03 November 2011

FRC: Sharman Panel recommends improvements to reporting of going concern and liquidity risks

The recent financial crisis began in 2007 with defaults on sub-prime mortgages in the US affecting the valuation of financial instruments and restricting credit facilities in financial markets. As the credit crisis began to develop, the FRC issued in November 2008 an update of guidance on going concern and liquidity risks for directors of listed companies, and this was finalised in November 2009 after consultation, to be applicable to all companies for accounting periods ending on or after 31 December 2009. This brought together the requirements of company law, accounting standards and the Listing Rules on going concern and liquidity risk, and provided further guidance on applying them.

As part of its contribution to learning lessons of more general application from the credit crisis, the FRC published the Effective Company Stewardship (ECS) discussion paper in January 2011. The financial crisis had highlighted the importance of the identification, analysis and management of risk, not only in financial services. The FRC’s aim in publishing ECS was to reduce the likelihood that this message would be forgotten, by increasing transparency in the way that directors report on their activities, including their management of risk. It was clear that any lessons identified in connection with the particular challenges faced by directors, management and auditors where companies face going concern and liquidity risks would need to be put in the context of the recommendations made in ECS.

As discussed in ECS, important questions had been asked about the effectiveness of audit in circumstances where banks failed shortly after their financial statements received unqualified audit opinions. The questions included whether the risks and uncertainties facing the banks were adequately described and/or whether it was appropriate for the financial statements to be prepared on a going concern basis. These questions, which were asked in a number of UK and international reports and other fora arising from the credit crisis, also apply by inference to the effectiveness of going concern assessments by directors.

Going concern and liquidity risks continued to be critical reporting and audit issues and the aim of the Inquiry was to identify lessons for companies and auditors addressing going concern and liquidity risks; and to recommend measures, if any, which are necessary to improve the existing reporting regime and related guidance for companies and auditors in relation to these matters.

The Panel's key recommendations, on which it will now consult, are that the FRC should:

• establish protocols with the Department for Business, Innovation and Skills (BIS) and other regulatory authorities that will enable it to take a more systematic approach to learning lessons relevant to the scope of its functions when significant companies fail, through assessing the underlying circumstances.
• Harmonise and clarify the common purpose of the going concern assessment and disclosure process in the accounting standards and Code.
• Require the going concern assessment process to focus on solvency risks as well as liquidity risks, whatever the business, including identifying risks to the entity’s business model or capital adequacy that could threaten its survival, over a period that has regard to the likely evolution of those risks given the current position in the economic cycle and the dynamics of its own business cycles. It should also include stress tests of liquidity and solvency.
• Move away from a model where the company only highlights going concern risks when there are significant doubts about the entity’s survival, to one which integrates the directors’ going concern reporting with the directors’ discussion of strategy and principal risks.
• Move away from the three category model for auditor reporting on going concern to an explicit statement in the auditor’s report that the auditor is satisfied that, having considered the assessment process, they have nothing to add to the disclosures made by the directors about the robustness of the process and its outcome.

Full paper

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