One of the fundamental assumptions on which the general-purpose financial statements are prepared is ‘Going Concern'. Whether the business will continue or not in the foreseeable future determines the valuation of assets and liabilities between historical/fair value or liquidation value. Though the financial statements indicate the financial position as of a day and performance over the financial period, the stakeholders are interested to know what beholds the future. Whether the business is going to sustain or not? No business would agree that the end would near, there is always optimism that business will improve and grow. But then when there are challenges that are to be faced viz., currently the Pandemic, or obsolescence of technology, regulatory bans etc., there could be a setback for short time and business have, at times, learnt the art of survival through innovation and realignment to the market forces. However, other business had to shut down permanently. Shutting down of a business is a serious thing, considering job losses, regulatory compliance, asset disposal, etc.
Role of the Management
Management is responsible for preparation of the financial statements and hence it is also responsible for assessing the entity's ability to continue as a going concern and whether the use of going concern basis is appropriate to the circumstances. The assessment depends on the nature of business, economic environment, regulatory requirements and other factors. Some of the examples, could be due to Covid the most affected industries were Hotel, Tourism, Travel, Entertainment and many of the institutions had to close down considering uncertainty of future. There could be other circumstances where there are regulatory issues like banning a particular food product threatening the existence of the entity manufacturing it, or end of a license period beyond which the government would not extend it would affect companies in mining, telecom etc., Therefore, the financial reporting requirements explicitly require management to mention that the financial statements are prepared on going concern basis.
Role of the Auditor
Auditor's responsibilities are to obtain sufficient appropriate audit evidence regarding and conclude on, the appropriateness of management use of the going concern basis of accounting. Further, where there is a material uncertainty, the auditor is expected to report the same in a separate paragraph in the audit report. SA 570 deals with Going Concern. Typically, the management's assessment would for twelve months from the reporting date, but the auditor is expected to inquire even beyond the management's assessment that may cast significant doubt in the entity's ability to continue as a going concern.
Indicators that may cast significant doubt on the entity's ability to continue as a going concern (illustrative)
- Unfavorable financial conditions like - erosion of net worth, negative operating cash flows, reduction or absence of financial support, working capital issues, non-availability of financing.,
- Operational issues like loss of a key managerial person who was the reason for the success of the organization, loss of market share due to competition, logistic issues like non-supply from vendor, low returns, loss of critical assets, labor problems, loss of market, competition, etc.,
- Regulatory issues (Example, Govt. banning a particular food product, in case of race course the government did not extend the lease agreement of the land, or in case of a hotel the lease agreement was not extended, or significant changes in compliance requirements which is beyond the ability of the entity to manage.
- Other factors like catastrophes, example Covid pandemic.
Audit Procedures (in the order of SA - classified on the chapters of SA)
1. General Principles and Responsibilities (SA 200 to SA 299): One of the inherent limitations is the auditor's ability to detect material misstatements especially those on-going concern issues. Therefore, it is important for the auditor to ensure that the review of management's appropriateness use of the going concern is included in the audit planning and also included in the terms of audit engagement. The above assessment also requires to be sufficiently and appropriately documented with a detailed note Also important to consider the various laws and regulations which have a significant bearing, the non-compliance of which could trigger the continuity of business. Where the Auditor disagrees or concludes that Going Concern is not appropriate then it is the duty to communicate with those charged with governance and obtain their views and consider them in reporting. In case of joint audits, though the division of work is permitted, in my view, the assessment of going concern should be done as an entity as a whole. Any differences between the auditors needs to be settled by mutual discussions and if not, each auditor is entitled to issue a separate report on their respective conclusions.
2. Risk Assessment and Response to Assessed Risks (SA 315 to SA 450): Risk assessment is the most important part of audit procedure. The Risk Assessment requires auditors, in this context of going concern, should assess the risk of the ability of the entity to be a going concern considering their business, economic environment, operations and other financial issues. Depending on the outcome of the risk assessment, the auditor will decide on appropriate use of testing of controls and use of substantive or analytical procedures.
3. Audit Evidence (SA 500 to SA 599): Audit evidence is the proof of the auditor have concluded based on certain inputs which is validated. SA 570 in great details lay out the specific audit procedures in relation to Going Concern and reporting aspects. Whether it is in analytical procedures (indicating adverse financial or operation condition) or in assessing accounting estimates (aggressive accounting estimates and write offs) or subsequent events (any of the business conditions which could be an adjusting or non-adjusting event threatening the existence of the entity) etc., auditor should consider the possibility of going concern issues in result of applying these procedures. Further, also obtain written representation where essential and mandated.
4. Audit Reporting: (SA 700 - SA 701 read with SA 570):
- Where an entity has given sufficient disclosures on events or conditions leading to material uncertainty of a going concern and the auditor is satisfied with such disclosures (after having gathered enough audit evidence and following other audit procedures) include a paragraph ‘Material Uncertainty Related to Going Concern' in the audit report.
- If adequate disclosure is not made on material uncertainty, the auditor shall express a qualified or adverse opinion as the case may be.
- Where the Going Concern basis is inappropriate, auditor to express an adverse opinion.
Challenges in evaluating Going Concern
Some of the challenges or risks that auditor needs to consider in evaluating going concern:
- Management's inability to conclude considering volatile business condition;
- Start-up where the business model is completely new and there is no history of any other entity in similar business and there would be losses in the initial years and there is uncertainty of future viability;
- Prior period accounting issues that could now raise the question of going concern and it's impact on the previous audit report
- Counterparty credit risk
- Contingent liabilities actually materializing.
- Corporate governance failures.
Of course, the above is just a synopsis of the auditor's duties and responsibilities. Auditor's responsibilities have been increasing everyday and it is imperative for the auditor to be abreast of the client's business environment.
The author, Aditya Kumar S is a qualified Chartered accountant with 20+ years of experience in his field. He carries immense knowledge in his areas of expertise and interest, namely statutory audit, internal audit and SOX audit gained through numerous and varied client assignments he has dealt with. He is a partner in South India's well known mid-size firm.