Have you ever wondered if your business will still be running next year? That’s where the ‘going concern principle‘ comes in. As auditors, we’re here to break down what this accounting concept means to you.
Introduction
Under the going concern basis of accounting, the financial statements are prepared on the assumption that the entity is a going concern and will continue its operations for the foreseeable future. General purpose financial statements are prepared using the going concern basis of accounting, unless management either intends to liquidate the entity or to cease operations or has no realistic alternative but to do so.
Imagine putting a significant amount of hard-earned money into a business, only to learn several months later that it faces bankruptcy. A going concern report is vital information that can prevent losses. This crucial component of financial statement audit is not merely a formality; rather, it is a lighthouse that indicates a company’s financial stability and long-term viability. In this era, where business failures have the potential to affect the entire economy, knowing how to use going concern reporting is crucial for protecting investments, employment, and the economy as a whole. Going Concern report ensures the Investor’s confidence in the company, provides an early warning signal about potential financial difficulties, ensures compliance with regulatory standards, and helps manage risks.
Indicators Affecting the Going Concern Assumption
There are several indicators that suggest possible going concern problems. These can be broken down into financial, operational and external indicators.
Financial Indicators:
- Net Debt or Net Current Liability Position: When the value of liabilities exceeds assets, it may indicate potential insolvency.
- Negative Operating Cash Flows: Continuous negative cash flows from operations may suggest that the entity cannot generate sufficient revenue to sustain its operations.
- Fixed-Term Borrowings: Approaching maturity of significant borrowings without realistic prospects of renewal or repayment can pose a substantial risk. Continuous defaults and delay in repayment of loan installments.
- Poor Financial Ratios: Worsening financial ratios such as declining profit margins, increasing debt-to-equity ratios, and inadequate interest coverage ratios.
Operational Indicators:
- Loss of Key Management: The departure of key executives or management can disrupt the entity’s strategic direction and operational efficiency.
- Labour Issues: Strikes, labour disputes or high staff turnover could impact on entity productivity and stability in operations.
- Obsolete Technology – Lack of upgrading or maintaining technology can result in inefficient operations as well as increased costs.
Other External Indicators:
- Market Conditions: Changes in the economy, recession, shifts in market dynamics or increased competition can influence revenue and profitability of the organization.
- Legal and Regulatory Changes: New laws, regulations, or changes in government policy can impact on business operations and financial health.
- Natural Disasters or Pandemics: Some unforeseen events like natural disasters or pandemics could break down a company’s operations as well as its financial base.
Management’s Responsibility
- Explicit Requirement for Assessment:
Management often has to assess and disclose about the ability of an entity to continue as a going concern under various financial reporting frameworks. In making this assessment, both current and future occurrences are considered.
- Judgment and Uncertainty:
Management assesses using judgment whether uncertain events can occur in the future. Some factors that influence this judgment include, level of uncertainty, size and complexity of the firm; nature of business and external environment.
- Disclosure Requirements:
Therefore, once there is doubt over the company’s going concern assumption in existence, management should disclose main events or conditions causing such uncertainties together with steps in place to resolve these issues.
- Legal and Regulatory Frameworks:
In some jurisdictions, regulations or laws may contain detailed guidance on management’s evaluation of going concern assumptions.
- Continuous Monitoring:
In order to act promptly on probable questions related to their going concern status, managers should continuously observe risks associated with finance situation facing their entities.
Auditor’s Responsibility
- Evaluation of Management’s Assessment:
To determine if this is rational, auditors must assess management’s assessment against the background of supporting documentation.
- Sufficient Appropriate Evidence Acquisition:
Auditors need to gather sufficient appropriate audit evidence needed for determining whether there exists a material uncertainty concerning events or conditions that may cast significant doubt upon the ability of the entity to continue as a going concern.
- Independent Judgement:
This includes assessing the implications of the audit evidence collected, which auditors will do through their professional judgment. While performing this task, auditors should consider several factors such as any conditions or events which might impact on the continued operation of an entity as a going concern.
- Communication with Management:
In addition, auditors should also discuss and make known any matters affecting assumption about going concern to management including any support obtained and what actions were taken by management to mitigate those risks.
- Reporting Requirements:
Consequently, if these uncertainties are significant enough in nature then they ought to be appropriately disclosed in financial statements by auditors. Lastly, if managements’ disclosures fail to meet requisite standards an auditor may modify his opinion.
Case Study
1. Jet Airways: Once one of India’s largest airlines, is now one of the best example of a company struggling with going concern issues. Following were the issue in the company:
- Negative Cashflows
- Default on loan repayment
- Loss of key management
- Regulatory challenges
2. Dunzo: Deloitte, which audited the financial statements of Dunzo for the financial year 2022-23 (FY23), flagged material uncertainty over the quick commerce startup’s ability to continue as a ‘going concern’.
- Deloitte said Dunzo’s FY23 liabilities exceeded its assets by INR 325.8 Cr, which were incurred on account of high operational costs.
- The troubled startup reported a nearly 4X YoY rise in net loss to INR 1,801 Cr in FY23 on an operating revenue of INR 226.6 Cr.
- They were having problem in raising funds from investors.
Conclusion
Both management and auditors have an important role to play in determining whether a company can continue its operations or not. This is to be done by conducting an analysis of the firm as well as using appropriate judgement. It is pivotal for investors’ confidence and entity’s long-term sustainability that any signs which may put into jeopardy the assumption of going concern be spotted and dealt with promptly. These are live examples from Jet Airways and Dunzo that underline the significance of sound evaluation and prompt intervention in addressing issues associated with going concern. Being aware of these obligations and signals will enable stakeholders to cope better with contemporary challenges facing their businesses where ambiguity prevails all over.
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Authors: Punit Ruparelia, Partner, can be reached at [email protected] or +91 7977070887, and Raghav Somani, Associate Consultant, can be contacted at [email protected] or +91 8319393973.
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