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CPD technical article
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.
That confusion arises from the separate requirements of the financial reporting framework and auditing standards, and therefore worthwhile outlining them, explains Massimo Laudato.
This article was first published in the March 2012 UK edition of Accounting and Business magazine.
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Responsibilities of directors
Going concern is a fundamental assumption that underlies the preparation of the financial statements of all UK companies. Under the going concern 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.
Financial statements are prepared on a going concern basis unless the management or directors intend to liquidate the entity or cease operations, or have no realistic alternative but to do so. Under the Financial Reporting Standard for Smaller Entitles (FRSSE), 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 (Statutory Instruments 2008, 409 and 410) also include a presumption that a company will continue carrying on a business as a going concern.
The directors are required to consider and assess all the circumstances and facts known at the date the accounts are approved. The level of detail of the assessment and extent of procedures required will vary in accordance with the entity's size and complexity. It is recommended that it should involve, as a minimum, the preparation of a budget, trading estimates and cashflow forecasts and an analysis of the company's borrowing requirements and facilities, albeit smaller entities may not prepare such a detailed analysis.
The accounting standards lay down no maximum review period that the directors have to adopt in assessing going concern. However, the FRSSE and UK GAAP provide for the directors to 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 a requirement that the period considered should not be less than 12 months from the end of the reporting period. The directors of UK companies usually adopt a period of review of not less than 12 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:
- 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 going concern basis remains appropriate
- the use of the going concern is not appropriate
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.
Responsibilities of the auditor
International Standard on Auditing (ISA) 570 clearly outlines the objectives of the auditor about the use of the going concern basis in the accounts:
- to obtain sufficient appropriate evidence about 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 about events or conditions that may cast significant doubt about the entity's ability to continue as a going concern
- to determine the implications for the auditor's report.
Planning stage
ISA 570 requires the auditor to consider at the audit planning stage 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, then the auditor shall discuss with the directors 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 identify changes in the business since the last audit that are relevant to the current year audit.
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 is no exhaustive list of possible events and conditions capable of affecting going concern, as the significance of issues depends on the specific circumstances of the 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 further audit work could be designed and implemented to respond to such risks.
Evaluating management's assessment
The evaluation of the management's assessment of going concern is an essential part of auditing the going concern assumption.
The auditor's focus should be to obtain sufficient appropriate evidence to evaluate the management's assessment rather than to rectify the lack of analysis by management by producing an auditor's own detailed analysis.
Smaller entities often do not make an assessment using detailed procedures but 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 enquire about the consistency of financing prospects with its understanding of the entity.
Nevertheless, a detailed evaluation of going concern based on formal procedures such as budgets and cashflow forecasts 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. The auditor should also examine any relevant financial information.
Additional procedures
If the preliminary assessment or evaluation of management's assessment has identified events or conditions that may cast significant doubt on the entity's ability to continue as a going concern, the auditor shall perform further audit procedures to establish whether a material uncertainty about going concern exists.
The procedures will include reviewing management's plans for future actions for going concern, including, for example, enquiries about its plans to liquidate assets, borrow money or restructure debts, reduce or delay expenditures, or increase capital, to establish whether they are feasible and likely to improve the situation.
Also, if the entity has prepared cashflow forecasts and their consideration is critical to management plans for 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.
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 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.
Audit conclusions
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, then the auditor shall do so in the auditor's report.
For entities applying the FRSSE or UK GAAP such a disclosure is a requirement and its omission will also trigger a qualified opinion. If the auditor concludes there are no material uncertainties about 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 a material uncertainty exists, therefore requiring modification of 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 going concern disclosures in the accounts. If adequate disclosures are not included in the financial statements, the auditor shall express a qualified 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.
Massimo Laudato is a technical adviser at ACCA UK.
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