End of the year show: FDs prepare year-end accounts

Ask any FTSE main board director what kind of a view they have on the year ahead and, chances are, they’ll give you a weatherman’s reply: “Visibility 500 feet and closing”. Yet as virtually every auditor and finance director knows, if the audit profession was to throw up its hands and react with a blizzard of qualified audit reports, they’d be shooting themselves in both feet and the audit would soon become meaningless to users of accounts. If they don’t, and their clients sink without trace with a clean audit report nailed to the mast, they could be letting themselves in for some interesting litigation a year or so down the road.

Directors and auditors have some deep thinking to do as we pass the 31 December year-end date for many companies. The going concern issue is the most critical as it obviously not only affects the entire basis on which the accounts are prepared; it can also become a self-fulfilling prophecy if the auditors insist that it isn’t appropriate to use it, or if they qualify their audit letter in a way that gives current and potential creditors the willies.

However, everyone, including the regulator, has to tread carefully in the present climate so as not to throw organisations into a crisis unnecessarily. The Financial Reporting Council, the UK’s regulator with responsibility for promoting confidence in corporate reporting, has been very clear that directors and auditors will need to square up early to the challenges of making disclosures “relevant to going concern and liquidity risk”.

“The absence of confirmations of bank facilities does not in itself cast significant doubt on a company’s ability to continue as a going concern, nor necessarily require auditors to refer to going concern in their reports,” the FRC says, giving one example.

Andrew Vials, head of professional practice at KMPG, believes there is no doubt this is going to be a very challenging year-end. “If you looked hard enough you could probably find a material uncertainty everywhere, given the current turmoil in the markets, but going down that route would not be very helpful from a public policy point of view,” he says.

There may be litigation ahead if some users of accounts feel there is mileage in pursuing an audit firm should a company they have invested in go down, but Vials argues that there should be perfectly good defences available to auditors. “You can’t rule out litigation, but the defence has to be that proper judgements were taken on the evidence that was there at the time. Provided the accounts disclose the factors and judgements that were taken into account, one can expect the courts to realise that no one has a crystal ball,” he says.

“The key words are ‘material uncertainty that gives rise to significant doubt that the company can continue as a going concern’,” he says. There will be some difficult judgement calls around that, but where the threshold is not reached and a company gets a clean audit report, this does not mean that it is not obliged to disclose all the factors that the directors and auditors took into account.

The acid test is that investors should be able to see what has been done, and the more reasoning that is shown the better it will help the defence in a court scenario.

There is another problem that relates to all the valuations used at the 31 December year-end date. Commercial property, financial instruments, work-in-progress, pension scheme shortfalls ­ – it all has to have a value attached to it and it has to be good enough to keep the business afloat.

Commercial property will be attracting particular attention as it is difficult to value accurately in any market, never mind one that is moribund. It’s even worse trying to value part-built skeletons on which construction work has halted. Moreover, bankers and other lenders will be taking a particularly keen look at the valuations deployed in their borrowers’ accounts for they now find themselves on the horns of a dilemma ­ albeit one of their own making.

The problem, as one senior banker at a big four clearing bank tells Financial Director, relates to collateral on loans, particularly loans made against commercial property. We can distinguish between two different cases here: the first where the property is incidentally collateral for the loan as part of a floating charge, the second where the loan is specifically secured on that property.

Collateral damage
To take the first case first, as Andrew Clark, director valuations at property consultancy Colliers CRE notes, London commercial property prices have fallen by 40% or more over the past year. “Banks have a very definite issue when this happens as the loans are no longer covered by the collateral,” he says.

Our senior banker points out that while this may be so in a number of instances, it has become more or less standard practice in recent months for banks not to ask for more collateral to cover the loan. Instead, they will turn a blind eye to what is, after all, a theoretical, paper valuation, provided the company continues to pay at least the interest on the debt.

“It would be a very unwise bank that pushed a company into liquidation simply because the collateral on the loan had diminished in value,” he points out.

Then there is our second case, where the bank has advanced funding with the property as security. Kevin Cassidy, senior manager corporate business at Allied Irish Bank, points out that in boomtime, banks had to compete to win the debt mandate on large commercial property deals, such as prestige A-grade London or Edinburgh new-build office blocks. Some lenders were tempted to throw prudence to the wind and lend well beyond the usual 70% to 80% of value mark.

Moreover, with banks queuing up for the business, covenants on many of these deals were extremely light.

‘Non-recourse’ loans, where the lending was done purely against the property, and not supported by personal guarantees or by other security, became relatively normal. Now that property values have slipped so far, borrowers in these positions may be tempted to cut their losses, hand the keys back to the bank and walk away ­ leaving the bank with both debt and empty property.

“Are there clients who are struggling to meet payments in the current circumstances? Absolutely,” insists AIB’s Cassidy.

Work in progress, too, is another of those ‘future looking’ elements in the accounts that is going to pose challenges. It is easy enough to highlight the difficulties associated with valuing work-in progress simply by looking at the high street sales that took place pre-Christmas. How many of those retailers foresaw having to discount by 20% or more pre-Christmas and built that into their projections? And what are their forward projections on sales? “Everyone is tightening their belts so you have to discount quite heavily, or you have to take a very strong view on your ability to sell. If you sit on stock then you have to fund working capital for that much longer,” he says.

Companies that manufacture on relatively long forward contracts of three months or more will have to take a view both on their order base and ask if they have strong customers commitments that they are producing to, what is the client’s financial strength? If the company is getting some cash on account, and most longer term engineering contracts will build payment points into the cycle, can they get more cash from the customer before the work is finished?

“This is about everyone being sensible. If client companies cash manage at the expense of their suppliers they will do themselves long-term damage by damaging their supply chain. Management and auditors have to really work through the detail here,” says James Baird, Deloitte senior partner in Scotland. Again, though, he argues that simply putting an “uncertainty” warning into the accounts in respect of work in progress will help no one. “You have to put the detail in as to why there is uncertainty and that will vary from case to case.

The demand here, as elsewhere, is for greater due diligence and for probing and testing fundamental assumptions,” he warns.

Three come at once
Pension funds, particularly those with funds that are in the unfortunate position of having their three-yearly actuarial reports due around year-end, have similar dilemmas. None of them will want to crystallise losses.

With property investments in the doldrums and equities down by as much as 40%, trustees and FDs will have some severe funding challenges. UK employers could find themselves being asked for steep funding contributions precisely when all sources of cash are drying up all around them ­ and the pension scheme deficit is leaving an even bigger hole in the company balance sheet.

Christopher Nichol, who runs Standard Life Investments Global Absolute Return Strategy Fund ­ one of the few funds not underwater by the end of 2008 ­ says one of the lessons that employers, trustees and pension fund managers need to take away from the present catastrophe is that the old mantra of taking a diversified approach to portfolio investing is “quite simply bust”.

“What the crunch has proved is that in a massive downturn the only thing that rises is the correlation between asset classes ­ that tends towards one [perfect correlation],” he says. Perhaps it’s time to make a New Year’s resolution to go in search of a new fund management strategy.