Is “Going Concern” a concern for investors?
From time to time, companies may experience financial distress that varies from short term cash flow problems (liquidity) to issues that threaten their solvency. At these times, investors expect the directors and management to keep them well-informed about the issues and how they are being addressed so that they can make informed investment decisions. Therefore, going concern reporting is of great significance to shareholders and the investing public.
The going concern assumption is a fundamental principle in the preparation of financial statements. It is the assumption that a company does not have the intention nor the need to liquidate the company or cease operation. Under this assumption, assets and liabilities are recorded on the basis that the company will be able to realise its assets and meet its liabilities in the normal course of business.
Amid economic uncertainty, companies may face negative financial conditions that could lead to substantial doubts about the company’s ability to continue as a going concern. It is the responsibility of management to make an assessment of a company’s ability to continue as a going concern. In making this assessment, management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period.
However, financial reporting standards require the accounts to be drawn up under the going concern assumption except in the most extreme cases of financial distress, when a company has no alternative to liquidation or cessation of operation. Therefore, when a company is experiencing financial distress, financial reporting standards require that the company must disclose ‘material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern’.
When a company does not prepare financial statements on a going concern basis, it is required to disclose that fact, together with the basis on which it prepared the financial statements and the reason why it is not regarded as a going concern.
Examples of events or conditions that individually or collectively may cast significant doubts about a company’s ability to continue as a going concern:
- Negative working capital: When a company’s current liabilities exceed its current assets, it may indicate that the company has difficulties in paying its outstanding bills and creditors.
- Declining operating efficiency: Decline in efficiency ratios such as inventory turnover ratio, and receivables turnover ratio represents a decrease in the company’s operating efficiency.
- Low profitability: Persistent operating loss, low return on assets (RoA) or return on equity (RoE) indicate that the company’s assets are not effective in generating revenue or the company’s operations are not profitable.
- Declining market share: Loss of a major market or key customer(s) may cause uncertainty in the company’s future business.
- Loss of key management or employees: The departure of key personnel who cannot be easily replaced may place a burden on the business.
- Inability to comply with debt covenants: Non-compliance with the terms of loan agreements may result in financial penalties or loss of financing.
- Legal or regulatory issues: Pending legal or regulatory proceedings against the company that may result in substantial damages or penalties.
Auditors have a direct responsibility to conclude whether a material going concern uncertainty exists and, if so, to include a statement to that effect in their report. Investors can obtain additional information regarding the material uncertainties about the company’s ability to continue as a going concern by reading the auditor’s report. The Financial Reporting Council further discusses going concern reporting by listed entities and their auditors in its November 2021 edition of eNews, to help investors understand more about the role of auditors in relation to going concern.
Going concern reporting is a critical source of information to investors when companies are experiencing financial distress. Investors are reminded to read the financial statements and related disclosures to better assess the company’s financial health in making investment decisions.