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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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A return to old school?

accapr —  19 February 2013 — Leave a comment

tall building, modern CFO

By Jamie Lyon, head of corporate sector, ACCA

In a recent global survey of finance leaders by the ACCA and IMA (Institute of Management Accountants), there was one stand-out data point of significant interest on the priorities of CFOs. The data suggests an entire balance of different priorities, some of which are entirely consistent with the finance leaders growing mandate, particularly around business insight and risk, while others were more akin to their traditional finance responsibilities; cost management, control and working capital. This isn’t entirely a surprise and is consistent with soundings we get elsewhere across different markets. This is also a probable underlying story of re-adjustment post-crisis.

Pre-crisis, many CFOs were in deal-making mode and, over the last five years, merger and acquisition activity has generally been one-way traffic; it’s only now that we’re starting to see a potential surge. Pre-crisis too there was much talk of the role of finance as a business partner. The partnering agenda and drive for insight hasn’t gone away but there’s a sense post-crisis that most finance departments earn their spurs first and foremost on ensuring the business is effectively controlled, that it meets its regulatory requirements and that it protects and maximises the funds it creates. The crisis brought into focus sharply a refocus on the finance fundamentals, the importance of sufficient liquidity and strong financial control. Part of the rationale here also relates to the broader call out now for business practices that drive long-term sustainable performance.

To this end, CFOs have a tough job on their hands, balancing the need to develop financial strategies that are beneficial over the longer term, knowing most eyes continue to be on quarter-by-quarter results… and that’s no easy call for today’s finance leader.

Check out the full survey results here….

By Ian Welch, head of policy, ACCA

Just when it seemed that the debate on the future of audit was taking a well-earned rest for a few weeks until the EC's post-Green paper draft legislation (expected in November) the UK's accountancy regulator decides to stir the pot. 

In two wide-ranging reports out today, the Financial Reporting Council outlines the responses, and proposed follow-up to, its major consultation paper issued in January, Effective Company Stewardship – Enhancing Corporate Reporting and Audit. ACCA will be responding on all the various issues covered, including narrative reporting, risk reporting, and governance in due course, but here I will look at the auditing issues it has raised.

The first point to note is that on one of the EC's favourite issues – the length of time that auditors typically remain in post – the FRC has nipped in ahead of Commissioner Barnier and has floated the idea of mandatory tendering of audit firms after 10 years, or at least for companies to have to explain why tendering has not happened. The EC (and the US regulator, the PCAOB) seem to be favouring mandatory rotation after a similar length of time – so tendering might be seen as an attempt to coax Brussels into this softer, more palatable option. ACCA is opposed to forced rotation, which could add to costs and force companies to lose the most appropriate auditor, but it is hard to argue against having to put the audit out to tender once a decade. Given that some sort of reform is inevitable, that proposal would be one the profession should not go to the barricades to prevent.

But on the more fundamental issues of audit reform, the FRC comes out from its consultation process with a clear view – it is the audit committee, not the auditor, which should be responsible for providing the key information in annual reports; the paucity of which has led companies to come under strong criticism from users. The FRC also notes the Lords and Treasury Select Committees’ conclusions that 'audit is not meeting user and/or public expectations, and that there is a need for greater transparency about the judgements made by management and auditors in the course of preparing and auditing financial statements'. The EC and PCAOB meanwhile have both focused on the possible provision of such information by the auditors.

The audit committee should take the lead role, says the FRC, because the company is responsible for the report and statements and it is their views 'that are wanted by and should be reported to investors and other users.' The FRC argues that it is the board and management that have direct access to these users, so auditors should not be 'making judgements that are properly those of management'. Just to reinforce the point, the FRC says that auditors might be tempted to use boilerplate standardised language whereas the audit committee is 'more likely to be specific to the business.'

Given that the FRC has based its conclusions on 100+ responses from market participants and its accompanying document spells out the summary findings from those discussions with companies, investors and analysts, it makes disagreement difficult. After all, policy should be evidence-based. But while ACCA supports an enhanced role for the audit committee we should be wary of raising expectations too much and assuming this is a panacea to all problems. Also as some of the FRC's respondents point out, there is a concern at the 'circularity in the system that would arise from the [proposed] requirement for the auditor to review the report of the audit committee, which is supposed to be overseeing their work.'

There is not much to warm auditors generally in the report. The current audit report is 'opaque and wholly uninformative'. And there was, it seems, ‘little enthusiasm for external auditors to be given mandatory responsibilities for validating risk reporting'. Why so? The reasons given include that it was not appropriate for the company's willingness to take on risk to be assured as it was a commercial decision. This seems curious, given the strength of feeling among investors that the FRC has identified for more information on risk. And, except in relation to financial controls, 'it was felt that audit firms did not have the expertise to assess risk management and internal controls'. Yet in the US, there is a requirement for audit firms to report on internal controls. The FRC's main suggestion for improving auditing is to revise the auditing standards relating to reports by auditors to audit committees and so make auditors give greater detail on the factors they relied on in their judgements on areas such as controls, materiality and accounting policies.

While ACCA would agree that auditors should not seek to replace management's responsibilities, we have consistently argued for an extension of the role of audit to take on additional reporting in areas like internal controls, risk and governance. While we disagreed with much of the EC's Green Paper proposals on structural reform, we nonetheless applauded its willingness to look at an enhanced reporting role for audit. Ditto the PCAOB's proposed 'Auditor's Discussion and Analysis' free-flow report. The FRC has rejected these ideas and put the onus for communicating with shareholders and other users wholly on management and boards' shoulders.

By John Davies, head of technical, ACCA

The Financial Reporting Council (FRC) has issued new proposals on company stewardship. The report, Effective Company Stewardship: Enhancing Corporate Reporting and Audit, brings together some of the strands that the FRC and the government have been looking at over the past two years: active share ownership, narrative reporting, and independent audit. These are significant for directors, auditors, and members of audit committees.

Certainly, there is widespread and growing disenchantment with the ability of corporate reports to meet the information needs of shareholders. Too often, annual reports are too voluminous and detailed, or, at the other end of the scale, are marketing vehicles that contain vague or self-congratulatory content. If the FRC's ideas have the effect of concentrating boards' minds on what users really need to know, then that will be a positive development.

There is a similar groundswell of opinion that the audit needs to evolve in order to become more useful. Action on things like assurance on internal controls or the client's risk management systems has been called for by many stakeholders, both in the UK and around the world (ACCA's Ian Welch has written more about ACCA's work on audit previously; you can read Reshaping the Audit for the New Global Economy for more information).

It is the audit committee, though, that is probably impacted most by the proposals. The committee would be expected to assess the 'effectiveness' of the audit and to assume a heavier responsibility for ensuring that the auditor's independence is not compromised by their provision of non-audit services.

The FRC is certainly on the right lines in seeking to weave together reporting, auditing, and stewardship behind a common purpose of empowering more effective investor participation.