COVID-19 has created business opportunities for some entities, but for many, particularly those reporting in June, there have been negative impacts, resulting in a likely increase in modified auditors’ reports. Understanding the meaning and relative significance of auditors’ modifications and communication will be critical to users of financial reports.
By Liz Giust and Claire Grayston FCPA
Assessing the effect of the COVID-19 restrictions and the resultant sharp economic downturn on key items, such as goodwill, asset values, recoverability of debtors and recognition of revenue, will be extremely challenging for entities in the first instance, and then for the auditors.
Perhaps even more challenging, auditors will be assessing whether the entity is a going concern, and this may be the first time many finance teams or directors will have considered the question in detail.
The going concern assumption underpins the basis of preparation of the financial report, unless the entity is being wound up, in which case the financial report is prepared on a liquidation basis.
An entity is a going concern if it will be able to continue to pay its debts as and when they fall due, for a period of at least 12 months from the date of the auditor’s report.
While some businesses have traded through the crisis, others are in hibernation, hoping to come back to life as restrictions ease. There are significant uncertainties on the road ahead for many businesses.
How can auditors effectively evaluate management’s going concern assessments in these unprecedented times?
Auditors’ assessment of going concern can only be based on available information
Even though COVID-19 presents a very uncertain economic environment, it does not mean auditors can simply issue modified reports as a default position.
In essence, auditors must apply the requirements of auditing standard ASA 570 Going Concern. This has been reinforced by the recent joint Australian Accounting Standards Board (AASB) and Auditing and Assurance Standards Board (AUASB) publication The Impact of COVID-19 on Going Concern and Related Assessments May 2020 (AASB/AUASB Going Concern Guidance).
The AASB/AUASB Going Concern Guidance Appendix A (adapted from auditing standard ASA 570 for COVID-19) provides insight into how auditors might practically think about some of the key considerations in evaluating management’s going concern assessment.
These fall into four key considerations, which are equally valuable for entities and stakeholders to consider.
Consideration 1: Do events and conditions cast significant doubt on an entity’s ability to continue as a going concern?
The auditor cannot automatically assume COVID-19 is an event or condition that casts significant doubt over every entity’s ability to continue as a going concern. Auditors need to carefully consider the entity’s business and relevant circumstances in the light of management’s assessment.
Entities in the travel, hospitality or retail sectors are more likely to be negatively impacted, while benefiting from the government’s stimulus package, or the support of lenders.
A provider of essential services may not be negatively impacted, but the positive impacts may be short lived. The usual red flags are operating losses, a net current liability position, net cash outflows from operations, the company being monitored closely be external lenders, or failures in capital raising.
This list is likely to be extended in the current environment, with further indicators set out in the joint AASB/AUASB Going Concern Guidance.
Consideration 2: Does a material uncertainty exist?
If there is significant doubt about an entity’s ability to continue as a going concern, then the auditor needs to determine whether a material uncertainty relating to going concern exists based on management’s assessment – specifically, whether the potential impact and likelihood of the uncertainty being realised necessitates disclosure of its nature and implications.
For listed entities, if a material uncertainty does not exist, the auditor’s report may include discussion on management’s going concern assessment as a key audit matter, due to COVID-19. This will be the case where the auditor has spent considerable audit effort in evaluating the going concern assumption.
If there is insufficient evidence to establish if there is a material uncertainty and the issue is pervasive, as going concern impacts most of the financial statements, the auditor may then need to issue a disclaimer of opinion.
The flowchart in the joint AASB/AUASB Going Concern Guidance indicates that in usual circumstances, the auditor gives a disclaimer of opinion if management is unwilling to extend its going concern assessment.
However, in the current environment, management may simply not have sufficient information to determine whether or not the entity has a material uncertainty, even with extensive scenario planning.
Auditors, having evaluated management’s assessments, may not be able to reach a conclusion on going concern, which will necessitate issuing a modified opinion, or possibly even a disclaimer of opinion.
Consideration 3: Is the going concern basis of accounting appropriate?
If there is sufficient information to determine that a material uncertainty exists, the auditor needs to then determine whether the use of the going concern basis of accounting is appropriate. This can create difficult conversations between the auditor and the entity, as entities are understandably reluctant to conclude they are no longer a going concern.
Hayley Underwood, an audit partner at ShineWing Australia, says that in her experience, “clients don’t take kindly to auditors telling them that the audit opinion could be modified if they cannot provide sufficient appropriate audit evidence to support the going concern basis, so start having the conversation early”.
The reality is, however, that the auditor needs more than verbal representations to draw a conclusion.
The auditor may be placed in a situation where they cannot confirm whether the going concern basis of accounting is appropriate. What does the auditor do then, as it’s not entirely clear in the AASB/AUASB Going Concern Guidance?
Michael Gummery, an audit partner at HLB Mann Judd, points out that where going concern is based on a requirement to raise future funds, in the past it has often been possible to assess the reasonableness of budgeted future capital raising, especially where the entity has a past history of successfully doing so.
He notes that given current market conditions, the likelihood of successful future capital raising may be less certain for some entities, particularly unlisted entities that may be raising on future capital through private equity or other means.
“Although uncommon,” he notes, “I have seen situations where the level of uncertainty is so great that it prevents the auditor from gaining sufficient appropriate audit evidence to form an opinion on going concern.
“Disclosing a material uncertainty may not be considered sufficient, but conversely there may not be sufficient evidence to conclude that the going concern basis of accounting is inappropriate.
“In this situation you would likely have to issue a disclaimer of opinion, with a detailed explanation in the basis for disclaimer paragraph, so users of the financial statements understand how the conclusion was drawn,” he says.
The auditor may conclude that the going concern basis of accounting is inappropriate; for example, if the entity has a significant loan repayment in the forthcoming reporting period that it will not have the cash flow to repay, and the bank has confirmed it will not be extending the terms.
If the entity still prepares the financial statements on a going concern basis, the auditor is likely to have to issue an adverse opinion.
If the entity was to present the financial statements on a liquidation basis, and the auditor agreed that the liquidation basis was appropriate, the auditor’s opinion would be unmodified, but would necessitate an emphasis of matter paragraph drawing readers’ attention to the basis of preparation.
Consideration 4: Have appropriate disclosures been made in the financial statements?
If the going concern basis of accounting is still appropriate, the auditor needs to consider whether any material uncertainty exists, and ensure the basis for the conclusion by the entity that it is a going concern is appropriately disclosed. This disclosure would normally be in the basis for preparation paragraph in note 1 to the financial statements.
If the auditor is satisfied that the wording is appropriate, then the auditor will issue an unmodified auditor’s opinion with a “material uncertainty related to going concern” paragraph, referencing back to the disclosures in the financial statements.
When an auditor concludes that the disclosures are either inadequate or could potentially be misleading, but the entity will not revise the disclosure, the auditor will most likely issue a qualified auditor’s opinion.
If the impact is pervasive, it may necessitate an adverse opinion. The basis of qualification or adverse opinion should set out why the disclosure is inadequate or misleading.
Understanding the auditor’s conclusion on going concern is critical
COVID-19 will certainly bring scrutiny to the going concern question like never before. Difficult conversations will need to be had. Entities will be expected to provide their auditors with detailed and realistic going concern assessments based on the information available, as well as reasonable assumptions about the forthcoming 12 months.
It will be critical for auditors to ensure that the degree of work conducted supports the most appropriate opinion given the circumstances of the entity.
Most importantly, users need to read and understand the significant differences between the types of auditors’ opinions related to going concern, and read and understand the supporting basis paragraph included in the auditor’s report, along with relevant financial report disclosures, to understand the implications for the entity’s ability to survive, due to the COVID-19 crisis and its aftermath.