Auditing: Going, going, gone
- IFRS accounts are normally prepared on a going-concern basis following IAS 1
- Under ISA 570, auditors must check management’s assertions about going concern against the available evidence
- Where there are issues they can qualify their audit opinion
- The UK Sharman Committee stressed the importance of prudence in assessing going concern
- Critics of IFRS think the issue lies less with going concern and more with the reporting framework
The story of the clean-up after the 2008 financial crisis was one of pray and delay: pray for the recovery and delay the recognition of the bad stuff. It has served no end of zombie banks and debt-laden moribund retailers quite well. But when the music stops and the day of reckoning arrives, who warns investors – shareholders like pension funds – that a business is no longer a going concern?
The commonly held view is that it is the auditor’s job. The audit requirements for going concern are set out in International Standard on Auditing (ISA) 570, Going Concern. This explains that under the going concern assumption, an entity is viewed as “continuing in business for the foreseeable future”. Businesses should record their assets and liabilities on the basis that it will be able to realise its assets and discharge its liabilities in the normal course of business.
Unlike some reporting frameworks, International Financial Reporting Standards (IFRS) explicitly requires management to assess going concern. But, as with any forward-looking assessment, it contains an element of uncertainty. Indeed, ISA 570 makes three observations about the challenges: the more an assessment drifts into the future, the greater the uncertainty of outcomes; the complexity of an entity’s operations in the context of external events; and, crucially, the fact that an assessment about future events is based on current information that can change.
According to paragraph 6 of ISA 570 the auditor is responsible for obtaining sufficient evidence about the appropriateness of management’s use of the going concern assumption. The standard also envisages three tricky scenarios involving going concern:
• The assumption is appropriate but there is a material uncertainty;
• It would be inappropriate to use the assumption; and
• Management refuses to make or extend its assessment of going concern once auditors have raised the issue.
In the first scenario, the auditor must assess the adequacy of management’s disclosures and, if necessary, modify the audit report by including an Emphasis of Matter paragraph to point users of the accounts to the relevant disclosure in the financial statements. Where the disclosures themselves are inadequate or absent, and management refuses to fix the issue, the audit opinion must be either qualified or adverse.
The second scenario is doubly relevant to troubled companies. Take a business that is overladen with debt with no hope of its lenders throwing it a lifeline. In this case, although it is to be hoped that both management and auditors would agree that use of the going concern assumption is inappropriate, management might refuse to prepare accounts on a non-going concern basis and disclose the uncertainty surrounding the business’s future.
IFRS does not contain an explicit basis for preparing accounts where use of the going concern basis is inappropriate. In all likelihood, the only basis on which a business can prepare accounts is on a break-up or liquidation basis. This means that management must begin an orderly run-down of the company’s operations, pay off creditors and make a final distribution to shareholders if funds allow.
“IFRS explicitly requires management to assess going concern. But… it contains an element of uncertainty”
Now, where management refuses to make a disclosure about material uncertainty, the auditor has no choice but to make an adverse opinion. This simply means that the audit report will note that the financial statements do not give a true and fair view. In fact, this is the case regardless of whether or not there is a disclosure about the inappropriateness of management’s use of the going concern assumption.
But note that the auditors are not making their own assessment of going concern. It is also clear that where a company is under stress, an adverse disclosure by management, let alone a negative audit opinion, could push a company into liquidation.
In the wake of the 2008 financial crisis, the International Accounting Standards Board (IASB) rushed to ‘fix’ accounting. Much of its attention focused on banks. The accusation was that a flawed IFRS impairment model meant banks reported too little too late on underwater financial assets. But lurking in the shadows was the other too-little, too-late problem: going concern.
In March 2011, the UK Financial Reporting Council announced the Sharman Panel would examine the lessons for businesses and auditors in the context of going concern and liquidity risks. The panel reported in 2012 and urged the IASB to act. Curiously, their report highlighted the importance of prudence:
“The [Sharman] Panel also heard evidence that IFRS had resulted in a move away from prudence towards neutrality in providing financial information. Prudence involves weighting downside risks more heavily than upside opportunities. The panel concluded that, although financial reporting may benefit from this shift in terms of enhanced comparability, prudence remains important in making going concern assessments. Therefore, in making such judgements, directors should seek to ensure that the company is solvent and liquid on a prudent basis.”
Although in 2012 the IASB was justified in pointing out that prudence was alive and kicking in the reworked framework following the financial crisis, prudence had gone by the time the UK’s second-largest construction and services firm, Carillion, collapsed at the start of 2018.
In June 2012, the International Auditing and Assurance Standards Board asked the IFRS to clarify the going concern assessment. The IFRS proposed a narrow-focused amendment to International Accounting Standard 1 to clarify when a material uncertainty should be identified and what should be disclosed about it.
The description of the issue by IASB project manager April Pitman seems remarkably prescient of the numerous corporate collapses that were to follow, including Carillion’s.
She said: “Many people were concerned that there were a number of very high-profile failures where a company would reach its year end, a couple of months later the accounts would be signed and published and a couple of months [after that] the entity would fail. People were concerned that there had been no disclosure about this problem. That is why the [IFRS] Interpretations Committee thinks we need to address this as a narrow-focused amendment on a reasonably tight timetable which would be shorter than the annual improvements [project].”
Pitman added: “Our outreach indicated that the guidance relating to the basis for the preparation of financial statements works well but that there was diversity in practice about disclosure of material uncertainties and when the disclosure that is made is often too little and too late.”
Ultimately, the board refused to make the amendment. In some ways, the comments made by board members during the meeting are more informative than any disclosure could hope to be. As former Volvo finance boss Jan Engstrom put it: “I think it is a day-by-day, week-by-week management issue, if you are in this mess. That is the important information: that you are in a mess.”
When Carillion went under, there were no warnings about going concern. Or were there? Fixed assets – stuff you can sell off – accounted for just 5% of its assets. A whopping 40% came from intangibles – and most of that was goodwill. The lesson of the financialisation of business is probably that Carillion’s going-concern red flag was its IFRS balance sheet.