On 26 March the Financial Reporting Council (FRC), the Financial Conduct Authority and the Prudential Regulation Authority issued a series of actions in response to the COVID-19 pandemic which aim to ensure that relevant information continues to flow to investors during this time and to support the continued operation of the UK's capital markets.
This briefing note looks at some of the key messages set out in the guidance issued by the FRC for companies on corporate governance and reporting. This guidance has been updated twice since it was introduced – first on 12 May to include a new section on the preparation of interim reports and again on 20 May to include guidance in relation to exceptional or similar items and alternative performance measures.
This guidance provides helpful practical advice to companies that are preparing financial statements during this time. A clear message throughout is that companies should seek to provide information in terms that are specific to the company and to provide comprehensive disclosures of the judgments and assumptions applied in the preparation of the financial statements.
The FRC sets out three key messages to boards on corporate governance:
- Boards should develop and implement mitigating actions and processes to ensure that companies can operate in an effective control environment. The FRC recommends that boards look at the flow of management information and, where this flow has been interrupted, consider how they can maintain or complement any information which may not be available during this time.
- Boards should consider how they will secure reliable and relevant information on a continuing basis to manage future operations. The FRC recognises that some risk management processes and internal controls will be impracticable or temporarily relaxed during this time but boards should monitor these changes to normal practice carefully and seek to introduce alternative measures where necessary.
- Boards should pay attention to capital maintenance. Companies should ensure that sufficient reserves are available when a dividend is paid, and not just when the dividend is proposed, taking into account the current and likely operational and capital needs of the company.
The guidance provides a number of recommendations for companies to consider when preparing their annual reports during this time. The FRC notes that the key information needs of investors relate to the liquidity, viability and solvency of a company. Investors will also want to understand the key assumptions and judgments that a board has applied when assessing a company's resilience and in the preparation of the company's financial statements.
In terms of the strategic report, the FRC reminds companies that while COVID-19 is affecting all businesses, the critical implications and plans to mitigate the effects of the pandemic will vary for each entity and consequently the content of the strategic report should be specific to each entity. In setting out principal risks and uncertainties, a company should look at its specific resources, assets and relationships that are most under threat during this time and the steps being taken by the company to protect them.
The UK Corporate Governance Code requires that companies include a "viability statement", which broadly sets out that there is a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due over the period of assessment. Given current uncertainties the FRC recognises that boards may not be as confident in giving that statement but it has sought to reassure boards in the guidance by stating that they are only required to have a "reasonable expectation" of the company's viability and, during the current crisis, any reasonable level of expectation would naturally carry a lower level of confidence. Boards should, however, be clear on a company's specific circumstances and the degree of uncertainty about the future and the company's viability statement should set out any qualifications or assumptions.
Going concern and material uncertainties
The International Accounting Standards require financial statements to be prepared on a going concern basis (unless of course there are plans to liquidate an entity or cease trading). The FRC expects that more companies will disclose "material uncertainties" to going concern during this time.
When assessing whether material uncertainties exist, boards should consider both the uncertainty and the likely success of measures by the company to mitigate this uncertainty. This task is understandably difficult during this time, but the FRC recommends that boards look at each company's specific circumstances, giving consideration to current and potential cash resources including access to existing and new financial facilities and government support measures. If a material uncertainty does exist the company should disclose it in terms that are as specific to the entity as possible and set out when the uncertainty may crystallise and the impact of this on the company.
Significant judgments and estimation uncertainty
The FRC encourages companies to provide as much context as possible for the assumptions and predictions underlying the amounts recognised in the financial statements. Companies should also disclose significant judgements made in applying accounting policies that have the greatest effect on the financial statements. The FRC notes that such disclosure of judgements, assumptions and sensitive estimates is more important than usual during this time.
Events after the reporting date
COVID-19 will be a non-adjusting event and consequently disclosures may be required for UK companies preparing financial statements for periods ended 31 December 2019. Companies with later reporting dates will need to consider how much of the impact of COVID-19 should be considered to arise from non-adjusting events.
Exceptional or similar items
The FRC notes that companies should consider whether additional items of income or expenditure arising from the COVID-19 crisis should be separately disclosed in accordance with their existing policies for exceptional or other similar items. The FRC expects that the nature and amounts of any such items should be presented in a way that is helpful to readers. The FRC notes that information about the effect of these or similar items on cash flows, and their timing, and tax will be relevant information for readers.
In relation to the effects of COVID-19 that are pervasive and hard to quantify, the FRC recommends that companies provide narrative disclosures explaining the nature of the items and the uncertainties around them. The FRC discourages companies from splitting discrete items on an arbitrary basis to try to quantify the portion relating to COVID-19 as this is unlikely to provide users with reliable information.
Alternative performance measures (APMs)
The FRC notes that APMs used in interim and annual reports and accounts should ordinarily be presented consistently year-on-year but that the COVID-19 crisis may have resulted in a company making changes to its operation or business model which may change the APMs used to run and monitor the business. The FRC recommends that, if this is the case, readers should be informed of these changes and provided with an explanation of why they provide reliable and more relevant information.
The FRC also notes that APMs which try to provide a measure of normalised or pro forma results, excluding the estimated effect of the COVID-19 crisis, are likely to be highly subjective and potentially unreliable and should not be provided.
The FRC notes that directors will need to exercise judgment about the nature and extent of the procedures that they apply to assess the going concern assumption at the half-yearly date. This may include disclosures of any material uncertainties to going concern, assumptions made about the future path of COVID-19 and the public health responses, the projected impact on business activities, the use of government support measures and access to bank and other financing.
The FRC provides examples of some of the issues which may trigger a requirement to reassess the going concern assumption and going concern and liquidity risk disclosures. This includes a significant adverse variation in operating cash flows between prior budgets and forecasts and the outturn in the first half of the year.
In the event that going concern has become a significant issue for a company since the previous annual financial statements, directors should undertake procedures similar to those that would be carried out for annual financial statements to ensure that all relevant issues have been identified and considered.
The FRC notes that while there is no legal or regulatory requirement for a company to engage their auditors to perform an interim review engagement, feedback from investors indicates that such a review provides useful assurance particularly during these times.
A full copy of the guidance can be found here.
The FRC's Financial Reporting Lab has sought feedback from investors on the disclosures investors wish to see and has published an infographic with the findings.
For tailored advice on this or related matters please get in touch with Partner Tom Swan at firstname.lastname@example.org or your usual Shepherd and Wedderburn contact.