GOING CONCERN ASSESSMENT BY MANAGEMENT

Ind AS 1 states that an entity shall prepare its financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. However, to prepare its financial statements on a going concern basis, the management first needs to assess the entity’s ability to continue as a going concern.

The above requirement of Ind AS 1 acts as a trigger for performing going concern assessment by management through ascertaining whether the existing events and conditions are favourable enough to justify the going concern assumption for the preparation of its financial statements. When the use of the going concern basis of accounting is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.

The going concern assessment and reporting thereof require a high degree of professional judgement and has become more relevant and complex in the present Covid-19 pandemic, that has created greater economic uncertainty and due to which many organisations are seeing downturns in their revenue, profitability and cash flows.

This article attempts to explain

a) how management should do the going concern assessment by highlighting the events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern and the evidence that management should consider to conclude the assessment, in case any such events or conditions are identified; and

b) scenarios that require disclosures in the financial statements.

 Preparers of financial statements, those charged with governance, users of the financial statements and their auditors may find this article helpful in understanding the concept of going concern and implications when the entity has a doubt about its ability to continue as a going concern.

 
Evaluation of going concern assessment by the auditor and reporting considerations in the audit report will be covered in the second part of this article.

GOING CONCERN ASSESSMENT UNDERSTANDING

Before initiating a going concern assessment, one must first understand how the going concern assessment needs to be performed, i.e., what kind of events and conditions should be considered, what should be the period covered for making this assessment, and how to assess such events and conditions once identified, to conclude.

 
Ind AS 1 outlines the principle for performing the going concern assessment but does not provide an explicit guidance to address all the above questions; it states that the management should consider all available information about the future, which is at least, but not limited to, twelve months from the end of the reporting period and the degree of consideration depends on the facts in each case. For example, when:

Considering limited guidance in Ind AS 1, management can draw reference from SA 570 (Revised) Going Concern, which illustrates events or conditions much in detail and, if they existed, may cast significant doubt on the entity’s ability to continue as a going concern.

Apart from the guidance given in SA 570, reference can also be drawn from some of the following recent industry-specific events and conditions:

EVIDENCE TO ASSESS THE EVENTS AND CONDITIONS

Once the events and conditions are identified, management needs to assess the financial implications of these events and conditions to conclude the entity’s ability to continue as a going concern. Given herein below are examples of some of the evidence that management should consider while performing going concern assessment:

•   Cash flow projections that show an ability to pay debts as and when they fall due after factoring realistic assumptions in the current market conditions;

•   If current conditions deteriorate further, detailed business plans covering the period under consideration;

•   Entity’s ability to obtain new funding upon the maturity of existing funding arrangements;

•   Evidence that debt covenants have been assessed and any risk of breaching them has been managed, such that they do not provide significant risk;

•   Ability to obtain a ‘financial support letter’ from the parent company for the next twelve months from the date of the latest balance sheet. However, a mere ‘Support Letter’ or ‘Comfort Letter’ will generally not constitute sufficient evidence to conclude on the appropriateness of going concern basis of accounting, unless the subsidiary’s operations are entirely dependent on the parent;

•   Financial ratios like current ratio, debt-service coverage ratios, etc., indicating inadequate profit or liquidity position of the company;

•   Covid-19 specific considerations1:

1.  Whether the entity is operating in a sector which is highly impacted,

2.  Whether the entity has plans and ability to restructure its debt obligations if required to ensure short-term solvency,

4. Government policies and measures in the countries in which the company operates,

5. Changes in the entity’s access to capital, impacted by measures taken by regulators (industry and / or financial) or banks,

6. The entity’s ability to prepare timely financial statements or other required information / filings, including delays in receiving financial data from operations in other countries, or material investees for consolidated financial statement,

7. The ability of the business model to operate under current Covid-19 restrictions and whether the business model will be sustainable post-Covid.

 
Although all the above illustrative events, conditions and evidences give a fair idea to address the what and how questions, yet going concern assessment requires a significant management judgement while concluding in the real-world situation, and with the pandemic in place, concluding going concern assessment has become more challenging.

 
Ind AS 1 though do not provide detailed guidance on the going concern assessment, but it does make management’s job a little easy by requiring adequate disclosures of the events and conditions identified, the assumption used, and judgement made to conclude the going concern assessment.

 
The principle is to give clear visibility to the readers of the financial statements so that they can make their own interpretations with the help of the disclosures. Also, these disclosures are of greater relevance in the present economic environment where the regulators like Securities and Exchange Board of India, Ministry of Corporate Affairs, European Securities and Markets Authority, Securities and Exchange Commission, etc., have placed significant focus on the going concern of the entities.

 
DISCLOSURE IN THE FINANCIAL STATEMENTS

The Table below summarises the broad category of scenarios and their disclosure requirement in the financial statements as per the requirement of Ind AS 12:

Further, section 134(5) of the Companies Act, 2013 also requires the Board of Directors to comment on the going concern assumption for the preparation of financial statements, as part of the Directors’ responsibility statement.

 
Similar to the Ind AS 1, AS 1 does not provide any such disclosure guidance on the material uncertainty and requires specific disclosure only in case 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.

 Let us take an example to see the application of the above scenarios:

 
Illustration

Company A  is in the hotel business and known for its luxury hotels across the globe. The company is successfully serving its customers and running its operations for several decades. However, the Covid-19 pandemic and resultant global lockdown had a severe adverse effect on its operations.

 
Some of the key points reflecting the current financial position and business of the company are as under:

 
(a) There was no sale in the first nine months of the current financial year due to the lockdown and there was minimal sale in the remaining three months due to the Government advisory of lifting the lockdown in a few of the cities where the company has its properties;

(b) The company has significant borrowings, a portion of which is due for payment in the next financial year; the company has not defaulted in any of its borrowings so far. The management is in discussion with bankers to increase the moratorium period for a few of its term loans;

(c) The company has not retrenched its work force; however, a pay cut of 25% has been made by the management considering the present cash flow position;

(d) Management is expecting to incur a significant cost for ensuring continuous sanitization of its properties globally;

(e) Management at present is focusing on its restaurant business by introducing home delivery services. It has also introduced catering services for organisations that are covered under essential services, such as hospitals, pharmaceutical companies, manufacturing units of essentials commodities, etc.;

(f) Governments in various countries are imposing lockdowns on an intermittent basis considering the number of Covid-19 cases, and at present there is no visibility about how long the pandemic will continue.

 
ANALYSIS

In the given scenario it is evident that the pandemic is the event that cast significant doubt on the company’s ability to continue as a going concern and hence a detailed assessment is required to be performed to conclude on the going concern assumption.

Let us see the step-by-step approach that management needs to take to perform the assessment.

Step 1: Identification of events and conditions

In the present case, the pandemic is the identified event that has resulted in a significant deficiency in the regular cash flow of the company and thus created a question about how it will realise its assets and honour its liabilities in the foreseeable future.

 Step 2: Assessing the evidence to evaluate going concern

Under this step, management needs to assess the following points to conclude the going concern assessment:

(a) Cash flow projection from operations, i.e., with the present situation, how much cash flow the company will be able to generate from its operations in the next 12 months and whether it will be sufficient to meet its contractual obligations. In order to do the said projection, the management needs to make certain assumptions like:

•  sales volume from restaurant business due to new home delivery and from catering services introduced by the management;

•  transportation cost for home delivery;

•  expenditure to develop a digital platform for placing online orders;

•  estimate of sales from the room rent for properties where the lockdown is removed;

•  estimate of additional cost that needs to be incurred to ensure sanitization;

•  advertising cost for the new initiatives taken by the management;

•  other operational costs;

•  Recoverability slippages in the receivables; and

•  Probability of getting additional credit period from the creditors.

The management also needs to be conscious that the above assumptions and projections should be based on the expected future trends and limited reliance should be placed on the historical performance and data. Given hereinbelow are the examples of evidence that management should consider to estimate the future trends:

•  consider research reports of analysts and third parties on the hotel industry,

•   data from World Health Organization or local institutions explaining the expected progression of the Covid-19 outbreak in the countries, and

•   data from government agencies about the severity and estimated duration of the economic downturn in the country and the actions that government may take to mitigate the effects.

(b) Quantum of borrowings that are due in the next 12 months, and status of extending moratorium period with banks;

(c) Probability of getting additional borrowings from banks for working capital management;

(d) Additional capital infusion that can be done by the promoters;

(e) Losses due to assets like investments, that are measured at fair value through profit and loss;

(f) Any other contractual liabilities, like derivative contracts that are due for settlement in the next twelve months.

Step 3: Preparation of financial statements and disclosures

Based on the outcome of the assessment performed in Step 2, management may need to conclude on two aspects:

– whether the material uncertainty exists, and if yes, then

– whether going concern assumption holds good.

 
In the given scenario, if the company is able to get additional funding from the promoter group or banks to run its operations for at least the next twelve months, then the management may conclude that the material uncertainty does not exist and hence the going concern assumption holds good. Accordingly, management needs to prepare the financial statements on going concern basis and adequate disclosure will be made with respect to judgement made by the management to mitigate the material uncertainties.

 
On the other hand, if the company is unable to obtain additional or sufficient funding from the promoter group or banks and it has to depend on the materialisation of its present business plan and drawing additional credit period from the creditors and bankers, then it may conclude that the material uncertainty does exist and it may or may not be mitigated. Accordingly, management might prepare financial statements on going concern basis along with adequate disclosures with respect to material uncertainties, management turnaround plan and significant judgement and assumptions taken for concluding going concern assumption.

 
However, in rare circumstances, the management may also decide that the going concern assumption does not hold good. This may happen if the management believes that the bankers and creditors will not provide any extension for the payment of their contractual dues and the present business plan will not generate adequate cash flows to meet its contractual obligations in their entirety, when due, and to run its day-to-day operations.

 
In that case, management needs to use an alternative basis of accounting for the preparation of its financial statements, e.g., liquidation basis, and the disclosure of that fact and the reason thereof needs to be disclosed in the financial statements.

TO SUMMARISE

The presence of Covid-19 has created economic instability across industries and has made the going concern assessment more critical and challenging. However, this challenge can be countered effectively if management do the identification and assessment of all the possible events and conditions that may cast significant doubt on the entity’s ability to continue as a going concern, in the light of the available guidance on financial reporting, and support their conclusion with sufficient appropriate evidence.

 
Once the management is done with its going concern assessment, the second step will be the evaluation of the going concern assessment by the auditors and reporting thereof in the auditors’ report.

 
The said aspect of going concern will be covered in the second part of this article that will touch upon 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.

References

Readers should also refer to the Annual Reports as referenced above in different industries to gain a practical understanding of the disclosures required to be made in the financial statements under various scenarios.