Going concern (ISA 570 Revised) and its effect on the audit report

BlueBird Airlines has lost money for three years. Its loans are due next year, and passenger numbers have fallen. The directors have prepared the accounts as if the airline will carry on for ever. The auditor must decide whether that is right.

If the airline may not survive the next twelve months, assets worth millions on a going concern basis might be worth little in a forced sale, and the users must be told. Going concern is one of the most important and most examined judgements in an audit.

This topic covers the going concern basis, the responsibilities of management and the auditor under ISA 570 (Revised), the indicators of doubt, the audit procedures, the conclusions the auditor can reach, and the effect on the report: no change, a material uncertainty section, a qualified or adverse opinion, or a disclaimer. The previous topics covered the standard report, and the next covers modified opinions in general.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence, completion and reporting (25% of marks). It covers:

• going concern: management and auditor responsibilities
• audit procedures and reporting on going concern (ISA 570)
• the effect on the audit report

CAMA 2020 and going concern

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

The going concern basis

Under the going concern basis of accounting, financial statements are prepared on the assumption that the entity will continue in operation for the foreseeable future and has neither the intention nor the need to liquidate or stop trading. IAS 1 requires management to assess the ability to continue. Says that the assessment must cover at least, but is not limited to, twelve months from the end of the reporting period.

ISA 570 (Revised) requires the auditor's work to cover management's assessment, which ought to look at least twelve months from the date of the financial statements. If the entity is not a going concern, the statements are prepared on another basis, usually a break-up basis, in which assets are valued at what they would fetch on a sale and liabilities include costs of closing down.

Responsibilities

Management and those charged with governance are responsible for assessing the ability to continue as a going concern, for using the going concern basis unless they intend to liquidate or cease trading or have no realistic alternative, and for disclosing in the statements any material uncertainty. Their assessment takes into account all available information about the future, including budgets, cash flow forecasts, financing arrangements, order books and plans for action.

The auditor is responsible for obtaining sufficient appropriate evidence about the appropriateness of management's use of the basis, and for concluding whether a material uncertainty exists about the entity's ability to continue. The auditor is not responsible for predicting the future: the report is not a guarantee of the company's survival, even if it carries no going concern comment.

The auditor must remain alert throughout the audit, not only at the end, since indicators may appear at the planning stage, during testing or at the review.

Indicators that cast doubt

In the BlueBird case, the indicators are recurring losses, heavy loan obligations and falling passenger traffic with rising operating costs. Together they are significant and need a thorough investigation.

Audit procedures

When events or conditions cast doubt, the auditor performs additional procedures, including:

• asking management for its assessment and for its plans for future action, and evaluating whether the outcome is likely to improve the position and whether the plans are feasible;
• analysing and discussing cash flow, profit and other relevant forecasts with management, evaluating the reliability of the data and the assumptions, comparing past forecasts with actual results and checking that the forecasts are consistent with the plans;
• reading the terms of loan agreements and determining whether there are breaches of covenants and what the lenders may do;
• reading the minutes of meetings of shareholders, directors and important committees for references to financing difficulties;
• enquiring of the entity's lawyers about litigation and claims and evaluating management's estimates of the outcome and financial effect;
• confirming the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties, such as guarantees or letters of support from a parent or director, and assessing the financial ability of the supporters;
• evaluating the entity's plans to deal with unfulfilled customer orders;
• reviewing events after the reporting period for those that mitigate or aggravate the position, such as new financing or a lost contract;
• checking the availability, terms and adequacy of borrowing facilities;
• reviewing news, regulatory correspondence and rating reports; and
• requesting written representations from management about its plans and the feasibility of its plans.

If management's assessment covers a period shorter than twelve months from the date of the financial statements, the auditor asks management to extend it. If management refuses, the auditor considers the effect on the report. If management has not yet done an assessment, the auditor asks for it, and considers a limitation of scope if it cannot be done.

Evaluating and concluding

The auditor evaluates whether there is a material uncertainty: events or conditions that may cast significant doubt on the entity's ability to continue, where the magnitude of the potential impact and the likelihood of it occurring are such that disclosure is needed to make the statements give a true and fair view. The auditor then decides:

1. whether the going concern basis is appropriate;
2. whether a material uncertainty exists; and
3. if so, whether the disclosure in the statements is adequate.

Reporting on going concern

The material uncertainty section. It follows the basis for opinion and draws attention to the note in the statements that describes the uncertainty. It says that these events or conditions indicate that a material uncertainty exists that may cast significant doubt on the entity's ability to continue as a going concern, and that the opinion is not modified in respect of the matter.

For example: We draw attention to Note 12 in the financial statements, which indicates that the Company incurred a net loss of ₦X during the year ended 31 December 20X6 and, as of that date, the Company's current liabilities exceeded its total assets by ₦Y. As stated in Note 12, these events or conditions, along with other matters set out in Note 12, indicate that a material uncertainty exists that may cast significant doubt on the Company's ability to continue as a going concern.

Our opinion is not modified in respect of this matter.

Going concern paragraph or qualified opinion?

The two are different tools. A material uncertainty paragraph is used when the statements are fairly presented and the uncertainty is adequately disclosed: the opinion is unmodified, and the paragraph tells users where to read about the uncertainty. A qualified opinion is used when the statements are materially misstated or the auditor cannot get evidence, for example because the uncertainty is not adequately disclosed.

The first helps users, and the second tells them that there is a problem with the statements. If the going concern basis is not appropriate and management has used it, the misstatement is both material and pervasive, and the opinion is adverse. For BlueBird, if the directors disclosed the losses, the loans and their plans in a note, the report has an unmodified opinion and a material uncertainty section.

If they disclosed nothing, the opinion is qualified or adverse.

Communicating with those charged with governance

The auditor communicates to those charged with governance the events and conditions found, whether they are a material uncertainty, whether the going concern basis is appropriate, the adequacy of disclosure and the effect on the report. In an entity with an audit committee, this goes to the committee. If the going concern issue arises at a listed company, the auditor considers whether the matter is also a key audit matter.

Where the uncertainty is a matter of significance, the auditor does not describe it as a key audit matter. It is reported in the material uncertainty section instead.

After the report date

If events after the date of the report but before the statements are issued suggest that the going concern basis is no longer appropriate, the auditor discusses them with management and considers whether the statements need amendment and whether a new report is needed. If the statements are already issued, the auditor decides what action is needed and may take legal advice.

Worked examples

1. The basis is appropriate and a material uncertainty exists, and disclosure is adequate.
2. The opinion is unmodified, with a material uncertainty section.

1. The statements are misstated by omission of required disclosure.
2. The opinion is qualified, or adverse if the omission is pervasive.

1. The basis is not appropriate.
2. The opinion is adverse, and the effect should be explained.

1. The auditor asks management to extend the assessment to at least twelve months.
2. If it refuses, the auditor considers the effect on the report, which may be a qualified opinion or a disclaimer.

How to score full marks

• Define the going concern basis and the twelve-month period.
• Group indicators as financial, operating and other, and apply them to the facts.
• Give procedures: forecasts, loan terms, support, later events, representations.
• Use a table of the four reports, and explain the difference between the paragraph and a qualification.

Common mistakes in the exam

• Qualifying the opinion where an uncertainty is properly disclosed.
• Using an emphasis of matter paragraph instead of a material uncertainty section.
• Forgetting forecasts and covenants.
• Saying the auditor is responsible for the future of the company.

Quick revision

• At least twelve months from the date of the statements.
• Indicators: financial, operating, other.
• Procedures: forecasts, loans, minutes, lawyers, support, later events, representations.
• Disclosed uncertainty: unmodified with a section. Not disclosed: qualified or adverse. Wrong basis: adverse.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

Spotted a mistake? Tell us and we will check it.