This article discusses the financial reporting and audit considerations for entities facing going concern challenges while preparing their financial statements
Business entities have many objectives, including making a profit and, to a large extent, maximising stakeholders’ interests. Business risks such as a harsh business environment, unfavourable government policies, and adverse effects of changes in macroeconomic indicators have continued to threaten the ability of entities to continue in business and achieve their objectives. The recent Covid 19 pandemic, which resulted in a global lockdown, significantly impacted businesses as some companies are yet to recover from the losses occasioned by the pandemic. Companies have continued to develop resilient strategies to enhance their ability to navigate these risk exposures. As a result, many entities struggle with going concern issues as they engage in various approaches to survive.
For reporting purposes, a business should assess its ability to continue in business for the foreseeable future and, as such, prepare its financial statements under the going concern assumptions.
The Concept of Going Concern
Going concern refers to a situation where an entity can continue business and discharge its financial obligations for the foreseeable future. Foreseeable future has been explained by IAS 1: “Presentation of financial statements” to mean at least 12 months from the end of the reporting period. This means that the entity has no intentions to liquidate or stop continuing with business or significantly reduce the scale of its operations in the next accounting period. An entity is assumed to exist and prepare its financial statements under the going concern assumptions as the value of assets will be realised and obligations discharged in the ordinary course of business.
Before an entity eventually starts facing serious going concern issues, the early warning signs are usually visible as they struggle to meet their obligations due to various factors. In assessing whether the going concern assumption is appropriate, management considers all available information about the future, which is at least but is not limited to twelve months from the end of the reporting period. Below are some indicators that an entity might be facing going concern issues:
- Pending litigation proceedings against the entity in which the outcome will result in a high probable outflow of economic resources that the entity may not be able to settle.
- Major loan repayments are falling due, which the entity will not be able to meet, and the inability to renegotiate terms of the financing arrangement.
- Adverse key financial ratios.
- Inability to settle distributions to equity holders in their capacity as owners of the business.
- A continuous decline in the entity’s financial performance has resulted in negative net assets.
- Unfavourable key financial ratios in leverage, liquidity, and profitability.
- Negative cash flows from the operating activities of the entity.
How Should Assets and Liabilities be Measured?
Paragraph 3.9 of the revised IASB Conceptual Framework states that financial statements should be prepared on the assumption that the reporting entity is a going concern and will continue operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to commence liquidation or cease business. If such intention or need exists, the financial statements may have to be prepared differently. If so, the financial statements should describe the basis used for the preparation.
Paragraph 6.1 of the framework states that elements recognised in the financial statements are quantified in monetary terms, and it requires the selection of a measurement basis.
The measurement bases include:
- Historical Cost: This is the costs incurred in acquiring or creating the asset, including the transaction costs.
- Current Value: These measurement bases provide monetary information about assets, liabilities, and related income and expenses, using information updated to reflect conditions at the measurement date. Current value measurement bases include [Paragraphs 6.10 & 6.11]:
(a) fair value (paragraphs 6.12– 6.16);
(b) value in use for assets and fulfillment value for liabilities (paragraphs 6.17–6.20); and
(c) current cost (see paragraphs 6.21– 6.22).
In line with the requirements of the conceptual framework, there is no specific measurement basis to be adopted when there is a going concern issue and liquidation is imminent. The standard requires an entity to use the current value method when circumstances regarding the entity have changed. The options available under the current value measurement method would be to adopt the fair value method.
When liquidation is imminent for entities struggling with going concern issues, the circumstances surrounding their continued existence would have changed as the financial statements will no longer be prepared under the going concern assumption. The objective of their financial statements, when not prepared on a going concern basis, will change to reflect prevailing commercial reality. This, therefore, means that the appropriate measurement basis to use should reflect the following:
Assets: The amount that would be received to dispose or sell the assets or that at which the value of those assets could be realised under liquidation proceedings.
Liabilities: The amount that would be paid to settle all the liabilities fully.
The fair value method is the measurement basis that reflects the nature of the above requirement in line with the revised IFRS framework. It is important to note that the fair value of the assets and liabilities should not be determined with reference to an active market as required by IFRS 13. The fair value in this instance should be the forced sales value as the entities do not have any other realistic alternative than to liquidate. This departure from the Fair value hierarchy in IFRS 13 should be disclosed.
Should the Going Concern issue be disclosed?
IAS 1 states that management should assess an entity’s ability to continue as a going concern when preparing financial statements. An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or cease trading or has no realistic alternative but to do so.
When management is aware, in making its assessment, 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 entity shall disclose those uncertainties. When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis in which it prepared the financial statements, and the reason for the entity is not regarded as a going concern. [IAS 1:25].
From the requirements of IAS 1, emphasis is on the disclosure of going concern issues when management assessment reveals that there are material uncertainties that may cast significant doubt upon their continued existence. In addition, IAS 1 requires that management disclose the basis upon which the financial statements have been prepared and whether there is any departure from the requirements of IFRS.
In line with IAS 10, when there is a going concern issue after the reporting period and before the financial statements are authorised, entities are expected to adjust their financial statements to reflect their commercial reality. This means the following:
- Assets: The conceptual framework, as explained above, requires that all assets, excluding cash and short-term instruments, be written down to the most likely amount for which they could easily be realised under forced-sale conditions. This would reflect their fair values under the current commercial reality.
- All non-current liabilities should be reclassified as current liabilities as they are expected to be settled within the next 12 months from the reporting period.
- Again, all current liabilities should be stated at the most likely amount reasonably required to settle the obligations at the measurement date.
- If contractual commitments may become onerous or a cancellation fee will be paid on existing contracts due to the liquidation, it would be reasonable to accrue for any of such foreseen costs.
Going concern implications for the Independent Auditor
Paragraph A27 of ISA 570 states that when the going concern basis of accounting is not appropriate in the circumstances, management may be required, or may elect, to prepare the financial statements on another basis (e.g., liquidation basis). The Auditor may be able to perform an audit of those financial statements provided that the Auditor determines that the other basis of accounting is acceptable in the circumstances.
The Auditor may be able to express an unmodified opinion on those financial statements, provided there is adequate disclosure therein about the basis of accounting on which the financial statements are prepared, but may consider it appropriate or necessary to include an ‘Emphasis of Matter’ paragraph in accordance with ISA 706 (Revised) in the Auditor’s report to draw the user’s attention to that alternative basis of accounting and the reasons for its use.
Summary and Conclusion
IAS 1 requires management to assess whether their going concern status is in doubt. If this is established, the financial statements should be prepared on a liquidation basis with the following taken into consideration:
- assets and liabilities are not stated at their historical costs but at their fair values, which is the amount reasonably required to realise their assets and settle the liabilities under the prevailing circumstances. This method could also be regarded as the net-realisable value method in line with conventional accounting practice.
- Disclose the basis of preparation and significant judgments made during the preparation.
- Indicate in the notes that the financial statement is not prepared under the going concern assumptions.
ISA 570 requires that auditors should challenge the going concern basis after management assessment to determine that the financial statements and related disclosures are reasonable and appropriate under the circumstances.
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