Why is it important for auditors to assess their clients going concern status during audit?
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This Audit and Assurance Faculty guide provides advice for auditors when testing the going concern assessments of reporting entities impacted by the coronavirus pandemic (COVID-19). It offers practical considerations in relation to ISA 570 requirements. COVID-19 has caused significant market upheaval and uncertainty for business. Many businesses have faced mandatory closures and reduced customer demand due to lockdown measures. While many governments have pledged financial support for businesses through loan programmes and salary grants, business survival may still be uncertain. The Financial Reporting Council’s March 2020 bulletin for auditors sets out matters to consider in relation to COVID-19. This guide builds on this important guidance by setting out practical considerations for auditors in relation to going concern. Management and auditors may conclude that it is not possible to provide a clear answer to some of the questions posed in this guide. Given the level of economic uncertainty that exists at present, this is to be expected, and addressing these questions should help management and auditors to identify the specific uncertainties that are relevant to the entity. This will help management determine the disclosures needed in the accounts, and assist auditors when assessing the impact of the uncertainties on the audit report. Going concern basis of accountingWhen preparing accounts, management will assess whether an entity is a ‘going concern’. Management’s assessment will typically involve looking at projections, such as sales and costs, and the timing of cash flows, although the format and approach is not usually prescribed in accounting standards. Accounting standards set a high threshold for departing from the going concern basis. For this reason, most accounts are, and are likely to continue to be, prepared on a going concern basis despite the pandemic. While the requirements of different financial reporting frameworks vary, typically management are expected to disclose, where applicable, that accounts have not been prepared on a going concern basis or the existence of material uncertainties that may cast significant doubt on going concern. Due to the wide-ranging impact of the pandemic on the global economy, many businesses will be facing material uncertainties regarding their ability to continue as a going concern. Under ISA 570 Going concern, a material uncertainty related to going concern exists when ‘the magnitude of its potential impact and likelihood of occurrence is such that, in the auditor’s judgment, appropriate disclosure of the nature and implications of the uncertainty is necessary’ to meet reporting framework requirements. Where this occurs, management should describe the material uncertainties as clearly and transparently as possible for users. Where management determines that there are no such material uncertainties, it may still be helpful to users for management to set out how this conclusion has been reached, given the current circumstances. Auditing going concernIn the UK, ISA (UK) 570 (revised September 2019) is applicable for audits of periods commencing on or after 15 December 2019. There is a requirement in the revised UK standard for a more comprehensive and structured auditor risk assessment as a starting point when considering going concern, and auditors may choose to consider the revised standard even if it is not adopted early. Evidence regarding going concern is often provided in the form of cash flow models and/or budget forecast models, as well as details of future sales pipeline projections. When testing going concern, it will be helpful to be aware of time and resource pressures faced by management and the finance team. They are likely to be facing additional pressures, such as a need to respond rapidly to business queries, and may be impacted by staff illness. It makes sense in the current circumstances to talk through with management at an early stage the approach to be taken during the audit, providing details of information required which are as clear and precise as possible. If early adopting the revised UK ISA, auditors are required to request the assessment at the risk assessment stage of the audit. Given the increased likelihood of material uncertainties and the possibility that some accounts will be prepared on a basis other than going concern, auditors are likely to view going concern as a heightened and/or significant risk area. Auditors will need to ensure they obtain sufficient, appropriate audit evidence when testing management’s assumptions and forecasts. The impact of COVID-19 may mean using alternative procedures and perhaps employing greater use of technology. The FRC’s March 2020 bulletin discusses audit evidence in the light of COVID-19. Auditors will need to continue to remain professionally sceptical throughout the audit and consider the potential additional challenges the business faces due to COVID-19. While undertaking their work, auditors may find it useful to consider the questions set out below. How has the business been impacted by COVID-19 to date, and how might it be impacted in the future?There are likely to be far ranging impacts across the business relating to the business model, supply chain, legal and contractual issues, employees, consumers, and working capital. Questions to consider include:
Does the nature of the business give rise to additional risks?Certain types of businesses are likely to be more impacted than others. Questions to consider include:
Will the business be able to access government support?Many governments around the world, including the UK government, are offering financial aid and other packages to support businesses. These vary from grants for employees ‘furloughed’ to low interest financing, depending on eligibility. If management has factored government support into their going concern assessment, questions to consider include:
What timelines for restrictions are factored into forecasts?There is significant uncertainty in jurisdictions around the world as to when restrictions on movement will be lifted, and this will increase estimation uncertainty in management’s cash flow forecasts. Management’s going concern assessment will need to consider and make assumptions about the timing of the lifting of restrictions, and the resumption of normal trade activities. Questions to consider include:
There may be central forecasts available that provide useful reference for management and auditors. However, any central forecast needs to be adjusted for specific business models, and judgements should be disclosed in accordance with applicable accounting standards. Care should also be taken to differentiate between scenarios from credible sources and forecasts from credible sources. How liquid is the business and what future finance does it have access to?When reviewing current cash levels, as well as forecast cash flow models, consider how the cash inflows reflect what is known about the nature of the business and management forecasts. Questions to consider include:
How solvent is the business likely to be over the longer term?Short term liquidity issues may result in a need to take on new loans. When reviewing longer term debt, consider the cost of servicing and paying off any new or delayed debts over the longer term. If businesses have deferred loan payments, how have they factored in any additional costs in the future? Also consider how covenants may be impacted by new or modified debt, including any accounting impacts. How have management stress tested their projections?Consider what scenarios and sensitivities have been included by management in the assessment of going concern; whether management have considered a sufficient range of scenarios, flexing their business model appropriately; and how plausible or remote the scenarios forecast are. Determine whether management have considered:
Reverse stress testing, which involves testing which scenarios would make a business model unworkable, can be a valuable tool for management when assessing going concern. Auditors may find it useful for reviewing management’s assessments. We will be issuing guidance for preparers and auditors on this topic shortly. Has the forecast model been tested thoroughly?Businesses often forecast cash flows and/or budgets in Excel based spreadsheets. These can range from highly complex models with multiple formulae and assumptions, to less complex spreadsheets with simple functions. In either case, the assumptions and scenarios that management use are likely to differ significantly from previous years. Pre-existing Excel models for going concern assessments may not be capable of being flexed or adapted for such a significant economic impact. This could introduce a higher risk of mechanical or computation errors in models. Auditors may find it necessary to undertake additional work on any changes to how a model functions, for example, reviewing changes to Excel formulas or updated assumptions, and testing whether the flexing of inputs results in expected outputs being calculated. In some cases this may require the use of specialists, especially for highly complex financial models. Similarly, if the business quickly builds new, highly complex models to assess going concern, consider the appropriate level of testing for the model itself, in addition to the inputs and assumptions. There may be government forecasts or industry data that provide useful reference or evidence when reviewing management’s assumptions. Auditors may also find it helpful to consider their past knowledge and experience of management’s forecasting. If management has a history of poor quality or inaccurate forecasts under normal operating circumstances, the risk is likely higher in these less certain times. Concluding on going concernAt the time of testing and concluding, the outcome of many scenarios, such as the possibility of a second wave of infections, may not be known or predicted with accuracy. Management and auditors will have to apply judgement and consider the specifics of the business and its operations. Given the heightened uncertainty, it is very likely that more businesses and auditors will need to consider reporting material uncertainties. Auditors will need to thoroughly test and conclude on management’s assessment of going concern and whether any material uncertainty exists. Assessments should cover at least 12 months from the date of approval of the accounts. To reach their conclusion, auditors will need to obtain sufficient, appropriate audit evidence, potentially in new and expanded ways. Once a conclusion has been reached, auditors will need to consider whether further disclosure is required, both by management in the financial statements and by the auditor in the audit report. The Audit and Assurance Faculty has prepared a guide on how to report on material uncertainties related to going concern which auditors may find helpful Resources
Reporting resources
Our thoughts are with everyone affected at this challenging time. We encourage all parties to stay up to date with the latest public health advice in their country. ICAEW’s Audit and Assurance Faculty is recognised internationally as a leading authority and source of expertise and know-how on audit and assurance matters. The Faculty has over 7,500 members drawn from practising firms and organisations of all sizes in the private and public sectors. Further resources can be found at icaew.com/aaf. Why going concern assessment is important for the auditor?Going Concern Disclosure
The going concern assumption is essential in establishing the value of an entity's assets and liabilities. The length of the forward-looking period matters because financial statements lose their relevance when updated audited financial statements become available.
Why do we have to consider going concern assumption in our audit?Going Concern Assumption
In particular, the implicit assumptions behind such an approach may no longer be valid in the current environment. Issues surrounding liquidity and credit risk may create new uncertainties, or may exacerbate those already existing.
What auditor should do regarding to his client's going concern assessment?If the auditor believes there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, he should (1) obtain information about management's plans that are intended to mitigate the effect of such conditions or events, and (2) assess the likelihood that such plans can ...
Why is it important to understand the client and the client's environment in audit?The auditor should obtain an understanding of the company and its environment ("understanding of the company") to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement.
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