Letters of support – a guide for auditors

When directors of a subsidiary entity are taking steps to satisfy themselves that the entity is a going concern and identify whether there are material uncertainties related to going concern, they may request letters of support from their parent entity (or another group entity). A parent entity may have issued letters of support to more than one of its subsidiaries.

These letters usually indicate a willingness to give appropriate financial support to ensure the subsidiary is able to fulfil its obligations. In most cases letters of support are not legally binding, and even if they are, may not on their own provide sufficient appropriate audit evidence. 

What is a letter of support?

A letter of support, also sometimes known as a letter of comfort, is commonly provided by a parent entity in respect of its subsidiary's financial obligations to a lender, or to help the directors of the subsidiary to meet their responsibilities with respect to going concern. They may also be provided to an entity by directors, shareholders, other entities within a group, or lenders.

Although usually not legally binding, letters of support are commonly used where the parent entity is unable or unwilling to give a legal guarantee but wishes to give some comfort in respect of the subsidiary's ability to meet its obligations. They are especially common where the subsidiary is loss-making, has net liabilities, or has high levels of intercompany creditors which the subsidiary may not have the assets readily available to repay were they to be called in.

The following are situations where subsidiary entities may commonly require letters of support:

• To provide comfort that the parent entity is not planning to restructure in the short-term.
• Where the subsidiary is short of cash, or not in charge of its cash function, to confirm that the parent will provide sufficient cash to enable the subsidiary to meet its obligations as they fall due.
• Where the subsidiary has a high proportion of the group cash, to give comfort that this will not be removed by the parent to provide funding elsewhere in the group.
• The subsidiary has one contract, or reliance on one customer.
• To provide comfort around policies and methodology with respect to transfer pricing arrangements between two group entities.
• The UK subsidiary entity conducts UK sales for an international group.
• The subsidiary acts as the sole supplier of a good or service to the group or otherwise only exists because of group structure, and there is perceived to be a risk that the group might decide to source elsewhere.
• The subsidiary is set up to provide pensions services to other group entities.

This guide focuses primarily on instances where a letter of support is being provided to support the going concern assumption, but the guidance may be applicable to other situations.

A reminder of the responsibilities of directors and auditors with respect to going concern

As part of directors’ responsibilities for preparing financial statements, directors are required to satisfy themselves that it is reasonable for them to conclude that it is appropriate to prepare financial statements on a going concern basis, and to identify whether a material uncertainty exists in respect of events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern.

Auditors are required to obtain sufficient appropriate evidence regarding the appropriateness of management’s use of the going concern basis; to conclude, on the basis of the audit evidence, whether a material uncertainty exists in respect of events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern; and to determine the implications for the auditor’s report.

What do the International Standards on Auditing (ISAs) say about letters of support?

ISA (UK) 570 Going Concern (Revised September 2019) A8-2 states that audit procedures may include, ‘Confirming the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assessing the financial ability of such parties to provide additional funds.’

A8-12 states that ‘The auditor also considers the business rationale for continued support, particularly if the entity is loss making, including what that support is predicated on (e.g., business or transformation plan, forecasts).’

And for smaller entities, A8-13 states that ‘Continued support by owner-managers is often important to smaller entities' ability to continue as a going concern. Where a small entity is largely financed by a loan from the owner-manager, it may be important that these funds are not withdrawn’, and ‘Where an entity is dependent on additional support from the owner-manager, the auditor may evaluate the owner-manager's ability to meet the obligation under the support arrangement. In addition, the auditor may request written confirmation of the terms and conditions attaching to such support and the owner-manager's intention or understanding.’

ISA (UK) 260 (Revised November 2019) 16-2 requires the auditor of Public Interest Entities (PIEs) to provide a report to the audit committee which explains judgments about events or conditions identified in the course of the audit that may cast significant doubt on the entity's ability to continue as a going concern and whether they constitute a material uncertainty. This report to the audit committee includes a summary of all guarantees, comfort letters, undertakings of public intervention and other support measures that have been taken into account when making a going concern assessment.

What does case law tell us about relying on letters of support?

The High Court’s judgment in the case of Carillion Construction Ltd v Zelf Hussain and Robert Jonathan Hunt (the Joint Liquidators of Simon Carves Ltd (in Liquidation)) 2013, was that letters of support provided by a parent company did not have contractual force. The letters did no more than provide the directors of the subsidiary with evidence from which they could confirm that the subsidiary’s accounts should be prepared on a going concern basis. More information on the High Court ruling is included in the Appendix to this guide.

The High Court ruling shows that a letter of support will usually not be legally binding. For a letter of support to create a binding legal commitment, the normal contractual requirements of offer and acceptance, consideration, certainty as to terms and intention to create legal relations will need to be satisfied.

Some directors may have been taken aback that the letters of support were not enforceable by the subsidiary, and some might not have been comfortable to confirm a company’s going concern status based on a non-legally binding letter. Expert evidence given in the case also suggested that some auditors would have regarded the letters as legally binding when this was not the case.

The ruling demonstrated that external parties could place little value on the letters if they do not have the features of a binding agreement. The fact that the letters were addressed to the directors of the subsidiary, not the subsidiary itself, was thought to be a factor in the ruling as well – for the purposes of the board of directors making the judgment themselves as to whether their subsidiary should continue to operate on a going concern basis.

FAQs / Considerations for auditors

The following is a list of issues to consider as an auditor when deciding whether to rely on letters of support as audit evidence:

Have the directors accumulated other supporting evidence to support the assumption that the entity is a going concern, and has the auditor accumulated other audit evidence?

For example:

• Recent audited financial statements of the parent entity providing support, with no material uncertainty relating to going concern;
• Up to date parent entity management accounts showing the latest cash position;
• Group cash flow forecasts prepared by the parent entity covering at least 12 months from subsidiary entity sign off;
• A history or track record of support being given by the parent in the past when needed;
• Consideration of the needs of other subsidiaries that the parent entity may also be providing support to;
• The strategic importance of the subsidiary to the group. Does it make sense for the parent to provide support?

The auditor must accumulate sufficient appropriate audit evidence to ensure the requirements of ISA (UK) 570 are met. As letters of support will not be legally binding if there is no contract in place, auditors, including those of smaller subsidiaries, should accumulate other going concern evidence.

On its own, a letter of support may not provide sufficient appropriate audit evidence of the entity’s ability to continue as a going concern and may mean that there is a material uncertainty related to going concern. While a legally binding agreement will generally provide more persuasive audit evidence than one which is not legally binding, it should not be regarded as sufficient appropriate audit evidence on its own. For example, the auditor still needs to evaluate the ability of the entity or individual to actually be able to provide the support (as discussed below).

There are circumstances where letters of support can, and do, provide good audit evidence. Letters of support that provide meaningful audit evidence should avoid boilerplate wording, and be worded in such a way that addresses the risks particular to that subsidiary. For example, some companies might be generating sufficient cash to survive and do not need financial support, but have large inter-company balances due on demand, or group loans that are due within a year of signing off the subsidiary financial statements that they would not be able to pay. In such cases, the letter of support could provide confirmation that inter-company creditor or loan balances will not be called for payment in the next twelve months.

Is the parent entity able to provide the support? (or if an individual is providing support to an entity, are they able to?)

Do parent entities or individuals have the financial means to provide support at the necessary levels to cover the subsidiary’s or subsidiaries’ obligations? Obtaining this information may be challenging – for parent entities with audited information in the public domain it may be more straightforward, but for other entities it may be more difficult. Even where the audited accounts of the parent can be obtained these may have been signed some months before the subsidiary’s going concern is being considered.

Should the auditor of the subsidiary not audit the entity providing the support, what steps has the auditor taken to ensure the entity is genuine? The level of audit work required will depend on how much reliance is being place on the letter of support.

Where support depends on one or more individuals, not all audit firms will have procedures sophisticated enough to form a conclusion on the individual’s ability to provide the support required, and in some cases it may not be possible at all. Sometimes it may be possible to get information about an individual’s wealth through, for example, what some auditors will refer to as ‘know your client’ (‘KYC’) procedures, or even ‘source of wealth’ checks. But this often only covers their assets and does not consider how liquid these are or what liabilities are also owed. Some firms will not accept letters from such individuals on this basis.

Where the auditor has been able to obtain sufficient evidence of an individual’s means, this should be kept up to date up to the signing of the auditor’s report, as the situation of an individual, like that of an entity, can change.

When was the letter of support provided?

A letter provided immediately prior to signing of the subsidiary auditor’s report is likely to be more reliable than one provided months earlier, or one that is just ‘rolled forward’ from a prior period.

However, although this timing may help make the letter of support more reliable as audit evidence, as it uses more up-to-date information, the case law suggests that a letter provided only in the course of preparation of the accounts may be a factor in determining that the letter is not binding. The ruling showed that a letter provided at that stage had the obvious purpose of enabling the directors (and the auditors) to determine whether the financial statements could be prepared on a going concern basis.

It is good practice to try and sign off the parent entity and subsidiary audit reports at the same time, as going concern work may need to be revisited or additional work performed the longer the gap between parent and subsidiary sign off. Letters of support provided during periods of economic uncertainty may require more frequent updates, to ensure the parent entity and the directors of the subsidiary have taken into account the most recent conditions. This is especially the case where a letter is provided on the basis of an economic outlook that is continuously evolving.

Accordingly, if there are delays in signing the financial statements due to the parent entity’s going concern assessment needing to be revised, or for other reasons, letters of support should be kept up to date.

Is the support letter being obtained from the right entity in the group?

It is important to consider what entity in the group should sign the letter of support. It is better where there is a direct parent-subsidiary relationship, but in some cases the parent entity might be an intermediate holding company with no means of supporting the subsidiary, and a support letter signed by the ultimate parent might provide better evidence of support.

Do the subsidiary financial statements disclose that their ability to continue as a going concern is dependent on the support of their parent and that the support is not legally binding?

Disclosure in the accounts of the subsidiary that the entity is reliant on the support of its parent entity is normally included when it is a key judgment of the directors in their determination that the going concern basis is appropriate. Such disclosure enables a reader to understand how the accounts have been prepared on a going concern basis. However, this disclosure does not normally say that the support has been given on a non-legally binding basis. If the auditor is concerned that the support is not legally binding, they would discuss improvements to the disclosures with management. This might also be a situation where the auditor concludes that a material uncertainty exists, and if so a paragraph should be included in the audit report drawing attention to this. Where management may be more willing to rely solely on a letter of support than the auditor, and does not consider there to be a material uncertainty related to going concern, but the auditor concludes that there is, inadequate disclosure by management could lead to the auditor providing a qualified or adverse audit opinion.

Is the support to the subsidiary disclosed in the financial statements of the parent entity?

Unless the subsidiary is claiming an audit exemption under section 479C of the Companies Act 2006, there is no requirement for the parent entity to disclose that they have issued a support letter to their subsidiaries. However, if the parent entity’s accounts do disclose this it provides further evidence of the strength of their commitment.

Is the parent entity or individual providing the support to any other entities?

Directors and auditors may want to consider whether they can rely on letters of support, and not disclose a material uncertainty where a parent has issued letters of support to all its subsidiaries and which may reduce its ability to provide support to all of them at once.

The parent may have provided similar letters of support to other subsidiaries. Is there a complete list of subsidiaries to which the parent provides support? Does the auditor know whether the parent has sufficient funds to support all subsidiaries if they were all to experience difficulties? Are there subsidiaries with later year ends where the level of support that might be needed has not yet been considered? Where the auditor does not audit the parent or other subsidiaries, information may not be readily available. ISA (UK) 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) covers cooperation between auditors of different components. What is reported between component auditors is likely to be key to understanding what support and guarantees are in place, and hence assess the parent’s ability to provide sufficient support to ensure the subsidiary in question is a going concern.

Reverse stress testing, as introduced in the Audit and Assurance Faculty’s guide Introducing reverse stress testing, may help to pick up potential going concern issues around letters of support.

Is there a cap on the letter of support?

Introducing caps on the level of support offered by the parent entity may provide more clarity and avoid boilerplate letters. It may also help the auditor of multiple subsidiaries, each provided with a letter of support by the parent entity, to establish whether the parent entity has sufficient assets to support them all concurrently. A cap may also indicate that the forecasts prepared by the parent and subsidiaries are more robust, and that the directors have given due thought to the forecasts and going concern. Even stronger evidence might be provided if the parent entity includes the amount of support in its budget.

Is the robustness of the letter qualified further by inclusion of certain wording?

Some letters of support may state that it is the parent entity’s ‘present policy’ or ‘current intention’ to ensure that its subsidiary is in a position to meet its liabilities. This does not mean that the support will not be provided, but may mean less reliance can be placed on the letter as audit evidence given the possibility that the parent entity is reserving the ability to change its stance. More cautionary wording may indicate the directors have given due thought to the support letter rather than just signing a standard letter, but where less reliance can be placed on the letter as a result, it is especially important for the auditor to consider what other going concern evidence has been obtained.

However, auditors should note that, unless a letter of support is legally binding, it is likely anyway that it only represents a ‘current intention’, regardless of whether that is explicitly stated or not.

Another potential wording issue that may need to be considered is where the letter includes wording to the effect that support is intended for ‘as long as the entity remains a subsidiary’. The robustness of the letter will depend on whether it is thought that there is a possibility that the entity could be disposed of during the period in which going concern is being considered.

What time period does the support letter cover?

Auditors may also consider whether the letter of support is restricted to a certain time period. If a time period is specified, and commonly this may be a period of 12 months from the date of approval of the accounts (rather than the date of the letter), the auditor will need to consider if that period is long enough and if necessary, ask for the letter to cover a longer period. The period covered by the support letter will need to be at least as long as the period that management has considered in its going concern assessment.

Conversely, if a longer time period is stated, or it is open-ended, this may indicate that the directors did not understand fully the nature of the letter, and this may constitute less strong audit evidence.

Was a support letter requested by the directors of the subsidiary?

Letters of support are addressed to the subsidiary entity, not to the auditor. Auditors may be provided with an insight into the subsidiary’s governance and internal control environment, if the production of a letter of support by the parent is requested by the auditor, not the directors of the subsidiary. The directors are required to satisfy themselves that the subsidiary is a going concern.

• Appendix: Case law

Further information:

• ISA (UK) 570 Going concern (Revised September 2019)
• ISA (UK) 260 Communication with those charged with governance
• Carillion Construction Ltd v Zelf Hussain and Robert Jonathan Hunt
• ICAEW’s Audit and Assurance Faculty’s guide - Introducing reverse stress testing