Financial Reporting

The going concern rule is a fundamental tenet in the preparation of most financial statements. Tony Featherstone explains the potential risk for directors and boards that fail to fully understand its implications.

A board of an emerging tech company must determine if the organisation is a “going concern” as part of its annual financial reporting. Under Accounting Standard AASB 101, a company is a going concern when it is considered to be able to pay its debts as and when they fall due, and when it can continue without any intention or necessity to liquidate or wind up its operations for at least the next 12 months.

That definition makes the board nervous. The company’s two largest contracts expire next year and may not be renewed. A government grant will soon end, leaving a hole in research funding. Together, these developments threaten the organisation’s viability. Another concern is the expected launch of a rival technology next year. It could supersede the emerging company’s products, slash the value of its intellectual property and make it harder to win contracts. The company’s going concern status is tenuous. The board studies various scenarios, tests management assumptions behind them and ensures the organisation has a Plan B. It concludes that spending could be cut, or fresh equity capital raised, if corporate landmines explode.

After careful consideration, the board believes management has reasonable grounds for its assessment that the company can continue as a going concern.

So does the firm’s auditor. Auditing Standard ASA 570 says the auditor must obtain sufficient audit evidence on the appropriateness of management’s use of the going concern basis of accounting in preparing the financial report, and whether a material uncertainty exists about the entity’s ability to continue as a going concern.

The tech company is insolvent eight months later. Contract losses killed its revenue and volatile equity markets made it impossible to raise capital or sell assets. Investors and the media attack the board for failing to recognise that the organisation was not a going concern.

A risk for boards

Going concern – a fundamental tenet in the preparation of most financial statements – is potentially a risk for boards that confuse going concern with insolvency or take a narrow view of the principle.

The above scenario is one of many that directors of private and public companies and not-for-profit enterprises that are incorporated as public companies limited by guarantee can face when satisfying themselves that the entity is a going concern.

Even public sector entities that operate on a for-profit basis may struggle to meet the going concern principle if government support for them is reduced or withdrawn, or the organisation is expected to be privatised. Insufficient funding or changes in government policy that affect public sector entities can also create going concern risks.

Governance stakes are high. Global economic and financial market volatility is making it harder for some directors, particularly those who govern smaller organisations, to satisfy themselves that their organisation is a going concern for at least the next 12 months.

In the not-for-profit (NFP) sector, uncertainty in state and federal government funding is weighing on going concern assessments. It is possible that some charities are preparing their accounts on the basis of being a going concern, despite the current outlook suggesting that the organisation will fail if it cannot successfully navigate deteriorating funding conditions.

Inevitably, the going concern principle attracts attention after corporate collapses, as was the case during the 2008-09 Global Financial Crisis (GFC), and more recently with this year’s demise of Dick Smith Holdings.

The electronic retailer’s board declared in the company’s 2015 Annual Report that there were reasonable grounds to believe it could pay debts as and when they became due, and its auditor (Deloitte) said the financial accounts gave a true and fair view of the consolidated entity’s financial position.

The Australian Institute of Company Directors (AICD) has long argued for clarification of the going concern principle. In a July 2014 submission, the AICD encouraged the International Accounting Standards Boards (IASB) to include within the Conceptual Framework for Financial Reporting a definition and detailed conceptual discussion of going concern – an accounting concept it said is “often misunderstood by users” and of increased interest to marketing and prudential regulators.

Michael Coleman FAICD, says there is confusion in the governance community around the going concern principle. “In my experience, some governance stakeholders confuse going concern, which is an accounting convention, with insolvency. Ultimately, the going concern principle requires directors to form a view on their organisation’s short-term sustainability. It goes to the heart of good governance.”

International lead

Australia, says Coleman, should debate whether to follow the UK’s lead and introduce a requirement for a strategic report that obliges companies to look beyond current-year earnings and provide a broader overview of shareholder value creation through narrative reporting. Most UK companies now prepare a strategic report, as well as a director’s report, in their annual report, a change introduced in 2013.

“There’s merit in discussing whether a similar requirement is needed in Australia,” says Coleman. “A strategic report would give boards greater scope to explain their organisation’s business model, strategy and business environment, and allow them to comment on its medium to long-term sustainability (three-five years). In theory, that should provide greater protection for boards that outline their thinking as to why the organisation is a going concern.”

Such information would help investors and other stakeholders, says Coleman. “Investors typically want to know if the organisation is sustainable on at least a medium-term view. The board’s assessment that the entity is a going concern for at least the next 12 months is often based on solvency issues, when it should be broader.”

Recent reporting changes are helping Australian entities report more meaningful information on their longer-term sustainability. The Australian Securities and Investments Commission’s (ASIC) guidance on the Operating and Financial Review (OFR), issued in March 2013, set out ways for boards to provide information that stakeholders would reasonably require to assess the entity’s operations, business strategies and prospects.

The OFR, a welcome change, does not go as far as the UK Strategic Report. Some large UK companies publish 50-60 page strategic reports that outline a range of key business drivers and performance indicators, and provide detailed operational reviews.

Often highly readable, the reports tell a story in text and graphics about the organisation’s performance, sustainability and prospects. Large Australian companies tend to prepare shorter, text-heavy OFRs that are arguably written for institutional rather than retail investors. Some are quite technical and do not always tell a clear story about the organisation’s business model. That could change as Australian companies become more comfortable with disclosing this type of information.

The UK also led audit-report initiatives that indirectly affect the going concern principle and have been well received in that market. In Australia, the Auditing and Assurances Standards Board (AUASB) issued auditing standards in December 2015 that adopted improvements made to the equivalent International Standards on Auditing by the International Auditing and Assurances Standards Board (IAASB).

Chief among them was a requirement to include communication on key audit matters in the audit report in the financial report for listed entities; the auditor’s responsibilities relating to other information; and greater focus on considering disclosures in financial statements.

Commentary on key audit matters will describe why certain matters in the audit report were most significant, and the auditor’s approach in addressing them. In some respects, the changes give directors better insight into key audit risks and how they are being addressed, and unravel the “black box” of auditing from an investor’s perspective. They should, over time, improve the audit report as another means of communicating with shareholders on the financial report’s most important elements – and give investors greater confidence.

However, extra layers of financial reporting may not be possible for smaller commercial companies and charities. Going concern assessments, at least in theory, are more straightforward for large companies that have significant assets, dominant market positions and capacity to sell assets or raise capital if needed.

Anne Robinson FAICD, former chair of World Vision Australia, says it can be hard for boards of some small charities to feel confident that their organisation is a going concern. “In some parts of the sector, charities are only one front-page public relations disaster away from insolvency. It only takes a few key donors to withdraw their support and the charity is on life support.”

She says massive disruption in NFP funding is threatening the viability of charities. For example, the full rollout of the National Disability Insurance Scheme (NDIS) from July 2016 will see government funding arrangements for some disability charities switched off. “Those that aren’t NDIS ready are technically insolvent because they won’t have enough cash flow. I don’t see how their boards could say they are a going concern.”

Charity boards, says Robinson, often rely on their organisation’s ability to survive funding shortfalls, volatile sector conditions or rising demand for their services. “The board might not be 100 per cent certain that the charity will be viable in the next 12 months, but directors believe the organisations will find a way to survive if conditions deteriorate.”

A low rate of insolvencies in the charity sector suggests that NFP boards are doing a good job, often in difficult conditions, of assessing financial viability. “You don’t see many distressed charities having to be bailed out,” says Robinson. “They survive on a low-cost model or merge with likeminded charities if there is no other option.”

Boards of startup ventures and other emerging companies can also struggle with the going concern principle. Startups, by their nature, can be volatile as they discover their customer base and business model, as can more established businesses that grow quickly.

Treading carefully

Emerging mining exploration, technology or lifescience firms can live from one capital-raising to another as they push towards earning revenue and profits. Their boards must be confident that the venture is a going concern for at least the next 12 months, even though it could run out of cash if fresh equity capital cannot be raised. The ability to raise debt capital from banks or other sources is another issue, as is the risk that the organisation could breach its loan covenants.

Dr Eileen Doyle FAICD, says going concern assessments are especially subjective for startup companies. “The board, management and auditors must be confident the organisation has a clear, viable plan in place to ensure it is a going concern. That’s not always easy in startups.”

Doyle is the former deputy chair of CSIRO and a current director of GPT Group. She says boards of such ventures must request detailed, ongoing cash-flow modelling (at least monthly) from management and rigorously test assumptions behind projections. “The board must understand what the company’s future finances look like under various scenarios. Directors must examine the drivers of these forecasts and their reliability.”

Doyle says the board must know the organisation has a plan to reduce its cash-burn rate – how much money it spends each month – should conditions deteriorate. “Knowing some spending can be put off if needed, until the next capital raising, makes the board more confident in the organisation’s capacity to operate as a going concern.” She advises startup companies to raise more equity capital than needed at the start, even if that means founders diluting their ownership. “Things always cost more and take longer than startups often realise. Having some cash in reserve adds to the board’s confidence about the organisation’s sustainability.”

Dr Katherine Woodthorpe FAICD, says the going concern assessment is straightforward in emerging ventures that have a secure funding stream, such as a long-term government grant, and a predictable cost profile. “It’s much harder when the income stream is less certain and the board cannot be sure of the organisation’s future cost profile as it grows.”

Woodthorpe holds several chair roles of NFPs, including Fishburners, a leading provider of co-working space for startups. She says rapid growth can also affect going concern assessments. “It’s not always about slow growth killing ventures; startups can become insolvent if they grow too quickly and take too many risks. The board must be confident the startup has the right processes and people to manage sustainable growth.

“The board might be confident in the organisation’s current revenue and cost profile, but a small change in markets could stop it being a going concern. The board needs to know that management has modelled a range of scenarios and understands what the company will look like should any eventuate.”