Understanding Going Concern: Insights from IFRS and the Companies Act 71 of 2008
The concept of going concern is fundamental in financial reporting and corporate governance. Both the International Financial Reporting Standards (IFRS) and South Africa's Companies Act 71 of 2008 emphasize its importance, albeit with different focal points. This article delves into the principles of going concern, its evaluation, practical measurement, what should be done if an entity is not a going concern, and the implications for businesses.
The Going Concern Assumption in IFRS
Under IFRS, the going concern assumption is a cornerstone of financial reporting. IAS 1, Presentation of Financial Statements, mandates that financial statements are prepared on a going concern basis unless management intends to liquidate the entity or cease operations, or has no realistic alternative but to do so.
Key Requirements:
Management’s Assessment:
Management must assess an entity’s ability to continue as a going concern for at least 12 months from the reporting date. This assessment involves considering all available information about the future, including cash flows, funding availability, and potential risks.
Disclosure Requirements:
If significant doubts exist about the entity’s ability to continue as a going concern, these doubts must be disclosed, along with the management’s plans to address them. If the financial statements are not prepared on a going concern basis, this fact and the basis of preparation must be disclosed.
Judgment and Evidence:
The assessment involves significant judgment, particularly in volatile economic environments. Evidence supporting the going concern assumption includes budgets, forecasts, and agreements with creditors or lenders.
Going Concern and the Companies Act 71 of 2008
The Companies Act 71 of 2008 also addresses the going concern principle, primarily in the context of directors' duties and responsibilities.
Key Provisions:
Solvency and Liquidity Test:
Section 4 of the Act requires companies to conduct a solvency and liquidity test to ensure they can meet their obligations for at least the next 12 months. This test is a statutory affirmation of the going concern assumption.
Directors’ Duties:
Directors must act in the best interests of the company and ensure that the company can continue its operations.
Section 22 prohibits reckless trading, which includes continuing business operations when there is no reasonable prospect of avoiding insolvent liquidation.
Business Rescue:
Chapter 6 introduces the concept of business rescue, allowing companies in financial distress to restructure under supervision. This provision is closely linked to the going concern principle, as it provides mechanisms to restore viability.
Practical Measurement of Going Concern
Measuring going concern involves both qualitative and quantitative assessments. Here are practical steps and examples:
Cash Flow Analysis:
Prepare a 12-month cash flow forecast to assess liquidity. For example, a manufacturing company might project its monthly sales revenue, operating expenses, and loan repayments to ensure it maintains positive cash flows.
Solvency and Liquidity Ratios:
Calculate key ratios, such as the current ratio (current assets divided by current liabilities) and the debt-to-equity ratio. For instance, a current ratio below 1 may indicate liquidity issues.
Revenue and Profit Trends:
Analyze trends in revenue and profitability. A retail business experiencing declining sales over consecutive quarters might need to reassess its ability to remain a going concern.
Debt Obligations:
Review upcoming debt repayments and assess whether the company has sufficient funds or access to financing. For example, a company with a bond repayment due in six months must evaluate its ability to refinance or generate cash.
Operational Dependencies:
Assess dependencies on key customers, suppliers, or markets. For instance, if a logistics company relies heavily on one client for 70% of its revenue, the loss of that client could threaten its going concern status.
Scenario Planning:
Conduct stress testing by modeling different scenarios. For example, a hotel chain might evaluate its financial stability under scenarios where occupancy rates drop by 20% or 40%.
What to Do if the Entity Is Not a Going Concern
When an entity cannot continue as a going concern, specific actions and adjustments are necessary:
Change in Basis of Accounting:
Financial statements must be prepared on a liquidation basis rather than a going concern basis. Assets are valued at their net realizable value, and liabilities are classified based on their expected settlement terms.
Disclosures:
Clearly disclose that the going concern assumption is not applicable.
Provide details on the reasons for the entity’s financial difficulties and management’s plans (if any) for winding down operations.
Immediate Financial Actions:
Identify and prioritize essential payments, such as employee wages and critical supplier payments. Cease non-essential operations to conserve resources.
Stakeholder Engagement:
Inform creditors, investors, and employees about the entity’s situation. Negotiate with creditors to extend payment terms or reduce liabilities.
Legal Obligations:
Ensure compliance with insolvency laws to avoid accusations of reckless trading. Consider voluntary liquidation or business rescue as appropriate under local regulations.
Plan for Asset Realization:
Develop a strategy to sell assets and settle liabilities in an orderly manner. Engage professional valuators or advisors to maximize recovery.
Implications of Going Concern Issues
Failing the going concern assumption has far-reaching implications:
Financial Reporting:
The financial statements must be prepared on a different basis, such as liquidation. This affects valuations, asset recoverability, and the classification of liabilities.
Stakeholder Communication:
Transparent disclosure is critical to maintaining stakeholder trust. Investors, lenders, and regulators scrutinize such disclosures for decision-making.
Corporate Actions:
Companies may need to implement turnaround strategies, negotiate with creditors, or explore business rescue options.
Practical Guidance for Accountants and Directors
Scenario Planning:
Develop multiple financial scenarios to understand potential outcomes.
Regular Monitoring:
Continuously monitor financial and operational indicators.
Professional Judgment:
Engage auditors and legal advisors early to validate assumptions and address potential issues proactively.
Stakeholder Engagement:
Maintain open communication with stakeholders to manage expectations and secure support.
Conclusion
The going concern principle is not just a reporting requirement but a reflection of a company’s operational viability. Adhering to IFRS and the Companies Act 71 of 2008 ensures transparency, fosters stakeholder confidence, and enhances corporate governance. By applying practical measures, understanding the actions to take when an entity is not a going concern, and implementing proactive strategies, companies can effectively navigate the complexities of going concern and ensure sustained success.
To learn more on the topic of Going Concern, do not miss the following webinar:
Date: 22 January, 2025
Time: Available from 08:00
Hours: 1.5 hours
CPD Units: 2
Category: Accounting
Group: Channel 1: Compliance
Format: Webinar
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📢 Join us on 15 January for an insightful 90 minutes webinar designed to help accountants confidently navigate the principles and requirements of Going Concern and Subsequent Events
🔑 What you’ll learn:
✅Definition and implications of the going concern assumption.
✅ Indicators of financial distress and factors that may challenge the going concern assumption.
✅ Types of events after the reporting period (adjusting vs. non-adjusting events).
✅ How to assess and disclose such events in financial statements.
✅ Explore practical examples and case studies to address common challenges in lease accounting.
✅ Real-world case studies demonstrating the importance of these concepts in ensuring transparency and accountability in financial reporting.
🌟 Why attend?
Stand out by mastering these essential competencies and earn 2 CPD units in accounting.
👩🏫 Your Presenter:
Faith Ngwenya, a seasoned accounting professional and leader in academia and industry standards, brings her wealth of experience to guide you through this critical topic.
💻 Format: Webinar
📅 Date: 22 January 2025
⏰ Time: Duration: 90 minutes
📚 CPD Units: 2
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