AUDITOR’S EVALUATION OF GOING CONCERN ASSESSMENT

The first part of this article on Going Concern had touched upon the various aspects of going concern assessment by management; this part will attempt to highlight the various factors that an auditor should consider while evaluating the going concern assessment performed by the management, disclosure in the financial statements based on the outcome of the evaluation, and reporting considerations under various scenarios in the auditors’ report.

The Covid-19 pandemic and the on-going economic developments have changed the traditional way of doing business and have created significant challenges for some of the industries to save their existence and to survive in the present economic environment.

Our regulators have also acknowledged the criticality of the situation and, to save the interest of investors and users of the financial statements, have increased their focus on the disclosures and reporting requirements related to going concern assumption used in the preparation of financial statements, and introduced new provisions in the reporting requirement wherever needed.

The Institute of Chartered Accountants of India has also introduced guidance with respect to the assessment and evaluation of the going concern assumption in the present economic environment and also an implementation guide to assist auditors to comply with the additional reporting requirements.

Although the above amendments and additional guidance were introduced to assist auditors in discharging their responsibilities and to save the interest of the users of the financial statements, they have significantly increased the responsibilities of the auditors and the criticality of their role in the true and fair reporting of the financial statements.

SA 570 (Revised) states that the auditor’s responsibilities are to obtain sufficient audit evidence on the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements and to conclude, based on the audit evidence obtained, whether a material uncertainty exists about the entity’s ability to continue as a going concern.

The auditor needs to be cognizant of this responsibility to obtain sufficient appropriate audit evidence on the appropriateness of the going concern assumption throughout the audit, and should start this evaluation from the audit planning stage, while understanding the entity’s business and assessing the risks of material misstatement in accordance with SA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment, by considering whether there are any conditions or events that, individually or in aggregate, raise significant doubt about an entity’s ability to continue as a going concern for a reasonable period of time and, if so, whether any preliminary assessment has been done by the management for those identified events and conditions.

If any such events or conditions are identified by the auditor at the audit planning stage or at any time thereafter, for instance, defaults on repayment of borrowings, legal action taken by creditors due to long outstanding, penalty imposed by regulators due to non-compliance that have a significant effect on the cash flows of the company, etc., then the auditor should also consider the possible effect of it on the identified Risks of Material Misstatements for other account captions and, accordingly, needs to plan and perform additional audit procedures to address them. For instance, the auditor may need to increase the risk of material misstatements for related account captions like creditors, borrowings, contingent liabilities, earlier cash flow projections, impairment of inventory or intangibles, etc., and perform extended audit procedures either by increasing the sample size or additional audit steps to address the risk identified from the development.

In the case of events and conditions that are identified and for which going concern assessment is performed by the management, the auditor is required to perform adequate audit procedures, if the other audit procedures performed as part of the audit are not sufficient to enable the auditor to conclude whether management’s use of the going concern basis of accounting is appropriate in the circumstances.

AUDIT PROCEDURES FOR EVALUATION OF GOING CONCERN ASSESSMENT
Given below are examples of some of the audit steps that can be considered for evaluating the appropriateness of management’s assessment of going concern:
– Understanding the specific conditions and events considered by the management and their possible financial implications,
– Indicators or events that may be identified by the auditors during the audit and their possible financial implications on the cash flow projections,
– Ensuring that the possible cash inflows and outflows from business, during the projection period, are reasonable and are in line with the management’s future business projections that were approved by the Board earlier,
– Whether Covid consideration has been taken into account by the management while taking the critical assumptions like revenue growth rate, discount rate, timing of cash inflows and outflows, and if yes, the evidence considered by the management to support them,
– Sensitivity analysis on the assumptions made by the management,
– One-off cash inflows should be supported by adequate documentation to substantiate that realisation is certain,
– Adequate provisions have been made towards any future contingencies and events,
– Guarantees and commitments to related and non-related parties and to their creditors or lenders,
– Any subsequent events that may have an impact on the going concern assessment made by the management,
– Inquire with the management as to its knowledge of events or conditions beyond the period of management’s assessment that may cast significant doubt on the entity’s ability to continue as a going concern,
– Where an auditor relies on a ‘support letter’ as evidence, the auditor should also evaluate the financial strength and capability of the parent or group company issuing the support letter to evaluate whether the parent or group company has the financial ability to discharge the obligations of the company. Further, the support letter should cover at least twelve months from the date of the financial statements and should be executed in a way so as to create a legal binding on the parent or group company to provide financial support when needed,
– Written representations from management regarding their plans for future action and the feasibility of these plans

Going concern evaluation considerations for small and medium enterprises
In case of small and medium enterprises, there can be a situation where the management has not performed a detailed, documented going concern assessment; in such cases the auditor should discuss with management the basis for the intended use of the going concern basis of accounting and whether events or conditions exist that, individually or collectively, may cast significant doubt on the entity’s ability to continue as a going concern. The auditor should also remain alert throughout the audit for audit evidence of events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern.

GOING CONCERN EVALUATION CONSIDERATIONS FOR CONSOLIDATED FINANCIAL STATEMENTS
In case of consolidated financial statements, the auditor of the parent entity is also required to report on the going concern assumption used by the management for the preparation of consolidated financial statements. In this case, the auditor of the parent entity needs to perform the evaluation of going concern assumption of the entities that are getting consolidated, by placing reliance on the audit report issued and work performed by the component auditors (if the parent auditor is not the auditor for all components).

However, the auditor needs to perform adequate audit procedures, in accordance with the guidance given in SA 600 Using the Work of Another Auditor, on the work performed by the component auditors such as review of work papers of going concern evaluation, minutes of meetings with management and component auditors, subsequent events, etc., before concluding the evaluation of going concern assumption for the consolidated financial statements.

Period covered for going concern assessment
Ind AS 1 Presentation of Financial Statements requires management to consider at least twelve months from the end of the reporting period for the going concern assessment; similar guidance is given in SA 570 (Revised) as well.

Here it is important to highlight that twelve months is the minimum period prescribed both by Ind AS 1 and SA 570 (Revised), and if the auditor, based on the audit evidence obtained, believes that the period of assessment should be extended beyond twelve months from the date of the financial statements, then the auditor should request management to do so.

However, if management is unwilling to make or extend its assessment, a qualified opinion, or a disclaimer of opinion in the auditor’s report may be appropriate, because it may not be possible for the auditor to obtain sufficient appropriate audit evidence regarding management’s use of the going concern basis of accounting in the preparation of the financial statements.

One example for the above scenario could be an entity whose license to do business is expiring in the thirteenth month from the end of the financial year and the cost of renewing the license is substantially high; in this case, the auditor may need to request management to extend its going concern assessment beyond twelve months to assess the certainty to renew the license and the source of finance to fund its renewal fees.

Reporting considerations
Based on the audit evidence obtained, the auditor needs to conclude whether in his judgement a material uncertainty exists related to events or conditions that, individually or collectively, may cast significant doubt on the entity’s ability to continue as a going concern, and accordingly needs to ensure the compliances with respect to the disclosures in the financial statements and reporting in the auditors’ report.

The Table below lists the scenarios and the related disclosure and reporting requirements as per Ind AS 1 and SA 570 (Revised) that the auditor needs to ensure:

*Reference can be made to the Annual Reports referred to in the first part of the Going Concern article to gain a practical understanding of the disclosures required to be made in the financial statements under various scenarios.

Like the Ind AS 1, AS 1 also does not provide any specific disclosure guidance on the material uncertainty and requires specific disclosures only when the entity has intentions or requirement to liquidate or curtail materially the scale of its operation, and as a result of which the financial statement needs to be prepared on an alternate basis.

(b) Scenarios for reporting in the auditor’s report:

*As per the requirement of CARO 2020 clause (xix), the auditor is also required to comment on the material uncertainties, with respect to the company’s ability to honour its obligation existing at the balance sheet date and that are due for payment within a period of one year.

It is worth mentioning here that the auditor should not consider communicating key audit matters as a substitute for reporting in accordance with SA 570 (Revised) when a material uncertainty exists. Accordingly, a separate heading that includes reference to the material uncertainty related to going concern needs to be included before key audit matters as per the Appendix of SA 570 (Revised).

PROFESSIONAL JUDGEMENT
Just as going concern assessment requires significant judgement by management, the evaluation of going concern assessment also requires significant professional judgement by the auditors. The example below demonstrates one such scenario:

Illustration
Company A is into the business of providing e-learning solutions and had started its operations two years back with a share capital of Rs. 50 lakhs. The company received the first round of funding of Rs. 50 crores from a PE investor in the first year of its operations; however, due to significant spend on advertising and e-learning content development, the company is running into significant losses.

The company is in the third year of its operations and expected to start generating positive cash flows by the end of the fifth year. The historical year-on-year revenue growth is 100% and the promoter is in discussion with the PE investors for the second round of funding. The company is not able to borrow from bankers due to unavailability of asset base and adequate guarantee.

The management strongly believes that the second round of funding is going to happen within the next few months considering past revenue growth and positive future outlook in the e-learning sector.

Analysis
In the present scenario, there are events and conditions that cast significant doubt on the entity’s ability to continue as a going concern; however, the management based on evidence like growth potential in the industry, past revenue trends and current negotiations with PE investors, has concluded that the going concern assumption holds good.

Based on the above conclusion of management, the auditor may consider the following points for evaluating the management’s assessment:
(a) Industry analysts’ research reports on the growth potential of the industry,
(b) Evidence of negotiations with potential investors to assess the progress of the next round of funding, like non-binding term sheets, email communications, etc.,
(c) Normal gestation period in similar industries to generate positive cash flows,
(d) Evidence to support future projections and cash flows that may include sales orders, inquiries from present and prospective customers, reasonability of assumptions like growth rate, estimated expenditure to run operations, etc.,
(e) Sensitivity analysis on the assumptions to see the implications in case there is a deviation,
(f) Present litigations against the company, if any, specifically on account of non-payment of dues,
(g) Alternate plan with management, in case the funding does not take place.

Considering the above facts, the auditor needs to conclude whether a material uncertainty exists regarding the going concern assumption for the preparation of financial statements and accordingly should exercise his professional judgement on the basis of the available evidence to conclude whether the going concern basis of accounting is appropriate.

Based on the above evaluation, the auditor needs to ensure the adequacy of relevant disclosures made by the management in the financial statements and appropriate reporting of going concern in the auditors’ report.

Documentation
As discussed in the preceding paragraphs, the evaluation of going concern assessment requires significant professional judgement and involves various critical factors that require detailed evaluation and discussion with management before drawing a conclusion, and as such it becomes very critical for the auditor to ensure adequate audit documentation demonstrating the audit procedures performed and evidence obtained by the audit team, to conclude the going concern assumption.

Given below are the main points that the auditor should consider while documenting the going concern evaluation:
– Events and conditions identified during the audit that the auditor believes may cast significant doubt on the entity’s ability to continue on a going concern basis;
– Minutes of meetings with management, discussing all such identified events and conditions and management responses addressing those events and conditions. Here it is important to highlight that the audit team while documenting these minutes of meetings should also ensure that such documentation should also cover the date and place of the meeting, the names of the participants and their designations, and acknowledgment from the participants of the matters discussed therein;
– Details of the business plan and other factors considered by the management to support the going concern assumption;
– Audit procedures performed and evidence obtained by the audit team to validate the management plan and assumptions;
– Minutes of meetings of any discussion / consultation held by the audit team with the senior audit partners or industry experts within the firm;
– Adequate documentation demonstrating the reliance placed on the Subject Matter Experts and audit procedures performed in accordance with the guidance given in SA 260 Using the Work of an Expert;
– Conclusion drawn by the auditor based on the audit procedures performed and evidence obtained;
– Disclosure implications in the financial statements, based on the conclusion drawn and whether it has been complied by the management while preparing the financial statements;
– Reporting implications in the auditors’ report based on the above evaluation and disclosures made in the financial statements;
– In cases where the auditor concludes that an emphasis of matter or a modified opinion is required to be issued, evidences of communication with Those Charged With Governance should also be documented as part of audit documentation.

TO SUMMARISE
The above discussion highlights that the evaluation of going concern assessment has become more critical and complex in the present economic environment and the auditor needs to adopt a more vigilant approach to address it effectively. The auditor, along with the various guidances that have been issued by the Institute of Chartered Accountants of India to assist the auditors to address the challenges in going concern, should also draw reference from other audits, of events and conditions that have raised significant doubts on the entity’s ability to continue as a going concern with their possible outcome, while concluding the evaluation of going concern assessment.