In the current economic environment it is likely that Directors’ of companies experiencing financial difficulties will need to carefully consider whether it is still appropriate to prepare the company’s financial statements using the going concern assumption.

The going concern assumption is the accounting basis upon which financial statements are prepared whereby, the entity is expected to:

1.  be able to pay its debts as and when they fall due
2.  continue in operation without any intention or necessity to liquidate or otherwise wind up its operations.
   

Below is a sample of events or conditions which are likely to give rise to business risks that individually, or collectively, may cast significant doubt about the appropriateness of the use of the going concern assumption (which are taken from ASA 570 Going Concern):

• the entity is in a net liability or net current liability position
• fixed-term borrowings are approaching maturity without realistic prospects of renewal or repayment; or there is excessive reliance on short-term borrowings to finance long-term assets
• there are indications that financial support by debtors and other creditors may be withdrawn
• there are negative operating cash flows, indicated by historical or prospective financial reports
• 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
• loss of key management without replacement
• loss of a major market, franchise, license, or principal supplier
• labour difficulties or shortages of important supplies
• technical developments which render a key product obsolete
• failure of other entities in the same industry.
  

In assessing whether an entity is a going concern, Directors’ are required by Australian Accounting Standards to consider the period of at least 12 months from the end of the reporting period.  Auditors are required by Australian Auditing Standards to assess the period from the date of the auditor’s current report to the expected date of the auditor’s report for the next corresponding period which will ordinarily approximate a period of twelve months.

However, it is also a requirement of Australian Auditing Standards that the auditor requests the Directors’ to extend their assessment to align with the auditors’ assessment period where the auditors are assessing for a period beyond that of the directors.

The determination of whether an entity is a going concern differs from whether any entity is solvent.  The assessment of going concern in made annually, as well as half yearly for disclosing entities and
is a requirement of Australian Accounting Standards.  The assessment of whether or not an entity is solvent is made on a daily basis.  ASIC Regulatory Guide 22: Directors’ statement as to solvency states that “...the directors should consider future debts to the extent that they will compete for payment with debts existing at the date of the statement”. It is a requirement of the Corporations Act 2001 that Directors’ of each company, disclosing entity and registered scheme provide a declaration regarding the solvency of the entity.  This declaration is made annually and half yearly for disclosing entities and forms part of the Directors’ declaration.

Where there is a material uncertainty regarding the entity’s ability to continue as a going concern, appropriate disclosures should be included in the directors’ report and the notes to the financial statements.  These disclosures include:

• the principal conditions which caused the appropriateness of the going concern assumption to be questioned, including an evaluation of their significance and possible effects
• plans and any mitigating factors including relevant prospective financial information where appropriate.
  

If there is any doubt over a company’s ability to continue as a going concern, it is essential that the matter be raised with the auditors and governing body of the entity as soon as practicable.

Where auditors have reasonable grounds to suspect that a company has or may be trading whilst insolvent, they have an obligation to notify ASIC in writing within 28 days pursuant to section 311 of the Act.

Going concern and liquidity risk

In challenging economic times, it has been widely publicised that liquidity risk increases and it is now a significant business risk facing many entities. Liquidity risk is the risk that a company will encounter difficulty in meeting its obligations associated with financial liabilities.

Increased liquidity risk will impact those entities with significant financial liabilities, such as bank overdrafts, bank bills, finance lease liabilities etc, and in particular entities with loan facilities due for renewal in the near future.  Where entities were once able to assume they would encounter no difficulties renewing such facilities, increased liquidity risk means this may no longer be the case.

Entities will need to pay careful attention to the adequacy of the liquidity risk disclosures contained in the financial report and ensure such disclosures comply with the requirements of AASB 7 Financial Instruments: Disclosures.

Liquidity risk disclosures include:

• the entity’s exposures to liquidity risk and how it arises
• the entity’s objectives, policies and processes for managing liquidity risk and the methods used to measure the risk
• a maturity analysis for financial liabilities that shows the remaining contractual maturities; and a description of how it manages the related inherent liquidity risk.

The Australian Institute of Company Directors and the Auditing and Assurance Standards Board have issued a joint publication, ‘Going Concern issues in financial reporting: a guide for companies and directors’, which further explains the notion of going concern and assessing going concern in challenging economic times, and assists company directors in performing and reporting on their going concern assessment.  The publication can be obtained here.