Current economic conditions demand a greater focus and fresh approach to auditing the going concern assumption

A declining economy as a result of a credit crisis and a looming recession provide a whole new playing field for doing business. These dynamic conditions, characterised by uncertainty and turbulence, also poses a most challenging task for auditors – assessing the appropriateness of management’s use of the going concern assumption and gathering sufficient appropriate audit evidence to support that assessment.

Remember the basics

Financial statements are prepared on the going concern basis if the entity can continue in business for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors. The entity’s assets and liabilities are recorded on the basis that the assets will be realised and liabilities discharged in the normal course of business.

One important point stands out of the above – “the foreseeable future”. What time period must be considered when assessing going concern? This is significant and requires clarity if one considers the state of flux the economy is under with every expert venturing an opinion as to when we can expect a turnaround, but no real consistency in any predictions. IAS 1 requires that all available information for a period of at least, but not limited to, twelve months from the balance sheet date must be considered.

The going concern assumption is ultimately management’s responsibility. The auditor’s responsibility lies in assessing the appropriateness of management’s use of the going concern assumption and adequate disclosure of any uncertainty that could cast doubt on the entity’s ability to continue trading as a going concern. This is a requirement for every audit, regardless of prevailing economic conditions.

The problem at hand

In assessing the entity’s ability to continue operating as a going concern management must consider all relevant information available, including but not limited to budgets, access to finance, terms of loan agreements, industry and economic conditions, etc. Ultimately the use of the going concern assumption will be based on management’s judgement of future events. It is impossible to predict the future with any kind of absolute certainty without making certain judgements on the most likely outcome of key events. There is also the emotional interest that could unintentionally influence management’s judgement. Management have a vested interest in the entity’s future prospects and would like to present a positive outlook.

The auditor must take into consideration all information management has made use of and also evaluate the underlying assumptions and conclusions drawn. The auditor should consider the skills, expertise and level of management involvement applied in the preparation of the information used to base judgement on. The auditor is not limited to evidence obtained from information management has used only. Evidence obtained throughout the audit and from audit procedures must also be used to support management’s assessment.

Although not applicable to every entity in every since a slow-down in economic activity does not hit everyone equally, the current economic conditions does increase audit risk with regards to the going concern assumption. This increased risk will naturally require the auditor to look deeper into the factors that have a bearing on the going concern assumption. Audit procedures must be designed to also investigate the effect of factors such as macro-economic conditions, strength of management, government’s plans for the industry, business plans, and strategy. Banks’ reluctance to grant credit as easily as they would have a year ago will also impact on the entity’s ability to outlast difficult trading conditions. The factors therefore are quite wide-ranging and broad.

Small and owner-managed entities

These entities are likely to be the hardest hit by a recession, particularly if they supply larger entities that are also struggling. Management’s going concern assessment is also likely to be less formal and certainly not as well documented as larger entities with formal board structures. However, the auditor should not be quick to judge the process followed by management in assessing going concern to be weak or flawed. Consider what is at risk, these owners rely on their business to feed their families and support their lifestyles. Any threat to their livelihood will be taken very seriously.

The lack of formality in the processes followed by management poses a challenge to the auditor who requires audit evidence. The auditor should look for reliable evidence of future plans and how management have reacted to the changing economic conditions, e.g. have budgets and cash flow forecasts been revised to account for the changing conditions, have plans to expand been revisited, does major changes in operations such as cutting advertising and over ordering suggest knee-jerk reactions by management. Cash flow problems and access to credit are possibly the greatest threats to these entities.

A fresh approach

From a practical perspective, what is the auditor looking for exactly? How can the auditor guide his audit team and overcome these difficulties? Consider the following guidelines.

• The business model – how rigid is the business model? Is it flexible enough to sustain a major decline in sales? Is there reliance on key services or products for which demand is on the decline? How sensitive is the entity to market conditions?
• Reliance on key suppliers or customers – Is the supply chain stable? Is there a single supplier or customer up or down the supply chain that has the ability to put other entities in the supply chain out of business?
• Reliance on a particular event in the future – Have management based their assessment on the specific outcome of a particular event in the future (e.g. securing a contract, selling a business unit), failing which the entity cannot otherwise be considered a going concern?
• Shareholder/group support – Look beyond simple proof of this support, consideration must be given to the shareholder/group’s actual ability to provide that support if needed. What is the likelihood of the entity needing this support in the foreseeable future?
• Loan agreements – Read the fine print, obscure clauses that may have been considered harmless under thriving economic conditions when the agreement was first signed may well prove to be a going concern threat under current conditions. Pay particular attention to loans that have been subordinated or are due on demand. Will the entity be able to satisfy this condition in the foreseeable future?
• Liquidity and access to credit – Annual facility renewal should not be depended on as there is no guarantee that banks will renew funding merely because they have done so in the past. How dependant is the entity on renewal or extension of these facilities? What is the bank saying? Keep in mind that a profitable entity with a steady market share can still run into problems if it does not have the cash flow to support operations.
• Management’s plans – Management are likely to have identified and made provisional plans to address any threats to the going concern assumption for operational reasons. Can those plans be implemented in practice and what is the likelihood of them achieving the desired results?

While this is not an exhaustive list of factors that must be considered, it does illustrate the need for auditors to think more broadly beyond what was simply done last year. In many ways, the auditor needs to wipe the slate clean and consider going concern for every entity from a fresh start.

Disclosure will be critical

The auditor must conclude on management’s use of the going concern assumption and all related disclosure. If a material uncertainty exists that casts doubt about going concern, the auditor needs to evaluate the adequacy of disclosure of the details of the uncertainty in the financial statements. How much of detail should be disclosed is debateable. Entities will be cautious of not wanting to give away too much information to competitors.

The auditor can find guidance in ISA 570 which prescribes minimum disclosure requirements under such circumstances. If the auditor concludes that a material uncertainty does exist even though the use of the going concern assumption is appropriate, ISA 570 requires an emphasis of matter paragraph to be included in the audit report.

Covered all the bases?

Apart from the increased risk of uncertainty regarding appropriate use of the going concern assumption, current economic conditions will have a pervasive effect on audit risk. Auditing valuation and impairment of assets and assets held for sale will pose its own challenges. Incidents of petty fraud and theft will be on the rise, as cost cutting initiatives could result in a weakened control environment. Perhaps the more serious matter is possible manipulation of results by management. One thing is for certain, prevalence of these factors only serve to increase audit risk which means more audit work and higher audit costs. In times when all are trying to limit costs this will not be well received by entities. The auditor needs to be conscious of any pricing pressure from clients and ensure that it does not threaten the quality of the audit work performed. There is of course the other extreme and possibly the lesser of the two evils, the risk of over auditing.

Assessment of the going concern assumption should be considered from the early stages of the audit to ensure that the effect on the financial statements can be evaluated and addressed in the audit plan from the start of the audit. This will also contribute to audit efficiency and limit audit fee increases, something every entity would appreciate of their auditors.

21 July 2009