Insolvency and the Going Concern

Abstract

ASA 570 Going Concern governs the operation of companies that meet the assumption of a going concern. Difficult financial periods put companies in situations where they may not be able to remain a going concern. In such scenarios, the company may need to close or get acquired. A going concern problem has no relationship with being in debt. It simply implies that a company cannot continue running. On the other hand, insolvency is the concept of either being unable to meet a company’s financial obligations. The concepts of going concern and solvency may be confused since they are both most applicable in difficult financial times. This paper analyzes the differences and similarities of the two concepts while at the same time reviewing the applicability of the two concepts in various scenarios.

(Keywords: Insolvency, Going concern, auditing)

Introduction

The going concern concept or assumption states that businesses should be treated as though they will continue to operate for an indefinite period of time or at least long enough to meet their objectives. In other words, it assumes that companies will not close down or be sold off in the near future (Adrian & Livia, n.d.). Companies that are expected to continue running are thereby said to be a going concern while those that are not expected to continue running are not a going concern. The ASA 570 Going Concern contains a list of possible events that may make the going concern assumption inappropriate due to operating, financial or other business risks (Carcello & Neal, 2003; Australian Institute of Company Directors, 2009). The list comprises the following conditions or events

• A net current liability or net liability position
• Negative operating cash flows
• Overdependence on short-term borrowing to meet long-term needs or fixed-term debts nearing maturity devoid of any realistic prospects of repayment or renewal
• Indications that lenders are withdrawing financial support
• Variation or withdrawal of terms of credit by creditors
• If a company’s debt repayment falls due at a point when the company needs financing for its continued existence
• A company shows inability to pay its loans on due dates or to comply with the terms of credit agreements
• Loss of a major supplier, market, license, franchise, or key customer
• Signs of a company being unable to handle increased competition in a dwindling market
• Failure to replace lost key management
• Closure of similar companies in the same industry (Adrian & Livia, n.d.)

According to the Corporations Act of 2001, a company is said to be solvent if it is able to repay all its debts when they are due and payable (DeFond, Raghunandan & Subramanyam, 2002). An insolvent company is one that continues to run despite its inability to meet or its debt repayment deadlines. This paper discusses and analyses the concept of going concern and its relationship to the definition of insolvency.

Methodology

The study of this paper is majorly done by literature review. It has been generated after a careful review of academic journals, internet resources as well as legal materials that cover the issues of insolvency and going concern. It is a doctrinal or qualitative research. Doctrinal research is after the rules that govern a certain aspect. Since this article covers the rules that govern the going concern, it is a form of doctrinal research. It covers the relationship between two important aspects of a business that are often confused. In this research, the various similarities are looked at and analyzed. Articles were selected on the basis of their reliability as well. All articles used were mainly academic materials which met peer review standards. Other articles were government materials that concerned the issues in question. Research was then done by the careful and extensive review of these articles to determine critically the relationship between insolvency and the going concern in the area in the area of auditing.

Sources were randomly sampled. Through the use of various platforms like Ebscohost, the university library database, government websites, and internet search engines, sources were selected after searching for keywords. Keywords used included going concern, insolvency and auditing. To limit the sources to the case of Australia, Australia was also used as a keyword. Once the search results were generated, relevant sources were selected randomly. This minimized bias in the results. This article is intended for use by company managements who would want a deeper understanding of the two concepts researched in this paper along with their relationship.

Discussion

The concept of going concern is one that has the most implications in regard to accounting principles. Such principles include the substance over form principle, consistency principle, cut off principle and conservatism principle (Adrian & Livia, n.d.).  If a company is a going concern, it has all the signs that it is going to be in operation over a period of the next one financial year. Companies are required to assess their ability to continue doing business before they prepare their financial statements (Australian Institute of Company Directors, 2009). This implies that every company will be required to review its capacity to continue operating as a going concern at least once every financial year. Rather than literally testing for the possibility of discontinuing business, the management is charged with the responsibility of identifying hints that show the possibility of discontinuing operations. On the other hand, testing for insolvency is a continuous process (Carcello & Neal, 2003). If at any point during the year a company is deemed incapable of meeting its debt repayment deadlines, then it is considered insolvent. A company is not actually charged with the responsibility of checking if it is insolvent. Instead, insolvency is just an unfortunate situation.

A company may be debt free but still not be a going concern (DeFond, Raghunandan & Subramanyam, 2002). If a hotel company, for example, is operating in Canberra Australia. Suppose, again, that this company is debt free but the company’s investors are considering selling out the company and investing elsewhere. In this case, the company is regarded not to be a going concern. On the other hand, the same business has no debts it is incapable of paying. For this reason, the company is still solvent (Adrian & Livia, n.d.).

There exist two forms of insolvency. First, there is factual insolvency in which a company’s liabilities exceed its assets (Asare, 1989). Second, there is commercial insolvency in which case a company is incapable of paying its debts. In this second case, the company’s assets may be more than its assets. In the case of commercial insolvency, the company may be regarded as one having a going concern problem. However, in the case of factual insolvency, a company may be able to operate in a state of a going concern (Asare, 1989). If a commercial insolvency exists, financial statement guidelines on going concern should be followed. While a company may continue to run in factual insolvency, the auditor should review whether the company is a going concern to ensure that the management is not misinformed. He should also request for a notification of receiving the information from the management.

The risk of insolvency is the risk that a company will be unable to meet its financial obligations with regard to its liabilities. It is important for a company determine its risk of insolvency at the time of determining if it is still a growing concern. This is because the two are interrelated. In difficult economic conditions, the low supply of funds technically increases a company’s operational and financial risks (Australian Institute of Company Directors, 2009).

In the process of financial reporting, a company will be required to pay attention to the risk of insolvency disclosures and provide substantial supporting documentation. Auditors are charged with the responsibility of assessing the processes of the management in preparing the disclosures of their risk of insolvency; assess the disclosures themselves along with their consistency and their relationship to the going concern assumption (Carcello & Neal, 2003).

Australian Accounting Standard has had a few changes with regard to the disclosure of the risk of insolvency. Companies are now required by to provide in their financial report:

• Risks occurring in their financial instruments which include risk of insolvency where applicable
• An estimation of their future cash flows
• Undrawn credit facilities and any limitations where applicable
• Covenant bleaches and defaults and the likelihood that such defaults will be reclassified as current liabilities
• Financial commitments that are unrecognized in the financial report (Carcello & Neal, 2003)

There are two approaches of valuing an insolvent business. First, the company may be valued using the income approach. This approach is made in case a company is likely to incur economic benefits in the medium to long-term (Asare, 1989). In that case, considerations should be made to determine if the company would be able to meet its obligations if restructured.

A company should run realistic cash-flow forecasts to determine income value. Valuers using cash flow forecasts drawn by others should be very careful as the person who drew the cash flows may be biased (Constantinides, 2002). A debtor may, for example, request a low valuation so as to restructure most of the company’s debts. In this case, a low valuation may be presented.

The market approach is employed in a company which is a going concern by reviewing the similar companies and applying the ratios of such companies to the company in question. These values may be obtained from the stock prices or form the M&A activity (Carcello & Neal, 2003).

The ASA 570 Going Concern recognizes two reasons why going concern problems may arise. The first category is when there are insolvency issues. In such cases, the auditor is provided with mechanisms for reporting the matter to the Australian Securities and Investments Commission as required by section 311 of the Corporations Act of 2001. The board of the company is required to create a report on the solvency of the company along with the financial report for the auditor to act upon.

Conclusion

The concepts of going concern and solvency are interrelated. A company with a high risk of insolvency is likely to depict risk of future operations. However, as noted, insolvency does not imply that a company is not a going concern and vice versa. Assessing a company for insolvency is a continuous process. It simply requires a company to check its capacity to continue meeting its financial obligations. On the other hand, a company is a going concern if its existence is not threatened in the near future. A company assesses aspect of going concern every time it is preparing its financial statements. If the company determines that it is not a going concern, it is required to report its assets as current assets since it determines that it may not be capable of doing business over a period of the next year. If a company determines that it is insolvent, it is charged with the responsibility of proving with sufficient documentation that the company is a going concern.

Companies should not be run if they are insolvent. If a company is found to be insolvent, the company should consider a variety of options in order for it to continue operation. These options include being acquired, liquidated or rescheduling its debts. This way, the company is able to legally settle most of its debts. The auditor is charged with the responsibility of checking a company’s insolvency risk only in relation to the going concern. The going concern should however be determined by the auditor and a proper documentation obtained.

References

Adrian, A., & Livia, M. Implications of going concern principle on company bankruptcy.

Asare, S. (1989). The auditors’ going concern opinion decision (1st ed.). [Place of publication not identified]: [publisher not identified].

Asare, S. (1992). The auditor’s going-concern decision: Interaction of task variables and the sequential processing of evidence. Accounting Review, 379–393.

Australian Institute of Company Directors,. (2009). Going Concern issues in financial reporting: a guide for companies and directors.

Carcello, J., & Neal, T. (2003). Audit committee characteristics and auditor dismissals following “new” going-concern reports. The Accounting Review, 78(1), 95–117.

Constantinides, S. (2002). Auditors’, bankers’ and insolvency practitioners’“going-concern” opinion logit model. Managerial Auditing Journal, 17(8), 487–501.

DeFond, M., Raghunandan, K., & Subramanyam, K. (2002). Do non–audit service fees impair auditor independence? Evidence from going concern audit opinions. Journal Of Accounting Research, 40(4), 1247–1274.

Harris, C. An expert decision support system for auditor going concern evaluation (1st ed.). Ann Arbor: University Microfilms International.

Mutchler, J. (1985). A multivariate analysis of the auditor’s going-concern opinion decision. Journal Of Accounting Research, 668–682. Auditing and Assurance Standard Board. (2006). Auditing Standard ASA 570 Going Concern