UK: Risk Management And Reporting

Last Updated: 6 January 2014
Article by Alasdair Steele

Alasdair Steele considers the FRC's proposed new integrated guidance on risk management and reporting which was published for comment last month.

Introduction

In September 2011, the Financial Reporting Council ("FRC") published a report, "Boards and Risk: A summary of discussion with companies, investors and advisers", which prefaced a review of the "Internal Control: Revised Guidance for Directors on the Combined Code" ("the Turnbull Guidance"). This started in January 2013 and led to a reviewed approach which was announced in June 2013. In November 2013, the FRC published the results of its review of the Turnbull Guidance and a consultation on proposed new guidance ("the guidance"). The FRC is proposing to integrate the Turnbull Guidance and its 2009 guidance on going concern and liquidity risk into one, with a view to drawing a distinction between the use of the phrase "going concern" in the context of financial reporting and assessing a company's viability as opposed to its use in accounting standards.

Overview

The UK Corporate Governance Code ("the Code") describes the role of the board as being "to provide entrepreneurial leadership of the company within a framework of prudent effective controls which enables risk to be assessed and managed". The FRC, in its report, acknowledges that "good stewardship by the board should not inhibit sensible risk taking that is critical to the growth and maintenance of economic activity". The key focus is on ensuring that boards assess and understand the risks being undertaken by their companies and then take informed decisions about the risks which are taken. The guidance seeks to assist companies in determining what the appropriate steps are in making that assessment and draws on the original Turnbull Guidance, much of which is preserved in the proposed new integrated guidance.

One of the desires of the FRC is to see material risk reporting being consistent throughout a company's report and accounts, whether in the context of the report identifying those risks, the measures taken to assess and mitigate those risks or the justification for adopting the going concern basis of accounting.

The proposed guidance

Responsibilities

Key to the guidance are the risk-related responsibilities which rest with the board, which are stated to include:

  • determining the company's risk appetite;
  • instilling an appropriate risk culture in the company;
  • identifying and assessing the principal risks to the company's business;
  • deciding how those risks are controlled, managed or mitigated;
  • deciding on an appropriate risk management and internal control system (which may be linked to remuneration policies); and
  • reviewing and ensuring that the risk management and internal control system is functioning effectively.

The guidance stresses that the board is responsible for setting out the risk management requirements and monitoring their effectiveness (and implementation), whereas management and employees are responsible for implementing (and taking day-to-day responsibility for) the board's requirements.

Exercising responsibilities effectively

The starting point of the guidance is that the board's ability to understand and address the risks facing the company constitutes a major risk factor in its own right. The board therefore needs to decide how it is going to exercise its responsibilities given its size; its composition, skills and experience; the nature of the company's business; and the types of risks which it faces. Following one of the themes of the Code and other guidance, the need for informed debate and constructive challenge at board meetings is highlighted. As well as ensuring that the board creates a forum for discussing risk-related matters, the guidance makes it clear that in addition to, for example, setting out the company's risk appetite and culture, the board needs to look at how they are implemented, communicated to employees and recognised. This means that boards need to think about how often they want to discuss risk-related matters, what information and reporting they require and what assurances they need to support what they are told. The guidance also specifically draws out the possibility of linking remuneration policies to observance of and support for the company's adopted risk policies.

Identifying/assessing principal risks

The board's objective should be to identify, and be aware of, those risks or combination of risks which may seriously affect the future performance, solvency or liquidity of the company, and to evaluate the likelihood of their occurrence. These types of risk may be within or outside the company's control but, in each case, the board needs to assess whether they need to be avoided, transferred, mitigated or tolerated. The guidance stresses that specific consideration needs to be given to those solvency and liquidity risks which would give rise to severe financial distress if they were to materialise. By solvency, the guidance is referring to the company's ability to meet its liabilities while liquidity is the means to meet its liabilities as they fall due. Appendix B to the guidance addresses how boards might consider applying stress tests to the company's business model in different risk scenarios, as well as reverse stress-testing (assuming a catastrophic situation and then working backwards to see how it might have arisen). Ultimately, the assessment process is one for the board to decide on in light of the stage of the company's development as well as the environment in which it operates, but boards should keep in mind that circumstances may change and the assessment process may need to be adapted accordingly.

Establishing the risk management and internal control system

This section of the guidance is largely drawn from the original Turnbull Guidance and elaborates on what boards should consider when they are developing their risk management and internal control systems. As well as setting out control activities and information and communication processes, the system should also include ongoing monitoring processes. The objectives of these systems should include reducing poor judgement, risktaking beyond the levels approved by the board, human error and deliberate circumvention of controls. In addition, they should address matters such as general compliance with applicable laws and how the company should respond to system failures and the occurrence of principal risks.

Reviewing the risk Management and internal control system

Throughout the guidance, there are references to the fact that it is not sufficient for a board to simply adopt a risk management and internal control system – it is also incumbent on the board to monitor the system on a continuous basis to review its effectiveness. It will be up to each board to decide both how it reviews and monitors the ongoing effectiveness of its systems and how often it performs that exercise. As part of the ongoing review process, boards should consider whether (and how effectively) all the principal risks have been identified and how they are mitigated, controlled or avoided. In addition, boards should undertake an annual review of the systems which will include a re-assessment of the key board responsibilities outlined above along with any changes which have occurred during the year. The FRC is proposing to amend Provision C.2 of the Code to include a new provision requiring that the annual assessment takes place and then confirming this in the company's annual report, together with an explanation as to how the company manages or mitigates its principal risks.

Communication

The section on reporting to shareholders and other stakeholders on risk-related matters is largely drawn from the Turnbull Guidance but will now include guidance on adopting the going concern basis of accounting (integrating the previously separate guidance on this topic). The FRC is also seeking to try and draw together the various parts of a company's annual report which address risk-related matters to try and ensure a consistency between them, namely:

  • the Companies Act and Code requirements to report on the principal risks and uncertainties facing the company;
  • the accounting standards reporting on the adoption of the going concern basis of accounting; and
  • the requirements in the Code and the Disclosure and Transparency Rules to report on risk management and internal control systems (including in relation to the financial reporting process).

Companies should, therefore, consider linking the review of the risk management and internal control system with the information on the principal risks facing the company and any material uncertainties relating to the adoption of the going concern basis of accounting. It may also be appropriate to link these reports to the description as to how the system relates to the company's financial reporting system. The guidance stresses that the information provided should be succinct, meaningful and relevant to the company, and should avoid boiler-plate and meaningless disclosure, so that disclosures are sufficiently specific to enable shareholders to understand their importance in the context of the company. For example, when looking at the company's principal risks and uncertainties, the board should focus on those risks which it considers to be the most important, including those which pose significant risks to the company's solvency and/or liquidity.

Additional guidance

Appendices D and E to the guidance contain examples of specific questions and matters which boards may wish to consider in reviewing the risk management and internal control systems of the company. These reflect the main body of the guidance and include:

  • risks which the board will, and will not, take;
  • how and when the risks inherent to the company's business model are assessed and reviewed (and how new risks are captured);
  • whether senior management demonstrates commitment to risk management, and whether employees take into account (and understand) the risk management and internal control processes;
  • how inappropriate behaviour is dealt with;
  • whether information received from management and others is timely and fit for purpose; and
  • whether non-executive directors get out and about enough to really understand the business and its people.

Going concern

Finally, as mentioned above, the new guidance includes the previous guidance on adopting the going concern basis of accounting, including the identification of any material uncertainties which may cast significant doubt on its ability to continue as a going concern. The starting point is that companies should adopt the going concern basis of accounting unless there are extreme circumstances which argue against it, usually an actual intention to cease trading and/or liquidate the company or where there is no realistic alternative to doing so. Where there are material uncertainties about the ability to continue as a going concern, but not so great as to deny the going concern basis of accounting, then appropriate disclosures need to be made. Disclosures may be required in times of severe distress (which would require the company to do something outside the ordinary course, such as a heavily discounted rights issue, fire-sale of a profitable asset or agreeing a standstill with the company's bankers) or where there are material uncertainties indicating future solvency or liquidity risks which are so great that they would threaten the ongoing adoption of the going concern basis. In assessing material uncertainties, the board needs to consider:

  • their likelihood of occurring and potential impact on the company;
  • the company's ability to mitigate against the possibility of those risks occurring or their consequences; and
  • the impact, both of the risks arising and of the consequences of any mitigating action, on shareholders and other users of the financial statements.

Material uncertainties will usually occur in circumstances which give rise to severe distress, leaving no other alternatives to taking action which is outside the normal course or where the board considers that such distress will arrive in the 12 months following the approval of the financial statements.

Conclusion and next steps

Boards are likely to welcome any additional guidance which can be provided as to the satisfaction of their responsibilities and, in that regard, the inclusion of the examples of the types of questions and warning signs of trouble in Appendices D and E are to be particularly welcomed. As part of the consultation on the proposed guidance, the FRC is specifically seeking views on these appendices, including as to whether they are the right questions and examples and whether there are others which could be meaningfully included. Responses to the consultation are sought by 24 January 2014. The consultation paper can be viewed at www.lexisurl.com/CSR261.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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