Analytical procedures and going concern at the planning stage
Applicable Auditing Standards (based on HK Standard on Auditing 570)
Going concern is a fundamental principle in preparing financial reports and a vital assumption applied by the reporting entity. When going concern is claimed, the business necessarily means to continue operations for the foreseeable future with no indication to cease trade, liquidate, or seek protection from creditors to pay obligations. It also indicates the strength of financial statements and components that are being reported such as realizing assets and discharging liabilities. Going concern assumption undergoes auditing procedures to test if the assumption is appropriate and subsequently protect the decision-making implications of investors, creditor, suppliers, regulators and other users of financial statements.
When the business has shown historically profitable activities and business stakes as well as provides evidence for easy access of financial resources, detailed analysis on going concert test need not be imposed. Otherwise, the business will be applied with sequential audit trail set forth by pertinent auditing standards. Going concern assumption is significantly injected with judgment of future outcomes for certain events/ conditions. The soundness of these judgments is inclined on three notions. As they are pushed further into the future, outcomes become more uncertain. They are based on the contemporary facts relevant to the business. Lastly, judgments are affected by size and complexity of the business, nature and condition of operations and degree of impact of external factors.
Some events/ conditions that may cause business risks and contribution to doubt on going concern assumption are the following: financial (net current liability position, excessive reliance on short-term loans, signs of withdrawal of support from creditors, negative operating cash flows, substantial degradation of valued assets, inability to pay on due dates, inability to comply with loan agreements, inability to obtain financing for new product, adverse financial ratios, etc.), operating (loss of key management yet to be replaced, loose of major market and business partners, shortages on factors of production, etc.) and other factors outside company’s control. However, the business can mitigate the doubt by disclosing plans and strategies to solve the adversaries.
Two main tasks of auditors are assessing the validity of going concern assumption claimed by the business in preparing financial statements and evidence supporting such assessment. Procedures of evaluation include identification of events/ conditions leading doubt to going concern, evidence and risks of misstatements. In most cases, the management of the business executed preliminary evaluation that is required to be at least a going concern assumption for 12-month period. However, the review of auditor can involve consideration of periods exceeding this required period if the effort significantly affect going concern assumption for the original time frame. As judgment further in the future is more uncertain, evaluations exceeding the original period must have determined impact to going concern assumption.
The mitigation that management offers in the case the doubts to going concern validity is also audited to evidence feasibility and effectiveness. One useful tool and basis is cash flow analysis where consideration is applied to reliability of inputs that generate the information, adequacy of supporting variables in reaching the forecasts, historical accounts and current performance. When material uncertainty is proven, the financial statements of the business can gain an assessment that its contents have significant potential to mislead users. However, if material uncertainty is proven but going concern is assumed, financial statements must show events/ conditions that can increase significant doubt to going concern validity or simply directly state doubt to such validity. Regarding material uncertainty conclusions, the auditor can apply unqualified position where financial statements reflect them and sketch the important parts of the report that signal going concern issues. If they are not reflected, qualified or adverse position can explicitly explain material uncertainty.
Financial Position of the Business (i.e. IOL)
Average collection period is increasing since 2006. As a general rule, lower average collection period is optimal because the business need not wait long to receive cash payments from their credit sales. The performance of the business for this ratio indicates that it has difficult time in converting account receivables into more liquid assets (i.e. cash). It can also mean that the business is more exposed in acquiring bad debts and defaults. Cash conversion cycle is adversely affected because of the pressure imposed by longer collection periods. The time of outlaying cash and cash recovery is widened which signifies more time capital is tied-up to business processes (i.e. conversion of inputs to outputs). Due to this, the business is required to source out additional capital to maintain daily operations because most of its current capital is tied-up. This additional requirement is necessary to pay production expenditures, wages and overheads. Failure to address these costs can lead to interruption and stoppage of work or even disposal of value-creating assets that suggest bigger problems. High average collection period is aggravated/ mitigated by low/ high inventory turnover and high/ low average payment period.
Current ratio is decreasing since 2006. From stronger liquidity in 2005, the business dropped to a ratio less than 1 suggesting that it cannot pay its obligations as they fall due. These obligations are accounted to short-term liabilities such as debt and other payables while short-term assets that are used to pay them include cash, inventory and receivables. With reduced current ratio, the business has more obligations than potential payments and signals the need to source financing to various channels. The risk, however, is that the strain of overdue obligation which can force the business to enter credit agreements and other contracts that are obviously detrimental compared to options available if the strain is not too urgent or if it only has assets to pay them. Lower current ratio is related to higher average collection period which implicated likelihood of bad debts. With a more conservative analysis (i.e. getting the quick ratio), the exclusion of inventories, pre-paid expenses, and as proved, account receivables, can only aggravate the liquidity of the business.
Debt-equity ratio is rising since 2006. This indicates that the business is becoming more dependent on interest-bearing debt financing than less risky internal or equity financing. As a result, its earnings are also more volatile due to reductions by payment of the interest. It can also put the business into greater agreement risks mentioned in current ratio such as collateral of value-creating assets and disposal when debts are long overdue. In the case of dissolution, shareholders are in greater risks to recover investments because outside creditors are preferred in distribution of assets and may even demand the former to contribute to the losses. In 2007, the business is sourcing debt that is two-times larger than proceeds from equity which can trigger the preceding consequences. However, there is a need to investigate where the debt proceeds are invested. This is important because debt-financed projects with significantly high returns compared to debt interest (i.e. debt coverage) can alternatively increase earnings.
Gross profit ratio is decreasing since 2006. This can either mean that the business is generating fewer revenues or experiencing price increases on cost of goods sold than previous periods. As a result, it decreases its opportunity to create savings for engagements in the future and payment of unexpected expenses. Problems are likely rooted in ineffective production and marketing of products, inefficient relationship with suppliers and expensive logistics design. On the other hand, the negative figures pertaining to profit after tax ratio show that the business has no earnings (i.e. at loss) from 2005 to 2007. It is a difficult time for the business which various aggravations such as low collection period, current ratio and high debt-equity ratio. This can also indicates that the projects the business is entering and financing are not contributing to profitability. However, the ratio on profit after tax can be applied with tax holidays or incentives that can transform profit to positive figures.
Net asset per share is declining since 2006. Assuming that shares outstanding are constant, this indicates that the assets of the business have lower values and new value-creating assets are yet to be included in its operations. As a result, the interest and wealth of shareholders is not protected leading to their divestment. The preceding possibility can aggravate the problem of the business on sourcing out safer funds to pay current obligations, prevent stoppage/ litigation and finally to report its financial statements as a going concern. However, there is a need to investigate whether this ratio includes intangible assets which is eminent to the innovative products that the business is creating and planning to distribute.
Factors Evidencing Going Concern Problems
For the first product that the business launched into the market, it gained success although only temporary as shown by decline and moderate attention of the market for succeeding products. With the promises of the new program developed over a three-year period, history of profitability is difficult to attach to its operations. The market for Internet-based computer programs is exposed to numerous companies and similar products whose purchase decisions are unpredictable. For example, computer programs bought in the internet through online payment is a transaction viewed risky by the market while bogus offers are inevitable. As Internet business is global, predicting market response and demands is very difficult due to various culture, level of technology and economic status. With cheap prices tagged on the product, the business is unsure that its investments for research and profit targets will be met.
Further, its access to financial resources is very limited especially with its adverse financial ratio. It cannot rely on its debtors/ accounts receivables as it accumulated decreasing collection period, on its short-term creditors due to decreasing current ratio, on its long-term creditors due to increasing debt-equity ratio, on its retained earnings due to decreasing profit ratios and on its shareholders due to its decreasing assets per share. The raising of funds to finalize and launch the new product has been possible because of sourcing from personal savings or borrowing with relatives as the company started with financing on this method. Although this can evidence that the business has access to financial sources, additional working is required to validate the extent and depth of this kind of informal financing. The absence of sufficient evidence of profitable history and access to financial resources is a sign that probable going concern problem is demanding for proof.
The launching of the new product is regarded as the breakthrough of the business in reversing previous trading problems with other lines of products. However, this claim is inappropriate in judging events/ conditions to arrive at going concern assumption. It is not based on facts at the time of judgment because past trading problems are undermined. The success of the new product is related to the success of previous launchings. Further, forecasting that the new product will be completed and launched in six months time triggered uncertain outcome as it is judged further in the future. Three years that the product is under development and there is no evidence that its development is supported by a time-line. The fast-paced and ever-changing level of Internet technology likely deemed innovativeness of the new product designed three years ago obsolete. Its main features and forecasted reaction of the market are highly questionable with the level of technology today.
Forecasting the future performance of the new product is also exposed to several risks. Although there is evidence that the business is issuing shares, the declining performance of post-first product launched and cheap price supports the idea that it is under the category of small and medium enterprises. The environment is very competitive where big program developers can easily be pirated employees, sued due to infringement of trademark, and bought in case of financial difficulties. It is also operating on a research extensive industry where earnings are not certain until a new product is not only successful in production but more importantly appealing to market preference. There is also crucial emphasis on protection of proprietary and speed to market where the new product forecasted to be launched after six months can leak into the Internet or produced by other companies. The nature and condition of the business and the industry are very unpredictable and bounded by changes in regulation (e.g. applying for patents).
Solution to the Going Concern Problems
The business can present supporting details that can mitigate the implication of unhealthy financial statements. For example, lower collection period can be trade-off by higher inventory turnover or lower payment period. Lower current ratio can indicate high inventory turnover and shortage in cash assets is triggered by increase in bad debts due to lower collection period. In effect, favorable data about inventory and payment terms of the business can mitigate going concern problem. Further, high debt-equity ratio can reduce its inherent risk if loan documents can prove that most of the debts of the business are not interest-bearing. This can relax the requirement for interest coverage and minimize the vitality of the success of the new product in its launching. The negative profit after tax ratio can be relieved by government correspondence reflecting tax holidays that the business can use in the future. Data about the current level of shares outstanding can verify the cause why net asset per share is reduced. If it is caused by increases in issues, then the claim of the business that its assets are undervalued can gain ground.
Product features of the new product and its impact to purchasing decisions of users can be used. It can also compare how the new product is similar to the first product to claim the former turnaround impact to sales. Without this evidence, the forecasts that the new product is a breakthrough can only be assessed as having material uncertainty. Information about target market, previous sales data, contribution of each specific segment, and other marketing reports is necessary. The new product must also prove to assure that its features are compatible with the current needs of the market and the current level of technology. Certifications that the product already has patent to prevent piracy and value-decreasing actions from competitors. In simple terms, the business must provide information that the new product is supported by valuable, inimitable and non-substitutable features.
The business can also suggest plans on how to assure that the 6-month completion and launching of the new product is realistic. It can present project plans, milestones, funding allocation and actions in case of project failure. If the new product is proved to be valuable and has potential like the first product, the launching date is crucial to realize the cash flows and provide insight on how the business can protect its adverse financial ratios to becoming indication of bankruptcy. Delay in project completion can reduced its value creation as the general rule states that the money hold today is more valuable than the money that will be hold tomorrow (i.e. time value of money). Alternatively, the business can offer other plans to improve the current features of the product, increase investments in marketing, boosting relationships with business partners and the like. This engagement must be supported by annual budgets, monthly performance reports, correspondence with suppliers and distributors and even performance appraisal of employees.
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