19 November 2020
The coronavirus pandemic will continue to have far reaching micro and macro implications which will require businesses of all sizes to reassess their budgets and forecasts on a regular basis to manage cash flow as well as considering the impact on their going concern basis of preparation and annual accounts disclosure. RSM, ICAEW and the FRC have already issued a variety of resources to assist preparers and auditors assess the going concern status used in the annual accounts so this article provides links to those and focuses on one new announcement, ie how could the relaxation of the wrongful trading laws affect management’s going concern assessment?
What does the legislation and FRS 102 say?
The Business Secretary announced prospective changes on 28 March 2020 to enable UK companies undergoing a rescue or restructure process to continue trading, giving them breathing space that could help them avoid insolvency. The draft legislation was issued in late May and received royal assent on 25 June 2020, the consequences of which we explain here.
The changes to insolvency laws temporarily suspends the application of s214 ‘Wrongful trading’ of the Insolvency Act 1986 from 1 March 2020 for an initial period of 7 months, hence potentially limiting the risk of directors being held personally liable for losses arising from wrongful trading under the Insolvency Act when acting in good faith. There have been no proposed changes to the fraudulent trading laws in section 213.
Commentary from lawyers online has suggested this change to wrongful trading laws will have little effect in practice given case law already exists to protect directors from sudden and unexpected downturns in the business, and it also mentions that other sections of the Insolvency Act 1986 (eg s213 fraudulent trading) remain in place.
The requirements of FRS 102 and auditing standards are unchanged including the responsibilities of directors around going concern. An entity adopts the going concern basis of accounting unless management either intends to liquidate the entity or to cease trading or has no realistic alternative but to do so. Disclosure is required of any material uncertainties which may cast significant doubt over the going concern status. Management must also disclose significant judgements, so even if there are no material uncertainties disclosure may still be required.
Directors’ fiduciary duties under the Companies Act 2006 (eg s170-182) remain in full force, including:
- s172: promoting the success of the company, which is caveated with the need, in certain circumstances, to consider or act in the interests of creditors of the company.
- s174 Duty to exercise reasonable skill, care and diligence.
- s175 duty to avoid conflicts of interest, s177 duty to declare interest in proposed transaction or arrangement.
- Directors keeping appropriate minutes of all their meetings under s248 and s249.
In addition, the directors should still have regard to s.239 (s.243 Scotland) ‘Unfair preferences’ of The Insolvency Act 1986 to ensure that in paying certain creditors they are not creating a potential preference which makes that creditor “better off” than the majority of other creditors in advance of any insolvency proceedings.
Whilst as accountants and auditors we are not giving legal advice it is possible some directors may have a conflict of interest as both a shareholder, director, as well as a debtor and creditor through any director loan account balances. Advice of an insolvency specialist should be sought in such cases.
Practical impact and interpretation for preparers
If an entity relies upon the June 2020 insolvency law changes to allow it to continue to pay staff, reclaim costs from the government and incur additional credit, these will be indicators of material uncertainties that may cast significant doubt on the going concern status of the entity. Management will be required to consider whether they can prepare accounts on a going concern basis with adequate disclosure or need to use an alternative basis of preparation.
If the directors are relying upon these changes to the insolvency law in their forecasts, consideration should be given to referring them to an insolvency practitioner or lawyer to explain their responsibilities, the range of solutions and consequences for them.
The directors can use these changes to insolvency law to prepare more aggressive cash flow forecasts than may have previously been possible under the wrongful trading laws. This may result in forecasts that show a potential inability to settle debts as they fall due in the short term before recovering in the medium term. Directors’ are still required to prepare forecasts and come to a management conclusion on going concern and if, due to the extra latitude their forecasts go slightly deeper into the red, they need to have a recovery plan in place.
The assessment of whether an entity has the ability to continue as a going concern is likely to be one of the most significant judgements management need to make in the current climate. Even if there are no material uncertainties, which may cast significant doubt on the entities ability to continue as a going concern, entities should document the judgements made in the assessment and detail them in the accounting policies.
As such (and as outlined by the FRC papers by the FRC Lab reports on investor expectations and disclosure of going concern, risk and viability, as well as from the last recession) there is a presumption of disclosure around going concern in small, medium and large entities accounts
- Entities should continue to prepare their short, medium and long term forecasts, flexed for various scenarios to assess the cash requirements of the business and their headroom within available facilities. Dependent upon the outcome of these forecasts, they should consider what additional financial assistance (eg job retention scheme) maybe required during this time.
- Forecasts should be continually assessed as the conditions around the pandemic evolve and the assumptions previously used may no longer be accurate or valid. For example, the entity may have assumed it would receive government support such as the Job Retention Bonus in February or March 2021 and this will no longer be the case as the scheme was delayed in November.
- Whilst the relaxation of the insolvency laws may appear to provide a little more headroom within these forecasts, if directors wish to avail themselves of these provisions, they should seek professional advice from an insolvency practitioner.
- Disclosure should be presumed to be required in all annual accounts – either of the material uncertainties, or why the entity believes there are none. Entities should start with the macro-economic conditions, how they affect the entity, what they have done about them, and their conclusion why they consider using the going concern basis of preparation is appropriate.
- Read our summary of the FRC Lab reports on investor expectations and the impact of coronavirus on the disclosure of going concern, risk and viability.
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