Charles Wilson of Trowers & Hamlins LLP considers the increased use of emphasis of matter paragraphs in relation to going concern statements contained in company's accounts.

In the current economic climate, auditors' reports are being scrutinised more than ever before by shareholders, lenders, employees and others keen to determine the actual financial health of companies. The content requirements of audit reports for UK companies are set out in the Companies Act 2006 and must state clearly, amongst other things, whether in the auditor's opinion, the annual accounts give a true and fair view.

Company accounts must be prepared in accordance with the Companies Act or in line with international accounting standards and both assume that the company carries on its business as a going concern unless there are ‘special reasons’ for not doing so, for example, if the company in question has ceased trading, is in the course of liquidation, or the directors have no realistic alternative but to liquidate the company or to cease trading.

In deciding whether the going concern basis is appropriate, directors should consider various factors including existing budgets and forecasts, borrowing requirements and market/product trends. Directors are required to take into account all available information about the period of 12 months following the date of approval of the accounts.

With falling property values, adverse trading conditions which affect cash flow profitability and the difficulty of obtaining new or replacement finance from lenders, directors may be finding it harder to conclude that there are no ‘material uncertainties that lead to significant doubt upon the entity's ability to continue as a going concern’. Auditors too, are required by accounting standards to determine in their judgement whether such material uncertainties exist.

Auditors may conclude that it is necessary to qualify their opinion, disclaim an opinion, issue an adverse opinion or modify their report by including an emphasis of matter paragraph. If the auditors conclude that the disclosures are not adequate to meet accounting standards requirements, including the need for financial statements to give a true and fair view, they are required to qualify their opinion, and provide an explanation. If auditors conclude that a material uncertainty exists that leads to a significant doubt about the ability of the company to continue as a going concern, and those uncertainties have been adequately disclosed in the financial statements, they are required to modify their report by including an emphasis of matter paragraph.

Essentially, an emphasis of matter is a spotlight shone by the auditors in their audit report on certain disclosure(s) in the directors report and annual accounts to draw the reader's attention to them. 

As accounting standards do not define what constitutes ‘material uncertainties that lead to significant doubt upon the entity's ability to continue as a going concern’, both directors and auditors may be left to exercise a high level subjective judgement. Such judgement will necessitate assessing both the probability of an event occurring and the impact it will have if it does occur.

Consider for a moment how difficult this determination might be in the context of a company which is assuming the continuation of its bank facility. In certain circumstances it could breach its facility covenants, which may lead to the pulling of the facility and refinancing the facility on acceptable terms with an alternative lender may take considerable time or not be possible. Directors and audit committees should ensure that records of their deliberations are kept in case there is any comeback against them or their company.

Mindful of their legal and regulatory obligations, directors and auditors may well err on the side of caution in making going concern disclosures and modifying audit opinions. This may give rise to unwelcome consequences such as a lender withdrawing or declining bank facilities, suppliers stopping or interrupting the provision of credit or landlords seeking to exercise break clauses.

For listed companies, it may result in a fall in investor and market confidence leading to share price falls and/or increased volatility. If you are a director of a company whose auditors include an emphasis of matter paragraph in their report full dialogue with your investors, suppliers, your workforce and other relevant parties should be top of your agenda.

The difficult economic environment that companies are operating in requires directors to carefully assess whether it is reasonable to use the going concern basis in their annual accounts, and to ensure that there has been proper disclosure of going concern risks and other uncertainties. The Accounting Practices Board has published a bulletin (Bulletin 2008/10, December 2008) on going concern issues during the current economic conditions. The Financial Reporting Council (FRC) has also published two sets of guidance for directors of listed companies and for companies that adopt the financial reporting standard for smaller entities. The FRC guidance is designed to help directors of companies assess going concern and to make appropriate and adequate disclosures in a financial statement).

It is important to stress that an emphasis of matter paragraph is not a qualified opinion and does not mean that the company concerned will cease to continue. Emphasis of matter paragraphs may have some positive effects, in that readers of financial statements will benefit from the highlighting of material uncertainties and stakeholders may see management of companies addressing going concern uncertainties at an earlier stage and with more vigour.

Charles Wilson is a partner of Trowers & Hamlins LLP specialising corporate and commercial law.
Tel: 020 7423 8511
Email: cwilson@trowers.com [1]