Going Concern - A Bigger Picture
Published March 2013
A business environment where challenges are constantly escalating and reshaped by many factors - economic conditions, globalisation, technological advances, demographic and similar factors - are driving stakeholder expectations and creating the environment in which businesses are operating. Against this backdrop is the question of how well they are communicating with their stakeholders and how effective corporate reporting is, with the annual report being the highlight. In the coming weeks, many leading companies will be delivering their annual reports with their key messages for stakeholders.
Some companies will be particularly challenged with whether their business plans are actually delivering success and the ability to continue operations, which may ultimately raise the going concern question.
There is nothing simple in many cases in making those deliberations and forming judgements in an uncertain environment. To assist with the process, and to develop some consistency of standards, the Financial Reporting Council (FRC) has recently issued a Consultation Paper 'Revised Guidance on Going Concern', aimed primarily at company directors with proposed revisions also being made to International Standards on Auditing in the area. The FRC previously issued Guidance in 2009.
A Matter of Judgement
The FRC Guidance sets out the circumstances in which a company should be judged to be a going concern referring to its Corporate Governance Code where it states:
'...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'
Whether an entity is a going concern is a matter of judgement not fact, reflected in the use of the words 'is judged to be a going concern'.
There is considerable scope for differing interpretations as to whether and when a company should be judged to be a going concern.
In the light of this and other similar factors, including the major problems identified in the banking sector, the FRC commissioned in March 2011 an enquiry by the Sharman Panel to identify lessons from the financial crisis and recessionary environment for companies and auditors, addressing going concern and liquidity risks.
The Sharman Panel reported in June 2012 and following on from its report the main recommendations of the FRC on which the revised guidance for directors is based are as follows:
- Consider the threats to the company's business model and capital adequacy, over a period longer than twelve months, looking through the economic cycle and the company's own business cycle.
- Develop a high level of confidence that solvency and liquidity risks can be managed effectively during the period of at least twelve months from date of approval of the financial statements.
- Always disclose the significant risks to the company's solvency and liquidity and how they are being managed, as part of its discussion of principle risks in the business review.
- Confirm that the company has undertaken a robust going concern assessment.
In addition, auditors should consider the board's report on the robustness of its assessment and the resulting disclosures and confirm in their report that they have nothing to add or draw attention to. The proposed revisions to auditing standards call for auditors to consider circumstances where they are aware of:
- Information that would indicate that the annual report and accounts taken as a whole are not fair, balanced and understandable in relation to the going concern status of the entity
- Matters related to the going concern status of the entity that the auditor communicated to the audit committee which are not appropriately addressed in the section of the annual report that describes the work of the audit committee.
Key to the directors' assessment of and reporting on going concern are its integration with an enitity's business planning and risk management processes, with a focus on both solvency and liquidity risks, identifying risks to the entity's business model or capital adequacy that could threaten its survival. Stress testing should be undertaken of the key assumptions underlying models and projections with an appropriate level of prudence, and disclosures made in annual reports should reflect on these.
The conclusion drawn by the FRC is that risks identified should not be judged to threaten survival, and therefore going concern, if the board can develop a high level of confidence that, if those risks were to crystallise, actions (whether within or outside the normal course of business) will be available to it that will be effective in addressing those risks.
Because a high level of confidence is not absolute, the likelihood and impact of failure or the impact of severe mitigating actions may necessitate disclosure in the financial statements of material uncertainties.
The Sharman Report recommends that the FRC seek to develop a common international understanding of the use of the term 'going concern'. The FRC is seeking to influence the outcome of international developments in relation to both accounting and audit matters.
Going forward, the Sharman report recommends that the FRC should take a more systematic approach to learning lessons relevant to its functions when significant companies fail or suffer significant financial or economic distress but nonetheless survive.
New Guidance - Change in Emphasis
The focus of the 2009 Guidance is on periodic assessment of short term liquidity - the ability to generate cash and maintain adequate financing facilities to meet liabilities as they fall due.
The 2013 Guidance seeks to build on these factors but to go further and engender a more broadly-based and more continuous assessment of going concern - one that is integrated with the processes for setting strategy, managing risks and running the business and that includes an assessment of the business model in the longer term and the company's adaptability in the face of economic and financial stress.
The proposed revised Guidance retains the principle of the foreseeable future for assessment of going concern risk being a minimum period of twelve months over which boards should assess going concern. It does however place increased emphasis on it being consistent with the periods appropriate for effective business planning and management in the particular circumstances. This increases the level of judgement to be exercised by directors in carrying out individual aspects of the assessment process, such as evaluation of medium term strategic plans and budgets and stress testing.
Going concern assessment and reporting, incorporating both shorter-term liquidity and longer-term solvency, is a fundamental part of providing stakeholders with confidence in the stability and effective stewardship of an entity.
In meeting this need in these uncertain times, companies that create a platform in their reporting that explains the business model, performance and future strategic direction, with appropriate linkages between the 'front-end' of the annual report and the financial statements, will stand in good stead with their stakeholders.
First published in Finance Dublin Online.