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1 ISSN 2299/6206 KPMG FORUM Quarterly contains articles written by KPMG experts in Poland who explore the challenges and problems arising in their daily work. kpmg.pl nr

2 2 KPMG Forum Editorial office: KPMG Sp. z o.o. ul. Chłodna Warszawa T: F: kpmg.pl Editor in Chief: Magdalena Maruszczak Supervising editor: Anna Gajewska-Płomińska Design studio: KPMG Sp. z o.o.

3 KPMG Forum 3 TABLE OF CONTENTS Enhancing the value of auditor reporting Agnieszka Müller-Grządka... 6 Solvency 1.5 in 2014 Witold Florczak, Marta Zielińska... 9 Price of stock-listed shares vs. their fair value Tomasz Regulski...13 Polish Construction Study 2013 Steven Baxted...17 Bonus system within sales forces Andrzej Musiał, Jan Karasek, Agnieszka Emerling A new approach to activating the unemployed Mirosław Proppé, Paweł Darski... 24

4 4 KPMG Forum KPMG offices in Poland Warszawa ul. Chłodna Warszawa T: F: E: Kraków al. Armii Krajowej Kraków T: F: E: Poznań ul. Roosevelta Poznań T: F: E: Wrocław ul. Bema Wrocław T: F: E: Gdańsk al. Zwycięstwa 13a Gdańsk T: F: E: Katowice ul. Francuska Katowice T: F: E: Łódź al. Piłsudskiego , Łódź T: F: E: kpmg.pl firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Printed on recycled material Cyclus Print

5 KPMG Forum 5 Experts contributing to the issue 3/2013 Agnieszka Müller- Grządka Marta Zielińska Witold Florczak Tomasz Regulski Steven Baxted Agnieszka Emerling Andrzej Musiał Jan Karasek Mirosław Proppé Paweł Darski kpmg.pl youtube.com/kpmgpoland twitter.com/kpmgpoland facebook.com/kpmgpoland

6 6 KPMG Forum Audit Enhancing the value of auditor reporting The independent auditor s opinion and report arguably represent the most important outcome of the examination process of an entity s financial statements as they form the primary means of the auditor s communication with its stakeholders. The importance of the auditor s opinion has been reiterated by the Polish Financial Supervision Authority (Komisja Nadzoru Finansowego, KNF) by considering qualified audit reports as one of the main criteria for selection of the issuers financial statements for the regulator s annual review of their compliance with the International Financial Reporting Standards. In its report of 26 February 2013, KNF considers independent auditors role as that of the first external line of defence in its quest for eliminating non-compliance or irregularities within the issuers financial statements. Of course, some may argue that the auditor s opinion and report are also the most boring elements of an entity s annual report. Some good news for those who do share this view: enhancing the value of auditor reporting is currently one of the areas of focus for the International Auditing and Assurance Standards Board ( IAASB, Board ). Enhancing the value of auditor reporting first made it to the Board s agenda in 2006 when its first academic research was commissioned. Subsequently, 2 formal consultation documents were issued by IAASB, the latest in mid The debate is also fuelled by the European Commission s activities reflected in its Green Paper on the role of a certified auditor and audit market structure ( Audit Policy: Lessons from the Crisis, 2010), the considerations of the Public Company Accounting Oversight Board (Concept document, 2011) as well as those of the International Organization of Securities Commissions (IOSCO) in its document titled Auditor Communications (2009) including proposed enhancements to auditor reports aimed at bridging the expectation gap, being a difference between what users expect from the auditor and the financial statements audit, and the reality of what an audit is, and elimination of a binary character of audit opinion. Reducing the expectation and information gap (i.e. the divide between what users believe is necessary to make informed investments and fiduciary decisions, and what is available to them through audited financial statements, auditor reports or other publicly available information) shall not be executed by making changes to auditor reporting only. Many pundits advocate the need for enhancing overall quality of corporate governance as well as that of financial reporting and underlying financial reporting standards. Therefore, any proposed improvements to the quality of auditor reporting should go hand in hand with initiatives aimed at enhancing clarity and legibility of financial statements. Nevertheless, let us now return to improvements to auditor reporting proposed by the IAASB, some of which are presented below: additional information to be included in the auditor s report to highlight matters that, in the auditor s judgement, are likely to be most important to users understanding of the audited financial statements or the audit. Including auditor conclusion on the appropriateness of management s use of the going concern assumption in preparing the financial statements and an explicit statement as to whether material uncertainties in relation to going concern have been identified. Prominent placement of the auditor s opinion at the beginning of the document. Whilst the last suggestion on the above list (i.e. the opinion paragraph coming first in the auditor s report) will arguably not lead to much controversy, the remaining two may result in numerous comments from financial statements preparers, investors as well as auditors themselves. Let us look at these two issues more closely then.

7 Audit KPMG Forum 7 Additional information on the financial statements and the audit Under the Board s proposals, additional commentary would form a mandatory portion of the auditor s report issued in conjunction with audits of financial statements of all public interest entities, in particular listed securities issuers. For the remaining entities, additional commentary would be voluntary. The potential spectrum of matters to be discussed by the auditor is very broad and may include areas of significant management judgements (e.g. in relation to an entity s accounting practices, including accounting policies, accounting estimates and financial statement disclosures), significant or unusual transactions (e.g. with related parties), and other matters of audit significance such as those requiring significant judgement on the auditor s side. The commentary s objective would not be to repeat the information already disclosed by an entity s management. In practice, however, selecting the commentaries to be included in the auditor s report may represent a real challenge considering varying needs of different users of the financial statements: some users require assistance in going through increasingly complex financial information in the financial statements, some expect auditors to share their views on the company s operations and performance, whilst others expect hints on matters to be discussed with the entity s management. One cannot ignore potential legal ramifications of the auditor disclosing information that was not made available by the entity within its financial statements, nor the concerns of some that the auditor may be seen as primary source of information about the entity. In our view the solution might be for the auditor to only refer to those matters already discussed in the financial statements. As for the additional commentary on the audit process, the Board s recommended improvements have by and large enjoyed a favourable reception, in particular from investors who would appreciate increased transparency about what kept the auditor up at night. Still, given the selective character of such auditor s disclosure, a number of questions arise, such as whether the users, absent an intimate knowledge of the entire audit methodology, will be in a position to properly interpret the information on the audit procedures applied. Will the additional information users obtain and read increase their confidence in the opinion on the financial statements as a whole, or will it only be viewed as a sort of warning? Quite possibly it may also lead to doubts as to whether the auditor has in fact performed all of the procedures necessary within the given area. In view of the above, the Board faces a difficult task of determining adequate and clear cut criteria for inclusion of additional commentaries in the auditor s report. Such criteria should be flexible enough to enable consistent application EXAMPLE OF CURRENT AUDITOR S OPINION Report on the Financial Statements Introduction Responsibilities of Management and Those Charged with Governance Auditor s Responsibility Basis for Qualified/Adverse Opinion Opinion Emphasis of Matter Other matter Specific Comments on Other Legal and Regulatory Requirements Report on the Company s activities by auditors in any jurisdiction, and at the same time they should prevent superfluous extension of the auditor s report in size, for instance to several pages. More explicit statement on going concern The current financial crisis has led to increased expectations of the financial statements users as to early warning information from the auditors on the audited entities upcoming problems with liquidity and/or going concern uncertainties. What also needs to be reemphasized in this context is the segregation of responsibilities of the auditor and management in the above respects. In accordance with International Accounting Standard 1 Presentation of Financial Statements management encumbers the sole responsibility for the assessment of an entity s ability to continue as a going concern within the foreseeable future (the period not shorter than 12 months from the end of the reporting period) with disclosure required in the financial statements of any material uncertainties related EXAMPLE OF PROPOSED AUDITOR S OPINION Report on the Financial Statements Opinion Basis for Opinion Going concern Auditor Commentary Other information (for instance Report on the Company s activities) Responsibilities of Management and Those Charged with Governance, including Management responsibilities Relating to Going Concern Auditor s Responsibility Specific Comments on Other Legal and Regulatory Requirements

8 8 KPMG Forum Audit A number of commentators underline that changes are also indispensable at the level of particular entities (for instance through the strengthening of corporate order as well as through the enhancement of the quality of financial reporting), as well as at the level of financial reporting standards, which are applied in the process of preparation of financial reports of various emitting entities. to events or conditions that may cast significant doubts upon the entity s ability to continue as a going concern. International as well as National Auditing Standards require the auditor to verify management s assumptions and based upon the procedures performed, including the analysis of information in the financial statements, to formulate the appropriate opinion. Therefore the IAASB s recommendations do not in any manner increase the auditor s responsibilities nor the scope of audit procedures to be applied. Nevertheless, the inclusion of an explicit statement in the auditor s report may lead to a risk that the financial statements users will place undue reliance thereon. In our view, the requirement for the auditor explicitly comment the audited entity s ability to continue as a going concern should be accompanied by the requirement for the entity to disclose more forward looking Agnieszka Müller-Grządka DPP Director KPMG in Poland information, such as, e.g. significant business and operational risks along with the determination of their potential effects on its ability to continue as a going concern. What next? Given current plans to adopt International Auditing Standards in Poland in the near future, both auditors and the financial statements users should closely monitor the Board s activities leading to the new standard on auditor reporting. All stakeholders wishing to express their views on the subject will be given the opportunity do so once the IAASB publishes a draft of the standard by the end of this year. from 1994 to 2007 worked in the Audit Department where she was responsible for examination of financial reports of companies from various sectors of the economy; From 2007 in DPP; From 2007 the member within the National Council of Expert Auditors (KRBR) committee with regards to opinioning of legal deeds

9 9 KPMG Forum Audit KPMG Forum 9 Solvency 1.5 in 2014 Introduction On 27 th March 2013 public consultations were launched by EIOPA with regards to the draft Guidelines related to the preparation for Solvency II (the Guidelines). The Guidelines followed the Opinion of EIOPA on interim measures regarding Solvency II published on the 20 th December EIOPA has been existing for a relatively short period (i.e. from January 2011) and the current consultation process related to the Guidelines is only the second process of this type in the history of the institution. The first one referred to the Guidelines on Complaints-Handling by Insurance Undertakings, the final version of which was published in The area of the current consultations appears much more complex and in many aspects the process will be unprecedented. The timeline of Solvency II Within the consultation process four documents were open to commenting till 19 th June 2013, covering the following areas: system of governance, a forward-looking assessment of undertakings own risks (based on ORSA principles), submission of information to regulators as well as pre-application for internal models. Unfortunately comments could not directly refer to the Cover Note, although the section General comment included in the templates for commenting each of the four documents mentioned above might potentially be used. Similarly, the explanatory texts available on the EIOPA website with regards to the aforementioned four documents were not subject to the public consultations, even though these include relevant additional information. Therefore, it may be expected that part of the comments might also refer to these texts. The publication of the final version of the Guidelines is planned for autumn Within the following two months national competent authorities (NCAs) are obliged to confirm whether (and to what extent) they intend to comply with the Guidelines (the comply-orexplain rule). The approach adopted by the Polish Financial Supervision Authority shall be of great importance for Polish insurance companies, however, as of now it is uncertain how quickly they will receive access to this information (at the latest: after the publication of the Polish Financial Supervision Authority s reply on the EIOPA website, as it was in the case of the Guidelines on Complaints-Handling by Insurance Undertakings). Currently EIOPA assumes that the Guidelines will be effective starting from the beginning of 2014 and that the final implementation of the Solvency II Directive will take place by the 1 st January 2016.

10 10 KPMG Forum Audit Nevertheless, certain dates included in the Guidelines may be subject to deferral, depending on the result of negotiations of the Omnibus II Directive. Insurance companies have to know the principles of SCR and technical provisions calculation for the purpose of the Guidelines (for instance submission of information to regulators) and subsequently also under Solvency II. The implications of introduction of the Guidelines for the insurance market Even though the Guidelines are to be effective as of the 1 st January 2014, this does not mean that insurance companies are expected to fully meet all of the requirements arising thereon already at that date. The Guidelines introduce the phasingin approach, which means that the expectations with regards to the degree of preparation to Solvency II will gradually increase over the interim period (i.e. the years 2014 and 2015), at the end of which insurers should be fully compliant with the Solvency II Directive. The question is what approach will be adopted by the national competent authorities (NCAs). Under the Guidelines they are not required to take supervisory actions if during the interim period an insurance company fails to comply with the Guidelines (in particular the Pillar I requirements). On the other hand an unsatisfactory progress in the Guidelines implementation is unlikely to be left without a response from the NCAs, which are obliged to report on annual basis (by the end of February each year) to EIOPA on the progress of the market they supervise. While the works on the Pillar I (quantitative requirements) have already been carried out for a few years now (as part of the QIS exercises as well as through preapplication processes) and also within the Pillar II (system of governance) a lot has already been done, it seems that currently the Pillar III (public and regulatory disclosure) puts the greatest challenge for insurance companies. Submission of information In particular, the Guidelines introduce specific dates for reporting to the national competent authorities under the Solvency II rules. The following shall be required: one annual report a year prior to the Solvency II implementation (i.e. under current assumptions as of the 31 st December 2014, within the deadline of 20 weeks from that date for solo insurance companies and 26 weeks for the Groups), two quarterly reports for 2 quarters preceding the Solvency II implementation (i.e. under current assumptions as of 30 th September 2015 and 31 st December 2015, within the deadline of 8 weeks from the respective date for solo insurance companies and 14 weeks for Groups). The reporting required in the interim period does not include the complete set of documents defined within the Final Report on the Solvency II reporting and disclosures requirements published by EIOPA in July 2012 (not all elements of QRTs and descriptive RSR / SFCR reports) nor is it obligatory for all insurance companies (certain thresholds are defined for the interim period, which exempts the smallest insurers from the reporting requirements). Nevertheless, the comments appearing on the market suggest that a significantly more limited reporting scope was expected, especially considering that in parallel the reporting in accordance with the current regime is maintained. Moreover, the division of the reporting templates into quarterly and annual is rather blurred, since within the annual reporting also selected quarterly QRT are obligatory (for instance related to A significant challenge for insurance companies may be constituted by the requirements in the area of outsourcing, since the Guidelines related to the key functions have to be adhered to regardless of whether these functions are executed through own employees or external companies.

11 Audit KPMG Forum 11 technical provisions). It is also difficult to say in what way the Polish Financial Supervision Authority will execute its right to extend the reporting obligations onto the smallest insurance companies and to include additional reports into the reporting scope (national specifities). System of governance The Guidelines on the governance system are divided onto a few chapters, including general governance, fit and proper requirements, risk management, the prudent person principle, own funds, internal audit and actuarial functions, outsourcing as well as group specific requirements. The role of so called administrative management or supervisory body or AMSB (i.e. in the Polish reality the Management Board and the Supervisory Board) is strongly underlined. According to the Guidelines the members of these bodies need to have adequate qualifications, knowledge and experience, effectively communicate with committees and people playing a key role in the risk management process (feedback loops) as well as properly document their decisions (with reference to the information obtained from the risk management system). Similarly, the Guidelines define requirements with regards to the key functions (actuarial, risk management, compliance, internal audit) within the insurance company. The Guidelines also impose extensive documentation obligations, including a number of policies and procedures, which every insurance company is expected to possess and enforce in certain areas (like underwriting, investment activity, asset-liability management, operational risk, risk mitigation techniques or capital management). General characteristics of these documents are described as well as the elements, which (at the minimum) such documents should cover. A separate chapter is devoted to the investment activity in the context of the prudent person principle, in particular defining key risk indicators as well as reasonably prudent approach to certain investments classes (e.g. unit- or indexed-linked investments, instruments not publicly listed or derivative instruments). A significant challenge for insurance companies may be constituted by the requirements in the area of outsourcing, since the Guidelines related to the key functions have to be adhered to regardless of whether these functions are executed through own employees or external companies. Apart from a separate (last) chapter related to the Group specific requirements, Group aspects are also mentioned in a number of guidelines included in the preceding chapters (for instance with regards to AMSB tasks, organisational and operational structure or the internal reviews of the system of governance). Forward-looking assessment of the undertakings own risks As underlined in the Cover Note, the Guidelines are consistent with the final version of the Guidelines on the ORSA published by EIOPA in July Basically, the assessment of three main aspects is required: 1. assessment of overall solvency needs, 2. assessment of whether the undertaking would comply on a continuous basis with the Solvency II regulatory capital requirements and the requirements regarding the calculation of technical provisions, 3. assessment of deviations from the assumptions underlying the solvency capital requirement calculation. Similar materiality thresholds have been introduced as in the submission of information area, however, only with respect to selected Guidelines (points 2 and 3 above). The forward-looking assessment of the undertakings own risks should be carried out at least once a year, and within 2 weeks from its completion the insurance company should submit the final report to the national competent authority. Pre-application for internal models Already in March 2010 CEIOPS published the guidelines on the preapplication process. In the case of some larger insurance companies such processes have been in progress for a number of years already. The new EIOPA Guidelines aim at improving convergence of supervisory practices in this area. During the pre-application process the NCA should assess the level of preparation of the insurance company for the actual application of the internal model in the risk management and decision taking processes as well as form a view whether the insurance company is prepared for the situation that its internal model is not approved by the NCA and all of the potential capital planning implications. The Guidelines address the areas such as model changes, use test, assumption setting and expert judgement, methodological consistency, probability distribution forecasts, profit and loss attribution, calibration approximations, validation, documentation, external models and data as well as the functioning of colleges of supervisors. Summary As underlined by EIOPA in the Cover Note, the important role of the Guidelines is to motivate insurance companies to systematic progress in the implementation of Solvency II,

12 12 KPMG Forum Audit so as not to waste what had already been achieved especially considering that along with the further delay of the Solvency II implementation date a risk that the preparations in this area will be suspended, increases. Therefore, insurance companies should review their existing implementation plans of the Solvency II Directive, adjusting these to the Guidelines, especially within the scope of Pillars II and III. The busiest period is expected in the first half of 2015 when (under current assumptions) the first annual report required by the Guidelines should be submitted and in parallel the reporting under the current regime will be continued. Moreover, also in other areas covered by the Guidelines, a year after they became effective the expectations of NCAs with regards to the degree of preparation for Solvency II will certainly increase. Marta Zielińska Supervisor, Actuarial Service KPMG in Poland Marta is the fellow of the Polish Society of Actuaries Since joining KPMG in 2004, Marta has been focused on the audit of life and non-life insurance companies. For the last couple of years she has been specialising in the actuarial area. She performs financial statements audits based on local accounting regulations, IFRS and US GAAP as well as MCEV audits. She has been involved in actuarial consulting, calculations and reviews of employee benefits provisions, reviews of reserving processes as well as due diligence engagements regarding insurance companies. Witold Florczak PhD Director, Actuarial Service KPMG in Poland He joined KPMG at the beginning of 2012 He specializes in projects related to actuarial valuations, Solvency II and risk management in insurance companies. Witold possesses 16-years of experience in insurance industry, his experience covers actuarial practice as well as risk management, including: Solvency II, MCEV and EC calculations both for life and pension companies, product pricing, financial projections, statutory and group reporting, green field operations and M&A assignments. His past roles involved setting up new facilities starting without a team and building up the resources. He has worked on technical deliverables as well as high-level plans and leadership within projects and the business. He is the fellow of the Polish Society of Actuaries and the associate of British Institute of Actuaries He is the member of the Solvency II working within the Polish Insurance Association. Witold is an author of publications in industry press.

13 Corporate Finance KPMG Forum 13 Price of stock-listed shares vs. their fair value Price of shares vs. fair value Is the fair value of stock-listed companies reflected by the price of their shares? Answering this question requires first of all to define the term of the fair value. Although there are several definitions of the notion, the most frequently applied is the one included in the Polish Accounting Act (article 28, item 6 of the Accounting Act of 29 September 1994), wherein the fair value is defined as an amount for which a given asset could be exchanged and a liability settled in an arm s length transaction, between willing, well-informed and non-related parties. Different levels of the value i.e. how to compare apples to apples Before determining whether the price of the stock-listed shares reflects their fair value, let us consider the issue of different levels of the value. Thus, from the perspective of shareholders of stock-listed companies, which of the levels presented at the Fig. 1 should be analyzed? Given that the subject of trade are usually minority stakes and the major market participants are private investors or institutional minority investors the share price should correspond to the fair value of the liquid minority interest (level 3). This approach seems to be further substantiated by the analysis of premiums paid by investors as they call tender offers for selling shares during which a purchase of a controlling stake is planned (Fig. 2). Such premiums reflect a difference between the level of the liquid minority interest and the level of the controlling stake, or, in some instances, the level that comprises the synergy-arising benefits (e.g. obtainable by investors after taking over control) (level 1) or Fig.1 Basic levels of the value the irrational value (e.g. taking into consideration investor s sentiment). When are share prices equal to their fair value? Once the fair value is defined and the level of value that reflects share price determined, it is eventually possible to investigate whether and when the share price may be equal to its fair value (from the perspective of minority shareholders). To address the question, we need to scrutinize the basic Source: KPMG s analysis

14 14 KPMG Forum Corporate Finance Fig. 2 The analysis of public tender offers announced at the Warsaw Stock Exchange between 1 January 2009 and 15 January 2013 Source: KPMG s analysis components of the above-presented definition of the fair value as well as other key issues that may influence how the fair value is reflected by share prices. Transactions between well-informed parties The concept of the capital market assumes that all its participants should have an equal access to the information. In practice, however, investors may be divided into three major categories: a) people with access to essential, price-creating information on a company and its environment these are usually members of the management board or the company s key employees who are at the same time the company s shareholders, b) institutional investors, particularly those with significant stakes of shares, which have a facilitated access to companies management boards, c) individual investors with access only to publicly available information. In theory, none of the above groups should enjoy privileges connected with obtaining information. In particular, such differences should not occur between individual and institutional investors since their transactions are usually a substantial part of a stock trade. It happens, though, that management boards are more inclined to cooperate with and provide information to financial investors, perceived as long-term shareholders that could attract the interest of other shareholders. As a result, information available to individual investors can be delayed or limited, which in consequence leads to disproportions in the access to the information. This may particularly occur in small companies with inadequately performing investor relations department or in case of capital markets that are not well regulated in terms of ensuring equal access to information for all investors. Transactions between non-related parties The nature of stock exchange transactions considerably narrows the possibilities of executing transactions between related parties (conducted on non-market terms). Thus, it may be assumed that, apart from extraordinary situations, transactions are concluded between non-related parties (and if the parties are related, then the transactions follow market principles).

15 Corporate Finance KPMG Forum 15 Given that the subject of trade are usually minority stakes and the major market participants are private investors or institutional minority investors the share price should correspond to the fair value of the liquid minority interest. As a consequence, the condition of non-relation is thereby met. Transactions between willing parties As a matter of principle, the condition of concluding transactions between willing parties seems to be met in any instance. In order to execute a transaction, it is necessary to submit the sell or buy order, which essentially excludes the possibility that the transaction will not meet with any interest. Clearly, instances of incorrect orders do happen, but they constitute a marginal fraction of all executed transactions. Voluntariness of concluded transactions Apart from the elements listed in the definition of the fair value, there are also other issues that may impose a significant impact upon the price of shares and how it reflects the company s fair value. One of these is voluntariness of concluded transactions. As in case of willingness of parties, also voluntariness may be assumed to occur in the majority of transactions concluded at the stock exchange. Still, there are situations in which the principle of voluntariness is debatable, such as when investment funds are forced to sell owned shares as a result of a large scale redemption of units by the funds participants. This may be particularly intense during financial crises or economic slowdowns, when individual investors cancel their units in order to minimize the risk of investing in shares. The scale of the process forces investment funds to sell the shares of companies which otherwise would have been kept. The less liquid stakes of shares are sold by the investment funds, the bigger impact this process has upon the prices of shares. Liquidity of shares Another key issue is the liquidity of the listed stakes of shares, understood in this case as a proportional quantity of a company s shares owned by minority shareholders ( free float ) and the nominal value of such stakes as well as the value of the average daily turnover of company s shares. In such instance the principle seems to be relatively simple the larger part of shares (of a bigger value) is held by minority shareholders and the bigger daily trade of such shares is carried out, the higher probability that the price of shares reflects their fair value. Naturally, this is the consequence of the fact that in case of large free float stakes of shares, it is very difficult for individual shareholders to influence the share price by purchasing or selling shares, unlike small stakes, easily-controllable even by the shareholders with inconsiderable financial resources. The New Connect market at the Warsaw Stock Exchange serve here as a good illustration prices of listed companies may shoot up by several or even a few hundred percent within just a few days, to fall down equally fast back to the initial level. Non-liquid companies also seem to present the risk, as the investors who own their shares will be unable to sell them for the current price. In other words, the value of such company is in fact lower than the one arising from their share price. When it happens, the fair value of such stakes of shares should be analyzed from the perspective of non-liquid minority interest, that is, with an additional discount in comparison to the liquid stakes (as presented in the Fig. 1). Market sentiment Another significant element likely to influence the reflection of the fair value by the price of shares is the investors sentiment for the sector in which the company operates or the sentiment for share investments in general. In such a situation, as investors decide to sell or purchase shares of a given company, they take into account the condition of the whole sector or a general situation of capital markets, while often disregarding such company s characteristics of operation, which

16 16 KPMG Forum Corporate Finance may substantially differ from other entities within the given sector. Such tendency may cause the fair value of given entities to be significantly overor underrated. It is well illustrated by the dot-com bubble that took place at the turn of 20th and the 21st century. Without conducting detailed analyses and research, investors purchased shares of the Internet sector companies, the majority of which offered little more to its potential shareholders than just splendid visions and ideas. As a result, the share prices of such companies were much higher than their fair value. So does the price of shares equal their fair value? One of the major tasks and assumptions of stock exchanges is the valuation of shares of stock-listed companies. Is such a valuation namely, the share price a reliable reflection of an entity s fair value? The deliberation above indicates the issue to be conditioned. If the share price was to reflect the fair value, certain factors must occur at the same time the market where companies are listed needs to be adequately regulated to ensure, among other things, an equal access to information or the control of transactions between related parties. The companies themselves should treat their shareholders uniformly and the free-float share stakes should be sufficiently liquid. Also, a caution is advised in the valuation of shares of companies that are found in extreme stages of a business cycle, when the capitalization may be over-or undervalued. In any case, a common sense and an adequate analysis of the planned investment is the reasonable course. What about the stock market in Poland? Upon the above analyses, it seems that in the case of the largest entities listed at the Warsaw Stock Exchange the price of shares should reflect companies fair value. This may be proved by the KPMG analyses of differences between (a) the prices of shares comprised in recommendations of stock analysts for specific companies (applying to WIG20 and mwig40 companies) and (b) the prices of shares on the eve of publishing particular reports 1. The analyses indicate that the differences between current and recommended share prices may on average reach up to 15%, though there are also instances when such difference is considerably larger. Assuming that: (i) valuations prepared by analysts reflect the fair value of specific entities and (ii) valuations are made from the perspective of a controlling stake value (Fig. 1) or the range between the controlling stake and the liquid minority stake (when the recommended price is calculated as an average of income-based and market valuation method), the differences in prices reflect discrepancies between particular levels of value and are coherent with the analysis presented in the Fig. 2. Therefore, the prices of shares of the largest entities listed at the Warsaw Stock Exchange are indeed likely to reflect their fair value. Unfortunately, when it comes to smaller companies, the amount of issued recommendations disallows similar analyses to be performed. 1 The analysis of 233 recommendations or analytical reports published by brokerage offices between January 2012 and January 2013, applying to 41 companies comprised in WIG20 and mwig40 indexes of the Warsaw Stock Exchange. Tomasz Regulski Manager, Corporate Finance Group KPMG in Poland Master of science, Independent University of Business and Administration in Warsaw, faculty: Economy. Tomasz Regulski joined KPMG in Tomasz has extensive experience in the field of project management, mergers and acquisitions, capital market transactions and business valuations. Prior to KPMG he worked in Corporate Finance Group in KBC Securities N.V. and in Kredyt Bank S.A. Tomasz specializes in business valuations as well as financial model development and reviews. Tomasz is a member of a dedicated Valuation and Modelline Team within Corporate Finance Group which undertakes valuations for transaction, accounting (according to relevant financial reporting standards), legal, tax and other purposes. This team also performs purchase price allocations, reviews of valuations and feasibility studies prepared by other entities as well as develops and reviews financial models.

17 Audit KPMG Forum 17 Polish Construction Study 2013 The construction industry is currently facing numerous challenges, particularly financial difficulties and even bankruptcies are not very uncommon. In order to provide insight into the market situation KPMG in Poland together with CEEC Research and Norstat Poland carried out a survey among the top building and construction company executives (CEOs) and board members of 143 large, medium and small general construction and civil engineering companies. The survey was performed in March and April Similar surveys were carried out in the other Visegrad Group countries; in February 2013 for the Czech Republic, March 2013 for Slovakia and June 2012 for Hungary. Overall Market Expectations Unfortunately most executives predict a decline in the sector in Poland for The decline is expected to reach 11%, which represents increased pessimism compared to a year ago when companies expected a decline of 4.3% for In fact a decline in the building and construction sector for 2013 is now expected by 80% of executives while a year ago that percentage was significantly lower at 55%. Expectations in the Czech Republic, Slovakia and Hungary were not as negative, with 2013 declines of 4.4%, 4.6% and 2.2% respectively predicted by industry executives in these countries. Expected development in building and construction The executives do not expect any noticeable rebound in the Polish construction industry in 2014 either with a further expected decline of 1.0%. Market Share Expectations Companies were also asked if they expect to increase their market share in the current conditions. For 2013 better performance than their competitors is anticipated by 38% of construction executives compared to 33% a year ago. Nevertheless the current sentiment is the lowest among the Visegrad Group countries with 59% of companies in the Czech Republic, 46% in Slovakia and 51% in Hungary anticipating better performance than their competitors. The outlook for 2014 indicates a moderate improvement with more than half of executives (54%) confident that they will be able to increase their market share in 2014.

18 18 KPMG Forum Audit Expected market share change in 2013 comparison with the previous year likely partially impacted the results. In terms of the different segments the situation is worse in civil engineering companies, which indicate a more significant drop in capacity utilisation to 52% compared to 62% a year ago while general construction companies indicated 65% capacity utilisation compared to 71% in There were similar findings for other surveyed countries with Czech Republic, Slovakia and Hungary reporting 65%, 63% and 59% capacity utilisation respectively. Backlog of Contracted Work Capacity utilisation(%) Capacity Utilisation Our survey indicated that the average capacity utilisation of construction companies has lowered by 6 percentage points in comparison with the March 2012 survey. Current average capacity utilisation runs at 60%, which means the third decrease in a row. Worse weather conditions at the time of the survey in Companies were also asked about their backlog; ie. looking forward the average number of months that construction companies have contracted work to be completed. This has further decreased since the March 2012 survey with companies having orders for the next 6.7 months compared to the next 7.7 months last year. In other countries the situation varied with Czech Republic, Slovakia and Hungary reporting a backlog of 6.9 months, 6.2 months and 2.7 months respectively. For 2013 better performance than their competitors is anticipated by 38% of construction executives compared to 33% a year ago.

19 Audit KPMG Forum 19 Methods used for acquiring new contracts Key problems faced by companies Although the large construction companies in Poland have the longest period of future contracted work, this number has decreased considerably in comparison with the previous year (currently 8.8 months on average compared to 11 months in 2012). Similarly the number of respondents with more pre-negotiated contracts has currently sharply decreased. Only 15% of companies have more contracts than a year ago (compared to 19% in 2012). The share of respondents with fewer contracts has increased from 37% in 2012 to 53% in Acquiring New Contracts Again this year Polish construction executives continue to indicate tenders as the most effective method for acquiring new contracts. The average evaluation of the effectiveness of this method has reached 7.4 points (0=minimum 10=maximum). On the other hand, personal contacts, quite positively viewed as one of the previous methods of getting new contracts in 2012, have now lost some of their importance (6.0 points in 2013 compared to 7.8 in 2012). Due to a low number of orders/contracts on the market, one third of companies (32%) are currently willing to accept an order with a zero or negative profit margin. This indicates a slight drop of 2 percentage points in comparison with The share of companies willing to breach their internal risk management policies in order to get a new contract is unchanged from 2012 at 58%. Challenges Encountered by Companies When inquiring about the main problems faced by construction companies at the moment executives most frequently mention the high cost of labour (99%; 6.2 points), tough competition (98%; 6.5 points) and bureaucracy (97%; 6.5 points) as challenges to growth. Further difficulties which the companies have to face are connected with insufficient demand from the public sector and high material costs. Companies Priorities Lastly we asked executives what are the main areas the construction executives will focus on in the next twelve months? The key priority for the Polish construction companies is an increase in the operational efficiency of the company. This priority has been indicated as the most important (confirmed by 97%;

20 20 KPMG Forum Audit 7 points). Other important priorities for the Polish construction companies are an improvement of the purchase process (94%; 6.4 points) and optimising of financing (95%; 6.1 points). The current year findings represent the most pessimistic results since the survey was carried out for the first time in 2008, in comparison to past expectations in Poland as well as in comparison to other Visegrad Group countries. In the case of the general construction sector, a lack of access to financing is one of the primary causes and there are no signs for improvement at present. Whereas in case of the civil engineering sector the situation is different, the negative sentiment can be partially attributed to the fact that significant investment projects financed by EU funds are coming to an end. New projects financed by the EU budget for the period from 2014 to 2020 are expected to be announced shortly, allowing new construction projects to start in Therefore some improvement in the civil engineering sector is expected in 2015 as a result of the realization of the new EU budget. Priorities of companies for the next 12 months Steven Baxted Partner, KPMG in Poland Head of the Real Estate and Construction group in Poland and a member of the CEE KPMG Real Estate Steering Committee More than 19 years of experience with KPMG providing Audit, Acquisition/Disposal and other attestation services to clients Assisting clients in Poland since 1999 and previously in Canada from 1993 to 1999 Responsible for the annual publications CEE Property Lending Barometer and Construction in Poland ( Budownictwo w Polsce. )

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