Massimo Laudato, technical adviser at ACCA, considers the issues surrounding the audit of going concern
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In recent years, during the period of credit crisis and economic downturn that has affected the world’s economy and the banking and financial sectors in particular, it has been argued in many circumstances by different parties that the assessment and the disclosures contained in audited accounts and auditor’s reports in respect of the ability of a company to continue in business in the foreseeable future as a going concern were not satisfactory, particularly in respect of entities that collapsed not long after their financial statements prepared on a going concern basis were issued.
Questions were also raised about whether the actual requirements regarding going concern assessment and reporting included in various financial reporting frameworks were indeed adequate.
However, while some financial reporting frameworks, including UK GAAP and IFRS, include explicit requirements for the management to make a specific assessment of an entity’s ability to continue as a going concern and for disclosures to be made in connection with going concern issues, the crux of the matter is that management’s going concern assessment involves making a judgement, at a particular point in time, about inherently uncertain future outcomes of events and conditions. In practice the current requirements placed on a company’s directors and auditors are those of establishing whether the use of the going concern basis for the financial statements is appropriate on the grounds that management does not intend to liquidate the entity or cease trading in the foreseeable future, or has no realistic alternative but to do so, and to disclose material uncertainties affecting such assessment. However the going concern assessment undertaken for financial reporting purposes is not intended to provide a guarantee that the company will remain a going concern until the next accounts are issued.
International Standard on Auditing (UK and Ireland) 570
International Standard on Auditing (UK and Ireland) (ISA) 570, Going Concern, stresses such point as the going concern assessment is made at the date of the approval of the financial statements and takes into account the relevant facts and circumstances known at that date; therefore judgments that were reasonable at that time may be inconsistent with future events and circumstances that may cause an entity to cease to continue as a going concern.
Nevertheless, beside the high profile cases that attract the attention of the media and of the general public, the audit of going concern is reported by the audit regulators and supervisory bodies in various jurisdictions to be one of the most problematic areas of the audit process, one where the work performed by audit firms often results insufficient or unsatisfactory, particularly in relation to the audit of smaller entities. This shortfall is likely to derive from a number of factors, probably including underestimation by directors and auditors of the importance of the relevant going concern requirements, and it is of particular concern in respect of a matter that is a catalyst of public attention and that is capable of significantly affecting business confidence.
When financial statements are prepared on a going concern basis, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business, as it is assumed that the entity will continue in business in the foreseeable future.
ISA 570 deals with the auditor’s responsibilities in auditing the management’s use of the going concern basis in the preparation and presentation of the accounts. The standard sets the objectives of the auditor’s work and the specific requirements to fulfil. In addition ISA 570 clarifies the respective responsibilities of the management of the company and of the auditor in assessing the entity’s ability to continue in business as a going concern.
Whereby the management, or the board of directors specifically, of the entity is responsible for undertaking the going concern assessment and making related disclosures in accordance with the applicable financial reporting framework, the auditor is responsible to make its own evaluation of the management’s conclusions about the use of the going concern assumption in the accounts and to conclude whether a material uncertainty exists in that respect. There is often confusion, or a lack of awareness, about the roles of management and auditors in the assessment of going concern and the related reporting process in the financial statements, which arise from the separate requirements of the applicable financial reporting framework and of the auditing standards, and it is therefore worthwhile outlining them.
The responsibilities of management and directors
Going concern is a fundamental assumption that generally underlies the preparation of the financial statements of all companies. As already mentioned, under such assumption an entity is viewed as continuing in business for the foreseeable future and therefore it accounts for its assets and liabilities on the basis that it will be able to realise and discharge them in the normal course of business rather than in a winding up.
In particular under the provisions of both UK GAAP and IFRS (specifically IAS 1, Presentation of Financial Statements) financial statements are prepared on a going concern basis unless the management or directors either intend to liquidate the entity or cease operations, or have no realistic alternative but to do so. In accordance with both frameworks, directors are required to satisfy themselves that it is reasonable for them to conclude that it is appropriate to prepare financial statements on a going concern basis.
The going concern assessment required to be performed by directors should consider all the facts and circumstances about the foreseeable future of a company known at the date of approval of the accounts. The level of detail of the assessment and extent of procedures required would vary in accordance with the size and complexity of the entity.
While it would be advisable for the assessment to include, as a minimum, the preparation of a budget, trading estimates and cash flow forecasts and an analysis of the company’s borrowing requirements and facilities, such a detailed analysis may not be necessary for smaller and less complex entities that have a history of profitable operations and ready access to financial resources.
Larger companies or those with more complex business models may need substantially more procedures as part of the going concern assessment, such as annual reviews of medium and long-term plans, analysis of the major aspects of the economic environment in which they operate (market size, market share, competitors etc) and financial and operational risk management.
The period of time that needs to be considered by directors for assessing going concern is not set at a maximum by the accounting standards. However the FRSSE provides that management should disclose in the accounts where the period considered in making its assessment is less than twelve months from the date of the approval of the accounts. FRS 102 instead mandates consideration of a period of at least twelve months from the approval of the accounts. Under IAS 1 there is a requirement that the period considered should not be less than twelve months from the end of the reporting period. While the review period under the FRSSE may be less than twelve months from the balance sheet date, when that is the case, ISA 570 requires the auditor to request management to extend its assessment period to at least twelve months from the balance sheet date. Additionally management should duly take into account relevant events and conditions beyond the minimum period of assessment prescribed by the standards to satisfy themselves as to whether the use of the going concern basis is appropriate.
When conducting their going concern assessment, the directors will have to evaluate which of three potential conclusions is appropriate to the circumstances of the company. In particular they may conclude that:
- There are no material uncertainties that may cast significant doubt about the company’s ability to continue as a going concern;
- There are material uncertainties related to events or conditions that may cast significant doubt about the company’s ability to continue as a going concern but the use of the going concern basis remains appropriate; or
- The use of the going concern is not appropriate.
Both UK GAAP and IFRS require directors to make disclosures about the existence and the nature of material uncertainties that lead to significant doubts about going concern. A material uncertainty is one whose potential impact and possibility of occurrence is so significant that appropriate disclosures of the uncertainty are necessary for the financial statements to give a true and fair view, ie one whose omission would be misleading for the users of the accounts. The specific disclosures that should be made are not codified in the standards but they should outline the facts and circumstances that create the uncertainties in a clear manner and should also include an indication that the company may be unable to realise its assets and discharge its liabilities in the normal course of business. Directors should also indicate on what grounds they consider the use of the going concern basis to be appropriate in view of the identified uncertainties.
Difficult economic conditions actually impact companies in different ways and provide additional challenges to all the parties involved in preparing financial statements. However it cannot be assumed that a period of difficult economic conditions, as a systemic uncertainty affecting all economic operators, means, by itself, that a material uncertainty exists about a specific company’s ability to continue as a going concern. Each company should be subject to a going concern assessment that is rigorous and balanced and takes into accounts its specific circumstances in light of the general economic conditions.
The responsibilities of the auditor
ISA 570 clearly outlines the objectives of the auditor in respect of the use of the going concern basis in the accounts:
- To obtain sufficient appropriate evidence regarding the appropriateness of management’s use of the going concern basis;
- To conclude, on the basis of the audit evidence, whether a material uncertainty exists in respect of events or conditions that may cast significant doubt about the entity’s ability to continue as a going concern; and
- To determine the implications for the auditor’s report.
ISA 570 requires the auditor to consider going concern at the early stages of the audit, in particular when performing risk assessment procedures at the planning stage. At that point the auditor should consider whether there are events or conditions that may cast significant doubt about the going concern assumption. In order to do so the auditor should discuss with management their preliminary assessment of going concern, ascertain whether they have identified issues that may have a significant impact on going concern and how they plan to address them. If management has not performed such a preliminary assessment, the auditor shall discuss with them the grounds on which they intend to use the going concern basis and ask them whether there are events and conditions that may significantly affect going concern. Such discussion normally takes place at the preliminary meeting with the client that is set to update the permanent information about the entity and to identify changes in the business since the last audit that are relevant to the current year audit.
The discussion with management about going concern issues helps the auditor to determine whether the use of the going concern assumption is likely to result in a significant risk of material misstatement and to plan audit procedures in response to such a risk.
Events and conditions that may cast doubt about the going concern assumption could be of financial, operating or other nature. ISA 570 highlights a number of such events and conditions that are commonly encountered in real life and that the auditor should be familiar with. It is worthwhile listing them as a helpful aide memoire:
- Net liability or net current liability position.
- Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment; or excessive reliance on short-term borrowings to finance long-term assets.
- Indications of withdrawal of financial support by creditors.
- Negative operating cash flows indicated by historical or prospective financial statements.
- Adverse key financial ratios.
- Substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
- Arrears or discontinuance of dividends.
- Inability to pay creditors on due dates.
- Inability to comply with the terms of loan agreements.
- Change from credit to cash-on-delivery transactions with suppliers.
- Inability to obtain financing for essential new product development or other essential investments.
- Management intentions to liquidate the entity or to cease operations.
- Loss of key management without replacement.
- Loss of a major market, key customer(s), franchise, license, or principal supplier(s).
- Labour difficulties.
- Shortages of important supplies.
- Emergence of a highly successful competitor
- Non-compliance with capital or other statutory requirements.
- Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that the entity is unlikely to be able to satisfy.
- Changes in law or regulation or government policy expected to adversely affect the entity.
- Uninsured or underinsured catastrophes when they occur.
In respect of events and conditions that may affect the going concern assumption for smaller entities, the auditor should bear in mind that size may negatively affect their ability to withstand adverse conditions. The auditor should give attention to circumstances that are of particular relevance to small entities, like:
- The risk that banks and other lenders may cease to support the entity,
- The possible loss of a principal supplier, major customer, key employee, or
- The possible loss of the right to operate under a license, franchise or other legal agreement.
The auditor of a small entity should invariably question management as to whether the above circumstances exist or are likely to materialise and document such enquiries in the planning documentation.
The presence of one or more items above does not necessarily indicate that a material uncertainty exists (ie one that would need to be disclosed for the accounts to give a true and fair view), especially as management’s plans to address them or the presence of other counter-balancing factors may mitigate the significance of such items for a specific company.
The examples indicated are not an exhaustive list of possible events and conditions capable of affecting going concern, as such a list could not be possibly compiled given that various issues may be more or less significant depending on the specific circumstances of an entity.
The importance of identifying events and conditions that may impact going concern at the planning stage, via discussion with management, is that risks of material misstatement can be identified and assessed so that necessary further audit work can be designed and performed to respond to such risks.
Evaluating management’s assessment
The evaluation of the management’s assessment of going concern is an essential part of the auditor’s work in the audit of the going concern assumption and is a procedure that is expressly required by ISA 570.
The focus of the work of the auditor should be that of obtaining sufficient appropriate evidence to evaluate the management’s assessment rather than rectifying the lack of analysis by management by producing an auditor’s own detailed analysis.
ISA 570 recognises that the auditor may have to deal with an assessment by management that is not supported by a detailed process or examination. When that is the case the auditor will still have to question the grounds on which management have assumed that the entity will continue as a going concern and should also discuss the type of going concern assessment that would be relevant to the circumstances of the client, in order to conclude whether the use of the going concern is appropriate.
Notwithstanding the above, a detailed assessment of going concern based on formal procedures like budgets, cash flow forecasts etc. is likely to provide the most persuasive audit evidence to evaluate the management’s assessment. In such circumstances the auditor should make enquiries about the process followed by management to make the assessment, evaluate the assumptions on which the assessment is based and management’s plans for future action; additionally the auditor should examine relevant financial information used for the assessment.
In evaluating management’s assessment of going concern, the auditor shall cover the same period as that used by management and as required by the applicable financial reporting framework. However if the period of the assessment considered is less than twelve months from the balance sheet date then, in accordance ISA 570, the auditor shall request management to extend the assessment to at least twelve months from that date. While IAS 1 requires the assessment to cover at least twelve months from the balance sheet date and FRS 102 mandates twelve months from the approval of the statements, the FRSSE does not mandate a specific period and only requires disclosure of the fact that the period considered is less than twelve months from the approval of the accounts. The auditor of a small entity may therefore need to ask management to extend the assessment to twelve months after the balance sheet date, as failure to do so would result in a limitation in scope of the audit work and in the auditor being unable to conclude on the use of going concern basis with a consequential qualification of the auditor’s report.
Considerations for smaller entities
As mentioned above, often smaller entities do not make an assessment using detailed procedures but rather rely on in-depth knowledge of the business by management and anticipated future prospects. In such cases the auditor may not need to perform elaborate procedures to obtain sufficient evidence about the management’s assessment but may, for example, discuss with management the medium- and long-term financing of the entity, examine documents supporting their contentions and evaluate and inquire the consistency of the financing prospects of the entity with the auditor’s understanding of the entity. ISA 570 also suggests that, when it is necessary for a small entity to extend the period of going concern assessment to twelve months after the balance sheet date, that may be achieved by discussing and inspecting relevant documentation, like orders received for future supply that can reasonably be fulfilled and agreements/arrangements for financing facilities.
In the context of the going concern assessment for smaller entities, the continued support of the owner-managers is often crucial and often blindly assumed to be granted. The auditor should not, in fact, make that automatic assumption and should obtain appropriate evidence as to whether the owner-managers intend and are able to continually support the entity in the foreseeable future.
For instance if the entity is largely financed by a loan from an owner-manager, the continuation of the entity may depend on the subordination of the owner’s loan in favour of banks or other creditors. Alternatively an entity may be able to obtain essential financing only if the owner-manager provides a guarantee with his or her personal assets as a collateral. The auditor should therefore obtain documentary evidence of the loan subordination or of the guarantee. Additionally if an entity’s continued existence is subject to the future further support of the owner-manager, the auditor will need to evaluate whether the owner-manager will be capable of meeting the entity’s future obligations by enquiring the possible sources of funding available to the owner. Regardless of the ability of the owner-manager to continue to support the entity in the foreseeable future, the auditor should obtain written representations from the owner-manager that he/she intends to do so.
Apart from considering the period assessed by management, ie at least twelve months from the balance sheet date or from the date of approval of the accounts (depending on the reporting standards adopted), the auditor should also be alert to the possibility that there could be known events or conditions beyond that period that could cast significant doubt about the use of the going concern assumption. For such purpose the auditor should ask management to indicate any known events or conditions beyond their period of assessment that may cast significant doubt about the ability of the entity to continue as a going concern.
Additional audit procedures
If the preliminary assessment (risk assessment procedures) at the planning stage or the evaluation of management’s assessment has identified events or conditions that may cast significant doubt about the entity’s ability to continue as a going concern, the auditor shall perform further audit procedures to obtain appropriate evidence to establish whether a material uncertainty about going concern, ie one that should be disclosed for the accounts to give a true and fair view, exists.
The procedures will include:
- A review of the management’s plans for future actions in respect of going concern, including, for example, enquiries about their plans to liquidate assets, borrow money or restructure debts, reduce or delay expenditures, or increase capital, in order to establish whether they are feasible and likely to improve the situation.
- If the entity has prepared cash flow forecasts and their consideration is critical in the management’s plans in respect of going concern, the auditor shall evaluate the reliability of the underlying data used in the forecasts and determine whether the assumptions underlying the forecast can be adequately supported by evidence. The analysis of the cash flow forecasts can also be extended by comparing forecasts for recent prior periods with historic results and the forecasts for the current period with actual results to date.
- Consideration of whether any additional facts or information have become available since the date of the management’s assessment.
- Where management’s assumptions include continued financial support by third parties and such support is important to the ability of the entity to continue as a going concern, the auditor may need to request written confirmations, including terms and conditions, from those third parties and to obtain evidence about their ability to provide support.
- Written representations from management regarding their future action plans and the feasibility of the plans.
Further procedures that the auditor may perform to conclude whether a material going concern uncertainty exists include:
- Analysing and discussing the entity’s latest available interim financial statements.
- Reading the terms of debentures and loan agreements and determining whether any have been breached.
- Inquiring of the entity’s legal advisers regarding the existence of litigation and claims and the reasonableness of management’s assessments of their outcome and estimate of their financial implications.
- Performing audit procedures regarding subsequent events to identify those that either mitigate or otherwise affect the entity’s ability to continue as a going concern.
- Obtaining and reviewing reports of regulatory actions.
The additional procedures performed allow the auditor to conclude whether events and conditions affecting going concern result in a material uncertainty that needs to be disclosed in the financial statements. However that is not always the case, as further audit procedures should take into account mitigating factors that reduce the potential impact and likelihood of the uncertainty so that the auditor may conclude that it is not material to the financial statements.
Audit conclusions and reporting
On the basis of the evidence obtained, the auditor shall conclude whether a material uncertainty exists that may cast significant doubt about the ability of the entity to continue as a going concern. As mentioned, a material uncertainty is one that requires, in the auditor’s opinion, disclosure of its nature and implications for the accounts to give a true and fair view.
The conclusions reached by the auditor and the implications for the auditor’s report in different circumstances may be summarised as follows:
Swipe to view table
|Auditor’s conclusion||Consequence for the auditor’s report|
|The auditor concludes that the use of the going concern basis is appropriate and no material uncertainties are identified.||An unmodified auditor’s report is issued.|
The auditor concludes that the use of the going concern assumption is appropriate but a material uncertainty exists and he/she determines that:
|The auditor’s report will not be qualified but will include an Emphasis of Matter paragraph highlighting the existence of a material uncertainty and drawing attention to the note in the accounts that includes the going concern disclosures.|
The auditor concludes that the use of the going concern assumption is appropriate but a material uncertainty exists and he/she determines that:
The auditor’s report shall express a qualified opinion or adverse opinion in respect of the inadequate disclosures.
The auditor’s report should also indicate that there is a material uncertainty in respect of going concern.
|The auditor concludes that the use of the going concern assumption is inappropriate but the financial statements have been prepared on going concern basis.||The auditor’s report shall express an adverse opinion.|
|The auditor concludes that the use of the going concern assumption is inappropriate and directors have not prepared the accounts on a going concern basis but on a suitable alternative basis (for example break-up basis) and appropriate disclosures are included.||The auditor’s report may express an unqualified opinion and include an Emphasis of Matter paragraph about the alternative basis used.|
The audit work performed in respect of going concern throughout the performance of the audit engagement and the conclusions reached by the auditor should be appropriately documented in the audit file. In particular it is recommended that the following items are clearly recorded:
- The risk assessment procedures about going concern at the planning stage, including notes of the discussion with management;
- A record of management’s assessment and assumptions;
- Details of audit evidence obtained;
- Specific events and conditions that may cast doubt about the going concern assumption and details of further procedures performed;
- Details of identified material uncertainties about going concern;
- Written representations from management/owners about future plans and continued support of the entity;
- Written representation from third parties about support of the entity;
- Evaluation and conclusions about the use of going concern and related disclosures in the accounts and consequences for the auditor’s report.
ACCA Technical Factsheet 143, The impact of the credit crunch in the audit of small companies, includes a number of examples and detail guidance about circumstances affecting the going concern assumption of small entities’ accounts, together with an analysis of possible audit procedures that could be taken in response.
An example of illustrative documentation for the audit of going concern of a smaller entity is reproduced below. The example has been adapted from those published in Practice Note 26, Guidance on Smaller Entity Audit Documentation (Revised), issued by the Financial Reporting Council in the UK and Ireland.
Example 11 – audit working paper: going concern
Client: Bulls Restaurant and Hotel Limited
Year end: 31 January 20X1
Prepared by: Richard Cannon - Date: 18 May 20X1
Reviewed by: Sarah Cole - Date: 19 May 20X1
Trading during the current economic conditions has been 10% down on previous years, although Bulls have been able to reduce costs. Management has prepared a cash ﬂow forecast for the 12 months from the year end date (1 February 20X1 to 31 January 20X2) – ﬁle ref. L12. This exercise involved the shareholder, Lisa Swann (who is an accountant), in addition to Fred and Jo. It formed the basis of a discussion with the company’s bankers at a meeting in February X1 where the overdraft facility was agreed for a further year to 28 February 20X2.
Work undertaken during the audit:
- Discussed with management their plans for the company for the period up to 28 February 20X2 (more than 12 months after the balance sheet date). They expect that there will be no further deterioration in trading levels, meaning that the maximum overdraft during the period will be £30,000, which is £20,000 short of the current overdraft facility. Budgets prepared by management in the past have proved to be reasonably accurate.
- Reviewed ﬁgures included in the cash ﬂow forecast for 12 months to 31 January 20X2. These have been prepared on the basis of: trading at January 20X1 levels continuing until late in 20X1, when a slow recovery is assumed; gross proﬁt margins being maintained at recently experienced levels; previously planned expansion being delayed until late in 20X2 at the earliest.
- Compared cash ﬂow forecasts for the ﬁrst three months of the year to actual results. No signiﬁcant differences noted in turnover and gross proﬁt margins.
- Obtained a copy of the letter to the company agreeing the overdraft facilities to 28 February 20X2 (ref. F40). The directors have stated that they have no reason to believe that the overdraft facility (which is not dependent on the property valuation) will not be successfully renegotiated in February 20X2.
Although the current economic outlook is uncertain, there are no indications that Bulls will not continue in operational existence for at least one year from the balance sheet date.
Disclosures made in the ﬁnancial statements in connection with this matter are clear and understandable.