During the period of difficult economic conditions that has engulfed the World’s economy and the banking and financial sectors in particular from approximately 2007 onwards, the media and the general public appeared to have become more sensitive about going concern assertions included in companies’ financial statements and auditor’s reports.
In many circumstances it has been argued 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 possible responsibilities of the auditing profession as a whole in the financial crisis and about whether the actual requirements regarding going concern assessment and reporting included in various financial reporting frameworks were indeed adequate. In the UK the debate has actually led to the launch by the Financial Reporting Council (FRC) of the Sharman Inquiry whose purpose was to identify lessons for companies and auditors about the going concern assessment, drawing on the experience of dealing with these issues in times of difficulty (including during the credit crisis), and to recommend measures necessary to improve the existing reporting regime.
The Sharman Inquiry has so far resulted in preliminary conclusions and recommendations issued in November 2011 with a final version of the report expected in February 2012. The panel of inquiry recognised a substantial expectation gap between what some users of the going concern assessment and reporting process expect and what it actually is. It is early days to establish what changes to the going concern requirements the Inquiry’s recommendations will bring about, however the current requirements placed on a company’s directors and auditors are not intended to provide a guarantee that the company will remain a going concern until the next accounts are issued. Both FRC’s guidance ‘Going Concern and Liquidity Risks: Guidance for Directors of UK Companies 2009’ and International Standard on Auditing (ISA) (UK and Ireland) 570 ‘Going concern’ stress 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 a judgement valid at that time may be overturned by subsequent events and circumstances.
ISA (UK and Ireland) 570 deals with the auditor’s responsibilities in auditing the management’s use of the going concern basis in the preparation of the accounts. The clarified 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 in the UK) 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 assessment of the management’s conclusion 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.
Going concern is a fundamental assumption that underlies the preparation of the financial statements of all UK companies. 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 realize and discharge them in the normal course of business. 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. Under the Financial Reporting Standard for Smaller Entities (FRSSE), UK Generally Accepted Accounting Principles (UK GAAP) and International Financial Reporting Standards (IFRS) 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. Additionally the Accounts Regulations for small, medium and large-sized companies (SI 2008 No. 409 and 410) also include a presumption that a company will continue carrying on a business as a going concern.
The assessment required to be performed by directors should consider all the facts and circumstances of an individual 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. It is recommended that it should involve, 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, albeit smaller entities may not prepare such a detailed analysis. 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 review period adopted by directors for assessing going concern is not set at a maximum by the accounting standards. However the FRSSE and UK GAAP provide that directors should disclose in the accounts where the period considered as the foreseeable future is less than one year from the date of the approval of the financial statements. Under IFRS there is instead a requirement that the period considered should not be less than twelve months from the end of the reporting period. However the guidance issued by the FRC about going concern and liquidity risks requires the directors of all UK companies to disclose if the period of review is less than one year from the approval of the accounts. It follows that the directors of UK companies usually adopt a period of review of not less than twelve months from the date of approval of the statements.
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:
The accounting standards require directors to make disclosures about the existence and the nature of material uncertainties that lead to significant doubts about going concern. 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. 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 difficult economic conditions affecting many companies mean, of 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.
ISA (UK and Ireland) 570 clearly outlines the objectives of the auditor in respect of the use of the going concern basis in the accounts:
ISA 570 requires the auditor to consider at the planning stage of the audit 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.
Examples of events and conditions that may significantly affect going concern are listed in ISA 570 and could be of financial, operating or other nature. They include net liabilities, current net liabilities, borrowing facilities unlikely to be renewed or replaced, inability to pay creditors or to comply with the terms of loan agreements, the loss of a major market, key customer, supplier or management or pending legal or regulatory proceedings that the entity may not satisfy. There could not be an exhaustive list of possible events and conditions capable of affecting going concern, as issues may be more or less significant depending on the specific circumstances of an entity, however the going concern assessment carried out at planning stage should be aimed at identifying risks of material misstatement in the accounts so that necessary further audit work could be designed and implemented to respond to such risks.
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.
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. 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 supporting documents and evaluate and enquiry the consistency of financing prospects with its understanding of the entity.
Notwithstanding the considerations 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, about the assumptions on which the assessment is based and about management’s plans for future actions; 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.
If the preliminary assessment (risk assessment procedures) 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 sufficient appropriate evidence to establish whether a material uncertainty about going concern 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 its 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.
Additionally 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. That could be done by comparing forecasts for recent previous periods and the current period with actual results.
The auditor shall also consider 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 such support.
Written representations from management and directors regarding their future action plans and their feasibility also need to be obtained by the auditor.
On the basis of the evidence obtained, the auditor shall conclude whether a material uncertainty exists in respect of events and conditions that, either individually or collectively, may cast significant doubt about the ability of the entity to continue as a going concern. A material uncertainty is one whose potential impact and probability of occurrence requires, in the auditor’s opinion, disclosure of its nature and implications for the accounts to give a true and fair view.
A specific reporting requirement is placed on UK auditors by ISA 570. If the period considered for the management’s assessment of going concern is less than one year from the date of approval of the financial statements and the directors have not disclosed that fact, the auditor shall do so in the auditor’s report. For entities applying the FRSSE or UK GAAP such a disclosure is a requirement, not for companies using IFRS though, and its omission will also trigger a qualified (‘except for’) opinion.
If the auditor concludes that there are no material uncertainties about the use of the going concern assumption, an unmodified audit report should be issued.
The auditor may conclude that the use of the going concern assumption is appropriate but that a material uncertainty exists and in such case it should modify the auditor’s report. If the auditor determines that the accounts adequately describe the nature and implications of the material uncertainty and the management’s plans to deal with it and disclose clearly that the entity may be unable to realise its assets and discharge its liabilities in the normal course of business, the auditor will not qualify its report 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. If adequate disclosures are not included in the financial statements, the auditor shall express a qualified or adverse opinion.
If the financial statements have been prepared on a going concern basis but the auditor concludes that the use of the going concern assumption is inappropriate, the auditor’s report shall express an adverse opinion. If however the 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 may express an unqualified opinion on those accounts and include an Emphasis of Matter paragraph about the alternative basis used.
The audit working papers should clearly document: