Banks need not always warn investors if they receive state support, FRC-backed report says

The Sharman Inquiry, set up by the Financial Reporting Council (FRC) to consider improvements to the company audit regime, concluded in its report (66-page / 690KB PDF) that state-backed bail outs were often a "normal funding source" for banks and that public disclosure could have a disproportionate effect on their liquidity.

"The FRC [will] need to consider making clear that liquidity support from central banks may be a normal funding source for a bank and therefore reliance on such support, if reasonably assured, does not mean that the bank is not a going concern," it said. "The key issue for banks is that in practice any signalling of material uncertainties about their going concern status may trigger a liquidity shock and potentially a run on the bank."

It was enough that the bank's directors and auditors, as well national financial regulators, were satisfied that the bank would "remain solvent through the [emergency funding] cycle", the report said, in order to avoid triggering unnecessary panic. The existence of liquidity stresses "should not always ring alarm bells of impending failure", it said.

Despite the "especially intense nature" of the risks applicable to banks, a disclosure regime distinct from that of other large companies "should not be necessary", it added.

A company is considered to be a 'going concern' if it is able to function without the threat of going into liquidation for the foreseeable future, usually regarded as at least the next 12 months. Publicly reporting any risks to a company's ability to function as a going concern was not, according to inquiry head Lord Sharman, "primarily to inform outsiders of distress" but rather to ensure that "the company is managed to avoid such distress, while still taking well-judged risks".

"Our final recommendations aim to refocus the going concern process, in light of lessons learnt from the financial crisis, so as to support better risk decision-taking, ensure that investors and other stakeholders are well-protected and informed about those risks and sustain an environment in which directors recognise, acknowledge and respond to economic and financial distress sooner rather than later," Lord Sharman, who is also chairman of insurance group Aviva, said. "In reaching our recommendations... our primary purpose has been to reinforce responsible behaviour in the management of going concern risks for companies."

The report recommended that the FRC attempt to clarify the various definitions of going concern and related risks used by auditors, accountants and in corporate governance requirements, both nationally and internationally. Going concern assessment should focus on both solvency and liquidity, and make use of stress tests to ensure these levels will remain adequate in a range of scenarios. Solvency in an accounting context refers to a company's ability to meet its liabilities; while liquidity refers to the amount of assets it has available to it that can easily be converted into cash.

The FRC should also review its existing guidance for directors to ensure that going concern assessment is considered as part of a company's business planning and risk management processes, and consider factoring going concern reporting into its proposals for effective company stewardship. Doing so would enable directors to provide an ongoing "fuller picture" of the risks a company is facing, rather than only highlighting risks at the point where these raise doubts about the company's survival.

It also recommended that company auditors provide an explicit statement on whether they have anything to add or emphasise in relation to any disclosures made about going concern status by company directors.

The FRC will "embark on a careful consideration" of how best to take the report's recommendations forward, its chief executive Stephen Haddrill said. It recently concluded a joint consultation process with the Government which will give it a new set of statutory powers designed to streamline its existing governance arrangements and tighten its focus.

"The final report has made significant ground in exploring the implications of the Panel's preliminary recommendations and how these may be taken forward," Haddrill said. "In doing so, it provides much further analysis of the issues identified and this should assist the FRC is developing these recommendations in the UK and in promoting them on the international stage. We will explore the matters relating to banks with the Government, the Bank of England and other stakeholders."