Preliminary Report and Recommendations of the Panel of Inquiry – An Introduction from Lord Sharman

Download the The Sharman Inquiry: Preliminary Report and Recommendations

Introduction from Lord Sharman

When the Financial Reporting Council asked me to lead this Inquiry in early 2011, the recent credit crisis and subsequent recessionary environment had led to much discussion about the quality of information that companies provide on their financial health and ability to withstand stresses in the short to medium‐term. Going concern and liquidity risks continued to be critical reporting and audit issues and the aim of the Inquiry was:

• to identify lessons for companies and auditors addressing going concern and liquidity risks; and
  
• to recommend measures, if any, which are necessary to improve the existing reporting regime and related guidance for companies and auditors in relation to these matters.

The Inquiry was also asked to have regard to the proposals in the Financial Reporting Council’s paper – “Effective Company Stewardship – Enhancing Corporate Reporting and Audit”.

The Panel received much interesting and insightful evidence both in responses to the Call for Evidence and through a number of wide‐ranging discussions in meetings with individuals and organisations. We are grateful to all those respondents and commentators for the quality of their submissions.

Although recent events most spectacularly exposed the vulnerabilities of the banks, which has led to many developments relevant to their going concern assessments, the Panel’s primary aim was to learn lessons that could be applied more generally. Many of the identified lessons learned by banks (such as the importance of rigorous stress testing) can be applied elsewhere, if appropriately adapted. Chapter 7 also considers whether there is a need to develop a special regime for banks.

The viability of a company’s business model and the risks to its success are fundamental aspects of stewardship and governance. The purpose of the going concern assessment and disclosures should be to provide information to stakeholders about these matters and they should be designed to encourage appropriate business behaviours (good risk decisions, informing stakeholders about those risks and early identification and attention to economic and financial distress).

There are a number of ways in which the current requirements present barriers to these desired behaviours: expectation gaps persist about when to give more detailed disclosures about going concern; the perception that a high hurdle for doing so implies less need for a robust going concern assessment process and for stakeholders to understand the key risks and vulnerabilities, below this threshold; and the binary disclosure model heightens fears that significant doubts disclosed will become a self‐fulfilling prophecy of failure.

The purpose of the going concern assessment should be clarified to address the expectation gaps identified. The Panel is also recommending changes that would integrate going concern reporting with the Effective Company Stewardship proposals – a move to a model in which the directors always report how they arrived at the going concern statement, as part of their discussion of strategy and principal risks in the company’s narrative report, with the audit committee report confirming that a robust process has been undertaken and demonstrating its effectiveness. Auditors may then only need to signal where the directors fail to adequately describe their process and its outcome.

Outside the financial services sector, the principal focus of the going concern assessment appears to be on liquidity risk. Both solvency and liquidity risks are important considerations in understanding risks to the viability and success of the company. The Panel is recommending that for all businesses the going concern assessment should focus not only on short term liquidity risks but also on solvency risks that could threaten the company’s survival over the business cycle or that could cause significant damage to the community and environment, bearing in mind the directors’ responsibilities under the Companies Act 2006.

These proposals should encourage greater integration of the going concern issue into the entity’s wider on‐going risk management and governance processes and reporting, encourage greater openness between companies and investors and enable investors and other stakeholders to be better informed on a ‘business as usual’ basis about a company’s key vulnerabilities.

This initial report is a consultative document. The report sets out the Panel’s preliminary recommendations and conclusions. Our principal focus to date has been on developing appropriate recommendations for listed companies. Views are being sought about extending the final recommendations to, or adapting them for, other entities.

The Panel intends to issue a final version of its recommendations in February 2012 in the light of responses received and further discussions held between now and the end of the consultation period on 31 December 2011.