Sunday, November 13, 2011

UK Sharman Panel Breaks New Ground on Auditor Going Concern Opinions

In what may be a seminal report on auditors and going concern, the UK Sharman Panel recommended a process to produce a going concern opinion that envisions a key role for company directors, audit committees and auditors. The panel would also require the going concern assessment process to focus on solvency risks and liquidity risks, as well as identifying risks to the entity’s business model or capital adequacy that could threaten its survival. The Sharman Panel wants to move away from a model where the company only highlights going concern risks when there are significant doubts about its survival, to one which integrates the directors’ going concern reporting with the directors’ discussion of strategy and principal risks.

Essentially the Sharman Panel recommends a model for auditor reporting on going concern in which there is an explicit statement in the auditor’s report that the auditors are 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. Similarly, the Panel recommends that the audit committee report illustrate the effectiveness of the process undertaken by the directors to evaluate going concern by confirming that a robust risk assessment has been made; providing an explanation of the material risks to going concern considered and addressed; and identifying any that they have not been able to resolve.

The Sharman report was initiated by the Financial Reporting Council, the UK counterpart to the PCAOB. Lord Sharman, Chairman of the Panel, said that, while the work of the Panel emanates from the financial crisis, companies in all sectors can do more to improve their management and disclosure of risks relating to going concern, liquidity and solvency. There should also be early identification and attention to economic and financial distress, he noted. Lord Sharman was the Liberal Democrat Spokesperson for Trade and Industry/Business and Regulatory Reform from 2001 to 2010. Before that, he held numerous senior UK and international positions with KPMG. The other two members of the Panel are Roger Marshall, Interim Chair of the FRC’s Accounting Standards Board, and David Pitt-Watson, Chair of Hermes Focus Funds, and former Finance Director of the Labor Party.

While the financial statements essentially provide a backward looking perspective on the company, noted Lord Sharman, the going concern statement given in accordance with the Listing Rules or the Corporate Governance Code provides a forward looking perspective. Importantly, a main purpose of the requirement for a going concern statement is to provide information to investors and stakeholders about the solvency and liquidity of the company; and about the directors’ stewardship and governance in that respect.

The Panel recommends that the going concern assessment reflect the right focus on solvency risks, not only on liquidity risks, 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. Also, the going concern assessment should be more qualitative and longer term in outlook in relation to solvency risk than in relation to liquidity risk; and include stress tests both in relation to solvency and liquidity risks that are undertaken with an appropriately prudent mindset. Special consideration should be given to the impact of risks that could cause significant damage to the community and environment.

The Panel posits that an expectation gap exists between what stakeholders expect and what directors and auditors actually deliver. This expectation gap may result from an expectation that the absence of disclosure by directors, and the absence of a modified audit opinion in respect of the going concern status of the company, can be taken as a guarantee that the company will not collapse or fail.

With a nod to the key role of disclosure in this area, the Panel recommends that the FRC move away from a model where disclosures about going concern risks are only
highlighted when there are significant doubts about the company’s survival to one which integrates going concern reporting within a broader disclosure model in which the directors always report how they arrived at the going concern statement, as part of their discussion of strategy and principal risks in the company’s narrative report, with the audit committee report confirming that a robust process has been undertaken and illustrating the effectiveness of the process undertaken by the directors. The audit committee report should also provide an explanation of the material risks to going concern considered and addressed; and identify any that they have not been able to resolve.

The Panel believes that the auditor should comment in the audit report on the going
concern section of the narrative report and of the audit committee’s published report, if these fail to provide the required information, and otherwise state that it has nothing to add.

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