct to facilitate movement of staff into smaller players.

  1. Is there anything else the Government should consider in deciding how to take forward the CMA’s findings and recommendations?

The Government has a major role in lobbying for international action to increase competition and quality, as these proposals cannot work if implemented solely in the UK.



Simon Laffin                                                                                                28 August 2019

The Baked Bean Audit

Heinz baked beansWhat if the government insisted that every time you bought a tin of Heinz baked beans, you had to buy at least half a tin of Crosse & Blackwell ones too? You would have to explain to the grocery regulator why you chose Heinz, and if it thought that your choice was the wrong one it would mandate you to buy differently, publicly shame you and even take control of your grocery shopping as a punishment. You might not feel so great about it, but there’s no doubt that sales would rise for Crosse & Blackwell, who could then choose to invest the extra cash in improving its product, reducing its costs, or simply pay higher dividends.

The Competition and Markets Authority (CMA) is recommending this degree of intervention and forced joint-buying for the audit industry. The CMA report on the audit industry has many shortcomings; a lack of evidence, poor use of data, and a sharper ear to preferred interest groups. It clearly placed great weight on the views of politicians and investor corporate governance lobbies, but little weight on the views of companies and particularly not to chairs of audit committees;

“There are widespread public concerns about audit quality. While some Audit Committee Chairs (ACCs) and companies questioned whether there was a systemic and significant quality problem, the views of investors – the ultimate customers of statutory audits – were more supportive of our analysis that there is a persistent problem of variable or poor audit quality.”

The CMA suggested – without any evidence – that audit chairs were anyway likely to favour the Big Four if they had previously worked for them;

“The presence of ex-Big Four employees on Audit Committees is perhaps unsurprising given that the Big Four do employ a disproportionate share of financial professionals…However, it raises questions about whether Audit Committee members’ greater familiarity with the Big Four might lead them to favour Big Four firms when assessing audit tenders.” 1

Few would question that the audit market is too supply-side concentrated in only four companies. But the CMA is suggesting that the problem is demand-side driven. The purchasers of audit are making suboptimal choices, perhaps because audit chairs are just appointing their alma maters. The CMA also got itself into quite a spin trying to understand why ‘cultural fit’ was a helpful criterion for the selection of someone you are going to be working closely with for the next seven years, so it concluded that part of the problem is that audit committees are just looking for a friendly or compliant audit partner.

The CMA couldn’t quite persuade enough people that the choice of auditor should be taken completely out of the hands of the audit committee, but wants the regulator to; mandate minimum standards for the appointment and oversight of auditors; monitor compliance by audit committees; and issue reprimands to ‘non-performing’ committees. The CMA is silent on what those standards are, how the regulator will monitor them and how it can be sure that a regulator’s view will be superior to experienced directors working with the business and elected by shareholders.

The dual buying/joint audit remedy will increase cost and complexity for companies, but will also force revenue and market share towards smaller audit firms. This will, by definition, reduce market concentration. It may prove successful in increasing long-term audit competition if those non-big 4 firms seize the opportunity, or it may just be a long-term subsidy to possibly lower quality players, depending on how good the non-big 4 really are. In any case, the CMA has launched the project in the certain knowledge that it won’t be around to take responsibility by the time we know the ultimate outcome.

What worries me is the dismissive attitude that the CMA, regulators and politicians have for non-executives and the audit committee in particular. Independent non-executives are the key to our modern corporate governance, and yet the CMA wants audit committees to be supervised to an extraordinary degree. Auditor choice is to be mandated with joint audits and the process is to be reviewed by a regulator, who can ultimately take over the appointment decision. What would this say about the quality and integrity of our non-executives?

Even more concerningly, what does it say about the state of our regulators? Following the recent accounting scandals, regulators have lost faith in our basic corporate governance, whilst becoming more confident of their overriding wisdom. Most audit committees feel that the accounting scandals have demonstrated that the quality of regulation of audit firms is poor and needs to be drastically improved. But here we have regulators concluding that the answer is in fact more and wider regulation extended to audit committees.

Audit committees do need to face up to questioning, but it needs to be thoughtful. Do we expect audit committees to find fraud and accounting irregularities, if neither management nor auditors spot them? Do we expect boards to provide complete assurance that no company will ever go bust? How do we help boards to identify risks in their companies that might be signs of poor accounting practice or future financial instability? To help answer those questions, government needs to work with boards to understand better the issues, not just extend regulation and threats;

  • Does the audit industry need more or just better regulation?
  • Do we hold boards primarily accountable for running companies, or do we need to regulate them more?
  • Do we trust non-executives to provide sufficient independent challenge on boards, or do we side-line them by regulating more?
  • How do we help boards to identify and manage financial and accounting risks?

Otherwise we are back to the government deciding it knows best which baked bean is right for us.



1 This is a proposition that of course the CMA could have tested, but choose not to.



The audit punch-bag: Where is the voice of industry?

Punchbag auditStorm clouds are gathering over the audit market. Government, politicians, media and regulators are all queueing up to condemn companies and auditors over the few, but well-publicised, failures of certain companies. Lack of knowledge about the audit process is no bar to these opinion-formers. Meanwhile industry bodies are supine in defending business and signally failing to provide the missing knowledge as to what actually happens and what went wrong.

Having attended some 200 Audit committee meetings across 10 companies of all sizes and ownerships over the last 25 years, I have seen how audits actually work for companies and shareholders.

Is there a fundamental problem with the audit process?

There are hundreds of thousands of audits completed every year in the UK. There has been a handful of, admittedly large, company failures in recent years. There are even fewer cases where an auditor has been found culpable, remembering that it is not an auditor’s job to stop a company failing. There certainly have been issues in auditing, like any business, but it is not legitimate to conclude that the system is fundamentally flawed based on a few examples.

Has greater regulation helped in the past?

In 1998, I along with many other Finance Directors pleaded with the then competition regulator, the Monopolies and Mergers Commission, not to allow the merger of Coopers & Lybrand with Price Waterhouse. This, coming soon after the demise of Arthur Anderson, would mean that we would be left with only four global auditing firms. Industry was ignored, as the regulator knew better and convinced itself that competition would be maintained. Move forward 20 years, and the current regulator, the Competition and Markets Authority, is without a single blush of shame, looking at whether the Big Four are too concentrated. Industry told them 20 years ago that this was a bad thing. What chance that the regulator will listen to industry this time?

The European Union decided in 2014 that the answer would be compulsory tenders and controls on non-audit work. This hasn’t increased competition between auditors and especially non-Big Four, who haven’t won more work. It has created an industry in pitching for new audits, which itself disadvantages the smaller players who cannot afford such expense and who are increasingly not bothering to pitch for larger company work. Moreover, the banning of a company’s auditors from doing non-audit work has actually reduced choice where other Big Four firms are already providing tax, advisory or internal audit services. The choice can end up between two firms, one of whom might then be ruled ineligible as a long-standing incumbent.

In the UK, audit quality is monitored by the Audit Quality Review team, part of the Financial Reporting Council. It reviews about 25 audits for each of the Big Four and a handful each for another four firms. The reviews are effectively an audit on the audit. Although the AQR says that it contacts each Audit Committee Chair at the start and sometimes at the end of each review, there is no evidence in the reports that any weight is attached to their views. For example, the typical Audit Committee concerns; responsiveness, clarity on technical issues and speed are not mentioned in these reports. It is clear that the regulator feels it knows best what makes a good audit.

In short, the evidence is that greater regulation and intervention have proved at best ineffective, largely counter-productive and have actually reduced competition in the audit market.

Is new regulation going to help?

The Government has asked the Kingman inquiry and the CMA to look at aspects of the audit process. There are two key themes; increasing competition in the audit market and looking at a regulator taking over the responsibility for appointing a company’s auditors.

Increasing competition in the audit market

Commentators often wonder why so many companies, especially large ones, principally use the Big Four. The answer is simple. Multinational companies need to be sure that they will get a high-quality audit in all their countries, and the Big Four have the best international networks. Coordinating different auditors in different countries with different technical outlooks and rules is an unwanted significant additional complexity for companies.

There are high quality people in all audit firms, but, from my experience, there is significantly less quality in depth in the non-Big 4. They don’t have the resources, attractiveness and career development that the largest players do. If the objective is higher quality audits, forcing companies to employ less well-suited auditors is a strange response.

Breaking up the Big Four would be very problematic. These are international alliances of companies, so breaking up the UK firms wouldn’t solve the issue the international issue. It is very difficult to imagine that a coordinated multilateral effort could successfully break up the alliances across the world. The Government could encourage or subsidise the non-Big Four to merge, invest, grow their expertise and better develop international partnerships, but this feels pretty tricky. The most plausible change would be to force UK firms to divest all their non-audit work. The auditors worry that this would make audit firms less attractive as employers, and that this would damage audit quality. They may well be right, but industries also have a habit of accommodating such change, not least by increasing salaries.

A regulator appointing auditors

Some believe that companies select auditors who are more malleable to management. However, I can find no suggestion that some auditors are too lenient in any of the AQR reviews of audits, nor indeed any other evidence of this anywhere else. My experience from seven tenders that I have participated in, is that auditors are chosen largely on how sharp, commercially-aware and technically-competent the lead partner and top team are. Never has an auditor even implied that they would allow management more leeway than others. Moreover, if this were the case, then our whole governance structure with independent non-executives and audit committees would be failing. The answer then would be in governance change, rather in imposing audit appointments.

On what basis would a regulator appoint an auditor to an individual company? Would they use sector expertise? This would inevitably lead to a greater concentration of audits as it would be self-reinforcing. Would it be a cab-rank principle like barristers? But this couldn’t cope with companies needing sector-expertise or international coverage. How would allocating audits on a ‘buggins’ turn basis contribute to effective competition between auditors? If a company were allocated a poor performing audit partner, what recourse could it have when the audit is imposed on them? And how would this enhance competition?

An audit does much more than simply agree a profit number. A good audit works closely with management in order to get under the skin of a business and use that knowledge to make judgements, challenge assumptions, identify risks and suggest improvements in processes. The Audit Committee, in consultation with management, is in a good position to assess an auditor’s success in achieving this. How would a regulator be better placed to make this call for an individual audit, along with thousands of other appointments that it would have to make?

There is a problem, but how do we get to a solution?

There are issues with the quality of some audits, but there is no evidence that this is widespread. In fact, the continued repetition of Carillion and BHS as evidence actually suggests that there are relatively few known examples. Clearly there were issues to investigate at Carillion, BHS, Patisserie Valerie, and Conviviality, but no-one is really trying to understand how the audit process contributed to those failures. The media, government, Select Committees and regulators have focussed on allocating blame to individuals. This is not the same as understanding what happened. In fact, searching for blame is pretty much guaranteed to block thoughtful impartial analysis.

It does make sense not to allow any company to become too important to an audit firm. It may well be helpful to separate out completely non-audit work from all audit firms. But making auditors more nervous and cautious about signing off a company’s going concern statement won’t save companies from going bust. In fact, it is likely to increase it, as companies that could perhaps have been saved, have to through in the towel after being unable to get their accounts signed off as a going concern.

The current pressure to increase audit regulation is likely, on past experience, to be counter-productive. It may buy some good headlines for a beleaguered government, but responsible regulation has to be built on evidence, clear thinking and understanding of all the consequences (whether intended or not). It also requires the humility that would come from accepting the failures of past measures and decisions.

The likelihood is that we will end up with more regulation proposed by the ‘great and the good’, few of whom have actual experience of company audits, based on little evidence, but genuflecting to politicians with little or no understanding of business.

And where is the voice of business? The trade bodies remain craven to the government and fearful of a political backlash. The accountancy bodies, dominated by auditors, keep their heads down. It is no wonder that companies are likely to end up being the punch bag for yet more political games.


Motherhood & apple pie – the latest corporate governance regulations for private companies

Wates cover

The FRC has set out new proposals for more corporate governance regulation (the Wates Report) for large private companies.

This is my response to the consultation.





High quality regulation should focus on outcomes and provide evidence to support new rules and principles. Both the government and the FRC seem to be impervious to either. The Wates proposals identify neither outcomes nor evidence. They require private companies to disclose more about governance, but don’t identify who will use this information nor what they will do with it.

The FRC has missed another opportunity to research and think deeply about why companies get into difficulties and how it can reduce the likelihood of this happening. Clear corporate governance is probably a ‘good’ thing for all companies, but there is little evidence that it actually leads to better outcomes. The corporate governance principles proposed for private companies are well-meaning and are hard to disagree with, but, as currently written, are not specific enough to be other than a gentle nudge to companies, and more likely a cause of more boiler-plate wording in annual reports. A few specific questions for companies to answer would give clearer disclosure. The Principles need also to be applied to the actual governance of companies, rather than their legal structures.


  1. What is the objective?

It is not clear what the objective is of this exercise. Paragraph 2 talks about a loss of public trust in big business. Paragraph 3 refers to the ‘privileges of limited liability status’ and lower reporting and accountability requirements than listed companies, highlighting public interest in whether companies ‘operate in a sustainable and responsible manner’. The Consultation Questions explain that ‘The Principles and the guidance are designed to improve corporate governance practice…’ Presumably, the assumption is that ‘good’ corporate governance will build public trust. Sadly, the evidence from the listed arena is that this is not true. Carillion, for example, complied very closely with the Corporate Governance Code.

The foreword explains that the Principles are intended to help companies comply with a new legislative requirement on governance. The FRC is simply responding to a government edict. Without a clear objective, it is not easy to test whether the principles meet their aim, other than to turn a vague statutory requirement into something that companies can comply with.

There is no estimate of how many companies will be caught by those provisions, nor how much it will cost to comply, and least of all any idea of what the benefit will be.


  1. Are the Principles sufficiently specific to achieve the objective?

The Principles themselves are a set of very high-level statements, with which it is difficult to disagree. It’s unclear how a company can realistically claim not to comply with them. Turn each of the sentences into the negative and see who would claim that this applies to them;

  1. The board does not promote the purposes of the company.
  2. The board does not have an effective chair. The size of the board is not guided by scale & complexity of the company.
  3. The board does not have a clear understanding of its accountability and terms of reference.
  4. The board does not promote the long-term success of the company.
  5. The board does not promote executive remuneration aligned to sustainable long-term success of the company.
  6. The board does not have meaningful engagement with material stakeholders.

 What status does the more specific “guidance for consideration” have? It appears to be largely discursive, so would not need to form part of a company’s assessment as to whether it complies with the principles.  It seems that the FRC has pulled back from being too prescriptive, but in doing so has ended up with principles that, whilst undoubtedly worthy, are largely motherhood and apple pie.


  1. Do the Principles and guidance take account of the various ownership structures of private companies?

The Companies (Miscellaneous Reporting) Regulations 2018 confuses legal structure and governance. Legislators appear to believe that every company has a board that manages that individual business on a day to day basis. This may be true of some independent companies, but it doesn’t take account of group structures. A number of subsidiary companies may together constitute a group, which is managed by a board at that level. The size tests apply at company, rather than consolidated level. Yet many holding companies do not directly employ significant numbers of employees, not have large revenue themselves. The Regulations will therefore miss some large groups that are presumably the principal intended target of this legislation. It may also cause subsidiaries to invent bogus governance to comply or have to explain why they don’t comply.

The FRC should make it clear that the Principles apply to the board that actually constitutes the main governance for each entity, irrespective of the legal structure, provided that this is explained and disclosed in each company annual report. A subsidiary could simply report that its main governance structure sits with a parent entity and that details will be found in that company’s report and accounts.

The FRC should also clarify that the tests for the need to comply (employee numbers, turnover and net assets) should apply to the consolidated accounts, rather than the parent company alone.


  1. What more could be done?

To make these proposals have any meaning, the FRC should consider making adequate disclosure a key part of the Code. I appreciate that this is implied, but it should be made explicit and specific. The proposals in the guidance could be backed by a small set of simple disclosure requirements;


  1. Describe the values by which the Board and the Company operate.
  2. How does the Company promote behaviour in line with its values whilst discouraging misconduct and unethical practices?

Board composition

  1. How are board members appointed and what relationship does each have with the shareholders or parent group?
  2. What does each board member bring to the board?

Board responsibilities

  1. Describe how the board governs the company, including through use of subcommittees.
  2. How does the board ensure that the company systems and controls work effectively?

Opportunity and risk

  1. How does the board evaluate and manage risk?
  2. What is the board’s appetite for risk?


  1. How does the board set remuneration for directors and senior executives?


This list of disclosure questions should be kept short and high level. The risk is that everyone will want to add a question, but the longer the list the greater likelihood of a box ticking mentality and boiler plate answers. This should be the minimum number of questions that a company would need to answer to give adequate disclosure on the Principles.




Carillion – What can we learn?

Carillion vans

The collapse of Carillion was a tragedy, especially for its 45,000 employees and 25,000 pensioners. In an earlier article, I looked at its last Annual Report to see if there had been clues that could have tipped readers off to the impending catastrophe. Since then, we have had Select Committee hearings and their January 2018 turnaround Business Plan has been released. This now gives quite a bit more colour to understand better what happened and what lessons can be learned to improve corporate reporting.

This was a business with a yo-yo strategy and difficult execution

In 2009, Carillion had a strategy review, which concluded that it should halve the size of its UK construction business and double the size of its Middle East and Canada businesses. By 2013 however, Carillion changed its strategy again, and stopped bidding for work in Canada (other than PFI) and would no longer bid for traditional construction work in the Middle East (unless export finance was agreed). However, it seems that the die was cast and long-term contracts already signed in Canada and the Middle East proved fatal in 2018.

It wasn’t just a faulty strategy that was the problem. Its rescue Business Plan1 in Jan 2018, concluded; “The Group had become too complex with an overly short-term focus, weak operational risk management and too many distractions outside of our ‘core’”.

When things went wrong, they appear to have gone wrong quickly

Carillion signed off its Annual report in March 2017. At that time, cash was ‘…broadly in line with the budgeted position for the first couple of months of the year…” (recalled Keith Cochrane2, then a non-executive director, later Interim CEO from July 2017). At the AGM on 3 May 2017, Richard Howson, Cochrane’s predecessor as CEO, announced3 to the markets that; “trading conditions across the Group’s markets have remained largely unchanged since we announced our 2016 full-year results in March.”.

However, at ‘the beginning of May’2 the board learned that the internal reporting of contracts had been incorrect, with management accounts netting off receivables and payables, and therefore reducing the apparent cash risk. The board then commissioned the external auditors (KPMG) to conduct a review of the accounting. This concluded that the published accounts had correctly grossed up the amounts, but that the internal reporting was wrong. This, however, sufficiently unnerved the board that it then commissioned a second report from KPMG, initiated “around the end of May2, to examine the cash recoverability of its largest contracts.

This second KPMG review: “driven largely by a deterioration in cash flows on a number of major contracts, which occurred particularly as we went through Q2” (according to Keith Cochrane2) concluded that there needed to be an £845m provision made.

The provision was announced4 to the markets on 10 July 2017. The auditors5 concluded this some four months after signing off the original accounts.

The business had major risks that weren’t clear from their Annual Report

Zafar Khan, Carillion’s short-lived CFO from January to September 2017, told the Select Committee2;

If you look at the 2016 annual report, and if you look at the key risks identified within that, my view is that the setbacks and issues that we experienced in 2017 were largely related to the risks that we had set out in the 2016 annual report. What was not anticipated at the time was the number of risks that crystallised in the end, and also the quantum of the impact that we had to deal with.”

However, it seems that 6 to 8 long term contracts came to a scheduled end in 2017, but this had not been flagged in the 2016 annual report6. Khan explained2;

“Another factor that I do not think has been given enough attention is that, going into 2017, we had a number of large-ish contracts in our UK construction business that were coming towards completion…We had a good pipeline of opportunities…”

The top risks disclosed in the annual report were;

  1. Work winning
  2. Contract management
  3. Pension liability
  4. Brexit

But the risks that seem to have brought the company down were in fact;

  1. Contract management
  2. Working capital management
  3. Excessive cash outflow breaching debt facilities

All of these are of course linked, and stem from the fundamental problem of poor contract management. Carillion’s stated6 mitigations of the contract management risk were;

Adoption of rigorous policies and processes for mobilisation, monitoring and management of contract performance. Regular performance reviews…Independent peer reviews of contracts…and contract health checks undertaken by internal audit

These mitigations don’t sit easily with admissions now being made by directors.

Long term construction contracts are difficult to manage

Long-term contracts have many complexities and risks, not least as changes are made over several years with cash flow trailing. Keith Cochrane explained2: “If you take the Qatar job…this is a job that had doubled in size. It had 2,500 design variations to it, and essentially we were not paid for 18 months prior to the business failing.”

Richard Howson gave an example2 of Crossrail. The initial contract was for £30m, but by the end of 2014 costs were £90-£100m, with Carillion having been paid only £76m. The final revenue was eventually agreed at £100m and the rest of cash received at the end of the contract.

Zafar Khan put it bluntly2: “Carillion has some quite large contracts…and cash flows on those can change over a short period of time.”

Carillion had to finish long-term construction contracts as it got full payment only at the end, and on many contracts, if it walked away the client could appoint another contractor thereby also losing performance bonds. Carillion didn’t have the right to suspend work on the Qatar contract. The Qatari client, in dispute with Carillion, appointed another contractor in June 2017 to complete the works at Carillion’s cost, also jeopardising its £54m performance bond.

But Carillion contributed to the problems

Philip Green, the Chairman, admitted2; “There were some examples where negotiations around the contract itself were done too quickly, and the lesson learned was that if we had spent longer on the actual negotiations, some of the risks may well have been able to be mitigated.”

Carillion found it difficult to collect cash due on some of its contracts

Keith Cochrane said2; “…as it (the group) sought to exit from certain key markets and start to refocus itself on its core, that required us to take a different perspective on our ability to collect outstanding receivables in those markets.”

But then he suggested2 operational issues:

‘…there was a lot of focus on reported debt across the business. Was there the same focus on collecting cash, day in, day out…?”

There were concerns about the accounting

The new CFO, Emma Mercer, appointed in September 2017, told the Select Committee2 that she saw: “slightly more aggressive trading of the contracts” than in her previous experience.

“As part of Keith’s strategic review, we had changed the way we were looking at some of the services contracts, and that resulted in an increased position at the end of September, in terms of an additional £200m of provision.” Confusingly, the interim results7 published that month, described this provision as having “minimal impact on cash

Emma Mercer explained2 about contract accounting;

“…you have to exercise judgement over all sorts of things: when the contract is going to get finished; how much we are going to receive; if we are claiming against anybody; what entitlement we may have…both the number of contracts we were taking judgement on and the size of those judgements had increased….when we saw the deterioration…because we were already at a more aggressive position, it was very difficult to withstand those deteriorations on those projects.”

The numbers were huge

The May 2017 contract review led to an £845m provision being made. Of this, £375m related to the UK and £400m related to Canada and Middle East, particularly in Oman and Qatar. The Qatar contract alone owed £200m.

In total Carillion wrote £1.1bn off against its contracts, including £215m related to service contracts. In 2017, net debt increased by £850m, £1.1bn higher than expected. It used £834m working capital (of which £371m related to 9 construction contracts). Average net debt was £886m. It then projected1 to use another £234m working capital in 2018 and 2019, including £325m related to nine construction contracts. On top of this, it planned for another £131m cash restructuring cash costs in 2017-19.

Carillion ran out of cash and debt facilities

Carillion tended to focus on ‘cash conversion’, ie underlying cash inflow from operations divided by underlying cash from operations. This seems a strangely static snapshot view for a business based around long-term contracts with complex cash flows. The ‘cash conversion’ over the three years to 2016 was 119%, 104% and 117%, appearing to show a healthy cash generation. But year-end net debt was actually flat over that period at £219m. Underlying cash from operations of course excludes all the bad news; pension top-ups, non-recurring items, interest, tax and capital expenditure.

Reducing net debt was stated as being a key objective in the 2016 annual report, but the amount of net debt wasn’t then given as one of its 14 key performance indicators. Furthermore, focusing on year-end net debt was of little value when you realise that average net debt was more than double this.

In the 2016 annual report, debt facilities were stated as £1.4bn. With only £85m to mature in 2017 and additional funding secured after the start of the year, facilities should have been still around £1.4bn when Carillion went into compulsory liquidation. On 30 June 2017, Carillion had net debt of £571m. We now know1 that average net debt during 2017 was £886m. In December 2017, it announced8 that it had got agreement to defer covenant testing (probably net debt to Ebitda) until April 2018, suggesting that it was at least close to breaching them. Net debt actually rose by £791m in 2017, driven by £834m of working capital outflow.

Using nearly £800m of cash on top of a year start net debt of £200m, would imply a year-end net borrowing of about £1bn, against £1.4bn of facilities. If you add the cash outflow to the 2016 average net debt of £587m, this suggests a pro-forma average debt of £1.4bn. It therefore is easy to imagine that their peak debt outran their facilities of £1.4bn. The fact that the average net debt at £886m was so much lower than this implies that there was a serious ‘run’ on working capital towards the end of the year.

So what lessons are there for reporting from the collapse of Carillion?

Companies should be more balanced in writing about themselves

The Strategic Report must, by law, contain a fair, balanced and comprehensive analysis of the company’s development, performance and financial position.

I suspect that there is a growing practice of annual reports being written by professional writers, thereby becoming increasingly an arm of the PR/communication industry. Carillion’s text in its annual report boasts about pretty much every aspect of their business. This is little different to most annual reports. But in Carillion’s case, ex-directors are now making statements that do not sit comfortably with what the board wrote so recently in the annual report.

An annual report is never going to be an impartial review. What organisations, including regulators and politicians, ever write impartial reviews of their own performance? This is difficult to legislate for, but it may be appropriate to hold directors to account if something goes seriously wrong that is not discussed as a risk in the annual report.

Discussion of risks needs to be integrated into the whole report

The risk section in the annual report is of little use. Carillion is typical in that it lists ‘top’ risks and then gives mere platitudes about mitigation. The mitigation section gives no feel of the real risk, or the ability to avoid or reduce the impact of the risk occurrence. As is standard practice, its declared risks are listed together in a few tedious pages. There is insufficient information for the reader to become better informed, even if bothered to read the whole thing.

The key to risk management is to integrate it into decision-making, not ghettoised as a separate activity or schedule. Annual reports would be much more informative if they tackled each risk together with the relevant business activity or segment. For example, the section on construction contracts could have had a discussion of their inherent risks. At the very least, every risk should have a discussion of how the company reduces the chance of the risk happening (“avoidance”), how it will know when things are going wrong (“detection”); and how it would react if the risk did crystallise (“mitigation”)9. Risks also require numeric quantification as well as words.

Cash needs to be taken even more seriously

Carillion’s use of cash conversion (underlying operating cash flow/underlying operating profit) was not fit for purpose. It excluded too many cash items and did not reflect the complex cash flows of its long-term contracts. It’s impossible to define a single cash metric for all businesses, but companies should think hard about how to communicate cash effects. Carillion could have shown segmental cash flow and return on capital. This might have provided some warning about the cash flow characteristics that eventually proved fatal.

There is far too much emphasis on year-end cash. Businesses fail when their peak cash usage breaks through facilities. Companies should be more explicit about average and peak debt, and explain why if this differs significantly from year-end levels.

The viability statement was introduced to give some comfort on future cash flows and debt over a period longer than a year. Regulators have tended to fixate on the length of the look forward, but actually this misses the point. As a result, half of Carillion’s viability statement6 is justifying its looking forward only three years. But this business didn’t start to deteriorate years later. It apparently started the month after annual report stated6;

“On the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.”

It’s clear that without some quantification of the assumptions made and scenarios tested, the viability statement assurance is of very limited value.


The Carillion annual report is a very typical one, glossy smooth talk and adhering to the rules, regulations and corporate governance requirements. However, it is also an example of the inadequacies of such reports. It fails to convey adequately the risks that the business was running, its volatile working capital and long-term working cash flows.

Some changes that would help in reporting are;

  1. Companies need to more balanced about their company, talking about downsides as well as the wonders. Boards should take back writing and editorial rights from copywriters.
  2. Strategy and segmental performance sections should discuss risks, cash flow, and capital employed. The current risk section should be broken up and risks tackled in the relevant section of the body of the report.
  3. Discussion of the risk appetite should be integrated into the strategy section.
  4. Discussions of risks need to be more detailed, covering at least avoidance, detection and mitigation, with numeric quantification.
  5. The going concern and viability reviews should require more detail and quantification of how they have been stress tested.

This isn’t just about the annual report. This would also help to focus board discussions and potentially alert directors to looming issues. Risk management has to be a major part of every management and board discussion, not just a periodic review by a committee and internal audit.


1 Carillion Business Plan January 2018

2 Business, Energy and Industrial Strategy and Work and Pensions Committees; Oral evidence: Carillion, HC 769, Tuesday 6 February 2017

3 RNS issued 3 May 2017

4 Trading Statement 10 July 2017

5 The FRC has opened an investigation in relation to KPMG’s audit of the financial statements of Carillion plc. The investigation will cover the years ended 31 December 2014, 2015 and 2016, and additional audit work carried out during 2017.

6 Carillion Annual Report 2016, published March 2017

7 Carillion Interim Results 29 September 2017

8 Carillion RNS statement 22 December 2017

9 This methodology for reviewing risks is discussed in my blog

Carillion – a salutary reminder on due diligence

Carillion Annual Report cover

Carillion has entered the pantheon of cursed companies following its recent failure. Politicians and the media have worked themselves in another fit of righteous indignation about greedy management and incompetent boards. The search is out for people to blame, shame and even prosecute. Regulators, sensing the flow of the political wind, are climbing on the bandwagon and looking for blood.

Non-executive directors are reasonably enough feeling nervous. They are at the centre of corporate crises such as this. Already some Carillion directors have had to resign from other roles and the non-execs will be contemplating an enormous black mark on their CV’s. Being a non-exec in this form of collapse can be terminal for any career.

Do your due diligence

One lesson for non-executives is to do careful due diligence before you contemplate joining a board. Another lesson is that non-executives need to be sceptical of what they are told around a board room table, applying due diligence principles to what they see and read.

Most candidates take the financial health of a company, especially a well-known or large one, for granted. This is a dangerous assumption. Two companies that I joined as a non-exec proved to have potentially fatal toxic derivatives. Carillion recruited two new non-execs onto its Audit Committee in the couple of months before going bust.

Read the Annual Report

Although full of guff and regulatory noise, the Annual Report generally should tip you off to issues. In my experience with the toxic derivatives, they were indeed listed in the Annual Reports, but were so surrounded by reassuring jargon that it took several interrogations of the CFOs to confirm their real nature. In fact, the words in the Annual Report are very unlikely to warn you. Despite the regulators attempts to ensure that reports are balanced and fair, they are still largely promotional documents.

I am not attempting here a technical analysis of the Carillion Annual Report. Nor do I wish to criticise the directors (there are many others only too keen to do that). My objective here is to use 20:20 hindsight to look at whether there were clues even in the 2016 Annual Report that could at least have raised questions in non-execs minds, and to offer these as lessons for other non-execs doing due diligence.

The words

Virtually all the text is confident and devoid of doubt, as is pretty standard for most annual reports. However, amongst all the good news, there was one clue: “In 2016, we made good progress in a number of our markets, while managing and mitigating the effects of more difficult trading conditions in others.” Given companies natural reluctance to air their problems, a reader should highlight any cautionary statement like this. The Board will have had a very good reason to include such a comment.

Overall however, you wouldn’t have got much balanced information from the words. Most of the clues lie in the numbers, particularly those that are not discussed in the text.


There had been two years of decline in ‘secured and profitable’ orders from £18.6bn to £16.0bn, which possibly was an early sign of slowing growth. Of this £12.2bn was support services. Given that support services annual revenue was £2.7bn, the ‘order book’ looks as if it is adding up all future contracted service revenues. This is therefore not as impressive as it looks. Furthermore, the reader should ask if this future revenue is actually all unconditional or subject to performance conditions.


Underlying operating margin had fallen for two successive years from 5.6% to 4.9%. This should have been of concern. However, given the revenue growth, the business recorded two years of underlying EPS growth from 33.7p to 35.3p. The question therefore is whether Carillion was buying less profitable business, just to keep its growth going.

Long term contracts can be inherently volatile. Costs are generally booked as incurred and revenue – and hence profit – are, broadly speaking, booked on a pro rata staged basis. This is calculated using % contract costs incurred so far against forecast total contract costs times the full contract revenue. If individual contract costs run to plan, there is little problem, but if costs start to escalate, then there can be a big swing from pro-rata profit to whole contract loss. There isn’t much discussion of this in the Annual Report, other than noting the accounting policy and that the Audit Committee had reviewed the accounting and found it ‘reasonable’. There is no way of knowing whether the Committee deliberately used such a mild word to suggest that they were not very enthusiastic about the accounting or whether this was a synonym for ‘true and fair’. Either way, a reader might have queried it. For all the length of the new external auditor’s report, it simply lists all the work they did, without drawing a specific conclusion on this issue.

There was a big increase in non-operating costs from £5m to £40m, excluded from ‘underlying profit’. These were largely redundancy and closure costs. Costs excluded from underlying are always of interest.

Net debt and cash flow

On the one hand, the company seemed happy with its cash flow and debt;

“Cash flow from operations represented 117 per cent of profit from operations.”

“The Group continues to have substantial liquidity with some £1.5 billion of available funding…The vast majority of the Group’s £1.5 billion of funding matures in November 2020 and beyond.”

On the other hand, there is a clue that they are not as happy as they appear to be;

“We will also begin reducing average net borrowing by stepping up our ongoing cost reduction programmes and our focus on managing working capital.”

The year-end net debt ratio to EBITDAR rose from 0.6x to 0.8x. But average net debt was 2.7x bigger than the year-end debt, implying an average net debt to EBITDAR of 2.2x, a very different picture. There is no explanation in the annual report why year-end net debt is so much lower than the average. Maybe there was a consistent big seasonal swing, but this seems unlikely in this industry. In its absence, a sceptical reader might draw the conclusion that the year-end balance sheet was being managed aggressively.

There is evidence of working capital issues as the construction contracts receivables increased by 60% to £615m, perhaps indicative of cash flow problems with such contracts. Other receivables and prepayments also rose by 36% to £750m. Finally, Carillion was having a little trouble in getting paid, with trade receivables that were over 3 months old more than doubled from £25m to £55m. Carillion had managed its working capital by lengthening many payment terms to 120 days. As a result, its trade payables were rising and suppliers were being encouraged to use an Early Payment Facility, whereby they would borrow against their receivable from Carillion to keep their own business going despite such slow payments.

The group’s net debt was growing. Both year-end and average net debt rose by just under £50m, although £68m was due to foreign exchange offset by £34m from selling shares in PPP joint ventures. The report was a little dismissive of the foreign exchange loss, half of which was ascribed to a US dollar private placement debt. This latter was apparently fully hedged, but it is not clear where the corresponding hedging benefit appeared.

However, the group claimed to have ‘a strong funding position’. £1.4bn of funding was available at Dec 2016 (of which £0.7m was undrawn), plus additional funding then secured the following month, gave a total of £1.5bn. The only mention of any debt covenants in the report is in the going concern section, where the board confirms ‘comfort that funding covenants will continue to be met’. In retrospect, a reader might have wished for the details  of those covenants.

The Group therefore continues to have substantial funding…over the medium term’, with only £85m of facilities maturing in 2017. When Carillion went bust, with a reported only £29m in cash, you would have assumed that it had at least £1.4m in debt facilities. It looks as if failure to meet the undisclosed covenant conditions caused facilities to be withdrawn, triggering the eventual liquidation.


Net promoter score (a measure of customer satisfaction) fell dramatically from +36 to +22, which the company ascribed to ‘challenges of mobilising new contracts’, although there was no evidence that new contracts were growing in number. Anecdotal reports suggested that there was a growing unhappiness with customers and a few high-profile disputes had surfaced.

Segmental profitability

“…the wider outlook for volumes and margins across the (Middle East) region is expected to remain challenging…”

Middle East construction services revenue grew by 19% to £428m, but at a tiny net margin of 1.9%. The commentary recognises the low margin, but point to a further £15bn of contract opportunities, without discussing whether these would be at a higher margin. The segmental analysis reveals year-end net assets employed of £206m, which with an operating profit of £8m, suggest a return on capital of only 3.9%. This assumes of course that the year-end net assets are representative, yet we know that the group’s average net debt is 2.7x higher, so the real return on capital was likely to be lower. It wouldn’t have taken much of a cost overrun for this return to be wiped out. There is no discussion of segmental capital returns in the Annual Report.

Other construction services also grew fast by 21% but at a net margin of only 2.1%, down from 2.9% the previous year. A margin target margin is given here as 2.5% to 3.0%. The Company is able to claim that it satisfies this target by adding in joint ventures where the £9.0m profit share exceeds its £8.9m revenue share. There is nothing like a 100% net margin joint venture to improve reported performance. Mention is made of ‘managing risks in order to deliver our target margins and cash flows’, although there is no further discussion of cash flows. The segmental reporting reveals year-end net assets of £190m. With a profit of £32m, this suggests a decent return on capital of 17%, although this is probably flattered by year-end working capital being below the average.

Recent acquisitions were underperforming. There isn’t any reference to this in the commentary, but buried in the financial review is £15.6m of non-recurring credit. This would seem to be good news, but is in fact a reduction in consideration to be paid for two acquisitions whose EBITDA is ‘lower than the stretching targets agreed’. ‘Nevertheless, these businesses have performed well…’. The report does not define what it means by ‘well’.

The pension scheme

£47m cash pa was being put into the defined benefit pension scheme, whose IAS9 deficit had ballooned to £805m from £394m the previous year. The deficit payments look light, being based on a 15-year recovery period, as a rule of thumb is more like a 10-year period. This was a warning sign that cash payments would be likely to rise significantly at the next triennial valuation (due in 2017). The absurdity of pension accounting rules is that the P&L was actually being charged only £6m (the rest effectively goes through reserves). Unlike many companies that have closed their increasingly expensive defined benefit pension schemes, Carillion kept theirs open for employees when necessary ‘to meet the requirements of work winning’. A reader might ask whether the costs and risks of this were fully built into those contracts.

Goodwill & deferred tax

Carillion had a lot of goodwill on its balance sheet – £1.6bn compared to £0.1bn of fixed assets. The rules say that goodwill has to be justified on whether it can be backed by prospective profit flows. This is a potential double whammy. The reader should note that if performance falters, large potential write-offs in goodwill become necessary, exacerbating the financial pain.

A similar problem exists with deferred tax assets, which were £164m. These can only exist where you are forecasting sufficient forward profits to justify them. Poor performance can lead to these being run down quickly.

Corporate Governance

Carillion appears to have been exemplary in its corporate governance, as described in the annual report. The board fully complied with the governance code. Employee engagement rose from 68% to 73%; employee volunteering increased from 18% to 30%; and the gender balance improved, with 38% of employees being female. The board had an external review of its effectiveness and 29% of the board were female. The previous Remuneration Committee was approved by 80.6% of the votes.

Regulators might note this. If Carillion obeyed all the rules, then maybe the rules are not really the be all and end all to company performance after all. Perhaps Regulators could focus on understanding why companies fail, rather than grandstanding the latest governance flavour of the month.


The Annual Report boasts that; ‘Rigorous risk management processes that identify, manage and mitigate risk are fundamental to the success of our centralised operating model.

However, this rigorous process did not identify liquidity as one of the top ten Group risks (although the pension liability was regarded as high impact/high risk). The top risk was winning new work, but it didn’t mention the risk that new work might be loss-making or cash consuming.

The new requirement for a Viability Statement was intended to highlight precisely such looming cash crises as Carillion, but stakeholders were reassured;

“On the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.”

 In fact, there was insufficient information in the Annual Report to give a reader comfort on liquidity and viability. Perhaps the regulators need to study this again.



There are many cautionary lessons here for a non-exec in using an annual report as part of their due diligence on any company;

  1. Pay limited attention to the words, except where there is any hint of caution or bad news. Accept that boards will naturally enough always accentuate the positive in writing about their business, but apply scepticism yourself.
  2. Always question whether numbers are unconditional. Future revenue and pipeline numbers are unlikely to be guaranteed. Banking facilities can often be withdrawn.
  3. Watch out for specialised accounting, such as long-term contracts. Some rules say that profit must be booked before it becomes unconditional. Do not assume that the accounting rules are designed to protect the investor.
  4. Take a close look at non-underlying costs. They may well be genuinely one-off or technical, but they may still be important.
  5. Cash is king. Businesses don’t go bust because they make a loss, but because they run out of cash, sometimes even when profitable.
  6. To understand the usefulness of borrowing facilities requires you to know not just the amount and maturity but also any conditions under which facilities might be withdrawn. This includes covenants, but there may also be other conditions too.
  7. Study working capital seriously. It is the most likely source of cash problems in a profitable business. If the company is making strenuous efforts to manage working capital, it may be under strain.
  8. Year-end quoted cash numbers are of limited value. Focus on the average balances and try to find out the peak numbers too.
  9. If there is evidence of general or growing customer discontent, treat this as potentially serious.
  10. Segmental profitability matters, but you will probably need to look at the numbers rather than rely on the commentary. Try to understand revenue trend, net margins, net capital employed and cash flows by segment. Check that the business is growing the high margin/return segments.
  11. Underperforming acquisitions are an amber light. Businesses under pressure may seek to alleviate this by acquiring other companies.
  12. Defined benefit pension schemes are now commonly in deficit, not because company contributions have fallen, but because monetary policy has led to very low interest/discount rates. However, higher cash contributions will follow and these are not reflected in profit.
  13. Good corporate governance is very important, but more important is high quality, experienced directors doing a diligent job in the board room. Box ticking governance codes in reality provides little reassurance on company performance.
  14. Risks and mitigations disclosed in the annual report are generally fairly meaningless, and provide no real reassurance. As in Carillion’s case, it’s often the risks that are not mentioned that prove fatal.


Simon Laffin


NB. All quotes are from 2016 Carillion Annual Report