Definition of going concern
Going concern is a fundamental accounting concept. Financial statements are normally prepared on the assumption that an entity is a going concern. Going concern implies that the entity will continue its operation in the foreseeable future. It is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations. If there is such an intention or need, the financial statements are prepared on a basis different from the basis on which a going concern prepares its financial statements.
What should be that different basis is not stipulated in IFRS. An entity needs to decide the most appropriate basis in view of the existing circumstances.
In assessing whether an entity is a going concern, usually a detailed analysis is not required if the entity has a history of profitable operations and has access to financial resources. However, in certain situations detailed analysis is required. IFRS (IAS 1, Presentation of Financial Statements) stipulates that in assessing if the going concern assumption is appropriate the management should take into account all available information about the future.
The period covered should be at least 12 months from the balance sheet date, but it should not be limited to the same. The assessment of the validity of the going concern assumption involves judgement about outcome (of events and conditions), which is uncertain. The uncertainty increases significantly the further into the future a judgment is being made about the outcome of an event or condition. Therefore, usually the 12 month period from the balance sheet date is considered appropriate.
Examples of events and conditions that individually or collectively give rise to significant uncertainty on the ability of an entity to continue its operations are: net liability or net current liability position; absence of realistic prospect for renewal or repayment of long term loan approaching maturity, inability to comply with key terms of loan agreements, adverse key financial ratios, loss of key management without replacement, labour difficulties or shortage of essential inputs, non-compliance with statutory requirements, and change in the government policy.
UK Coal in its balance sheet for 2007 disclosed:
“In forming its opinion as to going concern, the Board prepares a working capital forecast based upon its assumptions as to trading as well as taking into account the available borrowing facilities in line with the Treasury Policy above. The Board also prepares a number of alternative scenarios modelling the business variables and key risks and uncertainties, both as summarised in the Operating and Financial Review.
Based upon these, the Board has concluded that the Group has adequate working capital and therefore confirm their belief that, it is appropriate to use the going concern basis of preparation for the financial statements of the Company and the Group”.
No assurance for long term sustainability
The size and complexity of the entity, the nature and condition of business and the degree to which it is affected by external factors affect the judgement of the outcome. Any judgement on future is based on information available when the judgement is made. Subsequent events can contradict a judgement which was reasonable when made. Therefore, it is not easy to form a judgement on the validity of the going concern assumption. The use of going concern assumption in the preparation and presentation of financial statements does not provide an assurance for the sustainability of the entity in the long term.
IFRS (IAS 1) stipulates when management is aware, in making an 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. There is no such requirement under the Indian GAAP. There is another disclosure requirement under IFRS, which is similar to that required under the Indian GAAP. An entity that does not prepare financial statements on a going concern basis discloses that fact together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern.
International Standard on Audition 570 (ISA 570) lays down the responsibility of the auditor. The auditor’s responsibility is to consider the appropriateness of management’s use of the going concern assumption in preparation of financial statements, and consider if there are material uncertainties on the entity’s ability to continue as a going concern that need to be disclosed in the financial statements. The auditor should be alert as to the existence of events and conditions and consequent business risks that cast significant doubt as to the ability of the entity to continue its operation. When the auditor identifies such events and conditions he carries out certain additional audit procedures and discusses with the management about the significance of those events and conditions. The auditor should be satisfied about the adequacy and appropriateness of the management’s assessment process and the adequacy of disclosure, if doubt about the going concern assumption exists. This requires the auditor to understand the business model of the entity and the dynamics of the business environment.
IAS 570 stipulates the auditor cannot predict future events or conditions that may cause an entity to cease to continue as a going concern. Accordingly, the absence of any reference to going concern uncertainty in an auditor’s report cannot be viewed as a guarantee as to the entity’s ability to continue as a going concern. Such stipulations in auditing standards make investors uncomfortable. They depend on the judgement of the auditor and such stipulations while protect the auditor put investors in a hapless situation particularly when the going for the entity, which is large and complex, is not good.
Perhaps there is a need to review the defensive approach that auditing standards usually adopt. In the current business environment, it is not unreasonable for investors to depend on auditors to ensure that disclosure of uncertainties, if any, is adequate. However, in absence of such a disclosure requirement in Indian GAAP, it is unlikely that companies will disclose going concern uncertainties voluntarily.
Public sector perspective
Usually the going concern assumption in the preparation of the financial statements of a public sector enterprise is not questioned when funding arrangements are backed by the Centre. However, where such arrangements do not exist the auditor has to evaluate the management’s assessment of the going concern assumption. Indian GAAP does not require disclosure of the method/ technique that the entity uses to assess whether it is a going concern.
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