The Sharman Inquiry, instituted by the Financial Reporting Council (FRC) in 2011, aimed to scrutinize and improve the reporting of liquidity risks and other factors threatening the viability of entities as going concerns. This inquiry was catalyzed by the widespread public concern following the 2007-2008 financial crisis, during which several financial institutions, despite receiving clean audit reports, required substantial bailouts.
Historical Context
The global financial crisis of 2007-2008 exposed significant flaws in the financial auditing and reporting processes. Banks and other financial institutions, which were deemed financially sound by their auditors, faced liquidity crises that jeopardized their survival, ultimately necessitating government intervention.
Prompted by these events, the Financial Reporting Council established the Sharman Inquiry in 2011 to explore the adequacy of existing auditing standards, specifically relating to the assessment of liquidity risks and going-concern judgments.
Key Events and Report Findings
- 2011: Establishment of the Sharman Inquiry by the Financial Reporting Council.
- 2012: Publication of the Sharman Inquiry Report by Lord Sharman and colleagues, featuring key recommendations aimed at improving auditing practices.
The Sharman Inquiry Report emphasized that an auditor’s assessment of an entity’s status as a going concern should transcend the mere appropriateness of applying the going-concern concept in financial statements. It should incorporate a broader range of judgment factors, including:
- Liquidity risks
- Market conditions
- Management’s future plans and projections
Detailed Explanations and Recommendations
Going Concern Assessment
The report recommended that the going-concern assessment process should involve comprehensive stress-testing and scenario analysis to evaluate potential risks. Auditors are encouraged to apply professional skepticism and consider worst-case scenarios while forming their judgments.
Reporting and Transparency
To enhance transparency, the Sharman Inquiry suggested that entities disclose detailed information about their liquidity risks and the methodologies used to assess their viability as going concerns. This includes clearer communication of assumptions, uncertainties, and potential risk factors.
Mathematical Models and Formulas
Though the Sharman Inquiry focuses more on judgment and qualitative assessments, certain financial models are relevant:
- Liquidity Coverage Ratio (LCR):$$ LCR = \frac{\text{High-Quality Liquid Assets (HQLA)}}{\text{Total Net Cash Outflows over 30 days}} $$
- Stress Testing Models: Used to simulate various adverse conditions and assess an entity’s ability to withstand them.
Diagrams and Charts
graph TD
A[Start of Inquiry] --> B[Analysis of Liquidity Risk]
B --> C[Assessment of Going Concern]
C --> D[Stress Testing and Scenario Analysis]
D --> E[Transparency and Reporting Enhancements]
Importance and Applicability
The Sharman Inquiry’s recommendations have significant implications for:
- Auditors: Enhancing their responsibility and methodologies for going concern assessments.
- Regulators: Strengthening corporate governance frameworks.
- Investors: Providing better insights into the financial health and risks of entities.
Examples and Considerations
- Example: A bank experiencing significant withdrawal pressures can use stress testing to project liquidity needs under different scenarios.
- Consideration: Balancing the detailed disclosures against potential competitive disadvantages.
Related Terms with Definitions
- Liquidity Risk: The risk that an entity will not be able to meet its short-term financial obligations.
- Going Concern: An assumption that an entity will continue to operate for the foreseeable future.
Interesting Facts
- The Sharman Inquiry was one of the first significant steps taken post-2008 financial crisis to reform auditing practices and improve the robustness of financial reporting.
Inspirational Stories and Famous Quotes
- Lord Sharman: “The role of an auditor extends beyond numbers; it is about understanding the very essence of an entity’s operational viability.”
Proverbs, Clichés, and Expressions
- Cliché: “Forewarned is forearmed” – emphasizing the importance of thorough and forward-looking risk assessment.
Jargon and Slang
- Professional Skepticism: An attitude that includes a questioning mind and a critical assessment of audit evidence.
FAQs
Q: Why was the Sharman Inquiry initiated?
A: It was initiated in response to the financial crisis of 2007-2008 to address deficiencies in the reporting of liquidity risk and going concern assessments.
Q: What are the key recommendations of the Sharman Inquiry?
A: Key recommendations include broader assessment criteria for going concerns, increased stress testing, and enhanced transparency in reporting.
References
- Financial Reporting Council (2012). Sharman Inquiry Report.
- Lord Sharman et al. (2012). Recommendations on Liquidity Risk and Going Concern.
Final Summary
The Sharman Inquiry played a pivotal role in reshaping financial auditing and reporting practices. By advocating for a more comprehensive and transparent approach to assessing liquidity risks and an entity’s viability, it has contributed to bolstering the overall integrity and reliability of financial reports, ensuring better preparedness for future economic challenges.
