Friday, August 29, 2014

Big Four Supports Proposed Going Concern and New Future Viability Statements Based on Sharman Panel

The Big Four generally support the U.K. Financial Reporting Council’s proposed changes to the Corporate Governance Code implementing the recommendations of the Sharman Panel on going concern statements and a new statement on the company’s future longer-term viability. As conceived by the FRC, these would be two separate and distinct statements that would increase the usefulness of financial statements to investors as envisioned by the Sharman Panel. A going concern statement for accounting purposes only would be codified, and a new statement on the company’s ongoing viability past the 12-month going concern statement would be introduced.

The suggested wording of the new provision is that the directors should state whether, taking account of the company’s current position and principal risks, they have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due, drawing attention to any qualifications or assumptions as necessary. The directors should indicate the period covered by this statement, and why they consider that period to be appropriate.

The Sharman Panel was commissioned to examine the particular challenges faced by directors, management and auditors where companies face going concern and liquidity risks and to consider how such challenges should be addressed in the future. Lord Sharman, Chairman of the Panel, said that, while the work of the Panel emanated 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

In their comment letters, the Big Four broadly supported the FRC’s drive to implement the Sharman Panel’s recommendations and achieve better reporting to shareholders. For example, PricewaterhouseCoopers believes that the FRC’s current proposals reflect the Sharman recommendations appropriately and have considerable conceptual merit.

However, it is unclear from the consultation document how the latest proposals will affect the responsibilities of the auditor. In its comment letter, PricewaterhouseCoopers said that the scope of any related reporting by the auditor needs to be reasonably based on the scope of work undertaken for the purposes of the audit. If the reporting is similar to that proposed in the consultation, that is whether the auditor has anything material to add to the directors’ disclosures, then PwC would consider that it may be too ‘loose’.

In particular, because the proposed directors’ disclosures go beyond financial matters, the auditor would in effect be asked to report on matters not directly relevant to the financial statements. PwC is generally and more broadly concerned that auditors are increasingly being expected to include additional statements in the audit report that are not supported by specific work procedures. Even if the parameters are clear in the relevant auditing standards, most users of annual reports will not take these on board, creating another gap between their expectations and auditors’ actual responsibilities, and potentially devaluing the content of the rest of the audit report.

PricewaterhouseCoopers noted that the proposed viability and going concern assessments are closely linked. Each statement is part of the company telling a coherent story about how risks are assessed and managed. Nevertheless, the two statements are distinct and serve different purposes.

PwC said that the relationship between the two needs to be made clearer in the guidance and in the FRC’s communications to the market in relation to the Code; the different purpose of each should also be very clear. Doing so would help to show how the FRC’s proposals are not out of line with the going concern model that is used around the world.

In the view of PwC. going concern will remain at the center of the financial reporting model. In making this assessment, directors must consider all available information about the future, so any material uncertainty must be reflected in the going concern statement regardless of its expected timing. The use of the going concern assumption is a matter of accounting policy, and so it’s important that directors make a clear and definitive statement of the appropriateness of the assumption.

In making a longer term viability statement, said PwC, directors would typically take account of a wider range of risks and associated probabilities, as more risks become relevant over longer time periods. Much of the value of the viability assessment will be in formalizing the need to identify the considerations that are relevant, such as the principal risks affecting solvency, and to decide on the seriousness of each matter identified. This purpose is sufficiently captured by the requirement that viability statements should be framed around an explanation of how the directors have assessed the prospects for the company, including the period covered and why that period is appropriate.

A statement of viability should, naturally, be consistent with the directors’ vision of the future direction of the company. Therefore, PwC believes that the viability statement should, explicitly, be structured around a description of a company’s strategic planning process, giving enough information to allow users to understand the judgments underpinning the plan.

PwC would expect companies to disclose and explain the period covered by the strategic plan (and therefore their viability assessment), the reason why that period has been chosen, the risks they identify, and their views on the likelihood of those risks crystallizing within the chosen period. These disclosures are also likely to be an important element of an annual report which is fair, balanced and understandable.

Despite the safe harbor provisions of the Companies Act, directors generally want to minimize any perceived extension of their liability when making new formal statements. In the case of the viability statement this could lead to unintended consequences such as statements that cover inappropriately short time periods, and/or SEC-style lists of all possible risk factors instead of the expected more tailored and relevant disclosures. To address this, so that directors feel empowered to make useful disclosures, it is vital that they understand what needs to be done.

In the view of PwC, it is likely that much of what would be required to make a viability statement is already part of the strategic planning process of many companies. However, the guidance accompanying the Code should encourage all companies to reconsider the rigor that is applied to the strategic planning process.

In its comment letter, Ernst & Young agreed that companies should make two separate statements, one on whether the directors considered it appropriate to adopt the going concern basis of accounting in preparing the financial statements and one on the broader assessment of the company’s ongoing viability since the two serve different purposes, bring focus to the board’s deliberations and are equally important for users of financial statements.

However, that said, E&Y urged the FRC to set a clearer expectation that the time periods for the assessment should normally be linked to a company’s strategic or business planning cycle or another appropriate period determined by the directors. While the guidance does refer to investment and planning periods as one of the factors a board should consider when determining the period for an assessment, E&Y questioned whether the reference to investment periods will be interpreted consistently by all boards and whether the period for holding long term assets in some sectors, such as extractive industries, could be too long for a realistic viability assessment.

Given the uncertainty, E&Y suggested the reference to investment periods be removed. In addition, the firm noted that further FRC guidance on the location of the viability statement would create consistency and help users find this important statement. E&Y suggested that a logical and user-friendly location for the statement might be as part of the principal risks disclosure. This location could mitigate the risk of boilerplate and separate the statement from the financial statements and the separate statement on going concern basis of accounting.

KPMG noted that the two proposals for the Code contain two binary statements on going concern and long-term viability. This may not be the best approach, said KPMG, and the better approach may be to require disclosure, with explanations, of potential threats that may develop over the longer term and become actual threats to the business. This must be more than a list of risks, said KPMG, but should describe which risks would most impact insolvency over time.

Deloitte supports the new future viability statement that allows boards the flexibility to look forward over a period of time that best fits their business planning and investment cycles. The firm supports having two separate and distinct statements on going concern and future viability.

The viability statement will allow boards to tailor their disclosure to the company’s circumstances within the parameters of existing planning cycles. But with this flexibility will come variability. Deloitte believes that drafting the disclosure will be challenging and that disclosure will evolve over time in response to investor feedback. The FRC should consider adopting some best practices in this area after some experience.

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