These troubled economic times have sparked renewed interest in whether or not businesses are a going concern.  
 
Story Anthony O'Brien  
 
The past 18 months has presented arguably the toughest operating environment for Australian companies in living memory. The impact has been acutely felt in the area of financial reporting and in particular, directors' and auditors' assessments of a company's ability to continue as a going concern.  
 
Going concern underpins the preparation of the annual and financial reports of Australian companies. Australian Accounting Standards require directors to consider whether there are material uncertainties that would lead to significant doubt about a company's ability to continue to pay its debts over at least the next 12 months and to make adequate disclosures in the financial report if uncertainties are identified. Auditors are required by Australian Auditing Standards to evaluate the directors' assessment of the company's ability to be a going concern.  
 
Vijay Vijayasekaran of Grant Thornton, says the assessment of an entity's ability to continue as a going concern is the responsibility of its management. “Nevertheless, Auditing Standard ASA 570 - Going Concern, requires an auditor to consider whether there are events or conditions and related business risks which may cast significant doubt on the entity's ability to continue as a going concern and, if necessary, adequately warn shareholders and others of the existence of such uncertainty. These issues might relate to the reduced availability of credit created by the current economic downturn, any impact of company earnings and the future ability to finance debt and the impact this will have on the directors' assessment and the disclosures in the financial report and the audit report.”  
 
UNCERTAIN CONDITIONS  
Despite claims of evidence of green shoots in some tea leaves, most business and economic experts continue to pursue a line of extreme caution for the prospects of corporate Australia. With this in mind, Australian Institute of Company Directors (AICD) chief executive, John Colvin, says: “Difficult or uncertain economic conditions present challenges for directors, who need to ensure that they prepare thoroughly for their assessment of going concern and make appropriate financial report disclosures.” In light of this, the AICD and the Auditing and Assurance Standards Board (AUASB) have issued a publication, Going Concern Issues in Financial Reporting: A Guide for Companies and Directors, which explains the concept of going concern and assists company directors in completing their going concern obligations.  
 
AUASB chairman, Merran Kelsall says the publication, which is available free online at auasb.gov.au or companydirectors.com.au, will help company directors in planning and preparing their going concern assessments and address auditor feedback, prior to the preparation of the financial report. “This will help to avoid any last minute going concern issues for the organisation,” Kelsall says. “Appropriately addressing the auditor's requirements in undertaking the company directors' going concern assessment is essential to minimise the risk of the auditor issuing a qualified audit opinion due to a scope limitation or inadequate financial report disclosures of going concern issues.”  
 
Aimed at listed companies and their directors - but useful for other entities - the guideline also examines the distinctions between an 'unqualified audit opinion with an emphasis of matter' paragraph, a 'qualified' audit opinion and a 'disclaimer' of audit opinion, which are not always well understood by some readers of financial reports. It also explains the nature and range of possible auditor's opinions relating to going concern issues, to enable directors to be better informed of the audit implications.  
 
The Institute drew the attention of its members to the going concern issue earlier in the year with the release of the Essential Guidance for the 2009 Financial Ahead, (See story below). The guide provides a number of steps for assessing going concern and is available from the Institute's website charteredaccountants.com.au.  
 
RENEWED FOCUS 
Michael Coleman, national managing partner - risk and regulation, KPMG, and chairman of the AICD's Reporting Committee (co-contributors with AUASB), explains that the liquidity crisis and aspects of the global financial downturn are at the core of the renewed interest in going concern.  
 
“[However the concept of going concern] isn't anything new and in fact directors and auditors need to consider whether or not a company is a going concern every time they sign a director's statement attached to a set of financials or an audit opinion.  
 
“In this current environment, it's a much more rigorous job than it typically would be and we need to focus much more on the issues.  
 
“But now because of the uncertainty in the marketplace, many entities that typically would have a strong balance sheet are all of a sudden in a place where they need to think twice about how they approach their banks for their borrowing arrangements and whether or not they've got enough borrowing capacity to deal with the issues that are going to come their way,” says Coleman. “So there's nothing particularly unusual about going concern, it's just important that directors are alert to the issue because it's going to demand much more of their time and effort than it typically would.”  
 
Andrew Stringer, head of audit at the Institute, agrees the current business climate has created renewed focus saying there's “nothing like seeing some major international collapses associated with a shortage of liquidity or credit” for increased attention on whether a company is a going concern.  
 
“Very much one of the major impacts has been on companies' access to credit,” says Stringer. “In the good times, banks were quite happy to roll over financing. Nowadays that's become a whole lot more tenuous and we all know that anecdotally and perhaps from personal experience that the banks are looking very, very closely at their lending and are imposing much tougher conditions. If they are prepared to make credit available to you or to your business, it is far more likely they will impose tougher conditions and potentially be much more willing to withdraw credit if there are breaches of covenants.”  
 
KPMG's Coleman adds: “You find that businesses with loans are unsure about whether or not they can roll them over or renew them. Other considerations include whether or not interest rates are going to be prohibitively more expensive, whether stronger customers will still be in business and whether a business can maintain sales levels. All of those things are reflective of changes in the general marketplace. There is a lot of variability in the way in which even strong entities need to consider their ongoing activities.”  
 
Coleman cautions company directors to consider issues such as guarantees to subsidiaries, cash flow projections and even the business model. “It's important that the business model continues to be sustainable in the current market,” he says. “For example, there have been reports that luxury goods makers are not doing as well as they were. Yet the boom industry at the moment is movie theatre attendances because people are seeking less expensive entertainment and spending less time at restaurants to save money.”  
 
In this environment Coleman says in the majority of cases, company directors need to think more deeply about whether the business is a going concern. “In an economic environment that's not as robust as it was, presumably your cash flow projections are lower than usual but you're still going to have to keep on paying your loans and your interest. In this instance, businesses must determine whether their cash flow projections are appropriate.”  
 
Additionally in the current environment, banks are looking closely at companies that might breach their borrowing covenants. “So if a company actually breaches its covenants, directors need to be certain the bank is still going to be willing to continue to extend its current funding arrangements,” explains Coleman. There are examples of businesses that have approached their banker for a relatively modest increase in borrowing requirements, only to walk away with a reduced loan-to-valuation ratio (LVR) and higher interest rate. “Under those circumstances are you sure that you can continue to get funding?”  
 
SOLVENCY 
According to Coleman the most important thing for company directors in relation to going concern is to recognise that there can be a difference between going concern and solvency.  
 
“Directors need to focus on the fact that they are making a formal statement in their directors' declaration that they can pay their debts as and when they fall due,” explains Coleman. “In this current marketplace they need to be sure they can justify that statement, rather than just signing the declaration believing that it is correct.” 
 
Clearly the current environment has also created more pressures for auditors. Australian Auditing Standards require auditors to review the directors' going concern assumptions and to determine whether there are events or conditions that might indicate doubts about a company's ability to continue as a going concern. 
 
Stringer agrees the current environment has created more pressure for auditors, but this has not shifted more responsibility their way. “First and foremost the primary responsibility of the directors via the management of the company is to consider the appropriateness of the going concern assumption,” explains Stringer. 
 
“An independent outside professional, the auditor, views the judgments made by management and directors of the company. That is a very tricky process, made even trickier through the current economic downturn. 
 
“The auditor conducts an assessment of the appropriateness of the directors' and management's use of the going concern assumption and then uses his or her experience and knowledge - based on the information available - to assess the reasonableness or otherwise of that assumption and whether there are any other things that management perhaps should have taken into consideration.”  
 
Stringer explains it is the auditor's responsibility to assess management's use of the going concern assumptions for a period of approximately 12 months from the date of signing the audit report to the expected date of signing the audit report the following year, rather than the next financial yearend, which is “actually quite an important distinction to make”. 
 
Grant Thornton's Vijayasekaran says there are a number of models that have been developed to help identify financially distressed entities. “Significant progress has been made in the development of such models since the pioneering research by Beaver (1966) and Altman (1968),” says Vijayasekaran. “In more recent times, Ohlson's model (1980) and Shumway's model (2001) have been highly successful as bankruptcy prediction models, especially in predicting bankruptcy of small firms. Some models use accounting ratios and others use accounting ratios and market information. Many studies have identified the use of bankruptcy prediction models by auditors as a potential analytical procedure for evaluating the going concern question.” 
 
However the available models tend to be fairly complex and highly mathematical and have not been popular with auditors. Auditors have therefore mostly relied on observed conditions, says Vijayasekaran, such as operating losses, negative operating cash flows, negative working capital and so on to draw their-conclusions on the financial strength of an entity.  
 
Stringer has not seen widespread use of models in practice either. “I don't think there's one model and that's why [the job of the auditor] is so tricky, because it varies from company to company,” he says. “Auditors need to stay in touch with clients to understand their businesses and the risks they're exposed to.”  
 
Steps for assessing a going concern 
AASB 101 Presentation of Financial Statements states management needs to assess whether the entity can continue as a going concern. Issues to consider in making this assessment include: 
> assessing funding sources: this involves the review of banking arrangements, the availability of external finance and whether there are assets, which can be sold for cash 
> checking compliance with debt covenants. Any breaches must be rectified before the reporting date, otherwise the loan must be classified as current 
> confirming a guarantor(s) can continue to provide the guarantee 
> checking key customers and suppliers will continue to operate and do not face any financial difficulties themselves 
> the overall impact current economic conditions may potentially have on the industry in which the company operates - this will include noting any decline in sales 
> ensuring forecasts and budgets are updated to reflect broader market conditions. This will enable the identification of any deficiencies and how they can be addressed 
> ensuring that forecasts and budgets are prepared so auditors are able to meet their obligations to consider going concern of the entity for at least the 12 months from the date of the audit report, and not merely until the next annual reporting date (30 June 2010). 
 
Source: Essential Guidance for the 2009 Financial Year Ahead, The Institute of Chartered Accountants. 
 
Insolvency vs going concern 
The Corporations Act 2001 defines 'solvency' as being able to pay all of one's debts, as and when they become due and payable. A director is assessed as= having allowed a company to trade while insolvent when he or she has allowed the company to incur new debts when there are not reasonable grounds to believe that it will be able to pay its debts as they become due and payable. According to Michael Coleman, national managing partner - risk and regulation, KPMG, going concern is a different concept. “Going concern is an accounting concept that involves a presumption that the business is going to be in a position to keep on going over a period of time, typically 12 months. The concept is built into the accounting standards and the accounting standards require you to undertake the assessment.” 
 
To illustrate this point, take the example of a sole purpose entity such as a mining company. Due to market forces, there may no longer be a demand or desire for its product, making it uneconomic to remain open. Under these circumstances directors may choose to close the mine and leave it under care and maintenance.  
 
Presuming the company has sufficient cash reserves to meet the cost of care and maintenance, it could still be solvent. The mine itself would not be a going concern because its mining operations are inactive, but could still be solvent because there is sufficient cash available to enable it to continue to pay its debts.  
 
Under such a scenario, the assets of the company would need to be valued on a basis that reflects their care and maintenance status, not as a going concern