VideoTalk about being stuck between a rock and a hard place. Back in the autumn of 2007, Paragon Group, a UK-based buy-to-let mortgage specialist with £10 billion (€11.2 billion) of assets under management, had a £280m credit facility due to expire the following year. Paragon's board members had two choices, recalls CFO Nick Keen. They could negotiate a rollover facility with banks or they could turn to a rights issue that would hopefully raise enough cash to pay off the existing facility. Neither was ideal.
As the subprime debacle was just starting to take its toll, the "increasingly difficult" negotiations on the rollover facility with a syndicate of banks left Paragon with an expensive offer, Keen says. As for the rights issue, it wasn't just the fact that it would be taking place "in an environment of uncertainty" that gave Paragon's board pause for thought. With a September year-end, the decision about what to do to shore up the firm's balance sheet coincided with the signing-off of its annual accounts with auditors Deloitte. The auditors made it clear that the rights issue, despite being fully underwritten, made them jittery. If it went ahead, Deloitte cautioned, it would have to insist on including an "emphasis of matter" (EOM) in its 2007 annual report. This was a daunting prospect for the company, not to mention its shareholders, customers and other stakeholders, who might view the EOM as a warning that Paragon may not continue to be a going concern.
Nonetheless, Paragon opted for the rights issue and received what in those days was a relatively rare EOM. The cash call was completed successfully — in February 2008, raising £287m — leaving its most recent annual report with a clean bill of health. It has now match-funded all its loan portfolio to maturity, without any debt maturing until 2017.
Paragon is an exception to the rule. According to Company Reporting, an Edinburgh-based business information research house, few companies manage to survive as their former selves after receiving an EOM. The list of fallen companies include British Energy, Corus and MyTravel. (See the table at the end of this article.)
But as the number of corporate insolvencies rises — there were 169,000 last year in Europe, an increase of more than 13% on the previous year, according to credit insurer Euler Hermes, and predictions of even more in 2009 — auditors are not hiding their intentions to give a less-optimistic view in this reporting season. After all, the audit firms risk big hits to their credibility if they sign off accounts only then to see clients go under.
As a result, companies are working harder than usual this season to avoid the dreaded EOM appearing in their annual financial statements. In fact, even fundamentally sound firms now claim that their auditors are demanding more extensive disclosures before their reports are signed off.
Watchdogs are also weighing in. Both the New York—based International Auditing and Assurance Standards Board and the UK's Financial Reporting Council recently published documents reminding directors and auditors about their going-concern responsibilities. Companies must demonstrate to stakeholders that their reports are being prepared on the assumption that their company is viable for at least 12 months from when its accounts are signed off — no small feat given how quickly market conditions have been changing lately.
What can CFOs do to prevent their companies from receiving modified audits? And how should they react if an EOM does make an appearance?
An Ounce of Prevention
The starting point for any of these discussions is in the boardroom, says Bertrand Boisselier, a partner at Deloitte who was formerly senior vice president of finance at French IT services company Atos Origin. CFOs, he advises, should focus more than ever on the quality of information fed to board members. After all, he says, "nobody will throw stones at someone who discloses assumptions fully and intelligently, even if assumptions are susceptible to being wrong very quickly these days."
As for what auditors are looking for in these disclosures, there aren't many surprises. In addition to the usual risk factors and financial information, auditors "want to see management capable of taking alternative courses of action such as cutting capex to preserve cash if there is a sudden deterioration in trade or bank credit, or the flexibility on overheads," says Graham Clayworth, head of public policy at BDO Stoy Hayward. "What is different is that CFOs need to make sure they document and record what they are doing when making a judgement on going concern."
That can be more difficult than it sounds. "We've always had an open and proactive dialogue with our auditors, but in today's environment, the glass is considered half empty," says Elke König, CFO of Hannover Re, a German reinsurer with gross annual premiums of around €8 billion. With a December year-end, König has been spending much more time discussing issues such as valuation, modelling and profit forecasts with auditors from KPMG. One of the trickiest discussions has been around the value of financial instruments that are now barely tradeable. Even in calmer times, "there are always new ideas and guidance on how to value and disclose such assets, both from auditors and regulators, and sometimes at short notice," she says.
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