By Matthew Rees, Director, and Carol Der Garry, Partner, Forensic Risk Alliance
Karan Deepak, Associate at Forensic Risk Alliance also significantly contributed to this article.
Throughout most of 2020, businesses faced uncertainty caused by the COVID-19 pandemic. Periodic lockdowns, travel restrictions and reduced consumer confidence led to many of them experiencing precipitous declines in sales, soaring losses, and upheaval to their business operations. Despite strong progress in some vaccination programs, this uncertainty is unlikely to dissipate for a while particularly with the emergence of new, more virulent strains, and the threat of further waves of infections. This is illustrated by the recent warning issued by Cineworld over its ability to continue as a going concern, after reporting a $3 billion loss in its 2020 financial statements.
The purpose of this article is to examine the impact of the pandemic on the issue of Going Concern in the preparation and auditing of financial statements.
While public companies have issued quarterly trading updates during the pandemic, Going Concern disclosures within Annual Reports are now being subjected to careful scrutiny. During 2020, the Financial Reporting Council (FRC) markedly increased its focus in this area and issued guidance related to Going Concern. This year, the government has shown its eagerness to focus on the audit industry by replacing the Financial Reporting Council with a new, more stringent, audit watchdog, the Audit, Reporting and Governance Authority.
In light of the FRC’s actions, audit firms will be under yet more pressure to obtain sufficient evidence to evaluate and conclude on Going Concern related decisions and disclosures. This is of course in accordance with the existing ISA 570, under which the auditor must determine the appropriateness of management’s use of the Going Concern basis of accounting in the preparation of financial statements, and to conclude, based on the audit evidence whether a material uncertainty exists about the entity’s ability to continue as a going concern.
The intensity of already challenging circumstances will be amplified by this pressure on auditors. The need to comply with additional regulatory guidance and practical difficulties caused by ongoing COVID-19 restrictions will combine with the potential for tension between the auditor, company management and investors. These tensions will only be alleviated by auditors’ adherence to auditing standards and maintenance of transparency, trust and collaboration between the parties.
Impact of COVID-19 on Going Concern Assessments
The uncertainty that COVID-19 presents across the wider economy has added to the complexity of the Going Concern assessment made by management. Companies rely on cash to fund short and long term activities. In times of financial difficulty, cash reserves are often depleted and loan facilities drawn down to keep the company afloat. Day-to-day expenditure is prioritised over capital investment. The need to service increasing levels of debt and underinvestment may lead to a downward spiral and, ultimately, corporate failure.
Companies often have inflexible business models, which when subject to prolonged stress can suffer long term or terminal damage. Despite extensive government support, the pandemic has severely reduced cash flow for large sections of the economy; this cash-starvation may pose adverse Going Concern related effects for 2021 and beyond. Although a Going Concern conclusion may seem a binary choice, many factors must be taken into account when forming such a conclusion. The effects of the pandemic have increased the difficulty of this assessment.
Directors face challenges such as determining whether their available funding will be sufficient to keep the enterprise afloat. One method used in such evaluation is ‘Stress testing’ using a simulation to determine the viability of a company to deal with one or more hypothetical adverse economic events. One such test, for example, would be to analyse the likely response of a company to extended slumps in revenue.
In the context of COVID-19, the FRC have encouraged reporting entities to disclose detail on the rationale for their Going Concern assessment and to be transparent and comprehensive in documenting reasons behind their assessment. This represents a shift away from the ‘tick-the-box’ exercise of simply stating whether a company is a Going Concern. Disclosures could include the stress testing scenarios, assumptions about government support, mitigations of potential covenant breaches and decisions relating to cutting short-term expenditure.
The FRC has also encouraged and provided guidance to audit firms on the expected scrutiny of management’s decisions on Going Concern. This guidance includes increasing the number of experienced audit partners consulted during the audit of Going Concern, expanding the range of audit procedures (such as re-performing stress tests, as well as probing the reliability of underlying data and assumptions) and providing additional training and support to teams for COVID-19 related matters. Notwithstanding the typical staffing and time pressures experienced during audit busy seasons, the FRC highlighted the importance of Going Concern and urged Audit Firms to adapt appropriately.
A challenge to the independence of the auditor?
The FRC, have warned audit firms that enhanced scrutiny of the Going Concern assessments is an inevitable consequence of pandemic-related disruption. The significance of any doubts around Going Concern to decision making by stakeholders, including investors, customers and suppliers, means that this will be a particularly sensitive area.
Directors themselves are likely to be all too aware of increased attention being paid to disclosures by existing and potential investors. They will naturally wish to portray as positive a picture as possible. Directors may also be hesitant to provide detailed disclosures that may lead to banks withdrawing the finance on which the company depends. At the same time, auditors will be deploying rigorous procedures to gain the necessary assurance. The situation was acknowledged by the FRC where they encouraged stakeholders to take into account the unprecedented nature of these times when deciding how to react to the disclosures.
The tension is exacerbated by the expectation gap between the statutory role of an auditor and that perceived by users of the financial statements. The auditing standards do not require the auditor to decide the Going Concern status of a company on their behalf. Rather, they have to form a conclusion on the appropriateness of management’s use of the Going Concern assumption. The auditor must determine that a material uncertainty does not exist that casts doubt on the ability of an entity to continue as a going concern for a period of less than 12 months. Furthermore, for PIES and listed entities, further disclosures are required on how the assessment was evaluated. Auditors placing greater emphasis on Going Concern during a global pandemic is likely to result in a greater number of management’s conclusions being challenged. This places the auditor in a precarious position whereby audit quality and the need for objectivity and independence competes with maintaining cordial client relations.
The challenges of auditing Going Concern during COVID-19
Historically Going Concern has seldom been assessed as a significant risk for the purposes of audit planning. This means that little audit work has been required on this topic. Now, as a result of pandemic-related stresses, the FRC has called for extensive procedures to be followed irrespective of the risk assessment, which will pose both technical and logistical challenges to auditors.
Primarily, the FRC has called for an increased use of ‘specialists’ when auditing Going Concern. An example of this would be the use of M&A specialists to aid in assessing the operating viability of the company. However, in a separate but concurrent initiative, the FRC have also called for audit practices to be ‘ring fenced’ from the rest of the firm’s business lines to mitigate risks associated with conflicts of interest. The conflicting initiatives may lead to ring-fenced audit departments struggling to obtain specialists from within the same firm. In practice, this is a longer-term challenge as ring fencing is expected to be implemented over several years.
In their guidance, the FRC has also called for reviews of Going Concern assessments by multiple partners, as well increasingly detailed substantive procedures to conclude on the viability of any sensitivity analysis carried out by the audited entity on ‘worst case scenarios’. Increasing the amount of partner involvement in an audit can suppress audit profitability. Furthermore, during busy seasons, firms are often resource constrained, spreading experienced personnel more thinly over a greater number of audits may have an adverse effect on audit quality.
Audit firms may also face challenges in fully assessing the true impact of COVID-19 has on the companies they audit. The pandemic and its effects on normal life is a contemporary issue which has emerged rapidly and brought huge uncertainty to short and medium terms outlooks. Audit firms have been challenged to build mechanisms to enable audit teams to tailor audit procedures appropriately. By way of mitigation, audit teams are required to increase communication with those charged with governance and display greater prudence when assessing the information provided to them. This may lead to audits not being completed to time – another issue highlighted by the FRC. The regulator has stated that late completion is understandable, and the auditing firms should be more open with the FRC and those charged with governance on these matters.
What does 2021 hold?
The current audit cycle will see a greater emphasis on Going Concern. Due to an increased number of companies facing severe and ongoing business disruption, it is inevitable that future viability will be in doubt for many of them. Therefore, management’s conclusions, reporting and disclosure of the Going Concern Assessment, and the related external audit opinions will face enhanced scrutiny by regulators and stakeholders. In such circumstances transparency is essential so that investors understand the extent to which COVID-19 has impacted businesses. Furthermore, from an audit perspective, setting expectations early during the audit, and ensuring that audit team have sufficient time and resources are important considerations.
However, the fact remains that it is important to recognise the tension that lies at the heart of this matter. Auditors will be under immense pressure to deal with this tension and deliver reliable assurance over financial statements while fulfilling the demands placed on them by both today’s extraordinary circumstances and intensified regulatory expectations.