Insights

Capital Quarter: Show your weak side

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Changes to going concern disclosures will require more than just a superficial shift, but the transition to a far more transparent mind-set.

Traditionally, the going concern note that forms part of a company’s financial statements has been fairly simplistic: either the company is a going concern, or it’s not.  The Financial Reporting Council (FRC), has thrown a spanner in the works of this customary practice: it wants companies to explain why. 

As a result of this, not unreasonable new requirement, company management teams will now have to explain how they have reached their conclusions and outline why they believe their company is a going concern, or alternatively, why it is not.  A vague statement to the effect that management has looked at the cashflow forecasts and it hasn’t got any more funding, will no longer be sufficient.

Management will need to give a much more detailed story about the assessment process they have used to reach their conclusions, including why management chose to employ a particular assessment methodology.  For example, management will need to explain why they chose to consider three scenarios and not five; outline why the scenarios they chose for their going concern analysis are reasonable; why, based on that analysis, they chose one particular scenario; and how they have reached their ultimate conclusions.  To this end, the FRC has published guidance to help management navigate the steps it needs to take to reach its going concern conclusions. 

Covid-19 crystalised concerns about the usefulness of going concern notes that have been rumbling in the background since the financial crisis in 2008.  The existential nature of the threat the pandemic posed to many businesses came out of the blue and wasn’t something about which the vast majority of management teams had given any prior thought.  The new requirements are a move to address that lack.   

There are a great many potential, probable or remotely possible events and developments that could have a dramatic impact on a business, but none are currently being clearly addressed in company going concern disclosures.  That’s about to change.  In future, management will need to answer questions about disaster planning and worst case scenarios as part of their going concern assessment.

Although only guidance at this point, it is strict guidance, and feeds into a bigger picture drive towards greater transparency by the FRC and other regulatory bodies.  The guidance gives a clear indication of the FRC’s thinking around potential changes to the way auditors will be able to sign-off going concern notes in future; directors’ liability, and the need for consistency and coherence across all management statements, at the front and the back end of the financial statements.   

As something that is signed-off by both a company’s directors and its auditors, the going concern note will be increasingly seen as a serious disclosure and management will need to get it right.  The FRC is unhappy with the current levels of going concern note clarity: businesses have failed – with Carillion being the stand-out example, and it feels investors and users of accounts are not getting the full story.

Transparency, like honesty, is the best policy.  Management needs to make investors and other users of company accounts, aware of what has happened and could potentially happen to impact the business – the bad as well as the good.  Putting mistakes in the public domain will, paradoxically, strengthen management’s position if an issue should later threaten a company’s ability to continue as a going concern. 

This level of transparency is a difficult mind-set transition for management which always wants to put its best face forward to investors.  Giving away sensitive information feels risky.  While it is true that the more management is open, the more it opens itself up to challenge, it is equally true that investors and users of accounts will have a greater appreciation and understanding of why management made certain decisions and chose particular courses of action.

Highlighting a company’s weak points and explaining how management plans to deal with them, should be seen more as a strength from an investor’s perspective.  The majority of companies already do the analysis and forecasting required by the new guidance, but only share the work they are doing to build sales and grow, for example.  Arguably, sharing the work a company is doing to deal with its threats and ensure it remains operational, is even more important.  It also makes it more difficult for investors and other users of company accounts, to point a critical finger after the event.

The arrival of Covid-19 may have been the catalyst for recognising the usefulness of the going concern note, but the return to post-pandemic normality and withdrawal of Government support measures will illustrate its importance in practice.   Potentially, a great many businesses will face existential difficulties linked to the repayment of government loans and deferrals, increased petrol and gas prices, the impact of high inflation, cross-border supply issues and trading challenges, as well as new Doomsday scenarios linked to war in Europe and climate change catastrophe.  Transparency will be key to keeping investors on side.

We are living in interesting times.  Notwithstanding the financial crisis, it seems that businesses will need to navigate far more testing, complex and difficult waters than any that companies have faced in recent decades. With that in mind, of all the statements that management is required to make about its business, there is none likely to be more important than a reasoned assessment about whether the company will survive into the following year.

Written by Nicholas Joel in our London office.