# 21. GOING CONCERN
(INCORPORATING ISA 570)
# 21.1 Definition
The going concern assumption is a fundamental principle in the preparation of financial statements. It implies that the entity will continue in operation for the foreseeable future. It assumes that the entity has neither the intention nor the necessity of liquidation, or of curtailing materially the scale of its operations.
Therefore, when financial statements are prepared on a going concern basis:
- .It is assumed that the entity will continue in operating existence, for at least the next twelve months from the balance sheet date;
- .Assets are recorded on the basis that that the entity will be able to realise them at their recorded values in the normal course of operations; and
- .Liabilities are recognised on the basis that they will be discharged during the normal course of business.
# 21.2 Respective Responsibilities of the Management and the Auditor
# 21.2.1 Management's Responsibilities
IAS 1, "Presentation of Financial Statements", states, "When preparing financial statements, management shall make an assessment of an entity's ability to continue as a going concern. Financial statements shall be prepared on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so".
Making the going concern assumption involves judgement. Management will need to consider the following factors:
- .Since the degree of uncertainty associated with the outcome of an event increases the further into the future the judgement relating to that event is made, IAS 1 specifies that management considers information at least twelve months from the balance sheet date.
- .Judgement about the future is based on information available at the time that the judgement is made and can be contradicted by subsequent events.
- .The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors all affect the judgment regarding the outcome of events or conditions.
When there is a history of profitable operations and a ready access to financial resources, management may make its assessment without detailed analysis.
Examples of some events or conditions (as highlighted by ISA 570) that may cast significant doubt about the going concern assumption, and which management will need to consider are:
- 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 debtors and other 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.
- Loss of key management without replacement.
- Loss of a major market, franchise, license, or principal supplier.
- Labor difficulties or shortages of important supplies.
- Non-compliance with capital or other statutory requirements.
- Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that are unlikely to be satisfied.
- Changes in legislation or government policy expected to adversely affect the entity.
IAS 1 further states, "When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity's ability to continue as a going concern, those uncertainties shall be disclosed. When financial statements are not prepared on a going concern basis, thatfact shall be disclosed, together with the basis on which the financial statements are prepared and the reasons why the entity is not regarded as a going concern".
# 21.2.2 Auditor's Responsibilities
The engagement team should consider the appropriateness of management's use of the going concern assumption in the preparation of the financial statements. The engagement team should further consider whether there are material uncertainties about the entity's ability to continue as a going concern that need to be disclosed in the financial statements.
# 21.3 Audit Approach
As per ISA 570, "In obtaining an understanding of the entity, the auditor should consider whether there are events or conditions and related business risks which may cast significant doubt on the entity's ability to continue as a going concern".
ISA 570 further states, "When planning and performing audit procedures and in evaluating the results thereof, the auditor should consider the appropriateness of management's use of the going concern assumption in the preparation of the financial statements". Assessing the entity's ability to continue as a going concern at the planning stage allows for more timely discussions with management, review of management's plans and resolution of any identified going concern issues. It will also affect the nature, timing and extent of the auditor's further procedures in response to the assessed risks.
The engagement team should also remain alert throughout the audit, for any events or conditions that may indicate that the entity's ability to continue as a going concern is doubtful, and assess the impact of those events or conditions on the assessment of risks of material misstatement.
The engagement team should note that there may exist events or conditions that may cast a significant doubt on the entity's ability to continue as a going concern and that there might be factors mitigating those events or conditions, e.g. the effect of an entity being unable to make its normal debt repayments may be counter-balanced by management's plans to maintain adequate cash flows by alternative means, such as by disposal of assets, rescheduling of loan repayments, or obtaining additional capital. Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable alternative source of supply.
If management has not made a preliminary assessment of the entity's ability to continue as a going concern, the engagement team should inquire from management whether there are any conditions or events, such as those identified in Section 22.2.1 above, that exist. The engagement team should also discuss with management their basis for assuming that the entity will continue as a going concern.
# 21.4 Audit Evidence
The engagement team should evaluate management's assessment of the entity's ability to continue as a going concern and consider the same time period as used by management, under the relevant financial reporting framework. However, if this is less than twelve months from the balance sheet date, the engagement team should ask management to extend the assessment accordingly. This evaluation is a key audit consideration of the going concern assumption and includes reviewing the assumptions on which the assessment is based and management's plans for future action. The engagement team should also inquire of management about any events or conditions existing beyond the period of assessment, which could affect the going concern assumption and be alert to the possibility of such events or conditions occurring during the audit process.
If adequate disclosures are not included in the financial statements, the engagement team may consider the need to obtain a statement in writing from the management as to whether the going concern basis is appropriate. For larger entities, a statement is only likely to be valuable if supported by forecasts and budgets and schedules of borrowing facilities. For smaller entities, with uncomplicated circumstances, it may be appropriate for a written assertion to be prepared, as a record of any discussions held. In such circumstances, the management must take responsibility for the record, which should give sufficient details of their opinion. Any statement should ideally be obtained early in the audit process, and may need to be confirmed in the letter of representation - See Section 23 of the Manual. (A sample representation is covered in Form 02.02 - Letter of Representation set out in Part E of the Manual).
In certain instances, the engagement team may wish to obtain a letter or support or subordination to support the going concern assumption of the entity. A sample letter of support is set out in Appendix I of this Section. This letter of support is a guarantee from third parties, (such as the parent company, directors or shareholders, or the entity's bankers and other creditors) that they will continue to financially support the entity to enable it to meet its liabilities as they fall due, for at least the next twelve months from the date the financial statements are approved for issue, while a letter of subordination is usually provided by a creditor or lender subordinating an entity's debt to other payables. If the entity's total debt's less the liquid assets exceed the subordinated debts, a letter of subordination alone will not give the required protection.
The letter should be addressed to the entity and copied to us as the auditors. The letter should ideally be prepared by a lawyer. It should always be ratified by the board, and the financial statements should adequately disclose the existence of this letter.
The engagement team should consider the need to perform further audit procedures to obtain satisfaction on the appropriateness of the letter of support or subordination. Such audit procedures may include inspection of the financial statements of the third party providing the letter of support or subordination (if the third party is a parent company or creditor). In the case of the entity's bankers, the evidence would be an agreement for renewal of facilities.
# 21.5 Additional Audit Procedures when Events or Conditions are Identified
When events or conditions have been identified (either at the planning stage or during the course of the audit) which may cast significant doubt on the entity's ability to continue as a going concern, the engagement team should:
- (a)Review management's plans for future actions based on its going concern assessment;
- (b)Gather sufficient appropriate audit evidence to confirm or dispel whether or not a material uncertainty exists through carrying out audit procedures considered necessary, including considering the effect of any plans of management and other mitigating factors; and
- (c)Seek written representations from management regarding its plans for future action.
Other evidence that may be considered includes:
- .Analysing and discussing cash flow, profit and other relevant forecasts with management, and reviewing the assumptions underlying such forecasts.
- .Analysing and discussing the entity's latest available interim financial statements.
- .Reviewing the terms of debentures and loan agreements and determining whether any have been breached.
- .Reviewing minutes of the meetings of shareholders, those charged with governance and relevant committees for reference to financing difficulties.
- .Inquiring of the entity's lawyer regarding the existence of litigation and claims and the reasonableness of management's assessments of their outcome and the estimate of their financial implications.
- .Confirming the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assessing the financial ability of such parties to provide additional funds.
- .Considering the entity's plans to deal with unfilled customer orders.
- .Reviewing events after period end to identify those that either mitigate or otherwise affect the entity's ability to continue as a going concern.
Form 04.02 - Going Concern Review Programme set out in Part E of the Manual provides guidance on some of the audit procedures that may be adopted in carrying out a review of going concern.
# 21.6 Audit Conclusion
Based on the audit evidence obtained, the engagement team should determine if, in the it's judgement, a material uncertainty exists related to events or conditions that alone or in aggregate, may cast significant doubt on the entity's ability to continue as a going concern.
If the use of the going concern assumption is appropriate but a material uncertainty exists, consideration should be given to whether the financial statements:
- (a)Adequately describe the principal events or conditions that give rise to the significant doubt on the entity's ability to continue in operation and management's plans to deal with these events or conditions; and
- (b)State clearly that there is a material uncertainty related to events or conditions which may cast significant doubt on the entity's ability to continue as a going concern and, therefore, that it may be unable to realise its assets and discharge its liabilities in the normal course of business.
If adequate disclosure is made in the financial statements, an unqualified opinion should be expressed but the auditor's report should be modified by adding an emphasis of matter paragraph that highlights the existence of a material uncertainty relating to the event or condition that may cast significant doubt on the entity's ability to continue as a going concern and draws attention to the note in the financial statements that discloses the matters set out in the paragraph above.
In extreme cases, such as situations involving multiple material uncertainties that are significant to the financial statements, it may consider it appropriate to express a disclaimer of opinion instead of adding an emphasis of matter paragraph.
If adequate disclosure is not made in the financial statements a qualified or adverse opinion, as appropriate, should be given (See Section 23 of the Manual). The report should include specific reference to the fact that there is a material uncertainty that may cast significant doubt about the entity's ability to continue as a going concern.
If, in the engagement team's judgment, the entity will not be able to continue as a going concern, an adverse opinion should be expressed if the financial statements have been prepared on a going concern basis.
In some circumstances, where management feels that preparation of the financial statements on a going concern assumption is not appropriate, the financial statements may be prepared on an alternative authoritative basis. If the engagement team determines that this alternative basis is appropriate, an unqualified opinion may be issued, if there is adequate disclosure made in the financial statements. However one may be required to include an emphasis of matter paragraph in the auditor's report to draw the user's attention to that basis.
If management is unwilling to make an assessment on the going concern assumption when requested to do so by the engagement team, one should consider the need to modify the auditor's report as a result of the limitation on the scope of the audit work.