91. It is not only Carillion's revenue accounting that has been called into question since the company collapsed. Two major credit ratings agencies, Moody's and Standard & Poor's, claimed that Carillion's accounting for their early payment facility (EPF) concealed its true level of borrowing from financial creditors.311 They argue the EPF structure meant Carillion had a financial liability to the banks that should have been presented in the annual account as "borrowing". Instead Carillion choose to present these as liabilities to "other creditors". Moody's claim that as much as £498 million was misclassified as a result, though Carillion's audit committee papers show the actual figure drawn was slightly lower at £472 million.312
92. The Financial Reporting Council (FRC) would not confirm whether they agreed with this assessment.313 They set out the relevant accounting standards and noted that the precise terms of any supply chain financing arrangement will dictate how it is accounted for. They did write, however, that they "encourage disclosure of complex supply chain arrangements".314 Carillion's financial statements did not highlight the EPF.315 Some analysts, however, spotted it.316 Carillion's board minutes in April 2015 refer to "disappointing" UBS analysis that had factored both the pension deficit and the EPF in Carillion's total debt position. The May 2015 minutes state that the shorting (betting against) Carillion shares was up significantly and that the "bulk had followed the UBS note in March".317
93. Carillion's classification of the EPF was advantageous to its presentation of its finances in two main ways. First, presenting drawing on the EPF as "other creditors" excluded it from total debt. It was consequently not incorporated in a debt to earnings ratio which was a key covenant test between Carillion and its lenders.318 Carillion announced in its third profit warning on 17 November 2017 that it was likely to breach that covenant.319 Had £472 million been classified as debt, it would most likely have breached this covenant test far earlier.
94. Second, Carillion's EPF treatment helped hide its failure to generate enough cash to support the revenues it was recognising. Carillion had a target of 100% cash conversion: for cash inflows from operating activities to at least equal underlying profit from operations. It consistently reported that it was meeting this target.320 It could do this because the EPF classification allowed it, in cashflow statements, to present bank borrowing as cash inflow from operations, rather than from financing activities.321 Moody's found that between 2013 and 2016, Carillion reported cash inflows from operations of £509 million, a conversion rate of over 100% on group operating profit of £501 million.322 But reclassifying EPF inflows of £472 million as financing activities would mean out of an operating profit of £501 million, only £37 million was cash-backed, a conversion rate of 7%. This exposes Carillion's accounting revenue practices: revenue will at times correctly be recognised before the cash comes in, but as the C&AG said, "if your cash never really comes in, that may be a sign that you need to look about how you have been accounting for these businesses".323
95. The Carillion board have maintained that the £845 million provision made in 2017 was the unfortunate result of sudden deteriorations in key contracts between March and June that year. Such an argument might hold some sway if it was restricted to one or two main contracts. But their audit committee papers show that at least 18 different contracts had provisions made against them. Problems of this size and scale do not form overnight. A November 2016 internal peer review of Carillion's Royal Liverpool Hospital contract reported it was making a loss. Carillion's management overrode that assessment and insisted on a healthy profit margin being assumed in the 2016 accounts. The difference between those two assessments was around £53 million, the same loss included for the hospital contract in the July 2017 profit warning.
96. Carillion used aggressive accounting policies to present a rosy picture to the markets. Maintaining stated contract margins in the face of evidence that showed they were optimistic, and accounting for revenue for work that not even been agreed, enabled it to maintain apparently healthy revenue flows. It used its early payment facility for suppliers as a credit card, but did not account for it as borrowing. The only cash supporting its profits was that banked by denying money to suppliers. Whether or not all this was within the letter of accountancy law, it was intended to deceive lenders and investors. It was also entirely unsustainable: eventually, Carillion would need to get the cash in.
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311 Moody's, Carillion's collapse exposes flaws in the accounting for supply-chain finance, 13 March 2018; S&P Global Ratings, Carillion's Demise: What's at stake?, 23 March 2018
312 Moody's, Carillion's collapse exposes flaws in the accounting for supply-chain finance, 13 March 2018; Carillion, Group short term cash flow forecast, 22 December 2017 (not published)
313 Letter from the FRC to the Chairs, 21 March 2018
314 As above.
315 There is one reference to the early payment facility in the 2016 Annual Report and Accounts within the strategic report section, but nothing in the financial statements. Carillion plc, Annual Report and Accounts 2016, p 13
316 Carillion plc, Minutes of a meeting of the Board of Directors, 2 April 2015
317 Carillion plc, Minutes of a meeting of the Board of Directors, 6 May 2015
318 The ratio was net debt to EBITDA (earnings before interest, taxes, depreciation and amortisation).
319 BBC News, HS2 contractor Carillion's shares hit by profit alert, 17 November 2017
320 Carillion plc, Annual Report and Accounts 2016, p 18
321 Cashflow statements break down how cash is generated within a company. The cash flows from operating activities is essentially the cash that been generated through trading, whereas the financing cash flows show the cash generated through borrowing and equity. By presenting money borrowed under the early payment facility as "other creditors", it's classification within the cashflow can be seen as part of the company's operating activity rather than a financing activity.
322 Moody's, Carillion's collapse exposes flaws in the accounting for supply-chain finance, 13 March 2018
323 Oral evidence taken before the Liaison Committee on 7 February 2018, HC 770 (2017-19), Q7 [Sir Amyas Morse]