Yesterday, the UK parliamentary inquiry into the collapse of Carillion, a major construction and outsourcing company, focused on KPMG, the company’s auditors for the last 19 years. KPMG had tough time, particularly in explaining its audit of goodwill, a major point of concern. Carillion’s balance sheet at 31 December 2016 had non-current assets of £2,163m, and £1,571m was attributed to goodwill.
In accounting, goodwill is essentially the difference between the purchase price of an investment (another business) and the values attributed to various assets and liabilities acquired. Carillion’s 2016 financial report made 156 mentions of “goodwill” and said that “Positive goodwill is recognised as an asset in the consolidated balance sheet and is subject to an annual impairment review”. This is permitted by current accounting standards.
Carillion’s methodology was that “The Group annually carries out an impairment assessment of goodwill using a value-in-use model which is based on the net present value of the forecast earnings of the cash-generating unit (‘value-in-use’). This is calculated using certain assumptions around discount rates, growth rates and cash flow forecasts”. Carillion’s directors concluded that there was no impairment and hence, as in previous years, no impairment charge was made to the income statement.
However, there are number of issues. Can goodwill really be allocated to underlying assets in any meaningful way? How sceptical were KPMG? Carillion used models to estimate the value, but models only produce answers from in-built algorithms and the numbers cannot easily be corroborated in any independent way and auditors can easily go along with whatever the models generate.
More significantly, should Carillion have written-off some or all of its goodwill as it was in a dire financial state. At an earlier parliamentary hearing, its finance director said that the company pursued “aggressive” accounting practices and profit recognition on long-term contracts was optimistic. Supply chain creditors were forced to extend credit to around 126 days and one former executive claimed that by mid-2016 the business was in serious financial trouble.
Carillion was certainly not earning super profits to justify retention of unimpaired goodwill in its balance sheet. For the period 2005-2017, its cash/profit margins between 2%-5%. For the period 2009 to 2016, Carillion paid out £554m in dividends, almost as much as the cash it made from operations. During 2012-2016, Carillion paid out £217m more in dividends than it generated in cash from its operations. This was partly funded by debt and the rising debt created a liquidity crisis which would eventually sink the company. Carillion also had a £800 million deficit on its pension scheme.
In July 2017, Carillion announced that its cash flow forecasts were flawed. It wrote down £845m worth of contracts and another £200 million was written off in September 2017. The write-downs wiped out the £730m of shareholder funds. This state of affairs did not occur overnight.
So the big question is how KPMG was able to corroborate management assertions about goodwill. If significant amounts of goodwill had been written off, the company would have become technically insolvent. This would have impaired its ability to pay dividends and performance related executive pay.
Parliamentary Committees would not accept that goodwill of Carillion had not been impaired and asked KPMG partner to explain. The responses were defensive with KPMG partners saying that the financial statements are the responsibility of the management, and that accounting was in accordance with accounting standards. The information from the audit report and notes to financial statements was recited but did not seem to satisfy the legislators.
Finally, the committees confronted KPMG’s with its shortcoming in auditing goodwill. These came from the annual audit quality inspection reports, based on cold reviews of a sample of audits, published by the Financial Reporting Council (FRC). The 2017 report identified “Weaknesses in the audit approach adopted for goodwill impairment, including insufficient professional scepticism and challenge of management’s assessment; and insufficient evidence of involvement by the group team in the component auditor’s work relating to a material acquisition. Insufficient challenge of management’s assumptions in relation to the impairment of goodwill and other intangibles, with undue reliance placed on evidence which supported management’s assumptions/ position. We continue to identify a number of concerns in relation to the audit of valuations, loan loss provisions and impairment reviews of goodwill and other intangibles”
The above issues were not one-off. The 2016 audit quality inspection report said: “We identified a number of concerns in relation to the audit of valuations, impairment reviews of goodwill and other intangibles … Insufficient challenge of management regarding, in one case, the consistency of the financial projections … there was insufficient testing relating to key estimates and judgements used in the valuation of acquired intangible assets … the audit team did not sufficiently challenge management’s identification of cash generating units”.
The 2015 audit quality inspection report said: “We reviewed the audit of goodwill and other intangible assets on eleven audits. In four audits there was insufficient testing of the reliability of forecast cash flows used within the impairment assessment of goodwill or the capitalisation of development costs. In one of those audits and one further audit, we identified related financial statement disclosures that were erroneous or potentially misleading. In another audit, we considered the level of challenge regarding the allocation of brand assets to cash generating units to be insufficient”.
The audit inspection reports suggest persistent flaws in the KPMG approach to audit of goodwill. The weaknesses were being identified at the time when KPMG was permitting Carillion to carry forward unimpaired balance of goodwill. Whether the FRC sample included any Carillion audit is open to conjecture.
The citation of the audit inspection reports by legislators drew typical defensive responses from KPMG partners – ‘we have changed our procedures’, we have learnt from the past’, etc. This is unlikely to have impressed the parliamentary committees.
KPMG has been doing audits for over a century. If third parties still need to instruct the firm on how to do audit something as mundane as goodwill; one must ask serious questions about the ethos of the firm, its quality control procedures and the quality of its audits.
Prem Sikka is professor of accounting and finance at the University of Sheffield and emeritus professor of accounting at the University of Essex. And he is the 2017 recipient of The Accountant & International Accounting Bulletin's editor’s award: The Abraham Briloff award for extraordinary contribution in promoting transparency and public accountability of businesses.