GOING CONCERN

　　It is essential that candidates preparing for the Paper F8 exam understand the respective responsibilities of auditors and management regarding going concern. This article discusses these responsibilities, as well as the indicators that could highlight where an entity may not be a going concern, and the reporting aspects relating to going concern

　　Candidates attempting Paper F8, Audit and Assurance will need to have a sound understanding of the concept of going concern. Among other syllabus requirements, candidates must ensure they are aware of the respective responsibilities of auditors and management regarding going concern. The provisions in ISA 570, Going Concern deal with the auditor’s responsibilities in relation to management’s use of the going concern assumption in the preparation of the financial statements.

　　THE CONCEPT OF GOING CONCERN

　　An entity prepares financial statements on a going concern basis when, under the going concern assumption, the entity is viewed as continuing in business for the foreseeable future. The term ‘foreseeable future’ is not defined within ISA 570, but IAS 1, Presentation of Financial Statements deems the foreseeable future to be a period of 12 months from the entity’s reporting date.

　　The concept of going concern is an underlying assumption in the preparation of financial statements, hence it is assumed that the entity has neither the intention, nor the need, to liquidate or curtail materially the scale of its operations. If management conclude that the entity has no alternative but to liquidate or curtail materially the scale of its operations, the going concern basis cannot be used and the financial statements must be prepared on a different basis (such as the ‘break-up’ basis).

　　MANAGEMENT’S RESPONSIBILITY

　　The concept of going concern is particularly relevant in times of economic difficulties and in some situations management may determine that a profitable company may not be a going concern, for example because of significant cash flow difficulties. It is important that candidates understand that it is the responsibility of management to make an assessment of whether the going concern presumption is appropriate, or not, when they are preparing the financial statements. In order to conclude as to whether, or not, an entity is able to continue in business for the foreseeable future, management will have to make judgments on various uncertain future outcomes of events or conditions. ISA 570 outlines three factors that are relevant and which management must take into consideration when determining whether, or not, an entity can prepare the financial statements on the going concern basis:

　　 The degree of uncertainty associated with the outcome of an event or condition increases significantly the further into the future an event or condition or the outcome occurs. For that reason, most financial reporting frameworks that require

　　an explicit management assessment specify the period for which management is required to take into account all available information.

　　 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 affect the judgment regarding the outcome of events or conditions.

　　 Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events may result in outcomes that are inconsistent with judgments that were reasonable at the time they were made. (1)

　　Question 5(b) in the June 2010 exam (Medimade Co), for eight marks, required candidates to: ‘Identify any potential indicators that the company is not a going concern and describe why these could impact upon the ability of the company to continue trading on a going concern basis.’

　　The scenario presented to candidates gave an abundance of warning signals that management’s assessment of going concern may not be appropriate in the circumstances. These warnings signals were:

　　 a growth in the level of competition Medimade Co faces

　　 a significant decline in demand for its products

　　 failing to re-invest in new product development

　　 difficulties in recruiting suitably trained scientific staff

　　 an inability to agree suitable financing terms with the bank

　　 investing $2m in new plant and machinery using an overdraft (a short-term borrowing facility which carries higher rates of interest)

　　 delayed payments to suppliers with some suppliers withdrawing credit and insisting on cash on delivery, which further impacts the overdrawn balance at the bank

　　 cash flow forecast showing a significantly worsening position within the next 12 months.

　　In the Paper F8 exam, candidates must be able to identify factors that may have an impact on an entity’s ability to continue as a going concern. The factors present in Question 5 of the June 2010 exam are not exhaustive and there are many other indicators that an entity may not be a going concern, such as:

　　 inability to pay dividends to shareholders

　　 major losses or cash flow difficulties that have arisen since the reporting date

　　 adverse key financial ratios

　　 indications of withdrawal of financial support from the bank or other financial institutions

　　 negative operating cash flows

　　 major debt repayments falling due which the entity will not be able to meet

　　 pending legal or regulatory proceedings against the entity that may, if successful, result in claims that are unlikely to be satisfied

　　If there are any material uncertainties relating to the going concern assumption, then management must make adequate going concern disclosures in the financial statements.

　　AUDITOR’S RESPONSIBILITIES

　　As mentioned earlier, it is not the auditor’s responsibility to determine whether, or not, an entity can prepare its financial statements under the going concern presumption; this is the responsibility of management. The auditor’s responsibility under ISA 570 is to obtain sufficient appropriate audit evidence about the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements, and to conclude whether there is a material uncertainty about the entity’s ability to continue as a going concern.

　　In the June 2010 exam, question 5(c) required candidates to: ‘Explain the audit procedures that the auditor of Medimade should perform in assessing whether or not the company is a going concern.’

　　When faced with such a requirement, candidates must be careful not to produce a list of generic audit procedures, but instead identify and highlight the factors from the scenario that may call into question the entity’s ability to continue as a going concern. Once these factors have been identified, candidates should then be able to think about the procedures the auditor may adopt to establish whether the factors mean the going concern presumption is appropriate in the circumstances, or not.

　　In Question 5(c) of the June 2010 exam, if candidates simply wrote ‘Obtain confirmation from the bank that the overdraft facility will be renewed’ this will generate no marks for two reasons:

　　 The scenario clearly says that Medimade’s bankers will not make a decision on the overdraft facility until AFTER the audit report is completed.

　　 A bank, or other financial institution, is not going to give this sort of information directly to the auditor.

　　Candidates should generate the audit procedures specifically from information contained in the scenario to demonstrate application skills, and candidates should refer to the model answer in the June 2010 exam to make sure the procedures they have generated are specific to the scenario.

　　Many candidates fall into the trap of relying on ‘discussions with management/directors’ and ‘obtaining a written representation’. Candidates must appreciate that while discussion/inquiry is a valid audit procedure under ISA 500, Audit Evidence, such a procedure is always used in addition to other procedures – in other words, inquiry on its own will not generate sufficient appropriate audit evidence. Similarly ISA 580, Written Representations recognises that while written representations

　　do provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any of the matters with which they deal.

　　Other procedures that the auditor may adopt to establish whether the use of the going concern presumption is appropriate in an entity’s particular circumstances could be:

　　 Reading minutes of shareholders’ meetings to identify any current, or potential, cash flow difficulties.

　　 Liaising with the entity’s legal advisers concerning any ongoing litigation or future litigation and assessing the reasonableness of management’s assessments of their outcome and the estimate of their financial implications.

　　 Evaluating the entity’s plans to deal with unfulfilled customer orders.

　　 Obtaining and reviewing reports of regulatory actions.