The Going Concern Chimera

Someone pays for my bread and butter, and I am asked to find faults in his work, and sometimes uncover his sleights of hand. In this scenario, why would I bite the hand that feeds me? Well I must do that, a certain certification authority says for reason that I am sworn to do so. Under this dispensation, I would be pretty much between a rock and a hard place. Rather an onerous existence it would be for me, if I rigorously go on nit-picking and unearthing the muck. Auditing is one of some such professions.

The auditors’ work has this inherent precept that doesn’t seem much like at arm’s length with the company’s management. This arrangement has lasted since organised entrepreneurship began. For lack of information dissemination devices, no earthshaking misdeeds came to fore. This is not to say that banks and investors were not being systematically mislead since decades. They were, and they accepted it as more or less axiomatic. As for protection against recoveries turning sour, bankers asked for stiff securities. That mind set alleviated the need for a thorough appraisal of the company’s proposal, auditor’s report included. Bankers slept well: nerves soothed by the mortgage documents they had put in their strong rooms.       

Financial statements of a company in business are based on the assumption that the entity is a going concern – the idea that a company will continue to operate indefinitely, and will not go out of business and liquidate its assets. For this to happen, the company must be able to generate and/or raise enough resources to stay operational. There are two major parties in the assessment of a company as a going concern: the company’s management and its auditors.

With negligible exceptions, the management in control of the company puts its trepidations aside and boldly asserts its confidence in future. It goes on doing so until its imminent implosion is public knowledge. The stage comes when the management, or at least the some top decision makers, know that the situation is getting out of hand. Sucked into the whirlpool they need to take drastic actions to correct the earlier wrongs. Some of those steps can be very different from the widely announced business plans; it takes enormous courage to chart a divergent course. They fall for easier solutions. Believe me, doctoring numbers is the easiest cover, and chances of living happily ever after without being found out are better that what a layman would guess. In this not-so-straight venture the company gets its lifelines on the basis of auditors’ reports. Therefore for a wide range of self-interests the company readily claims itself to be a going concern. Granted that most companies taking such a road would eventually fall by the wayside, some thought must be given to the stakeholders who can only be a hapless spectator.

Faced with fraud-prone architecture, management thinkers should reengineer the checks and balances and enlarge the battery limits for auditors. As it stands now, the auditors’ stand is exemplified in the words of Jeremy Jennings, European regulatory and public policy leader at Ernst & Young. He says that “It’s the responsibility of management to assess whether or not a going concern basis is appropriate in the current economic climate”.

You see it loud and clear here, don’t you? Mr Jennings says that the company directors should be honest and forthcoming: all would then be well and hunky dory. With this shirking and shunning, auditors would merrily go on justifying their trade. One has to surmise then that in auditors’ view, company management should truthfully state that they have serious (or, other) apprehensions that their business model may have gone haywire, and they doubt whether they would exist in one, two, or five years to come.

It would seem odd in view of the guiding principle laid down in the International Standard on Audition 570 (ISA 570), whereby “the auditor’s responsibility is to consider the appropriateness of management’s use of the going concern assumption in preparation of financial statements, and consider if there are material uncertainties on the entity’s ability to continue as a going concern that need to be disclosed in the financial statements”. It further says that “The auditor should be alert as to the existence of events and conditions and consequent business risks that cast significant doubt as to the ability of the entity to continue its operation. When the auditor identifies such events and conditions he carries out certain additional audit procedures and discusses with the management about the significance of those events and conditions. The auditor should be satisfied about the adequacy and appropriateness of the management’s assessment process and the adequacy of disclosure, if doubt about the going concern assumption exists”.

This requires the auditor to understand the business model of the entity and the dynamics of the business environment. There is only one way such a clear and precise direction can be interpreted: auditor is to go into existing and consequent business risks inherent in the client’s business model as well operational indiscretions.

Don’t surmise that yet, though. The IAS 570 relents. It goes on to stipulate that the auditor cannot predict future events or conditions that may cause an entity to cease to continue as a going concern. Accordingly, the absence of any reference to going concern uncertainty in an auditor’s report cannot be viewed as a guarantee as to the entity’s ability to continue as a going concern.

There you go, then. Auditor has rather a convenient escape route to a problem that affects shareholders, employees and myriad other stakeholders. The auditor is absolved of any errors in reading what may sometimes be plain to many informed independent analysts, and of course, of not-so-evident skeletons that they could have dug out if probing investigation was carried out. Asish Bhattacharyya wrote in Business Standard in May 2009 that “perhaps there is a need to review the defensive approach that auditing standards usually adopt. In the current business environment, it is not unreasonable for investors to depend on auditors to ensure that disclosure of uncertainties, if any, is adequate”. Mr Bhattacharyya is on the button, but for the use the use of word “perhaps”.

And I have issues with the current climate and current environment refrain. In spite of Enrons and Satyams, there is no climate change involved here; it has been the same since entrepreneurs looked for capital beyond what they could put into the venture. The lenders and external equity contributors had a need for assurance from the borrower. From hired goons to auditors in Seville Row suits cropped up. Assurors had to be wooed and kept on the borrowers’ side; and they were wooed, cajoled and kept in good humour all along. It doesn’t need elaboration that all possible shenanigans were used. Businesses, on the brink for a whole lot of reasons, have routinely failed. Stakeholders have routinely been taken for a ride.    

We, in India, have not even felt the need for going concern statements. In the Indian GAAP (Generally Accepted Accounting Principles), there is no requirement of such a disclosure from the company where it would on its own volition mention uncertainties in near future. With the adoption of International Financial Reporting System (IFRS) from 2011, some such requirement have come in.

Be as it may, it would not solve the inherent fallacy that auditor would accept the management’s statement on going concern. The irony is that auditor’s can be such a noble profession. How difficult is the endeavour to think afresh and obtain a better scheme of things that with the on-going fuzzy role separation between the management and the auditor, one wonders. The consequences of inaction on this issue are well known, ranging from misled masses to literal ruination of quite a few.

Auditors argue that the prognosis for future takes you into the realm of estimates, trend analyses, and factoring in potential problems. Conclusions drawn are therefore not certainties but most probable outcomes. Auditors say that it is probably an overkill to scare the investors on the basis of probabilities.

But, hang on a minute here, though. Plans by their very nature are for future; and they are essentially made sitting in present. All projections into future are always estimates. The entrepreneur himself also puts in his risk capital into the project on the basis of his own analysis and creating a business plan. Billions and trillions are invested today in projects that appear feasible in future. Financial institutions invest monies in projects by looking at the best available information from past, present and the proposal document that appears feasible to them. And commercial banks routinely approve working capital annually on the basis of stocks, creditors and whatever else. Surely all these players do their research, analysis and projections using audited accounts as one of the most authentic tools.

A company however has a lot many stakeholders other than the promoter-entrepreneur, term lenders and the overdraft provider. In a listed company, there are widely-dispersed shareholders and investors in the debt paper. Go a step further: there are utility companies who have counted upon this company as a consumer. Take it further, and you have hundreds or thousands of employees who put their trust in the company’s management for their livelihood and their children’s future. None of these have wherewithal to make exhaustive independent judgements on the company’s performance.

Going concern stipulations in auditing standards, mentioned earlier, may protect the auditors but do not serve as unassailable documents for the investors. Still more irksome is the fact that while lending investors such as banks have manpower resources to analyse beyond the auditor’s report, small investors spread the world over get to look only at audited financial statements.

Something stinks here. The question is whether “going concern” is assumed or to be reassessed annually. I say, in auditing the company’s books, the auditing accountants have a duty to confirm with the investors in the company, such as commercial banks and term lenders whether they will continue their support in the coming twelve months and beyond. In addition, for a comprehensive going concern reassessment, factors, e.g. substantial operation losses incurred in the current year, continuous availability of operating credit, potential litigation, chance of technology or product obsolescence, possible loss of a major customer etc. should come into consideration.

If auditors were to insist on a thorough assessment, and find that the company’s health is apparently iffy, the company directors will need to convince auditors they have realistic plans to dispose of assets and borrow money if they need cash or that they could restructure debt. Financial institutions’ foreboding would come in, as they would be reluctant to continue lending to companies in the short, let alone in medium term.

The nub of the matter is if the company directors were to be totally trusted in revealing the state of the company, there isn’t any need for a third-party inspection. Obviously that isn’t the case. Or else, giving a company the benefit of the doubt would not have culminated into lawsuits down the road by angry investors, as it happened in the infamous Enron scandal, which laid low Arthur Andersen, one of its top names. More recently Price water house Coopers has been dragged into the scandal around India’s Satyam Computer Services – whose chairman quit after saying its profits had been overstated for years, and two of their employees were arrested. And these are two of the top-5 audit firms. There are denizens of auditors who would sign on anything with or without the riders, for the simple fact that their livelihood depends on the client companies. The audit firms were found culpable in spite of their refrain that they were misinformed by the company directors.

Though not as directly as the company directors are, auditors too are responsible to the tax-collecting authority, and therefore the tax-payer. Why then the auditors not do a more intrusive study of their client companies, and say it like it is rather than malinger their incapacity. Don’t investors deserve a truer picture, warts and all? Accountants do not want to open up their definition of going concern because they need to guard their turf. The company directors do not want the concept opened up either, because some of their dirty linen would scare the investors and lenders away. In this scenario, the disturbing fact is that the lending institutions hold mortgages on borrowers’ assets, but small investors in distant places are investing on the strength of auditor’s credibility and vague impressions of the key entrepreneur’s persona. It is akin to betting without knowing the odds.

Entrepreneur should not be done away with, for without them there would be no products and services in the economy. It is also not my case that the auditors as a whole are superfluous in this process. There is need for all-encompassing terms of reference for the audit work. I am certain, auditors too would like that their product be of good value to all its users. And we shall also figure out as to who should compensates for the auditor’s good work, and it may well not be the company being audited. Towards that, for larger good, it would not be too much of a stretch to treat a company as a common pool resource (CPR) to which a large number of people’s future is moored.

Pradeep Goorha