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It seems that every time I open the broadsheets someone else is attacking the Support Services Industry. Recent examples have derived from the profit warnings at Connaught and ROK and not satisfied with the fact that public sector spending on services is set to fall in the short term, the focus for criticism seems to have changed to governance related issues and the interpretation of accounting policy.
Questions have been asked about the way that long term contracts are accounted for with many leading analysts calling for a change in accounting standards to help separate the good from the bad. It seems clear to me that it is not in the best interest of the long standing CFO or Audit Partner to highlight such grey areas as that in turn will reflect badly on them and may lead to the FD’s sudden departure as we have seen recently at ROK.
I have two questions for our Interim community;
1. How can the Chairmen and Chief Executives of Support Services companies ensure that the results that they are communicating to the City are not based on accounting policy grey areas?
2. How can the Support Services companies who manage long term contracts build confidence with the City analysts?
Mark Kitchen is Head of Business & Support Services at Interim Partners.
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August 20th, 2010 at 12:21 pm
I believe the key is the establishment of company policies that are applied robustly and deliver prudence both at a contract & company level.
There is an overriding need for prudence, realism, honesty & accuracy in contract estimates whereas generally low sector profitability may hinder this. If company results deteriorate, Chairmen & Chief Executives may actually drive a further reduction in prudence.
Chairmen and Chief Executives need to accept consistently prudent initial under estimates with an expectation of over delivery at contract end. They must also require centrally held contingencies.
Chief Executives should lead monthly major contract reviews & develop a culture of openness & honest about reporting bad news as well as a strong risk management culture.
Boards must debate, agree and set in stone basic accounting rules for long term contracts to minimise grey area accounting. For example, sensible companies recognise little, if any, element of unagreed commercial claims (such as variations) whilst others retain profit contingencies on all contracts.
There is no grey area with regard to the second question. The only way for Support Services companies to build confidence with City Analysts is to consistently deliver on their promises and predictions.
August 20th, 2010 at 3:14 pm
Having a stated (and acceptable) accounting policy on a key issue is one thing – internal implementation of a strong financial control process to ensure actual compliance with the policy is quite a different matter.
The principle of controlling long term contract profit recognition is quite simple – management need to forecast the financial outcome of a contract, and then allocate that financial outcome to accounting periods on the basis of the stated policy.
Where it can go wrong (leaving aside any deliberate mis-accounting of actual costs or revenues), is that forecasts are overly optimistic, perhaps driven by external profit expectations (which should in any event be conditioned by the Board) and fail to be either reviewed or updated sufficiently frequently, or fail to take into account specific or general risks inherent in any forecast.
Having been responsible for long term contracts in a different sector (funded aerospace engineering programmes) – the approach I adopted was for monthly re-forecasts and detailed review of contracts, and the maintenance and review of contract-specific risk registers, which enabled an informed management and judgement call on the robustness of the forecasts and hence the profit recognised each period. Based on the risk profile of each contract, a centralised forecast contingency was maintained. Any appropriate contingency releases ( for example risks crystallising at a lower level or being managed away) were phased in on a quarterly basis – the overall result therefore generally being manageable upsides each quarter. So, I would argue that it is not for the accounting standard setters to deal with issues that are really the responsibility of the CFO and the Board, and to some extent the auditors in policing the processes.
Whilst a more robust and, probably, conservative approach to forecasting outcomes, may well result in lower reported profits in the short term – the longer term value benefits of delivery against expectations and management demonstrably being in control will more than outweigh this – and thus address the second question.
August 22nd, 2010 at 7:23 pm
It is important within the Support Services arena of long term contract accounting that pipelines, order books, contract start-up costs and WiP etc are reported prudently and consistently. This, from experience and sector knowledge, is reported on this basis within many businesses in the sector, although there is always an exception to the rule. And it is these exceptions that puts doubt in the mind of analysts towards the rest of the sector constituents.
For example, whereas the vast majority of support services businesses I have been involved in write contract start-up costs to P&L when they occur (i.e. the most prudent basis), it would appear from the financial press that Connaught were capitalising their mobilisation costs and then writing them down on a straight line basis over the life of the contract (thus assisting the profitability during the earlier part of the contract). This may be as a result of some of the pressures felt within the PLC environment to constantly report better results – although my understanding is that PLC competitors such as Mears take the more prudent route.
I have also heard rumours in the past that some order books/pipelines of less prudent businesses include full contract values as opposed to the amount of business that they are specifically contracted for in order to massage a consistently growing order book.
To answer the two questions specifically, Chairmen and CEOs must have a firm grasp of finance themselves in order that they can satisfy themselves that the procedures put in place by the FD are the correct ones for their business, are easily understandable and extremely robust – i.e. will stand up to City/Investor scrutiny and stress testing and work as they should.
The second question can be answered by ensuring the report and accounts quite clearly state the methodology used to calculate pipelines, order books, work in progress and profit levels, along with all assumptions used. By showing in the report and accounts that a consistently prudent set of policies and procedures are being used, and then describing the metrics and methodology behind them, there should be no areas of doubt left, thus giving the analysts confidence of the solidity underpinning the numbers. The Management Team then need to deliver what they forecast to demonstrate that they are in control of the future destiny of the business.
August 23rd, 2010 at 8:10 pm
I was both Group FD and then Group CEO at M J Gleeson Group Plc from January 2006 to December 2008. Gleeson was a hybrid construction business covering housebuilding (traditional and regeneration), contracting (rail, water, civil, concrete specialist), land trading business and support services business to the social housing sector. A lot of the projects were long-term contracts using PFI.
On entry I found a Group in breach of its banking covenants. I soon became Group CEO and conducted a review of all assets, liabilities and contracts. As usual I found understated liabilities and overstated assets and a lack of operational and financial awareness amongst the management teams as to the the contracts that the various parts of the Group had entered into.
The challenges at Gleeson were very similar to those at Inchcape Autotmive, a subsidiary of Inchcape Plc, were as MD I inherited a business with numerous long-term service delivery contracts and an operational and financial team a distance away from knowing the basics of the contracts.
What have I learned about both senior general and financial management of businesses that have to deal with complex service agreements over long periods? Well here goes ;
1. The Audit Committee of Plc’s should engage more deeply in accounting policy selection for key contracts
2. Internal audit should focus on contracts that they consider key risks to the Group and ensure that they really understand what the contract says and the team delivering it also understand it and are actioning it in reality
3. The FD should stay on the conservative side of any accounting policy. Anyone remember that accounting convention?!! It had its uses.
4. The FD should be strongly engaged in their own periodic reviews of the contracts, both a numbers review and on the ground maybe working in the buisness on actual understanding of complex service delivery. Get your hands dirty
5. The CEO should be a strong leader of both selecting which contracts to bids for, review and understanding of the bid process, engage the people in the business during the bid process who will be delivering the service to ensure the business can actually deliver at the grass roots levels, stay engaged at the bid level stage, review monthly key contracts at monthly management reviews (yes, really understand what is happening), talk to the customer, do not be afraid to talk to employees delivering the service and ensure that the operational team are really delivering what they contracted to deliver
6. The Group FD should be strong enough to ensure that any business unit FD is both experienced in the sector via appropriate recruitment and selection processes and that business unit FD is always supported so that he can “cry out loud” if he feels the contract is either off track or they are under pressure to take profits too early
7. All you FD’s out there. Really ensure you can reconcile profit to cash. Cash is king and unless you have never worked in a cash crisis situation with banks, then try to get that experience. You will really then understand the detail of long-term contract accounting!
8. Analysts. Well what can I say? Too many are unwilling to really ask challenging questions so that they understand the commercial terms and accounting policies of the contracts and then when it goes wrong, they all cry wolf. Analysts, please do your jobs from day one. A lot of this can be said of shareholders. Too many times I sat in meetings with no real challenge. In reality, you enjoy those really challenging analysts, shareholders and banks stakeholders, as long as you know your stuff!
9. Management teams take charge of meetings with analysts and shareholders and put accounting policies and the risks amnd rewards of the contracts on the agenda. If analysts and shareholders fail to take heed they have no comeback on you. It is a responsibility you have.
10. Risk management. Really understand what contract terms you are signing up to.
11. The Group CEO and Group FD should ensure they get invovled at the most basic level possible. “Back to the shop floor” is actually an invaluable exercise to really understand what goes on in your business.
12. Create an open and transparent culture. There is no one out there that I have worked for who has not made mistakes. It happens. When they do happen, deal with them quickly and openly and learn from them.
August 27th, 2010 at 7:37 am
Whilst agreeing with all the comments from the previous contributors, in the end its all about cash. Any educated reader of published accounts, which an analyst should be, will be able to reconcile the operating cashflow to free cashflow or at least ask the questions. Any costs incurred and charged to the balance sheet rather than P&L should be obvious, questioned and evaluated just as they will ask for details of the contrcat pipeline. There have been rumours for some time about a least one of the companies mentioned by Mark. Soemtimes Analysts fall in love with success and neglect the clear signs. I though many people had learnt from the Dot Com boom and crash of the last decade that you always “follow the cash”.
August 27th, 2010 at 3:51 pm
I think we would expect profit forecasts from the services industry to fall or falter given the current economic climate. I assume the crticisms are hitting the optimists in the industry the most. Any company that has been optimistic rather than conserevative with their accounting policies and forecasting models are likely to take a bath when ecomonic condsitions deteriorate significantly. Rememeber the banking industry!
Those of us who have been involved in modelling complex business cases for long term contracts, any long term projects, outsourcing contracts or activity with significant capitalisation based on ecomomic value, know that there are significant differences in outcome depending on the key assumptions chosen… and how a contract is interpreted.
The only true way to evaluate a major contract is to understabnd it and then assess all the major assumptions used and see some sensitivity analysis. However, we are being optimistic if we expect this sort of disclosure which would be very sensitive and difficult to both parties. It takes a brave auditor to say an FD is being overly optimistic. There is also somthing about human nature in all this. How many FD’s get fired for being optimistic? Cautious FD’s used to have a limited life span.
We should also understand that both UK GAAP and IFRS give considerable leayway in interpretation when it comes to accounting for contracts. The key issue is how optimistic or bullish the orgainsation has been. As Warren Buffet said you only find out who is swimming without any trunks when the tide goes out.