Southwest One losses obscured by 'shambolic' accounting

Outsourcing venture Southwest One obscured the extent of its losses with an unusual combination of understated costs and post-dated credits

Regional outsourcing venture Southwest One obscured the true extent of its financial losses with a highly unusual combination of understated costs and post-dated credits in its 2010 accounts, according to an analysis of the firm's accounts by Computer Weekly.

The accounting errors lowered Southwest One's costs when it was close to collapse at the start of this year and then buried the losses when it finally disclosed them last month.

The error raises questions about what really happened in January 2012, when Southwest One warded off bankruptcy with a £10m loan from IBM – which owns 75% of the venture – and went into contract renegotiations with key customer Somerset County Council.

The local authority, Southwest One's largest outsourcing customer and minority owner, was trying to reduce the contract. But the truth about Southwest One's troubled financial position did not emerge until six months later, after it had completed the major part of the renegotiation.

Southwest One refused to say if it intentionally hid losses to avert its collapse. But its accounting errors are so unusual they led one forensic accountant to say that, at the very least, the outsource venture's accounts are "inexplicable, shambolic and incompetent", and that the truth behind Southwest One will not be known until it answers questions about what happened.

Understated costs

Southwest One understated its 2010 costs in January this year by recording a large and highly unusual fall in fees charged by IBM. 

Its parent provided a secured loan that allowed its directors to state it was a going concern. The joint venture then went into the final round of renegotiations with Somerset council without the true extent of its losses known.

Six months later Southwest One restated its costs. IBM had not cut its fees after all.

Southwest One timeline

18 September 2007 - Somerset County Council forms Southwest One, a shared services company, with IBM and Taunton Deane Borough Council.

29 September 2007 - Somerset awards £400m, 10-year outsourcing contract to Southwest One, promising £190m back-office and procurement savings.

20 March 2008 - Avon & Somerset Police Authority joins Southwest One, taking part ownership.

May 2009 - Conservatives, led by Ken Maddock, campaign against Southwest One in local elections.

4 June 2009 - Conservatives win control of Somerset council from Liberal Democrats and begin a review of the Southwest One contract with the aim to renegotiate.

16 November 2009 - Southwest One reports £57m 2008 turnover, 92% derived from Somerset council, with 54% of revenue paid out for IBM goods and services.

June 2010 - Somerset council report calls for Southwest One contract to be renegotiated.

30 September 2010 - Southwest One reports that IBM fees went up to 81% of revenue in 2009, while Somerset Council cut payments by 16%.

3 June 2011 - Somerset Council publishes 2010 report of Southwest One review.

17 January 2012 - IBM secures Southwest One debt with £10m loan, on trade debt of £40m.

19 January 2012 - Southwest One files 2010 accounts four months late, saying revenue were down 61% on 2008, with Somerset payments down 42% and IBM fees down to 35% from 81%. The venture has delivered just £6m of promised £190m savings.

15 February 2012 - Somerset County Council leader Ken Maddock says Southwest One has failed. Renegotiations over contract continue.

2 March 2012 - Somerset Council takes strategic services back off Southwest One.

23 August 2012 - Southwest One restates 2010 accounts, revealing £10m of undisclosed IBM fees and offsets increased costs with previously undisclosed IBM credit note. IBM payments were 81% of revenue, not 35% as previously stated. Southwest One's 2011 revenue was down 63% on 2008. Somerset County Council's 2011 payments were down 51% on 2008.

31 August 2012 - Southwest One sues Somerset County Council for non-payment of contracted fees.

Southwest One had in fact been £10m worse off than it said it was when its future hung in the balance in January 2012. But when it published its true costs in August 2012, another accounting error effectively buried the increased loss that should have resulted from the IBM costs.

Southwest One offset the loss with a post-dated credit from IBM. This credit - additional to the £10m rescue loan IBM put up in January 2012 - allowed Southwest One to avoid declaring that its 2010 losses were higher than it originally said.

It was not usual for Southwest One to pay high fees to IBM. It paid 85% of its revenue to IBM in 2009 - that was £28.2m. But Southwest One's 2010 accounts on 19 January 2012 showed that IBM had made a year-on-year cut in fees of 73% in 2010 - to just £7.8m, or 35% of revenue - giving its outsource venture relief at a time of crisis.

Yet the restated 2010 accounts showed on 28 August 2012 that Southwest One's IBM fees had still been 82% of revenue after all. It paid £18.5m for IBM goods and services, out of £22.5m earned in revenue from outsource partners Somerset County Council, Taunton Deane District Council and Avon & Somerset Police Authority. That figure was £10m more than it declared in January 2012.

Had the true cost of IBM fees been declared in January 2012, it would have pushed Southwest One's 2010 losses up to over £40m. But Southwest One had also discovered an IBM credit note from 2010, for £9.512m - precisely enough to offset the £10m increased costs after they had been balanced against other minor differences in its restated cost sheet. 

Thus Southwest One presented its true 2010 costs without having to increase its 2010 losses at all. It restated its 2010 numbers without any change to its headline profit and loss, and with the true costs buried in the notes of the accounts.

Important questions

Both moves raise important questions. Southwest One's single biggest cost of business was the fees paid to IBM, its majority parent. A 73% cut in IBM fees could not have gone unnoticed by Southwest One and IBM finance officers when they signed off the original, mistaken 2010 accounts in January 2012. 

The £10m of invoices are unlikely to have been lost without questions being asked and searches conducted. IBM UK would not have also mislaid £10m of charges for goods and services provided to Southwest One in 2010. Yet when Southwest One filed its accounts in January all record of this £10m was gone.

Neither did Southwest One have any record of a £9.512m credit note from IBM in 2010 when it filed the accounts in January. 

If Southwest One had booked an IBM credit note of £9.512m in 2010, how did it happen to be precisely the amount required to offset a complex balance of restated costs that did not arise until halfway through 2012? This comprised a precise balance derived from costs other than those attributed to IBM, and a balance that IBM could not have known in advance of those minor non-IBM costs being restated as well.

And if Southwest One had indeed booked an IBM credit note of £9.512m in 2010, it should have already been factored into its cost account. When its 2010 costs were increased by £10m of mislaid IBM fees in August, this would have gone straight in as a loss, because there would have been no previously unaccounted credit note.

Southwest One was not prepared to answer any of detailed questions Computer Weekly asked about these affairs (see box, below right).

A Southwest One spokeswoman said in a written statement: "All published financial and personnel information on Southwest One is contained in the 2011 Annual Report which is externally audited and available to the public at Companies House."

The unanswered questions for Southwest One

  • How did Southwest One (SW1) mislay £10m of invoices from IBM in 2010?
  • How did SW1 also lose a £9.512m credit note from IBM in 2010?
  • What did SW1 do to verify the unusual £10m, 73% cut in IBM's 2010 fees?
  • Why did it not see that the 73% cut was a mistake when it filed the 2010 accounts in January?
  • Why did SW1 fail to see its invoices from IBM didn't tally with its accounts?
  • How was the mistake overlooked when IBM fees were usually, at 80%, SW1's biggest cost by far?
  • What did SW1 and IBM think had changed for IBM's fees to fall so much in 2010?
  • What happened between SW1 filing its 2010 accounts in January and filing its restated 2010 accounts in August that produced the missing IBM fees credit note?
  • When in 2010 did IBM provide SW1 with £9.512m credit notes?
  • When in 2010 did IBM file the invoices for the £10m fees that SW1 lost?
  • Who at IBM signed off SW1's 2010 accounts?
  • How did IBM not spot the errors?
  • How was the £9.512m IBM credit note in 2010 just enough to cover costs restated in 2012?
  • Why did SW1 need to mention this credit note in its restated 2010 accounts?
  • What was the purpose of the credit note for IBM and for SW1?
  • What did SW1 receive for the payments made to IBM for goods and services in 2010?
  • How have IBM's fees been cut again 2011, when the 2010 cuts were in error?
  • Would IBM financiers have backed SW1 if its 2010 costs were not understated?
  • Did SW1 intentionally miss £10m IBM fees out of its 2010 accounts to reduce the impact of losses when it was facing collapse, seeking financial backing and renegotiating its contract with Somerset County Council, its lead partner?
  • Did SW1 intentionally avoid restating its 2010 losses by taking a credit note supplied by IBM in 2012 and applying it to the 2010 accounting period retrospectively?

'Complete fiasco'

But John Brace, a respected forensic accountant and former president of the Association of Chartered Certified Accountants, looked at the accounts and said that Southwest One had important questions to answer.

"The whole thing looks to me like a complete fiasco - totally shambolic. At the very least there appears to be incompetence here in compiling the figures. Beyond that it would be very difficult to make any categorical statements from these accounts without further information," Brace said.

"But it seems incredible that they overlooked payments of £10m to their parent, the non-payment of which had unusually reduced its costs below what had been normal. It seems like an extraordinary mistake," he added.

"It is rather inexplicable that they could have made such a mistake with the amount of money paid to IBM, which is its biggest single cost."

Southwest One may simply have got in a complete muddle, said Brace. But he found the credit note especially curious. It would not normally be something a company declared at all, he said. It would normally be a correction of an invoice sent in the period. So it would not be booked and neither would the invoice. Now Southwest One had booked the costs and the credit note.

"It suggests the credit note was something standalone. It was raised for a specific purpose. And it wasn't a reduction of the charges per se. It was something separately given back by IBM. You can only speculate on that, which is always dangerous. There is insufficient information there to explain what has gone on. All you can do is ask questions," said Brace.

But he added: "You are either paying for goods and services or not. That must be abundantly clear when you process the invoices from IBM."

Southwest One also had to restate its 2009 numbers. This suggested a degree of incompetence that did not look good for a company trying to sell its services as the back-office of local government, said Brace.

In addition to the £9.512m post-dated credit note IBM gave Southwest One, the supplier gave another £10m credit note to offset costs again in the 2011 accounts published on 28 August. After receiving the credit note, Southwest One's 2011 operating loss was just £8.7m - prompting reports that it was past the worse of its troubles. 

Along with the two credit notes and loan, totaling £30m, IBM also has unpaid fees of £38.2m on Southwest One's books, bringing its total credit with the outsourcing venture to nearly £70m - though it appears IBM wrote off £19.512m of that as soon as it was advanced.

"There is a letter of support in place from IBM United Kingdom Holdings Limited, confirming its intention to support the company and enable it to meet its commitments in any liquidity shortfall," said Southwest One's directors in its 2011 accounts.

"Cumulative losses to date have in effect been funded by an unsecured credit facility from IBM," they said.

Brace said: "IBM appears to be giving Southwest One financial support such that it can carry on trading. 

"There may be a greater prize if they can pull this off and make it work. They may well stand by it for the full term of the contract in the hope they will actually deliver value at the end of the day. 

"On the other hand it might be typical of these outsourcing contracts. It's gone horribly wrong and Somerset appears to be trying to get out of it."

Failed business model

Southwest One was in a difficult situation at the point it understated its costs. Its directors said its business model had failed, that it could not cover its start-up costs and that losses would continue. It was suffering because Somerset council had made a sudden cut in payments to Southwest One after the Conservatives won control of the authority in 2009, reducing the outsource venture's earnings. Somerset had set the venture up with IBM. But by January 2012, when Southwest One directors wrote of their plight, Somerset had cut its payments by 51%, or £26.8m.

Somerset had already cut its Southwest One payments nearly in half by the end of 2010, putting the venture's payments to IBM in stark relief. So it would appear the directors front-loaded Southwest One losses to wipe the slate clean, putting the company £30m in the red. 

Shored up with IBM finance, they launched an ambitious plan for Southwest One to make up its shortfall by bidding for outsourcing business from local government bodies in other counties. IBM's investment with Southwest One now seems to depend on that ambitious plan.

Furthermore, the 2010 cut in IBM fees appeared again in Southwest One's 2011 accounts, almost identically. IBM fees to Southwest One were set by an Assistance Services Agreement between them and presented as a conjunct to the original 2007 contract. The convention in outsourcing is for fees and revenues to be balanced over the life of the contract. Somerset complained this was too inflexible as it tried to cut its side of the deal. Now IBM has cut its fees to Southwest One again to £7.9m, or 36%. 

Southwest One has declined to say what it receives for those fees, nor the reasons for the reduction in fees paid and the way they were accounted for. IBM has said that questions about Southwest One should be referred to Southwest One for response.

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