The credit crunch, the lack of liquidity and capital of the banks as they battle with Basel II are well documented. Is the next crisis of confidence, however, about to hit corporates and private equity houses as auditors argue there are material uncertainties existing around portfolio companies’ going concern?
The business review, now required by the Companies Act 2006 in directors’ reports, could become the key area of debate in reports and accounts. In this economic climate, business reviews are almost certainly going to speak about uncertainties around current financing arrangements (whether committed or uncommitted) and potential changes in financing arrangements, such as critical banking covenants.
Risks arising out of current credit arrangements, including the loss of credit insurance, heightened dependency on the performance of key suppliers and customers and the uncertainties surrounding the potential impact on the economic outlook to business in general are also likely to emerge.
The codified duties of directors has been introduced under the new UK Companies Act and directors have an increased exposure in relation to their assessment in supporting a going concern statement and appropriate regulatory disclosures.
It is going to be necessary for directors to provide evidence to support their conclusions and have detailed contingency remedial action plans. The squeeze on corporate cash flows means that liquidity risk is likely to be a material risk for many more entities this year. As a consequence, a greater number of companies are likely to need to present relevant disclosures concerning liquidity risk in their director’s reports.
While it is standard for auditors to ask for bank lenders to confirm facilities as part of a year end process, we are entering a period when bankers may be reluctant to provide positive confirmations that facilities will continue to be available.
Such a failure to confirm facilities does not mean that the accounts have to be qualified but it may well lead to increased disclosures on liquidity risk and material uncertainties. These are likely to require further work to be undertaken by directors to show what future plans they have to deal with financing risk.
As directors have long pointed out, assessing the going concern assumption involves making a judgement at a particular point in time about the future outcome of events or conditions which are inherently uncertain. Generally the degree of uncertainty associated with the outcome of an event or condition increases further into the future when a judgement is being made about the outcome of the event or condition.
A requirement for increased committed capital from private equity houses is a key concern in 2009. While auditing as a profession has been silent on this point to date, rumours abound that private equity houses will be required to provide letters of comfort or further guarantees for future funding of portfolio companies.
In the future, accounts are likely to contain significant liquidity and going concern related disclosures and we are likely to see auditors’ modifying their reports to highlight a material matter, relating to a company’s going concern.
Investee directors are going to be put in a very difficult position this year and members of the audit committee of a company are going to have an increased risk of liability to third parties compared to any time in the medium to short-term past.
It is going to be an interesting reporting season and investee directors, portfolio directors and private equity houses themselves need to take early advice from appropriate professionals to minimise their risk and to identify up front what they will actually be saying in these public documents. Internal controls and risk management systems will be under more scrutiny than at any time since Turnbull. Boards will have to come up with analyses of risks facing the business and how those risks are going to be addressed in even more detail, unfortunately including having to amend long-term group strategic plans to reduce any exposure to liquidity risk and counterparty default risk.
It is likely that it will soon be a requirement of the Financial Reporting Council that disclosures relating to risk are brought together in a single section of a company’s annual report or key disclosures are brought together by way of a note including cross references. Is the need to give guarantees and letters of comfort to portfolio companies going to crystalise early restructurings or administrations of portfolio companies? For once directors’ liabilities and duties are real – counterparties will be relying on your statements.