AU 341: The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern

AU-C 570: The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern

AU EFFECTIVE DATE AND APPLICABILITY

Original Pronouncements Statements on Auditing Standards (SASs) 59, 64, 77, and 96.
Effective Date These statements are now effective.
Applicability Audits of financial statements in accordance with generally accepted auditing standards (GAAS).
NOTE: The Statement applies in the audit of any type of entity. It is applicable to both profit-making and not-for-profit organizations. Thus, it would apply, for example, in the audit of a municipality. Also, the Statement applies to both GAAP (generally accepted accounting principles)–basis financial statements and OCBOA (Other Comprehensive Bases of Accounting)–basis financial statements, (e.g., cash or modified cash basis, tax basis, or regulatory basis). However, it does not apply to liquidation-basis financial statements.

AU-C EFFECTIVE DATE

SAS No. 126, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, is effective for audits of financial statements for periods ending on or after December 15, 2012.

SAS No. 126 does not change or expand SAS No. 59, as amended, in any significant respect. The Auditing Standards Board (ASB) has moved forward with the clarity redraft of SAS No. 59, as amended, so that it is consistent with the format of the other clarified SASs that were recently issued. However, the ASB decided to delay convergence with International Standard on Auditing 570, Going Concern, pending the Financial Accounting Standards Board’s (FASB’s) anticipated development of accounting guidance addressing going concern.

AU-C DEFINITION OF TERM

Source: AU-C 570.07

Reasonable period of time. A period of time not to exceed one year beyond the date of the financial statements being audited.

OBJECTIVES OF AU SECTION 341

The “going concern” concept has long been a tenet of financial accounting. It has been called an assumption, a concept, a basic fixture, and a postulate, and has usually been stated somewhat as follows:

Continuation of entity operations is usually assumed in financial accounting in the absence of evidence to the contrary.

The auditor has an obligation to make an assessment of a client’s ability to continue as a going concern.

Note that the section does not mandate any procedures especially and solely directed to searching for conditions or events that would indicate a going concern problem. The obligation is to assess the information obtained from procedures used for other purposes.

Report modification may result solely from substantial doubt about continued existence regardless of whether there is any uncertainty associated with the recoverability and classification of recorded amounts. Under this section, continued existence has a separate status. There could be substantial doubt about continued existence even when there is no question about recoverability and classification.

When the audit report is modified for a material uncertainty, the opinion is unqualified, but disclosure of the going concern uncertainty is made in an explanatory paragraph that follows the opinion paragraph. This type of uncertainty is the only one that requires a report modification.

The section states that “a reasonable period of time” is a period not to exceed one year beyond the balance sheet date.

OBJECTIVES OF AU-C SECTION 570

AU-C Section 570 states that:

. . . the objectives of the auditor are to

a. evaluate and conclude, based on the audit evidence obtained, whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time;
b. assess the possible financial statement effects, including the adequacy of disclosure regarding uncertainties about the entity’s ability to continue as a going concern for a reasonable period of time; and
c. determine the implications for the auditor’s report.

FUNDAMENTAL REQUIREMENTS

Auditor’s Responsibility

The auditor should evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited (i.e., the balance sheet date). However, the auditor is not required to design audit procedures specifically to identify conditions and events that indicate a “going concern” problem.

Procedures Required

The auditor should consider whether the results of his or her usual audit procedures indicate that there could be substantial doubt.

Additional Procedures

If the auditor has substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, he or she should:

1. Obtain information about management’s plans to mitigate the problem
2. Assess the likelihood of effective implementation of the plans
3. Identify those elements that are especially significant to mitigating the going concern problem and plan and perform auditing procedures to obtain evidential matter about those elements

Prospective Financial Information

If prospective financial information is significant to management’s plans, the auditor should obtain that information and should consider the adequacy of support for the significant assumptions. The auditor should pay special attention to those assumptions that are:

1. Material to the prospective financial information
2. Particularly sensitive or susceptible to change
3. Not consistent with historical trends

Auditor Conclusions—Substantial Doubt Exists

If the auditor concludes that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, he or she should (1) consider whether the condition is adequately disclosed and (2) modify the auditor’s standard report by including an explanatory paragraph (following the opinion paragraph) or disclaim an opinion. The auditor’s conclusion should be expressed in the report using the terms “substantial doubt” and “going concern.”

Auditor Conclusions—Substantial Doubt Does Not Exist

If the auditor concludes that substantial doubt does not exist about the entity’s ability to continue as a going concern for a reasonable period of time, he or she should consider whether the matter needs to be disclosed.

NOTE: The absence of reference to substantial doubt in the auditor’s report does not mean that the auditor is providing assurance about an entity’s ability to continue as a going concern.

Inadequate Disclosure

If the auditor concludes that the entity’s disclosures about its ability to continue as a going concern for a reasonable period of time are inadequate, the auditor’s report should be qualified or adverse because of a departure from GAAP.

NOTE: The need to consider the adequacy of disclosure of going concern problems is independent of the auditor’s decision to modify the audit report; that is, disclosure may be necessary even when the report is not modified.

Documentation Requirements

If, after considering the aggregate of events and conditions identified during the audit, the auditor believes that there is substantial doubt about the ability of the entity to continue as a going concern for a reasonable period of time, the auditor should document all of the following:

1. The conditions or events that led to the auditor’s belief that there is substantial doubt about the entity’s ability to continue as a going concern.
2. Those parts of management’s plans that are particularly significant to overcoming the adverse effects of conditions or events.
3. The auditing procedures performed and evidence obtained to evaluate management’s plans.
4. The auditor’s conclusions about whether substantial doubt about the going concern issue remains.
  • If substantial doubt exists, document the possible effects of the conditions or events on the financial statements and the adequacy of the related disclosures.
  • If substantial doubt is alleviated, document the conclusion about whether disclosure of the principal conditions and events that led the auditor to believe there was substantial doubt is needed.
5. The auditor’s conclusion about whether to include an explanatory paragraph in the audit report to reflect the conclusion that substantial doubt remains. If going concern disclosures are inadequate, the auditor should document the conclusion about whether to express a qualified or adverse opinion to reflect the GAAP departure.

INTERPRETATIONS

Eliminating a Going Concern Explanatory Paragraph from a Reissued Report (August 1995)

An auditor may be asked by the client to reissue the audit report and eliminate the going concern paragraph. Such requests usually occur after the going concern matter has been resolved. The auditor has no obligation to reissue the audit report. However, if the auditor decides to reissue the report, he or she should

1. Audit the event or transaction that prompted the request to reissue.
2. Perform the procedures in Section 560.
3. Consider at the date of reissue the conditions and events that related to negative trends, internal matters, external matters, and other indications of financial difficulty. Also consider at the date of reissue management plans, including prospective financial information, the financial statement effects, and the effects on the audit report.
4. Perform any audit procedures considered necessary.
5. Reassess the going concern status of the entity.

TECHNIQUES FOR APPLICATION

Procedures

The auditor’s evaluation of whether there is a substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time (not to exceed one year beyond the balance sheet date) is based on his or her knowledge of relevant conditions and events that exist at, or occurred before, completion of fieldwork. It is not necessary for the auditor to design audit procedures specifically to identify conditions and events that indicate a going concern problem. Regular auditing procedures are sufficient.

Regular auditing procedures that may identify conditions and events that indicate a going concern problem include the following:

1. Analytical procedures. Analytical procedures used as a substantive test or used in the planning and overall review stages of the audit may indicate:
a. Negative trends
b. Slow-moving inventory
c. Receivable collectibility problems
d. Liquidity and solvency problems
2. Review of subsequent events. Subsequent events, such as the bankruptcy of a major customer, confirm adverse conditions that existed at the balance sheet date. Other subsequent events that indicate a possible going concern problem include:
a. Collapse of the market price of the entity’s inventory
b. Withdrawal of line of credit by bank
c. Expropriation of entity’s assets
3. Review of compliance with the terms of debt and loan agreements. Violation of debt covenants results in debt default.
4. Reading of minutes. Minutes of meetings of stockholders, board of directors, and board committees may indicate:
a. Potentially expensive litigation
b. Loss of lines of credit
c. Loss of a major supplier
d. Changes in the operation of the business that could result in significant losses
5. Inquiry of legal counsel. Responses to inquiries of the entity’s legal counsel about litigation, claims, and assessments could indicate possible significant losses because of product liability claims, copyright or patent infringement, contract violations, and illegal acts.
6. Confirmations concerning financial support. Confirmation with related parties and third parties of the details of arrangements to provide or maintain financial support may indicate loss of bank lines of credit or loss of third-party guarantees of entity indebtedness.

Indications of Going Concern Problems

Regular audit procedures such as those described above may reveal conditions and events that indicate there could be substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time. Examples of these conditions and events (going concern warning signs or red flags) are as follows:

1. Negative trends:
a. Declining sales
b. Increasing costs
c. Recurring operating losses
d. Working capital deficiencies
e. Negative cash flows from operations
f. Adverse key financial ratios
2. Internal matters:
a. Chaotic and inefficient accounting system
b. Loss of key management or operations personnel
c. Work stoppages or other labor difficulties
d. Substantial dependence on the success of a particular project
e. Uneconomic long-term commitments
f. Need to significantly revise operations
3. External events that have occurred:
a. Legal proceedings
b. Legislation or similar matters that might jeopardize operating ability
c. Loss of a key franchise, license, or patent
d. Loss of a principal customer or supplier
e. Uninsured catastrophes such as drought, earthquake, or flood
4. Other indications of possible financial difficulties:
a. Default on loan or similar agreements
b. Arrearages in dividends
c. Denial of usual trade credit from suppliers
d. Noncompliance with statutory capital requirements
e. Seeking new sources or methods of financing

Consideration of Management’s Plans

If, after considering the conditions and events described above, the auditor believes there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, he or she should consider management’s plans for addressing these conditions and events.

Management’s plans may be classified as follows:

1. Plans to dispose of assets
2. Plans to borrow money or restructure debt
3. Plans to reduce or delay expenditures
4. Plans to increase ownership equity

Plans to Dispose of Assets

If management plans to dispose of assets, the auditor should consider the following:

1. How marketable are the assets that management plans to sell?
2. Are there any restrictions on the disposal of assets?
3. What are the possible effects of disposal?

Marketability of Assets

The auditor should do the following:

1. If the assets are securities, review market quotations to determine price and volume.
a. If the securities are unlisted, review management documentation and correspondence with prospective buyer.
2. If the assets are intangible assets—patents, franchises, copyrights—review the following:
a. Cash generated by the asset over the previous years
b. Management’s documentation of estimated sales price
c. Correspondence with prospective buyer
3. If the assets are long-lived assets—property, plant, and equipment—review the following:
a. Current market for the assets and current market value
b. Management’s documentation of estimated sales price
c. Correspondence with prospective buyer
4. If management contemplates sales of receivables to a financial institution, review the following:
a. Allowances for doubtful accounts, and sales returns and allowances
b. Management’s documentation of estimated sales price
c. Correspondence with financial institution
5. If the assets are a complete segment of the entity, review the following:
a. Segment operations over the previous years
b. Management’s documentation of estimated sales price
c. Correspondence with prospective buyer

Restrictions on Disposal of Assets

Under certain circumstances, the entity may be prohibited from disposing of assets. If management contemplates disposal, the auditor should do the following:

1. Review all loan agreements
2. Review mortgages, financing arrangements, and other asset encumbrances

Effects of Disposal

The auditor should consider possible adverse effects of the proposed disposal of assets. He or she should do the following:

1. Discuss with management the estimated effect of the disposal on the continuing operations of the entity.
2. Prepare pro forma financial statements of the entity, after excluding the assets that will be disposed of.
3. Analyze the pro forma financial statements to determine the effect of the disposal on operations and cash flows.

Plans to Borrow Money or Restructure Debt

If management plans to borrow money or restructure debt, the auditor should consider the following:

1. How available is debt financing?
2. Is collateral available and sufficient?
3. Are there restrictions on additional borrowing?
4. Are there existing or committed arrangements to restructure or subordinate debt or to obtain guarantees of loans to the entity?

Availability of Debt Financing

The auditor should do the following:

1. Review management’s plan.
2. Determine if there are existing or committed arrangements, such as lines of credit.
3. Determine feasibility of factoring receivables. Consider the impact on operations of factor’s fees and interest charges.
4. Ascertain the availability of assets for sale-leaseback arrangements.

Availability and Sufficiency of Collateral

If there is a question about an entity’s continued existence, it is probable that it will not be able to borrow funds without collateral. The auditor should consider the availability and sufficiency of assets as collateral. Assets to be considered are the following:

1. Marketable securities
2. Receivables
3. Inventories
4. Property, plant, and equipment

Restrictions on Additional Borrowing

Existing loan agreements may prohibit the entity from borrowing additional funds. To determine this, the auditor should do the following:

1. Review mortgage agreements.
2. Review bond indentures.
3. Review bank loan agreements.

Existing or Committed Arrangements

If there are existing plans or commitments to modify existing loans or to guarantee existing or new loans, the auditor should do the following:

1. Review management’s plans for:
a. Debt restructuring
b. Subordination of existing debt
c. Obtaining loan guarantees
2. Review correspondence and documents pertaining to the arrangements.
3. Confirm the arrangement with the other party, for example, the bank.

Plans to Reduce or Delay Expenditures

When a question arises about the continued existence of an entity, it is not uncommon for the entity to reduce or delay expenditures, such as the following:

1. Repairs and maintenance
2. Advertising
3. Research and development
4. Additions to property, plant, and equipment

If management plans to reduce or delay these expenditures, the auditor should do the following:

1. Review management’s plans.
2. Discuss with management the plan’s effects on operations.

Plans to Increase Ownership Equity

When a question arises about the continued existence, it is not uncommon for the entity to offer equity capital to an investor. Also, it is not uncommon for investors to search for entities in need of additional capital.

Ordinarily, in these circumstances, the entity will sell its stock to the investor at a discount from market value. In certain circumstances, the investor may have plans to bring profitable businesses into the troubled entity to use the troubled entity’s net operating loss carryforward. In these situations, the auditor should do the following:

1. Review the plan.
2. Determine the tax consequences of the plan.
3. Determine the plan’s impact on existing shareholders.
4. Discuss with management the adequacy of the investment.

The auditor’s concern is that the funds will be sufficient to ease the liquidity problem and to provide sufficient working capital.

Consideration of Management Forecasts

The auditor is not required to examine management forecasts; however, he or she should read these forecasts and apply his or her knowledge of the client. The auditor should pay special attention to cash flows and the implementation of management plans. The auditor is interested in whether the forecasts provide a reasonable basis for the belief that the entity will be in business a year from the current balance sheet date.

Obtain Management Assumptions

The auditor should ask management for its assumptions, especially assumptions about the following:

1. General economic conditions
2. Industry economic conditions
3. Sales
4. Cost of sales
5. Cost of labor
6. Expenditures for plant and equipment
7. Selling, general, and administrative expenses
8. Borrowings, interest expense, and extension of lines of credit
9. Income taxes, if any

Sources of Management Assumptions

The auditor should ask management for sources for its assumptions in developing the prospective data, especially the following:

1. Assumptions material to the forecasts or projections
2. Assumptions that are unusually uncertain or sensitive to variation
3. Assumptions that deviate from historical trends

Possible sources for assumptions are the following:

1. Government publications
2. Industry publications
3. Economic forecasts
4. Entity budgets
5. Labor agreements
6. Sales backlog
7. Debt agreements

When the auditor reads management’s assumptions, he or she may want to consider the following:

1. Historical trends of the entity
2. Historical trends of the industry
3. Comparison of prior year’s forecasts with actual results

Internal Consistency of Assumptions

Management assumptions should be internally consistent. Examples of this internal consistency are the following:

1. There should be a logical relationship between net cash flow and the following:
a. Sales
b. Expenses
c. Expenditures
d. Receivables
e. Payables
2. There should be a logical relationship between sales and the following:
a. Cost of sales
b. Labor
c. Rent
d. Advertising
3. There should be a logical relationship between income statement items and balance sheet items such as the following:
a. Sales to receivables
b. Cost of sales to inventories
c. Sales to working capital

Financial Statement Effects

Substantial Doubt Exists

If the auditor concludes, after considering management’s plans, that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, he or she should consider possible effects on the financial statements and the adequacy of the related disclosure. Disclosure might include the following:

1. Conditions and events creating the doubt, such as recurring operating losses, negative cash flows, working capital deficiency, and violation of debt covenants
2. Possible effect of conditions and events, such as a cutback in operations, a layoff of employees, or a bankruptcy filing
3. Management’s evaluation of the significance of the conditions and events and any mitigating factors
4. Whether operations may need to be discontinued
5. Management’s plans, including relevant prospective financial information
NOTE: It is not intended that the prospective financial information should meet the minimum presentation guidelines of Statement on Standards for Accountants’ Services on Prospective Financial Information, Financial Forecasts and Projections. Also, the inclusion of prospective financial information does not require procedures beyond those required by generally accepted auditing standards (see above, “Consideration of Management Forecasts”).
6. Information about recoverability or classification of recorded asset amounts or the amounts or classification of liabilities

Substantial Doubt Does Not Exist

After considering management’s plans, the auditor may conclude that substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time does not exist. In these circumstances, the auditor should nonetheless consider the need to disclose the conditions and events responsible for the initial doubt and any mitigating factors, including management’s plans.

Effects on the Auditor’s Report

If the auditor concludes that substantial doubt exists about the entity’s ability to continue as a going concern for a reasonable period of time, the auditor’s standard report should include an explanatory paragraph, following the opinion paragraph, to reflect that conclusion. In these circumstances, the auditor ordinarily expresses an unqualified opinion (see the next section, “Disclaimer of Opinion”). The auditor may no longer express a “subject to” opinion for any uncertainty (see Section 508, Reports on Audited Financial Statements). The auditor’s conclusion should be expressed using a phrase such as “substantial doubt about its (the entity’s) ability to continue as a going concern.” The report wording must include the terms “substantial doubt” and “going concern” and should be stated unconditionally.

The following (from AU 341.13) is an example of an explanatory paragraph:

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note X to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Disclaimer of Opinion

Instead of issuing an unqualified opinion with an explanatory paragraph following the opinion paragraph, the auditor may disclaim an opinion if he or she concludes that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time. A disclaimer of opinion is permitted at the auditor’s discretion, but never required.

Inadequate Disclosure

If the auditor concludes that the entity’s disclosures about its ability to continue as a going concern for a reasonable period of time are not adequate, the auditor’s report should be modified for a departure from generally accepted accounting principles. This may result in either a qualified (except for) or adverse opinion (see Section 508).

Prior Period Audit Report

The fact that the auditor is issuing a “going concern” report on the current period financial statements does not imply that a going concern problem existed in the prior period. Therefore, the auditor’s report on prior period financial statements presented for comparative purposes with the current period financial statements need not be changed.

Subsequent Period Audit Report

The auditor may have issued a “going concern” report on the prior period financial statements that are presented for comparative purposes with the current period financial statements. If the going concern problem has been resolved during the current period, the explanatory paragraph included in the auditor’s report on those prior period financial statements should not be repeated.

AU ILLUSTRATION

The following checklist may be used by the auditor to assess his or her doubt about a client’s ability to continue as a going concern and to evaluate management’s plans for addressing the issue.

Illustration 1. Going Concern Checklist
_______________
[Client]
_______________
[Audit Date]
Instructions
This checklist should be used in every audit of financial statements to assess whether there is significant doubt about the “going concern” assumption. It is divided into two parts. Part I should always be completed. Part II should be completed only when, as a result of completing Part I, the auditor concludes that significant doubt may exist.
If an item is not applicable, insert “N/A” in the Yes/No column.
Part I

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Part II

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