Assessing the Going Concern Assumption in the Current Economic Environment

HKAS 1 and HKSA 570 acknowledge that entities with a history of profitable operations and ready access to financial resources may not need a detailed analysis to support the going concern assumptions. However, the effect of the global financial crisis and economic downturn are likely to be that such an approach will no longer be appropriate for many entities. Our recent business experiences show that many entities are lack of availability of finance and have liquidity problems. It is not guaranteed that these entities will remain a going concern in the coming future even their businesses have been profitable for a long period of timeBelow we will discuss the matters which are important to management and auditors when they are in consideration of the use of the going concern assumption in the preparation of the financial statements in the current environment. Making an assessment of an entity’s ability to continue as a going concern As it is the responsibility of management to make an assessment of an entity’s ability to continue as a going concern when preparing financial statements (HKAS 1), management should be aware of the impact of the global financial crisis to the business of an entity and those material uncertainties related to the events and conditions which may cast doubt on the entity’s ability to continue as a going concern.In assessing whether the going concern assumption is appropriate, management has to take into account all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period in accordance with HKAS1. Factors to consider in assessing going concern Management may need to consider a wide range of factors relating to current and expected profitability, debt repayment schedules and potential sources of replacement financing in making their assessment. For example: Reviewing borrowing facilities: are they coming up for renewal? Will they be renewed? Review budgets and forecasts to see if (and when) there are going to be any adverse changes in income and costs and what action should be taken. Consider whether there will be any large cash outflows due out in the immediate future (for example a large corporation tax payment). Review credit terms granted by suppliers and consider whether these terms are going to be subject to an adverse change. Review any key terms which are present in any banking or other credit facilities. Events and conditions which may cast doubt on going concern HKSA 570 Going Concern requires auditors, when planning, performing audit procedures and in evaluating the results thereof, to consider whether it is appropriate for management to us the going concern assumption in preparing financial statements.Auditors should identify the events and conditions which may cast doubt on the entity’s ability to continue as a going concern. Such events and conditions include: Financial Net liability or net current liability position. Fixed-term borrowings approaching maturity without realistic prospects of renewal of repayment; or excessive reliance on short-term borrowings to finance long-term assets. Indications of withdrawal of financial support by debtors and other creditors. Negative operating cash flows indicated by historical or prospective financial statements. Adverse key financial ratios. Substantial operating losses or significant deterioration in the value of assets used to generate cash flows. Arrears or discontinuance of dividends. Inability to pay creditors on due dates. Inability to comply with the terms of loan agreements. Change from credit to cash-on-delivery transactions with suppliers. Inability to obtain financing for essential new product development or other essential investments. Operating Loss of key management without replacement. Loss of a major market, franchise, license, or principal supplier. Labor difficulties or shortages of important supplies. Other Non-compliance with capital or other statutory requirements. Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that are unlikely to be satisfied. Changes in legislation or government policy expected to adversely affect the entity. Disclosures Hong Kong Financial Reporting Standards require disclosures of risks and uncertainties that assist users of the financial statements to understand the challenges facing by the entities, including: 1. Specific disclosures of material uncertainties related to events or conditions that, alone or in aggregate, may cast significant doubt upon the entity’s ability to continue as a going concern (HKAS1); 2. Disclosures of the nature and extent of risks arising from financial instruments (HKFRS7); and 3. Disclosures of key sources of estimation uncertainty about the carrying amounts of assets and liabilities (HKAS1). Forming the opinion on the financial statements in the Auditor’s report regarding the appropriateness of using the going concern assumption The current economic conditions are likely to increase the level of uncertainty existing when management makes their judgment about the outcome of future events or conditions. The auditors should carefully evaluate and conclude the appropriateness of management’s use of the going concern assumption based on the audit evidence obtained as well as consider the adequacy of disclosures, in particular, those relating to the significance of uncertainty, in forming an opinion on the financial statements. HKSA 570 provides detailed guidance and implication on the appropriate format and wording of the auditor’s report. The modifications to the auditor’s report for different situations are summarized as follows: SituationModification to auditor’s report Going concern assumption appropriate but a material uncertainty exists - Adequate disclosure is made - Adequate disclosure is not made - Add an emphasis of matter paragraph - Express a qualified or adverse opinion Multiple uncertainties having significant impact to the financial statements existMay consider a disclaimer of opinion instead of adding an emphasis of matter paragraph Going concern assumption inappropriate while financial statements prepared on a going concern basisExpress an adverse opinion Management is unwilling to make or extend its assessmentModify the auditor’s report as a result of the limitation of scope Conclusion Although the current financial crisis increase the difficulties in assessing an entity’s ability to continue as a going concern, it is necessary for management and auditors to meet their responsibilities by making clear to users of the financial statements the reasons why the entity is a going concern, the assumptions on which that conclusion is based and the risks that events may turn out differently. Disclaimer: The publication contains information in summary form and is therefore intended for general guidance only. This publication is not intended as legal, accounting or other professional advice and should not be relied upon as such. If legal, accounting or other professional advice or expert assistance is required, the services of a competent professional should be sought. Neither Reanda Lau & Au Yeung Limited nor any related entity shall have any liability to any person or entity that relies on the information contained in this publication. For details, please refer to: the Hong Kong Accounting Standard 1 - Presentation of Financial Statements (issued by the HKICPA in March 2004); the Hong Kong Standard on Auditing 570 –Going Concern (issued by the HKICPA in June 2005); and “Audit Considerations in respect of Going Concern in the Current Economic Environment”, Staff Audit Practice Alert, the International Auditing and Assurance Standards Board, January 2009.