Assessing going concern: what ‘small’ clients need to know

One of the most fundamental concepts in the preparation and presentation of accounts is the concept of going concern.  While this concept is a ‘fundamental’ concept, it is one that often causes the most amount of confusion amongst practitioners – particularly in respect of the disclosure requirements.

Over the last couple of years we have seen previously profitable companies run into financial difficulty.  Phrases such as ‘the current economic climate’ and ‘financial crisis’ dominate the media almost on a daily basis.  Auditors have been lambasted for their (alleged) involvement in bringing about the financial crisis (which I am a firm believer is not the case) and the profession has also had to deal with a raft of new guidance about clients’ going concern.

Back in 2009, the Financial Reporting Council (FRC) issued ‘An Update for Directors of Listed Companies: Going Concern and Liquidity Risk’ which gives some quite comprehensive guidance on the issues relating to going concern and the disclosures which should be made in financial statements depending on the client’s individual circumstances.

This article will look at the concept of going concern and how it applies to those firms which apply the Financial Reporting Standard for Smaller Entities (FRSSE) (effective April 2008) to their clients.

It is the responsibility of the directors of a company to prepare accounts which give a true and fair view.  This is an overarching principle under the Companies Act 2006 and the fundamental issue which needs to be addressed is whether (or not) the going concern presumption is appropriate in their individual circumstances.  The requirement to prepare accounts which give a true and fair view is applicable to smaller companies who may choose to take advantage of audit exemption and the directors of such companies also have a responsibility to ensure the going concern presumption is appropriate in their circumstances.

The FRSSE (effective April 2008) states that the accounts of a company will not be prepared on a going basis if:

• the directors determine that they intend to cease trading; or
• if there is no realistic alternative but to do so.

The FRSSE (effective April 2008) also goes on to say that the directors must:

(a)  assess whether there are any significant doubts about the entity’s ability to continue as a going concern;

(b)  disclose any material uncertainties, of which the directors are aware in making their assessment; and

(c)  disclose where the period the directors have considered in making their assessment has been limited to a period of less than one year from the date of approval of the annual accounts.

The words ‘from the date of approval of the annual accounts’ have been put in bold type because this is a common mistake made by directors of companies who think that they only have to look 12 months from the balance sheet date.  Given that accounts are usually prepared some time after the year end, looking forward 12 months from the balance sheet date will be inappropriate.  The directors need to look forward 12 months from the (expected) date of approval of the accounts themselves.

Assessing going concern

The problem with assessing going concern is that it is very much subjective and involves a lot of judgment.  These problems are also accentuated by the fact that directors may well make judgments relating to going concern, and thus prepare the accounts on the going concern basis, but that is not a guarantee that the company will necessarily be in existence 12 months after the accounts have been approved.

Companies which are financially sound and which have a tight control over the budgets and cash flow are in a much better position to assess the applicability of going concern than companies which have very tight cash flows and operate ‘hand to mouth’ with no real available information to assist them in making their assessment of going concern.

Companies that prepare budgets may look at where their profitability and cash flows will be at certain times in the future.  These are particularly useful where companies may suffer from seasonal declines in cash flow or where the business is of a certain cyclical nature.

If borrowing facilities are coming up for renewal with no indications that the financier is prepared to renew the borrowings, this could cast significant doubt on the company’s ability to continue as a going concern.  The directors need to consider the likelihood that the company’s borrowing facilities will be renewed and if not, how likely is it that they can secure borrowing facilities from other financiers.

Assessing going concern need not be overly complex and in smaller companies should be a much more simple process than for those companies which have much more complex operations.

For the accountant dealing with clients which are not subjected to audit, they too have a responsibility to ensure they do not put their names to accounts which may not show a true and fair view – particularly those accountants which are members of professional bodies such as ACCA.  A question which is frequently asked is “how do I assess whether the client’s going concern is in doubt despite their claims to the contrary?”  Whilst not exhaustive, the following list will give some pretty good indicators that your client’s going concern ability really should be re-assessed:

Recurring losses with no real indicators that the company is going to return to profitability.

• An insolvent balance sheet.
• Negative operating cash flows in cash flow forecasts.
• Inability to stick to credit terms imposed by suppliers or loss of credit from suppliers.
• Breach of loan agreements.
• Loss of key employees, customers and suppliers.
• Pending litigation issues.
• Loss of a major contract (or the impending loss of a major contract).
• Technical obsolescence of goods.
• Withdrawal of borrowing facilities or indicators that borrowing facilities will not be renewed.

Disclosure requirements

Companies which are not subject to external audit must still assess going concern and must still disclose any material uncertainties of which the directors are aware in making their assessment (FRSSE (effective April 2008) paragraph 2.12).

I have heard some accountants subscribe to the belief that it is absolutely mandatory that disclosure relating to going concern must be made, even if the going concern presumption is appropriate in the circumstances.  Indeed the guidance issued by the FRC does advise by including a paragraph saying:

‘No material uncertainties that cast significant doubt about the ability of the company to continue as a going concern have been identified by the directors.’

In reality, I would expect few companies make this disclosure because if there’s nothing to disclose then why disclose the fact that there is nothing to disclose! Indeed the FRSSE (effective April 2008) only requires material uncertainties that have arisen from the directors assessment which may cast significant doubt on the company’s ability to continue as a going concern.

Auditors’ responsibilities

Where companies are audited, the auditors are not responsible for making an assessment on the company’s ability to continue as a going concern.  Their responsibility is to gather sufficient appropriate audit evidence to corroborate management’s assertion that the going concern basis is appropriate in the company’s circumstances.  In summary, the auditor should:

• qualify the audit report if the auditor concludes that a material uncertainty exists which relate to events or conditions which may cast significant doubt on the company’s ability to continue as a going concern which has not been adequately disclosed in the financial statements; or
• add an emphasis of matter paragraph to the auditor’s report if the auditor agrees with the directors’ conclusion on going concern and that any material uncertainty regarding going concern is fully explained in the accounts.

Conclusion

Clients should be advised to consider the applicability of the going concern presumption depending on their circumstances – particularly if the company has sustained a heavy bad debt (e.g. the loss of a major customer) or in reality the company is running out of cash and the future is bleak.

In reality few sets of accounts will be prepared on any other basis other than the going concern basis, but accountants in practice should be alert to any indicators that may cast doubt on a client’s going concern ability and encourage additional disclosures (by reference to the FRC’s Guidance for Directors of UK Companies 2009) because that contains some very good comprehensive examples of the disclosures which may be relevant in certain situations.

Category: Accounting and standards, Audit