Proxy voting firm Pensions & Investment Research Consultants (PIRC) has written to all FTSE 100 companies warning them not to overlook any discrepancies between the assets reported in their group accounts and those in their parent or holding company accounts.
In a letter addressed to finance teams and boards, PIRC’s managing director Alan MacDougall said the “collapse of Thomas Cook and Carillion have shown that balance sheet resilience cannot be taken for granted.”
The letter, a copy of which IPE has obtained, goes on to note: “A feature in each case was material differences between the net assets of the group as shown in the group accounts and the net assets of the holding company as shown in the ‘company’ accounts.
“Both Thomas Cook and Carillion showed material deficits of the group net assets compared to those in their holding company accounts – a ‘net asset deficit’ – due to a decline in group net assets.”
PIRC added that this asset shortfall could in the worst case mean a company needs to raise new capital or might be unable to afford to pay a dividend.
In a statement, the Financial Reporting Council, the UK’s audit watchdog, told IPE: “Our risk based approach to monitoring corporate reporting includes consideration when a discrepancy might exist between group net assets and the carrying value of investments in subsidiaries in the holding company’s accounts.”
The FRC, which an independent review is transitioning into a new regulatory authority after an independent review, is also responsible for setting the UK’s corporate governance and stewardship codes.
An IPE review of two audits conducted by Big Four auditor KPMG shows that the firm already checks for any potential discrepancy between group and holding parent assets.
A KPMG spokesperson told IPE: “We mandate that the audit report must include a key audit matter for the parent specifically, in almost all cases this will be the investment in subsidiaries.
“In group financial statements we therefore include in our audit report our view on the risk, our response (in terms of procedures we perform) and our findings.”
Group companies ≠ group
The PIRC intervention highlights the important distinction both legally and financially between the different companies in a group and the group as a whole.
In the case of a UK listed company, a group is usually made up of a parent company and its various subsidiaries. It also prepares separate or individual financial statements for each subsidiary and for the parent or holding company.
In addition, it produces a single set of consolidated accounts for the whole group. It is these group accounts that are referred to when listed companies report their results.
Listed entities in the European Union are required under EU law to prepare those consolidated accounts in accordance with International Financial Reporting Standards.
The group is not the same as the parent company – nor is it a legal entity in its own right.
Group accounts deal with three important accounting issues: goodwill, internal transactions, and non-controlling interests.
Goodwill typically arises where a company completes a merger or acquisition and accounts for the difference between the amount it paid and the net value of the acquired assets.
Supporters of this accounting construct argue that it represents the additional value or synergies arising from the merger. Critics, however, say that it is a plug to make the books balance in a way that is of no genuine value.
“The implication of such accounting was that the company had made a bad acquisition, which we now know to be true”
Tim Bush, head of corporate governance and financial reporting at PIRC
Tim Bush, PIRC’s head of corporate governance and financial reporting, said: “It has been clear for a long period of time that the balance sheet of Thomas Cook’s holding company was defying gravity while the balance sheet of the group was not.
“The implication of such accounting was that the company had made a bad acquisition, which we now know to be true.”
PIRC is now urging FTSE 100 firms to display a parent company balance sheet prominently in their financial statements. It also wants companies that do not currently present one to do so.
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