Memo 6 ~ MVF auditor’s report.  What is its significance ?

Updated 20th July 2007

Recent MVF practice has been to include the annual reports of the Chairman, the Chief Executive and the Auditors in full within the January Newsletter together, with an abridged version of the accounts.  These provide comforting assurances to the membership (and the outside world) that MVF is doing a great job in terms of growth and profitability.  Fair enough, and it deserves recognition of all those who worked hard and conscientiously to achieve it.  It is, after all, highly preferable to the sorry performance over the years, of many UK agricultural supply cooperatives.  Profit (as opposed to loss) is essential to a supply cooperative’s sustainability but is not a measure of its success.  This lies on the extent to which the provision of goods and services to its members is providing them with financial advantages in their farming businesses.
 
My own reading of the full Mole Valley accounts, and notes thereto for 2005, together with the separate accounts prepared for SCATS Countrystores plc and Southern Valley Feeds Ltd (formerly Pye-Bibby) led me to raise a number of questions prior to the 2005 AGM.  Having not received the promised written reply, I was invited into a meeting with the Chairman and the Company Secretary who assured me that they fully shared my concerns and were taking steps to address those issues.  “Watch this space!” was their only message from the meeting.  Accordingly, at the AGM I only sought clarification from the Auditors on how they had managed to provide a 'true and fair' opinion in their audit report, in spite of what appeared to a layman to be anomalies in some of the accounting concepts adopted, and also in some differences between the written report claims, the relevant figures or the reality experienced by members. 

 When space-watching provided no answers from the Chairman to my original questions I addressed a letter to the MVF Independent Auditors, PricewaterhouseCoopers (PwC).  Previously described simply as Auditors.  The word “Independent” was not introduced until the MVF 2001 Accounts, possibly coinciding with an increase in the non-audit advisory services provided by them?

Because the correspondence is lengthy, the resultant findings are summarized below 

Postscript        The 2006 MVF auditors’ report introduced a new qualification to the context for interpreting the significance of a ‘true and fair’ opinion.  In addition to the assurance that it is “in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board”, we are further assured that it complies with “United Kingdom Generally Accepted Accounting Practice.”  It is not easy to see how this additional assurance helps members’ understanding of the auditors’ report.

 The full text of my correspondence to PwC is set out below

12th September 2006

Dear Sirs

I am an Ordinary Shareholder in Mole Valley Farmers Ltd and it is from that position that I am writing this letter to PwC in their role as Mole Valley’s independent auditors.  It would be misleading of me not to disclose that I happen to be the person named as founder of MVF in 1960 who then worked within the Company variously as its first chairman and then as its chief executive and/or director until 1985: for the following ten years I worked on a part-time basis in conjunction with development work in Africa.  My interest in agricultural co-operation dates from 1946 and was included within my post-graduate work at the Agricultural Economics Research Institute in Oxford in the late 1950’s.  Over the period from the 1960’s up to current date, I have witnessed the decline and fall of the majority of the larger supply co-operatives, mostly for reasons, which contained similar aspects of misguided direction and eventually, the disaffection of their core farmer shareholder base.  Within the Annex attached to this letter I have set out a number of points arising from reading the Annual Report and Accounts for 2005 for MVF, SCATS and SVF.  I find these to contain some apparent anomalies and errors, which have resulted in the overall presentation providing a misleading picture for our farmer shareholders.  Please correct any flaws within my analysis that may assist in my better understanding. 

My reason for writing at this time is not to apportion blame but to state my hopeful expectation that this year’s presentations will provide shareholders with a more accurate and meaningful picture of MVF’s co-operative achievement for its south west co-operative farmer shareholders, within its wider overall group activities. 

For MVF this should be a necessary condition to qualify for a true and fair audit opinion.  

Although its operation as a private limited company requires conformity with the disciplines imposed by the Companies Act 1985, Mole Valley has confirmed emphatically its co-operative credentials within the 2005 Reports.  It is this factor which is necessary for Board justification of the MVF policy of no dividend and no capital growth in the value of Ordinary Shares.  The best interests of shareholders is interpreted as the cost savings provided by the low farm input prices made available to them and it is the percentage of these in the case of MVF which is the true performance indicator.  Increased sales which derive mainly from a large expansion of trading area, coupled in some cases with an element of price subsidization, are not relevant criteria upon which co-operative success can be claimed. 

To what extent does the MVF’s audit opinion take into account these relevant co-operative principles involved?  Going forward, the relevance of this question is heightened by the transfer of Mole Valley’s fertiliser business into a separate joint venture company and the proposed transfer of Mole Valley feeds into SVF.  Large sectors of Mole Valley’s business will then fall within the remit of companies which are not run in accordance with co-operative principles. 

Any enlightenment you can offer regarding this matter would be most helpful, together with your observations and answers on points I have raised within the attached Annex. 

Yours faithfully

John James MBE

cc: MVF Chairman and the Trustees of the Mole Valley Trust Deed 

Annex

In the MVF 2005 Annual Report and Accounts the PB acquisition is referred to in the Chairman’s Report and the Chief Executive’s Review, both of which form part of the audited financial statements.  The SVF loss of £140,000 is modestly referred to by the Chairman as “not as yet contributing significantly to the bottom line”, followed by “I can assure you that they are budgeted to do so before very long.”  The parameters for this budgeting are not disclosed, so shareholders will expect these to be those adopted within the accounts, thereby establishing a precedent for continuing in subsequent years, no doubt on the grounds of the need for consistency. 

The Chief Executive’s review does not mention the SVF loss, but does refer to “a small operating profit before exceptional charges and goodwill write off.”  The only recognised “exceptional charge” appears to be the £68,000 bad debt arising from monies owed by Pye Bibby prior to its collapse shortly after the acquisition, but this is not apparent from the MVF accounts – only from the SVF accounts.  It was written off by inclusion within the £2.212 million administrative expenses prior to, not after, calculation of operating profit.  On the other hand, the costs of acquisition of £379,000, which many shareholders would expect to be treated as an exceptional item for write-off in the first year, were in fact included within the £3.155 million “goodwill” figure, for write-off over a period of 20 years. 

Neither of the two reports referred to above provide any information of the financial magnitude of the PB acquisition and this is not readily apparent from the abbreviated Accounts sent out to all shareholders, other than by comparing the “Company Balance Sheet” with the consolidated one, and the Group Cash Flow Statement.  Only the few shareholders who obtained and studied the full accounts will learn that, of a capital investment of almost £8 million, more than £3 million is represented as goodwill, described in the accounts as an Intangible asset.  These are important issues for shareholders to understand in their appraisal of any financial benefits that may accrue to them through this very large acquisition.

The Profit and Loss Account is presented in consolidated format thus including the accounts of Southern Valley Feeds Ltd.  A separate column, however, is set out to distinguish acquired activities from continuing ones.  As a concept I find this commendable, but some of the details that become apparent provide a materially different picture to that which is presented in the report extracts referred to above.  The most significant of these is seen in the line item “Net interest payable and similar charges.”  The 2004 figure of £24,000 had been reducing annually as trading profits accrued, so the 2005 expectation would have been for a net credit of, say, £20,000.  The turn around of this into a sum payable of £220,000 represents the equivalent of £240,000 paid by MVF on behalf of SVF.  The reason for omission of this from the Acquired activities column was explained at the AGM as being due to the bank loan for the acquisition having been raised on an MVF bank account, and the accounts were therefore legally correct.  After the meeting Paul Heal agreed with me that this anomaly could have been easily rectified by the submission of an MVF invoice to SVF.  In the P&L account, the line item “Goodwill amortisation” for the SVF acquisition is shown as £96,000 which, without benefit of the Notes, would accord with the “write-off” expectation in the report extract.  In reality, this is just the tip of an iceberg, consisting of an annual liability of £158,000, which will continue until the year 2025! 

The Directors were fully entitled to have made their own assessment of the useful life of goodwill purchase as being twenty years.  Board members are, however, acutely aware of the problems of the livestock industry and, in particular, of the rapidly reducing numbers of milk producers, coupled in many cases with a higher proportion of feed coming from straights, cereals (including wholecrop) and maize silage.  The volatile picture which emerges from these factors taken together means that even a five year forward prediction is a risky business.  My concern about the 20 year amortisation is in the impact of this within the accounts as presented for the SVF part year.  The £96,000 shown (full year equivalent £158,000) contrasts with the £420,000 of a 5 year amortisation period (full year equivalent £631,000). 

These figures show that using the more realistic maximum amortisation period of 5 years would have increased the first period loss of £140,000 by a further £324,000.  The full yearly impact would be an annual difference (for the first 5 years) of £473,000 (£631k - £158k).  These figures may need to be increased if MVF’s warranty claim of up to £296,000 against the Administrator is unsuccessful.  Unless the 20 year period is reduced to a maximum period of 5 years, members will be entitled to construe this as the equivalent of a further hidden subsidy paid by the parent company. 

Most shareholders would, however, be unaware of these facts and hence unable to recognise that the reports present a distorted and incomplete picture of the PB acquisition.  In addition to the above I find three other issues, which contribute to shareholders lack of understanding about their Company and the extent to which it fulfils its Co-operative claims. 

The first of these is prompted by the growing confusion caused by the use of the terms Group and Company.  The first two pages of the annual accounts are Consolidated P&L and Consolidated Balance Sheet.  It is clear from the content of these that ‘Consolidated’ has the same meaning as ‘Group’.  These are then followed by the ‘Company Balance Sheet’, also signed by MVF Chairman David Burke.  Within the Notes to the Accounts the terms Group and Company are widely used to differentiate between two separate entities.  There is nothing misleading about these descriptions but there is difficulty in understanding exactly what the ‘Company’ is, if it is not the ‘Group’.  SCATS and SVF are both separately registered private limited companies, whose activities have to be excluded from the Group in order to arrive at ‘Company’ accounts, but what exactly is the legal status of the residual Company registered in January 1961 named as Mole Valley Farmers Ltd?  Has this company (the Company) simply changed into a Group by the addition of separately costed wholly owned subsidiaries? 

Putting aside the structural semantics, there are some important issues for shareholders in making an objective appraisal of Board direction and performance in any given year.  The extract from the ‘true and fair’ opinion of the Auditors referred to above is stated to cover both the Company and the Group, which is not unsurprising since PwC is also Auditor to both SCATS and SVF, in which roles they have arrived at similarly ‘true and fair opinions’ concerning the financial statements of each of these two companies. 

The terms of reference for the subsidiaries have been promoted as profit maximisation, since the reasons given for their acquisitions was principally enhancement of their parent company’s profitability for the benefit of its farmer members. 

A shareholder’s evaluation of the PB acquisition will therefore require accurate and complete parent company charging for all the goods and services provided to SVF, which should include an annual interest charge for the £3+ million which MVF provided in cash out of shareholders’ funds.  Only when SVF accounts show a surplus over and above these charges together with the Bank loan and amortisation subsidy items referred to above, can it be claimed that the acquisition is profitable.  The aggregate “profit” of SCATS after 3 years of operation is only equivalent to paying the parent company 5% interest on the cash funding provided. 

The second issue relates to some misconceptions in the Reports relating to gross profit margins.  In one it is stated that “one key performance indicator which we regularly use to appraise our performance ‘is gross profit margins’ ” … and “Unlike most businesses, wherever possible we seek to target a reduction.  This year it has reduced slightly to 16.9% which is in line with the Mole Valley Farmers’ ethos of trying to provide products to our farming members at low prices”.  Similarly, in the other review, in respect of profit levels remaining fairly static “this is in part due to our continuing aim of reducing gross margins”…  and “We have achieved a slight drop again this year”. 

It is my belief that both reviews are intended to convey the message that MVF is striving to reduce the extent of mark-up added to the cost of supplies into the Company.  That, for a Cooperative, is a highly commendable ambition, but within the MVF accounting system, manufacturing and transport charges are added into “Cost of sales” before these are deducted from turnover in the P&L accounts to determine a figure which is represented as Gross Profit (or Gross Profit Margin as a percentage of G.P).  Having spoken to the Chairman I fully accept that his comments on Gross Margins were in no way intended to mislead.  He had assumed that Cost of Sales in the accounts was made up entirely by external purchases, without inclusion of internal costs.  Most other MVF shareholders would have made a similar assumption. 

The unreliability of movements in Gross Margins in Mole Valley’s case stems from two factors:-

 My final point relates to MVF engaging our elected auditors as financial advisors, of which I thought FSA disapproved, even though I recognise the potential for cost saving in the advisory role, due to the understanding of MVF systems and rationale obtained through the audit process.

 I have noted from constitutional review issues discussed with Trustees, for example, that the legal opinion of MVF’s lawyers is that the separate class of Trading Shareholders should be discontinued.  Trustees were told that PwC, in their advisory role, disagreed with this and that no such change was necessary.  Asked who it was that had been responsible for the introduction of these trading shares, the answer given was PwC.  Some shareholders, but not myself, might suggest some parallel aspects in the issues referred to earlier in this letter, when they read (in Note 6 to the 2006 accounts) that £135,000 was paid in fees to the MVF auditors as part of £379,000 PB costs of acquisition.  I am not suggesting that PwC’s lead role in the production of a due diligence report, which must have been highly influential in encouraging the MVF Board to go ahead with this acquisition, would have caused reluctance to expose the anomalies referred to above.  I do however, know some shareholders who would. 

No written answers were received to my questions in the letter and annex but eventually I was offered a meeting with Paul Heal and Tony Hemus for November 14th, which I accepted.  The business of this meeting is confirmed in my letter to PwC dated 19th November.  I should explain that Paul Heal had served his 10 year stint as head of the PwC audit team at which time the team leader had to be changed.  Tony Hemus is his successor. 

19th November 2006

Dear Paul and Tony, 

Thank you both for meeting with myself and daughter Nicola on Tuesday 14th in response to my letter and Annex dated 12th September. 

You stated that your agenda was to explain the PwC approach to an audit and for this purpose you had downloaded several pages of coloured charts from your website.  As your time was said to be limited to one hour, I stated that my agenda was the content of my letter and enclosures.  My main problem had been to try to understand how PwC had been able to arrive at a 'true and fair' opinion concerning the Annual Report and Accounts 2005 in spite of the examples I had pointed out of mis-leading statements and accounting concepts included within them.  Underlying my questions was my assumption that the MVF audit would need to take full account of Mole Valley's principal activity as defined within the Report of the Directors as continuing “to be that of a cost-saving farmers' cooperative”. 

You explained to me that the Mole Valley audit did not require any consideration other than the mandatory factors defined within the Companies Act 1985 and the MVF Articles of Association.  My objection that the Chairman's Report had stated clearly that “Mole Valley Farmers is, and always will be a Farmers' Cooperative”, did not make any difference to the audit approach, since it was not considered relevant.  Indeed, Paul made the audit team's position clear with the categorical statement that “Mole Valley Farmers is not a Cooperative”, in terms of the 1985 Act.  

I had, of course, expected that, on behalf of PwC you would have been able to justify the grounds for your stated audit opinion.  I had not, however imagined how bizarre these grounds would seem to a farmer member who is frequently told that Mole Valley is a Cooperative and this is why he is not paid an annual dividend and should not expect his ordinary shares to increase in value.  I am still surprised for example that the MVF Directors' Report statement “The principal activity of the group continues to be that of a cost-saving farmers' cooperative” is held not to be inconsistent with the accounts, and evidently did not require that fact to be stated in your audit report in accordance with Memo 235 para (3) of the 1985 Act.  The requirement of Memo 238 that all members should receive a copy of the Directors Report has not been followed for the past two years.  Both these factors are consistent with minimizing information to shareholders, though the exact opposite is stated by MVF in stressing the importance of open communication with members. 

The cooperative-denial approach of the PwC audit team has a considerable influence in providing answers to the main points that I raised in my letter of 12th September viz 

The fact that the format in which the SVF accounts are incorporated into the Consolidated P&L account is a grotesque distortion of reality and is propped up by comments in the Chairman's Report and the Chief Exec's Review, is not of any significance to the PwC audit process beyond routine checking that the accounts figures accord with primary documentation.  I.e. MVF's provision of £4m interest free loan, plus payment of circa £240,000 in interest charges for the part year do not require any comment.  This will leave the door open for reasonable assumption that the SVF accounts are intended to cover up the bitter reality of this ill-conceived use of shareholder's funds.

PwC also act, separately, as Auditors to Southern Valley Feeds Ltd for whom they have also provided a 'true and fair' opinion.  Presumably this is acceptable if the Mole Valley fairy godmother is adjudged to be a sustainable phenomenon for SVF and, similarly, as a continuing benefactor for SCATS plc.  Should not a proviso to this effect be included within the SVF audit opinion?

From the Audit stand point, elimination of the cooperative factor also removes potential complications arising from the growing complexity of the differences between Mole Valley Farmers Ltd the “Company” and the “Group” since all can be adjudged as having the common commercial objectives of profit maximization and incremental share values. How, one wonders, is this matter viewed by the Mole Valley Audit Sub-committee?  Does it not highlight the need for the terms of reference for the MVF audit to include parallel appraisal of MVF (“The Company”) in its avowed cooperative role?

Similarly, assertions regarding a cooperative desire to reduce Gross Margins as a key performance indicator do not require any audit comment, however erroneous and inappropriate they may be.

On the queries I had raised regarding the wisdom of MVF employing PwC as financial advisors in addition to their audit role, I was informed that this had now become common practice.  Regarding the quality of the advice received, confidentiality would not permit comment. 

I fully understand your position in not being free to comment on a number of points I had raised, pointing out to me that these should have been addressed to the Company.  In view of my lack of success in getting replies to correspondence addressed to the Chairman I will be pleased to accept your advice to contact Andrew Jackson, whom you mentioned by name twice in this context. 

Although you did not express any enthusiasm for my suggestion that a footnote to the Auditor's report would be useful in avoiding my previous misunderstanding being repeated, I hope that you will give this some further thought.  For example, it could be very simple and read thus 

“In the audit opinion stated above the use of the word 'fair' should not be construed as in 'fair play' or in 'a fair result' and the word 'true' should not be confused with the concept of 'truth”.

Yours sincerely

John James

cc: MVF Chairman and the Trustees of the Mole Valley Trust Deed 

I have received no comment from PwC on this second letter, from which I assume that my record of the meeting is basically accurate.  Neither have I received any comment from the MVF Chairman nor from the Chief Executive, both of whom had copies of all the correspondence in accordance with specific advice from the Auditors.  From this silence should I construe that my subject matter does not really interest or concern them? 

Prior to having sight of the 2006 accounts, I had expressed the hope that we might find that some points had been duly noted and may even have led to a more straightforward presentation to the Members in the 2006 Report and Accounts. 

Regrettably this optimism was unfounded. All those interested in the future of our farming Cooperative are recommended to ask for the full version of the 2006 Accounts.  If concerned about subsidiaries as well, why not ask for a copy of the annual Report and Accounts of Southern Valley Feeds Ltd and of SCATS plc at the same time?

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