Much ado about going concern

aksaroya —  11 September 2013 — Leave a comment

By Jane Fuller, former financial editor of the Financial Times and co-director of the Centre for the Study of Financial Innovation think-tank

the city

The Financial Reporting Council’s draft proposals to reform going concern and liquidity risk have been roundly criticised by some, but their main thrust is eminently reasonable.

In the post-crisis angst, one of the most awkward questions has been: why were all the banks that needed rescuing by the taxpayer given a clean bill of health in their last annual reports as going concern?

The cry that something must be done was irresistible – cue last year’s masterful report from Lord Sharman. And it did contain some radical suggestions: directors should focus on solvency as well as liquidity; they should think about threats to the company’s existence over the business cycle; and they should be more open with investors about the risks.

While the reform case is compelling, the implementation guidance from the Financial Reporting Council (FRC), was never going to be as elegantly written. Nevertheless, it should have been a simple exercise in putting into practice the principles that most had agreed.

So why has it caused a fuss? Some have declared the proposals will hit business growth, while others have fretted they will hinder UK companies in raising capital because potential investors will not understand the amplified reporting of uncertainties.

My sympathies lie with the FRC on this, although it has again committed the sin of over-prescription. Sharman may have had the radical elements, but there is no proposal for the UK unilaterally to lower the bar for preparing the accounts on the assumption that the business is a going concern rather than on a liquidation basis.

It is more tricky when there are ‘material uncertainties’ about the company’s viability for the ‘forseeable future’. This aims to get directors to think more carefully about the resilience of the business model and capital structure in the context of whatever cycle it is subject to. If they spot anything likely to threaten viability, it should be declared – and presumably accompanied by an ’emphasis of matter’ (EoM) item in the auditor’s report.

This, too, is a high hurdle. We are talking about potential insolvency, not just a profit warning. If it nudges the number of EoM paragraphs from a very low level, so be it.

But the most important reason for not getting hung up on the gone, or nearly gone, end of this debate is that the bulk of the improved disclosure will be in the narrative report. Users of accounts want better risk reporting. This includes prioritising the most serious risks and being much more transparent about how these might crystallise and their potential severity. The proposed stress tests are welcome on this count.

Practice is already improving – and so it should after all the other reforms on stewardship and governance. Take a look at the risk reporting of Premier Foods, a heavily indebted company operating under a lender agreement. The one thing missing from its helpful risk and risk mitigation layout is the specifics of the loan covenants.

So we get to the core of the issue: how does a board demonstrate good stewardship of a company’s assets and liabilities? Not by glossing over uncertainties for fear that investors will flee. On the contrary, honesty is the best policy. This includes being honest about the limitations of both going concern and risk reporting. The guidelines refer to ‘reasonably predictable’ shocks and ‘the inherent ability to predict future events’. As ACCA’s response points out: ‘There will always be events that cannot be foreseen.’

The overreactions to the FRC’s guidelines stems from concern that the regulator is asking too much of directors’ ability to predict. Strip away the unnecessary detail, however, and the main demand is reasonable: show us how you manage the known unknowns. As for the unknown unknowns, despite appearances, it is OK not to predict the unpredictable.

This article first appeared in Accounting and Business, June 2013

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