COVID-19 guidance on going concern: five key areas for auditors to consider
COVID-19 Guidance on going concern: Five key areas for auditors to consider.
The impact of COVID-19 will vary from business to business but there will be few that are not affected whether directly or indirectly. Consideration of the impact is very likely to form part of the directors’ assessment when preparing their strategic reports and financial statements and auditors will require to assess the impact of any uncertainties on the audit report.
As always, auditors must remain professionally sceptical, and follow the requirements of International Standard on Auditing (ISA) (UK) 570 Going concern. Note that the ISA was revised in September 2019 for periods commencing 15 December 2019 onwards, and the new requirements require significantly more documentation and consideration in support of the auditor’s conclusion. Firms will of course need to determine whether they will early adopt the latest version of ISA (UK) 570.
This guidance highlights five key areas which auditors may wish to consider when auditing going concern, and in considering the challenges presented by the pandemic. Of course, each audit has to be assessed on a case by case basis and the key areas are not intended to be exhaustive. The key areas are:
The risk assessment process
The coronavirus pandemic has significantly increased going concern risk for a large number of entities. As there is an increased likelihood of material uncertainties in relation to going concern, this must be appropriately reflected in the auditor’s risk assessment.
At the planning stage, auditors will more frequently assess going concern as a significant risk area (or an area of higher risk). It is important that this is appropriately reflected and weighted in the assessment of inherent risk and the auditor can demonstrate the impact on the audit approach. It is not enough that the risk is simply highlighted and left for consideration at the completion stage of the audit.
In conducting the risk assessment process, and the auditor’s preliminary assessment of going concern, documented considerations may include:
The extent of pre-existing going concern issues in the business
This will include an existing net liability or weak asset position, history of operating or trading losses, and other financial or operating pressures which may have led to significant going concern considerations or a modified audit opinion in a prior year.
Whether the principal activity of the audit client, or the business sector it operates in, gives rise to additional risk
While companies across all industry sectors have been impacted, there has been a significant impact on exposed sectors such as travel and hospitality; retail, the leisure industry; auto trade, parts and equipment; and oil and gas. This list is not intended to be exhaustive.
Whether the business model of the audit client been impacted
While some businesses have been able to adapt to a different business model (e.g. a retailer moving online or a restaurant moving to a delivery-only service) many have faced severe restrictions resulting in significant reduction or cessation of trading activities. There may also be changes in demand for a product or service which could last into the medium or long term.
The extent to which cash flow been impacted
Important considerations will include whether customers have been delaying or postponing payments to the business and whether any have ceased to trade. Firms should also consider the entity’s current cash position and its general access to additional finance, including government assistance, debt or equity from directors and the availability of any additional credit facilities.
Loans, whilst providing immediate assistance in relation to liquidity, may negatively impact the longer-term solvency of the business.
Furthermore, consideration will need to be given as to whether there have been any breaches of covenant terms, or indeed whether any are likely over the period under review. If that is the case, then how have the directors mitigated the impact of such breaches / likely breaches?
Whether the entity’s supply chain has been impacted
Logistics and other supply disruptions can have significant implications on an entity’s ability to trade and will impact working capital. There may be a significant knock-on effect on the supply chain of the entity as a result of the lockdown restrictions and ongoing social distancing measures.
The extent to which staffing and employment has been impacted
While initially this will include the number of staff furloughed, also consider the extent of redundancies and the number of staff required or indeed able to operate effectively under social distancing measures. There may also be wider issues around staff absences and loss of key personal due to the virus.
Whether there are underlying legal or contractual issues
This would include onerous lease contracts; breach of contractual terms for delivery of services; and pension obligations.
The type of assets held by the entity
Consideration should be given to the types of assets held by the audited entity, both tangible and intangible and whether they may subject to impairment e.g. property, inventory, receivables and goodwill.
There will be no ‘one size fits all’ approach to documenting the impact of COVID-19 on the risk assessment process, however, firms may consider tailoring existing procedures to facilitate how judgements and conclusions are documented, and the impact on the audit approach.
Evaluating management’s assessment of going concern
When preparing financial statements, management assesses whether the entity is a ‘going concern’. Note that the accounts will always be prepared on a going concern basis unless management either intends to liquidate the entity or cease trading (or has no realistic alternative but to do so). It is vital then that management has clearly considered the impact of the pandemic on the entity, with key consideration on whether the entity has sufficient funds to continue to meet its obligations as they fall due.
As there are implications for the audit opinion where the auditor is unable to obtain sufficient appropriate evidence, it may be helpful for auditors to set a clear expectation of the level of evidence required to support management’s assessment, which will usually be supported by financial forecasts and cash flow projections.
Any forecasts or projections must be revisited and revised regularly, and management’s assessment should model a range of scenarios to assess the impact of different potential decreases in sales and increased costs on the cash and balance sheet position.
Such sensitivity analysis should include a remote but possible pessimistic scenario. Further key considerations for auditors in critically assessing these forecasts may include:
- As some businesses will see reduced customer demand, or changes in demand, whether there has been suitable consideration of the sources and certainty of future income.
- Whether management’s assessment includes an appropriate timescale for the lifting of restrictions – and ensuring that this has been reassessed in line with current guidance and conditions, including further outbreaks of the virus.
- Where restrictions have been appropriately considered, whether any return to ‘normal’ trade reflected in the projections is realistic.
- Whether any cost savings reflected in projections are feasible and whether there is evidence of cost increases which have not been accurately reflected. This could include costs to restart production, increased staff and materials costs, additional financing costs, plus any costs relating to government grants.
- When reviewing current cash levels and future cash requirements, consideration of the availability of cash to the entity including the existence of additional credit facilities.
- Whether the entity has negotiated payment holidays or renegotiated the terms of a loan. Appropriate evidence should be obtained in support of how these are reflected in projections, including any revised terms and restrictions, and whether there is a further financial impact, for example, additional charges or additional interest.
- With new or existing finance or loans, the auditor should consider whether there are covenants in place which could put the business at risk, including those sensitive to changes in asset value.
- Where management indicates that the lender has waived any covenant terms, the auditor will require appropriate evidence in support of this. In some situations, the banks are also tending to replace existing covenants with a cash headroom trigger test, normally set around 20% – 30% over base case company cash need forecasts.
- If forecasts include provision for insurance claim receipts related to COVID-19, there should be appropriate evidence to support this.
- In group scenarios, where reliance is being placed on financial support or guarantees of another group entity, there will need to be clear evidence of written contractual evidence of such support. Whilst previously a letter of support from the parent may have been sufficient, this may no longer be so. The viability of this support also needs to be considered re the financial strength of the parent company or other group entity providing the support/guarantee.
Firms should also consider whether there will be practical difficulties in obtaining evidence given restrictions on travel and access to premises, and the extent of alternative procedures which can be performed remotely.
If the auditor cannot obtain sufficient appropriate audit evidence, the implications for the auditor's opinion on the financial statements should be considered in accordance with ISA (UK) 705 Modifications to the Opinion in the Independent Auditor’s Report (Revised June 2016).
Reporting a material uncertainty related to going concern
Where there are material uncertainties that cast significant doubt on going concern, further disclosure will be required in the financial statements and the audit report. Guidance on the wording of the auditor’s opinion in this regard can be found in ISA (UK) 570.
A key consideration for auditors will be around the adequacy of disclosures made by management in their financial statements and strategic reports. These disclosures should set out the key information sources, judgments and assumptions as at the date of making the assessment and should provide sufficient information about the impact of COVID-19 on the entity to inform the users of the financial statements.
Disclosures should also clearly state that there is a material uncertainty that may cast significant doubt on the entity’s ability to continue as a going concern.
The quality of the disclosures made by the directors in the financial statements and the underlying supporting evidence will be key when the auditor considers the opinion that they will issue on the financial statements. Firms are reminded that ‘commercial sensitivity’ is not a suitable excuse for management to exclude certain disclosures in the accounts. Similarly, the fact that a company is owner managed does not exempt the entity from this requirement.
Where the auditor considers that the directors have appropriately disclosed the material uncertainty in the financial statements then the auditor does not modify the opinion but, under a separate heading entitled Material Uncertainty Relating to Going Concern, draws attention to the note in the financial statements that disclose the matter, states that events and conditions indicate a material uncertainty exists and that the auditor’s opinion is not modified in respect of this matter.
Where disclosure of material uncertainties by the directors in the accounts is considered inadequate by the auditor, a qualified or adverse opinion will be required, depending on the pervasiveness of the matter.
It is recommended that auditors set a clear expectation of the level of disclosure required in the financial statements, and the potential implications for the audit report if these are not met.
Where the auditor has not obtained sufficient and appropriate evidence in support of management’s assessment, or in rare cases involving multiple uncertainties that are significant to the financial statements as a whole, it may be appropriate to issue a disclaimer of opinion. ISA (UK) 705 (Revised June 2016) provides further guidance on these issues.
Note that some auditors may have to report a key audit matter and should refer to ISA (UK) 701 for further guidance
Regular and effective communication
In the current climate, the auditor must communicate regularly with management and those charged with governance. The impact of the pandemic on entities is changing rapidly, and the validity of assumptions and conclusions can change over a very short time.
Auditors should consider how they will communicate to management and those charged with governance in a timely manner, on both reporting and other matters.
Note that ISA (UK) 570 sets out the requirements for communication when events or conditions are identified which may cast doubt on an entity’s ability to trade as a going concern, including whether there is a material uncertainty, the appropriateness of management’s use of the going concern basis, the adequacy of related disclosures in the financial statements, and the implications if any for the audit report.
Timing of the auditor’s reassessment of going concern
Further to the above point, the auditor must continue to reassess their conclusion over going concern and this will continue up to the point of signing the audit report.
Before signing the audit opinion, this may require the provision of further evidence and/or information by management, and further consideration, by the auditor, of the disclosures in the financial statements.
It is crucial that the audit file fully documents all steps in arriving at the conclusion on going concern, including changes to the auditor’s expected opinion over time. This is especially important where going concern has been highlighted as a risk area, but a clean audit opinion has ultimately been signed.
ICAS and ICAEW guidance for directors of SME companies
ICAS guidance on going concern for directors of large companies
FRC Covid-19 bulletin for auditors
FRC guidance on qualified and modified audit opinions
IAASB Staff Audit Practice Alert: Going Concern
ISA 570 (Revised September 2019)