Going concern assumption is one of the 3 fundamental accounting assumptions whose appropriateness is assumed in the preparation of financial statements.
It describes the assumption that it is assumed that the entity will continue in operational existence for the foreseeable future or the financial statements assume that there is no intention nor necessity to liquidate or significantly curtail the scale of operations; or put more simply - the entity can meet its financial obligations as they fall due.
The importance of the assumption
If the going concern assumption was to be abandoned some of the following implications for the financial statements would become apparent:
- Fixed assets: Fixed Assets are classified as fixed assets therefore they have a future benefit to the organisation. If therefore the organisation is not a going concern, then there is no such future benefit. Fixed assets (FA) would have to be classified therefore as current assets (CA). FA are valued for accounts purposes at depreciated cost values which values may have no relationship to the market value of those assets. If the entity isn’t a going concern, FA would have to be valued at realisable amounts.
- Prepayments & Intangibles: If the organisation ceases to be a going concern, some prepayments and intangible assets cease to exist and to have any value.
- Long term liabilities crystalise and become immediately payable meaning that they become current liabilities.
- New liabilities may appear requiring to be recognised such as closure costs, redundancies or even leave pay.
- If a fundamental accounting assumption is departed from then the departure must be explained and justified in a note to the accounts and must also be referred to in the Auditors Report.
The Auditor’s duty
Because management will assume the appropriateness of the going concern assumption while preparing the financial statements, the auditor must obtain sufficient evidence that management application of the going concern assumption was justified.
Should the auditor conclude that the assumption was not appropriate to the circumstances of the entity then he must advice the management to prepare the accounts on other than a going concern basis and should the management refuse to do so, then the auditor should consider qualifying his audit report.
The indications or risk that continuance as a going concern may be questionable could come from financial statements or from other sources
- Liabilities are more than the assets of the company.
- Borrowings with fixed repayment dates approaching maturity without realistic prospects of renewal or repayment, or excessive reliance on short-term borrowings to finance long-term projects undertaken by the company.
- Adverse key financial ratios e.g. current ratio below one;
- Substantial operating losses.
- Inability to pay creditors on due dates.
- Difficulty in complying with terms of loan agreements e.g. failure to pay interest and principal on due dates.
- Change from credit to cash on delivery transactions with suppliers.
- Loss of key management without replacement.
- Loss of major market or customer.
- Labor difficulties or shortage.
- Non compliance with capital or other statutory requirements. This could lead to the company being wound up under the law.
- Pending legal cases against the entity that may, if successful result in judgements that could not be met.
- Changes in legislation or government policy that adversely affects the client’s business.
Indicators that the going concern assumption is questionable might be mitigated or countered by other factors. E.g. the effect of a company being unable to repay its loans may be countered by plans by management to dispose of some of the assets to raise money for settling the loan. The auditor should consider the effects of these steps taken by management and evaluate whether the company is a going concern or not.
Example of some of the steps management might undertake to save the company from being liquidated (mitigating factors)
- Selling of some of the company’s fixed assets with the aim of raising money to retire some of the loans falling due.
- Borrowing money to settle some of the loans and other debts falling due. e.g. a company can obtain a loan from the bank to retire debentures falling due.
- Restructuring debt. This may involve rescheduling the repayment date or converting debt into equity.
- Reducing ordinary expenditure. The company can suspend planned expenditures such as the acquisition of new production plants.
- Requesting shareholders to inject more capital into the company.
The Auditor’s Procedures
When a question arises regarding the appropriateness of the going concern assumption, the auditor should gather sufficient appropriate audit evidence to attempt to resolve to the auditor’s satisfaction the question regarding the entity’s ability to continue in operation in the foreseeable future.
Procedures that an auditor carries out when the going concern assumption is questionable include:
- Analysing the company’s cash flows, profits and other forecasts and hold discussions with management to determine how the company’s future looks like.
- Reviewing events after the balance sheet date for items affecting the entity’s ability to continue as a going concern e.g. If the company’s year end is on 31 December and a loan was repayable on 15 January the following year, the auditor should consider whether the company has been able to repay the loan and if not what measures have been undertaken.
- Review the terms of debenture and loan agreements and determine whether they have been breached. Breach of loan contracts could lead the company to receivership or liquidation.
- Read minutes of meetings of directors and shareholders for reference to factors that could lead to the collapse of the company. If the company is facing liquidity problems this will ordinarily feature in the board meetings.
- Inquire from the company’s lawyers regarding any legal suits against the company. Instances where the company’s existence is threatened by the potential effects arising from legal claims against the company, the auditor should consult the client’s lawyers and establish the potential effect.
- The auditor should also consider and discuss with management its plans for the future such as plans to liquidate assets borrow money or restructure debt or delay expenditures or increase capital.
When the auditor concludes that the going concern assumption is not appropriate to the circumstances of the entity he must discuss this with management and review any plans management have to keep the company as a going concern. These plans should be Specific and if dependent on third party support then the auditor should obtain written confirmation from that third party.
Letters of Support
There are occasions when an entity on the face of its balance sheet is insolvent and accordingly the going concern assumption would be inappropriate. There may however be shareholders, directors or other creditors prepared to provide support to keep the entity as a going concern. Should that be the case the auditor should obtain through the management written letters from these parties. These letters are ordinarily called letters of support
Implications for the Auditors Report
If the auditor is satisfied that the going concern assumption was appropriate to the circumstances of the entity, there is no need to mention that fact in his audit report.
If the appropriateness of the going concern assumption is dependent on the outcome of a future event such as negotiations to obtain new financing, then the auditor may refer to this as an emphasis of matter.
When the auditor is convinced that the entity is not a going concern and management have prepared the financial statements on the going concern assumption; then the auditor should:
- Consider the materiality of the adjustments that would be necessary to bring the accounts to other than a going concern basis and if not material, then the need to mention it in his audit report.
- If the adjustments would be material, then the auditor should mention the financial effect and qualify his audit report.
PLEASE NOTE THAT: It is possible that a qualified report, (that the entity is not a going concern) could hasten the death of the company. The auditor should not refrain from qualifying his report even if it leads to the loss of a client or death of a company.]