Memorandum submitted by The Institute of Chartered Accountants

in England and Wales

 

INTRODUCTION

 

The Institute of Chartered Accountants in England and Wales (ICAEW) is pleased to be able to submit written evidence to the Business and Enterprise Committee as part of its current inquiry into financial support for small and medium size businesses (SMEs).

As a public interest body, the ICAEW is committed to working with Government and regulators as well as wider market participants in order to help restore business confidence.

The SME sector forms a vital part of the UK economy and its resilience in the current climate will be a key factor in terms of the speed with which the economy begins to recover. Many of the ICAEW's 132,000 members either advise or run SMEs and this submission draws upon their insight and expertise.

 

 

Executive Summary

 

1. In the current economic climate, banks are understandably more cautious about new lending as well as the renewal of existing finance. They are also under conflicting pressures on whether to improve capital ratios or to increase access to finance for businesses of all sizes. (1.1)

 

2. Research undertaken by the ICAEW indicates that this is likely to have a material impact on the ability of SMEs to weather the current downturn, in particular as a result of finance becoming more difficult to secure. ICAEW interviews with businesses and firms across the UK support this research. (2.1)

 

3. In the context of this limited availability of credit, SMEs can act to improve their position by taking steps to improve their management of working capital. (2.6)

 

4. For the proportion of SMEs who require a statutory audit, there is an additional challenge of reporting 'going concern' uncertainties. Market conditions in 2009 are likely to result in a higher proportion of company disclosures, together with an increase in the number of modified audit reports, as compared to previous years. (3.3)

 

5. The ICAEW believes that there are practical steps that can be taken by Government, regulators and the profession to help mitigate the risk of damaging misinterpretations of company disclosures and modified audit opinions by investors, credit reference agencies and finance providers. (3.8)

 

6. While the recent Pre-Budget Report (PBR) contained some welcome measures for SMEs, the ICAEW has concerns regarding the effectiveness of both the headline VAT rate change and the Government's access to finance package as measures designed to help improve the credit environment for SMEs as well as the wider economy. (4.1, 5.1)

 

7. The Government's Lending Panel, also announced in the PBR, needs better sources of independent data if it is to fulfill its monitoring role effectively. (6.1)

 

8. The ICAEW is committed to working with Government, business bodies, banking institutions and the SME sector in order to help publicise information and good practice designed to improve financial management during the current downturn. (6.2)

 

1. Challenges facing the Banking Sector

 

1.1 Given the current economic climate, banks and wider financial institutions are understandably more cautious about new lending as well as the renewal of existing finance. Lending to businesses becomes more risky as a result of poor trading conditions and falling assets prices. Consumer lending becomes more risky as job insecurity increases.

 

1.2 The banking industry is also facing conflicting challenges. The political community wants to see increased lending to small businesses. Regulators have encouraged banks to improve their capital ratios. Both are legitimate demands.

 

1.3 If banks increase their lending levels this raises the risks they accept, capital requirements rise and capital ratios weaken - which is why lenders are likely to be increasingly unwilling or unable to make new loans to SMEs or guarantee that existing financing arrangements will be renewed.

 

1.4 While the recent Government re-capitalisation of banks has helped to stabilise the financial positions of a number of major institutions, it is not yet clear whether these interventions will be sufficient to significantly stimulate bank lending.

 

 

2. Challenges facing SMEs

 

2.1 The ICAEW Quarterly Business Confidence Monitor suggests that, in the increasingly challenging business environment, access to finance is becoming more difficult and careful cash flow management is essential for all sizes of entity.

 

2.2 The 2008 Q4 UK Business Confidence Monitor shows that three in every ten firms (30%) report that access to capital has become a greater challenge to their performance over the last 12 months - up from 12% last year. This trend is apparent across all sizes of business. Firms are also increasingly likely to report that bank charges have become more of a challenge to business performance - up to 20% this quarter from 13% in Q3.

 

 

Impact on organisation's performance - change versus 12 months ago

% Greater challenge

Q4 2007

Q1 2008

Q2 2008

Q3 2008

Q4 2008

Your access to capital

12%

16%

20%

23%

30%

Bank charges

14%

12%

13%

13%

20%

Late payment from customers

19%

18%

18%

22%

28%

 

 

2.3 As the economic slowdown takes hold and access to credit remains constrained, late payment from customers is emerging as another major challenge for business - 28% of firms identify this as a greater challenge than a year ago (up from 22% in Q3). Further information about the ICAEW Business Confidence Monitor is contained in Appendix Two.

 

2.4 Qualitative research undertaken by the ICAEW in October and November also suggests that businesses are facing significant difficulties with regard to late payment of commercial debts as well as withdrawn or reduced credit insurance facilities. In addition, businesses complain of increased arrangement fees for finance facilities and increased interest changes as finance providers widen margins as part of the re-pricing of risk. Further qualitative analysis is contained in Appendix One.

 

2.5 What is clear is that banks are becoming more cautious about lending and are taking a much firmer line with companies than in recent years. They face a particular difficulty in lending to the SME sector due to its diversity and its size and as a result tend to classify customers according to their size and assessed credit risk. For many SMEs, bank lending decisions are based on credit analysis supported by an automatic decision support system (i.e. using a score card), supplemented by a final decision by a relationship manager. There is generally no fixed review process to assess the credit risk of smaller business while SME are often unable to build a continuous relationship with bank staff.

 

2.6 In this context smaller entities can act to improve their position, in particular, by adopting improved practices for managing working capital.[1] Further, where possible, SMEs should take steps to reduce their risk profile, for example by improving the quality, quantity and transparency of information they provide to lending institutions. SME companies are required to provide financial reports whether they are audited or not. Other SMEs will use financial reporting information for specific ends such as engagement with HMRC or for investment purposes.

 

2.7 An SME's management of its working capital will form part of a bank's lending decision. Banks will want to see cash flow forecasts, as well as historical accounts to be able to verify that a company has sufficient cash flow to service a debt going forward. Anecdotal evidence suggests that SMEs, especially unincorporated sole traders, often have difficulty managing their cash flow properly. Such entities need to be extra diligent about sound financial management in the current climate. In particular, they should focus on managing working capital, which includes: proper cash flow forecasting, taking into account the impact of unforeseen events, market cycles, loss of customers, early request for payment by creditors and late payment of debtors.

 

2.8 There are a number of other common practices which need to be reviewed in the current context:

 

SMEs can often improve their basic credit management - how they chase up their debts, the speed at which they invoice for goods or services, and the payment monitoring arrangements they have in place to check invoices on a regular basis.

Some SMEs could improve reporting of financial performance coupled with better forecasting systems of future trading and cash flow.

 

Many SMEs are inappropriately financed, placing too much reliance on term loans and overdraft, to the exclusion of factoring and invoice discounting, leasing and hire purchase.

 

Some businesses concentrate on trying to achieve good seasonal or quarterly results. Concentration on performance in this way can lead to lack of attention to working capital performance.

 

Many SMEs fail to prepare or put in place financial contingency plans to help tide them over unexpected events.

 

It is crucial that SMEs work to maintain good credit ratings and a credit file that demonstrates to others that they have successfully managed credit previously. Having a good credit rating helps to reduce the cost of borrowing and makes it easier for an SME to access funds.

 

Good communication with customers and suppliers is essential in avoiding disputes. Collaboration and understanding of respective positions can go a long way in helping to manage working capital.

 

2.9 In 2006 the ICAEW set up the SME Funding Adviser Scheme under the chairmanship of Sir Michael Snyder, Partner at Kingston Smith and former Chairman of the City of London Policy and Resources Committee, and with the active involvement of BERR and HM Treasury. The objective of the scheme is to ensure that businesses receive independent advice on the most appropriate form of business finance out of the range of available options and to assist businesses to meet finance provider requirements for financial reports and forecasts (profit, cashflow and balance sheets etc).

 

2.10 For the larger end of the SME sector, the Corporate Finance Faculty of the ICAEW has established a 'Fundraising on AIM' forum - a free platform for businesses to attend aimed at fast growing, young companies considering flotation as well as those looking for further funding.

 

2.11 The Faculty's 'Funding for SMEs' forum provides information on all aspects of the 'funding ladder': bank finance, government schemes, angel/venture capital and flotation. The Faculty also publishes good-practice guidelines and is currently working with DBERR to produce comprehensive guidance on government funding schemes (debt and equity).

 

 


3. Challenges for audited SMEs

 

3.1 All publicly listed companies and companies that exceed a threshold of staff numbers, turnover, or assets are required to be audited. In addition, banks or lending institutions may require businesses to be subject to an audit as a term of a loan agreement. According to Companies House, 143,600 companies in total submitted full audited accounts during the 12 months to 31 March 2008.

 

3.2 Although publicly listed companies are generally large businesses, a proportion of companies that exceed the audit threshold and a significant number of audit-exempt companies that opted for an audit to fulfil the terms of loan agreements will be SMEs in terms of the general definition of staff numbers (under 250).  Listed SMEs are significant engines of economic growth while SMEs that are audited for other reasons are likely to be ambitious, high-growth businesses.

 

3.3 Given the current economic environment, the ICAEW anticipates that a higher proportion of 2008 year end annual reports, compared to previous years, are likely to contain disclosures relating to 'going concern' - i.e. the company's ability to continue in business for the foreseeable future. Similarly, the auditors will need to refer to the directors' disclosure of this uncertainty in the audit opinion.

 

3.4 The ICAEW welcomes the guidance for directors recently issued by the Financial Reporting Council (FRC) regarding going concern and liquidity risk disclosures in the current difficult economic climate. The guidance emphasised that many companies will be faced with increased uncertainties and that these need to be disclosed in an open and transparent fashion. The forthcoming Accounting Practice Board (APB) bulletin on emphasis of matter will also provide guidance for auditors when they consider these issues. The ICAEW has encouraged the APB to publish guidance as a matter of urgency, prior to the end of the year so that auditors are able to plan their audit work accordingly

 

3.5 The ICAEW believes that, in many cases, potentially damaging investor reactions to these disclosures and modified audit opinions may be caused by misinterpretations of the information - and as such may be avoidable given sufficient market understanding and awareness.

 

3.6 In particular, investors and other users of financial statements need to be aware that, even in those cases where the directors have concluded that there are going concern material uncertainties, it does not mean that the company concerned will cease to continue. Going concern uncertainty is less important in many ways than the nature of the uncertainties and the proposed management response.

 

3.7 Further, if auditors conclude that a material uncertainty remains which may cast significant doubt on the company's ability to continue as a going concern and this uncertainty has been adequately disclosed in the financial statements, the auditor will modify the audit opinion by including an 'emphasis of matter' explanatory paragraph highlighting those disclosures. Such a paragraph does not affect the auditor's opinion, which is modified but 'clean' or unqualified. This distinction is very important.

 

3.8 Faced with the challenge of going concern the ICAEW recommends that the Government, regulators, the accountancy profession and banking industry work together to help ensure that:

 

Banks and lending institutions make every effort to raise awareness about the difference between modified and qualified audit opinions;

 

Directors and Auditors follow the APB guidance;

 

Where modifications occur, investors and other businesses respond in a measured and advised manner; and

 

Media reporting of emphasis of matter paragraphs should avoid using misleading or emotive language that gives the impression that a qualified audit opinion has been issued.

 

3.9 The ICAEW encourages wide public dialogue and parliamentary scrutiny of the going concern uncertainty issue in order to advise and educate the wider market. A full briefing on the going concern issue is included in Appendix Three.

 

 


4. ASSESSING THE IMPACT OF PRE-BUDGET REPORT ON SMALL BUSINESS FINANCE

 

4.1 While there were a number of welcome measures for small business in the PBR the ICAEW has concerns regarding the likely effectiveness of both the headline VAT rate change and the Government's access to finance package in substantially improving the credit environment for SMEs.

 

4.2 In regards to the temporary reduction in the VAT rate from 17.5% to 15%, the ICAEW is concerned that:

 

At a macroeconomic level, the temporary reduction will have only a minor impact on consumer purchasing behaviour, particularly for low income consumers;

 

For many businesses the administrative burdens and costs of pricing transition will outweigh any likely benefits; and

 

For those businesses that hold prices and thereby benefit from the VAT reduction, the effects of that advantage will be small compared to other cash flow difficulties - for instance as caused by falling demand or higher import prices due to the falling pound.

 

4.3 The ICAEW supports the Government's efforts to improve access to finance for SMEs announced in the Pre-Budget Report. However, given the relatively limited scale of intervention and the significant amount of time that it will take to set up and market new finance facilities, the ICAEW questions the overall impact on business confidence that the proposed measures will provide.

 

4.4 In the Pre-Budget Report, the Government announced:

 

The creation of a Small Business Finance temporary guarantee scheme to enable up to 1bn of new Government supported lending by banks.

 

An Export Credits Guarantee Department's temporary scheme to support a 1bn facility to provide smaller exporters with better access to short term working capital.

 

An RDA Loan Fund totalling 25 million, modelled on the Advantage West Midlands transition loan fund to help businesses over the next six months.

 

A capital fund of 50 million providing equity or quasi-equity to SMEs who are overleveraged.

 

4.5 In the overall context of bank lending of 54 billion to SMEs, according to the British Bankers' Association figures of 30 September 2008, the packages announced offer only limited assistance to the financing difficulties faced by SMEs. The ICAEW awaits details about how all of the above measures will work, i.e. when they will be available and how businesses will access them.

 

4.6 Within the overall small-scale equity market the proposed capital fund scheme does not represent a significant intervention. The ICAEW would also draw attention to the lack of previous experience for RDAs (apart from Advantage West Midlands) of RDA Loan Fund schemes to assist businesses in difficulties. Consequently we are concerned about the amount of time it will take to set up the appropriate structure to administer and market the scheme.

 

4.7 The Government also highlighted an EU announcement that the European Investment Bank (EIB) will make a 1bn fund available to SMEs in the UK by the end of 2008. There are only three banks utilising the existing EIB funding - Barclays, Alliance & Leicester and Close Brothers. Their use of the current facility is on a significantly lower scale than that now proposed. Some banks, who are not part of the current scheme, have expressed interest in negotiating a facility with EIB, however these negotiations will take time. Even when these facilities are in place it will take time for the new banks to train staff, market the scheme and start receiving applications.

 

 

5. WIDER Pre-Budget Report measures designed to help business

 

5.1 The ICAEW welcomes the Government's announcement to introduce flexible payment arrangements which will help taxpayers struggling to pay tax bills. This approach will build upon HMRC's approach to tax debt problems experienced by farmers during the Foot & Mouth crisis. We believe that this system worked well in ensuring the financial survival of many farmers who otherwise may have faced ruin.

 

5.2 The ICAEW also welcomes the proposal to extend loss relief carryback from one year to three years. This should help businesses offset current losses against earlier profitable years and thereby receive a tax refund. This announcement reflects a similar measure introduced in 1991 at the time of an earlier economic downturn. The three year carryback was maintained until 1997 when the carryback period reverted to one year.

 

 

6. The Lending Panel AND WIDER COOPERATION

 

6.1 The Lending Panel, announced in the PBR, to improve monitoring of lending to households and businesses should include representations from SMEs, company directors, auditors and lending institutions. The ICAEW recommends that the Lending Panel obtains better data if it is to fulfill its role of monitoring lending to business. Current information consists of high-level aggregate data from the Bank of England and the British Bankers' Association. Independent, statistically robust data is required to inform its monitoring of lending, particularly to the SME sector.

 

6.2 The ICAEW is keen to work with the government, business bodies and banking institutions in order to provide information to the SME community to raise awareness of the importance of sound financial management in the current climate. In particular, this information should focus on managing working capital, which includes: proper cash flow forecasting, taking into account the impact of unforeseen events, market cycles, loss of customers, early request for payment by creditors, late payment of debtors.

 

 

 

APPENDIX ONE

 

The impact of the credit crunch on UK businesses

 

Introduction

 

In October and November 2008 ICAEW Regional Directors visited chartered accountants in business and practice across the country. Issues relating to the economy were also discussed at length during meetings of ten Regional Strategy Boards across England and Wales.

 

This report assembles grass-roots evidence from finance professionals dealing with the many ramifications of the recession. This can be summarised by a comment from a member in the East of England:

 

'The situation appears to have deteriorated significantly in the last 6-8 weeks. In September there was a feeling that only certain sectors, such as property and banking were being affected. Now there is significant lack of confidence spilling into most sectors and businesses are looking to cut their costs.'

 

The availability of finance

The banks are unwilling extend credit and they are exercising their right to call in overdrafts. More damaging, for individuals, is that they are also calling in personal guarantees. - West Midlands

In the case of a company supplying home-ware, the bank reduced the overdraft by one-third and refused to re-assign a personal guarantee on the departure from the board of the guarantor. As a direct result, the company called in receivers. The personal guarantee is being exercised and the business is unlikely to be sold as a going concern. - West Midlands

The re-valuation of assets is having a serious impact. The view among SMEs is that banks should take a longer view of their viability by accepting that property prices will stay low for some time. A lower property valuation should not be a reason to withdraw support if there is no pressing need to realise the value of the assets. - West Midlands

Banks are still reasonably loyal to long-established customers. However, they are widely thought to be using the pretext of the financial crisis to shed their riskiest debts. - West Midlands

 

Banks are refusing to fund the cash-flow needs of SMEs. Owner managers are putting their own money back into their companies. But there is a limit to how much they can afford and how long they will be willing and able to do so. - West Midlands

 

A manufacturing company which employs 110 people has been asked by a leading bank to pay off its 75,000 overdraft. It is likely the company will close as a result. - West Midlands

 

A leading bank wants to renegotiate the existing loan to a charity with a very strong asset base from base +1.5 per cent to Libor +3.5 per cent and charge four times the normal arrangement fee. - West Midlands

 

A solicitors' practice found a leading high-street bank withdrawing its overdraft and offering no further advances. - West Midlands

 

A leading high-street bank pulled an overdraft for a small business when its overdraft was temporarily at zero. In this case, staff agreed to work unpaid for one month before the business received money due from a major customer. - West Midlands

 

Banks are raising their interest rates, fees and charges. Because of the downturn, predicting sales, profits and cash flows has become more uncertain. There is therefore greater risk, and this is making the banks more cautious. - Wales

 

Many businesses are turning to Finance Wales who are reported to be very busy (Finance Wales is a small investment bank, set up with European funding, and managed by the Welsh Assembly). There is a feeling that Finance Wales will be more understanding of the difficult economic position; their interest rates are higher than banks, but they will lend unsecured, which banks will not. - Wales

 

Corporate finance activity has practically ceased. This is regarded as the consequence of the banks' refusal to lend. "Corporate finance has died. There's no money out there". - East Midlands

 

Certain corporate finance deals are still happening, such as the sale and purchase of large corporates' non-core businesses, at the 25million to 50million level. However, good deals are failing to happen because they cannot be financed. - East Midlands

 

The relationship between the small business and its bank is very difficult at the moment because the local corporate banker appears to have no authority and is micro-managed by his/her head office. - East Midlands

 

The banks are pretty loyal to existing customers but are largely shut to new business. - East Midlands

 

Personal guarantees are often required where they were not expected and the amount of security demanded is higher than anticipated. "At the moment things are hard if you are borrowing". - East Midlands

 

When Advantage West Midlands announced a 4 million turnaround fund for SMEs in financial difficulty, the agency received 100 enquiries in two and a half days. - West Midlands

 

There have been no first-hand reports of businesses being refused renewal of an existing overdraft or loan but plenty of examples of their being refused relatively small increases in borrowings, often to cover short term cash requirements. - East Midlands

 

Smaller firms trying to raise money were experiencing difficulty and it was reported that any firm needing to renegotiate finances over the next 12 months 'would be in for a big shock'. - South East

 

'Banks are closed for business at the moment'. They are being accused of levying exorbitant fees. A general comment was that the banks really need to do something now to break the deadlock. - South East

 

Smaller firms are experiencing difficulty raising funds. There is concern about activities of banks. It is difficult for SME clients to find funding despite bank claims that they are lending. Also, banks are consistently changing local personnel making it difficult to establish working relationships. - South West

A medium-sized construction company successfully re-negotiated its credit facilities with its bank. But there was a considerable delay between the date of the meeting and the final decision which left the business teetering on the edge of a financial black hole. - West Midlands

There is no evidence yet that the Credit Crunch is beginning to ease. The liquidity that the Government has pumped into the banking sector is not yet flowing through into easier terms or access to working capital. - Yorkshire & Humber

 

There have been frequent reports of clients being moved from overdrafts to term loans and/or invoice finance even if facilities are not due for review - especially those clients who are going to their bank to request an extension of an existing line; this may well result in a complete renegotiation of all banking facilities, and an unwelcome increase in rates charged. - Yorkshire & Humber

 

Trade credit is drying up: nervous creditors are analysing accounts and cutting credit limits; equally, the availability of leasing or factoring finance is not easy. - Yorkshire & Humber

 

That said, almost all lenders say that they are open for business, and we were given examples of two corporate finance deals that have completed safely, with no more than a 0.5% increase in the rates being offered. - Yorkshire & Humber

 

Interest rates charged by banks still high, bad debts are increasing. The costs of defaults will be three to four times pre credit crunch levels. There will be insolvencies among large businesses. Consumer confidence is underpinned by house price inflation. - London

 

Smaller firms report that there is still CF activity, but fewer deals are happening. More work around the renewal of finance, where banks are variously reported as being far too risk averse and charging higher interest than previously - 4-5% over base is the norm where it was 2-3% over base. To add further fuel, renewal fees are also being increased significantly by banks. - Northern region

 

Small businesses with bank overdraft facilities coming up for renewal are finding rates increased from 2% above base rate to 4.5% above base rate as a minimum. This applies to all sectors and is soon expected to have an impact on small business profitability. - East Midlands

 

Interest rates are far more geared to risk than they used to be and "risky" customers will be charged significantly more than 4.5% above base rate. - East Midlands

 

Banks' fees for arranging overdraft and loan facilities have increased enormously. One interviewee reported increases of "thousands". Another reported the most extreme case he had ever heard of - an arrangement fee of 1,500 last year had grown to 30,000 in the summer of 2008 on a facility of 3 million. - East Midlands

 

At the larger end of the market, one example given was an arrangement fee in negotiation of 2-3million on a facility of 50million, which must be renewed in six months time when another fee may very well be charged. - East Midlands

 

Businesses have examples of overdraft and loan facilities being increased between 2 and 4% upon renewal and arrangement fees vary from 1,000 for relatively small amounts to 5% for amounts over 100,000. - North West

 

 

Knock-on effect on SMEs

 

Cash-flow

 

Stable businesses finding issues paying VAT bills, and difficulties finding funding from banks. This combined with increasingly late payment, likely to cause business failures. - South West

 

Cash-flow has slowed as everyone is delaying paying bills. - South East

 

Bad debts, and the time to taken to pay and be paid for goods and services have all increased. Respondents felt that on balance the delays were, as yet, more a result of prudence and caution than an inability to pay - but this situation may well change. Several accountancy practices are working closely with clients facing challenges -in many of these cases there will be one or more recent invoices still unpaid; there is a looming choice between increasing exposure from continuing to act in the hope of nursing the client through, or seeking to reduce exposure but making it more likely that the client will fail as a result. - Yorkshire & Humber

 

Chartered Accountancy firms report that clients are concerned about cash flow or already experiencing cash flow difficulties. One partner with a portfolio of medium and large businesses reported that approximately 20% of his clients were currently breaching their bank facilities or struggling with their cash position. Their only option is to trim their costs and their workforce. - East Midlands

 

Late payment is becoming more of a problem. Businesses desperate for sales are reluctant to turn down orders and are having to chase debts more assiduously. - East Midlands

 

 

HMRC

 

Many practices found HMRC were not exactly sympathetic! Some small businesses are struggling to pay VAT bills but HMRC using discretionary powers to penalise. This is putting small firms out of business unnecessarily. Given some leeway these businesses are viable. - South West

 

The more punitive powers of HMRC towards businesses already experiencing cash flow difficulties, is reported to have resulted in business failures. There are two specifics: The first relates to late payment of VAT which, after three consecutive late payments, results in massive surcharges on the business; the second concerns HMRC's powers to withdraw the Construction Industry Scheme as a consequence of the employers' late payment of PAYE, causing severe and sometimes fatal damage to a business' cash flow. - East Midlands

 

 

Credit Insurance

 

Credit insurance has been highlighted in relation to the US car-manufacturing giants but it is becoming a serious problem for SMEs, who insure their credit risks for peace of mind and sometimes because it is a condition of invoice discounting. - West Midlands

 

"If insurers withdraw credit on a whole industry or whole territory basis, rather than after a proper assessment of the individual companies concerned, the wheels of commerce will slow down even faster and the feared recession will become even more a self-fulfilling prophecy." - West Midlands

 

 

Prospects for 2009

 

No-one believes that this will be a short recession. The underlying causes and the lack of real solutions means that the recovery will be retail led, and it will take some time to restore consumer confidence. Most companies are looking at the first quarter of 2010 before any real signs of recovery and a few, mainly in the corporate events and hospitality sector are predicting a gloomy 2012. - North West

 

Business Links report that the number of New Start businesses has not dropped in the last two months but there has been a 70% drop in the number of enquiries. This is expected to lead to a sharp downfall in new Starts in early 2009. - North West

 

At the moment very few businesses show signs that they might not pull through a recession though weak businesses are struggling, including early start-ups and/or undercapitalised businesses. - South East

 

There is evidence to support the fact that Liverpool has bucked the trend to some degree but this is due largely to 2008 being the year of European Capital of Culture. Many believe that the city will have a harder time than other areas of the North West in 2009- 2010 as the reality of the recession hits home. - North West

 

Many companies are deciding not to replace staff who are leaving and will rely on 'natural wastage' as far as possible. However, many believe that redundancies will be inevitable as the recession settles in during 2009. - North West

 

It is believed that the majority of job losses in the financial sector in Manchester and the wider North West related directly to the recession will probably occur post Christmas period whilst those associated with the re-structuring process will be seen throughout 2009 and even into early 2010. - North West

 

Some companies feel that the pipeline of business is running out and are concerned about what might happen in 3-6 months. However, for some clients in the South East business is still booming. Practices are not seeing businesses adopting large scale redundancy programmes but the first enquiries on how to manage such programmes are trickling in. - South East

 

While members are aware of many businesses attempting to reduce their employee numbers, large-scale job losses are still rare; it is more usual at the moment to look for early retirements, or to seek not to replace a person who leaves. - Yorkshire & Humber

 

The current situation will not change at least until Q2 2009; it is not known when everything is going to be stabilised, confidence is knocking everybody. - London

 

Insolvency practitioners say demand for their services is still only "steady" rather than overwhelming. However, they believe this is because many personal and corporate insolvencies are being postponed until after Christmas, either on the grounds that the festive season might just provide a financial lifeline or, in the case of individuals, that they may as well eat, drink and be merry while they can. - West Midlands

 

Start up enquiries are increasing. The RDA announced a 10m package of measures recently, including assistance for start up businesses. There is no sense from members that these enquiries include an increased proportion of distress start-ups. - Northern Region

 

 

 

APPENDIX TWO

 

The ICAEW Business Confidence Monitor

 

The ICAEW has been conducting the UK Business Confidence Monitor since June 2003. The BCM provides a snapshot of the state of the economy informed by our members; chartered accountants who advise and run businesses of all sizes across every economic sector in the UK. It is one of the largest and most comprehensive quarterly reviews of UK business confidence - c1000 interviews each quarter among senior business professionals across all UK regions, commercial sectors and sizes of businesses. Reports and other materials are distributed to a wide range of national and regional public policy stakeholders, reaching the highest levels of government and parliament, including the Bank of England. The BCM provides a robust tool on which government and regional authorities can base decisions for developing both business and economic policy.

 

 

Appendix Three

 

ICAEW Going Concern Policy Briefing, 4 December 2008

 

Going Concern

 

ICAEW calls for greater understanding of the going concern uncertainty expected in 2008 audited financial statements

 

1. The 'going concern' basis:

 

'That the business entity is viewed as continuing in business for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors pursuant to laws or regulations.'[2]

 

Financial reporting is at the heart of modern markets and the going concern basis is a fundamental concept in financial reporting. Normally, assets and liabilities are reported on a going concern basis - i.e. that the company will continue for the foreseeable future.

 

Company directors must prepare financial statements on a going concern basis unless they intend to liquidate the business or to cease trading, or have no realistic alternative but to do so. In deciding whether the going concern basis is appropriate, directors examine existing budgets and forecasts, assess borrowing requirements, and review other information as needed. Directors are required to take into account all available information about the future which is at least, but not limited to, one year from the date of approval of the financial statements. This is an exceptionally difficult task in the current market climate.

 

The auditor evaluates the directors' assessment and considers whether there are events or conditions which may cast significant doubt on the company's ability to continue as a going concern. As a result, the auditor may seek further audit evidence.

 

If, after obtaining further audit evidence, a material uncertainty remains which may cast significant doubt on the company's ability to continue as a going concern and this uncertainty has been adequately disclosed in the financial statements, the auditor will modify the audit opinion by including an 'emphasis of matter' explanatory paragraph highlighting those disclosures. Such a paragraph does not affect the auditor's opinion, which is modified but 'clean' or unqualified. Alternatively, where disclosures are deemed not to be adequate, the auditor will issue a qualified opinion and provide the required additional disclosures.

 

2. What is the issue?

 

Given the current economic environment, the ICAEW anticipates that a significantly higher proportion of 2008 year end annual reports are likely to contain disclosures relating to going concern and liquidity, together with an increase in the number of modified audit reports, as compared to previous years.

 

The nature of the market reaction, and the full market implications of a rise in these disclosures and modified audit opinions, will be heavily affected by the levels of understanding and awareness regarding the cause of this likely rise.

 

If investors and others do not respond proportionately to emphasis of matter paragraphs explaining going concern uncertainty, and do not take into account the current exceptional economic circumstances, the issue has the potential to undermine wider business confidence.

 

 

3. Why are modified audits expected to rise?

 

The economic environment is currently challenging, with low levels of business and consumer confidence. The ICAEW 2008 Q4 Business Confidence Monitor found that UK business confidence had fallen for a sixth consecutive quarter to reach the lowest level since the monitor began. Commercial and domestic property value, which underpins a large proportion of credit facilities, has been falling. In addition, adverse trading conditions have negatively impacted on profitability and cashflow. These factors all reduce the likelihood that lending institutions, already inclined to be more risk averse, will renew existing credit lines.

 

This may well result in directors concluding that there is a need to disclose that a material uncertainty exists that leads to significant doubt on the company's ability to continue as a going concern. Similarly, the auditor will need to refer to the directors' disclosure of this uncertainty in the audit opinion.

 

 

4. How might businesses and investors react to modified audit reports?

 

If the wider market is insufficiently prepared and readers of audit opinions do not understand why a company is including going concern or liquidity risk disclosures or why an audit opinion has been modified, there is the potential for a number of damaging effects:

 

A funder/lender may react by withdrawing or declining to renew credit facilities, damaging an otherwise viable business that may be reliant on those credit arrangements;

In some cases, a modified audit opinion could be interpreted as businesses having breached loan covenants;

Suppliers may stop or interrupt providing credit facilities to a business, disrupting its trading activities;

Landlords may seek to enforce break clauses in property lease arrangements;

General business confidence and investor sentiment may be damaged.

 

 

 

 

 

5. The importance of wider market understanding of going concern uncertainty

 

Market participants need to be fully aware of what emphasis of matter paragraphs mean in the current business environment.

Investors and other users of financial statements need to be aware that, even in those cases where the directors have concluded that there are material uncertainties, it does not mean that the company concerned will cease to continue. Going concern uncertainty is less important in many ways than the nature of the uncertainties and the proposed management response. Conversely, where the directors have concluded that there are no material uncertainties, and the auditor concurs, it does not mean that the company is guaranteed to continue in business until the date of the next financial statements.

 

The ICAEW believes that, in many cases, the damaging potential reactions to modified audit opinions, summarised above, may be caused by misinterpretations of the 'emphasis of matter' in those modified audit opinions - and as such may be avoidable given sufficient market understanding and awareness.

 

The ICAEW welcomes the guidance for directors recently issued by the Financial Reporting Council (FRC) regarding going concern and liquidity risk disclosures in the current difficult economic climate. The guidance emphasised that many companies will be faced with increased uncertainties and that these need to be disclosed in an open and transparent fashion. The forthcoming Accounting Practice Board (APB) bulletin on emphasis of matter will also provide guidance for auditors when they consider these issues. The ICAEW has encouraged the APB to publish guidance as a matter of urgency, prior to the end of the year so that auditors are able to plan their audit work accordingly

 

 

6. Background to audit reports and the role of company directors and auditors

 

All publicly listed companies and companies that exceed a threshold of staff numbers, turnover, or assets are required to be audited. In addition, banks or lending institutions may require businesses to be subject to audit as a term of a loan agreement. Although publicly listed companies are generally large businesses, a proportion of companies that exceed the audit threshold and a significant number of audit-exempt companies that opted for an audit to fulfil the terms of loan agreements will be small and medium sized businesses. According to Companies House, 143,600 companies submitted full audited accounts during the 12 months to 31 March 2008.

 

Directors have a requirement to prepare the financial statements on a going concern basis unless they intend to liquidate the business or to cease trading, or have no realistic alternative but to do so. In making these assessments, if management is aware of material uncertainties that may cast doubt on the entity's ability to continue as a going concern, they need to disclose these uncertainties within the financial statements. They may however conclude that the financial statements cannot be prepared on a going concern basis. This also needs to be disclosed with details of why the business is not a going concern and highlight the basis on which the financial statements are prepared.

 

The auditor reviews the information used by directors in drawing their conclusion that the going concern basis is appropriate. The auditor also considers disclosures about going concern and liquidity risk made in financial statements. If the auditor concludes that the disclosures are not adequate to meet the requirements of accounting standards, including the need for financial statements to give a true and fair view, they are required to qualify their opinion and to provide their reasons for doing so.

 

Where a material uncertainty exists that leads to significant doubt on the company's ability to continue as a going concern, the auditor has the following choices:

 

Where the directors have concluded that the going concern basis is appropriate:

Where the uncertainty has been adequately disclosed in the financial statements, the auditor will issue an unqualified opinion, modified by including an emphasis of matter paragraph. If there are significant multiple other material uncertainties, auditors may disclaim their opinion instead of adding an emphasis of matter paragraph but these material uncertainties can relate to matters other than going concern.

Where the uncertainty has not been adequately disclosed in the financial statements, the auditor will issue a qualified opinion, stating the reasons why, or give an adverse opinion

 

 

 

Where the directors have concluded that the going concern basis is not appropriate:

Where the directors have followed an alternative basis, to which the auditor agrees, and have provided adequate disclosure in the financial statements, the auditor can issue an unmodified report (in relation to going concern) Such situations are rare.

 

An audit opinion without reference to going concern is not a guarantee that a business is a going concern.

 

For further details on the processes for assessing going concern uncertainty for audit opinions, please see the Financial Reporting Council guidelines.[3]

 

The FRC, in its press statement of 27 November 2008, says that it 'recognises that the global liquidity squeeze and its impact on the wider economy increases the challenges for directors in preparing corporate reports this year.... more time may need to be spent by directors and audit committees planning the year end activities, reviewing key assumptions and models used in financial reporting and in reviewing the significant accounting and disclosure judgements.' The FRC has therefore published an Update for directors of listed companies on reporting on going concern and liquidity risk.

The ICAEW plays a key part in making sure that the responsibilities of all parties are clarified and understood whether they be directors, auditors or other third parties (such as investors and lenders).

 

 

7. Recommendations

 

The government, regulators, accountancy profession and banking industry should work together to help ensure that:

 

Banks and lending institutions make every effort to raise awareness about the difference between modified and qualified audit opinions;

Directors and Auditors follow the APB guidance;

Where modifications occur, investors and other businesses respond in a measured and advised manner; and

Media reporting of emphasis of matter paragraphs should avoid using misleading or emotive language that gives the impression that a qualified audit opinion has been issued.

 

The ICAEW encourages wide public dialogue and parliamentary scrutiny of the going concern uncertainty issue in order to advise and educate the wider market.

 

 

December 2008



[1] Working capital management refers to the management of current or short-term assets and short-term liabilities. Components of short-term assets include inventories, loans and advances, debtors, investments and cash and bank balances. Short-term liabilities include creditors, trade advances, borrowings and provisions. The major emphasis is, however, on short-term assets, since short-term liabilities arise in the context of short-term assets.

[2] Paragraph 3 of International Auditing Standard (UK and Ireland) 570 Going Concern

[3] http://www.frc.org.uk/images/uploaded/documents/Bulletin2006_6%20web%20optimized.pdf and The Auditing Practice Board's International Standard on Auditing (UK and Ireland) 570 (ISA (UK and Ireland) 570) Going Concern guidelines for auditors