Going concern – final recommendations of the Sharman Inquiry
In March 2011 the Financial Reporting Council (FRC) launched the Sharman Inquiry to identify lessons for companies and auditors about the going concern assessment, drawing on the experience of dealing with these issues in times of difficulty (including during the credit crisis), and to recommend measures necessary to improve the existing reporting regime.
The Sharman Inquiry resulted in preliminary conclusions and recommendations issued in November 2011, which have been followed by the final report and recommendations published on 13 June 2012.
The final recommendations of the Inquiry are likely to bring about changes to the going concern assessment and reporting requirements in the UK that will be implemented by amendments to the FRC’s guidance for directors, to that on auditing committees and to the UK accounting and auditing standards.
The proposals will not apply equally to all companies, with the more onerous ones applicable only to listed entities and some other high profile entities. The five recommendations issued by the panel of inquiry address:
- making the going concern assessment process, risks and conclusions always transparent, not just when a fundamental uncertainty exists;
- having a clearer definition of going concern and a common understanding of the purposes of the assessment and thresholds to be used;
- integrating going concern assessment with business planning and risk management;
- enhancing the role of the auditor in reporting on going concern;
- enhancing the FRC’s monitoring of and responses to corporate failures and near misses.
Always making transparent the going concern assessment, risks and conclusions
The Panel’s recommendation in this respect involves superseding the current model where disclosures about going concern risks are only highlighted when there are significant doubts about the entity’s survival (a fundamental uncertainty).
Instead, going concern reporting should include the directors’ going concern statement and how they arrived at their conclusion about it within the context of the information given by the company about its business model, strategy and principal risks as required by the Governance Code and Companies Act.
Additionally, the audit committee report should illustrate the robustness of the going concern assessment process and any limitations it may have had.
The further disclosures involved by this recommendation will affect listed companies and few others and will be included in the narrative report, while the disclosures about the appropriateness of the going concern basis of accounting and any material uncertainty disclosures required by the accounting framework will remain in the notes to the financial statements.
The purpose of making the going concern assessment process, risks and conclusions transparent is to provide information to stakeholders about the economic and financial viability of the company and to help demonstrate the directors’ stewardship and governance of the company in that respect. For that purpose this recommendation is linked to the implementation of the proposed FRC’s Effective Company Stewardship (ECS) requirements and should be implemented via amendments to the UK auditing standards and FRC’s guidance for directors and auditors.
Definition of going concern and common understanding of the purposes of the assessment and thresholds to be used
The Panel’s recommendation is that the FRC should seek to engage with the International Accounting Standards Board (IASB) and the International Auditing and Assurance Standards Board (IAASB), ideally to agree a common international understanding of the purposes of the going concern assessment and connected financial statements disclosures, and of the related thresholds and descriptions of a going concern, and should clarify these matters in the UK standards and guidance, if possible in line with such international consensus.
The Panel found that the description of what constitutes a going concern, of the purposes of a going concern assessment (which include both true and fair accounting and company stewardship purposes), and of the related thresholds for disclosures were possibly inconsistent between the various relevant sources applicable in the UK, such as UK GAAP, IFRS, auditing standards, Governance Code and the various guidance for directors and auditors. This inconsistency leads in fact to different interpretations by different people of the same or similar circumstances undermining the effectiveness of the assessment.
To remove the perceived inconsistencies in the various sources, the Panel recommends that the FRC should take the international community with it, and avoid divergence from international standards, rather than make changes to UK accounting and auditing standards and then seek to influence the international community to follow the same approach.
This recommendation will involve changes to guidance and standards and will apply to all companies.
Integrating going concern assessment with business planning and risk management
The Panel’s recommendation is that the FRC should amend its guidance for directors to ensure that the going concern assessment is integrated with the directors’ business planning and risk management process and that it focuses on both solvency and liquidity risks. In such a way the thinking that emerges from the going concern assessment can inform the company’s risk decision making and can improve its ability to identify and respond to signs of economic and financial distress.
The assessment of solvency risk, which appears to be currently neglected in the overall assessment of going concern in favour of liquidity risk, should include identifying risks to the entity’s business model or capital adequacy that could threaten its survival, and considering their evolution over a period that takes into account the stage of the economic cycle and the specific business cycle(s) of the company.
In addition the assessment of going concern should be more qualitative and longer term in outlook in relation to solvency risk than in relation to liquidity risk and should include stress tests both in relation to solvency and liquidity risks to be undertaken with an appropriate level of prudence.
This recommendation will be applicable to all companies, as the Guidance for Directors applies to all UK companies; however, the guidance needs to be applied by directors in a manner that is proportionate to the nature of their business, and therefore smaller and less complex companies will not be required to perform overcomplicated assessments.
Enhancing the role of the auditor in reporting on going concern
In relation to the role of the auditor, the Panel’s recommendation is that, in addition to addressing the basis of accounting and material uncertainty disclosures, the auditor’s report should also include an explicit statement as to whether the auditor has anything to add or emphasise in relation to the narrative disclosures made by the directors about the robustness of the going concern assessment and its outcome.
The extension of the role of the auditor in going concern reporting will entail changes to the auditing standards and will be limited to the audit of listed companies and of a few other companies subject to the future ECS requirements.
Enhancing FRC’s monitoring of and responses to corporate failures and near misses
In respect of learning lessons from significant companies’ failures or their considerable economic or financial distress, the Panel’s recommendation to FRC is that it should take a more systematic approach to conducting selective inquiries, either alone or in conjunction with BIS or other regulatory authorities, to investigate into such circumstances. For such purpose the FRC should consider developing adequate protocols with BIS and other regulatory agencies.