Carillion Scandal and Ratio Analysis: A Financial Accounting Report

This report examines the Carillion scandal, a significant failure in financial accounting, and analyzes the use of ratio analysis in assessing a company's financial health. The report begins by defining accounting and its subgroups (financial accounting, financial reporting, and management accounting) and discusses the ethical rules that should govern accounting practices, including relevance, reliability, comparability, and understandability. It then explores the debate between the traditional view of accounting as neutral and the radical view of accountants as agents of social and economic change, arguing that accounting is often influenced by external factors and political pressures. The Carillion case is presented as a prime example of accounting failures, detailing how financial mismanagement, including acquisitions, dividend traps, and flawed business models, led to the company's collapse despite the lack of reported issues by major auditing firms. The second part of the report focuses on ratio analysis, explaining its advantages (ease of comparison, analytical devices, predictive value) and limitations (environmental factors, accounting biases, seasonal variations, discrepancies in definitions, limited comparisons). The report concludes by emphasizing the importance of careful consideration and contextual evidence when using ratio analysis to avoid falsified conclusions. The report references several accounting and finance literature sources.

“Accounting is the art of recording, classifying and summarizing in a significant manner and
in terms of money, transactions and events which are, in part at least, of a financial
character, and interpreting the results” (Kempner,1968). Its origins reside with farmers
predating the 12th century in which it was used to make comparisons between who had the
most wealth based on the amount of and type of animals they owned. In modern day,
accounting is used to answer 3 basic questions what profit the business has made, how
much does the business owe and how much it is owed. Accounting is split into different
subgroups in which each performs a different task. Financial accounting is the process of
classifying and recording monetary transactions of an entity in accordance with established
concepts and standards, with presentation delivered by means of income statements,
balance sheets and cash flow, during and at the end of an accounting period. (CIMA, Official
Terminology, 2005). The other subgroup, financial reporting is the process of
communicating financial accounting to users of such information. Users of this are
management who use this information to operate the business more effectively and
external stake holders such as investors, customers, regulators, who use this information to
determine whether to get involved with a certain company or to implement restrictions.
Furthermore, management accounting is the application of these principles to create,
protect, preserve and increase the value for the stakeholders involved. These groups
together, perform the task of making sure a company is financially stable.
The traditional ideology of what accounting does, being the provider of unbiased
information in order to facilitate social and economic activity by others. To comply with this,
the FRS 18 identifies four ethical rules, Relevance, reliability, comparability and
understandability (Financial reporting council, 2000). Relevance pertains to the information
being useful for its intended purpose, being presented on time, influential on decisions and
confirming what users already think. Reliability, meaning that information is realistic,
objective and prudent- relating to a degree of cation when conditions are uncertain. In
addition comparability dictates that financial statements can be compared from one period
to another, meaning methods and information preparation should be consistent over time.
Finally, understandability dictates that “capable of being understood by users having a
reasonable knowledge of business…….and willingness to study with
reasonable diligence” (FRC, 2000, para. 41). Therefore, having prerequisite knowledge is a
must. By abiding by these ethical rules, firms will gather neutral, objective results that
provide a faithful presentation of economic reality. A radical accounting ideology in which
accountants are agents to promote social and economic change has become more
prevalent. Tinker (1991) argues that accounting shouldn’t just be a passive representation of
reality, but a tool. Whilst, Solomons (1991) states that accountants jobs are to portray
certain aspects of society, not change it. The latter view is commonly excepted, although
Tinker does raise some substantial questions that will be discussed later on.

“Financial reporting is usually seen as something very neutral, mechanical and objective, a
process that simply measures the economic facts pertaining to a firm” (Palea, 2016).
Accounting may aim to achieve this, although this is rarely the case as when compiling the
many rules and accounting standards, external factors often drive away neutrality. Tinker’s,
(1991) critique on Solomons map analogy dictates that we don’t judge a map on how well it
represents facts, as maps are never shapes of the original, used as a political tool shaped by
recreational, religious, economical and other interests. A study by Ryan et al. (2000) frimly
stated that public sector accounting process has been increasingly influenced by powerful
constituents. This political arena, often uses forms of voting to reach an agreement, where
lobbying is involved to conform to a certain agenda. Not only is this constricted to the public
sector, but the private sector may be even further prone to these activities. The Financial
accounting foundation, although being a non-profit organisation, received substantial
funding from Enron corporation, which then approved a change in accounting methods
from accrual to market to market (Culpan and Trussel in Huu Cuong, Nguyen, 2011). This
unprecedented change in policy, distinctively shows that Enron influenced the FASB, thus
proving the economic interest group theory of regulation. Due to the quantative nature of
accounting, many items are omitted from accounting such as social and environmental
factors. There is currently no accounting and auditing standards devoted to environmental
issues within the UK. To encourage business to take up voluntary environmental reporting,
the Chemical industries association has seen some success, with some companies finding
that it’s a valuable business exercise, gaining valuable information at a relatively low cost
(Gray et al, 1998). In regard to social accounting, UK companies, especially the larger ones
produce a significant amount of social data, with an expectation to disclose information
relating to corporate governance, charitable and political donations and many more. The
Body Shop has been at the frontier of these latest developments, adhering to the growing
trend in corporate social awareness (Thebodyshop.com, 2020). Overall, accounting is
inherently bias from the reasons stated prior, although a push towards neutrality through
using qualified members, independent of constituent pressure with implementation of
environmental and social accounting may lead to a more inclusive version of accounting.
demonstrate how accounting was used to conceal useful information which lead to
corporate collapse (gap between talk and action)
A prime example of accounting failing to do what it is meant to, can be exemplified by the
Carillion scandal. Being the UKs 2nd largest construction and facilities management company
with over 43,000 employees and working on projects such as the Battersea powerplant, the
company was thought to be too big to fail. However, a collapse at the beginning of 2015
leading to over 1.5Bn in debts and a substantial pension deficit, has lead many to believe,
financial mismanagement is to blame (BBC News. 2020). Prior to their collapse, a number of
red flags appeared, firstly Carillion was in the midst of a chain of large acquisitions, with the
last being with Balfour Beatty, who got cold feet and backed out of the deal. Due to this,
their portfolio of subsidiaries grew to span aviation, education, health care and defence.
Dividend traps coupled with complex long-term contracts meant that their statements
seemed sound and backed by cash flow. Although this was not the case, their thin operating
margins and build up of troublesome contracts, with mention to Qatar which created over

£180 million in debt, £110 million over the previously enlisted figure and with no provisions
made to cover. Furthermore, their flawed business model for quick cash and acquisitions
with rising debt meant that their books misrepresented their reality, with 84% of their
business in 2016 being made up of goodwill (Accountancy Age, 2020). Auditing by the four
largest firms, Deloitte, PwC, EY and KPM, failed to report any issues prior to their
bankruptcy, even after their first profit warning and £845M write down in value of their
contracts. Overall, poor leadership, rotting corporate culture and an inability for auditors to
perform the very task they are payed to do, lead the demise of Carillion, with reforms over
the accounting system set to take place to make sure this doesn’t happen again.
PART 2, second question
Ratio analysis is a tool used by accountants to analyse information from the financial
statements of a business, they can determine various aspects of a firm such as profitability,
liquidity and solvency (Corporate Finance Institute, 2020). Though almost every company
uses them, they have drawbacks that need to be put into consideration when coming to
conclusions from the data. The advantages of using this method is that it’s a easy quick
method of comparison, meaning that all firms no matter the size are able to carry them out.
Furthermore, they can be used for fairly simple analytical devises and carry predictive value
(Horrigan, J. 1968). This allows firms to better financially prepare for the coming years and
to highlight areas that need to be adhered to. Key areas that ratios are used in are
profitability, efficiency, liquidity, financing and investment. Although useful, there are
several limitations and precautions that have to be recognised. Whilst, analysing trends,
awareness to environmental factors such as the political and economic climate are key
factors that need to be considered. An example could relate to downturns in the economic
cycle in which key ratios such as earnings per share may not be a reflection of the
companies individual performance. Internal factors also give light to holes amongst ratio
analysis. As stated in previous paragraphs, accounting always holds a bias and may not be a
full representation of the firms position. Incorrect statements through misrepresenting
information will therefore lead to incorrect ratios. Seasonal variations aren’t accounted for
as some firms, especially within the agriculture sector may have no inventory until crops are
harvested and therefore have distorted ratios (Elliot and Elliot, 2015). Although most
countries use regular accounting standards, there are discrepancies amongst ratio
definitions, furthermore different measurement bases with revaluations done at different
periods of time throughout the year. Lastly, ratios when use for comparison is limited to the
relative size and company type as capital ratios and employees will be different if one firm is
more capital intensive and producing varying levels of output. Overall ratio analysis are key
to assessing and understanding a companies performance with ease, whilst also being able
to compare amongst other companies. However, careful consideration needs to be
implemented paired with contextual evidence so that resources aren’t wasted on falsified
conclusions.

References
accounting references
Jack J. Kempner, The Basic Concepts of Accounting, 30 Mont. L. Rev. (1968).
CHARTERED INSTITUTE OF MANAGEMENT ACCOUNTANTS. (2005). CIMA official
terminology. Oxford, CIMA. http://site.ebrary.com/id/10216774.
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https://www.frc.org.uk/accountants/accounting-and-reporting-policy/uk-accounting-
standards/standards-in-issue/frs-18-accounting-policies
Tinker, T. (1991). The accountant as partisan. Accounting, Organizations and Society, 16(3),
pp.297-310.
Solomons, D. (1991). Accounting and social change: A neutralist view. Accounting,
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Huu Cuong, Nguyen. (2011). Are Accounting Standards Neutral or Unbiased?. 146-152.
Ryan, C., Dunstan, K. and Stanley, T. (2000). Local Government Accounting Standard-setting
in Australia: Did Constituents Participate?. Financial Accountability and Management, 16(4),
pp.373-396.
Horrigan, J. (1968). A Short History of Financial Ratio Analysis. The Accounting
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Elliot, B., and Elliot, J., (2015), Financial Accounting and Reporting, 7th edition, Pearson :
London.
Gray, R., Collison, D. and Bebbington, J., 1998. Environmental and social accounting and
reporting. Financial reporting today, pp.179-214.

Thebodyshop.com. (2020). 2016 Sustainability Report | The Body Shop. [online] Available at:
https://www.thebodyshop.com/en-gb/about-us/our-commitment/enrich-not-exploit-
sustainability-report-2016?clear=true [Accessed 6 Mar. 2020].
BBC News. (2020). Carillion: Six charts that explain what happened. [online] Available at:
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Mouck, T., 2004. Institutional reality, financial reporting and the rules of the
game. Accounting, Organizations and Society, 29(5-6), pp.525-541.