The COVID-19 pandemic has reshaped the global economic landscape, leading to considerable financial turbulence and unprecedented challenges for businesses. For external auditors, assessing the solvency and going concern of entities has become even more critical.
Recognizing these changes, a recent joint publication by the Australian Accounting Standards Board (AASB) and the Auditing and Assurance Standards Board (AUASB) offers essential guidance on the impact of COVID-19 on financial report preparation and audit considerations.
The Essence of Going Concern and Solvency Assessments
At the core of financial reporting is the concept of ‘going concern’. It rests on the assumption that an entity will continue its operations in the foreseeable future. Solvency, on the other hand, pertains to an entity’s ability to meet its long-term obligations. In the light of COVID-19, the external environment of many entities has drastically altered, raising questions on their financial viability and throwing their going concern status under scrutiny
An example follows:
Context: An electronics manufacturer sourcing raw materials globally, with a complex supply chain that spans multiple countries.
Impacts due to COVID-19:
- Supply Chain Disruptions: Restrictions and lockdowns in various countries led to challenges in procuring necessary components, leading to production halts.
- Unforeseen Expenses: The manufacturer had to incur additional costs for alternative sourcing, expedited shipping, and employee health and safety measures.
Auditor’s Going Concern Analysis:
- Operational Viability: The auditor would assess if these disruptions could result in prolonged halts in production, impacting the manufacturer’s ability to fulfill orders and generate revenues.
- Financial Strain: With reduced revenues and increased costs, the company’s profit margins might be significantly impacted, affecting its ability to meet its obligations.
- Management’s Adaptability: An evaluation of the management’s actions to address these challenges, like diversifying suppliers, renegotiating contracts, or finding cost-saving measures, would be fundamental in assessing the company’s ability to continue as a going concern.
It’s likely that business will continue to feel impacts for some years. External auditors have both an obligation and an opportunity to identify these issues with their clients.
Implications of COVID-19 on Going Concern
The pandemic has led to significant economic disruptions, affecting revenue streams and leading to unforeseen expenses. Businesses have faced:
- Supply chain disruptions
- Closure of physical locations
- Altered consumer behaviour
Given these challenges, auditors must delve deeper into assessing whether management’s going concern assertions are backed by substantial evidence. Specifically, auditors should:
- Examine the feasibility of management’s plans to mitigate the impact of COVID-19.
- Review the appropriateness of management’s cash flow forecasts and underlying assumptions, especially in the context of the post-COVID environment.
- Consider the relevance of post-balance date events and their implications on the going concern assessment.
Solvency Assessments in the Post-COVID Era
COVID-19 has stressed the importance of liquidity and solvency for entities. Auditors should be more vigilant in:
- Scrutinizing the liquidity position: This involves understanding the entity’s access to funding and its ability to convert assets into cash.
- Assessing solvency risks: Debt covenants, maturing liabilities, and potential breaches should be under the auditor’s radar.
Moreover, government aids or concessions received due to the pandemic might have specific terms attached that affect an entity’s solvency position. Auditors should be aware of these nuances.
The Role of Professional Judgment
Given the unpredictability and diverse impact of COVID-19 across industries, auditors need to exercise heightened professional scepticism. The AASB-AUASB guidance suggests:
- Continual reassessment: As new information emerges, auditors must reassess their judgments related to going concern and solvency.
- Emphasis on evidence: Assertions by management must be corroborated with objective evidence, especially when considering the uncertainties presented by COVID-19.
Importance of Clear Communication
Transparent communication between auditors, management, and those charged with governance is paramount. Misunderstandings related to the implications of COVID-19 can lead to misjudgements in financial reporting. Auditors should ensure:
- Open dialogue with management about the assumptions and judgments related to going concern and solvency.
- Thorough discussions with audit committees or those charged with governance, especially when there are significant concerns regarding the entity’s viability.
What practical steps can external auditors take address these issues?
- Dive deeper into the company’s liquidity ratios, current ratio, and quick ratio to assess short-term solvency.
- Analyse debt-to-equity ratios and interest coverage ratios to understand long-term solvency.
- Critically assess the reasonableness of management’s assumptions in relation to cash flow forecasts, especially those related to the duration and severity of COVID-19’s impacts.
- Evaluate the feasibility and effectiveness of strategies that management has put in place, such as cost-cutting measures, renegotiating debts, or diversifying revenue streams.
- Ensure that the entity has complied with any new financial or regulatory relief provisions and consider the implications of these provisions on solvency.
- Investigate any breach of loan covenants or other contractual obligations which could trigger solvency concerns.
- Engage more frequently with management to understand real-time challenges and decisions.
- Collaborate with other assurance providers or specialists, if necessary, to gain insights into specific industries or areas affected by the pandemic.
The guidance provided by AASB and AUASB serves as an invaluable compass in these turbulent times, emphasizing the importance of evidence-backed judgments and clear communication.
The National Audits Group – More than Just Auditors
n the evolving financial landscape, the National Audits Group is acutely aware of the complexities introduced by the COVID-19 pandemic.
Recognizing the heightened importance of solvency and going concern assessments, the firm has taken proactive measures to refine its communication strategies and protocols with clients.
This ensures that issues related to the pandemic’s impact on financial reporting are not only well-understood but are also rigorously addressed as per the latest guidance and standards.
For further information, contact us directly at 1300 734 707.
- Going Concern and Related Assessments – A joint Publication by the AASB and AUASB – June 2023
- The impact of COVID-19 on Going Concern and Related Assessments. AASB-AUASB – May 2020
- ASIC releases first integrated financial reporting and audit surveillance report - 17 November 2023
- Solvency and Going Concern Assessments – Post COVID Update for External Auditors - 25 September 2023
- Embracing Digital Disruption: How Auditors harness the power of technology for financial reporting - 17 July 2023