Going concern - Indicators of problems

Learning Outcomes

After completing this article, you will be able to identify and explain key indicators suggesting doubts over an entity’s ability to continue as a going concern. You will understand both financial and operational warning signs, the importance of auditor vigilance, and the practical procedures required to assess going concern risk as expected in the ACCA Foundations in Audit (FAU) exam.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand the concept of going concern and be able to identify early warning indicators of going concern problems. This article directly addresses:

• The definition of going concern and its significance to the preparation of financial statements
• Common financial and operational indicators of going concern issues
• The auditor’s responsibilities regarding the review of going concern status
• Audit procedures for evaluating going concern
• The importance of considering disclosures when material uncertainties are identified in the financial statements

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes a "going concern"?
   1. A business planning to cease operations in the next six months
   2. A business expected to continue operating for at least twelve months
   3. A business that achieved profitability this year
   4. An entity with a significant loss this period

2. Name two financial indicators that may suggest a business is not a going concern.

3. True or false? Operational challenges, such as loss of a major customer, can be an early warning of going concern problems.

4. What should an auditor do if doubts exist about the going concern status of a client?

Introduction

The going concern assumption is fundamental to the preparation of financial statements. It presumes that a business will continue operating for the foreseeable future and has neither the intention nor the need to liquidate or significantly reduce its operations. When this assumption may not hold, additional disclosures and audit consideration are required. Early identification of going concern risks is critical for directors, auditors, and users of the financial statements.

Key Term: going concern
The assumption that an entity will continue in operation for at least twelve months from the reporting date, with no intention or need to liquidate or curtail its activities significantly.

GOING CONCERN: WHY IT MATTERS

Financial statements are normally prepared on the basis that the company will remain in business in the coming year. If this is not appropriate, significant adjustments would be required—for example, assets would be measured at realisable value rather than cost, and liabilities might become immediately payable.

It is the responsibility of management to assess and conclude on the appropriateness of the going concern assumption. The auditor must then evaluate the assessment and be alert for indicators suggesting otherwise.

WHAT ARE INDICATORS OF GOING CONCERN PROBLEMS?

A going concern problem is any event or condition that casts significant doubt on an entity’s ability to continue operating. These may be financial, operational, or external in nature.

Financial Indicators

• Net current liabilities or negative working capital
• Persistent operating losses or negative cash flows
• Overdue or unpaid borrowings, inability to secure finance
• Breach of loan covenants or over-reliance on short-term debt
• Non-payment or suspension of dividends

Operational Indicators

• Loss of key management or employees
• Loss of major customers, suppliers, or markets
• Shortages of critical supplies or disruptions to production
• Labour problems (strikes, disputes)

Other Signs

• Legal or regulatory proceedings threatening the entity’s viability
• Major pending or actual lawsuits with uncertain outcomes
• Non-compliance with statutory, capital, or regulatory requirements
• Any plans announced by management to liquidate or cease trading

Key Term: material uncertainty
A situation where events or conditions may cast significant doubt on the entity’s ability to continue as a going concern and require disclosure in the financial statements.

AUDITOR RESPONSIBILITIES: STAY ALERT TO WARNING SIGNS

Auditors must maintain professional scepticism and actively look for signs that could indicate going concern problems. Where indicators exist, they are required to do further work to evaluate management’s plans, the adequacy of disclosures, and the overall suitability of the going concern basis.

Key Term: professional scepticism
An attitude that includes a questioning mind, alertness to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.

WHAT SHOULD AUDITORS DO WHEN INDICATORS ARE PRESENT?

If going concern indicators are found, the auditor should:

• Assess management’s plans to address these issues (e.g., refinancing, new capital, cost reductions)
• Analyse cash flow forecasts and challenge the assumptions
• Review events after the reporting period up to the auditor’s report date
• Verify the existence of funding lines and the ability to renew or raise finance
• Check compliance with loan agreements and covenants
• Ensure adequate disclosure is made in the financial statements about any material uncertainty

If the auditor concludes material uncertainty exists but disclosures in the financial statements are adequate, no modification to the audit opinion is needed beyond drawing attention to those disclosures. If disclosures are inadequate or the going concern assumption is inappropriate, modifications or qualification of the audit opinion may be required.

Worked Example 1.1

A company has breached a major loan covenant, is experiencing cash flow problems, and management reports plans to secure additional funding. What should the auditor do?

Answer:

• Obtain copies of all loan agreements and correspondence with the lender.
• Review cash flow forecasts prepared by management, assessing whether assumptions are reasonable and supportable.
• Inspect evidence of management’s negotiations to renew or replace loan facilities.
• Consider the likelihood of the company obtaining the funds required and the adequacy of related disclosures in the accounts.
• If uncertainty remains, ensure the financial statements highlight the risks and consider referencing this in the auditor’s report if necessary.

Worked Example 1.2

The auditor learns after year-end that a company’s largest customer has gone into liquidation, representing 40% of annual sales. What is the going concern implication?

Answer:

• This is a significant operational indicator, as losing such a customer seriously affects future revenue.
• The auditor should assess the impact on revenue, cash flows, and profitability.
• Review management’s plans to replace the lost customer or reduce costs accordingly.
• Consider whether this event creates a material uncertainty requiring disclosure or adjustment in the accounts.

Exam Warning

A common mistake is to focus solely on financial figures. Operational changes, legal disputes, or loss of key personnel may be just as significant as losses or negative cash flow. Examiners expect you to identify a wide range of indicators.

Revision Tip

Learn the main financial and operational warning signs for going concern and practise linking them clearly to required audit procedures.

Summary

Early identification of going concern issues is central to the auditor’s responsibilities. Both financial results and operational developments can raise doubts. ACCA candidates must know the typical indicators and the required audit responses—evaluate management’s assessment, perform further procedures, and check for proper disclosure.

Key Point Checklist

This article has covered the following key knowledge points:

• Define the going concern concept and explain its importance in audit and financial reporting
• Recognise common financial, operational, and other warning signs of going concern problems
• Explain auditor duties when going concern indicators are present
• Identify suitable audit procedures in relation to going concern risks
• State the importance of adequate disclosure in the accounts for material uncertainties

Key Terms and Concepts

• going concern
• material uncertainty
• professional scepticism