‘Nothing lasts forever’. However, in accounting parlance, one of the fundamental accounting assumptions used by the management for preparation and presentation of financial statements is ‘Going concern’ which assumes that an enterprise will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. Indeed, the assumption of a going concern is critical to the decision and usefulness of financial information under the accrual basis of accounting. Investors and creditors ordinarily invest in or transact with enterprises that they expect to continue its operations in future. It is also the justification for following historical cost basis for accounting its assets and liabilities.
SA 570 lays down the auditor’s responsibility with respect to the management’s use of going concern assumption in the preparation of financial statements.
General purpose financial statements are prepared on a going concern basis, unless the management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. When the use of the going concern assumption 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.
An enterprise may be required by either the reporting framework or by statute to specifically state that the financial statements have been drawn up on a ‘going concern basis’. Eg., in the Indian context, directors are required to specifically assert in the directors’ report that the financial statements of the company are prepared on going concern basis. Where reporting framework does not contain an explicit requirement to assess ‘going concern’, management’s responsibility for the preparation and presentation of the financial statements nevertheless includes such a responsibility. The minimum period over which such assessment is to be made is normally one year (12 months).
The auditor is required to obtain sufficient appropriate audit evidence about the appropriateness of management’s use of the going concern assumption.A Based on this evidence, the auditor should evaluate management’s assessment of the entity’s ability to continue as a going concern. SA 570 envisages two scenarios:
a. Use of going concern assumption is appropriate but a material uncertainty exists
b. Use of going concern assumption is inappropriate
Under scenario (a), the auditor would need to evaluate whether a material uncertainty exists relating to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern, including evaluating mitigating factors, if any. A material uncertainty exists when the magnitude of its potential impact and the likelihood of its occurrence is such that, in the auditor’s judgment, appropriate disclosure of the nature and the implications of the uncertainty is necessary for a fair presentation of the financial statements. The disclosure would also include a statement to the effect that the entity may be unable to realise its assets and discharge its liabilities in the normal course of business. Where adequate disclosures have been made, the auditor would need to express an unmodified opinion and include an Emphasis of Matter paragraph to highlight the material uncertainty which casts a doubt on the entity’s ability to continue as a going concern. In cases where adequate disclosures have not been made, the audit report would need to be qualified.
Under scenario (b), if the auditor concludes that going concern assumption is inappropriate, the accounts cannot be prepared on a going concern basis. If these are in any case prepared on agoing concern basis, the auditor would need to express an adverse opinion.
A tabular presentation of the approach is given below:
Material uncertainty arises from conditions which cast doubt about the going concern assumption and such conditions could be financial, operational or statutory in nature. We will try to understand some of these conditions with examples.
Financial condition resulting in material uncertainty
Case Study 1
ABC Limited (‘ABC’) is a company incorporated in India and is a wholly owned subsidiary of PQR Investment Ltd (‘PQR’), an investment company based in Mauritius. ABC Limited is engaged in the business of process research and development and analytical services. As at 31st March 20X0, ABC has accumulated losses aggregating to Rs. 600 lakh as against paid-up capital of Rs. 250 lakh. The accumulated losses have exceeded the net worth of the Company. The current assets of the company as at 31st March 20X0 stand at Rs. 120 crore, whereas the current liabilities due for payment over the next one year are Rs. 100 crore, i.e. ABC does not have a net current liability position. Management contends that it has no intentions of discontinuing business operations and believes that the Company will be able to continue to operate as a going concern and meet all its liabilities as they fall due for payment based on support from PQR. Management provided a confirmation to this effect letter from PQR Investment Limited to the auditors as evidence of support. The accounts of ABC were prepared on a going concern basis. Was this basis appropriate per requirements of SA 570?
Analysis
The existence of accumulated losses exceeding the net worth represents a financial condition of material uncertainty. In the instant case, PQR, the parent company provided a confirmation extending financial support to ABC to enable it to continue as a going concern. While SA 570 requires auditor to obtain written confirmation from the parent confirming the support, it also makes it incumbent upon auditors to evaluate the parent company’s ability to provide the requisite financial support. It is pertinent to note that PQR is an investment company. In such a case, the auditors would need to consider additional factors like whether PQR has the necessary wherewithal to provide financial support and if PQR was a mere investment vehicle then evaluating whether the shareholders of PQR have the ability to provide support and if yes, consider obtaining confirmation from the shareholders to that effect. Mere reliance on the confirmation would not suffice. Management would need to make detailed disclosures stating that the accounts have been prepared on going concern on the basis of financial support guaranteed by the parent company would be required to be made in the financial statements. The auditor would need to include in his audit report, a Matter of Emphasis highlighting this condition. Alternatively, where the auditor is satisfied with the appropriateness of the going concern assumption, he would not be required to include a Matter of Emphasis in his audit report.
Case Study 2
XYZ Winds Limited (‘XYZ”) is in the business of manufacturing windmills. XYZ has a paid up capital and reserves of Rs. 200 crore as at 31st March 20X5. XYZ has been incurring losses for the last three years however the Company has a positive net worth as at 31st March 20X5. XYZ had borrowed funds aggregating to Rs. 150 crore by way of foreign currency convertible bonds (FCCBs) on 1st April 20X0 which were due for repayment on 1st January 20X5. In view of continuing losses, XYZ was unable to repay the FCCBs on the due date. The Company also has overdue amounts payable to creditors and certain other lenders as at 31st March 2013. The current liabilities as at 31st March 20X5 amount to Rs. 800 crore whereas current assets stand at Rs. 550 crore. The Company is in negotiations with the FCCB holders and is working on various solutions with them to ensure settlement of their dues. The Company is also taking various steps to reduce costs and improve efficiencies to make its operations profitable. The final outcome of the negotiations is pending as on the date the financial statements are approved by the Board. Does this
situation trigger a
material
uncertainty
leading to the going concern
assumption being challenged?
Analysis
The fixed term borrowings are overdue for pay- ment. The given situation
also represents a net liability or net
current liability position. The Com- pany’s ability to continue as a going concern
is in part dependent on the successful
outcome of the discussions with the FCCB holders as well its ability to
generate/source additional cash flows to
repay its liabilities in the short-term. An assess- ment covering qualitative
and judgmental aspects needs to
be made, an illustrative
inventory of which could include:
• Whether management has a history of success- fully refinancing or renewing the entity’s debt obligations as they come due
• Whether management has made sufficient progress in negotiating with planned funding source(s), if any and whether management has provided evidence to support its assertions rela- tive to progress
• Whether the uncommitted funding amount is significant or insignificant relative to the total funding need
• Ability and willingness of the owners to provide additional capital to fund the liquidity crisis.
If based on additional procedures performed, auditors are satisfied with the appropriateness of the going concern assumption, the auditor would need to include a matter of emphasis in their re- port highlighting the fact that the accounts have been prepared on a going concern basis despite the material uncertainty. Management would need to make enhanced disclosures about the material uncertainty as well as mitigating factors. Where the auditor is not satisfied with the appropriate- ness of the going concern assumption, he would need to issue an adverse opinion.
Case Study 3
Moon Metals Limited (MML) is in the business of manufacturing of hot rolled steel plates. The paid up capital of MML as at 31st March 20X0 is Rs. 2,000 crore as against accumulated losses of Rs. 2,250 crore. Due to the sluggish market conditions in the steel industry, high rates of interest and short tenure of loans taken, MML was unable to repay significant portion of loans from financial institutions/banks as per the repayment schedule. The overdue amount of such loans including over- due interest, as at 31st March 20X0 aggregates to Rs. 1,000 crore. Further, loans aggregating to Rs. 500 crore are due for repayment within one year from the Balance Sheet date. The aggregate loans outstanding as at 31st March 20X0 amount to Rs. 4,000 crore.
In view of the deterioration in the steel market conditions, the management of MML submitted a omprehensive Financial Restructuring Plan (CFRP) in April 20X0 to the Corporate Debt Restructuring Group (CDR) consisting of all the secured lenders of the company. The CFRP, inter alia, provides for conversion of promoter loans into equity, buy- back of certain unsecured loans at a discount, additional equity infusion by promoters, enhanced cash flow projections through cost rationalisation, operational efficiencies, renegotiation of contracts and other cost control measures to improve Com- pany’s operating results; all these factors ultimately resulting in improvement of the company’s net worth. The CFRP is under consideration by the CDR as on the date of approval of the accounts,
i.e. 30th June 20X0.
The liabilities due for repayment amount to ap- proximately Rs. 2,500 crore, which is greater than the currently expected cash flows from business and any committed or contracted sources of funds of the Company. The Company’s ability to repay its loan and related liabilities falling due up to 31st March 20X1 is dependent on the Company being able to successfully implement the actions proposed in the CFRP. What factors need to be reckoned, if the accounts for the year ended 31st March 20X0 were prepared on a going concern basis in the above case?
Analysis
In this case study, the Company has been admit- ted to CDR whereby management has provided commitments in lieu of the CDR restructuring the loans and waiving off existing events of defaults/ penal interest and provision of further finance. In addition to the factors explained in the analysis to Case Study 2 above, the auditors would need to evaluate the following aspects:
• Analysing and determining the reliability of cash flow, sales, profit and other relevant forecasts prepared by the management, the auditor may consider consulting corporate finance experts to validate these assumptions.
• Considering historical evidence of growth and profitability of the entity as well as the industry in which the entity operates
• Considering apparent feasibility of plans to reduce overhead (e.g. existence of labor agree- ment restrictions) or administrative expendi- tures, to postpone maintenance or research and development projects, or to lease rather than purchase assets
• Whether the company’s financial health has de- teriorated significantly or its operations changed significantly since the reporting date
• Assessing the ability and intent of the promot- ers to fulfill the funding commitment, assess- ing whether the commitment is sufficient and enforceable The time horizon over which the evaluation of the mitigating factors in this case would transcend beyond one year.
Depending on the status of approval of the CRPF and consideration of the factors listed above, the auditor would need to perform additional proce- dures to evaluate management’s assessment of going concern. Where in the auditor’s evaluation, the going concern assumption is appropriate, he would need to include a matter of emphasis in the audit report and ensure that detailed disclosures are made in the financial statements. Where the auditor is not satisfied with the appropriateness of the going concern assumption, he would need to issue an adverse opinion.
Operational condition resulting in material uncertainty
An operational condition may arise where an en- terprise is formed for achieving a stated objective and the objective is either achieved or becomes infructuous. For e.g. a project office that was constituted to execute the contract for construc- tion of a power plant for a power generating company would get annulled on completion of the project or where the contract with the power company gets cancelled.
Legal condition resulting in material uncertainty
A going concern issue may also arise where the operation of an enterprise is subject to licensing by statutory authorities and such license is with- drawn or cancelled thereby entailing a cessation to the enterprise’s existence. In the Indian con- text, a recent example of the applicability of the legal condition resulting in material uncertainty of an enterprise to continue as a going concern is the cancellation of telecom licenses of certain operators by the telecom regulatory authorities leading to termination of business operations for those operators.
It is easier to evaluate going concern for enterprises operating in a mature industry experiencing turbulent times. However, for enterprises that operate in nascent or niche environments, this evaluation could pose difficulties. Consider the case of a company which is engaged in drug discovery and whose net worth is completely eroded. For such cases, the auditors would need to apply heightened professional skepticism to conclude appropriateness of going concern assumption, as this would involve evaluating factors such as fu- ture cash flows from development of molecules, success in clinical trials, ability to sell the product at development stage or engage a partner for further development, outsourcing of development of molecules etc.
In the Indian context, companies operating in the aviation industry have been encountering going concern issues. The operating results of these companies continue to be materially affected mostly by extraneous factors such as high aircraft fuel costs, significant depreciation in the value of currency, declining passenger traffic and general economic slowdown. Some of these companies have continued to prepare the financial statements based on their ability to explore various options to raise finance to meet short-term and long-term obligations, promoter commitment to provide op- erational and financial support and amendments to FDI policy which may improve investor sentiment towards the aviation industry.
Concluding remarks
As the world deals with the cascading impacts of the financial crisis, which continue to this day, the global economy has had to find a course through uncharted waters. The growing complexi- ties in companies’ balance sheets due to the global economic crisis and foreign exchange volatility have triggered a debate over one of the basic premises of financial accounting — every company is a ‘going concern’ that will not go out of busi- ness or liquidate in the foreseeable future. Going concern issues have significant ramifications for companies such as market capitalisation, ability to raise resources, employee retention, protection of stakeholders interests, investor confidence and so on. The significance of the going concern concept is also evident in the valuation of the assets of the business as ‘going concern’ also forms one of the basis on which businesses are valued.
Where going concern assumption is no longer appropriate, the financial statements would need to be prepared under the liquidation basis of ac- counting whereby the carrying values of all assets (including fixed assets) are presented at their estimated realisable value and all liabilities are presented at their estimated settlement amounts.
In fact, a going concern assumption being invali- dated post the balance sheet date is considered to be an adjusting event. Accounting Standard 4 requires assets and liabilities should be adjusted for events occurring after the balance sheet date that indicate that the fundamental accounting assumption of going concern is not appropriate. The Companies (Auditor’s Report) Order, 2003 specifically requires the statutory auditor to report whether disposal of a substantial part of the as- sets has affected the going concern of a company. Similarly, the reporting requirement under CARO 2003 with respect to erosion of net worth and incurrence of cash losses is also aimed at assessing the financial health and as a corollary, the going concern of a company.
In practice, evaluating the appropriateness of a going concern assumption can be highly judgmental and SA 570 provides adequate guidance for an auditor to make this assessment.
