At a glance
Looking at least 12 months ahead to assess and establish whether an entity remains a “going concern” is a routine exercise conducted as part of preparing annual financial statements. Any entity that prepares financial statements in compliance with International Financial Reporting Standards (IFRS) or Australian Accounting Standards (AAS) is required to undertake this assessment to ensure the financial statements are prepared on a going concern basis.
The forward-looking assessment, which can pose challenges even during normal times, is likely to be significantly more difficult in many industry sectors due to the economic uncertainties arising out of COVID-19. The going concern assessment is primarily the responsibility of the preparers of financial statements, although the assessment and conclusions must also stand up to scrutiny by auditors.
For a historically profitable entity with sufficient liquidity and ready access to finance if needed, the going concern assessment will require minimal effort during normal times.
This may continue to be the case for some businesses that meet the criteria and are unaffected by the current crisis (e.g. utility providers, technology infrastructure, telecommunications) and others that are seeing an upturn in business activity (e.g. pharmaceuticals, healthcare providers, grocery retailers, online retailers).
A good track record is just one indicator
Of course, past profitability and liquidity should be considered along with prospects. A short-term revenue spurt does not necessarily indicate sustained profitability. Even the most stable and successful organisations may need cashflow projections and forecast operating results based on reasonable assumptions to support the going concern assessment.
It makes good business sense to look ahead and put some thought into where a business is likely to be in six to 12 months. This forward-looking assessment will not only provide comfort to auditors, but also to an entity’s management and investors.
Shaun Steenkamp, Finance Partner – Enterprise Property & Strategic Sourcing at National Australia Bank says, “Preparers will need to carefully assess all previous going concern assumptions in light of the current environment.”
A stable and successful business operation could be the exception rather than the norm during these difficult economic times. All around us, we are seeing indicators of severe disruptions in economic activity that could have an impact on the going concern assessment.
Many sectors have had to completely shut down their operations either due to government enforced requirements, or due to lack of customers. This includes airlines, tourism, hospitality, entertainment, and many retail operations such as clothing. Closure of manufacturing facilities and a reduction in commercial transport has resulted in severe interruption to supply chains as well.
Some thought needs to go into how the new concept of “economic hibernation” will affect the going concern assessment. Many of the Australian governments’ stimulus packages are aimed at providing financial support to businesses that have either closed down completely or reduced their operations significantly. This financial support is expected to tide them over until such time that the economy is restarted.
Finance from different sources
In addition to financial support from government, some businesses may need support from their finance providers as well. Some listed entities are reaching out to investors through equity raising offers.
Others, including non-listed entities, are approaching their debt providers to either restructure existing debt arrangements or establish new lending arrangements. Yet others are turning to governments for rescue packages to keep them afloat through the crisis.
“Access to funding sources, such as shareholder funds or credit, might not be as readily available when a significant portion of the economy is seeking the same access,” says Steenkamp.
Steps being taken to shore up business balance sheets will factor into the going concern assessment. Although there are some uncertainties around when normal economic activity will restart, estimates will need to be made around when this will happen to feed into cashflow projections and financial forecasts based on operating activities and results.
These estimates will have to be based on reasonable assumptions. Any uncertainties associated with these and other assumptions made in determining that the going concern basis is appropriate will need to be fully disclosed in the financial statements.
Steenkamp says: “Financial institutions have announced various initiatives to assist where they can. But, for assessing the going concern assumption over at least 12 months, it will be important for preparers to consider their long-term ability to repay debt in a subdued economic environment.”
Alternatives to the going concern basis
Going concern assessments based on overly optimistic and unreasonable assumptions are unlikely to pass the audit test. Investors and financiers may not take kindly to misleading or inappropriate going concern assessments by entities.
It is unusual for financial statements to be prepared on a “non-going concern” basis, but we live in unusual times. According to Siva Sivanantham, Director – Financial Reporting Advisory at Grant Thornton Australia, “an entity should only move to a basis of accounting other than the going concern basis if the entity has made a decision to shut down or has no realistic alternative but to do so.
“For example, if an entity goes into administration and sells its business because there is no realistic alternative and will then be winding up, a non-going concern basis would be appropriate”.
“Accounting standards are written from a going concern perspective and do not prescribe or define any alternative bases of accounting (such as ‘liquidation basis’) where the going concern basis is no longer appropriate,” says Sivanantham.
“General industry practice is to follow the recognition and measurement requirements in accounting standards as closely as possible even when the going concern basis is no longer appropriate,” he adds.
The Australian Accounting Standards Board (AASB) is developing guidance on applying the going concern concept against the COVID-19 backdrop. They are also considering guidance on the accounting principles that could be followed when the going concern basis does not apply.
Legal obligations and going concern
In addition to the going concern assessment, directors are also required to make a declaration of solvency under the Corporations Act that there are reasonable grounds to believe that the entity will be able to pay its debts as and when they become due and payable.
Regulatory Guide 22 Directors’ statement as to solvency (RG 22) issued by the Australian Securities and Investments Commission envisages a qualified statement if there are material uncertainties surrounding a company’s solvency or a negative statement if it is clear that the company is insolvent and will be unable to pay its debts as and when they fall due.
Included within the economic measures announced by government in response to the COVID-19 crisis is a six-month temporary “safe harbour” for directors to protect them from personal liability if they continue to trade while insolvent.
The interplay between the going concern assessment and the impact of uncertainties on the directors’ statement as to solvency and when they need to qualify that statement, needs consideration, particularly in the context of the recent provision of insolvent trading relief to directors.
Shaun Steenkamp and Siva Sivanantham are members of the CPA Australia External Reporting Centre of Excellence