Evaluating Going Concern Issues

11.4 Evaluating Going Concern Issues

The concept of going concern is fundamental to financial reporting and underpins the preparation of most entities’ financial statements. When users of financial statements see numbers reported under generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), they are typically relying on the assumption that the reporting entity will continue operating for the foreseeable future (usually at least 12 months from the date the financial statements are issued). In this section, we examine the responsibilities of both management and the external auditor, explore conditions or events that may raise doubts about going concern, and discuss procedures and reporting requirements when substantial doubt exists.

1. The Going Concern Concept

Under the going concern presumption, an entity is expected to continue operations long enough to realize its assets, discharge its liabilities, and execute its planned business strategy. This assumption is critical because the measurement and classification of many assets and liabilities are based on the premise that the entity will carry on normal business activities. If there is a high likelihood of impending financial or operational distress that could lead to liquidation, a different basis of accounting—one not predicated on the going concern assumption—may be needed.

1.1 Key Definitions

• Going Concern – The assertion that an entity will remain in operation and not liquidate in the near term, typically for at least one year after the issuance date of the financial statements (or the balance sheet date, depending on the applicable framework).
• Substantial Doubt – A condition that arises when it is probable the entity cannot meet its financial obligations as they become due within the next year (or the specified assessment period).

2. Responsibilities for Going Concern Evaluations

2.1 Management’s Responsibilities

Management must make an explicit evaluation of the entity’s ability to continue as a going concern. This includes (but is not limited to):

1. Evaluating if there are any extant or forecasted conditions that could threaten the entity’s viability, such as recurring losses, negative cash flows, or indicators of severe liquidity constraints.
2. Identifying mitigating strategies to address these conditions, such as seeking new financing, restructuring operations, disposing of assets, or cost containment efforts.
3. Preparing financial statements under the going concern assumption unless it is clear that liquidation is imminent, in which case a different basis of accounting may be required.

Different financial reporting frameworks specify the period for which management’s evaluation must cover. Under U.S. GAAP (outlined in ASC 205-40 and AU-C 570), the period is typically at least 12 months from the date financial statements are issued. Under IFRS (IAS 1), the evaluation looks at least 12 months from the balance sheet date.

2.2 Auditor’s Responsibilities

The auditor’s primary responsibility related to going concern is to evaluate the appropriateness of management’s use of the going concern basis of accounting and to ascertain whether there are conditions or events that give rise to substantial doubt. This typically involves:

1. Reviewing management’s assessment and supporting evidence.
2. Considering known or discovered conditions that might undermine going concern (e.g., compliance with debt covenants, liquidity crises, etc.).
3. Evaluating the feasibility of management’s planned mitigating actions.
4. Determining if the disclosure regarding going concern in the financial statements is adequate.

The auditor’s conclusions on going concern can influence the wording of the audit report, potentially including an Emphasis-of-Matter (EOM) paragraph (for nonpublic entities) or Explanatory paragraph (for public entities) highlighting the going concern uncertainty but not necessarily modifying the audit opinion.

3. Indicators of Going Concern Doubt

Numerous conditions or events might trigger a more in-depth review of going concern. Common red flags include:

1. Negative Financial Trends:
   • Recurring operating losses.
   • Negative cash flows from operations.
   • Adverse key financial ratios such as a current ratio of less than 1.0 or a significant negative net worth.

2. Cash and Liquidity Shortfalls:
   • Difficulty meeting financial obligations on time.
   • Expiring credit lines without any prospect of renewal.
   • Breaches of loan covenants.

3. Internal or External Factors:
   • Loss of principal suppliers or customers that severely impacts revenue.
   • Unresolved legal proceedings or regulatory actions that threaten ongoing operations.
   • Unpredictable events (e.g., natural disasters, significant changes in market conditions).

4. Other Warning Signs:
   • Labor difficulties or strikes that hamper business activities.
   • Management’s plans to cease operations in a particular line of business without a viable alternative.
   • Dwindling demand for core products or services.

4. Audit Procedures for Evaluating Going Concern

When go­ing con­cern doubts arise, the auditor should design specific procedures to gather relevant evidence. These procedures go beyond the standard risk assessment queries. Common activities include:

1. Inquiries with Management:
   • Discuss the financial viability of current and planned operations.
   • Gain insights into planned mitigating actions (e.g., cost reductions, restructuring, financing).
   • Confirm the availability of additional open lines of credit or financing sources.

2. Reviewing Forecasts and Projections:
   • Examine budgets and cash flow forecasts for at least 12 months into the future.
   • Compare forecasts to historical trends, assessing the reliability of past projections and identifying any large discrepancies.
   • Evaluate the reasonableness of assumptions underlying projected revenues, operating costs, and financing inflows.

3. Key Ratio and Trend Analysis:
   • Perform ratio analyses (current ratio, quick ratio, debt-to-equity ratio) to spot alarming changes or persistent negative trends.
   • Use analytical procedures to identify unusual fluctuations in operating results or financial positions that may signal deeper problems.

4. Inspecting Supporting Documentation:
   • Review contracts, debt agreements, or board minutes for clues about impending covenant defaults or liquidity crisis.
   • Examine legal or regulatory correspondence that might cast doubt on the entity’s viability.

5. Validating Feasibility of Management’s Mitigations:
   • Assess whether proposed asset sales are actually marketable.
   • Review agreements for new financing or capital injections.
   • Investigate the reasonableness of planned cost-cutting measures to see if they significantly improve cash flows.

5. Reporting Considerations When There Is Substantial Doubt

After gathering and evaluating all relevant evidence, auditors reach a conclusion regarding going concern:

1. No Substantial Doubt
   If the auditor determines there is no substantial doubt about the entity’s ability to continue as a going concern, or that substantial doubt has been alleviated by management’s plans, no special mention in the audit report is typically required.

2. Substantial Doubt Remains
   When substantial doubt exists and management’s plans do not sufficiently mitigate concerns, the auditor should:
   • Include a separate subsection or an Emphasis-of-Matter paragraph in the audit report for nonissuers, drawing attention to the disclosures in the financial statements.
   • For public companies (issuers), add an Explanatory paragraph highlighting the existence of substantial doubt about the entity’s ability to continue as a going concern.
   • Ensure the financial statement disclosures are adequate regarding the conditions or events leading to the uncertainty.

3. Inadequate Disclosures
   If disclosures about going concern are omitted or inadequate, this deficiency can lead to a qualified or adverse opinion. The severity depends on the significance of the omission and the auditor’s judgment regarding the magnitude of the potential misstatement.

6. Visual Overview of the Going Concern Evaluation Process

Below is a Mermaid diagram summarizing the steps typically taken by management and the auditor when evaluating going concern:

    flowchart TB
	    A((Start)) --> B{Management Assessment}
	    B --> B1[Assess Negative Trends<br>Liquidity Shortfalls<br>Other Red Flags]
	    B --> B2[Develop Mitigation Plans<br>(Financing, Restructuring, etc.)]
	    B --> C[Auditor Evaluates<br>Management's Assessment]
	    C --> D{Substantial Doubt?}
	    D -- Yes --> E[Disclosures<br>and EOM/Explanatory<br>Paragraph]
	    D -- No --> F[No Going Concern<br>Disclosure Needed]
	    F --> G((End))
	    E --> G((End))

In practice, communication between management and the auditor is continuous and iterative. If negative trends persist or new evidence emerges, the auditor revisits management’s plans to assess whether they remain viable.

7. Best Practices and Common Pitfalls

• Best Practices:

1. Early Assessment: Management should initiate going concern evaluations well before year-end to allow sufficient time for implementing corrective actions or securing financing.
2. Transparent Disclosures: Provide clear and concise disclosures in the financial statements when uncertainties exist. This helps users make informed decisions.
3. Reasonable and Supportable Assumptions: Ensure assumptions used in forecasts or projections have a basis in historical performance and industry data.

• Common Pitfalls:

1. Over-Optimistic Forecasts: While hope for positive changes is natural, overestimating revenue growth or underestimating costs can be misleading and damage the reliability of financial statements.
2. Inadequate Documentation: Failure to properly document procedures, assumptions, and mitigating strategies can lead to incomplete audit evidence and potential opinion modifications.
3. Delayed Course Corrections: Waiting too long to address going concern issues often leaves management with few options to recover, and heightens auditor skepticism.

8. Practical Example: StarTech Manufacturing

StarTech Manufacturing has operated profitably for many years. Suddenly, due to the loss of a major customer, its revenues plummeted. Meanwhile, production costs remained fixed. Management’s preliminary forecasts revealed negative cash flows for at least eight months, raising concerns about meeting debt obligations.

• Management’s Plans: StarTech proposed two solutions—renegotiating payment terms with suppliers and pursuing a short-term loan.
• Auditor’s Evaluation: The auditor examined StarTech’s historical success in renegotiating terms and noted that the supplier had typically agreed to extended terms. Further, the auditor reviewed an engagement letter from a local bank indicating a likelihood of a short-term loan approval.
• Outcome: Substantial doubt about going concern was alleviated by these feasible mitigation plans. The auditor concluded that no separate emphasis paragraph was necessary. However, the auditor recommended that management disclose in the notes to the financial statements the extent of the measures taken to ensure liquidity.

9. References and Resources

Official References

• AU-C Section 570: “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern” (AICPA).
• PCAOB AS 2415: “Consideration of an Entity’s Ability to Continue as a Going Concern” (PCAOB).

Additional Resources

• IFRS IAS 1: Provides guidance on identifying material uncertainties about going concern.
• Articles in the Journal of Accountancy describing real-world case studies, including issues arising from economic downturns or health crises.

Quiz: Going Concern Evaluation Fundamentals

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