Clarity of reporting in current economic conditions

Current economic conditions provide particular challenges to all involved with annual reports and financial statements. Financial markets continue to be stressed and the general lack of liquidity is having a significant effect on a wide range of businesses with many having genuine difficulties in maintaining profitable trading levels and generating sufficient cash flows to manage working capital requirements.

The downturn in fortunes has led to companies having to consider fundamental questions regarding liquidity, going concern, asset impairment and other related issues in what is likely to be a much more focused manner than in previous years.

Going concern – reporting considerations

The uncertainties generated by the current economic and liquidity difficulties have raised additional questions for those charged with governance of entities to address in concluding on the basis on which the entity is preparing its financial statements this year.

The Financial Reporting Council (FRC) in the United Kingdom has recently issued three documents providing guidance for directors and audit committees:

• An update for directors of listed companies: Going concern and liquidity risk
• Challenges for audit committees arising from current economic conditions
• Study: Going concern and liquidity risk disclosures

These are clearly of relevance to Irish companies.

Some of the key messages which are considered in detail in the FRC documents are:

• Act now – well in advance of completion of the annual report
• Full and appropriate disclosure is fundamental
• The general economic situation at the present time does not of itself necessarily mean that a material uncertainty exists about a company’s ability to continue as a going concern
• Preparation of the financial statements on a going concern basis is not a guarantee that a company will remain a going concern until the next annual report is issued
• The absence of confirmation of bank facilities does not of itself necessarily cast significant doubt on the ability of an entity to continue as a going concern

Going concern is a fundamental accounting concept that underlies the preparation of financial statements. Guidance issued by the Financial Reporting Council in 1994 highlights some major areas in which procedures are likely to be appropriate in assessing going concern, including:

• Forecasts and budgets
• Borrowing requirements
• Liability management
• Contingent liabilities
• Products and markets
• Financial risk management
• Financial adaptability

The 1994 Guidance notes that this list is not exhaustive and the significance of factors will vary from company to company. In the current economic climate, many of these factors will have increased in significance which will require directors to consider them with more rigour and formality. The 1994 Guidance is currently subject to review and update by the FRC.

Liquidity concerns

A fundamental consideration in assessing an entity’s ability to continue as a going concern is its exposure to liquidity risk. The current squeeze on corporate cash flows means that liquidity risk is likely to be a material risk this year for many more entities. Where liquidity risk is material, IFRS 7-‘Financial Instruments: Disclosure’ requires:

• Disclosure of information that enables users to evaluate the nature and extent of the entity’s exposure to liquidity risk
• Narrative disclosures explaining how liquidity risk arises in the business and how it is managed in practice
• Summary numerical data about liquidity risk based on the information that is provided to key management personnel, often the Board of Directors
• Certain mandatory disclosures such as maturity analysis of financial liabilities

  These disclosures are supplemented by disclosures required by other IFRS standards, which include those in IAS 1 ‘Presentation of Financial Statements’ on capital management and critical judgements.

  Disclosure – scope for improvement

  The FRC published a study on going concern and liquidity risk disclosures in the financial statements of listed companies that have adopted IFRS 7. The FRC study concluded that, rather than having disclosures in a number of different parts of the annual report, it would be helpful to have disclosures together or at least cross-referenced. It would be useful if the note included:

  • Paragraph 1 – to explain cash and borrowing positions and how liquidity risk is managed in practice
  • Paragraph 2 – to explain whether confirmation of the renewal of banking and other facilities has been sought and if so whether those confirmations have been obtained
  • Paragraph 3 –to state that the use of the going concern basis of accounting is appropriate and explaining the basis of that conclusion

  The FRC Study also concluded that for many companies the disclosures made regarding the management of liquidity risk was generic rather than specific in nature and shed little light on how the business managed its day to day cash flow and borrowing levels.

  Guidance for audit committees

  The FRC Guidance – Challenges for Audit Committee arising from Current Economic Conditions – summarises key issues for audit committees to consider when preparing for year end reporting processes. These issues are summarised as follows:

  • Year-end planning considerations
  • Liquidity risk and going concern
  • Reliance on assumptions and models for cash flow and valuation information
  • Significant accounting and reporting judgements

  The guidance lists a number of potential key questions in each area that may be relevant to audit committees as they seek to address these challenges.

  The Guidance emphasises that effective systems are particularly vital at times of economic stress in order to react to fast-changing markets and to help manage an increased risk of error, omission and fraud when management and supporting finance teams are under abnormal pressure. Audit committees will wish to gain assurance in this regard and to be satisfied that resources are in place to support and audit difficult year end judgements.

  Goodwill – impairment review

  A major issue in difficult economic conditions for many entities is the valuation of goodwill. The downturn in the economy and business conditions means that assumptions used to value goodwill will need to be revised which in some cases may lead to an immediate write down of goodwill while many companies may need to deal with disclosures in a much more informative and clear manner.

  Volatile market conditions mean that many companies will need to consider a wider range of reasonably possible outcomes when performing sensitivity analysis on their cash flow projections that support asset valuations and asset impairment assessments.

  The FRC reviewed the December 2007 annual reports of 32 U.K. listed companies within the FTSE 350, companies that had reported significant amounts of goodwill in their annual financial statements.

  The FRC reported the following overall conclusions:

  • For many companies, disclosures were more generic then specific with only a handful of companies providing information that was directly relevant to their business;
  • Narrative information about the way in which key assumptions are identified and quantified tended to be vague;
  • Only a minority of companies surveyed provided information by cash generating unit (CGU), even where significant amounts of goodwill were allocated to more than one CGU;
  • Only eight companies gave informative sensitivity information about the level of changes in assumptions that would be required for the carrying value of goodwill to reduce to its recoverable amount;
  • Only four of the companies surveyed reported that reasonably possible changes to their assumptions would lead to a goodwill write down and thus trigger the extended disclosures required by IAS 36.

  The conclusions drawn demonstrate that there is considerable opportunity for companies to refine and improve goodwill disclosures which are most likely to assume additional importance in a period of deteriorating economic conditions.

  With the significant changes in business risks arising from the credit crisis and deteriorating economic conditions, companies are being confronted with business challenges and risk management issues which have not been of such major concern during less stressful times. Directors and audit committees need to ensure that these risks are identified and managed from an early stage. Processes need to be in place to ensure that appropriate disclosures are made in financial statements. Communication lines between companies and their boards, auditors and the investing and general stakeholder community need to be open, clear and unambiguous during these difficult times. The ability to manage this process in the most communicative and transparent manner should stand a company in better light with investors and stakeholders than if a more obscure approach is adopted.

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