A QS perspective: lessons to be learned from Carillion’s demise

The demise of Carillion on 15 January 2018 was, and for many probably still is, a highly emotive and political issue.

There is a reason this was the subject of a Parliamentary inquiry (the Collapse of Carillion inquiry). The amount of money owed to creditors by a business that was deemed too big or too important to fail was astronomical: £29m cash in the bank yet £6.9bn of liabilities and, of that, 30,000 small businesses owed £2bn (yes, you read that correctly, two billion great British pounds).

In a mini-series focused on financial issues facing contracting businesses in the UK construction industry, it felt necessary to explore some of the lessons from Carillion’s insolvency. These can be used to understand how we, as a community of quantity surveying and construction professionals, ensure it is not repeated in the future.

The source of information used to write this article are a combination of my own experience, industry press articles and Bob Wylie’s book titled Bandit Capitalism. The article is structured to present four areas for consideration in our current and future working practices.

Early Payment Facility

I remember being involved in the agreement to an Early Payment Facility (EPF) with Carillion when I was working for a specialist subcontractor owned by a main contractor.

For those interested, Carillion supply chain members were given a choice: accept 120-day payment terms of sign-up to the EPF. If you signed up to the EPF, your payment was made to you by a bank (e.g. Santander, Royal Bank of Scotland etc) on the day you requested it and you paid a fee for the privilege. At a point in the future, Carillion repaid the bank.

It was sold as a benefit to the supply chain however, in Carillion's collapse, what transpired is the accounting benefit that the EPF, essentially a debt factoring scheme, gave Carillion. In effect, Carillion masked its short term-liabilities as long-term liabilities thereby artificially improving its acid-test / quick ratio (short term assets versus short term liabilities), particularly when it was compared to competitors

The EPF was controversial at the time, and I am pleased that it does not appear to have re-surfaced elsewhere.

Negative accruals

There are very few exceptions where a negative accrual might be considered appropriate. An example might be erroneous cost allocation which would distort the financial position if a negative accrual is not used. If it is used, it should exist for no more than one reporting cycle.

In the context of Carillion, negative accruals were being used to reduce the forecast cost of a project rather than show a claim amount as unsecured revenue (presumably knowing that the claim had very little prospect of success). This created a balance sheet smokescreen that hid the true scale of the business’ debts as its liabilities were suppressed.

In the day-to-day management of a business, negative accruals used in this way, reduce transparency because the normal metrics like cost to complete, receivables, levels of uncertified revenue etc either do not indicate a problem or do not reveal the full extent of the problem.

Project financial reports

In recent articles and podcasts, I have spoken about the importance of accurate and robust project financial reports. Those monthly outputs are not just a mechanical exercise: they are relied upon by directors, owners and financial stakeholders underpin the valuation of a business.

In Carillion’s case, the business valuation plummeted from £5bn to £250m in just three days. In what is described as the worlds largest Ponzi scheme, £850m of project losses came to light in the short period between the sign-off of statutory accounts and the public announcement that these losses had been uncovered.

The obvious question was how losses of that magnitude were not known when the accounts were signed-off? Those losses did not materialise in that period and were known about for some time. But how did the business accounts become so polluted that they had very little resemblance to the actual performance of the business?

It is remarkable and only serves to emphasise the importance of accurate and robust financial reports. These should be prepared compliant with the rules and any departures from those rules should be transparently controlled.

Suicide bidding

When you secure a construction contract, you can report the anticipated revenue (e.g. the contract sum) in your accounts at the margin you expect to return. However, that margin is not actually earned unless, and until, the contract is performed in full.

The term ‘suicide bidding’ describes a situation where a contractor underbids a contract to secure that contract at all costs. There might be circumstances where a business takes the risk of this approach, and either bets on its ability to increase the price through the contract, or on the prospect of securing other contracts in the future which have better returns.

A decision to submit a tender at a certain price and / or the final agreement of the contract is never straightforward. There are commercial realities and the submitted price needs to be weighed against prospects of success and business needs. They are tough calls to make and they are made every day in the construction industry.

In the case of Carillion, the turnover, margin and cash boost on contract award became essential for survival and delivering the actual margin became less important, which is a mindset to avoid at all costs.

Final reflections

The issues in this article only scratch the surface of a very complex issue, and I have tried to keep these very focused on the things that a QS might experience and / or be involved in when performing their day-to-day duties (whilst sticking to my five minute article time limit).

One thing that has played on my mind when I researched this topic and wrote this article is whether current tech tools and data science approaches might have prevented the collapse. It is a hypothetical proposition and whilst I think the issues would have been more visible thereby allowing earlier intervention, I am not sure whether it would have done much to alter the human behaviour that were ultimately behind this collapse.

I hope the article gives you some food for thought or maybe even causes you to stop and reflect on a current situation you are dealing with. It certainly has for me, and has been a sobering reminder that this should never be allowed to happen again.

In next week’s article, as we continue our mini-series focused on financial issues facing contracting businesses in the UK construction industry, I will cover some tell-tale signs that financial issues might be prevalent and give some practical advice on how you might manage those situations.

Look out for that one!

p.s. if anything in this article, or any of our articles, resonates with a challenge you are experiencing, check out our Bringing The science of Quantik® to you initiative where we offer a tailor-made session aimed at helping you tackle your project or business challenge (link below).

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