Fund Governance

Crises, financial statements and being prepared

What are the implications for financial statements, audits and audit committees during a crisis? Covid has underlined how during a crisis management and boards need to work more closely together than normal, sharing more data more effectively. They are then best placed to keep clients, shareholders and regulators in the loop.

Covid has stress-tested many firms’ crisis management procedures, and lessons have been learned as preparations are made for future challenges. Regarding financial reporting, it has become clear that as a crisis hits businesses must be able to manage more information more effectively. The frequency of interaction between boards and managers needs to increase, but as well, each director must receive the information they need to form an independent judgement. They must not rely on management.

Data driven strategic decisions
To take the virus crisis as an example, in the early days, data about receivables, potential impairments, and liquidity needed to be gathered and shared quickly with key decision makers. When these scenarios were understood, thoughts could then turn to strategic questions about whether cost savings might needed to be made, whether the business model should be adapted, and the different time horizons for action. Management needed to react and be proactive, with directors aware of these options and ready to offer assistance by questioning decisions.

A key challenge when a crisis hits is how lenders pay more attention to credit lines. If facilities are used to keep businesses afloat, or to invest into new business areas, then lenders might be more understanding. However if it’s about borrowing to refinance loans then scrutiny will increase. Companies need to be prepared for these conversations with well formulated reports.

Adapting financial reports
If a crisis occurs just after the end of the financial year, financial statements and audit processes will need to adapt. Even when the focus is on business survival, it is important for directors to remember their reporting obligation to investors. They must ensure that reports truly and fairly represent the company’s financial position, taking account of “”adjusting” and “non-adjusting” events that have occurred outside the reporting period. For example, Covid was a non-adjusting event in that it didn’t change the details of accounts reflecting what occurred pre-lockdown, but is necessary to explain the nature of the crisis on the business and its operations. If the extent is significant then disclosures might need to be expanded. It is also good practice for the event note to include details of the discussions held between management and the board.

In the financial sector, asset valuations needed to be reassessed. For liquid assets this can be relatively straightforward process, but for illiquid assets like real estate and private equity a fresh assessment could be required to consider the impact. For some illiquid assets, valuations are generally made once a year, so there is often a likelihood that substantial change has occurred and thoughts have to be given to how these can be factored into reports. It might be necessary to build illiquidity discounts into valuations. Sometimes the board audit committee might be best placed to take the lead, and it might be necessary to open these deliberations to all board members.

Going concern assessments
Sometimes the biggest challenge is making the going concern assessment, in which the annual report features a view on whether the firm will be viable in a year’s time. For this the firm will have to assess its ability to access capital, the liquidity position, options for receivables recovery, cash-flow, the debt situation, as well as any market and operational disruptions. The situation of key suppliers and clients will also enter into these considerations. All of this has to be understood and explained, with contingency plans. A position might also need to be taken on whether discretionary payments such as bonuses and dividends will be paid. Lengthy discussions and agreements will be needed between the board, management and auditors.

Ultimately boards and management need to think of their feet, reacting quickly to novel events. Ensuring they have reliable, fresh data doesn’t guarantee that the right decisions will be taken, but it gives these key players the best chance to ride out a crisis.

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