Authors: Prashanth Vellanki & Suchendra Kumar
The unprecedented situation owing to COVID 19, has disrupted most businesses around the world. As businesses stare at deteriorating economic environment, reduced revenues and cash flows, Going Concern assessment is probably one of the most challenging areas for the management and auditors. Keeping this in view, standard setters around the globe have issued Practice Alerts/Guidelines to assist management and auditors in assessment of going concern in this environment. The objective of this article is to summarise the following guidelines
Going Concern Assessment Guidance included in ICAI Accounting and Auditing Advisory on “Impact of Coronavirus on Financial reporting and the Auditors consideration”
IAASB Staff Audit Practice Alert on “Going Concern in the Current Evolving Environment” Going Concern Guidance included in ACCA Paper titled “The impact of Covid-19 on Audit and Assurance – challenges and considerations”
Background:
As per Section 134(5) of the Companies Act, 2013 the Board of Directors of every company is required to make a statement in the Directors’ Responsibility Statement that the annual accounts are prepared on a going concern basis. Under the going concern basis of accounting, the financial statements are prepared on the assumption that the entity is a going concern and will continue its operations for the foreseeable future unless management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. When the going concern basis of accounting is used, assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business.
SA 570(Revised) requires the Auditor to
Obtain sufficient appropriate audit evidence regarding, and conclude on, the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements;
Conclude, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern; and
Report in accordance with the said standard
On account of changed circumstances due to COVID 19:
Management’s assessment of the entity’s ability to continue as a going concern is likely to be more challenging and management may need to provide additional and more robust disclosures in the financial statements relating to events or conditions affecting the entity’s ability to continue as a going concern
There is a corresponding need for the auditor to perform additional or enhanced audit procedures for the auditor to be able to conclude on the appropriateness of management assessment. Changes to the Auditor’s report may be expected, depending on the nature of the entity and circumstances, in the form of “Material uncertainty related to Going Concern” in accordance with SA 570(Revised) or Modifications of the auditor’s opinion where necessary or new key audit matters.
Considerations for Assessment
As per SA 570 (Revised), when performing risk assessment procedures as required by SA 315, the auditor shall consider whether events or conditions exist that may cast significant doubt on the entity’s ability to continue as a going concern and shall evaluate management’s assessment of the entity’s ability to continue as a going concern.
The COVID-19 pandemic is likely to have significant implications for global economies and markets for certain industries such as restaurants, entertainment, hospitality, retail and travel especially aviation. The downturn will result in a significant increase in both the volume and severity of events and conditions that may in some instances cast doubt on an entity’s ability to continue as a going concern. However, this does not necessarily mean that a material uncertainty automatically exists―the increased risk of significant doubt on an entity’s ability to continue as a going concern will rather depend on the nature and circumstances of the entity, including the industry in which it operates.
Examples (as specified by IAASB) of events or conditions that may exist as a result of the COVID 19 pandemic and corresponding impact on Management assessment and Auditor consideration while evaluating management’s assessment include.
AASB of ICAI has specified the following considerations that management should include in their assessment:
Regulatory Considerations
The impact of measures taken by governments in all the countries where the entity operates.
Changes to the entity’s access to capital impacted by measures taken by regulators (industry and/or financial) or banks.
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 statements.
The entity’s ability to meet regulatory ratios.
Operating environment considerations
General considerations include restructuring of the entity/ group (actual or planned) and its business (e.g., store closures, workforce reduction) that may be needed to generate sufficient cash flows. The auditor should determine if there are any restrictions on disposing of assets, such as in existing debt agreements or actions subject to Board approvals. Other considerations related to the operating environment include but are not limited to:
The level of lost revenue and cash flows including the effect of rebates, refunds and allowances.
The level of pricing and volume volatility impacting revenue.
Impact of foreign exchange fluctuations including the impact of any hedging arrangements to reduce uncertainty.
The risks relating to delivering products and services (e.g., workforce being ill / plant and facilities being inaccessible / inventory unable to reach end markets).
Significant deterioration in the value of current assets – particularly inventory and whether management has considered possible write downs or write-offs of inventory.
Loss of existing contracts and future contracts, particularly if facilities are being repurposed to support restructuring or recover losses arising due to COVID-19.
Inability to honor certain terms of contracts leading to penalties by regulators/ counterparties and suitability of invocation of force majeure clauses.
Foreign exchange fluctuations and how these have been considered.
Customers finding other sources of supply during the COVID-19 pandemic and not returning. The ability of the business model to operate under current COVID-19 restrictions and whether the business model will be sustainable post COVID-19 (e.g., travel and leisure industry).
Raw material pricing due to sourcing challenges and the related impact to projected gross margin levels.
Increase in operating costs or cost of supplies due to restrictions related to COVID-19 and anticipated additional costs on account of adjusting to post COVID-19 scenario.
Supply chains interruptions due to delays in overseas supplies (no longer just-in-time).
Grants and other relief provided by governments (such as relief in the form of deferral of payments).
Overseas supplies no longer available due to overseas governments’ actions.
Costs associated with temporary suspension of operations.
Restart costs - certain processes may require extended restart periods or remediation or require regulatory approvals before production can begin, supply chain may not be resilient in the circumstance and not able to restart in accordance with the entity’s plans.
Liquidity considerations
Operational considerations:
Risk relating to receivables (delays or failures of counter parties, requests for changes in payment terms).
loss in ability to factor trade receivables due to uncertainties over collectability.
Impact of trade financing products such as letters of credit, forfeiting, shipping and payment terms, etc.
Risk of significant business expansion into a new sector that is not sustainable in the future.
Adverse movement in bond yields leading to deterioration of value of investments and impact on recoverability due to adverse market movements
Funding considerations:
Understanding the sources of available cash – shareholders (including related parties), lenders.
Position of asset liability mismatch especially in case of financial institutions and the adverse implications of such ALM gap.
Determination of whether funding facilities are on demand or committed, any representations or warranties required by funding agreements and if there is a risk of funding being withdrawn.
The impact on funding due to but not limited to:
o Potential covenant breaches.
o Material adverse changes/material adverse event clauses in debt agreements.
o Debt maturity profile and impact of COVID-19 on refinancing risk.
Clarity on how any accounting for exceptional items or adjusting items will be treated in determining covenant compliance.
Risk of contingent liabilities (bank guarantees, performance guarantees, bonding, etc.).
Risk that the parent company will no longer support the business.
Management information and forecasting capability considerations
Quality and timeliness of the financial and operational information used to manage the day to day business.
Appropriateness of methodology or approach to short-term cash forecasting.
Management’s track record on forecasting expenditure such as cost reductions, plant restarts due to COVID-19.
Whether management prepared a reverse stress test of liquidity, solvency and where applicable, covenant compliance to consider the maximum downside risk that would need to be managed through.
Whether management has put in place actions in defining contingency plans for all aspects of the
Mitigating Factors
Further, the following considerations may mitigate the risks listed above which the auditor may consider:
• Any mitigating actions available to management (e.g., capital expenditure reductions, reduction in dividends, suspension of non-performance based bonuses, deferral of payments of principal and interest, cost reduction actions, working capital reduction, taxation payment holidays or deferrals or COVID-19 driven government funding, asset liquidation, government supported staff retention schemes and other governmental measures).
• Arrangements with lenders to lend against any government guaranteed cash flows (if available) to improve liquidity. Nevertheless, the auditor should consider whether the impact of any mitigating factors have been reflected in the revised business plan or forecast (e.g., reduced capital expenditure may impact production and in turn may reduce revenues), and whether these actions are feasible and in the control of management, or do these actions rely on third party or government actions.
Period of Assessment – Look Forward Period
The period for which management’s assessment is required is set out in financial reporting frameworks (Ind AS 1, Presentation of Financial Statements and AS 1, Disclosure of Accounting Policies). Ind AS 1 and AS 1 require that all available information about the future, which is at least, but not limited to, twelve months from the end of the reporting period, should be considered by management. SA 570 (Revised) requires the auditor to cover the same period as that used by management to make its assessment unless the period is less than 12 months, in which case, the auditor is required to request that management extend its assessment to 12 months from the date of financial statements.
Further, Paragraph 15 of SA 570 (Revised) sets out that, the auditor shall inquire of 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. The auditor should remain alert for and consider the consequences of known or expected events that will occur soon after the twelve months from the end of the reporting period (e.g., ceasing of operations or slowing due to supply chain issues, significant reduction in sales due to restricted operations for non-essential retail businesses, maturing of debt and strained cash flows, or loan covenants that may not be met during the evaluation period (e.g., because of a significant reduction in fair value of investments and other assets), or an entity will be unable to pay its creditors shortly after the twelve months from the end of the reporting period).
Additional procedures when events or conditions are identified
As per SA 570 (Revised), If events or conditions have been identified that may cast significant doubt on the entity’s ability to continue as a going concern, the auditor shall obtain sufficient appropriate audit evidence to determine whether or not a material uncertainty exists related to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern (hereinafter referred to as “material uncertainty”) through performing additional audit procedures, including consideration of mitigating factors. Paragraph 16 and Paragraph A 16 include examples of audit procedures that are relevant to this requirement.
As it is likely, that the COVID-19 pandemic will result in events and conditions that may cast significant doubt on an entity’s ability to continue as a going concern, it is also more likely that auditors may need to perform the additional audit procedures. In addition, the auditor may also wish to consider whether management has:
Developed and implemented actions and processes so that they can continue to operate an effective control environment, in particular how key reporting and other significant controls have been addressed in changed circumstances.
Consider how they’ll secure reliable and relevant information, on a continuing basis, in order to manage future operations, including for example, the flow of financial information from other parts of businesses.
IAASB in its Staff alert has provided the following focus areas for auditors on account of COVID corresponding to the procedures provided in Paragraphs 16 and A16:
Implications for the Audit Report
Paragraphs 17 and 18 of SA 570 (Revised) require the auditors to
evaluate whether sufficient appropriate audit evidence has been obtained regarding, and shall conclude on, the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements.
Based on the audit evidence obtained, conclude whether, in the auditor’s judgment, 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.
Further, the standard requires the auditor to determine whether the financial statements provide adequate disclosure about the identified events or conditions related to going concern and, as applicable, management’s plans in this regard.
While the impact of COVID 19 pandemic may amplify events or conditions giving rise to modifications to the auditor’s report or opinion, it does not itself mean a modification is inevitable. This will depend on the facts and circumstances in each entity. Similarly, the level of disclosures required will depend on facts and circumstances. Not all entities are affected by current evolving environment in the same manner or to the same extent. The auditor uses professional judgement in determining the adequacy of disclosures and the implications of inadequate disclosures on the auditor’s opinion or on the auditor’s report.
The potential implications for the auditor’s report are summarized below:
Conclusion:
The considerations and focus areas provided by ICAI/IAASB will assist the Management and Auditor in assessing and evaluating the Going Concern assumption. However, it is imperative to note that these considerations and focus areas cannot serve as a common template that can be applied across Companies/Industries. Care should be taken to assess or evaluate going concern on the basis facts and circumstances of each case. Further, enhanced disclosures enable the users of financial statements to understand the judgments taken and basis for the conclusion on going concern assessment by Management/Auditor.
Note: Guidance/Practice alerts issued by IAASB or AASB of ICAI are issued to guide or assist the management or Auditor to comply with the requirements set forth in specific standards/regulatory requirements. They do not override the Standards on Auditing or Accounting standards.