IAS 1 Presentation of Financial Statements recognizes the going concern assumption as one of the fundamental assumptions that underlie the periodic financial statements of enterprises. The meaning of going concern can be said to be that the financial statements assume that the enterprise will continue in operational existence for the foreseeable future, or put another way the financial statements assume no intention or necessity to liquidate or curtail significantly the scale of operation or put more simply that the enterprise can meet its financial obligations as they fall due. The going concern idea is very well established in accounting and there is an authoritative document, ISA 570 Going Concern, The student is advised to read it in detail. The points to note however are:
i. The importance of the principle
ii. The auditor's duty
iii. Indications of the inapplicability of the principle
iv. Counter indications
v. Audit procedures
vi. The impact on audit reports in practice.
The importance of the principle:
We will probably understand better how important this principle is if we consider the implications of abandoning it. The effects of abandoning the principle include among others the following:
a) Fixed assets would need to be valued at realisable values and not depreciated cost.
b) Fixed assets would have to be classified as current assets as they would have no future benefits to the organization.
c) Stock would have to be regarded at lower of cost or forced sale net realisable value.
d) Prepayments and intangible assets may have no future benefits.
e) New liabilities may appear such as redundancy pay, leave pay and closure costs.
f) Long-term liabilities may crystallize and become immediately payable hence they cannot be classified as long-term liabilities.
g) The departure from the assumption, the reasons for this departure and its effect need to be explained in the accounts in accordance with IAS 1.
The auditor's duty
The auditor has a duty to express an opinion on the truth and fairness and compliance with legislation, of the accounts. The valuation basis adopted in preparing the accounts assumes that the company is a going concern in accordance with IAS 1. Therefore, for the auditor to form an opinion he should consider whether he has reasonable grounds for accepting the applicability of the going concern assumption. It follows therefore; he must carry out sufficient work to ensure that this assumption is justified. He therefore looks for evidence that the company is likely to continue trading for at least the next 12 months from the balance sheet date or 6 months from the date of the audit report or more practically, he looks for evidence that there is no indication to the contrary. He must however take account of significant events which are likely to occur even later.
In the event that the auditor considers that the company is not a going concern, he should advise the directors accordingly and ensure that the accounts are prepared on a market value or a break-up basis. If the directors refuse to comply then the auditor will have to qualify the accounts as a whole to the effect they are not true and fair. It is not possible for the auditor to rely on an assessment of the going concern position at the balance sheet date alone because the accounts usually only become public knowledge much later after the balance sheet date. It therefore becomes necessary to take into account events taking place after the year end and before the AGM which may affect the company as a going concern.
Indications of inapplicability of going concern
Insolvency, unfortunately, is a growth industry as the economy suffers a down turn and therefore for a majority of enterprises in Kenya, the abandonment of the going concern assumption is no longer a remote possibility. Consequently, on all audits the auditor must consider whether or not his client is a going concern. ISA 570 gives numerous indications of going concern inapplicability.
That the auditor has found indications of going concern non-applicability does not of itself justify immediate conclusion that the entity is not a going concern. He must also seek for counter-indications or mitigating factors. This may include the following:
a) Ability to raise cash by selling assets
b) Ability to obtain new sources of finance for example leasing, factoring debts, hiring plant.
c) Opportunities of rearranging debt repayments or conversion of long term debt into equity.
d) The possibility of a rights issue.
e) Support from other group companies or from associated companies.
f) The possibility of making alternative trading arrangements.
The auditors procedures
In forming an opinion on the going concern position of a company, the auditor should:
a) Investigate the company, its background, its plans for the future, review of cash flows and financing plans;
b) At every stage of the audit search for and evaluate evidence for and against the going concern applicability;
c) If he is in doubt, and the directors have formulated plans for the continuation of the company, he should evaluate these plans, ensuring that:
1. All parts of the plan are consistent with each other;
2. If the plans are contingent on the response of third parties then he should seek third parties written confirmations;
3. Ascertain that the plans are specific rather than general;
4. Review the supporting evidence for the plans if available for reasonableness;
5. Seriously consider any professional advice obtained by the directors;
6. Consider any potential support from other group companies by looking at any contractual obligations, directors intentions and the ability of the group company to give the support.
d) Consider whether he has sufficient evidence to form an opinion on the applicability of the going concern assumption.
In the vast majority of cases, the going concern assumption is appropriate and if applied no mention need be made in the auditor's report.
In rare incidences, notes to the accounts may make reference to the going concern assumption. This may include references to continued favourable trading or availability of finance. It may be that the going concern assumption is not in doubt, but for a full understanding of the accounts there is need for amplification of these notes. In such cases, the auditor may use an emphasis of matter which is not a qualification and is allowed in ISA 700
When the auditor has complete doubt about the going concern assumption he may be required to qualify his report and this is a highly charged area for the auditor because an expression in his audit report that a company is not a going concern may in itself bring about the closure of the company. The auditor should therefore:
a) Not refrain from expressing a qualified opinion even though this may lead to receivership or liquidation;
b) The auditor should consider materiality, if the adjustments required on abandoning the going concern assumption are not material, then no qualification should be given;
c) If the auditor concludes that there is doubt then he should consider the consequences for the figures in the accounts. For example, he should obtain an estimate of the necessary provision against stock or the redundancy payments.
In practice because of the difficulties involved in making adjustments to the accounts and producing them on a break up basis, accounts in most cases in Kenya are produced on the going concern assumption and qualified by the auditor on the grounds that the going concern assumption may not be appropriate.