New proposals on going concern guidance and auditing standards.
The Financial Reporting Council (FRC) has outlined its proposals for implementing some of the recommendations made by the Sharman Panel, subsequent to its inquiry into going concern and liquidity risks, in a consultation paper that includes a new ‘guidance on going concern’ for directors and proposed amendments to related auditing standards. The FRC is seeking responses to the proposals by 28 April 2013.
In March 2011 the FRC launched the Sharman Inquiry to identify lessons for companies and auditors about the going concern assessment where companies faced going concern and liquidity risks, including during the financial crisis, and to recommend measures necessary to improve the existing reporting regime. Click here to see ACCA’s analysis.
The final recommendations from the Sharman Panel were published in June 2012. Click here to see ACCA’s analysis.
The Panel’s recommendations that the FRC is proposing to implement are those of:
a) Clarifying the purposes of the going concern assessment and disclosure requirements and the various descriptions of a going concern included in the Corporate Governance Code and the accounting and auditing standards;
b) Amending the guidance for directors to ensure that the going concern assessment is integrated with business planning and risk management and focuses on both solvency and liquidity risk;
c) Making the going concern assessment process, principal risks considered and conclusions reached always transparent, not just when there are doubts about the entity’s survival, and require the directors to confirm that a robust going concern assessment has been made.
d) Requiring the auditor to make an explicit statement as to whether there is anything to add or emphasise about the directors’ going concern disclosures.
A. Clarifying the purposes of the going concern assessment and reporting and the descriptions of a going concern
The draft Guidance explains that the primary purpose of the going concern assessment undertaken by directors is that of making sure that the risks that could threaten the company’s survival are properly identified and managed, having regards to the interests of shareholders, creditors and other stakeholders.
In turn the purpose of the company’s reporting on going concern is twofold:
a) Stewardship purpose –which is that of providing information to stakeholders about the company’s economic and financial viability, so that the board’s stewardship and governance can be demonstrated and shareholders can be enticed to engage with the board;
b) Financial reporting purpose – which is that of establishing and disclosing going concern information that is needed for the financial statements to give a true and fair view.
As part of the stewardship purpose, companies applying the Corporate Governance Code are required to make a statement in their annual report that the business is a going concern, together with any supporting assumptions or relevant qualifications. Additionally the Guidance requires such companies to confirm in their annual report that the board undertook a robust going concern assessment and to illustrate how effective the assessment is in respect of significant solvency and liquidity risks considered and how they were addressed.
To fulfil the financial reporting purpose, the board is required, under IFRS and UK GAAP, to disclose in the financial statements if it concludes that the going concern basis of accounting is not appropriate and if there are material uncertainties about the entity’s ability to continue as a going concern.
In the draft Guidance the stewardship purpose of going concern reporting is given more relevance as it is more in line with the primary purpose of the assessment of identifying and managing the risks to the company’s survival.
In the Guidance for Directors issued in 2009 the going concern assessment was required on a periodic basis for the annual or half-yearly financial statements as the primary purpose was that of assessing whether the going concern basis of accounting was appropriate.
The draft Guidance instead requires integrating going concern assessment with on-going business planning and risk management and with overall management of the business, rather than being an isolated exercise undertaken when preparing financial statements. In this way going concern assessment and reporting should support better decision making within the business, the delivery of appropriate information to stakeholders about specific risks taken and more responsiveness by management to economic and financial risks. Then the periodic accounting conclusions and disclosures on the going concern basis of accounting and material uncertainties should follow naturally from the assessment.
The Guidance also indicates the threshold to be used in judging a company a going concern when the directors make the statement in accordance with the Code’s requirements that the business is a going concern.
Fur such purpose a company ‘is judged to be a going concern if, for the foreseeable future, there is a high level of confidence that it will have the necessary liquid resources to meet its liabilities as they fall due and will be able to sustain its business model, strategy and operations and remain solvent, including in the face of reasonably predictable internally or externally generated shocks’.
This description of when an entity should be judged to be a going concern for the purpose of the Code’s rules is included in the new Guidance to draw a distinction from the threshold used for financial reporting purposes.
In fact the accounting and auditing standards do not require the direct determination of whether a company is or will continue to be a going concern, but rather set out criteria to determine when the going concern basis of accounting should be disapplied, namely when the company has no realistic alternative to liquidation or to cease trading.
Under the old Guidance the threshold used to identify material uncertainties and to conclude whether the company is a going concern for the purpose of the Code rules was basically linked to the financial reporting threshold. Such threshold is very high and does not involve a high level of confidence that a company adopting the going concern basis of accounting will avoid liquidation or will not cease trading in the foreseeable future. In fact the new Guidance explains that the criteria for disapplication of the going concern basis of accounting may not be reached even when the company is not judged to be a going concern under the new description.
Under the new Guidance the threshold applicable to material uncertainty disclosures and for judging a company a going concern changes from that for financial reporting purposes to that of the new description of a going concern.
B. Integrating going concern assessment with business planning and risk management processes
The new Guidance requires integrating going concern assessment with on-going business planning and risk management and with the overall management of the business, rather than being an isolated exercise undertaken periodically when preparing financial statements. In this way going concern assessment and reporting should support better decision making within the business.
In particular the Guidance requires that the going concern assessment should include a review of the company’s solvency and liquidity position and related relevant risks which should be driven by the company’s business planning and risk management processes to allow the board to conclude whether the business is a going concern.
The review should focus on both solvency and liquidity risks, with a more qualitative and longer term focus on solvency risks, and should also identify those solvency risks that could affect the company survival over the general economic cycle and its own business cycles. The review should also include prudent stress tests for both solvency and liquidity.
Unlike the old Guidance which focused primarily on liquidity risks (especially the availability of financing facilities), the current draft places relevance on both solvency and liquidity.
Solvency is the ability of the company to meet its liabilities in full, i.e. the ability to manage its capital in the long run to have an excess of assets over liabilities. In order to achieve that the company must be able to operate a business model which is capable of delivering over time a continuing economic return for its providers of capital. In other words solvency is about the viability of the business model and the maintenance of its capital.
Liquidity is instead the ability of the company to liquidate its assets and/or to generate cash profits or to access new sources of short term finance at the pace needed to meet its liabilities as they fall due. Liquidity is therefore more a measure of the ability of the company to survive in the short term.
Based on the solvency and liquidity review, the board should decide whether the financial statements should be prepared on a going concern basis and whether there are material uncertainties about the company’s ability to continue as a going concern.
The going concern assessment undertaken by the board should consider the foreseeable future, which is what the board knows or should reasonably be expected to know about the future. Such a period is therefore not fixed, however the board is expected to develop a high level of confidence that solvency and liquidity risks can be managed effectively for at least the period of 12 months from the date of approval of the financial statements.
Whilst the old guidance focused primarily on budgets and cash flows forecasts and facilities, which were reviewed for a minimum period of one year, the new one requires additional qualitative consideration of solvency risks over longer periods, through the economic cycle and the company’s own business cycles, by means of stress testing and other considerations. The length of the period considered beyond one year should be broadly consistent with what is necessary to effectively manage the business given the nature of its activities, industry conditions and position in the economic cycle.
As far as small and medium sized entities (SMEs) are concerned, the new Guidance stresses that the importance of assessing the ability to continue as a going concern is essentially the same for all companies. SMEs may have less complex trading, organisational and financing arrangements and also less sophisticated business planning, risk management and internal control systems. However the identification and management of solvency and liquidity risks is nonetheless important for SMEs, whose directors are required to perform an assessment that is appropriate and proportionate to the circumstances of the company. Whilst budgets, cash flow forecasts and profits projections need to be considered by the boards of SMEs, some stress tests are also likely to be needed. In particular the Guidance suggests that sensitivity analysis on key aspects of financial performance like sales projections or cash collection would be needed also for smaller companies.
C. Making the going concern assessment and reporting transparent
For companies that are required to include in their annual report, in accordance with the Code rules, a statement that the business is a going concern, the key elements of going concern reporting outlined by the new Guidance are:
a) The conclusion as to whether a company is a going concern should be included as part of the business review in the context of the description of the company’s strategy and principal risks.
b) The business review should also include an explanation of how the directors arrived at the going concern conclusion and should specify the significant solvency and liquidity risks threatening the survival of the company and how they were managed.
c) The board’s confirmation that a robust going concern assessment was undertaken and illustration of how it obtained assurance about that.
d) Confirmation in the financial statements that the going concern basis is adopted or, if not, an explanation and a description of the alternative basis adopted:
e) Appropriate disclosures in the financial statements about any material uncertainties about going concern
f) Explicit conclusions in the auditor’s report about the going concern assessment and reporting and an emphasis of matter paragraph where there are material uncertainties.
Under the new requirements going concern reporting moves away from making disclosures only when there are significant doubts about the entity’s survival, to go towards a model that integrates going concern reporting with other mandatory narrative reporting of a company in terms of an entity’ performance, business model, strategy and principal risks.
The narrative reporting should as far as practical stand alone in giving a clear explanation about the solvency and liquidity risks, about the company’s ability to continue as a going concern and about the board’s stewardship of the company in this respect with appropriate (but not excessive) links to other disclosures, like those included in the financial statements. There should also be some degree of continuity between the discussion of significant solvency and liquidity risks in the business review and any disclosed as material uncertainties in the financial statements.
D. Inclusion of a specific statement in the auditor’s report about going concern
The FRC’s consultation paper also includes proposed amendments to International Standards on Auditing (ISAs) (UK and Ireland) 260 ‘Communication with those charged with governance’, 570 ‘Going concern’ and 700 ‘The auditor’s report on financial statements’.
The amendments will apply only to the audit of companies that apply the Code and will require the auditor to:
- Communicate with the audit committee about the robustness of the directors’ going concern assessment and its outcome, including any related disclosures in the financial statements;
- Consider whether matters in respect of going concern, communicated to the audit committee as required above, are not appropriately addressed in the audit committee section of the annual report; and
- State in the auditor’s report whether he has anything to add or draw attention to in respect of the director’s going concern disclosures.