Nov

Guidance on going concern for companies

Posted by Steve Collings

Going concern has moved up the ranks in the profession over recent years, due in large part to the recent economic crisis – indeed even the most profitable companies can see themselves in financial difficulty due to cash flow constraints or in the worst cases the reporting of profits which are not cash-backed to mislead users into thinking the entity’s financial position and performance is better than it actually is.

One of the most fundamental (and material) issues in companies both large and small is the concept of going concern. Going concern can never be said to be immaterial and it is the duty of all companies to ensure that the going concern basis of preparing financial statements is applicable in the individual circumstances. While the concept of going concern is a fundamental concept, it is still one that often causes a certain element of confusion among practitioners – particularly when it comes to the disclosure requirements. In the past companies have been severely criticised for inadequate disclosures (as have audit firms who have audited such companies) and as a consequence, professional regulators have issued various amounts of guidance regarding the issue of going concern.

Under current UK GAAP (FRS 18 Accounting Policies and the FRSSE (effective April 2008 and January 2015) and EU-adopted IFRS), it is the responsibility of the directors of companies to satisfy themselves that the use of the going concern basis of accounting is reasonable so as to conclude that the financial statements give a true and fair view. Where there are ‘material uncertainties’ relating to the entity’s going concern status, then there should be additional disclosures made in the accounts.

Under the going concern concept, it is assumed that a company will continue in operation for the foreseeable future and that there is neither the intention, nor the need, to either liquidate it or to cease trading.

Guidance on going concern assessments and disclosures

In October 2009, the Financial Reporting Council (FRC) issued a document titled ‘Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009’. Whilst this document was issued some five years ago, it still has particular relevance today.

The guidance itself brings together the requirements of the Companies Act 2006, accounting standards and the Listing Rules on going concern and liquidity risk for small, medium and large companies as well as providing guidance on their application.

The document itself is fairly brief, spanning at just 26 pages, and deals with three principles in dealing with going concern:

Assessing going concern
The review period
Disclosures

The Appendices then offer examples of going concern disclosures in certain situations as well as key questions for boards.

The guidance applies to accounting periods ending on or after 31 December 2009 and superseded the guidance which was issued in 1994 for directors of listed companies. The 2009 version of the guidance extends to all sizes of companies for both annual and half-yearly financial statements.

Assessing going concern

The first principle in the guidance deals with the assessment of going concern. Principle 1 says:

Directors should make and document a rigorous assessment of whether the company is a going concern when preparing annual and half-yearly financial statements. The process carried out by directors should be proportionate in nature and depth depending upon the size, level of financial risk and complexity of the company and its operations.

There is no ‘one-size-fits-all’ where the assessment of going concern is concerned and directors of all companies are required to make a going concern assessment. The directors of a company cannot use the going concern basis of accounting if they intend to cease trading, or go into liquidation or they have no realistic alternative but to do so. In such cases this will mean change of basis in preparing the financial statements which will have an impact in the carrying amounts of assets and liabilities recognised in the financial statements.

Example – going concern basis not appropriate

Company A has lost a large contract in the year to 30 November 2014. In addition, the company’s bankers have also expressed their unwillingness to continue to support the company and have ‘called in’ both the bank loan and overdraft. The loan and overdraft in combination are significant and the directors have been unsuccessful in negotiating refinancing with other banks and finance houses. The directors have concluded that they have no realistic alternative but to place the company into liquidation and cease trading.

Clearly in this scenario the going concern basis of preparing the financial statements as at 30 November 2014 will not be appropriate and in such cases the ‘break-up’ basis of accounting is used. Under this basis fixed assets will be reclassified to current at their expected realisable value. Long-term liabilities will be reclassified to current and additional disclosures will be made within the financial statements to explain that the company is not regarded as a going concern and to explain the basis on which the financial statements have been prepared.

The guidance issued by the FRC acknowledge that small companies must still have regard to the going concern status of the entity. However, the extent of the directors’ review process will depend on both the nature and size of the company as well as the complexity of the business. In reality, assessing going concern in a smaller enterprise is likely to be much simpler than that for medium-sized and large companies as small companies tend only to have one business activity and a limited number of creditors and providers of finance. Notwithstanding this simplicity, the directors’ must still document and address, to the extent necessary, their plans to manage the company’s borrowing requirements, cash flow timings and the company’s exposure to contingent liabilities.

Example – going concern assessment in a subsidiary

Company B is a subsidiary company and has a year-end of 30 November each year. The directors of Company B are not planning on making any going concern assessments in the belief that this is the responsibility of the parent company.

The directors of Company B are incorrect in their belief that the going concern assessment of a subsidiary is the responsibility of the parent company. The guidance confirms that directors of subsidiary companies need to make their going concern assessment taking into account:

the need for support from the parent company or fellow subsidiaries;
the ability and willingness of the parent company or fellow subsidiaries to provide such support; and
the risks to the company’s going concern status arising from support that it has undertaken to provide to other members of the group.

In assessing the going concern status of the subsidiary, the subsidiary’s directors should also consider the degree of autonomy the subsidiary company has and how the subsidiary fits into the group’s activities and future plans. The directors should also consider the particular business risks which might arise that could threaten the appropriateness of the going concern basis when preparing the individual subsidiary financial statements.

The amount of evidence which the directors of a subsidiary company collates and retains to support their assessment of going concern is a matter of judgement – again there is no ‘one-size-fits-all’ where this is concerned. The directors’ judgement will also usually involve their experience of dealing with the parent company over a period of time as well as taking into current facts, events and circumstances pertinent to the subsidiary.

Procedures relevant to all companies

The guidance offers procedures which all companies should generally adopt when assessing going concern, including:

Budgets and forecasts

The guidance recognises that budgets and forecasts prepared by an entity are long-established techniques in business management. Assumptions used in the preparation of such budgets and forecasts can be subjected to sensitivity analysis or ‘stress-tested’ which tends to offer a more likely outcome.

The guidance suggests that directors should prepare a budget, trading estimate, cash flow forecast or other equivalent analysis covering such a period as the consider appropriate.

Borrowing facilities

Directors should carefully consider the terms of borrowing arrangements (especially where covenants have been incorporated by the financiers). This is primarily to ensure that the terms and conditions are not breached which might result in the lender ‘calling in’ the loan which would then potentially bring into question the entity’s ability to continue as a going concern.

It is the responsibility of the directors to be satisfied that there are adequate financing arrangements in place for the entity. Where there are any potential deficits, arrears or breaches which may arise then directors should enter into discussions with the lender sooner rather than later to avoid potential problems crystallising.

Procedures relevant to medium and large businesses

The guidance suggests that directors of medium and large businesses assess going concern beyond the use of forecasts and budgets and look to their long-term plans as an indication of how the directors expect the company to fare in the future. The guidance also suggests regard be given to the following for medium and large businesses:

Products, services and markets

Directors should gather information to support major aspects of the economic environment in which their business operates. They should pay particular attention to the size of the market, its strength, the entity’s share of the market and assess whether there are any economic, political or other factors which might result in a change to the market.

For products or services, directors should consider their suitability to the market in which they operate as well as their quality and expected life.

Cash flow timings

In assessing the financial plans for the business, the directors need to be satisfied that cash inflows are adequately matched to cash outflows and that there are no long periods where projected cash flows are negative which may result in cash flow difficulties. Projected outflows should include liabilities such as loan repayments, corporation tax liabilities, other tax liabilities as well as other commitments (eg hire purchase payments).

Contingent liabilities

The company’s exposure to contingent liabilities should be assessed by the directors and must also include the company’s potential exposure to cash outflows involving legal proceedings, guarantees, margin or other credit support provision under derivative contracts, environmental costs and product liability.

Financial/operational risk management

The directors should consider those risks which are most significant to the business in terms of financial and operational risk. Foreign currency exchange risks are an example cited in the guidance. In addition, counterparty risk arising from concentration on key suppliers or customers who might also be facing financial difficulty should be considered.

Sensitivity analysis and stress testing

The critical assumptions used in forecasts and budgets should be subjected to sensitivity analysis/stress testing. Sensitivity analysis involves assessing the extent to which the headroom against facilities varies with changes in assumptions (such as changes in interest or exchange rates). Stress testing enables the directors to assess the effect of a combination of pessimistic, but plausible, estimates or assumptions.

Auditor’s responsibilities over the going concern assessment

It is not the responsibility of the auditor to conclude whether the entity is a going concern – this responsibility rests with the directors. The auditor’s responsibility is to evaluate the directors’ assessment of the company’s ability to continue as a going concern.

Where the auditor determines that a material uncertainty exists which may cast significant doubt over the entity’s ability to continue as a going concern, then the auditor will modify the report (but not the opinion) by the inclusion of an ‘emphasis of matter’ paragraph in the audit report (directly underneath the opinion paragraph). This is, of course, subject to the disclosures in the financial statements concerning the material uncertainty being adequate.

Half-yearly financial statements

Companies admitted to trading on AIM or on the PLUS-quoted markets must prepare interim financial reports and include half-yearly financial statements. In recognition of this requirement the guidance acknowledges the need for directors to assess the use of the going concern basis of preparing financial statements at the half-yearly date. The guidance recognises the following issues which might give rise to the need to re-examine the going concern assumptions and going concern and liquidity risk disclosures:

a significant adverse variation in operating cash flows between prior budgets and forecasts and the outturn in the first half of the year;
a significant reduction in revenues or margins forecast for the second half of the year;
a failure to obtain renewal or extension of bank facilities that had been anticipated; and
a failure to sell capital assets for their expected amounts or within previously forecast timeframes.

When going concern becomes an issue since the last annual financial statements, the directors should carry out the same procedures they would have carried out for the annual financial statements to ensure all relevant issues have been considered.

If no new issues have been identified that brings into question the last assessment made, the directors will need to undertake procedures to roll forward the previous budgets and forecasts by the length of the half-yearly period.

If the auditor has been engaged to review the half-yearly financial statements, ISRE (UK and Ireland) 2410 Review of interim financial information performed by the independent auditor of the entity will require the auditor, among other things, to inquire as to whether the directors have changed their assessment of the entity’s ability to continue as a going concern. In addition, if the auditor becomes aware of events or conditions which cast significant doubt on the ability of the company to continue as a going concern, the auditor must inquire of the directors as to their plans for future actions, consider the feasibility of those plans and whether the directors believe those plans will improve the situation.

The review period

The second principle in the guidance deals with the review period for going concern. Principle 2 says:

Directors should consider all available information about the future when concluding whether the company is a going concern at the date they approve the financial statements. Their review should usually cover a period of at least twelve months from the date of approval of financial and half-yearly financial statements.

The important aspect concerning principle 2 is the period of review. This should be for at least 12 months from the date of approval of the financial or half-yearly financial statements – not 12 months from the balance sheet date which is where some companies have gone wrong with this guidance.

In undertaking their review, directors should consider all available information about the future including information which they have obtained from budgets and forecasts. The FRSSE, UK GAAP and EU-adopted IFRS all provide for a minimum period that should be reviewed by the directors when assessing going concern (although the extent of the review period is a matter of judgement and in some situations it might be appropriate to obtain information for longer periods).

Auditor’s report

If the review period of the director’s assessment of going concern is less than 12 months from the date of approval of the financial statements and this fact has not been disclosed within the financial statements, the auditor is required to make reference to the review period being less than 12 months from the date of approval of the financial statements in their report.

Half-yearly financial statements

As with the review period above, the directors of companies preparing half-yearly financial statements must also consider all available information concerning the future at the date of approval of the half-yearly financial statements including information obtained from budgets and forecasts.

Companies reporting under EU-endorsed IFRS are required to apply the provisions in IAS 34 Interim Financial Reporting in their half-yearly financial statements. IAS 1 Presentation of Financial Statements at paragraph 26 says that in assessing whether the going concern assumption is appropriate, management takes into account all available information about the future, which is at least, but not limited to, twelve months from the end of the reporting period. This paragraph also applies to half-yearly financial statements.

However, where companies preparing half-yearly financial statements use UK GAAP and who are subject to the disclosure and transparency rules (DTR) are required to refer to the FRC’s Half-Yearly Financial Reports statement to which the DTR refers.

Disclosures

After the directors have undertaken an assessment of going concern using the appropriate review period and have assessed the going concern basis having regard to all the available information at their disposal, the directors are then required to make appropriate disclosures within the financial statements relating to the entity’s going concern ability.

Principle 3 in the guidance says:

Directors should make balanced, proportionate and clear disclosures about going concern for the financial statements to give a true and fair view. Directors should disclose if the period that they have reviewed is less than twelve months from the date of approval of annual and half-yearly financial statements and explain their justification for limiting their review period.

Once the going concern review is done, there are three conclusions which can be drawn:

the going concern basis of accounting is appropriate because there are no material uncertainties related to events or conditions that may cast significant doubt about the ability of the company to continue as a going concern; or
the use of the going concern basis is appropriate but there are material uncertainties related to events or conditions that may cast significant doubt about the ability of the company to continue as a going concern; or
the going concern basis is not appropriate.

The disclosure requirements are set out in the FRSSE, UK GAAP, EU-endorsed IFRS, Companies Act 2006 and for certain listed companies the Listing Rules.

UK GAAP and the FRSSE

Both the FRSSE and UK GAAP require an entity to make disclosures in the financial statements where the directors have identified a material uncertainty which may cast significant doubt about the entity’s ability to continue trading as a going concern. Directors should ensure that the disclosures set out the facts and circumstances in a manner which is proportionate to the nature (and size) of the company. Auditors will consider the adequacy of the disclosures made and if the auditors consider such disclosures to be inadequate this will have an impact on their audit report.

Strategic report

The 2009 guidance refers to the ‘business review’ which was required by Companies Act 2006 and which has now been superseded by the strategic report. Previously the business review was incorporated within the directors’ report, but the strategic report is a standalone report within the financial statements of medium and large companies which must be signed by a director or the company secretary.

The strategic report must refer to the principal risks and uncertainties faced by the company which should include

the main trends and factors likely to affect the future development, performance or position of the company’s business; an
information about persons with whom the company has contractual or other arrangements that are essential to the business of the company.

The main purpose of the strategic report is to assist shareholders assess how the directors have managed the success of the company during the reporting period and therefore it is not unreasonable to expect that the strategic report should contain an account of how the directors intend to respond to risks and uncertainties faced by the business. The guidance makes reference to certain issues which might require disclosure within the strategic report and include:

uncertainties about current financing arrangements (whether committed or uncommitted);
potential changes in financing arrangements such as critical covenants and any need to increase borrowing levels;
counterparty risks arising from current credit arrangements (including the availability of insurance where relevant) with either customers or suppliers
a dependency on key suppliers and/or customers; and
uncertainties posed by the potential impact of the economic outlook on business activities.

Disclosures relating to material uncertainties about going concern

Where the directors have concluded that there are material uncertainties about the company’s ability to continue as a going concern, the FRSSE, FRS 18 Accounting Policies and IAS 1 Presentation of Financial Statements all require disclosure about the existence and nature of these uncertainties.

The FRSSE and FRS 18 at paragraph 61(b) requires the directors to make explicit disclosure where there review period has not been extended to 12 months from the date of approval of the financial statements together with a justification for the decision.

Where a company uses EU-endorsed IFRS as their financial reporting framework, a failure to consider a period of at least 12 months from the balance sheet date would be contrary to the requirements within accounting standards for companies applying IFRS and hence this would also require the directors to justify their departure from such a requirement.

The guidance also provides for other disclosures which might need to be considered by directors which might have a bearing on going concern including:

Disclosures relating to financial instruments (including liquidity risk) where it is material.
Disclosures relating to undrawn borrowing facilities and any restrictions attached to the use of those facilities (eg covenants) where relevant.
Disclosure of defaults and covenant breaches.
Disclosure of sources of estimation uncertainty about the carrying amount of assets and liabilities.

Statement on going concern by certain listed companies

Listing Rule 9.8.6R (3) (13 December 2013) of the FCA Handbook requires that the following must be included in the annual financial reports of listed companies which are incorporated within the UK:

‘A statement made by the directors that the business is a going concern, together with supporting assumptions or qualifications as necessary, that has been prepared in accordance with ‘Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009, published by the Financial Reporting Council’.

Listing Rule 9.8.10R (1 April 2013) makes it a specific requirement that the auditor reviews the statement made by the directors that the business is a going concern before the annual report is published.

Where a listed company prepares a preliminary statement of annual results, the statement on going concern must be agreed with the auditor before it is published. In addition, the Listing Rules also require specific disclosure in the preliminary announcement of the nature of any likely modification contained in the auditor’s report which is to be included with the annual report.

Illustrative disclosures for going concern for small companies

The FRC’s guidance on going concern offers two examples which might assist directors when it comes to making disclosures in their financial statements. These are reproduced as follows (please note the guidance refers to the ‘Business Review’ and this has been substituted in the text below with the ‘Strategic Report’ following the introduction of Sections 414A to 414D CA 2006 for financial years ending on or after 30 September 2013):

Example 1 – a small company that has adopted the FRSSE and anticipates reduced sales next year

There has been a significant reduction in requests for estimates for new decorating work and the directors expect sales to reduce significantly next year. However, costs are expected to reduce accordingly and the company should be able to operate within its overdraft. The directors are not aware of any reason why the overdraft facility might be withdrawn. As a result they have adopted the going concern basis of accounting.

In the above example there are no material uncertainties regarding going concern. Generally in practice few companies make reference to going concern if they conclude the going concern basis is appropriate and there are no material uncertainties. Care should also be taken where going concern disclosures are concerned (especially where there are not any) as this may cause some discomfort with bankers and financiers (especially due to the wording used in the above example). Companies would ordinarily place such disclosures in the directors’ report as opposed in the notes to the accounts. Notwithstanding this view, the above example is contained within guidance issued by the FRC and hence firms should be aware of what is being said as opposed to merely ignoring it and so it follows that firms are advised to discuss with their clients the views of the directors on going concern disclosures in the company’s circumstances.

Example 2 – a small company that has adopted the FRSSE and has experienced difficulties in securing future work

The company has orders for work for the next two months. However, despite significant efforts, it has so far proved impossible to obtain additional sales orders. If new orders are not forthcoming, the directors will need to close the factory and make the employees redundant.

The directors have concluded that a material uncertainty exists that casts significant doubt upon the company’s ability to continue as a going concern and that, therefore, the company may be unable to realise its asses and discharge its liabilities in the normal course of business. However, given the continuing efforts to secure new orders, the directors continue to adopt the going concern basis of accounting.

Illustrative disclosures for going concern for companies other than small companies (including subsidiaries of large private or listed groups)

The FRC have included illustrative disclosures for going concern for companies which are not small and include companies who are subsidiaries of large private or listed groups. The idea behind these disclosures is to bring together going concern and liquidity risk disclosures although the guidance does acknowledge that such disclosures must be specific to the individual circumstances of each company.

Example 1(a) – a company with a significant positive bank balance, uncomplicated circumstances and little or no exposure to economic difficulties that may impact the going concern assumption

The company’s business activities, together with the factors likely to affect its future development, performance and position are set out in the Strategic Report on pages X to Y. The financial position of the company, its cash flows, liquidity position and borrowing facilities are described in the Finance Director’s Review on pages P to Q. In addition, notes A-D to the financial statements include the company’s objectives, policies and processes for managing its capital; its financial risk management objectives; details of its financial instruments and hedging activities; and its exposure to credit risk and liquidity risk.

The company has considerable financial resources together with long-term contracts with a number of customers and suppliers across different geographic areas and industries. As a consequence, the directors believe that the company is well placed to manage its business risks successfully despite the current uncertain economic outlook.

The directors have a reasonable expectation that the company has adequate resources to continue in operational existence for the foreseeable future. Thus they continue to adopt the going concern basis of accounting in preparing the annual financial statements.

Example 1(b) – a significant subsidiary where the subsidiary is financed by its parent and participates in group banking arrangements

The company’s business activities, together with the factors likely to affect its future development and position, are set out in the Strategic Report on pages X to Y.

The company is expected to continue to generate positive cash flows on its own account for the foreseeable future. The company participates in the group’s centralised treasury arrangements and so shares banking arrangements with its parent and fellow subsidiaries.

The directors, having assessed the responses of the directors of the company’s parent ABC Limited to their enquiries have no reason to believe that a material uncertainty exists that may cast significant doubt about the ability of the ABC Group to continue as a going concern or its ability to continue with the current banking arrangements.

On the basis of their assessment of the company’s financial position and of the enquiries made of the directors of ABC Limited, the company’s directors have a reasonable expectation that the company will be able to continue in operational existence for the foreseeable future. Thus they continue to adopt the going concern basis of accounting in preparing the annual financial statements.

Example 2 – a company with uncomplicated circumstances, some exposure to economic difficulties and either a current material bank overdraft or loan and a need to renew this facility in the foreseeable future albeit not imminently

As highlighted in note B to the financial statements, the company meets its day-to-day working capital requirements through an overdraft facility that is due for renewal on [date]. The current economic conditions create uncertainty particularly over (a) the level of demand for the company’s products; (b) the exchange rate between sterling and CY and thus the consequence for the cost of the company’s raw materials; and (c) the availability of bank finance in the foreseeable future.

The company’s forecasts and projections, taking account of reasonably possible changes in trading performance, show that the company should be able to operate within the level of its current facility. The company will open renewal negotiation with the bank in due course and has, at this stage, not sought any written commitment that the facility will be renewed. However, the company has held discussion with its bankers about its future borrowing needs and no matters have been drawn to its attention to suggest that renewal may not be forthcoming on acceptable terms.

Example 3 – a company with complicated circumstances, considerable exposure to economic difficulties and either a current material bank overdraft or loan that requires renewal and perhaps an increase in the year ahead

As described in the directors’ report on page X, the current economic environment is difficult and the company has reported an operating loss for the year. The directors’ consider that the outlook present significant challenges in terms of sales volume and pricing as well as input costs. Whilst the directors have instituted measures to preserve cash and secure additional finance, these circumstances create material uncertainties over future trading results and cash flows.

As explained on page X, the directors are seeking to sell a property to provide additional working capital. The company is in negotiations with a potential purchaser but there can be no certainty that a sale will proceed. Based on negotiations conducted to date, the directors have a reasonable expectation that the sale will proceed successfully, but if not the company will need to secure additional finance facilities.

As explained in the Strategic Report on page Y, the company has commenced discussions with its bankers about an additional facility that may prove to be necessary should the sale of the property not proceed or should material adverse changes in sales volumes or margins occur. It is likely that these discussions will not be completed for some time. The directors are also pursuing alternative sources of funding in case an additional facility is not forthcoming but have not yet secured a commitment.

The directors have concluded that the combination of these circumstances represents a material uncertainty that casts significant doubt upon the company’s ability to continue as a going concern and that, therefore, the company may be unable to realise its assets and discharge its liabilities in the normal course of business. Nevertheless, after making enquiries and considering the uncertainties described above, the directors have a reasonable expectation that the company has adequate resources to continue in operational existence for the foreseeable future. For these reasons, they continue to adopt the going concern basis of accounting in preparing the annual financial statements.

Key questions for boards

The FRC’s guidance provides some key questions which directors should ask when undertaking an assessment of going concern. The questions also include, where relevant, examples of factors that should be considered when assessing going concern. These questions (which can be found in Appendix III to the guidance) relate specifically to:

Forecasts and budgets
Borrowing requirements
Timing of cash flows
Contingent liabilities
Products, services and markets
Financial and operational risk management
Financial adaptability
Group companies
Documentation

[1] ‘Support’ for this purpose means both financial and non-financial support

Category: Accounting and standards, Audit

About the Author (Author Profile)

Steve Collings FCCA is a director at Leavitt Walmsley Associates Ltd and the author of over 30 books on the subjects of financial reporting and auditing, including 'IFRS For Dummies' and 'Financial Accounting For Dummies'. More about Steve's publications can be found by clicking on the 'Published Work' tab on the homepage. Steve is also a regular contributor of articles for www.accountingweb.co.uk, the UK's largest resource for professional accountants on a free subscription basis. Steve is trained in both UK and Ireland accounting standards and International Financial Reporting Standards and has lectured overseas on these subjects in the Caribbean and Singapore. Steve works closely with various professional bodies developing technical material, including Technical Factsheets and online courses. He has also served on the UK GAAP Technical Advisory Group at the Financial Reporting Council and works with the country's leading publishers in producing material on the subjects of accounting and auditing (both UK and International). Steve was named 'Accounting Technician of the Year' at the British Accountancy Awards and won 'Outstanding Contribution to the Accountancy Profession' by the Association of International Accountants. Follow Steve on X (Twitter) - @stecollings