Published On:Thursday, 8 March 2012

Posted by Muhammad Atif Saeed

The concept of going concern has been in the profession's headlines recently due to the current economic climate and it seems to be an area where practitioners and clients alike encounter difficulty in applying the concept.

The concept of going concern is a fundamental accounting principle and financial statements are prepared on a going concern basis when it is assumed that the company will continue in operation for the foreseeable future and there is neither the intention, nor the need, to either liquidate it or to cease trading.  Directors of small companies are not relieved of their duty to assess going concern because all company accounts are required, by law, to give a true and fair view.  Some directors consider a going concern review should only be undertaken by those companies who fall within the scope of statutory audit : this is not the case, and directors of small companies should consider taking advice to ensure that disclosures and accounting treatment of items within the financial statements conform to the Financial Reporting Standard for Smaller Entities (FRSSE).

In October 2009, the Financial Reporting Council issued guidance 'Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009'.  This guidance applies to accounting periods ending on or after 31 December 2009, however, the guidance covers existing requirements set out in Financial Reporting Standards and FRSSE and as a consequence, earlier accounting periods will be expected to comply with the guidance.

Principle 1 in the guidance states:

Smaller companies undoubtedly will undertake lesser work in assessing going concern, whereas larger, more complex companies, will undertake more detailed assessment of going concern.

Directors should assess going concern at least annually and it should be considered at an early stage.  In assessing going concern, directors should take into consideration key factors such as over-dependence on one customer, the extent of borrowing facilities and the likelihood of these being renewed if they are nearing maturity.

Some entities may prepare forecasts and budgets, and the guidance recognises that these are long-established techniques in business management, and undoubtedly medium and large companies will often have this information to hand.  Budgets and forecasts can only be as reliable as the underlying information used in their preparation and so realistic presumptions need to be made by the directors in preparing such budgets and forecasts.  In situations where the critical assumptions underlying the forecasts and budgets may be challenged, the forecasts and budgets should be revised so they predict the most likely outcome.

The guidance issued by the FRC suggests an entity, particularly a medium and large entity, prepare a sensitivity analysis in order to understand any critical assumptions on which any budgets and forecasts are prepared.  'Stress testing' is a concept which involves assessing the extent to which budgets and forecasts react to changes in variables such as changes in interest rates and exchange rates.

The lack of finance available to companies, particularly smaller companies, has been well-publicised of late.  Indeed, some entities are finding it increasingly more difficult to obtain finance or even renew existing borrowing facilities as banks and other financial institutions 'tighten their belt'. 

The renewal of borrowing facilities or the application for borrowing can be indicative of an company's ability to continue as a going concern and the guidance issued by the FRC does make the point that in the absence of confirmation from the lenders this does not, in itself, cast significant doubt upon the company having the ability to continue as a going concern.

Directors should assess the entity's exposure to contingent liabilities.  Where companies have frequent disputes with suppliers, the scope for contingent liabilities, which may result in legal proceedings giving rise to large outflows of cash in the future, is much higher than a company who does not have many disputes.

It is crucially important that directors obtain information about major aspects of their organisation from which they operate, in particular looking at what competitors are doing, how technically up-to-date their products or services as well as looking at other factors such as economic and political factors.

In assessing going concern, directors should take account of the timing of cash flows.  For example, if the company has a large outflow of cash due to take place in the year, directors should assess how this outflow of cash can be matched with inflows of cash.  This is particularly important if the company has a large tax liability to be settled or if loan repayments are falling due.

Principle 2 states:

This is where some directors often mis-interpret this principle.  The review period should be twelve months from the date of approval of the financial statements : not twelve months from the balance sheet date.

The guidance recognises that FRSSE, UK GAAP and IFRS each provide for a minimum period that directors should review when assessing going concern.  The guidance also recognises that the extent of the review period is a matter of judgement which is to be based on facts and circumstances which may mean that obtaining information for longer periods may be required.

Where an entity is audited, the directors' review of going concern is less than twelve months from the date of approval of the financial statements, and the directors' have failed to make such disclosure in the financial statements, the auditor's report must make reference to the fact that the review period is less than twelve months from the date of approval in their report.

Principle 3 states:

There are 3 conclusions which all companies can reach in assessing going concern:

·         The use of the going concern basis of accounting is appropriate because there are no material uncertainties related to events or conditions that may cast significant doubt about the ability of the company to continue as a going concern.

·         The use of the going concern basis is appropriate but there are material uncertainties related to events or conditions that may cast significant doubt about the ability of the company to continue as a going concern.

·         The going concern basis of accounting is not appropriate.

In situations where there are no material uncertainties, the accounts should be prepared under the going concern basis.  Relevant disclosures should be made in the financial statements including disclosures concerning the principal risks and uncertainties facing the company (the Business Review).  Listed companies are required to make further disclosure concerning:

·         The main trends and factors which are likely to affect the future development, performance or position of the company's business; and

·         Information about persons with whom the company has contractual or other arrangements that are essential to the business of the company.

The accounts should be prepared using the going concern basis but disclosure should be made in the financial statements concerning the material uncertainties that give rise to significant doubts about the going concern principle.

Where the directors conclude that the going concern basis of accounting is not appropriate in the circumstances, disclosure should be made on the accounting basis adopted (for example, break-up basis).