In this regular slot Ash Mehta provides an inside view of what’s happening in the City and how it affects you the private investor.

The Language of Going Concern

"Emphasis of matter" and other strange terms you don't hear in a booming economy

Going Concern

 Unless you are a government trade minister you probably aren’t seeing any green shoots. There is a good reason for that: there aren’t any! The main concern for most companies whether AIM-quoted, full-listed or private isn’t green shoots but whether they will still be in business in twelve month’s time. Already we have seen administrators appointed to a number of AIM companies including Fishworks, Oakdene Homes and The Real Hotel Group.

 So, with most companies having a year end of December the hot topic in the City during January has been the issue of going concern. The going concern basis implies that the board of directors believes (but doesn’t guarantee) that the company will be in business in twelve months time from the date of signing the accounts and prepares its annual accounts on that assumption. The directors must have a reasonable basis for making the going concern assumption as they may be held financially liable if the business were to fail in the following twelve months. They should also take soundings from their advisors. 

A partner in a leading mid-size law firm for AIM companies told me over lunch that his firm has been overwhelmed by the number of queries from companies about financial difficulties and going concern. So much so in fact that he has created a case study exercise to hone the advisory skills of his younger associates who haven’t been through such turbulent times before. The case study presents a rolling scenario in which a company goes through a number of events, including a downturn in trading, the failure of a firesale of a division to raise funds, a customer going insolvent, an underperforming Finance Director and a falling share price. Sounds far-fetched? Not these days.

Banks: Compliance and Covenants

As if there weren’t enough challenges for companies with their trading, various people around the City have been telling me about the strains their clients are under with banks withdrawing unused facilities from companies often with little reason to do so other than to protect their own capital bases. A Corporate Finance Director in a Nomad with a large AIM client list told me of a profitable, cash-generative software client of his with a long term loan which was “asked” by its bank to cut its dividend in order to accelerate repayment of the loan. The dividend cut has now been implemented and led to a 40% fall in the share price.

Banks are increasingly using non-compliance with covenants as a reason for withdrawing facilities. A covenant is a measure specified in the loan agreement with a minimum target the company must meet at regular intervals, often every month or quarter. For example a covenant could be that EBITDA is at least five times the interest charge on the relevant borrowings. Failure to meet the covenant target means that the lender is entitled to demand repayment of the loan which in extreme cases can push the company into administration.

Therefore, as a private shareholder, you’d think information on banking covenants would be an important note in annual reports of companies, giving shareholders the ability to assess the likelihood of a company committing a breach. However, whilst you can usually find a swathe of unenlightening information in a company’s annual report, I expect you’ll be hard pushed to find any information on banking covenants for the company’s borrowings.

Auditors Reports: Significant Doubt and Emphasis of Matter  

So, in that case, what should you look out for in the annual report? If it’s a nervous time being a director of a plc (and it is, believe me) then it’s an even more nervous time being an auditor of a plc. For that reason, go straight to the auditors report because the chances are that this year rather than being a bland page of standard wording you may find some words you haven’t seen in an audit report for some time.

“Significant doubt” about going concern doesn’t need translation. If you see this then it’s probably time to sell up and recover whatever you can for your shares. 

“Emphasis of matter” is more subtle, and translated from auditor’s speak means “you really should read this bit as it will draw your attention to something in the accounts that is important”. It doesn’t mean that the auditors don’t believe the accounts to be correct, but if you see this in your company’s audit report then do read it in detail and make sure you understand the issue they’re referring to. 

For the more rigorous private investor, I also suggest a read of “An update for directors of listed companies:

Going concern and liquidity risk” published by the Financial Reporting Council.                                    

The FRC is not known for producing succinct readable documents but this is an excellent guide to the issues that boards ought to be considering when assessing whether their businesses are going concerns and how they should comment on these matters in communications to shareholders. It’s best saved for a wet Sunday afternoon but at least when you go to the company’s AGM you’ll be well prepared to find out if the directors have gone through a proper process in considering your company’s going concern. You can judge for yourself whether you’re convinced and will continue to hold shares in the company. 

Despite spring being just a few weeks away, I suspect we’ll be seeing more emphasis of matter statements than green shoots for some time to come.

Update: January 2009: The Ross Factor

 Since this article was published the FSA has issued an amnesty for directors who hadn’t complied with the disclosure rules on granting security over shares and this has led to many companies disclosing transactions including Barclays, Pearson, Prudential, and Serco. The FSA hasn’t however amended the rules. I have written to the FSA to ask why if the rules were clear enough that they don’t need amending, there are no enforcement actions being initiated by the FSA for non-compliance by directors. The FSA’s approach seems to be if it’s a small problem it’ll bring actions but if it’s a big problem it’ll grant an amnesty; the FSA is emphasising to listed companies that it expects their boards to deal with breaches by directors. I’ll keep you posted on the FSA’s response.

ash@orchardgrowth.com

Ash Mehta is Chief Executive of Orchard Growth Partners which provides Finance Director consultancy services. He is also part-time Finance Director of Northbridge Industrial Services plc, an AIM-quoted hire company, and he sits on the Executive Committee of the Quoted Companies Alliance, the representative body for smaller quoted companies. The views expressed are his own and do not necessarily represent the views of those organisations or of Aimzine Ltd.

© Ash Mehta

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