Memorandum submitted by Ernst & Young (DFoB 11)

1. INTRODUCTION

1.1. We welcome the opportunity to respond to the Committee's inquiry into Dairy Farmers of Britain Limited (DFB). Ernst & Young LLP were appointed as auditors to DFB in 2002.

1.2. We issued an audit opinion on the consolidated financial statements of DFB for the year ended 31 March 2008 ('the 2008 accounts') on 31 July 2008.

1.3. No audit opinion has been issued in respect of the consolidated financial statements of DFB for the year ended 31 March 2009 ('the 2009 accounts') due to the incomplete status of the 2009 audit. DFB did not issue an interim report for the six months ended 30 September 2008 ('the 2008 interim accounts') and, therefore, we were not engaged to perform any procedures on the 2008 interim accounts. See Section 5 for more details.

2. EXECUTIVE SUMMARY

2.1. The 2008 audit was performed in accordance with International Standard on Auditing (UK and Ireland) 570 Going Concern ('ISA 570'). ISA 570 sets out the respective responsibilities of management and auditors in reaching a conclusion as to whether an entity is a going concern.

2.2. It is the responsibility of the directors of an entity to evaluate whether it is appropriate to prepare the accounts on the going concern basis, which involves considering the period extending at least twelve months from the date on which the accounts are signed.

2.3. It is the responsibility of the auditors to evaluate this assessment and consider the audit findings in the context of the audit opinion.

2.4. When planning the 2008 audit we were aware, through our regular meetings with management, that DFB were due to renew their bank facilities during 2008 and that the group was loss-making. Our audit plan for the 2008 audit, which we issued to the DFB Audit Committee in March 2008, included going concern as a key area of focus as a result and set out the additional procedures we would perform.

2.5. The group's forecasts for the three years ending 31 March 2010, which was the basis on which bank financing had been provided, had assumed losses in the year ended 31 March 2008 as the group sought to complete a planned restructuring of the business. The actual losses for the year ended 31 March 2008 were broadly in line with those that had been forecast. Our meetings with management had also indicated confidence that the bank facilities would be renewed prior to the signing of the 2008 accounts, which proved to be the case.

2.6. The three year forecast assumed that DFB would break even in the year ended 31 March 2009 and then return to profitability in the year ending 31 March 2010.

2.7. The directors of DFB concluded that the group was a going concern when the 2008 accounts were signed on 31 July 2008. The Directors' Report in the 2008 accounts states that "after making enquiries, the directors have reasonable expectation that the Group has adequate resources to continue in operational existence for the foreseeable future. For this reason, they have adopted the going concern basis in preparing the financial statements."

2.8. As a result of the audit procedures performed and the related audit findings, we were satisfied that management's evaluation was appropriate. Therefore, the audit opinion issued on the 2008 accounts was unqualified and did not include an emphasis of matter or disclaimer in respect of going concern.

3. BACKGROUND TO THE 2008 AUDIT OF DAIRY FARMERS OF BRITAIN LIMITED

3.1. DFB is a society registered under the Industrial and Provident Societies Act 1965. The 2008 accounts were prepared in accordance with the Industrial and Provident Societies Acts 1965 to 2002 and the Industrial and Provident Societies (Group Accounts) Regulations 1969. These Acts do not specifically address responsibilities of either directors or auditors as regards going concern.

3.2. Although not required to comply with the more prescriptive Companies Act 1985 or the FSA Listing Rules, the Board of DFB sought to adopt practices that were more akin to those of a listed entity wherever practical.

3.3. For example, the 2008 accounts includes a Corporate Governance statement which states that while "compliance with the Combined Code (the 'Code') is not mandatory for an Industrial and Provident Society, the Group believes it is appropriate to comply wherever practical to do so in order to maintain the high standards the Group aims to achieve."

3.4. In following this approach DFB also established an Audit Committee to whom we reported and which in turn reported to the Board of Directors. The Board of Directors consisted entirely of non-executive directors to whom the executive management team also reported.

3.5. Our communications to the Audit Committee included setting out our planned approach to the audit and our results and observations in formal reports issued at the planning and completion stages of the audit respectively. For the 2008 audit we formally met with the Audit Committee on four occasions. In addition, we met formally and informally with management throughout the audit cycle.

3.6. DFB also voluntarily adopted International Financial Reporting Standards ('IFRS') for the first time in the 2008 accounts, resulting in a restatement of the 2007 comparatives and the inclusion of additional disclosures required by IFRS 1 'First-time Adoption of International Financial Reporting Standards'. As the 2008 accounts state, as an Industrial and Provident Society this was not required and was instead a "voluntary adoption to follow 'plc' standards".

3.7. By following 'plc' standards wherever practical, including referring to the Combined Code and adopting IFRS, this resulted in greater disclosures in the 2008 accounts than would otherwise be required by an Industrial and Provident Society. For example, DFB included within the 2008 accounts a Business Review, a Statement of Corporate Governance and a Remuneration Report. In addition, though not required as an Industrial and Provident Society, the 2008 accounts also set out a statement as to the Directors' Responsibilities which states that the directors are "required to prepare the financial statements on a going concern basis, unless it is inappropriate to presume that the Group will continue in business".

3.8. As a result of voluntarily choosing to adopt IFRS in the 2008 accounts, DFB were required to comply with International Accounting Standard IAS 1 'Presentation of Financial Statements'. This requires that management make an assessment of an enterprise's ability to continue as a going concern. In assessing whether the going concern assumption is appropriate, IAS 1 paragraph 24 requires that "management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the balance sheet date" and that "financial statements shall be prepared on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so."

3.9. ISA 570 paragraph 3 states that under the going concern assumption, "an entity is ordinarily 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."

3.10. IAS 570 paragraph 9 states that the auditor's responsibility is "to consider the appropriateness of management's use of the going concern assumption in the preparation of the financial statements, and consider whether there are material uncertainties about the entity's ability to continue as a going concern that need to be disclosed in the financial statements" The auditor also "considers whether there are adequate disclosures regarding the going concern basis in the financial statements in order that they give a true and fair view. The auditor's procedures necessarily involve a consideration of the entity's ability to continue in operational existence for the foreseeable future. In turn, that necessitates consideration both of the current and the possible future circumstances of the business and the environment in which it operates."

3.11. IAS 570 paragraph 10 states that "the auditor cannot predict future events or conditions that may cause an entity to cease to continue as a going concern. Accordingly, the absence of any reference to going concern uncertainty in an auditor's report cannot be viewed as a guarantee as to the entity's ability to continue as a going concern."

4. AUDIT OF DAIRY FARMERS OF BRITAIN LIMITED FOR THE YEAR ENDED 31 MARCH 2008

4.1. In accordance with IAS 570 paragraph 11 we considered at the planning stage of the 2008 audit whether there were events or conditions, and related business risks, which may cast significant doubt on the entity's ability to continue as a going concern.

4.2. We set out in our Audit Planning Report to the Audit Committee, issued on 27 February 2008, our key areas of audit emphasis which included the renegotiation of banking facilities and the going concern assumption, review of financial and non-financial covenant compliance, impact of the "credit crunch" and related areas such as recoverability of trade debtors, stock valuation, goodwill impairment testing, accounting for restructuring costs and the valuation of defined benefit pension scheme liabilities.

4.3. It was known at the planning stage that the group's bank facilities (with HSBC) were due to expire in August 2008 with an option to extend for six months. Management had informed us in April 2008 that the meetings with HSBC had been positive and that it was expected that new bank facilities would be signed prior to the completion of the 2008 accounts.

4.4. In addition, in April 2008 management had confirmed that although DFB had been loss making for the year ended 31 March 2008, the result for the year ended 31 March 2008 were broadly in line with their three year plan, on which they were reporting to HSBC. This is referred to in the Chairman's Statement of the 2008 accounts.

4.5. Member resignations during the year ended 31 March 2008 had not been significantly different from those in prior years and were not identified by management as an area for concern with respect to the achievement of forecast results and going concern.

4.6. At the planning stage we observed that the management team appeared to be taking appropriate actions to remedy the risks arising from the group's financial position and that the going concern assumption had been discussed openly with management and the Audit Committee.

4.7. Our planned audit procedures to allow us to evaluate management's assessment of going concern for a period extending at least twelve months from the date on which the 2008 accounts were signed were set out in the Audit Planning Report. These were to include a review of covenants compliance to date, a review of forecasts and sensitivities of key assumptions, review of new bank facilities, review of post year end trading and cash flows and other post balance sheet events procedures. We note also that our team was supplemented by the appointment of an Ernst & Young audit partner independent of the engagement team whose role was to review and challenge our approach and conclusions in key areas of the audit particularly in relation to Going Concern procedures as highlighted at the planning stage of our audit work.

4.8. Our planned procedures are consistent with the guidance to auditors for the evaluation of management's assessment of going concern set out in ISA 570.

4.9. In completing our planned audit procedures, we identified that, as noted in 2.5 (above), the group's results for the year ended 31 March 2008 were in line with the first year of the three year forecast and the restructuring actions that management had planned within the three year forecast, including business restructuring and the restructuring of the members' capital arrangements, had been executed. Covenants for the year ended 31 March 2008 had been met and compliance had been forecast throughout the 12 months from the date on which the accounts had been signed.

4.10. The review of forecasts identified that, in addition to maintaining the existing relationships with key customers such as The Co-operative Group, continuing the growth of the 'localchoice' relationship with Tesco was a key factor in achieving future forecasts. The importance of this relationship was disclosed in the 2008 accounts - see and 4.19 below for further information in this regard, including evidence obtained regarding the Tesco Category Director and Manager's meeting with the DFB Council on 4 June 2008. In addition, we also obtained press releases and other relevant information from the Tesco website which referred to Tesco's plans to expand the availability of 'localchoice' milk. Maintaining membership numbers was also important and this is also referred to in the Future Outlook section of the 2008 accounts - see 4.21 below.

4.11. Our audit procedures also included reviewing a 'profit bridge' that compared the actual results for the year ended 31 March 2008 and the forecast for the year ended 31 March 2009 which enabled us to understand the necessary improvements and assumptions underpinning the forecast improvement in results in the 2009 financial year. Our audit procedures included testing of the key assumptions and areas of improvement including enquiries of the appropriate members of the executive management team and carrying out sensitivity analysis on these key assumptions.

4.12. As noted in 4.13 (below) the renewed bank facilities were signed on 15 July 2008 and we had obtained and reviewed these. Our subsequent events procedures, referred to in 4.17 (below) indicated a short fall against forecast results and cash flow, but that these were due to factors that were within management's control and, therefore, could be remediated during the remainder of the period. In addition, we noted that membership numbers were not subject to significant numbers of resignations and that while DFB had resigned from a contract with the Co-operative Group in the South East this had largely been anticipated by DFB. See 4.18 below for more information on both of these points.

4.13. We issued our Audit Results Report to the Audit Committee on 19 May 2008 with an Addendum issued on 22 July 2008 following the signing of the renewed banking facilities with HSBC on 15 July 2008 (the 'HSBC agreement'), both of which addressed the work performed on going concern. All findings and observations arising from the audit were set out in these two reports. These reports expressed our view that "the Board therefore need to be confident that the current year forecasts are achievable". This was in the context of goodwill impairment evaluation but is also relevant to their evaluation as to whether DFB is a going concern or not. The minutes for a meeting of the Board of Directors on 25 July 2008 noted that "the meeting held a lengthy discussion surrounding the achievement of business plans, and the Board's ultimate commitment to margin organisation." "Margin organisation" is the ability of the group to reduce prices paid to members in order to maintain margins on product sold within the business.

4.14. The HSBC agreement was for three years and provided DFB with facilities totalling £82.9 million. This consisted of invoice financing of £43 million, cheese stocking finance of £16.5 million, asset backed financing of £7.8 million, a term loan for a minimum of £10.6m and a revolving credit facility of £5 million.

4.15. The HSBC agreement had been provided based on DFB's forecasts for the three years ending 31 March 2010. The facility that was renewed in July 2008 had been entered into in August 2007 when the facilities in place prior to this were refinanced, resulting in an increased debt facility and a larger proportion of debt that was asset backed. Having met the forecast results for the year ended 31 March 2008 the same three year forecast that was reviewed by HSBC then formed the basis for the renewal of the facilities in July 2008.

4.16. We note that as at 31 March 2008, DFB's total bank borrowings were £47.3 million with cash of £4.4 million, resulting in net borrowings of £42.9 million. At 30 June 2008, DFB's management accounts were showing net borrowings of £54.4 million, still significantly within the available bank facilities.

4.17. Our Audit Results Report Addendum noted that results for the first three months of the post balance sheet events period were circa £1.1m behind forecast. This was primarily due to the Board of Directors' decision to increase milk prices paid to members by 0.5 pence per litre, which had not been included in the original budget, and the acceleration of restructuring costs that had been included in the forecast, albeit in a later month. Milk prices paid to members were within DFB's control, subject to monthly votes by the DFB Council, and therefore there was scope for milk prices to be reduced subsequently should it be necessary to achieve forecast results or cash flows. As noted in 4.13 (above) the Directors of DFB had confirmed in their meeting on 25 July 2008 their "ultimate commitment to margin organisation".

4.18. At the time the 2008 accounts were signed on 31 July 2008 we noted that there had been no significant change in member resignations. In a meeting with the Chairman of the Council on 18 July 2008 he had confirmed that the mood of the members was positive. We were aware that DFB had resigned from its South East supply contract with the Co-operative Group in July 2008, which represented circa 50 million litres of milk supply per annum, and prior to signing the 2008 accounts we had performed procedures to evaluate the impact of this on their ability to meet their forecasts for the year ended 31 March 2008. DFB had requested a significant price increase to continue supplying the Co-operative Group in the South East and as a result the potential loss of this contract was anticipated by management.

4.19. The 2008 accounts disclose the key customer relationships on which forecast results were based. The Future Outlook section of the 2008 accounts states that "DFB works with its existing strong customer base which includes a significant number of national retailers including the Co-operative Retail Trading Group, Sainsbury's, Morrisons, Waitrose and Asda. The Group is committed to maintaining these relationships whilst developing an expanded customer portfolio which together with the further development of the 'localchoice' milk initiative and our developing partnership with Tesco are seen as key to future success."

4.20. The success of the relationship with Tesco was an important factor behind DFB's forecast improvement in results. In considering this we noted the minutes of a DFB council meeting on 4 June 2008 in which the Tesco Category Director and Category Manager presented their outlook for the relationship between Tesco and DFB, which supported the assertions being made by DFB management.

4.21. However, the Future Outlook section also states that "as with any business, changing market conditions and the dynamics of the market itself - in the UK and overseas - could have significant financial effects. DFB is aware of these threats and imbalances and has contingency plans in place to offset their effects. There are also uncertainties surrounding market and commodity pricing and the potential effects this could have on membership numbers. As a member owned co-operative, DFB knows that our members are of critical importance to the future success of the business."

4.22. Management's formal evaluation in respect of the 2008 accounts was that it was appropriate to conclude that DFB would continue as a going concern for a period extending at least twelve months from the date on which the accounts were signed. As a result of our audit testing we were satisfied that management's evaluation was appropriate and we issued an audit opinion in respect of the 2008 accounts which was neither qualified nor modified in respect of going concern.

 

5. AUDIT OF DAIRY FARMERS OF BRITAIN LIMITED FOR THE YEAR ENDED 31 MARCH 2009

5.1. The commencement of our audit of the 2009 accounts was delayed until the week commencing 20 April 2009. Prior to this point, and subsequently, DFB had been investigating a number of strategic options for the group and, at their request, the start of the audit was delayed as long as possible so as not to incur potentially unnecessary costs. One of the options being pursued was for the members to provide further funding to the business in order to facilitate agreement of a revised HSBC banking agreement. We were asked to commence our onsite audit work prior to the DFB Council voting on this resolution in order that there could be a timely completion of the 2009 audit subsequent to the vote.

5.2. It was anticipated that an audit opinion would not be issued until the uncertainty relating to the strategic direction of the group was closer to resolution, which included in April/May 2009 further funding being provided by the members and the revision of the banking agreement with HSBC, which would then allow DFB and ourselves to consider whether the group was a going concern.

5.3. Following the decision of the DFB Council to vote against the request for further funding by the members, the audit was halted in the week commencing 11 May 2009. At this point we had not reached a position where we were able to report to the Audit Committee or issue an audit opinion.

5.4. No formal audit procedures took place during the period following the signing of the 2008 accounts and the start of the 2009 audit in April 2009 as DFB did not issue an interim report for the six months ended 30 September 2008. Therefore we performed no procedures on any interim financial information, we however continued to maintain contact with DFB's management, Chairman of the DFB Council and the Audit Committee Chairman on an informal basis. As a result we were kept informed of developments and strategic options that DFB were pursuing up until the appointment of PricewaterhouseCoopers as Receivers and Managers on 3 June 2009 .

 

Ernst & Young LLP
August 2009