Revenue accounting

83. What would aggressive accounting look like for a company like Carillion? Much of Carillion's revenue came from construction contracts that are inherently difficult to account for. Accruals accounting dictates revenue should be recognised when it is earned, not when it is received. For construction projects spanning several years, this means companies must assess how far to completion their projects are. This is usually done by reference to the costs incurred to date as a percentage of the total forecast costs of the project.283 Applying that percentage to the initially agreed contract price produces the revenue recognised.284 This puts a great emphasis on total estimated costs of a project. As KPMG's audit report on Carillion's 2016 annual report notes, "changes to these estimates could give rise to material variances in the amount of revenue and margin recognised".285 A company wanting to indulge in aggressive accounting would make every effort to minimise the estimates of total final costs to ensure that margins on contracts are maintained and greater amounts of revenue are recognised up front.

84. Deloitte, Carillion's internal auditors, explained that the company had two processes to review margins reported by site teams:286

i) monthly Project Review Meetings (PRMs) at which a management contract appraisal could adjust the site team's position; and

ii) peer reviews to "provide challenge to the financial, operational and commercial performance of contracts".

85. In July and August 2017, Deloitte examined peer reviews conducted between January 2015 and July 2017 of the contracts which made up the £845 million provision. They found that management contract appraisals tended to report higher profit margins than peer reviews.287 In 14% of cases, the peer review recommended a higher margin. In 42% of cases, three times as many, management used higher margins than recommended by the peer reviews.288

86. Deloitte noted that the differences between the two assessments were far from trivial: in more than half the cases where the peer review recommended a lower margin, the difference exceeded £5 million.289 A November 2016 peer review of the Royal Liverpool University Hospital contract suggested a loss of 12.7%, compared with the contract appraisal margin of 4.9% profit.290 The result was that the annual accounts published in March 2017 recognised approximately £53 million in revenue in excess of what would have appeared had the peer review estimate been used.291 The July 2017 profit warning included a provision of £53 million against that contract.292

Box 3: Case study: the Royal Liverpool Hospital contract

A private finance initiative contract for the design and construction of the Royal Liverpool Hospital was agreed by The Hospital Company (Liverpool) Ltd and The Royal Broadgreen University Hospitals NHS Trust on 13 December 2013. On the same date, The Hospital Company (Liverpool) Ltd awarded Carillion Construction Ltd (CCL) a five year, £235 million contract for design and construction.293

CCL began construction work in February 2014, with phase 1 due to be completed by 31 March 2017. As early as May 2015, however, delays were reported due to asbestos, pushing back expected completion to 30 June 2017.294 Carillion's Major Project Status Report in October 2015 acknowledged this delay but estimated a final profit margin of 5.5%, 2% more than their initial bid estimate.295

In November 2016, two cracks were discovered in concrete beams at the hospital. Following a review commissioned by CCL, less significant cracks were discovered in six further beams. Richard Howson told us that Carillion deserved credit for their actions, because "we did not just cover it up. We properly rectified, even though it cost, and those beams would probably never fail in their cracked state".296 However, Charles McLeod, Director of the Hospital Company, told us that five of the eight defective beams could have failed under the load of a fully operational hospital. He said failure to remedy the defects "could have resulted in at best, unsafe working conditions and at worst, injury and loss of life".297

Richard Howson said that the costs associated with rectifying the cracked beams occurred in the second quarter of 2017 and added "over £20 million of cost to our completion".298That may tally with Carillion's public unravelling but it does not accord with Carillion's own review process. A November 2016 peer review of the contract concluded that additional costs meant it was making a loss of 12.7%. Senior management disagreed, despite having evidence of the cracked beams alongside continued issues with asbestos, and recorded an expected profit margin of 4.9%. That led to approximately £53 million in additional revenue being recognised in the 2016 accounts, the same amount that the company eventually made a provision for on that contract in July 2017.

Carillion's insolvency has significantly delayed completion of the hospital. The Hospital Company has entered negotiations with alternative contractors and is working to agree a revised timetable for completion.299

87. Andrew Dougal, Chair of Carillion's audit committee, said he was unaware of these variances and first heard of them when Michael Jones, the Deloitte Partner responsible for Carillion's internal audit, raised them with him in September 2017.300 Michael Jones confirmed this and said Andrew Dougal was "concerned that these differences did not appear to have been followed up by management".301 Andrew Dougal conceded that "in hindsight, it would have been helpful for the audit committee to have this information so it could have factored it into its challenge of management's judgements".302

88. Carillion also recognised considerable amounts of construction revenue that was "traded not certified". This was revenue that clients had not yet signed off, such as for claims and variations, and therefore it was inherently uncertain whether payment would be received. In December 2016, the company was recognising £294 million of traded not certified revenue, an increase of over £60 million since June 2014, and accounting for over 10% of total revenue from construction contracts.303 The amount of revenue that was traded not certified was never publicly disclosed in financial statements, but was included in papers reviewed quarterly by the audit committee.

89. Zafar Khan, who signed off the 2016 accounts, said he did "not agree that there was a concerted effort to adopt aggressive accounting as such" and that the numbers reported "were appropriate, based on the information that was available at that point in time".304 As part of a contract review that led to the July 2017 provision, management were asked by KMPG to consider whether the results indicated that the 2016 accounts had been misstated due to either fraud or error. The position the board chose to adopt publicly was that there was no misstatement and that the provisions all related to the sudden deterioration of positions on key contracts between March and June 2017.305

90. Carillion's problems were not, however, restricted to just a few contracts: September 2017 audit committee papers showed that at least 18 contracts suffered losses over the March-June period.306 Internal board minutes show the board were aware of concerns about aggressive accounting methods. A June 2017 lessons learned board meeting minute noted that "management need to be aware that high-level instructions such as that to 'hold the position' (i.e. maintain the traded margin) may, if crudely implemented, have unintended consequences".307 Those minutes show that Andrew Dougal identified a "hold back of bad news", with regard to one major contract.308 He subsequently told us the contract in question was the Royal Liverpool Hospital.309 A board minute from August 2017 notes concerns from Keith Cochrane that long-serving staff in the business had a tendency to turn a blind eye to such practices. While there were corporate incentives to present a hugely optimistic picture, there were also individual incentives for staff rewarded on the basis of published results. March 2015 board minutes show the board was concerned that potential clawback of their bonuses should not include "retrospective judgements on views taken on contracts in good faith".310

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283 Carillion's notes to their financial statements confirm that this is the method that they were using, Carillion plc Annual Report and Accounts, p 96

284 Further complexity is added to this equation by the potential inclusion of insurance claims, incentive payments and variations arising on the initial contract. Carillion plc's Annual Report and Accounts 2016, p 96, stated that these are only recognised as revenue "where it is probable that they will be recovered and are capable of being reliably measured".

285 KPMG, independent auditor's report, included in Carillion plc's Annual Report and Accounts 2016, p 86

286 Letter from Deloitte to the Chairs, 13 March 2018

287 As above.

288 Letter from Deloitte to the Chairs, 27 March 2018

289 Letter from Deloitte to the Chairs, 13 March 2018

290 As above.

291 Deloitte quoted a difference of £53.9 million between those figures. Those figures were based on November reviews. The audit committee papers show that the year-end position recorded in the financial statements was based on a profit margin of 4.44%, which would equate to £52.5 million.

292 This figure was part of the initial provision figure of £695m that was presented to the Board on 7th July (August 2017 Audit Committee papers - not published). This was subsequently increased to £845m by July 9th, with a corresponding increase in the provision against Royal Liverpool of £15m (September 2017 Audit Committee papers - not published). Keith Cochrane explained that he personally took the decision to increase the provision over that weekend, Q240 [Keith Cochrane]

293 The Hospital Company (Liverpool) Ltd Annual report and financial statements, December 2014

294 As above.

295 Carillion Major Projects Status Report, October 2015 (not published)

296 Q447 [Richard Howson]

297 Letter from Charles McLeod, CBE, on behalf of the Hospital Company (Liverpool) Ltd, to the Chairs, 21 February 2018, p 3

298 Q445 [Richard Howson]

299 Letter from Charles McLeod, CBE, on behalf of the Hospital Company (Liverpool) Ltd, to the Chairs, 21 February 2018, p 3

300 Letter from Andrew Dougal to the Chairs, 5 April 2018

301 Letter from Deloitte to the Chairs, 13 March 2018

302 Letter from Andrew Dougal to the Chairs, 5 April 2018

303 February 2017 audit committee papers (not published)

304 Q273 [Zafar Khan]