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The “going concern” principle has been one of the fundamental concepts in the preparation of any financial statements for as long as most of us can remember. The application hasn’t changed significantly over decades but why do auditors, management and preparers of financial statements still disagree over this concept and why does it feel like everybody is more interested in this concept lately?
Firstly, why this is such an important concept
When financial statements are prepared, the preparers must decide on the values to be allocated to items such as plant and equipment, receivables, etc. However, the allocation these values is not straight forward. Consider, for example, a lathe that is used in the production process. This lathe may have many different values, depending on the purpose of the value. For example: (i) for insurance purposes, the replacement value of the lathe would be applicable, (ii) should you wish to sell the lathe, the market value of the lathe would be applicable and (iii) should you wish to use the lathe until the end of its operational life cycle, the value attributable to the lathe would in all likelihood be the amount of income that the lathe will generate over this period.
However, for the purposes of this article, we are interested in the measurement of value for use in financial statements. When preparing financial statements, we are required to ascertain a value and it is prudent to assume the business is planning to use the lathe economically until it’s no longer useful and then sell it for scrap value. Essentially, this is just the going concern assumption put in different terms.
Under the going concern assumption, we assume that the business will continue in operational existence for the foreseeable future and consume its assets and settle its liabilities in the normal course of events. This is the assumption that is used for all financial statements unless circumstances dictate otherwise.
Therefore, when businesses go through a difficult time, as most are experiencing at the moment, it becomes necessary to consider if the going concern assumption is still appropriate. For example, it would not be appropriate to apply the going concern assumption in the measurement of assets and liabilities if management has already made a decision to cease operations. This includes when management hasn’t made such a decision but it appears that they may have no realistic alternative.
This is exactly what is so difficult in today’s economic climate: Before COVID-19, many businesspeople would already have found it difficult to confirm, with any certainty, that their operations will be in operational existence for the foreseeable future. This is even more problematic in light of the pandemic as even if your business has a strong asset base, good product and a market for its products, there is still no guarantee that the business won’t fail because, for example, an important supplier didn’t survive lockdown.
If management, who know and understand the business and its environment so well, cannot foresee the future, spare a thought for the financial director who has to take responsibility for the financial statements. What about the auditor who is even further removed from the business but still has to decide if the use of the going concern assumption is justified?
On both ends of the spectrum, i.e. where the business is almost definitely a going concern as well as where it is unfortunately definitely NOT a going concern, there will possibly be a few cases where it will be easy to make a determination. However, in respect of all other businesses, management, preparers and auditors need to carefully consider the following:
- Revised budgets and cash flow forecasts. All the assumptions need to be reconsidered for a completely different world, with different customers, supply chains, etc.
- Alternative sources of finance, in the short, medium or longer term. Can the shareholders inject capital? Can we get a break from suppliers? Sell unproductive assets? Negotiate or increase an overdraft or other borrowings?
- It goes without saying that costs need to be cut as far as possible, if possible.
Unfortunately nobody has a reliable crystal ball, so despite all our best efforts we may still find it impossible to make a reliable assessment if the going concern assumption is still appropriate or not. In those cases, it will be helpful to disclose the events and conditions that have given rise to the uncertainty, the assumptions that were made, and sensitivity of all the assumptions, etc.
Users of the financial statements will understand uncertainty as long as this is fully disclosed. However, what they are not going to take kindly to, is being surprised with financial statements that are misleading and do not reflect reality.
Henk Heymans
Head of Audit, Johannesburg
