With the economic uncertainty, stagnated growth and liquidity crisis in recent times, there is no respite from high interest rates. Consequently, there have been many instances where the auditor’s report indicates uncertainties relating to the ‘going concern’ assumption used by the company in preparing its financial statements.
The ‘going concern’ assumption evidences a company’s ability to continue with its business in the foreseeable future. It indicates that the company has neither the intention nor the necessity for liquidation or materially curtailing the scale of operations. Further, it would realise its assets and discharge its liabilities in the normal course of operations.
The ‘going concern’ assumption, therefore, is one of the fundamental accounting assumptions, based on which the company’s financial statements are prepared. It would be of interest to note that when the ‘going concern’ assumption is validated, the assessment is usually made only for a period of twelve months.
Indicators
There are several established financial and operating indicators to look for while assessing a ‘going concern’ assumption. The financial indicators include the negative net worth of the company or its negative working capital, continuing operating losses, adverse financial ratios, inability to pay creditors, negative cash flow, and so on.
Operating indicators may include loss of major customer, supplier or market, outdated products, labour unrest or shortage of important resources. There could also be external factors such as non-compliance with statutory requirements and potential litigations against the company. In evaluating the indicators of a going concern, it is imperative to look at the mitigating factors as well.
The auditor and management alike could face challenges in assessing the ‘going concern’ assumption in the current economic environment. Although the onus is on the management to evaluate the material uncertainties surrounding the ‘going concern’ assumption and make appropriate adjustments/ disclosures in the financial statements.
Management’s responsibility
It is ultimately the management that is responsible for preparing financial statements. It should also assess the appropriateness of using this fundamental accounting assumption. Further, under the Companies Act, 1956, the directors of a company are required to declare in their report that the financial statements have been prepared on ‘going concern’ basis.
Auditors’ responsibility
The auditor has a crucial role in evaluating the appropriateness of the ‘going concern’ assumption used by the management in preparing the company’s financial statements. Standard on Auditing 570 (Revised) issued by the CA Institute deals with this issue. Inadequate disclosures in the financial statements, or inappropriate use of ‘going concern’ assumption leads the auditor to include this matter in his report for stakeholders’ attention.
Forecasts and budgets, in particular, cash flow projections supported by business plans are the most important components of ‘going concern’ assessment. The sceptical evaluation should include validating assumptions made by the management in its projections and its plan for future action. The current economic conditions, however, may challenge assumptions made in the past.
Relevance
Failure to make a proper assessment will render financial statements meaningless and may adversely impact stakeholders. One of the potential risks in the preparation of financial statements arises when the assessment of ‘going concern’ assumption is seen as ‘routine’ and not important. A fair evaluation by the management, as well as reporting by the auditor would lend greater credibility to company financial statements.
Harinderjit Singh is Partner, Price Waterhouse