In the wake of its investigation into KPMG’s auditing of collapsed construction company Carillion, the Financial Reporting Council (FRC) has written to the boards of companies in the sector warning them of the need to pay particular attention to accounting issues, including going concern, risk and viability reporting, and their business models
The six-page letter about their responsibilities in corporate reporting highlights the issue of judgments and estimates, pointing out that revenue recognition is important and must be based on reliable estimates of contract outcomes.
The letter states: ‘Effective systems and balanced judgment based on all current and relevant evidence are required when estimating the cost to complete long term contracts and future revenue streams from those contracts. This is especially important where significant risks (for example, demand risk, costs changes and contractual targets) are borne by the company.’
The FRC says there are some situations where management may need to quantify the key assumptions underlying their estimates for users to understand the company’s position and performance, and to facilitate intercompany comparison, and highlights paragraphs 125 to 133 of IAS 1 Presentation of Financial Statements on this issue.
The FRC says improved disclosures provide more granular information about a smaller set of judgements and estimates that have a significant impact on results, differentiating between business segments where necessary and explaining why certain assets were subject to significant risk of material change.
The regulator also advises that construction companies should consider the impact of IFRS 15 Revenue from Contracts with Customers, which is mandatory for years commencing on or after 1 January 2018. Where known or reasonably estimable, detailed quantitative disclosures of the effects of adopting the standard, with explanations of how accounting policies will change, should be provided in the last accounts before first time application.
On the issue of cash flow and net debt indicators, the FRC says clear information on the levels of debt, cash flows and the conversion (including the processes of conversion, such as invoice discounting and reverse factoring) of operating profits into cash is important.
The letter states: ‘It is sometimes unclear whether operating cash inflows recorded represent cash received from the customer/paid to the supplier or cash received from/paid to the third-party provider of these financial facilities.’
The FRC points out that amendments to IAS 7 Statement of Cash Flows (effective for periods beginning on or after 1 January 2017) require an explanation of changes in a company’s financing obligations over the period.
Its letter states: ‘Lack of disclosure in this area, particularly in non-recourse arrangements where the customer receivables are derecognised, may hide reliance or changes in the reliance that a company has on such facilities. We strongly encourage companies to provide detail about, and explanation of their reliance upon, these facilities.’
Regarding going concern issues, the FRC says auditors will need to remain alert to any events or conditions that may cast significant doubt on the company's ability to adopt the going concern basis of accounting throughout the audit. For those already handling 2017 financial statements, it advises they ‘should continue to revisit the appropriateness of their risk assessment and consider whether it needs to be revised to reflect the circumstances they find when carrying out their audit of the financial statements’.
The letter concludes: ‘Given the particular nature of the construction and business support services sectors, auditors and audit committees should be robust and challenging of accounting policies, judgements and estimates, principal risks and uncertainties and management’s assessment of whether it is appropriate to adopt the going concern basis of accounting.
‘Where any material uncertainties exist which need to be disclosed, or where the directors have concluded that there are no material uncertainties, the significant judgements made by the directors in reaching this conclusion must be disclosed.’
In November 2017, the FRC announced its priority sectors for 2018/19, which include construction and business support services. Consequently its regular audit quality review, corporate reporting review and thematic activities for the period will encompass companies in this sector.
Accounting and reporting framework for the construction and business support services sectors is here.
Report by Pat Sweet
