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April 29, 2009

Going concern incidence on the rise among smaller companies

Large listed companies have reported lower levels of going concern issues in their audit reports than anticipated but there has been a rise among smaller companies.

A PricewaterhouseCoopers UK (PwC) study found that only two companies had modified reports in analysis of the first 86 audit reports available from the FTSE 100 (45 reports) and FTSE 250 (41 reports) with 31 December year ends. Both of those companies were in the FTSE 250 and had an emphasis of matter paragraph around going concern.

Qualitative research was also carried out among PwC audit partners responsible for 30 FTSE 100 and FTSE 250 audits. It revealed companies had done more work to support their going concern assessment this year in more than 95 percent of cases.

PwC UK audit partner Andrew Ratcliffe admitted he was surprised the analysis did not pick up more modified reports.

“What has happened, which is good, is that management have done a pretty thorough job in this section among the larger companies,” he said. “There have been a limited number of cases where the auditors have said ‘I’m sorry, that’s not good enough you need to do more work’.”

A going concern assumption is issued by management to indicate that a company is able to continue operating for the foreseeable future. As the credit crisis has dried up access to credit for companies of all sizes, investors are placing close scrutiny on whether auditors believe companies are able to continue trading as a going concern.

Last year, PwC’s assessment of a similar sample of companies yielded no going concern issues but the heightened sensitivity surrounding this audit season had raised fears auditors could become overzealous in alerting investors to going concern problems.

Smaller firms more vulnerable

Although larger companies appear to be coping, smaller companies have produced a significantly higher number of going concern issues, forcing auditors to issue emphasis of matter paragraphs, which alert report users to issues within financial statements.

“Our London audit practice has issued more emphasis of matter paragraphs this year than last year,” said Charles Hutton-Potts, an audit partner at Grant Thornton UK, which audits the most Alternative Investment Market companies.

“I’ve personally issued more emphasis of matter paragraphs. Some of those have not just been on a going concern basis but actually some of the underpinning assumptions that the directors need to bring to the attention of shareholders.”

Hutton-Potts said smaller companies are more vulnerable to going concern issues because they are often more heavily geared, have less developed balance sheets and are subject to stricter covenant and borrowing conditions.

More work, more fees

Partners noted that companies have increased the level of disclosure surrounding going concern assumptions, which has led to an increase in the amount of work, cost and fees.

“Because the assessments have been more in depth and have been more stressed with more ‘what if?’ cases, there is more material to review and it takes you a bit longer to review it,” Ratcliffe explained.

“It’s increased what we’ve had to do but I wouldn’t say it’s a major factor. With some clients that are up against the wire and the cases are more troubled or there’s been a lot of iterations in discussions, the fee will go up.”

Hutton-Potts added: “Depending on the nature of the client the increased examination of going concern can easily add 5 to 25 percent to the planned workload. Because it is the more senior members of the audit team that tend to do the work it can have an impact on costs and fees.”

PwC sets up internal technical panels to consider difficult issues relating to audit. In the 2008 audit season, the firm had two panels but this year there has been 30 – an indication of the more careful approach auditors are taking.

“It’s certainly about being cautious but also the incidence of these problems is greater,” Ratcliffe said. “Bank lines are more difficult and banks are being tougher on covenants than they were a year ago. Whereas its good news that the larger companies seem to be getting through it, we shouldn’t be fooled to say it’s the same for everybody.

“You get down to the smaller companies and clearly there are some very troubled situations.”

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