In March 2011, just as Britain’s new coalition government was preparing to dramatically cut back on public spending, Carillion paid £306m to buy a company that helped consumers to take advantage of government-funded energy schemes.
Even by the now bankrupt outsourcing group’s somewhat indifferent standards, it would be a spectacularly mistimed move.
Based in Newcastle upon Tyne, where, perhaps ominously, it occupied the semi-deserted steel and glass tower built to house Northern Rock’s headquarters just before the bank’s 2008 collapse, Eaga was a contractor for public programmes promoting energy efficiency among the less well off.
Floated on the stock market in 2007, Eaga initially expanded rapidly, picking up disparate contracts, such as one to help the BBC complete the switch from analogue to digital TV.
But by 2011, the government was cutting back on the costly green initiatives as ministers tried to rein in runaway public spending. In late 2010, the company announced a profit warning when one of its major public projects was curtailed. The share price crashed, slashing Eaga’s market capitalisation to a level that put it in the sights of Carillion’s acquisitive bosses. And in early 2011, perhaps sensing a bargain by snapping up a business on its uppers, the group pounced.
In its press release announcing the deal, Carillion said the low-carbon market was to be a new “strategic area of growth” for the company and promised the takeover would “create a scalable platform to build the UK’s largest independent energy services provider”.
The reality was very different. And in January this year, shortly after Carillion’s collapse, the chairman of the group’s pension schemes, Robin Ellison, passed his verdict on the takeover in evidence to a parliamentary inquiry.
He described the Eaga deal as one of the biggest “headwinds” the company faced before its insolvency. A series of subsidy cuts by the government had crushed its business, forcing the Carillion group to “write off” its investment. “The company became virtually worthless,” Mr Ellison said.
Eaga may seem a footnote in the wider drama of Carillion’s collapse. The group was ultimately buried by a whopping £1.2bn landslide of contractual writedowns in mid-2017, most relating to its Middle Eastern construction activities. But the energy services subsidiary is central to some of the key accounting questions that continue to swirl around Carillion following its decision to file for insolvency six months ago.
These come at a time of rising concern about the weakening of accounting standards on both sides of the Atlantic, and how they enable companies to push out over-optimistic versions of their figures. UK companies such as Tesco and Quindell, an insurance software group, have been caught up in serious accounting scandals where revenues and profits were inflated. In the US, the industrial conglomerate GE faces investigation over the way it books revenues from the contracts it sells.
Carillion may have collapsed after restatements of contractual earnings erased six years of profits. But some believe its accounts were already straining at the boundaries of reality.
And at the heart of these concerns lies the Eaga acquisition itself.
As with many acquisitive service businesses, Carillion had few tangible assets on its balance sheet; items such as property or plant that were marketable and could easily be valued or sold off.
Instead the company’s books were stuffed with intangibles — not least the goodwill on its many deals. On Eaga, it wrote up £329m of goodwill, or more than 100 per cent of the purchase price. That was a big chunk of the £1.6bn in goodwill it accumulated in its accounts by 2016 — equivalent to 35 per cent of Carillion’s total assets.
This balance continued to grow almost to the company’s denouement. In the five years before 2017, the group impaired not a penny of its goodwill pile, despite growing circumstantial evidence that some of those assets might have slumped in value.
Carillion in numbers
Contractual writedowns declared in mid-2017 that led to Carillion’s collapse
Goodwill impaired by the outsourcing group in the five years before 2017
First-year loss for Carillion Energy Services (the renamed Eaga) on a 20% fall in annualised turnover
Bonuses for Richard Adam and Richard Howson in the two years before the company’s failure
Its avoidance of impairments was one of the reasons Carillion could continue paying dividends (and bonuses to managers). In 2016, despite the looming disaster, it paid a record dividend of £78m.
Goodwill is defined as the amount one company pays for another over and above the appraised value of the target’s assets, less any assumed liabilities. According to Karthik Ramanna, professor of business and public policy at Oxford university’s Blavatnik School of Government, it represents “the conjectural future profits that an acquiring manager hopes to realise through an acquisition”.
Thanks to the long M&A boom and recent accounting changes, this “hope” value has become a significant part of corporate balance sheets.
In the UK, companies used to amortise goodwill — meaning they took an annual charge against their profits, with a view to writing off the whole amount over a fixed period — generally about 20 years. But since 2005, they have been able to treat it as a permanent asset, only writing it down if it is deemed “impaired” by the company and its auditors. This is established by an annual impairment test.
The treatment is controversial. First, there is the question of whether goodwill has much status as an asset. It cannot be sold and, in the event of bankruptcy, almost certainly has no value. Companies still amortise other intangibles such as software and customer lists because of their uncertain value.
Then there is the concern that it allows companies to overstate the success of deals because it does not factor in the amount laid out to achieve the additional sales and profits. That encourages managers to push through marginal or even wasteful combinations.
“If an M&A is successful — and the acquiring firm generates the synergies it imagined at acquisition — the firm’s income recognises the revenues from the synergies but not all the costs, resulting in a double-counting of sorts,” Prof Ramanna notes in his book Political Standards. “This violates the basic premise of traditional accounting.”
There are also problems with the idea that impairment tests can keep balance sheets honest. One concern is its subjectivity. “Not surprisingly, a CEO who overpays in an [acquisition] is not particularly keen to publicly acknowledge that overpayment, so instances of firms declaring their goodwill as impaired are rare,” Prof Ramanna says.
He cites the reluctance of US banks to write down purchased goodwill even after the financial crisis. Of the 50 largest American financial institutions, only 15 wrote down any goodwill in 2008, although nearly 40 of them were trading well below book value at the time.
Carillion’s bosses appear to have shown a similar reticence. Almost from the moment of its purchase, Eaga faced a remorseless government squeeze on spending. In the first year, the newly renamed Carillion Energy Services recorded a 20 per cent decline in annualised turnover, and a loss to the tune of £113m, as it attempted to rationalise its shrinking business.
Sales continued to slump in subsequent years as the government cut more of the programmes that constituted its main activities. Spending on the government’s “Warm Front” fuel poverty programme run by Eaga fell from £345m in 2010-11 to just £100m the following year, before ceasing completely in January 2013. The contract with the BBC to handle the digital switchover reached its conclusion in 2012.
By 2016, CES’s revenue had shrunk to just £43m (95 per cent below its pre-takeover level), and it had run up cumulative losses of an astonishing £350m under Carillion’s ownership. The subsidiary had negative net assets of £194m and was only solvent, say its accounts, because of its parent’s explicit financial support.
But despite this, Carillion’s bosses simply sailed on regardless. They continued defiantly to maintain that CES was still worth at least £329m.
That they had such a free hand may seem rather puzzling. Under the accounting rules, Carillion could not after all simply ignore CES’s lamentable condition. It had to verify each year with its longstanding auditors, KPMG, that the subsidiary’s value had not declined. KPMG declined to comment.
Carillion had also to defend the position it took in its 2011 accounts, shortly after the purchase. This justified the goodwill on the grounds that it could achieve £25m of annual synergies from providing “existing and new customers with integrated support services solutions”. Yet by 2016, the subsidiary’s revenues were only just above this amount.
But that is to ignore the test’s extreme flexibility. The accounting rules allow companies to inject purchases such as Eaga into accounting groupings called “cash flow generating units” when conducting impairment tests.
These are not formal entities, but opaque constructs created by management containing assets they choose to bundle together. Bosses then produce business plans and cash flow forecasts for these units, from which they compute net present values, and thus test whether the underlying assets are worth more than the goodwill written up against them.
Not only does this process minimise the chance of an impairment, it depends heavily on the willingness of auditors to challenge the numbers plucked out by management. “It is a bit like the banks before the financial crisis,” says one accountant. “There is no objective market value for the asset, so you mark it to model. And if it’s bullshit, well, it is up to the auditors to call it out.”
Investors often glaze over when goodwill is mentioned. They pooh-pooh its importance on grounds that it is a “non-cash item”. But according to Natasha Landell-Mills, head of stewardship at the fund manager Sarasin & Partners, that is a mistaken assumption. “Of course, goodwill matters because it’s a measure of capital allocation,” she says.
Like all accounting measures it is linked to incentive mechanisms. For instance, had Carillion impaired Eaga, the board might not have been able to pay the group’s two top executives, Richard Howson and Richard Adam, £1.8m in bonuses in the two years before the company’s failure. “And that’s before you get to its impact on things like dividend paying capacity, potential creditworthiness or even solvency,” Ms Landell-Mills adds.
By 2015, accumulated goodwill was the one thing standing between Carillion and a brewing crisis. As the group’s bosses pondered but deferred an equity raising to cut its increasingly burdensome debts, they were determined to keep paying dividends. Mr Howson did not respond to request for comment and Mr Adam could not be reached.
Under UK law, companies can only make distributions if they have sufficient “distributable reserves” — or accumulated and realised profits — to do so. Paying dividends out of capital is illegal, as it can disadvantage other creditors, and can lead the directors to have to repay any illegitimate distributions that they make. In its 2015 figures, Carillion had £373m of shareholders’ funds (a rough proxy for distributable reserves) on its parent company balance sheet, out of which it paid a dividend of £77m.
Impairing goodwill means writing down the carrying value of a subsidiary and hence reduces shareholders’ funds — and the distributable reserves the parent company has available. Had Carillion then written down all the goodwill on Eaga, it would not have had sufficient reserves to pay that full dividend: the maximum would have been £44m.
“Cutting the dividend at that point because there weren’t the distributable reserves to pay it would have been a big red flag for investors,” says one analyst.
In 2016, the group had just £317m of shareholders’ funds left. Under any circumstances, after making such a writedown, it could not have issued any dividend, yet it paid out the record £78m.
Carillion’s fate now hangs with the UK’s Insolvency Service, which is probing its bankruptcy filing. It will decide whether the group and its auditors overstated its capital. But the episode shows how weak the UK’s so-called capital maintenance regime has become.
“A core purpose of accounts has always been to provide a mechanism for those providing capital to ensure their money is protected,” says Ms Landell-Mills. “This underpins trust in markets.” But a system has weakened the old requirement on auditors to question the sustainability of revenues and business models, and replaced it with a weaker, more tick-box approach.
Critics argue that innovations such as current cost accounting and ever looser goodwill rules have made it harder to distinguish between “realised profits” — the foundation stone of distributable reserves — and what are more conjectural measures of profit, such as the £1.2bn of surpluses on contracts that Carillion had to write down in the summer of 2017.
“If there is one good thing to come out of Carillion, it’s that it offers a salutary reminder about why preventing overstatement matters,” says Ms Landell-Mills. “Perhaps the most pressing question for policymakers is that — given our accounting rules are no longer designed to protect capital — who is enforcing our capital protection regime?,” she asks. “Anyone?”
This article was updated on June 18. Karthik Ramanna is a professor at Oxford university’s Blavatnik School of Government, not Saïd Business School
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