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.