Monday, June 25, 2012

UK Sharman Panel Breaks New Ground on Auditor Going Concern Opinions

In 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 going concern reporting with the directorial discussion of strategy and principal risks.

Lord Sharman said that the aim of the directors’ assessment and reporting of going concern risks is not primarily to inform outsiders of distress. Rather, it is to ensure that the company is managed to avoid such distress, while still taking well-judged risks. That judgment must rest with the directors, emphasized Lord Sharman, and regulators and policy makers must encourage them to discharge their duties in that regard with skill and in good faith. Therefore, in reaching its recommendations, the Panel’s primary purpose has been to reinforce responsible behavior in the management of going concern risks for companies.

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. The Panel’s final recommendation in relation to the auditor’s role is therefore an enhanced one in which, in addition to addressing the basis of accounting and material uncertainty disclosures, the auditor also considers the directors’ going concern assessment process and narrative disclosures about the going concern status of the entity and includes a statement in the auditor’s report as to whether the auditor has anything to add to or emphasize in relation to the disclosures made by the directors about the robustness of the process and its outcome.

The Panel found strong support for regular and more nuanced disclosure in narrative reporting, compared to the current more binary approach to reporting on going concern in the financial statements. The moment when a company moves from being a going concern to a gone concern is dependent on a variety of interrelated factors, noted the Panel, and it is therefore important to articulate the assumptions, caveats and sensitivities associated with the going concern status of the entity well before significant doubts about its ability to continue as a going concern emerge.

The report recommended that the Financial Reporting Council consider moving UK auditing standards towards inclusion of an explicit statement in the auditor’s report as to whether the auditor has anything to add to the disclosures made by the directors about the robustness of the process and its outcome, having considered the directors’ going concern assessment process. The Sharman group also urged the FRC to encourage the IAASB to accommodate this approach to the international auditing standards.

Similarly, the Panel recommended that the FRC engage with the IASB and the IAASB to agree on a common international understanding of the purposes of the going concern assessment and financial statement disclosures about going concern, and of the related thresholds and descriptions of a going concern.

The Panel also recommended 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 how they have been addressed.

The report noted that the success of audit committees in tightening up corporate governance in the past means that they are seen as the most appropriate type of body to implement these improvements. The Sharman panel noted that reporting by audit committees and auditors on the directors’ assessment of going concern should engender greater confidence in the process that is undertaken.

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.

In its preliminary report, the Panel posited 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. The Panel concluded from the comments received that there is a risk that there is not a sufficiently common understanding, in relation to going concern assessments, about the going concern threshold  or the degree of conviction with which a going concern statement is required to be made or about the purpose for which the assessment is made.

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.