Jess

Welcome to our third episode of RSM Audit Unlocked, where we're so excited to have you joining us once again. I'm Jess, a director in the RSM Brisbane office, where it's always sunny. 

Aimee

And I'm Amy. I'm a partner in the Melbourne office, where the coffee is strong and the audits are even stronger. And sassier. 

Jess

So today, Aimee, we have the juicy, juicy topic of Going Concern. So let's get straight into it. It's going to be a good one. Let's start with the basics. Tell me about what is the Going Concern Assumption? 

Aimee

Going Concern Assumption and principle is that a business, it's assumed that a business will be able to continue for the foreseeable future. So 12 months from the day of signing off the financial statements. So it's crucial for financial reporting, for transparency and underpins the reliability of the financial statements. And if the company are not Going Concern, then the financial statements will look a little bit different, not prepared on a Going Concern basis. And likely that our audit report would have a qualification in there as well. 
 

Jess

Yeah, so it's a pretty big topic. It obviously has a lot of impacts on the financials, the audit opinion. I suppose one of the big things we hear is, what's this term material uncertainty? 
How does it impact the financial statements? What is it? And how does it impact what's disclosed in the financials? 

Aimee

Great question, Jess. Love the Material Uncertainty. Unfortunately, it's more common than you would actually think with companies. So the Australian accounting standards refers to where there is a significant doubt that a business can continue as a Going Concern for the foreseeable future. So generally, we see a Material Uncertainty for fairly new start-up companies where there's Going Concern indicators and there might be pre-revenue generating. 
 

Aimee

So what does it mean for the financials in the audit report? That you would have Going Concern disclosures. So that would outline there's Going Concern indicators of X, Y and Z, but the directors believe that they were Going Concern because of certain factors like capital raises, etc. But what it means in the audit report is that we have a Material Uncertainty paragraph, which highlights that there's a Material Uncertainty and refers back to the note within the financials. 

Jess

Yeah, great. And can you give us an example of when a Material Uncertainty would be triggered? 

Aimee

Yeah, definitely. So as I mentioned, it's quite common for tech startups like small ASX listed small caps. And look, when we're the forecast of the company, we know that there's Going Concern indicators, but the forecast might include a capital raise, what's going to happen or expected to happen in the next six months. But it's not locked in. The companies are relying on it. And if they don't get the capital raise, then it means that there is a big question around the Going Concern of the company.

Jess

I think that's a really common one that we see a lot as well. And I think it's really important to unpack, what are some of the signs that a business may not be able to continue as a Going Concern from an auditor's perspective? Aimee, we're talking the red flags. What are they? 

Aimee

Okay. First big red flag that we look at when reviewing the financials of an auditor is their operating losses. 

Are there operating cash outflows because if a company is not generating cash, big red flag because obviously cash is king as we all know. Working capital deficiency where current liabilities are greater than current assets really shows that the company is under financial pressure. Other common red flags will be things such as clients having significant unpaid creditors such as tax liabilities, payroll taxes. 

Do they have any illiquid current assets such as slow moving stock? Do they have debtors that are uncollectible, and minimal cash reserves? And don't forget if there are any breaches of the current debt covenants and any loans that might be up for renewal where we don't have any other option of being able to renegotiate these, or not really any options to raise capital as well. 

Jess

Yeah. And what about some of the ratios? What are some of the key ratios we look at? 

Aimee

Key ratios for me is really around the interest cover, looking at EBITDA margins, as well as the debt to equity ratio. 

Jess

Yeah. I think there’s so many different flags to be looking out for as you're going. And I think you've also missed one of the key areas, some non-financial points. 

So, are the clients losing customers? Is there a major supplier that's in administration so they can't get their product? Do they have any legal matters outstanding? There might be claim or litigation against them. And let's not forget the old fear of another global pandemic of COVID. 

Aimee

That had a massive impact on sometimes positive, but a lot of the time real negative impacts on companies.

Jess

Yeah, we saw a lot of companies struggle through that. And all those things can really raise doubts around whether an entity continues with Going Concern. 

Jess

So you've been involved in obviously hundreds of audits over the years. What are some of the most common pitfalls that you see when it comes to Going Concern? There's often this myth, it's the auditor's responsibility to work through Going Concern, but that's not quite true.

Aimee

That’s where you're going wrong right at the start because it's not our responsibility. It's management's primary responsibility that they're providing us an assessment that they are a Going Concern at the end of the financial reporting period. So the main issues that we do come across when we're reviewing a company's Going Concern and undertaking the audit procedures. So it would be the biggest issue if there's no forecast at all. And there's no formal assessment around Going Concern that we can review as auditors. The forecasts have been rushed a few days in before signing and we've only just been provided the forecast just as we sign in. Given that it's a significant risk, we like to get into that early and really have those conversations with management just so we understand what the disclosures and the audit opinion will look like. 

Jess

And I think one of the issues for that timing issue is that people have given you their budget for the year. So a budget's normally based on their calendar year as opposed to looking out for 12 months from the date you're signing the accounts. So it's a rush at the end, to add the extras in, consider actuals. 

Aimee

And if you don't have detailed assumptions behind that, not a hard-coded forecast, we don't really understand what it's based on. If there's no detailed assumptions, it makes our job really hard. Sometimes if the directors are not across management's assessment and they agree with management's assessment, that can also make it really hard as well. 

Jess

You keep mentioning this term sufficient audit evidence. Can you give us some examples of what is sufficient audit evidence? 

Aimee

Well, we also mentioned around the forecast and really, do they have a good sales pipeline where they've got signed contracts in place that we can verify the sales figure in the forecast? Do they have any capital raises already locked in, any convertible notes, what's already been signed? They're kind of the main ones, but also letter of support from the parent entity. That's a really good level of audit evidence so we can conclude we're comfortable with the Going Concern of the company. 

Jess

And with that parent support letter, it's really important to make sure the parent can actually provide that support as well. 

Aimee

Exactly. You say when you get to that level, then you say, well, the financial statements of the parent company, do they actually have cash and working capital to be able to support it as well? 

Jess

Correct. There’s no point of a Going Concern entity providing support for another Going Concern entity. 

Jess

So in a perfect world then, as an auditor, what do you want to see management providing? 

Aimee

Love a three-way forecast, which is all linked and detailed - then that forecast might have detailed schedules behind it to see where the numbers come from. And they might stress test the forecast as well. Providing the forecast from day one of the audit is always good and having a formal assessment around Going Concern so that we can take that, we can look at the forecast and it all links together. It's a clear picture. And then we look at the actual results post year end and it all ties together and makes sense. And the conclusion management have drawn is all great. And we're comfortable with the disclosures in the financial statements. 

Jess

I think it's also important to mention the responsibility of those charged with governance. So at the end of the day, it's going to be the board signing off on the Going Concern of the entity, being able to continue into the future. So they should be really stress testing with management. What is management's assumptions and are they comfortable that they are reasonable and are they comfortable with the wording that's in the financials? 

Aimee

Exactly. They play a critical role and if they're not comfortable with the disclosures and the disclosures are misleading stakeholders, then that's where there might be legal proceedings and major issues where the directors and maybe even the auditors could get sued as result of incorrect conclusions around Going Concern. 

Not going to mention it in detail, but safe harbour provisions always a hot tip for directors, especially if companies are in not a strong Going Concern position. 

Aimee

So that's a wrap for this this episode. If you do have any questions off the back of the today or any anything else that you've listened to so far, please reach out to myself or Jess. We'd love to hear from you. 

If you found the episode helpful, we'd really appreciate you sharing it with anyone who you might think might benefit from it. 

Our next episode is a great one. We'll be unpacking top tips around capitalisation and E&E assets. Thanks for tuning in. See you next time.