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Small company financial reporting: going concern

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5th Mar 2009
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Steve Collings of Leavitt Walmsley Associates outlines the factors companies need to consider when deciding whether their accounts should be prepared on a going concern basis or not.

On 3 March 2009, the Financial Reporting Council (FRC) issued guidance for small company directors who adopt the Financial Reporting Standard for Smaller Entities (FRSSE)on how they decide whether the accounts they prepare should be prepared on a going concern basis or not, and if additional disclosure is required within the financial statements.

The guidance is a by-product of the current economic climate in which businesses (particularly small ones) are experiencing difficulties, especially where there is a lack of finance available.

The purpose of the guidance is to prompt directors of small companies to ask themselves whether the current climate and other economic difficulties has had any impact on the company’s affairs and whether the financial statements they are preparing would benefit from additional disclosure in order to give a true and fair view as required under the Companies Act.

True and fair
Directors of companies are required under the Companies Act 1985 and 2006 to prepare accounts which give a true and fair view. There are a significant number of companies who adopt FRSSE and choose not to have an audit; however this does not preclude the directors of such companies from preparing accounts which give a true and fair view under the Companies Act.

Going concern
The going concern assumption is a fundamental principle in preparing financial statements. Under this principle, a reporting entity is deemed to be a going concern for the foreseeable future if the directors do not intend to liquidate, cease trading or seek protection from creditors.

The directors of companies adopting FRSSE need to exercise a degree of judgement when assessing going concern. Such judgement will involve looking at certain aspects of the business which are inherently uncertain

In order to determine whether the entity is a going concern, FRSSE requires that the directors:

  • Assess whether there are factors which cast significant doubt on whether the entity can continue as a going concern.

  • Include disclosure notes within the financial statements concerning any material uncertainty of which the directors are aware of when making their assessment.

  • Where the period of their assessment is less than 12 months from the date of approval of the financial statements, disclosure of such within the financial statements is required.

Assessing going concern is not a new requirement issued by the ASB. In accordance with ISA 570 ‘going concern’, auditors of companies who report under FRSSE are required to perform audit procedures on the directors’ use of the going concern assumption.

The ASB have issued the guidance to highlight procedures that directors of companies who adopt the FRSSE may wish to implement. This will help them to determine whether the going concern basis of accounting is appropriate and outline any additional disclosures required in order for financial statements to give a true and fair view. The guidance is not absolute and circumstances will differ between companies, which will result in different methods being adopted to assess the appropriateness of the going concern basis.

Assessing going concern
Different companies will have different methods of assessing going concern, though it follows that a well managed company will be much more likely to secure any additional finance required to continue to trade than a company that is not well managed.

Consider the following examples:

Company A has produced its financial statements for the year ended 31 January 2009. The company has made a healthy profit for the financial year. Its cash reserves are very healthy and the company has no borrowing. It has a contract for services for the next three years with more contracts coming on board in the next 12 to 18 months. Current management information available suggests the company’s profits are to increase in the next two to five years and the company is on target to become the market leader in its field.

Company B has produced its financial statements for the year ended 31 January 2009. The company has sustained an unexpectedly high loss in the year (the first year in many). The loss was as a result of a major customer sourcing their products from a cheaper overseas supplier which Company B was not able to compete with. The company’s overdraft facility is nearing its limit and there is an arrangement to pay the previous year’s corporation tax liability with HMRC over a period of six months. There are currently three months left. The order book currently has approximately five months’ sales. Customers are taking longer to pay and suppliers are now reducing credit facilities.

Company A going concern

In assessing going concern, directors need to satisfy themselves that there are reasonable grounds for them to conclude that the company will not cease to trade within twelve months from the date of approving the financial statements.

The directors of Company A will need to establish whether there are any uncertainties which may cast doubt on their ability to continue to trade in the twelve months after the approval of the financial statements, though the analysis of such in relation to Company A does not have to be as significant as Company B.

Company B going concern

This company has sustained a loss for the financial year due to the loss of a major customer. The directors need to consider how the loss of this major customer will have on their ability to continue to trade in the twelve months following approval of the financial statements. In addition, the company has entered into an arrangement to pay their corporation tax as the overdraft is nearing its limit and the order book is only showing sales of approximately five months. Clearly there are cash flow difficulties which may well become more serious given that customers are taking more time to pay and suppliers are demanding less time.

Company B will therefore need to conduct much more analysis into whether to use the going concern basis of accounting from the information they have available to them (e.g. forecasts/budgets/credit terms/banking facilities etc.) and then document their decision if they decide that the going concern basis is appropriate.

If, however, the directors of Company B decide that there are material uncertainties of such significance that they have no other course of action available to them but to cease to trade, then the going concern basis must not be adopted.

Once the directors have concluded that the going concern basis is not appropriate in the circumstances, then the next step for the directors is to then assess the need for disclosures within the financial statements concerning the material uncertainties regarding the company’s ability to continue as a going concern.

Company B’s directors should also ensure that such a disclosure note is included in the abbreviated financial statements which are lodged with the Registrar of Companies.

Factors to Consider in assessing going concern
Some key factors to consider when assessing going concern are:

  • Reviewing borrowing facilities: are they coming up for renewal? Will they be renewed?
  • Review budgets and forecasts to see if (and when) there are going to be any adverse changes in income and costs and what action should be taken. Directors should also take into account any large cash outflows due out in the immediate future (for example a large corporation tax payment). Could arrangements to pay be implemented at HMRC to assist cash flow? Note, such budgets and forecasts should be prepared for a period of twelve months from the date of approval of the financial statements. Some companies might choose to prepare such budgets and forecasts for a period longer than 12 months or have ‘rolling’ budgets.
  • Review credit terms granted by suppliers and consider whether these terms are going to be subject to an adverse change.
  • Review any key terms which are present in any banking or other credit facilities.

Factors which may cast doubt on going concern:

  • Net liability or net current liability position in the balance sheet.
  • Withdrawal of credit or finance facilities.
  • Adverse key financial ratios.
  • Inability to pay creditors on the due dates.
  • Insistence of ‘cash on delivery’ or ‘pro-forma’ basis from suppliers.
  • Loss of a major licence, franchise or key customer/supplier.
  • Loss of key members of staff.
  • Technical obsolescence of a major product.
  • Large operating losses or significant deterioration in the value of assets used to generate cash flows.

Conclusion
The guidance issued by the APB should be tailored to each individual company’s specific circumstances and facts. Indeed, each company will have a different method of assessing their going concern and some companies may have to do significantly less analysis of their going concern than others.

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