Material uncertainties over FRC going concern guidance

IT IS A CASE of back to the drawing board for the FRC.

The UK reporting watchdog recently finished its consultation on implementing Lord Sharman’s recommended changes to the concept of going concern. The profession’s overwhelming response has been one of apprehension.

Lord Sharman’s investigation into going concern was set up in 2011 to look at audit and financial reporting shortcomings in the wake the financial crisis, particularly how banks’ disclosures were given a clean bill of health by auditors before subsequently needing to be bailed out by the state.

While Sharman’s general recommendation for a more broad-based going concern assessment that takes into account solvency as well as liquidity risks received widespread support from the profession, the FRC’s has been accused of “over-egging” its guidance.

“Lord Sharman’s recommendations were prepared sensibly. They haven’t been implemented very sensibly,” says Andrew Gambier, technical strategy manager at the ICAEW. “If this is put into regulation it will create problems for business.”

Gambier is hardly alone in his concerns. The ICAEW may have used the most robust language in its written response to the proposals, raising “grave concerns” and highlighting “fundamental flaws” in the FRC’s approach, ACCA’s own response – though more moderate in its language – was not that different, while representatives of the Big Four voiced similar anxieties at public meeting held by the FRC last month.

The over-arching concern is that the guidance will make it very difficult for companies – particlulalry SMEs – to raise finance and attract investment because they will be required to report more material going concern uncertainties. Investors, the detractors claim, will be unable to understand why such uncertainties are being reported.

Material uncertainty

The chief gripe is how the FRC defines the meaning of “material uncertainty”. According to the guidance, a material uncertainty exists when the board is unable to obtain a “high level of confidence” about the entity’s solvency and liquidity for the “foreseeable future” as now defined as the economic cycle.

According to Gambier this will set in chain a whole series of events that will result in the vast majority of businesses reporting material uncertainties and, therefore, receiving emphasis of matter paragraphs in their audit reports.

“Everybody will be giving a qualified going concern opinion if they are required to get to a high level of confidence. The level of confidence is too high and the foreseeable future is too long,” he says.

The ICAEW goes on to accuse the FRC of redefining the meaning of material uncertainty into a way of providing narrative reporting over the going concern conclusion; something that is well beyond what is best practice under IFRS or what standard setter the IASB is due to consider in terms of its own amendment to IAS 1 on the disclosure of material uncertainties.

“This is inappropriate and the FRC should allow the IASB to complete its work in this area, rather than unilaterally seeking to redefine international understanding,” the ICAEW said in its response statement.

ACCA goes on to suggest that the FRC should be more explicit that “foreseeable” means at least one year ahead from the approval of the financial statement, as the guidance remains significantly different from IFRS.

“Foreseeable future could mean 12 months from the balance sheet date or 12 months from the date of approval. These could be two very different things,” says Richard Martin, head of financial reporting at ACCA.

The FRC has also been grappling with how to clarify the stewardship and accounting purposes of the going concern assessment. The problem arises when, for stewardship purposes, directors disclose material uncertainties as to whether the business is a going concern, but a going concern for ‘accounting purposes’ is appropriate.

“That has created complexity,” says Martin. “You could say yes to one and no the other.” Pauline Wallace, head of public policy and regulatory affairs at PwC, echoed this sentiment at the FRC’s public meeting.

“I worry that we are getting into two different concepts of going concern…and blur the distinction between the two,” Wallace says. “We run the risk of confusing people if we force the two models together.

The FRC’s timetable for implementation has also been criticised as unrealistic. For businesses with a September year-end the first period is halfway completed, while there is uncertainty whether the guidance will impact businesses with a December year-end.

“The most immediate thing they need to do is issue a standard that won’t apply to businesses straight away. We want a proper lead in time for businesses to look at this,” says Gambier.

FRC response 

So what does the FRC make of all this? The regulator has come in for stinging criticism from the profession in the past, yet has pressed ahead with its plans regardless. For instance, the FRC pushed ahead with guidance that takes into account a firm’s revenue when dishing out fines when found guilty of misconduct.

Although the FRC put the guidance up for consultation, almost all the arguments put forward by the profession were rebutted by the FRC. Changes to going concern are arguably more profound and important, which suggests it is likely the FRC will be more attentive to the profession’s views. However, Melanie McLaren, executive director of codes and standards at the FRC, says it will not be retreating from its principles.

McLaren says she is pleased with “the widespread support for the principles and objectives” but allowed that the FRC “may well go back to the definition of going concern in context of the [corporate governance] code”.

“Where the definition is in the context of IFRS we might seek to influence but that is not in our remit,” she says.

“The types of comments we got back in consultation were that going concern used two different terms. We sought to address that head on. We might do something a bit more radical around the definition/terminology of going concern in the Code,” she says.

“Quite clearly let’s look at Lord Sharman’s recommendation for a more common understanding internationally of what going concern and material uncertainty means.”

McLaren’s comments should be welcomed by the FRC’s critics. However, she was adamant that the bulk of the FRC’s work was correct. “I wouldn’t want to say we will remove all the content we’ve got out there. We worked quite closely with Lord Sharman. He reviewed our guidance before consultation and considered it in line with his recommendations.

“We will listen to feedback including on implementation but will have to stand firm on our principles.”

Updated guidance is expected to be issued at the end of June.