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Importance of Going Concern Principle for Auditors

Discuss about the Work System Theory for Core Concepts Extensions.

In this article Altman & McGough, the going concern principle is famous when it comes to an entity. The entity includes all business organisations which include proprietorship, partnership, and association of persons or a company that includes both private and public. From an auditor point of perspective, it is important for them to disclose to the shareholders of the entity or the persons who has their stake in that entity (whether in terms of loans, shares or assets ) whether the entity is a going concern or not. Their research takes a stand on going concern that is defined as the entity’s ability to continue its business operations in the coming years. It is clear from the journal that the members may come and go but the company is bound to perform its activities for a longer time frame. Hence, the longevity of the company remains unaltered by any issues or happening.

As per Baldwin, an auditor is required to comment on the going concern disclosure requirements of the entity as per the IAS 1 of the International Accounting Standards Board (IASB). The auditors are required to comment on the going concern principle in the audit report published by them for that particular entity and this is clearly stated in the book. A specific statement is proposed by IASB to be included in the auditor’s report regarding whether the manner of accounting used by the management on the basis of going concern is appropriate or not. It is imperative from the finding in the book that the auditors are required to conduct a good quality of audit in order to ascertain that the management is providing a true and fair view of the financials. It is imperative that the auditor must provide an independent report of the business that helps the business to perform with ease and flexibility.

The auditors must review every decision taken as well as all the financial data very keenly to decide and comment on the going concern assumption that is aptly stated by Heeler. This includes going through the decision of the management taken during the current financial year as well as the decisions after the close of the financial year but before the signing of the auditor’s report. It is even stated how to report how the changes in the management decisions taken during the year are going to affect the entity’s future operations. Conducting a methodology as per the type of the business to ascertain whether the financials present a true and fair view. The auditors must also consider the financial capability of the entity, the evidences provided by the entity and if any liquidity problem persists then the efforts of the management to overcome those liquidity issues.  Based on these the auditors are required to comment whether the financials are prepared based on the going concern assumption.

Measures for Auditors to Provide a True and Fair View of the Financials

As per Levine & Prietula, even after these measures undertaken, if the auditor gives a qualified opinion, it is going to have a bad impact on the future of the entity. The stakeholders assumes any of the following a) the management has not presented a favourable balances of the financials or the performance of the entity is not correctly reported, b) The management of the entity is trying to hide the losses and thus presenting wrong figures which is apparently showing profits. The research is done on the management that exit in an organization and as a result of the same, the impact on the entity’s share has an adverse impact. The value of the shares in the market falls, the compensation structure of the employees of that entity is adversely impacted, the rate of interest on which the entity has taken loans from the market automatically goes high, the investors starts withdrawing their money from the entity based on the auditor’s report as they start losing faith in the entity’s performance.

As per Kalpan & Williams, one of the important tools for assuring the going concern assumption of the entity is to check the order book or work log book of the entity for the coming years. Only the management’s representation on the going concern will not help in ascertaining whether the entity is going to continue as a going concern or not. If the entity’s order book is full and it is capable enough based on the loans and its own generated fund to fulfil the contracts it has in its hand, an assurance can be generated that the  entity can be considered as a going concern entity for the coming years. Therefore, the overall scenario of the company determines how the company will perform in the coming days. The long term perspective of the company will be stabilized when the stability of the company is strong and has a good track record.

As per Beaver, there are various models also based on which the decision on going concern can be interpreted. As per Beaver, he made his research on 79 entities (failed and non- failed). He used financial ratios as a measure to trace this measure. The research stated that the current ratio that is ratio of current assets divided by the total assets and the ratio of net profit divided by total assets will give an idea regarding the bankruptcy of the entity in the coming year. His model predicted 90% and 88% of the cases accurately. Hence, was a major landmark that helped in forecasting the coming scenario and acted as a good scope for alert. As per Ohlson, logic analysis is a better and more accurate tool of analysing the going concern assumption of the entity. Seven financial ratios were used to identify the financially distressed entities.

Factors Influencing Going Concern Assumption of the Entity

Citron and Tafler made their analysis on the concept that if the company’s financial position is not proper, then an auditor must comment on the going concern viability of the entity. Mutchler on the other hand side identified few auditors’ comment that would help in identifying that a company is suffering from some financial crisis. Those comments included losses in terms of finance which can very well be identified through the cash flow as required to be prepared by all entities, inappropriate current assets, difficulties in taking loans and funds from the financial institutions, where the cash flow shows a negative balance, inability of the company to pay loans, evidences that the entity is going into restructuring, bankruptcy indication, problems in overcoming financial losses of the entity, operational financial losses, has received qualified opinion in respect of going concern in some previous financial years, where the liabilities of the entity are more than the assets of the entity and thus having a negative balance or that the entity is going to become a takeover target in the coming years.

As per Alter, the disclosure on the issue that the entity is a going concern or not will ultimately is reported by the auditor. However, they are also influenced by the management representations regarding their efforts on mitigating the financial losses. However, for a better presentation of the true and fair view of the financial statements, it is always better from the auditor perspective that an opinion on the going concern should be mentioned wherein the management’s efforts in mitigating the losses must also be mentioned which will always help the investors in taking fair decision as the picture in front of them with regards to the financials will be clear.

The emphasis on this aspect of accounting and assumption is given nowadays only for the basic reason that inspite of giving a clean audit report, the entities collapses in the following financial year or it becomes bankrupt. Thus an auditor based on the three factors: indicators of finance, evidence obtained by them both from internal and external factors and disclosure required to be made, should present an opinion on the going concern assumption of the entity.

Alter, S 2013, Work System Theory: Overview of Core Concepts, Extensions, and Challenges for the Future, Journal of the Association for Information Systems, vol. 14, no. 1, pp. 72-121.

Altman, E.I. & McGough, T.P 1974, ‘Evaluation of a company as a going concern’, Journal of Accountancy vol. 138, pp. 50-57

Baldwin, S 2010, Doing a content audit or inventory, Pearson Press.

Beaver, W. H 1996, ‘Financial ratios as predictors of failure’, Journal of Accounting Research, vol. 7, no. 2, pp. 179–192.

Citron, D. B., & Tafler, R. J 1992, 'The comparative impact of an audit report standard and an audit going-concern standard on going-concern disclosure rates’,  Auditing: A Journal of Practice and Theory, vol. 23, no. 2, pp.  119–130

Gilbert, W. Joseph J & Terry J. E 2005, ‘The Use of Control Self-Assessment by Independent Auditors’, The CPA Journal, vol.3, pp. 66-92

Heeler, D 2009, Audit Principles, Risk Assessment & Effective Reporting, Pearson Press

Kaplan, S. & Williams, D 2013, ‘Do going concern audit reports protect auditors from litigation?’ A simultaneous equations approach, The Accounting Review, 88(1), 199-232.

Levine, S. S., & Prietula, M. J 2013, Open Collaboration for Innovation: Principles and Performance, Organization Science, Harvard Press

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