With their take on the occasional ‘Dear CEO’ letter that comes out of the FCA, The Timebank are producing a range of ‘Dear Regulator’ letters for IFA Magazine readers. They’re focused on some of the thoughts and ideas on the direction of travel they believe the industry might like to see the regulator heading in. This month, Colin Fergusson, Head of Research and Consultancy at The Timebank, identifies some worrying behaviours which he feels the regulator should be acting upon in connection with Manufacturers.
Dear Regulator
Financial Adequacy of Manufacturers
For many years you have asked Manufacturers to report their financial position on a regular basis and this has been welcome.
As you have adjusted your requirements, however, holding debt or intangible goodwill has become less attractive in regulated companies. A presumably unintended consequence of this is that many firms now use non-regulated businesses to hold their debt or intangible assets.
The result may look like more firms are holding their required level of capital and seem less dependent on debt. Unfortunately, we worry that you have simply pushed this potential risk to a less transparent place that is out of sight for those who do not have the training to know where to look.
At The Timebank, we undertake due diligence research on Manufacturers for our distributor clients. We look beyond the regulated company and seek to look at associated companies to get the full picture for our clients. All too often we see some worrying behaviour, which you as the regulator should be aware of to avoid foreseeable harm to consumers.
We have grouped these into 4 practices:
- Unsustainable debt – it is not the level of debt that is a worry, but the level of debt compared to the profitability. An expanding company may be raising more debt to purchase competitors or invest in new services and products, but this is only sustainable if there is a trend of increasing income and profits.
- Unsustainable losses – companies make losses, there are years when income is lower or expenses higher than expected and no company should be forced out of business due to a short poor period of trading. The questions that need to be asked are what are the reasons for the losses and does that reason mean the losses are likely to be sustained or repeated?
- Excessive Capital / Income Withdrawals – taking dividends and income from a company is normal, but when the withdrawals are excessive compared to the profits made, an explanation should be requested. In most cases, there is a satisfactory explanation, and this behaviour should not impact on the future viability of the company. If, however, this is combined with either a rise in the cost of the company’s services or an increase in debt, there may be good reason to question the future viability of the company.
- Poor Accounting practices – like anything there is scope to interpret and apply accounting rules in different ways. Some practices are better than others, with the level of disclosure varying. There are two areas we look at, firstly inter-company transactions, where good practice is to clearly indicate the level of payments for services between related companies, making it easy to see where profits or losses have been transferred. The second area is the capitalisation of expenses, where an expense such as the development of an IT system is treated as an asset rather than a cost. This boosts the financial strength of the company, by making the assets larger and the profits/losses lower.
What would we like you to do?
Firstly, widen your financial reporting to include related companies with significant or material interest in or from the regulated company.
Secondly, be more qualitative in your requirements. Companies need to take on debt to invest and expand, they also will make losses, and withdrawals are made for various reasons but test them to ensure they are sustainable and justifiable.
Finally, look at the accounting reporting standards for the financial services sector and seek to ensure that the standard or reporting is better and more transparent than those required for companies outside of Financial Services.
We believe that these changes will improve the quality of regulation and we look forward to working together to promote good consumer outcomes.
Want to revisit The Timebank’s previous ‘Dear Regulator’ letter?
Dear Regulator… scams and your powers
About Colin Fergusson
Colin joined The Timebank in 2006. He is now head of Research and Consultancy within the business, where he assists firms, develops new services and enhances their current range of services.
He has over 30 years in Financial Services, is a Fellow of the CII and was amongst the first Chartered Financial Planners.
