Coronavirus (COVID-19): considering going concern – a guide for auditors Audit and Assurance Faculty guide for auditors
This Audit and Assurance Faculty guide provides advice for auditors when testing the going concern assessments of reporting entities impacted by the coronavirus pandemic (COVID-19). It offers practical considerations in relation to ISA 570 requirements.
COVID-19 has caused significant market upheaval and uncertainty for business. Many businesses have faced mandatory closures and reduced customer demand due to lockdown measures. While many governments have pledged financial support for businesses through loan programmes and salary grants, business survival may still be uncertain.
The Financial Reporting Council’s March 2020 bulletin for auditors sets out matters to consider in relation to COVID-19. This guide builds on this important guidance by setting out practical considerations for auditors in relation to going concern.
Management and auditors may conclude that it is not possible to provide a clear answer to some of the questions posed in this guide. Given the level of economic uncertainty that exists at present, this is to be expected, and addressing these questions should help management and auditors to identify the specific uncertainties that are relevant to the entity. This will help management determine the disclosures needed in the accounts, and assist auditors when assessing the impact of the uncertainties on the audit report.
Going concern basis of accounting
When preparing accounts, management will assess whether an entity is a ‘going concern’. Management’s assessment will typically involve looking at projections, such as sales and costs, and the timing of cash flows, although the format and approach is not usually prescribed in accounting standards.
Accounting standards set a high threshold for departing from the going concern basis. For this reason, most accounts are, and are likely to continue to be, prepared on a going concern basis despite the pandemic. While the requirements of different financial reporting frameworks vary, typically management are expected to disclose, where applicable, that accounts have not been prepared on a going concern basis or the existence of material uncertainties that may cast significant doubt on going concern.
Due to the wide-ranging impact of the pandemic on the global economy, many businesses will be facing material uncertainties regarding their ability to continue as a going concern. Under ISA 570 Going concern, a material uncertainty related to going concern exists when ‘the magnitude of its potential impact and likelihood of occurrence is such that, in the auditor’s judgment, appropriate disclosure of the nature and implications of the uncertainty is necessary’ to meet reporting framework requirements.
Where this occurs, management should describe the material uncertainties as clearly and transparently as possible for users. Where management determines that there are no such material uncertainties, it may still be helpful to users for management to set out how this conclusion has been reached, given the current circumstances.
Auditing going concern
In the UK, ISA (UK) 570 (revised September 2019) is applicable for audits of periods commencing on or after 15 December 2019. There is a requirement in the revised UK standard for a more comprehensive and structured auditor risk assessment as a starting point when considering going concern, and auditors may choose to consider the revised standard even if it is not adopted early.
Evidence regarding going concern is often provided in the form of cash flow models and/or budget forecast models, as well as details of future sales pipeline projections. When testing going concern, it will be helpful to be aware of time and resource pressures faced by management and the finance team. They are likely to be facing additional pressures, such as a need to respond rapidly to business queries, and may be impacted by staff illness. It makes sense in the current circumstances to talk through with management at an early stage the approach to be taken during the audit, providing details of information required which are as clear and precise as possible. If early adopting the revised UK ISA, auditors are required to request the assessment at the risk assessment stage of the audit.
Given the increased likelihood of material uncertainties and the possibility that some accounts will be prepared on a basis other than going concern, auditors are likely to view going concern as a heightened and/or significant risk area. Auditors will need to ensure they obtain sufficient, appropriate audit evidence when testing management’s assumptions and forecasts. The impact of COVID-19 may mean using alternative procedures and perhaps employing greater use of technology. The FRC’s March 2020 bulletin discusses audit evidence in the light of COVID-19.
Auditors will need to continue to remain professionally sceptical throughout the audit and consider the potential additional challenges the business faces due to COVID-19. While undertaking their work, auditors may find it useful to consider the questions set out below.
How has the business been impacted by COVID-19 to date, and how might it be impacted in the future?
There are likely to be far ranging impacts across the business relating to the business model, supply chain, legal and contractual issues, employees, consumers, and working capital. Questions to consider include:
- How has the business model been impacted? For example, a restaurant may have changed its business to an online delivery service rather than closing. The actions of other businesses in the same sector are likely to be relevant here.
- Are businesses in the supply chain at risk? This may limit the reporting entity’s ability to produce goods or services. Are alternative suppliers readily available, or difficult to find? How does the business intend to respond?
- Are there additional legal or contractual issues? For example, a business may have contractual liabilities for non-delivery of good or services, onerous contracts or large defined benefit pension schemes. Consider for example how trustees of defined benefit pension schemes are dealing with obligations relating to contributions, and, if the business is regulated, whether the business is at risk of not meeting regulatory requirements.
- How has the business dealt with the consequences of any significant staff absences? High rates of absence for key employees could result in an inability to operate, or operate effectively. If staff continue to work, there may be relevant regulatory requirements to consider, designed to reduce the spread of the virus.
- How have revenue streams been affected by impacts on consumers and customers? Disposable income is likely to have fallen for many consumers, which could lead to reduced demand for non-essential products and services in particular. Customers may delay or fail to pay outstanding or new debts. Has the business considered possible longer-term changes to revenue streams? It is possible for example that consumer tastes change as a result of a prolonged lockdown; sales may not return to pre-lockdown levels.
- How have business customers been impacted? Business-to-business operations may see reduced demand. Consider whether business customers are likely to agree to re-negotiate terms, and how the business has dealt with provisions for additional bad debts.
- How has cash flow and working capital more broadly been impacted? If customers are delaying payments to the business, this could impact its ability to meet running costs. Access to finance may have been affected by breaches of covenant terms, depending on lender decisions or concessions.
Does the nature of the business give rise to additional risks?
Certain types of businesses are likely to be more impacted than others. Questions to consider include:
- Has the relevant business sector been able to trade as normal or faced restrictions that have led to reduced or suspended trading? For example, businesses in the travel sector, such as airlines or hotels, and the suppliers who service them, are likely to see significant reductions in income due to the drop in the number of tourists and business travellers. Some sectors, for example pharmaceuticals, health care and grocery retail, may see increased sales. Some ‘non-essential’ businesses may experience higher sales volumes too, for example online-only retailers may potentially benefit from the closure of physical stores. Where there is rapid expansion the increased risk of over- trading should be assessed, particularly if customers have long periods of credit to pay for goods. There may also be issues with staff availability and supply chains that reduce the ability of the business to fulfil all orders.
- How are goods and/or services supplied? Operations which are highly automated and require little human input, for example warehouses making use of automatic warehouse pickers, may be less impacted than those relying on people to find and package goods due to the risk of staff illness and social distancing requirements. Warehouses that were not previously open for 24 hours a day may be able to spread shifts to remain compliant with social distancing requirements, while still meeting existing or increased levels of demand.
- Are there any pre-existing risk conditions in the business, such as a history of losses or a net liability position? These could be heightened in the time of crisis and beyond. The application guidance in ISA 570 provides examples of relevant financial, operating and other events or conditions.
Will the business be able to access government support?
Many governments around the world, including the UK government, are offering financial aid and other packages to support businesses. These vary from grants for employees ‘furloughed’ to low interest financing, depending on eligibility. If management has factored government support into their going concern assessment, questions to consider include:
- Eligibility: does the business meet the criteria to access the scheme(s) relevant to their forecasts? There may be strict eligibility criteria that limits access in practice.
- Conditions: are there any conditions which the business may potentially not be able to meet? How certain is it that government support will be received? If it is unlikely the business will be able to meet conditions over the longer term, this could result in an uncertainty related to going concern.
- Timing of cash flows: when will government support be received? How reasonable are management’s assumptions based upon government timetables? It will be helpful to consider the timing in the light of forecast outflows.
- Length of support: how long are government support packages due to last? Are extensions likely? If restrictions on movement last longer than the support package, or there is a secondary outbreak of the virus, how does management plan to address any shortfall? For some sectors, for example, hospitality or leisure, government support may end before a return to normal trading.
- Top-up commitments: has the business made any commitments to employees to top-up salary grants to cover normal salaries? How have these commitments been factored into forecasts?
- Repayment requirements: has the business factored in any need to repay financing? This could impact longer term solvency.
What timelines for restrictions are factored into forecasts?
There is significant uncertainty in jurisdictions around the world as to when restrictions on movement will be lifted, and this will increase estimation uncertainty in management’s cash flow forecasts. Management’s going concern assessment will need to consider and make assumptions about the timing of the lifting of restrictions, and the resumption of normal trade activities. Questions to consider include:
- How do local restrictions impact group components or critical aspects of the supply chain? Certain countries have been able to ease or lift movement restrictions internally. As conditions improve, businesses may shift operations to countries with lower outbreaks to mitigate risks to operations. This could impact the materiality and/or significance of certain components.
- What is the expected timing for the lifting of restrictions? It seems likely that a return to normal trading will take place slowly in many cases, with restrictions lifted in phases. Businesses which can control the number of customers in their premises to facilitate social distancing may decide to resume operations earlier.
- Has management planned for the impact of any secondary outbreaks?
- How is the nature of the business factored into assumptions about when trading resumes? It is likely that restrictions will ease sooner for manufacturing businesses than for hospitality or restaurant businesses. It may be helpful to consider current local public policy discussions and/or formal announcements, as well as any potential sensitivities to forecast scenarios.
- Are there likely to be temporary or permanent changes to the business model? For example, an increased propensity to work from home is likely to reduce demand for transport. Supply and demand may change as a result of restrictions on international trade, which could impact prices of materials, as well as selling prices.
- What sort of recovery has been forecast by management? Consider the shape of the forecast, for example, a quick V-shaped recovery or a slow L-shaped one. It is possible, if there are secondary outbreaks, that the recovery could take a W-shape. Consider whether management’s forecasts are reasonable in the light of the nature of the business and demand for the goods and/or services provided.
There may be central forecasts available that provide useful reference for management and auditors. However, any central forecast needs to be adjusted for specific business models, and judgements should be disclosed in accordance with applicable accounting standards. Care should also be taken to differentiate between scenarios from credible sources and forecasts from credible sources.
How liquid is the business and what future finance does it have access to?
When reviewing current cash levels, as well as forecast cash flow models, consider how the cash inflows reflect what is known about the nature of the business and management forecasts. Questions to consider include:
- What are the sources of future cash flows and how certain are they? Management may need to reassess this in light of COVID-19. As noted above, some businesses will see reduced demand and/or longer-term shifts in consumer demand. Government support in the near term may be more certain, but eligibility and conditions may reduce certainty.
- Does the businesses believe, where applicable, that that its disruption insurance will cover COVID-19-related losses? What evidence is there to support management's judgement where the terms are unclear?
- For cash flows from financing sources, do loan covenants or terms exist that could put the business at risk? Consider whether covenants are at risk of being breached due to issues such as changes in asset valuations or liquidity. Have banks waived any covenant terms? If not, this could lead to a material uncertainty. The timing of covenant breaches and any subsequent waivers could impact liquidity levels.
- Has the business renegotiated loans or applied for payment holidays, or is it likely to in the future? This could impact the timelines of cash inflows if renewals or renegotiations take longer than normal. There may be requirements or restrictions on renegotiating the loan. There may also be additional interest due from loan payment holidays, as well as costs incurred in renegotiating loans.
- What additional outflows have been forecast relating to COVID-19 – such as staff costs, overheads, financing, restart costs, and taxes for any government grants - once the crisis is over? The cost of resuming production will need to be considered, as well as the time it will take the business to start generating cash revenues.
- Which costs are fixed and which are flexible? This will be helpful to understand in the event of potential secondary outbreaks that may reduce trading. Are there any risks of performance clause breaches giving rise to penalties that have not been factored in?
- How feasible are any forecast cost savings? For example, is future capital expenditure committed, or could it be delayed or cancelled? If cost savings stem from reduced staffing through redundancy, management should have factored in the short-term cost of redundancy payments.
How solvent is the business likely to be over the longer term?
Short term liquidity issues may result in a need to take on new loans. When reviewing longer term debt, consider the cost of servicing and paying off any new or delayed debts over the longer term. If businesses have deferred loan payments, how have they factored in any additional costs in the future? Also consider how covenants may be impacted by new or modified debt, including any accounting impacts.
How have management stress tested their projections?
Consider what scenarios and sensitivities have been included by management in the assessment of going concern; whether management have considered a sufficient range of scenarios, flexing their business model appropriately; and how plausible or remote the scenarios forecast are.
Determine whether management have considered:
- The impact of any second wave of outbreaks and closures, or the loss of key members of staff;
- Risks to future viability arising, for example, from a change to business model or in consumer tastes due to the pandemic;
- The risk of breaches of covenants or regulatory requirements;
- Contingent liabilities – such as guarantees that might be called;
- Letters of support – if a parent company, its ability to provide support if multiple subsidiaries require support; and
- Any planned or likely dividends, and the impact on cash flows.
Reverse stress testing, which involves testing which scenarios would make a business model unworkable, can be a valuable tool for management when assessing going concern. Auditors may find it useful for reviewing management’s assessments. We will be issuing guidance for preparers and auditors on this topic shortly.
Has the forecast model been tested thoroughly?
Businesses often forecast cash flows and/or budgets in Excel based spreadsheets. These can range from highly complex models with multiple formulae and assumptions, to less complex spreadsheets with simple functions. In either case, the assumptions and scenarios that management use are likely to differ significantly from previous years. Pre-existing Excel models for going concern assessments may not be capable of being flexed or adapted for such a significant economic impact. This could introduce a higher risk of mechanical or computation errors in models.
Auditors may find it necessary to undertake additional work on any changes to how a model functions, for example, reviewing changes to Excel formulas or updated assumptions, and testing whether the flexing of inputs results in expected outputs being calculated. In some cases this may require the use of specialists, especially for highly complex financial models.
Similarly, if the business quickly builds new, highly complex models to assess going concern, consider the appropriate level of testing for the model itself, in addition to the inputs and assumptions.
There may be government forecasts or industry data that provide useful reference or evidence when reviewing management’s assumptions. Auditors may also find it helpful to consider their past knowledge and experience of management’s forecasting. If management has a history of poor quality or inaccurate forecasts under normal operating circumstances, the risk is likely higher in these less certain times.
Concluding on going concern
At the time of testing and concluding, the outcome of many scenarios, such as the possibility of a second wave of infections, may not be known or predicted with accuracy. Management and auditors will have to apply judgement and consider the specifics of the business and its operations. Given the heightened uncertainty, it is very likely that more businesses and auditors will need to consider reporting material uncertainties.
Auditors will need to thoroughly test and conclude on management’s assessment of going concern and whether any material uncertainty exists. Assessments should cover at least 12 months from the date of approval of the accounts. To reach their conclusion, auditors will need to obtain sufficient, appropriate audit evidence, potentially in new and expanded ways.
Once a conclusion has been reached, auditors will need to consider whether further disclosure is required, both by management in the financial statements and by the auditor in the audit report. The Audit and Assurance Faculty has prepared a guide on how to report on material uncertainties related to going concern which auditors may find helpful
Our thoughts are with everyone affected at this challenging time. We encourage all parties to stay up to date with the latest public health advice in their country.
ICAEW’s Audit and Assurance Faculty is recognised internationally as a leading authority and source of expertise and know-how on audit and assurance matters. The Faculty has over 7,500 members drawn from practising firms and organisations of all sizes in the private and public sectors. Further resources can be found at icaew.com/aaf.
How to report on material uncertainty related to going concern - a guide for auditorsAudit and Assurance Faculty steps for auditors
The impact of COVID-19, including the effects of government restrictions, in many cases will result in events or conditions that may cast significant doubt on a reporting entity’s ability to continue as a going concern. If such events or conditions exist, it is the responsibility of management to ascertain whether or not the entity is a going concern, and, if it is considered to be a going concern, whether there is, nonetheless, a related material uncertainty.
This Audit and Assurance Faculty guidance sets out the steps auditors need to take to ascertain whether material uncertainty disclosures in relation to going concern in the financial statements are adequate, and how these disclosures will then impact the audit report. It supplements the guidance in the faculty’s audit report guides.
Paragraph 9-2 (b) of ISA (UK) 570 (Revised September 2019) includes a definition of a material uncertainty related to going concern as follows:
An uncertainty related to events or conditions that, individually or collectively, may cast significant doubt on the entity’s ability to continue as a going concern, where the magnitude of its potential impact and likelihood of occurrence is such that appropriate disclosure of the nature and implications of the uncertainty is necessary for:
i. In the case of a fair presentation financial reporting framework, the fair presentation of the financial statements; or
ii. In the case of a compliance framework, the financial statements not to be misleading.
While the extraordinary nature of COVID-19 means that a material uncertainty seems likely to exist for a large number of businesses, any automatic assumption that COVID-19 has led to a material uncertainty, or to the need for any standard reference to COVID-19 in the audit report, regardless of circumstances, is open to challenge. The individual circumstances of the entity (or group) should always be considered.
It seems likely that some businesses, will benefit as a result of COVID-19 and that others that are adversely affected will not be affected to the extent that there is a material uncertainty. Some firms may decide as a matter of policy to establish a rebuttable presumption that material uncertainties exist, or that some reference will be made in the audit report to COVID-19, for all or a particular category of audits. In such circumstances, clarity regarding the circumstances in which the presumption would be rebutted, and specific examples thereof, are likely to be helpful in dealing with any subsequent challenge.
While specific reporting requirements vary, depending on the accounting standards applied, typically management would be expected to disclose when financial statements have not been prepared on a going concern basis, as well as details of any material uncertainty related to going concern.
For the purposes of this guidance, it has been presumed that there is sufficient appropriate audit evidence to enable the auditor to conclude that management’s use of the going concern basis of accounting is appropriate in the circumstances, but a material uncertainty related to going concern exists. However, this guidance also discusses the situation where there is no material uncertainty, but an auditor reports on key audit matters (KAMs) and includes one or more KAMs relating to going concern.
Determining whether there are material uncertainties
The auditor will need to obtain sufficient appropriate audit evidence in order to determine whether management’s use of the going concern basis continues to be appropriate, and, whether management has identified and appropriately disclosed any material uncertainties.
Paragraph 18-1 of ISA (UK) 570 (Revised September 2019) includes a new stand back requirement. This requires the auditor to take into account all relevant audit evidence obtained, whether corroborative or contradictory, before concluding on the appropriateness of management’s use of the going concern basis or whether a material uncertainty related to going concern exists.
It is possible that the auditor identifies a different material uncertainty related to going concern to that identified and disclosed by management.
Where management has concluded that there is no material uncertainty related to going concern, the auditor will need to determine whether that is appropriate and any resulting impact on the audit report. In this situation, management might still explain in the disclosures why, having considered the effects of COVID-19, there is no material uncertainty related to going concern. Concluding on whether or not there is a material uncertainty related to going concern is explored in the Audit and Assurance Faculty guide Considering going concern - a guide for auditors.
Where management has concluded that a material uncertainty related to going concern exists, the auditor will also need to conclude on whether disclosures made by management in the financial statements are adequate. This will also have an impact on the audit report.
The various circumstances that can arise (assuming the auditor obtains sufficient evidence to conclude on whether the use of the going concern basis of accounting is appropriate), together with the impact on the audit report, are set out in the following flow chart.
Determining whether disclosures are adequate
The auditor must determine whether the material uncertainty relating to the COVID-19 pandemic is adequately disclosed in the financial statements.
The auditor must determine whether the financial statements:
- adequately disclose the principal events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern;
- adequately disclose management’s plans to deal with these events or conditions; and
- clearly disclose that there is a material uncertainty related to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern, and, therefore, that it may be unable to realise its assets and discharge its liabilities in the normal course of business. If the disclosures do not specifically refer to ‘material uncertainty’ and to ‘significant doubt on the entity’s ability to continue as a going concern’, then it may be more likely the auditor will issue a modified opinion.
How auditors should approach disclosures included within other information
The auditor should also read the other information accompanying the financial statements, such as the strategic report or directors’ report, and determine whether disclosure of the material uncertainty within that other information is consistent with the disclosures in the financial statements, or whether instead any of the information is ‘incorrectly stated or otherwise misleading’.
The auditor should ascertain whether the disclosures within the other information are presented in a way that is fair and balanced, reflecting the entity’s individual circumstances in their true light. The disclosures might be expected to be included in the ‘Business review’ section of a strategic report, or the ‘Future developments’ section of a directors’ report. Indications that the disclosures are not fair and balanced would include situations where disclosures do not refer to ‘material uncertainty’, or if it is mentioned, it is not part of the sections mentioned above, but inconspicuously in a different section.
How to make the necessary changes to the auditor’s report
If adequate disclosure about the material uncertainty related to going concern is made in the financial statements, the auditor’s report should include a new section of the audit report with the heading “Material uncertainty related to going concern”.
The location for this section is not specified in ISA (UK) 570, but commonly it is included directly after the ‘Basis for opinion’ section.
The auditor should give a brief description of the circumstances that led to the material uncertainty and then draw attention to the note in the financial statements that discloses this matter and state that these events or conditions indicate that a material uncertainty exists that may cast significant doubt on the entity’s ability to continue as a going concern. It will also state that the auditor’s opinion is not modified in respect of the matter.
For periods commencing on or after 15 December 2019, a new, 'positive’ statement on going concern is required:
In auditing the financial statements, we have concluded that the directors’ use of the going concern basis of accounting in the preparation of the financial statements is appropriate.
For Public Interest Entities (‘PIEs’), other listed entities, those entities applying the UK Corporate Governance Code and entities subject to the governance requirements of the Companies (Miscellaneous Reporting) Regulations 2018 , the auditor is also now required to explain how they evaluated management’s assessment of the entity’s ability to continue as a going concern, and, where relevant, key observations arising with respect to that evaluation.
The conclusion on the directors’ use of the going concern basis and the explanations noted above for PIEs and the other entities identified above can either be included in the Conclusions relating to going concern section, or this section can be deleted and they can be included in the Material uncertainty related to going concern section, following the description of the circumstances that led to the material uncertainty.
See Appendix 4 of the FRC’s Bulletin: Illustrative Auditor’s Reports On United Kingdom Private Sector Financial Statements for an illustration of the standard wording, together with the wording required for PIEs and the other entities identified above.
The faculty’s guide, 'Going concern - Material uncertainty relating to going concern', provides more detail on wording for situations where the auditor concludes that a material uncertainty related to going concern is adequately disclosed. It includes an example “Material uncertainty related to going concern” section, as well as guidance on whether other sections of the auditor’s report require changes as a result.
How to report on key audit matters
If the audit report includes KAMs, then a material uncertainty related to going concern would by its nature be a KAM. However, ISA 701 requires that the matter be discussed in the separate ‘Material uncertainty related to going concern’ section rather than in the KAMs section of the audit report. It would be expected that the auditor includes a similar level of detail as if it were reported in the KAM section, including the audit response. The auditor needs to include a reference in the KAMs section to the “Material uncertainty related to going concern” section, for example by including the following wording before the KAMs themselves:
"In addition to the matter described in the material uncertainty related to going concern section, we have determined the matters described below to be the key audit matters to be communicated in our report."
The auditor could conclude that no material uncertainty exists relating to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern, but still determine that there are matters relating to this conclusion that are KAMs. Where this is the case, the auditor’s description of such KAMs could include aspects of the identified events or conditions disclosed in the financial statements, as well as the audit work performed that led the auditor to conclude that there was no material uncertainty and, as with any KAM, significant judgments made by the engagement team with respect to the matter. In such cases, the "Conclusions relating to going concern" section could refer to the KAM for the explanation of how the auditor evaluated management's assessment of the entity's ability to continue as a going concern.
The FRC’s COVID-19 Bulletin March 2020 also refers to other situations where the auditor might consider reporting COVID-19 as a KAM in its own right.
What to do if the auditor concludes that disclosures are not adequate
Practically, if the auditor does not consider that material uncertainties related to going concern are adequately disclosed, the auditor will determine which aspects of the required disclosures are missing, and communicate this to the entity’s management, with a view to management enhancing the disclosures.
If the auditor still concludes that material uncertainties related to going concern are not adequately disclosed, reference should be made to the Audit and Assurance Faculty’s guides Preparing a qualified audit report - disagreement or Preparing an adverse opinion audit report.
ICAEW’s Audit and Assurance Faculty is recognised internationally as a leading authority and source of expertise and know-how on audit and assurance matters. The Faculty has over 7,500 members drawn from practising firms and organisations of all sizes in the private and public sectors. Further resources can be found at icaew.com/aaf.
 The qualifying conditions are laid out in the Department for Business, Energy & Industrial Strategy’s The Companies (Miscellaneous Reporting) Regulations 2018 Q&A.