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SuzyOrr
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Posted: Wed Oct 8th, 2008 09:00 |
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Going Concern in a Credit Crisis – Call for Your Views
Steve Priddy
ACCA Director Technical Policy and Research
October 2008
One of the fundamental accounting concepts is that financial statements are prepared on a going concern basis – that is that there is an underlying assumption that the entity will continue in operational existence for the foreseeable future and that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations. The generally recognised alternative to the going concern basis is to assume that the business will be broken up. This may significantly diminish the carrying amount of assets previously reported in the balance sheet since it assumes that the assets will be subject to a forced sale and not realised in the normal course of business.
The extraordinary economic events of the last year have led to some spectacular business failures both within and outside the financial services sector. Deteriorating economic conditions and the drying up of liquidity have raised the importance of the going concern assumption up the corporate agenda, and, as a result, the Financial Reporting Council have revisited and proposed amendments to the guidance issued to Directors of Listed Companies first published 14 years ago. While the guidance is addressed to Directors of only listed companies, the FRC strongly encourages extension of its application to all directors in discharging their obligations under the Companies Act 2006.
The purpose of this note is to ask whether economic circumstances have changed so radically that the application of the going concern concept is no longer applicable or is in some way severely compromised. It is hoped that the note will stimulate discussion and debate among ACCA members and thereby inform the response of ACCA to the FRC consultation.
Without doubt, economic transactions, businesses and markets have increased in complexity since the original publication of the guidance. Increased computing power combined with increased intellectual human capital have led to vastly greater sophisticated business models. This is particularly the case within the financial services sector, but it is not confined to that sector. Computers can perform calculations at speeds unthinkable of a decade ago. At the same time accounting has had to understand and record transactions taking place over many years – the transactions of pension schemes or service concession arrangements over decades, for example. And of course markets have become increasingly global over the same period.
In these circumstances is it reasonable for Directors to actively consider whether their businesses will still be around in 12 months’ time – the current time line definition of the “foreseeable future”? And it is worth emphasising that the 12 month period recommended by FRC in its guidance is 12 months from the date of approval of the financial statements, not 12 months from the last Balance Sheet date. Practically this means that a company whose year end is 31 October 2007, but whose statements are approved by the Board of Directors in May 2008 is strictly making an assessment of going concern status through to May 2009.
In my opinion the current economic situation in no way reduces the responsibility of the Directors and their external Auditor, where appropriate, to actively consider the status of their company with regard to the going concern assumption. But perhaps we might consider some of the factors limiting an appreciation of the assumption, both from the perspective of the Directors and Auditor, but also from the perspective of the financial statement user.
Fundamental to the going concern status of the organisation is of course the ability of that organisation to generate free cash flow for the foreseeable future. Organisations will be producing cash flow forecasts and monitoring performance against those forecasts. Such forecasts will be central to discussions with funders around financing facilities and their terms. But such forecasts are not in the public domain – they form part of the management accounting of the organisation. What we do have in the public domain in addition to the P&L and Balance Sheet is the Cash Flow Statement (CFS).
Over the years of developing regulation and standard setting, the CFS has been sadly neglected. As a result it is perhaps less well understood and used. For example, a large group of companies which entered administration in September 2008 and whose financial statements were approved by the Directors in May 2008 showed a positive increase in cash in the 12 months to 31 October 2007 of £24.2m. So, perhaps the organisation was adversely affected in the year following. But inspection of that increase shows that there was actually a net cash outflow of £15.0m, dominated by an outflow of £46.5m on acquisitions and disposals. The positive increase was only achieved by Management of liquid resources of £20.4m and Financing of £18.8m. And further explanation of the Management of liquid resources shows that this was achieved by reducing sums on bank deposit, and Financing primarily by Loans drawn down. In other words the ability of the group to generate free cash from trading activities seems to be illusory and should have put any user of the financial statements on guard.
In my opinion the FRC update does not say enough about cash and cash flow generation. But the update is welcomed. It is clear that more organisations will be trading in difficult circumstances over the coming months. The benefits of actively considering the going concern assumption are fundamental to economic well being of companies. The cost of neglecting it is business failures and a further undermining of the trust between businesses, and between the stakeholders of those businesses.
However, it is your views we would like to hear. The FRC guidance is included with this note. Please leave a comment on this discussion board before 24th November.
Thank you.
Steve Priddy
ACCA Director Technical Policy & Research
Attachment: Going concern.pdf (Downloaded 72 times) Last edited on Wed Oct 8th, 2008 09:02 by SuzyOrr
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aziztayyebi
International Technical Policy & Research
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Posted: Fri Oct 10th, 2008 14:47 |
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Fascinating and extremely topical piece, given the current market turmoil. The issue seems yet more significant given the fact that companies, which albeit in hindsight, appeared to show signs of less than stable futures in their financial statements, being accounted for as going concerns. The accounts of XL Leisure Group plc, which was forced into administration in September 2008 (less than four months after their accounts were filed as giving a ‘true and fair’ view’), showed the company has been making significant operating losses in recent years (despite the internal sale of a subsidiary for a significant accounting profit). This coupled with the significant gearing of the company, which had left the company in a net current liability position of £60m in 2007 (2006: £8m), would surely have raised alarm bells for those signing the accounts. While due process was probably followed, the fact that there is scant reference to the apparent predicament of the company (the CEO report mentions difficult challenges, but with a promising and exciting future), no mention of missed payments on loan facilities etc., this surely brings into question the effectviness of the current requirements on reporting going concern.
Last edited on Fri Oct 10th, 2008 14:48 by aziztayyebi
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grahamfairclough
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Posted: Mon Oct 13th, 2008 16:20 |
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Going concern seems to be rather the thorn in the side of the audit profession. Each time a company goes bankrupt, the cry comes sooner or later of “where were the auditors”? Generally, the auditors were in their office as the events happened well after the year-end audit, but it remains an area that presents us with significant expectations gap, as well as some serious ethical dilemmas for the reporting accountant.
Investors in XL Airways will now no doubt be taking notice that their company’s auditors a few years previously had resigned, citing differences with management. This ought to have put the shareholders on notice, but it also ought to have put the new auditors on notice. We really can’t hide behind a screen that the investors ought to be doing a thorough going concern review for themselves – that really is an inalienable part of our job.
There are many businesses that intrinsically are subject to higher levels of going concern risk than others. Banks, insurance brokers and other institutions routinely deal with large numbers of risks that could individually put them out of business. Although Steve Priddy’s point is fair that increased use of IT has enabled more complex transactions to be undertaken, IT has also provided companies and their auditors with much greater scope to track and manage risk. I do not believe that IT can be blamed for the increased risk taking that we have seen in recent years, although I think it’s fair to ask whether the directors and auditors of certain institutions were sufficiently skilled to have a good understanding of the risks that the business was taking.
Modifying an audit opinion on grounds of going concern, including by means of extensive disclosures and an emphasis of matter paragraph, seem to offer rather academically appealing solutions to the problem. They don’t. The auditor of XL Airways would almost certainly have precipitated the collapse of the company and all the ensuing human misery if he/ she had made some mention of going concern as an elevated risk in the audit opinion. Current reporting on going concern provides us only with an option of doing nothing or going nuclear. Faced with this dilemma, most auditors do nothing. This is wholly unsatisfactory, but any suggestion that we can absolve ourselves of any responsibility for going concern assessment is equally unsatisfactory.
For a moment, let’s turn our attention to the market for traded debt. After all, the world market for debt is much bigger than the market for equities. The debt market has evolved a solution that seems to create less controversy than our hand wringing about going concern, in the form of credit ratings given by independent agencies. A bond rated CCC will require a much higher return than a AAA rated bond since it’s seen a higher risk of default, which is a closely related idea to going concern.
My suggestion is that a similar system ought to be introduced for audit reporting, with the primary responsibility on directors to make an assessment of their own going concern anxiety on a scale of A (for companies such as the National Lottery) to E (for companies agreed to not be going concerns). The auditor could then give negative assurance, or report by exception on this self- credit rating. For organisations such as banks, disclosures required by accounting standards such as IFRS 7 should largely do this job anyway.
I agree with Steve Priddy that the cash flow statement (or the statement of cash flows as we have to learn to call it) is a valuable source of information. All the information he mentions in his example should have been picked up by an informed investor. But it wasn’t. When people are making lots of money, they are not interested in looking for going concern problems where none is immediately apparent. That may not be rational, but it’s the way the world works and as a profession, we need to engage with that reality. We do ourselves no favours by blaming excessively passive investors as a get-out for excessively passive auditing.
So in summary, I think we all agree that the current system is not working and as the world economy enters turbulent waters, we simply cannot shrug our shoulders. Equally, absolving ourselves of a need to report on going concern is a fundamental breach of our duties and would widen the expectation gap to the expectation chasm.
The debt market provides its own remedy, which seems to work reasonably well. Let’s borrow it and do so without delay.
Graham Fairclough
(Graham Fairclough is managing director of BPP Professional Education in Belgium, Netherlands and Luxembourg).
Last edited on Thu Oct 16th, 2008 09:03 by grahamfairclough
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lisa113
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Posted: Tue Oct 14th, 2008 20:52 |
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There remains a huge expectation gap, as auditors seem still to be expected to have a crystal ball and be able to 'assure' users of financial statements that a company with an unmodified audit opinion is absolutely not going to fail.
The basic problem is that financial statements, and therefore the audit opinion, are based, of course, on historical information. Although it is a fundamental accounting principle that financial statements are prepared on a going concern basis, this is not very much of a guide to the future of a business, and therefore financial statements cannot be said to have much of a predictive value.
Maybe there should be more focus in financial reporting on making disclosures which are already mandatory under accounting standards more user-friendly. There are many disclosures which could potentially shed light on a company's going concern status, but the disclosures are often so hard to understand that, with the exception of the most financially aware, the users of the financial statements would be at a loss to know how to interpret the data. An example here would be the financial risk disclosures required under IFRS 7 / FRS 29. Many companies provide the necessary narrative and numerical disclosures on how they manage credit, liquidity and market risk, but I would suggest that in many cases, the disclosures would be meaningless to most shareholders and other users. Even when companies make an effort to explain these issues in detail, often in the Operating and Financial Review, the discussion is often wrapped up in jargon and diificult to penetrate.
Of course, enhancing disclosures will still mainly improve the understandability of the historic information provided, but enhancing the understanding of the position and performance of an entity may help the users of the financial statements to see where the company is heading in the future.
Another idea would be for companies to provide ratio analysis on the financial statements, along with an explanation of the trends and issues revealed. Forcing the disclosure of current ratios, gearing ratios, and ratios based on the cash flow statement would be a powerful way to summarise the company's performance and position. To be useful, this would have to be supplied alongside a discussion of the meaning of the ratios. Again, it could be argued that this would only shed more light on the year end position, and says little about the future, but ratio analysis can highlight key trends, which in turn can have a predictive element.
I would suggest then, that companies should work harder within the current reporting framework to make financial statements more user friendly, and to provide as far as possible information that can be used to improve the understanding of the business, which in turn may help to provide more of a predictive value.
Lisa Weaver
Training consultant, Kaplan Financial
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Mr.Market
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Posted: Wed Oct 15th, 2008 16:12 |
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| Auditors can always provide an opinion on the financial position of a company. However, this credit crisis is really a complicated one and the auditors might fail to understand the irrational behaviour of the fund managers. The financial institutions have acquired so many high-risk "time bombs" and the fund managers kept promoting financial products which carry excessive risks to the investors. Auditors have failed to recognise the underlying risks of this kind of undertakings which can lead to serious crisis and hence going concern problem (Is it within the responsibility of the auditors to report on this kind of risk?) These kind of risky conducts by financial institutions continued for several years despite several warnings have been given by some experts. Subsequently, financial institutions run their business as usual (going concern?) until the market could not accommodate so many "time bombs" and they finally exploded. Frankly speaking, it is difficult for the investors to anticipate the future performance of a company by merely looking at the financial perspective. Information on non-financial aspects is very important and complementary to financial information in making sound investment.
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sandyb
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Posted: Fri Oct 17th, 2008 09:02 |
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I agree that the directors of a company could take more responsibility for assessing their own company as a going concern - but surely this is ultimately the job of an 'impartial' auditor? After all, this is their job!
There have been a number of cases over the last few years (the XL example being one) where a company has gone bust and the auditors seem to walk away within their hands in their pockets, whistling and looking at the sky...'nothing to do with us'... perhaps it is the result of the way in which going concern is reported and classified, but it can't be denied that it's not acceptable for a company to appear solvent in an audit report, only to go bust a few months later. This calls into question how much a company can rely on the audit opinion, surely? Regardless of the financial climate, a system for reporting on going concern must be developed which can prevent this type of situation from occurring, and enable companies and shareholders to have confidence - even when times are hard.
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CumDiv
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Posted: Mon Nov 3rd, 2008 03:14 |
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It is not as much as going concern principle, but what Auditors are reporting on. How can an Auditor certify a set of Financial Statements as showing a true and fair view only for the company to go bust in few months? For a company to go bust, it doesn't take one day. There must have been some underlying issues. These issues must have come to the attention of the Auditor. What stops the Auditor from presenting a modified report if there are clear evidence(s) to put in doubt the true and fairness of any set of accounts? I have never read an account that does not present a true and fair view! I hate to say this that the exemption clause that the Directors of an enterprise are responsible for the preparation of financial statements and the job of an auditor is to express an opinion. Fine, agreed, then how can he ( the Auditor ) continue to express the same opinion year in, year out, whereas a company like XL group of campanies has a negative current asset!! We all know the celebrated case of Enron and Worldcom. Auditors have greater responsibilities than standing aloof, rubber stamping accounts and walking away when companies go bust. Auditors should have the courage to present modified reports when critical issues bothering on the health of organisations come to light. I have worked in the Audits the greater part of my working life, but I abhor and detest the hypocrisy of certifying a set of accounts that we all know that do not present a true a fair view! It bothers on the issue of intergrity really, commercialism and greed. Some Auditors actually collude with CEOs to perpertuate fraud. In some third world contries, poverty is an issue when the fee income of a firm depends largely on one or two clients, the courage would not be there to present a modified report lest he loses the client. That's where intergrity comes to play.
What about this part of the world where there is no poverty? It is greed! The Institute has a lot to do in this case. The clauses that exempt the Auditors from prosecution had made it too easy for them to go about the job without remembering that they have a duty of care, they are independent, not only that, they must be seen to be independent.
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grahamfairclough
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Posted: Mon Nov 3rd, 2008 08:26 |
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It's worth noting that the negative current asset issue of XL Airways isn't on its own sufficient evidence to conclude that the company wasn't a going concern, although it's something that ISA 570 requires auditors to consider. I just checked the accounts of Tesco for 2008 and they showed current assets of £6.3 billion and current liabilities of £10.2 billion. They're not about to go bust though - they simply manage working capital remarkably effectively. In the case of XL Airways, current liabilities would also be high because deferred revenue is a feature of the airline business.
This illustrates the point that identifying likely corporate failure is something that requires great judgement, deep understanding of the business and the big picture.
Of course, where an auditor fails to use scepticism appropriately, this is clearly unacceptable. We need to be careful though not to assume that auditors are in the pockets of management if they fail to precipitate the collapse of a company by modifying on grounds of going concern. Going concern reporting is always an ethical dilemma.
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eurocolumns
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Posted: Mon Nov 3rd, 2008 20:26 |
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Unfortunately, the going concern is not a 'yes or no' problem. It shouldn't be so simple.
Imagine you go to a doctor. You don't just want to know: I will live or I will die. You want to know about your health and the quality of your life for the future. You refer to diagnose.
Mrs. Weaver proposed above a reasonable step forward: a minimum financial analysis joining the financial statements. When a ratio is out of range, the reader should find an explanation in the financial statements.
What if we come up with a Statement of Ratios, equally important as the Income Statement?
There is a problem with self-regulation in the Audit profession. We disclaim lots of liabilities and responsibilities, we issue standards open to such degree of judgement and interpretation, hiding behind long phrases in the audit report, making sure we well define what an Audit does not do. What if, based on the Risk and Controls assessment we anyway perform, we undertake the responsibility to summarize a scoring of the quality of the company's internal controls, and the size of risks and threats?
Until we develop the professional stamina to adjust the standards in order to express meaningful information in the audit report, the banks will continue performing their own internal simplified financial ratios and just file the audit report behind the balance sheet somewhere in a file, knowing nearly nothing about the companies they credit, while the auditors keep confidential in their files the significant information.
The things above are achievable based on currently existing grounds, just by enhancement of reporting . We have knowledge on predicting corporate failure in stable environments. Of course, adaption of reporting standards is not an easy task.
What is even more difficult is to sit down and rejudge: what of what we do, needs to be changed. Now we are facing unstable environment, with new threats and domino-like effects in the economy. We may need to rethink some basics.
Maybe we should also consider a new standard on Recession Accounting, whereby we may consider mandatory disclosure on operational matters like exposure and dependencies of key suppliers, key clients, sensitivity analysis on decreasing demand, like IFRS7 is doing on financial matters.
Further, in extremis, we may embed in the financial reporting, in times of recession, disclosure on calculated negative effects (recession contingencies?) as the business valuers do on their adjusted net asset, based on the IVS (International Valuation Standards) and analysis of prospective data.
And we must move quickly, as the "expectation gap" is increasing too much. We, by self regulation, should reduce this gap by enhanced reporting, instead of persuading the users to reduce their expectations.
Last edited on Tue Nov 4th, 2008 12:34 by eurocolumns
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Steve Priddy
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Posted: Wed Nov 5th, 2008 09:17 |
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I am delighted that we have got a head of steam on this highly relevant topic.
May I just add in a couple of other points?
The contributors to date seem to have concentrated on the role of the auditor in the going concern assessment. I would like to remind us that the responsibility for actually doing the assessment lies with the Board of Directors. It would be good to get views as to how that responsibility is reaffirmed in the accounts preparation process.
Secondly the assessment, if one is preparing accounts in accordance with UK GAAP, is from the date of signing of the accounts. As I pointed out in my opinion piece, where a company is having difficulties agreeing overdraft facilities, then the date of signature could be as late as 9 months after the Balance Sheet date, and is then for a full 12 months' ahead. Is that a reasonable requirement in the current economic climate? The FRC believe it is in their updated guidance. What is the position in other jurisdictions, for example?
Thirdly the updated guidance introduces a fourth category of evaluation which fits between mild concern about going concern and the non applicability of going concern of the company? Do contributors feel this contributes to users of financial statements understanding?
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Ivaylo
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Posted: Wed Nov 19th, 2008 16:50 |
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The deadline is pressing, so I’ll get to the point.
I do agree that since the Caparo case the role of the auditors has been limited. And the burden of making the statement for the appropriateness of the going concern lies with the directors.
Considering the way it was presented in the previous post, it seems reasonable to say that a statement which is made having in mind the data at 31.03 cannot be expected to be valid at 31.10 when it involves predicting the future. And if we simply extend the foreseeable future period from 12 months after 31.03 to 12 months starting 31.10 this will lead us to issuing meaningless statement. Maybe there has been a period in human history when that was adequate method but this is not the case now. In my opinion reassessment of the facts that did lead to “going concern presumption appropriate” statement is needed at the time of signing the accounts if that time is later then 4 months after balance sheet date.
After all as far as I remember, no one can be accused for something that wasn’t a crime at the moment of committing it. The directors must have an opportunity to change their position after so much time elapsed.
What is new in the new category is the word “significant” used with “doubts”. Is this contributory to the understanding of the financial statements? Is it useful to know that the directors have serious doubts about the future of the company? Of course. However it is stated in the description of the 4th category that “where the company is not a going concern, the company is not necessarily insolvent” (54). Having that in mind I wonder what exactly the difference between the new 3rd category and the 4th one is. (51A and 52)
At one hand we have “the directors consider the company is unlikely to continue in operational existence for the foreseeable future” and on the other hand: “directors conclude that significant doubts exist about the company’s ability to continue as a going concern”.
Let’s simplify a little.
1. conclude… significant doubts exists… company’s ability to continue as a going concern…
2. consider…is unlikely to continue in operational existence…they should no…use… the going concern…
If we use common sense we can assume that in some manner consider=conclude and unlikely=significant doubts exists. Therefore we end up with “doubts if it can continue” and “should not continue” as the difference between 3 and 4 category.
It seems to me that the distinction made is between “its not sure weather things are so bad” and “we are done”.
That distinction seems fair and useful. However let’s assume that we have disclosure under category 2 like this: “…the directors continue to be involved in negotiations … and yet no demands for repayments have been received…”
Imagine that a demand for repayment is received. What is the category now? Is it under 3rd:”significant doubts exist about the company’s ability to continue as a going concern” or it goes directly to the 4th: “company is unlikely to continue in operational existence…”? How it is decided?
This could be clearer if some suggested text is added in 51A. Maybe like that:
“…The Company has pressing debts and one of them was demanded. The company will be able to pay the debt but this will be accompanied by certain problems in future like…”
That way 3rd category might be distinguished from the 4th and the 2nd.
For now it’s unclear. At least thats my opinion. But since I am only an internal auditor in the public sector it is not mandatory. I might be wrong.
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tyneham
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Posted: Tue Jan 13th, 2009 19:07 |
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ACCA or not, many people in the business world are concerned about doom and gloom, ground realities, insolvency and bankruptcy in volatile markets. Even lawyers, accountants, market analysts and auditors are already fired or facing long-term unemployment. Many companies are losing market share to small rivals, but are no short-cuts for sustainable success and prosperity. Businesses need bespoke survival strategies to reduce losses, improve efficiency, increase revenue, gain sustainable competitive advantage and outperform market competition. The strategies would help create new business opportunities and job. FixyaExperts.com investors target niche markets where consumer demand still continues to grow by over ten percent annually to 2030… http://www.FixyaExperts.com
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Dusty
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Posted: Mon Jan 26th, 2009 11:59 |
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tyneham wrote: . . . FixyaExperts.com investors target niche markets where consumer demand still continues to grow by over ten percent annually to 2030… http://www.FixyaExperts.com
Do I detect marketing going on here :-)
In those markets where the numbers are now going negative, many companies will soon be reporting 31 December 2008 results. There have been newspaper reports (eg. UK FT) already predicting a burst of going concern 'emphasis of matter' paragraphs in auditors' reports. Do we think users will understand these or be confused and need explanation?
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tyneham
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Posted: Mon Jan 26th, 2009 13:28 |
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Merely stating the facts, mostly about investments outside the UK. In one case FixyaExperts.com proposed increasing organic efficientcy by reducing 30% losses, and upgrading production to satisfy soaring demand which still is growing by 17% annually. ACCA readers would know that many investors/banks avoid the subprime scams. The prudent investors benefit.
Last edited on Tue Mar 3rd, 2009 09:51 by SuzyOrr
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Sakesha72
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Posted: Mon Mar 2nd, 2009 18:39 |
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Hi
I would like to point out the cases such as Satyam in India, where auditors failed to spot accounts cooking. The management of this company even got away with forging bank account balance for c. 1 billion USD. I know that creating bogus customers and overstating revenue and with creation of false advances in CFS are quite common, and yet such FSs get auditors approvals. Who should bear responsibility if such a company goes bust? It is possible, if one was cooking his accounts when market conditions were fine, but in reality the organisation is having liquidity problems, if demand becomes low.
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