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Going concern is too black and white

Lord Sharman’s report into going concern says more disclosure is essential, writes Rose Orlik

24 Nov 2011

By Rose Orlik

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GOING CONCERN reports should not be made on a binary basis and must provide better insight into risk management, Lord Sharman has concluded. His report, Going Concern and Liquidity Risks: Lessons for companies and auditors, produced for the Financial Reporting Council (FRC), states that more disclosure on how directors arrive at the going concern conclusion is essential, as this will encourage improved risk management.

Sharman’s focus is on behavioural change, encouraging directors to be more frank about the risks they face and take. No more should a going concern qualification signal certain doom, he argued. Currently, the binary model means directors report that a company is a going concern (viable), or will be if certain conditions are fulfilled. A verdict that the company is ‘not a going concern’ in effect means it will collapse, so it is almost never given.

So the binary yes-no model for going concern should be swapped for a report that details how directors arrive at their going concern conclusion, giving investors better insight.

“There is an expectation gap and it is caused partly by this binary reporting system,” said Sharman. “We need to lower the height of the hurdle for a qualifying statement on going concern, so directors are able to disclose risks sooner.”

Some stakeholders believe a going concern verdict is a guarantee against company failure. However, accounting standard IAS 1 merely states that a company is a going concern unless directors intend to liquidate, or have no other realistic alternative. This drastic prospect is seldom faced by directors, but saying that a company is a going concern just because it is not on the brink of collapse does not mean it is without risk.

Sharman has called on global standards setters the International Accounting Standards Board to consider amending IAS 1 to make a going concern qualification less dramatic and bring it into line with the FRC’s Effective Company Stewardship Code. He also asked the FRC to harmonise and clarify the purpose and disclosure process for going concern, and to examine related guidance for directors and auditors.

Three easy steps

Sharman envisions a three-step process, whereby directors disclose their going concern deliberations, audit committees comment on risk management and material threats, and auditors confirm they are satisfied with the process and make a statement to that effect. He believes auditors “will be comfortable” taking this extra step in assurance.

“The aim of these disclosures is to provide information to stakeholders. They should encourage appropriate behaviours such as good risk decision-making, informing stakeholders about those risks and early attention to economic and financial distress,” said Sharman.

Solvency issues were also addressed, with the panel saying it is material to company survival, even though going concern statements have traditionally focused only on liquidity risks.

The recommendations sound logical, but they throw up questions about the liability of risk reporting and whether participants will be happy with their newfound responsibilities. A recent Institute of Chartered Accountants in England and Wales (ICAEW) missive warned that risk reporting “creates as many problems as it solves”. Directors are reluctant to disclose their risk assessments for fear of handing competitive advantage to peers, the institute said, claiming investors share these concerns.

For this reason, directors affected by these proposals are also likely to be nervous when it comes to laying bare business strategies. In addition, there is widespread fear of spooking stakeholders with too many gory details, which limited disclosure in the first place.

A recent Audit Quality Forum event raised the spectre of transparency-focused disclosure requirements actually rendering decision-making more opaque. Participants warned that directors could be less frank in their discussions or avoid putting risks on paper for fear of confidential issues later becoming public knowledge.

Sharman dismissed the problem, saying that “this isn’t the case, in my experience”. But other stakeholders disagree. One FTSE 100 audit committee chief told the ICAEW: “If dialogue between the auditor and the audit committee was published, it would naturally reduce the openness and honesty of that conversation.”

A similar effect might occur if directors were made to publish all their thinking on going concern.

The inquiry also called for “a more prudent mindset in the going concern assessment than the neutral approach that is adopted for the purposes of financial reporting”, which some have taken as implicit criticism of accounting standards.

Marek Grabowski, FRC member and secretary to the panel of inquiry, said the group approached the problem from a behavioural point of view and hoped that removing binary reporting will encourage frank disclosure on going concern and risk management. “The panel wants to make directors more open in reporting the risks they face. This will be a gradual change framed in the context of the Effective Company Stewardship Code,” he added.

Stakeholders have until 31 December to comment and the panel will release its final recommendations in February 2012.

 

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