The collapse of U.K. builder Carillion four years ago is now threatening to inflict more than reputational damage on its former auditor, KPMG LLP. The “Big Four” accounting firm is facing a potential financial hit from a 1.3 billion-pound ($1.8 billion)
An investigation by the U.K. Financial Report Council into KPMG’s auditing of Carillion has yet to be made public. But the defunct company’s administrators aren’t waiting for the watchdog’s findings to be aired. Their complaint, filed in London's High Court last month and made public last week, alleges the accounting firm missed numerous red flags and was negligent in approving Carillion’s last three years of accounts.
The administrators have identified a host of construction contracts their lawyers say were not marked down in value despite evident operational difficulties and downbeat assessments by project managers. Had that reset happened, Carillion would have reported more than 1 billion pounds of cumulative pre-tax losses instead of 444 million pounds of total profit from 2014 to 2016 and so wouldn’t legally have been able to pay some 210 million pounds of dividends for those reporting periods, the claim says.
At the end of 2016, Carillion would have been shown to be in negative equity, and so would have ceased trading. It wouldn’t have hobbled on as it did for another year, losing an additional 1.1 billion pounds, a sum the administrators wish to recoup along with the shareholder payouts. The company finally went into liquidation in January 2018.
The court must decide whether KPMG could and should have made the same assessment. That will take some time. But even now, the clash should be a warning to the audit profession. KPMG will need to show it was suitably skeptical of the numbers Carillion put forward.
That applies to any audit client, but it’s especially the case in the construction industry, where contracts are more at risk of misstatement due to their reliance on assumptions about future profitability. Here, bearish analyst reports on Carillion and bets against the shares by hedge funds further reinforced the need for doubt.
The administrators haven’t been able to see how KPMG’s audit work was conducted. Their lawyers nevertheless posit that KPMG’s lead audit partner lost a sense of independence, citing regular hospitality offered by both sides and a 2017 email appearing to help management overcome likely challenges from their board’s audit committee.
“We believe this claim is without merit and we will robustly defend the case,” a KPMG spokesperson said in an email. “Responsibility for the failure of Carillion lies solely with the company’s board and management, who set the strategy and ran the business.”
The need for auditors to maintain boundaries with clients, and be seen to, is paramount. Watchdogs are rightly bearing down on this. Rival Big Four auditor Deloitte LLP got slapped with a record fine from the FRC in 2020 after the accounting regulator concluded the firm had “lost objectivity” in acquiescing to Autonomy Corp.’s misleading approach to revenue recognition prior to its disastrous takeover by HP Inc. (Deloitte unsuccessfully contested the sanction and said in a statement afterward that its audit practices and processes had evolved significantly since its work for Autonomy, and it continued to invest in its controls. Two of its partners fined in parallel said they believed they’d acted professionally, diligently and in good faith at all times.)
The fact is that the lucrative nature of audit work creates a constant challenge to staying objective. A company’s accounting firm will be appointed by the non-executive directors on its audit committee (subject to shareholder approval.) But it’s often possible for the executive managers to influence the selection of the audit firm and individual partners on the account. The risk is that the value of the contract to the firm makes auditors feel beholden to the managers whose numbers they are meant to be checking.
KPMG has been here before. In the year of Carillion’s collapse, the FRC lamented the firm’s failure to
