Feltex Carpets Limited
IPO Prospectus, Financial Reporting and Continuous Disclosure

The Commission has assessed Ernst & Young's conduct in regard to their advice regarding the transition to NZ IFRS and their review engagement of the FTX 31 December 2005 financial statements.

In the period leading up to the preparation of its first NZ IFRS accounts, FTX engaged Ernst & Young for the following services, and paid fees for such services:

FTX appropriately commissioned Ernst & Young to conduct a specific project to address its transition to NZ IFRS. This project was intended to provide an assessment of the significant impacts of NZ IFRS for FTX.

This work done by Ernst & Young in October 2004 did not identify for FTX, the different basis upon which debt is classified under NZ IFRS, in contrast to previous NZ GAAP. It did not highlight the requirement for non-current debt that there be an unconditional right to defer payment for twelve months.

The Commission recognises that in October 2004 FTX did not have a precarious debt position and therefore the classification of debt issue was not as significant for FTX as it was in 2005.

FTX engaged Ernst & Young to carry out a review of its 31 December 2005 interim financial statements. A review is not an audit. It provides a lesser degree of assurance, and is based primarily on information given to the reviewer by the client, rather than an independent verification of information provided.

NZ RS-1 Statement of Review Engagement Standards sets out review standards applicable to a review engagement.

In accordance with Review Standard 3 of New Zealand RS-1: Statement of Review Engagement Standards: a review engagement should be performed and its report prepared with due care by persons who have adequate training, experience and competence in the review of financial information.

The reviewer is required to obtain sufficient and appropriate evidence, primarily through inquiry and analytical procedures, to be able to express a negative assurance opinion in the review report.

Furthermore, the New Zealand Review Engagement Guideline (RG-1) paragraph 3 requires that if, based on enquiry and analytical review procedures, the auditor has reason to believe that the financial statements being reviewed may not give a true and fair view, then the auditor has a duty to carry out additional and more extensive procedures to enable a negative opinion to be expressed on the report or to conclude that that such an opinion cannot be given.

The 31 December 2005 review failed to pick up the non-disclosure of the covenant breaches, and failed to pick up the incorrect classification of debt by the company. In the Commission's opinion an adequate review would have identified both of these issues. The Commission believes that Ernst & Young, had it carried out the review engagement appropriately, would have enquired further into the company's debt arrangements, and read the Fourth Restatement. Even without doing this Ernst & Young should have considered the impact of a known breach of banking covenants on the company's financial statements. The breach of banking covenants should also have prompted Ernst & Young to enquire further about proper debt classification in terms of NZ IAS 1.

Gordon Fulton, an Ernst & Young partner, was the audit partner in charge of the review engagement for FTX's 31 December 2005 interim financial statements, although most of the field work was carried out by Ernst & Young Australia in Melbourne. He told the Commission that classification of debt was not specifically addressed as part of the review engagement by Ernst & Young and that Ernst & Young did not give FTX any specific advice regarding the classification of debt.

Stuart Painter, the partner of Ernst & Young Australia who led the work done by Ernst & Young Australia on the review engagement of FTX's 31 December 2005 interim financial statements, also gave evidence to the Commission. He testified that there was no specific guidance given to FTX by Ernst & Young and that FTX did not seek advice from Ernst & Young in regard to classification of debt in the 31 December 2005 financial statements. He stated that Ernst & Young expressed a negative assurance opinion to FTX regarding those financial statements; the classification of debt as a non-current liability was part of the financial statements; and nothing came to Ernst & Young's attention during the course of the review which suggested that the classification should be changed.

Mr Painter stated that FTX had failed to make the disclosure and that Ernst & Young, although aware of the covenant breaches, did not pick it up.

In accordance with Review Standard 7 of New Zealand RS-1: Statement of Review Engagement Standards, where the reviewer has cause to doubt the assertions provided to it by management, the reviewer should seek evidence to substantiate the assertions of management.

From its history as FTX's auditor, Ernst & Young had a thorough knowledge of FTX's business given that FTX was a long term audit and business client of Ernst &Young.

With such an in-depth knowledge of FTX, events such as the breach of banking covenants, changes to the Fourth Restatement and the new disclosure requirements arising from changes from NZ GAAP to NZ IFRS, should have prompted Ernst & Young to enquire further. It should have been apparent to Ernst & Young, as an accounting expert, to see the relationship between these matters and therefore conduct their review to ensure FTX's financial statements complied with NZ IFRS.

In its submission to the Commission, Ernst & Young, New Zealand asserts there was not a significant change in the requirements for classification of debt from previous NZ GAAP to NZ IFRS.

The Commission believes that Ernst & Young should have appreciated the significance of the change in requirements as a result of the change to NZ IFRS in terms of how this affected disclosure of the breach of banking covenants and the classification of FTX's debt.

Ernst & Young should have, upon learning that there had been a breach of banking covenants, sought confirmation that the breach had been formally waived, regardless of the opinion held by the directors about the banking relationship.

Ernst & Young relied on information provided by the company about FTX's banking relationship. In this regard, the failure of the company's directors to give sufficient weight to the legal effects of the breach of covenants and the changes to the facility agreement appears to have been compounded by Ernst & Young's failure to identify financial reporting errors.

The failures of the FTX board and Ernst & Young to appreciate the NZ IFRS requirement regarding the debt resulted from a lack of understanding of the NZ IFRS requirements by all parties. The directors assessed the company's debt primarily by reference to the bank's continuing, but informal, support for the company, not by reference to the rights of the bank under the Fourth Restatement. Ernst & Young relied, in the context of a review engagement, on FTX's views about the banking relationship. This reliance was misplaced, in view of the information available to the auditors concerning the fragility of the company's financial position, its dependence on the ANZ facility, the restatement of that facility in October 2005, and the breach of covenants in December 2005.

Review Standard 6 Documentation of NZ RS-1 requires the reviewer to document matters which are important in providing evidence that the review was carried out in accordance with the Review Engagement Standards and support the level of assurance provided.

The Commission would have expected Ernst & Young's working papers to discuss the basis for their conclusions; e.g.:

In reviewing Ernst & Young's working papers, the Commission has concerns that Ernst & Young did not ask the right questions.

Ernst & Young's main working paper on loans payable that addressed compliance with loan agreement provisions does not mention the 31 December 2005 breach, how the breach had been remedied, or whether the loans classified as non-current were unconditional. This is surprising given the known existence of a breach and the requirements of both NZ IAS 1 and NZ IAS 34.

A checklist completed in the course of the review included an item for noting whether there had been any loan default or breach of a loan agreement, not remedied on or before the reporting date. Ernst & Young marked this item "not applicable". There is nothing recorded on the checklist or otherwise in the review working papers that explains how this conclusion was reached.

In a separate going concern checklist that Ernst & Young completed for the review they responded as follows:

The Commission cannot see how negotiation of the Fourth Restatement in October meant that no issue remained in respect of the breach given that the breach occurred some months later on 31 December 2005.

It is difficult, if not impossible, in the context of a review engagement for the reviewer to rely simply on a "no indication of no bank support" when seeking to gain sufficient evidence that a breach has been remedied and that an unconditional right existed as at 31 December 2005. The nature of the assertions being made, i.e. the breach has been remedied and the facility is unconditional, should have prompted a reviewer to ask more questions, and in all likelihood seek access to relevant documentation or else seek independent assurances.

The Commission notes that there is differing evidence in regard to whether FTX provided a copy of the Fourth Restatement to Ernst & Young. Ernst & Young personnel indicated that FTX failed to provide to Ernst & Young a copy of the Fourth Restatement and a member of FTX's management team asserted that he did provide such a copy.

The Commission's conclusions regarding Ernst & Young's responsibilities do not turn on whether or not Ernst & Young was provided a copy of the Fourth Restatement.

It is particularly important for both companies and auditors to understand the terms of any review engagement which they enter into. The Commission takes the view that notwithstanding the particulars of a review engagement, auditors are reasonably viewed as advisers. It is reasonable under section 138 of the Companies Act for the directors of a company to rely on the accounting firm (whether their advice is given pursuant to an audit or a review engagement). The Commission believes that this view is widely shared by company directors in New Zealand.

In its submission to the Commission, Ernst & Young New Zealand asserts that an accounting firm (whether conducting an audit or a review engagement) is not an adviser to the directors of a company.

Ernst & Young, New Zealand takes the position that it is not appropriate for them to comment on whether directors might be able to assert a legitimate defence that they were relying on the advice of auditors.

The Commission considers that Ernst & Young failed in its professional responsibility by not recognising the change in the classification of debt from NZ GAAP to NZ IFRS and how this change affected FTX in December 2005.

The Commission does not consider that work done by Ernst & Young and the responsible partner Gordon Fulton, in their review of FTX's 31 December 2005 financial statements, met the required standards of a review engagement. Ernst & Young and the responsible partner failed to inquire sufficiently about the status of FTX's debt to ANZ, failed to identify that breaches of banking covenants were required to be disclosed, and failed to review the Fourth Restatement in order to understand the status of the banking relationship. The Commission believes that the work of Ernst & Young New Zealand and the responsible partner Gordon Fulton fell below the standards required by NZ RS-1 Statement of Review Engagement Standards. The Commission will refer Ernst & Young New Zealand and the responsible partner Gordon Fulton to the NZICA.

Since questions of liability under FRA do not arise in regard to the conduct of auditors of a company, the Commission is not able to refer Ernst & Young to the Registrar of Companies in regard to FTX's failure to disclose the breach of its banking covenants in its 31 December 2005 interim financial statements.