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Studies offer differing views on risk of failure

TWO separate studies released over the past month have highlighted the risk of insolvency among Australian companies.

The studies formed markedly different views on the degree of risk, however, leaving investors and business people with an awkward dilemma.

Should they accept the relatively benign findings of the Australian Securities and Investments Commission (ASIC) or the more alarming findings of risk analysis specialist Lincoln Indicators?

The answer could affect the way in which business people choose customers and suppliers, negotiate contracts and invest their money.

ASIC found that about 15 per cent of ASX-listed companies faced solvency issues.

Lincoln Indicators found the proportion of listed companies with solvency issues was much higher, at more than 50 per cent.

ASIC reviewed the audited full-year reports of more than 1,000 listed companies.

“There is a reasonably high incidence of auditors either qualifying company accounts or highlighting risks through ‘emphasis of matter’ commentary relating to going concern,” ASIC chairman David Knott said.

Specifically, ASIC found that the accounts of six companies had audit qualifications relating to their continuation as going concerns.

A further 160 companies had an ‘emphasis of matter’ in the audit report, which related to significant uncertainty about going concern.

An ‘emphasis of matter’ is required under Australian accounting standards to draw attention to matters in the notes of a financial report that are of particular importance to the company’s future as a going concern.

Mr Knott placed a positive interpretation on these results.

“This suggests that there is a reasonably high level of transparency in financial reporting on this significant matter,” he said.

“Overall, we believe that the level of compliance with existing accounting standards in Australia is high.

“However the initiatives currently under way to upgrade accounting standards, to fill unacceptable gaps and to implement better quality control of audit are all critical enhancements to our financial reporting regime.”

Mr Knott also concluded that the type of accounting abuses identified in the US did not pose a material risk in Australia.

This included risk areas such as capitalised and deferred expenses, recognition of revenue and recognition of controlled entities, all which were significant in producing misleading accounts at Enron and other high-profile companies in the US.

Lincoln Indicators’ senior analyst Paul Saliba believes ASIC’s review may have significantly underestimated the scope of solvency risk.

Lincoln Indicators’ most recent analysis of 1,091 listed companies concluded that 401 were exhibiting clear signs of financial distress and 150 were in a marginal state of financial health.

Eighty eight companies were considered satisfactory and 379 were rated as ‘strong’.

These findings are based on Lincoln Indicators’ own analysis of company accounts, which utilises seven key financial ratios.

These include profitability, retained profits, debt servicing ability, financial structure and gearing.

Some of the ratios used by Lincoln Indicators do not conform with commonly used definitions. For instance, the gearing ratio is defined as total liabilities as a proportion of total assets less intangibles.

Mr Saliba said Lincoln Indicators’ unique methodology had predicted company failures with 87 per cent accuracy over time.

He acknowledges it may overstate the level of risk “a little bit”, but argues it is better to err on the side of caution.

“Independent financial risk analysis reveals that concerns still exist over the reliability of Australia’s public company reports in highlighting insolvency risk,” Mr Saliba said.

“While auditors are more inclined to point out solvency issues of companies following the spate of One-Tel and HIH-style corporate collapses, the fact remains that many auditors are still walking a fine line between compliance and not wanting to upset the client.”

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