Sharman: Going concern too black and white

GOING CONCERN reports should not be made on a binary basis and must provide better insight into risk management, Lord Sharman has concluded.

His report, Going Concern and Liquidity Risks: Lessons for companies and auditors, produced for the Financial Reporting Council (FPC), said more disclosure on how directors arrive at the going concern conclusion was essential, as this will encourage improved risk management.

Currently, the binary model means directors report that a company either is a going concern (viable), or will be if certain conditions are fulfilled. A verdict of ‘not a going concern’ effectively means the company will collapse, so is almost never given.

“There is an expectation gap and it is caused partly by this binary reporting system,” said Sharman. “We need to lower the height of the hurdle for a qualifying statement on going concern, so directors are able to disclose risks sooner.”

Some stakeholders believe a going concern verdict is a guarantee against company failure.

However, accounting standard IAS 1 merely states that a company is a going concern unless directors intend to liquidate, or have no other realistic alternative.

This drastic prospect is seldom faced by directors, but calling a company a going concern just because it is not on the brink of collapse does not mean it is without risk.

Sharman has called on global standard setters the International Accounting Standards Board to consider amending IAS 1 to make a going concern qualification less dramatic and bring it into line with the FRC’s Effective Company Stewardship Code.

He also asked the FRC to harmonise and clarify the purpose and disclosure process for going concern and to examine related guidance for directors and auditors.

Sharman envisions a three-step process whereby directors disclose their going concern deliberations, audit committees comment on risk management and material threats and auditors confirm they are satisfied with the process and make a statement to that effect.

Sharman believes auditors “will be comfortable” taking this extra step in assurance, saying: “We will see if they are, that is why we are consulting on our findings.”

Solvency and liquidity issues were also addressed, with the panel saying both are material to company survival, even though going concern statements have traditionally focused only on liquidity risks.

Solvency is the company’s ability to service its liabilities in full and some stakeholders believe this can be adduced from the balance sheet.

However, Sharman insisted: “Risks to the business model and capital adequacy are critical and related elements of managing the entity’s prospects.”

The inquiry also called for “a more prudent mindset in making the going concern assessment than the more neutral approach that is adopted for the purposes of financial reporting”, which some have taken as implicit criticism of underlying accounting standards.

Marek Grabowski, FRC member and secretary to the panel of inquiry, said the group approached the problem from a behavioural point of view and hoped removing binary reporting will encourage more frank disclosure on going concern and risk management.

“The panel wants to make directors more open in reporting the risks they face and take. This will be a gradual change framed in the context of the Effective Company Stewardship Code,” he added.

Stakeholders have until 31 December to comment and the panel will release its final recommendations in February 2012.