'Going concern' - what will the auditors say by variablepitch349

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									‘Going concern’ – what will the auditors say?
Steve Gale outlines what the auditors will want to see, how firms should prepare and the ongoing process.
his year, as well as dealing with the usual issues that surround the production of year-end accounts, law firm heads of finance are having to spend rather more time thinking of the issue of ‘going concern’. From an external financial-reporting perspective, the ‘going concern’ question is one that only affects limited companies or limited liability partnerships (LLPs) – which include an increasing proportion of firms. Indeed, within the top-50, the number of traditional partnerships is now in single figures. The current economic climate provides the first significant challenge to firm results and operations on a professionwide scale for over a decade. Those firms facing their first statutory audit as an LLP may be finding that their auditors

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are taking as much interest in what they think might happen in the future as in what happened in the past. So, what will the auditors want to see and is it going to be a lot of work with no tangible benefit?

Back to basics – the ‘going concern’ basis Financial Reporting Standard 18 (Accounting Policies) requires an entity to prepare its accounts on the ‘going concern’ basis, unless the entity is being liquidated, ceased trading or is faced with no realistic alternative but to do so. In addition, company law as applied to LLPs, in the provisions concerning the preparation of financial statements, presumes the business is carried on as a ‘going concern’. www.fd-legal.com 13

So what does being a ‘going concern’ actually mean? Essentially, it is that the firm will have sufficient resources available to enable it to meet its debts and obligations as they fall due for the foreseeable future. In the UK, ‘foreseeable future’ means a period of at least 12 months from the date that the annual accounts are approved.

is uncertainty about the firm’s ability to carry on as a ‘going concern’, notwithstanding that the members might be confident that appropriate funding is forthcoming, will other readers of the accounts share that view? What impact will such disclosures have on the firm’s clients and staff ? Will the credit rating be affected?

Why are ‘going concern’ considerations important to members of an LLP? Under company law (as applied to LLPs), it is the duty of the members of the LLP to prepare annual financial statements and approve them. How this is put into practice may vary widely, depending on the structure of the firm. For larger firms, the responsibility may initially be delegated to the finance team, with little or no input from the members. When it comes to final decisions on form and content of the accounts, then the finance partner or management board may become involved. For some firms there may then be an audit committee (or a body serving a similar purpose such as a supervisory board) made up of partners not involved in day-to-day management. Even when it comes to the formal approval process, many firms will not have

What procedures should firms undertake? The process that a firm will need to go through in arriving at its conclusions will depend on the individual circumstances facing the firm. Those with significant cash balances and a core of stable, recurring work will probably require less analysis than one with significant borrowings, little recurring work and exposure to sectors most badly hit by the current economic conditions. Going back to the definition of ‘going concern’ highlights that there are three issues that really need addressing:
1. Assessing the availability of sufficient resources; 2. Understanding the debts and obligations that need to be covered; and, 3. Considering the foreseeable future.

So what does being a ‘going concern’ actually mean? Essentially, it is that the firm will have sufficient resources available to enable it to meet its debts and obligations as they fall due for the foreseeable future
every member involved in the process, as the LLP members’ agreement may have this power devolved, for example, to the equity members. Accordingly, those members not involved in either the preparation of the financial statements or the approval process are putting considerable trust in their fellow members to ensure that appropriate steps are taken, including the consideration and assessment of the ‘going concern’ basis. As regards ‘going concern’, the members should be satisfied (primarily) on two counts: That there are reasonable grounds for concluding that the firm is likely to avoid an insolvent liquidation for a period of at least 12 months from the date they approve the statutory accounts; and, The statutory accounts contain adequate and appropriate disclosure where that conclusion is subject to significant uncertainties in the future. It is the second of these matters that causes most consternation as there is a very real fear of creating the self-fulfilling prophesy. If the accounts disclose that there One thing is for sure – firms should discuss how they intend to approach the ‘going concern’ issue with their auditors at an early stage. Earlier in 2009, the Auditing Practices Board issued guidance to auditors reminding them of their responsibilities in respect of ‘going concern’. It’s not that their duty to consider ‘going concern’ has changed; it’s just that the level of work required this year is likely to be greater given the current economic circumstances. There are two points to remember when conducting ‘going concern’ reviews, and although they may appear obvious they are probably worth stating: First, ‘going concern’ is about cash not profitability – firms go out of business not because they make a loss, but because they run out of cash; and, Second, the nature of business is that incomings are generally much less predictable than outgoings. When thinking about the firm’s cash requirements, a good starting point is to make sure that the pattern of expenditure is understood fully. Expenditure, in this scenario, meaning ‘cash out’, not just what appears in the profit and loss account.

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The most significant and predictable expenditure for firms is the payroll, which comprises not only the pay run for the employees, but also the monthly payments of PAYE/NIC and pension contributions. The second largest regular cash drain is likely to be on property with quarterly rents and monthly rates. The VAT also needs to be paid, and monthly or quarterly loan repayments also need to be factored in here. Many other overheads are highly predictable and regular, and, in many cases, unavoidable. The one constituency not mentioned so far is the partners: they will expect their monthly drawings. Most firms also retain amounts from partners to cover taxation and use those retentions as a source of working-capital finance. It does mean, however, that there are large tax payments to make on 31 January and 31 July each year. In the definition of ‘going concern’, the reference is to debts and obligations ‘as they fall due’. For most of the payments outlined above, there are legal requirements or contractual arrangements that determine when a payment or obligation falls due. There may be a question as to whether the same is true of the partners’ drawings. When assessing the availability of resources, there are essentially three sources: Clients; Partners; and, External providers (normally banks). It is the clients that hopefully provide most of the liquidity that is needed, but they can only do that with the help of the partners. After all, clients rarely pay bills that have not been raised or sent. Regular billing and effective credit control also means a greater degree of certainty of client cash flows. This does not tell the whole story, however. When it comes to forecasting income, it is important to go back to the start and understand when work is going to be carried out and billed. Firms may need to consider forecasting chargeable hours in greater detail, considering factors such as the likely timing of holidays, training courses and so on, as this has an impact on billing and, consequently, cash collections. When it comes to external financing there are two key considerations: Are the current facilities sufficient? What is the prospect of being able to take out or renew facilities at a level that is sufficient? When putting together projections, it is highly likely that they will be for a period that goes beyond the renewal date for facilities. Forecasts should be realistic in terms of available financing and, if significant additional resources are needed,

then the auditors are likely to enquire as to how discussions are progressing with the banks. How far away the renewal date is, and the degree to which the facilities need to be increased, are both factors that influence the degree of uncertainty as to whether those facilities are likely to be forthcoming. The ability for partners to provide additional finance is, in the current climate, potentially one of the strengths of professional practices. Hopefully, partners are aware of the realities of economic life and are not already spending all of their anticipated profits. Practices may find that a pragmatic way of finding additional finance in the short-term is to delay final payments of profits. If it is appropriate to raise the level of capital, this could be done through retaining profits. From an external perspective, this is one way in which partners can demonstrate their confidence in their own business. The final element in the ‘going concern’ analysis is the ‘foreseeable future’. There is no hard and fast rule on how long this lasts, although if the period considered is less than 12 months from the date that the accounts are signed, then this should be disclosed in the accounts. If it is not, then the auditors have a duty to report this in their audit report. A challenge for firms is that very often the period required for the ‘going concern’ analysis is not one that is routinely considered in the management of the business, as it may be out of step with the budgeting process that might only extend to the next year end – possibly only seven or eight months from the date the accounts are signed (or even less). It is also important to remember the primary purpose is to provide evidence that, for the duration of that period, the firm will be able to meet its debts and obligations as they fall due. After concluding their assessment, the members need to make two decisions: 1. Whether it is appropriate to still prepare the accounts on the ‘going concern’ basis; and, 2. Whether the ‘going concern’ basis is dependent on uncertainties that are so significant that they should be disclosed in the accounts. When law firms first considered moving to LLP status, one of the problems often encountered was the issue of disclosure; although in reality what that meant was the disclosure of partners’ earnings. Other aspects of disclosure were either just accepted or, possibly, not contemplated at all. It is unlikely that many firms gave much thought to the possibility that they might have to disclose uncertainties concerning their assessment of being a ‘going concern’. This is hugely important – if the auditors disagree over the level of disclosure in the accounts, they have the potential to include those issues in their audit report.

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Auditors will need to understand how the estimates and assumptions that underlie the projections have been arrived at, and whether these are consistent with their knowledge of the business and appear realistic for the future. They will also want to understand the sensitivities within the projections to see whether these might have an impact on the validity of the ‘going concern’ basis. Some of those questions might be along the following lines, although they are by no means exhaustive or even appropriate in some circumstances: Where the projections indicate an improvement in performance (for example, in recovery rates or collecting of debts), what would be the impact if there was no improvement? By how much could partners and senior staff miss their chargeable-hours targets before the level of income and cash collection dropped to an unacceptable level? What would be the likely scenario if the firm’s highest billing partner left? What would be the likely impact if the firm lost one of its top-five clients? The problem with all of these is that there is not just one impact and, as a consequence, there might need to be more than one reaction. For example, if the firm lost one of its key clients, there would not only be the loss of income, but there is also the potential of having under-utilised staff and even partners. An important part of the process, therefore, is for the firm to have a clear idea of how it would react to variations from the projections.

What will the auditor do? Auditors need to consider two key issues in respect of ‘going concern’:
Whether they believe the approach that the firm has adopted in assessing ‘going concern’ is appropriate; and, Whether they concur with the result of assessment of ‘going concern’, including the level of disclosure, if any, required in the accounts. For auditors, the work on ‘going concern’ is not just a case of looking at some management accounts and forward projections – they need to consider how the firm has approached the assessment of ‘going concern’ and whether that approach is sufficiently robust. What is appropriate will depend on a number of factors, such as: The size and complexity of the firm; The nature of the practice; and, The quality, reliability and timeliness of normal management information.

A continual process Although the assessment of ‘going concern’ is needed for statutory accounts and audit purposes, it should be an ongoing process. Members of an LLP are subject to the wrongful trading provisions of company and insolvency law in much the same manner as directors of limited companies. Many of the considerations discussed might usefully become part and parcel of the management and governance of the firm. If they do, then not only would it provide further evidence to the auditors of the robustness of the approach to ‘going concern’, but it may also provide greater comfort to those partners not involved in the day-to-day management or governance of the practice.
Steve Gale is an audit partner in the professional practices group at Horwath Clark Whitehill LLP. He can be contacted at steve.gale@horwath.co.uk

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