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July 7, 2014
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August 11, 2014

The concept of going concern

ASL_1The concept of going concern is particularly relevant in times of economic difficulty. Business owners are faced with uncertainty and turbulence in the market, together with a slowdown in economic activity. It is crucial for every business owner to know whether his/her business will remain in operation for the foreseeable future. In the economic climate that we find ourselves in, this is not only relevant for the business owner but also for the creditors, credit providers, shareholders and the employees.

A going concern is defined as an entity that can continue in business for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors. The entity’s assets and liabilities are recorded on the basis that the assets will be realised and liabilities discharged in the normal course of business.

The financial statements of an entity are always prepared on a going concern basis, unless otherwise stated. Under the going concern assumption the entity is expected to continue in business for at least a period of 12 months as from the entity’s reporting date.

Going concern is an underlying assumption in the preparation of financial statements, hence it is assumed that the entity has neither the intention, nor the need, to liquidate or curtail materially the scale of its operations. If management are aware of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, the going concern basis cannot be used. The entity shall disclose those uncertainties in the financial statements, together with the basis on which it prepared the financial statements, and the reason why the entity is not regarded as a going concern.

MANAGEMENT’S RESPONSIBILITY

Management has a responsibility in terms of the Accounting Standards to assess whether the entity is a going concern when preparing the financial statements of the entity. In performing this assessment management will take into account, amongst others:

  • The current economic climate;
  • Judgements on various uncertain future events;
  • Current and expected profitability;
  • Liquidity and access to credit financing;
  • Reliance on key suppliers and customers; and
  • The rigidness of the entity’s business model.

ISA 570 (International Standard on Auditing no. 570), outlines three factors that management must take into consideration when determining whether or not an entity can prepare the financial statements on the going concern basis:

  • The degree of uncertainty associated with the outcome of an event or condition increases significantly the further into the future an event or condition or the outcome occurs. For this reason, most financial reporting frameworks that require an explicit management assessment, specify the period for which management is required to take into account all available information;
  • The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors, influence the judgment regarding the outcome of events or conditions; and
  • Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events may result in outcomes that are inconsistent with judgments that were reasonable at the time they were made.

If there are any material uncertainties relating to the going concern assumption, management must make adequate going concern disclosures in the financial statements.

AUDITOR’S RESPONSIBILITIES

While management has the ultimate responsibility to evaluate whether the entity will be a going concern in the foreseeable future, the auditor, in terms of ISA 570, has the responsibility to evaluate management’s assessment and to conclude on whether management’s assessment is deemed to be appropriate under the circumstances. The auditor will not only evaluate the key principles, assumptions and data used by management in their assessment, but will also consider the adequate disclosure of any uncertainty that could cast doubt on the entity’s ability to continue trading as a going concern.

Here it is important to note that your auditor cannot determine whether your entity is a going concern or not, as he/she does not have the in-depth knowledge of your business required to make such an assessment. Making such an assessment rests with management. Your auditor should however evaluate this assessment based on his/her knowledge of the business and information obtained from the audit procedures, but your auditor can never fulfil the responsibility of management to make such a going concern assessment.

REPORTING

In forming their conclusion on going concern, management will need to exercise judgement and evaluate which of three outcomes is appropriate to the specific circumstances of the company.

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Any material uncertainty that exists about the going concern assumption will evidently result in a modified (but not qualified) audit report.

An audit report that does not refer to going concern is not a guarantee that a business is a going concern. ISA 570 places no obligation on the auditor to refer to the going concern status of the entity if the auditor has determined that the going concern assumption as made by management is appropriate and that there is no material uncertainty that exists about whether or not the entity will continue as a going concern.

WHAT SHOULD MANAGEMENT OF A COMPANY BE DOING NOW?

  • Management should assess the entity’s ability to continue operating as a going concern, taking into consideration all relevant information available about the future, which is at least, but not limited to, twelve months from the end of the reporting period;
  • Management should focus early on going concern risks with full and appropriate disclosure in the financial statement;
  •  Management should engage in early discussions with their auditors should they be of the opinion that material uncertainty exists about the going concern status of the entity;
  • Management should ensure that the following events or conditions are adequately disclosed and communicated to the auditors prior to the commencement of the audit engagement:o    Should the entity be in a net liability or net current liability position;o    Should there be indications of withdrawal of financial support by debtors and other creditors;o    Should the entity be experiencing negative operating cash flows;o    If there are substantial operating losses or a significant deterioration in the value of assets used to generate cash flows;o    Inability to pay creditors on due dates;

    o    Inability to comply with the terms of loan agreements;

    o    If there was a change from credit to cash-on-delivery transactions with suppliers;

    o    Inability to obtain financing for essential new product development or other essential investments;

    o    Loss of key management without replacement;

    o    Loss of a major market, franchise, license, or principal supplier;

    o    Labour difficulties or shortages of important supplies;

    o    Non-compliance with capital or other statutory requirements;

    o    Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that are unlikely to be satisfied; or

    o    Changes in legislation or government policy expected to adversely affect the entity[1].

The significance of such events or conditions often can be mitigated by other factors and they do not necessarily constitute a risk for an entity to continue as a going concern. While this is not an exhaustive list of factors that must be considered, it does illustrate the need for management to think more broadly about their business operations.

The current economic conditions will have a pervasive effect on the business owner’s decision- making and strategizing. It is important that management be on the lookout for events and conditions that are indicators and early warning signs of possible going concern risks. Ultimately it is the responsibility of management to provide useful information about the entity’s financial statement position, financial performance and cash flows, to a wide range of users, to enable them to make effective economic decisions.

If you have any enquiries regarding the concept of going concern, please contact Alicia Viljoen (alicia@asl.co.za), or your responsible director.

[1]Refer to ISA 570, par. 8