Save content
Have you found this content useful? Use the button above to save it to your profile.
AIA

AccountingWEB.co.uk guide to the audit of going concern

by
31st Aug 2010
Save content
Have you found this content useful? Use the button above to save it to your profile.

Steve Collings explains the regulations relating to the going concern presumption and where it applies when conducting audits.

There has been a lot in the accounting press lately about the fundamental importance of the going concern presumption – so what is all the fuss about?

During times of economic difficulty, such as recession, an entity’s exposure to collapse is generally higher than in times of economic boom (the housing market is a prime example). If the directors of a company consider it appropriate to cease trading or liquidate the company, clearly the company will not be a going concern and the financial statements should not be prepared on a going concern basis. Instead, ‘break up’ values should be used – this concept is emphasised in FRS 21 ‘Events After the Balance Sheet Date’ at paragraph 14, which states:

‘An entity shall not prepare its financial statements on a going concern basis if management determines after the balance sheet date either that it intends to liquidate the entity or to cease trading or that it has no realistic alternative but to do so.’

Break up values cannot generally be used for an entity where the going concern basis is appropriate because such values ordinarily do not give relevant information to users who are seeking to assess the entity’s financial performance.

Responsibilities
ISA 570 ‘Going Concern’ stipulates that the management of an entity is responsible for assessing going concern which will involve making judgements concerning the future outcome of events or conditions which, at the time of assessing the going concern of an entity, are uncertain.

The auditor’s responsibility is to consider the appropriateness of management’s assessment that the going concern basis is applicable in the circumstances. In particular, the auditor must consider whether there are material uncertainties which may cast doubt on an entity’s ability to continue trading as a going concern for the foreseeable future. In many cases the auditor will consider the going concern presumption appropriate to an entity’s particular circumstances and no reference to going concern uncertainty will be made in the financial statements. This does not, however, guarantee that the entity is a going concern and should not be viewed as such.

Period of assessment
ISA 570 (UK and Ireland) requires management to make an assessment of going concern by looking forward at least 12 months from the date of approval of the financial statements. If management has used a period of less than 12 months from the date of approval, but has not disclosed that fact, the auditor should do so in their report. Confusion often surrounds this area because directors often assume that the period of assessment is 12 months from the balance sheet date.

Risk assessment
The auditor must consider whether there are any events or conditions, together with related business risks, which may cast significant doubt on an entity’s ability to continue to trade for the foreseeable future. Where the auditor identifies such uncertainties, the auditor must consider the effect such uncertainties have on the risk of material misstatement.

Figure 1
Company A operates in the waste disposal industry and the auditor of Company A is planning the audit of the financial statements for the year ended 31 March 2010. On 23 July 2010 legal proceedings were brought against Company A for the illegal dumping of toxic waste. Discussions with the directors confirm that the company is guilty of the offence and at present the legal advisors are unable to quantify the level of fines and penalties Company A may have to pay (though fines for the illegal dumping of such waste are known to be substantial). Company A is already suffering the effects of the recent recession with the loss of some key customers and as a result, cash flow has been tight.

In this illustration, the auditor has come across a situation where the effects of the company’s actions (the illegal dumping of toxic waste) is likely to have an effect on the company’s ability to continue to trade as a going concern.

Evaluating management’s assessment
Under ISA 570 (UK and Ireland), the auditor must evaluate management’s assessment that the going concern presumption is appropriate. In evaluating management’s assessment, the auditor is also required to ensure that any disclosures made in the financial statements relating to going concern (if any) enable the financial statements to give a true and fair view.

The amount of work required in assessing going concern will largely depend on the nature, size and complexity of the entity. For a larger and more complex entity more work will be undertaken to establish the appropriateness of the going concern basis than that of a small, owner-managed company with relatively simple internal controls.

In evaluating management’s assessment, the auditor must:

  • Consider whether the assessment period is reasonable in the entity’s circumstances.
  • Evaluate the systems in place which will warn management of future uncertainties.
  • Ascertain whether the entity is able to pay its creditors on the due dates.
  • Establish if the entity is trading at, or is in excess of, its agreed overdraft facility.
  • Establish if there are any major debt repayments becoming due for payment and if so, are funds readily available to meet the repayment?
  • Establish if the entity has experienced significant trading or other losses which are likely to continue for the foreseeable future.
  • Review cash flow forecasts/budgets covering a period of twelve months from the expected date of approval of the financial statements. Particular attention must be paid to the assumptions used in forecasted information as well as how sensitive such information is to changes in those assumptions and the systems used in making those assumptions.
  • Review minutes of meetings to identify issues beyond the balance sheet date which might indicate going concern problems.
  • Establish the likelihood of borrowing facilities being renewed.
  • Discuss the future plans for the entity with management.
  • Review any available management accounts or management information after the balance sheet date. If cash flow forecasts or budgets have been used, establish if the actual results after the balance sheet date are in line with the forecasts or budgets.

Reporting
The objective in ISA 570 (UK and Ireland) is for the auditor to gather sufficient and appropriate audit evidence to determine, on the basis of that evidence, whether a material uncertainty exists. The auditor must look at all events and conditions and consider whether such events and conditions, on their own, or when aggregated, would cast doubt on the entity’s ability to continue as a going concern. Where the auditor has concerns about the entity’s ability to continue as a going concern, the auditor should document the extent of those concerns.

If management have included disclosures relating to going concern within the financial statements, the auditor must consider the appropriateness of those disclosures insofar as giving a true and fair view. The auditor must also consider whether additional disclosures are required in order to give a true and fair view.

If the auditor concludes that the going concern presumption is appropriate, but material uncertainty exists, the auditor is required to consider whether the financial statements make adequate disclosure of the principal events or conditions giving rise to the material uncertainty. If the financial statements do make adequate disclosure, the auditor can express an unqualified audit opinion but include an emphasis of matter paragraph which will highlight the material uncertainty which may cast significant doubt on the entity’s ability to continue as a going concern.

Figure 2
Company A has incurred a loss in the year to 31 December 2010 amounting to £100,000 which results in the company’s current liabilities exceeding its gross assets by £45,000. Company A does not have any long-term liabilities. Management has deemed the entity to be a going concern and has made sufficient disclosures concerning going concern in order to give a true and fair view.

The auditor will include an emphasis of matter paragraph which can be illustrated as follows:

Without qualifying our opinion, we draw your attention to Note X in the financial statements which indicates the company has incurred a net loss of £100,000 in the year to 31 December 2010. As at that date, the company’s current liabilities exceeded its total assets by £45,000. These conditions, along with other matters detailed in Note X, indicate a material uncertainty which may cast significant doubt about the company’s ability to continue to trade on a going concern basis.

If the auditor concludes that the going concern presumption is inappropriate but management have prepared the financial statements on a going concern basis, the auditor must express an adverse opinion.

Figure 3
Company A has incurred a significant loss in the year to 31 March 2010 amounting to £100,000. On that date, Company A’s bankers confirmed that they would not be renewing the overdraft facilities and have called-in the overdraft amounting to £300,000. Company A has been unable to secure funding and is considering the option to liquidate the company. The directors of Company A have made no disclosure concerning the material uncertainties and have refused to make such disclosure or accept that the going concern basis is inappropriate despite them considering the option to liquidate the company.

In this instance, the auditor must express an adverse opinion which can be illustrated as follows:

The company’s bank overdraft as at 31 March 2010 was £300,000 and the company has been unsuccessful in re-negotiating the terms of this overdraft or seeking replacement finance. These events indicate a material uncertainty on the company’s ability to continue as a going concern as it may not be able to realise its assets and discharge its liabilities in the normal course of business. The financial statements, and the notes to the financial statements, do not disclose this fact.

Opinion
In our opinion, because of the omission of the relevant disclosures mentioned in the preceding paragraph, the financial statements do not give a true and fair view of the financial position of the company as at 31 March 2010, and of its results of operations and its cash flows for the year then ended in accordance with United Kingdom Generally Accepted Accounting Practice and do not comply with the Companies Act 2006.

Limitation on scope
The auditor must consider the need to qualify their opinion as a result of a limitation on scope in circumstances where management is unwilling to make or extend its assessment of going concern. This is because it is not the auditor’s responsibility to make an assessment of going concern – this responsibility rests with management. In situations where management has made an assessment which is less than one year from the expected date of approval of the financial statements, or it has not made an assessment at all, the auditor may not be able to gather sufficient and appropriate audit evidence to determine the appropriateness of the going concern presumption.

ISA 570 recognises that there may be very rare circumstances when an entity will prepare its financial statements on a basis other than a going concern basis because those charged with governance consider the alternative basis will give a true and fair view. In such situations the auditor will not qualify their report if they consider the alternative basis is appropriate in the specific circumstances and the relevant disclosures necessary to give a true and fair view have been made.

Steve Collings is the audit and technical director at Leavitt Walmsley Associates Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’ and lectures on financial reporting and auditing issues.

 

Tags:

Replies (0)

Please login or register to join the discussion.

There are currently no replies, be the first to post a reply.