Introduction
A critical element of preparing financial statements is determining the basis on which they should be prepared — a going concern basis or, if the company is not a going concern, an alternative basis. While making this determination may be relatively simple for most profit-making companies, this determination is exceptionally complex for a financially distressed entity, whose future may be uncertain. This article explores some considerations for the going concern assessment of such distressed entities.
Presenting on a Going Concern Basis
In the complex environment in which we currently operate, there is an increasing focus on going concern assessments, which are inherently subjective and multifaceted. The spotlight is on management (and, to some extent, the auditor) to ensure that an appropriate judgment is made. IAS 1 (IASB, 2022) requires that management assess the ability of the entity to continue as a going concern – i.e. that it does not intend to liquidate, cease trading or has no alternative but to do so – by evaluating, over at least the following 12 months, current and expected profitability, loan repayments and, where needed, possible replacement financing (among other factors). For companies that are in financial distress, where a lack of liquidity or solvency has affected normal trading, this assessment may be more challenging and contingent on certain outcomes.
Complexities for Distressed Entities
For a company going through a restructuring or business rescue process, challenges in assessing going concern emanate from the non-ordinary course situation and possible uncertainty about how the turnaround of the entity may play out. Some of these factors are discussed below.
Liquidity and Solvency
A company is deemed to be financially distressed when it appears it may be unable to pay all its debts, as they fall due within the immediately ensuing six months, or when it appears reasonably likely that this may be the case (Companies Act, 2008). This definition refers to commercial (or cash flow) insolvency, but a company may also be factually solvent or insolvent notwithstanding commercial insolvency. The immediate position may also necessitate a temporary cessation of trading.
However, despite potential or actual commercial insolvency, the assessment of solvency is made at a point in time and there may be further strategies for the entity that may “unlock” liquidity and resources, which will allow it to continue trading and return to solvency.
Business Rescue
Business rescue proceedings should (save for section 129(7) of the Companies Act, 71 of 2008 being applied) be entered into by a financially distressed company where there is a “reasonable prospect” of rescuing the company (Companies Act, 2008). The determination of reasonable prospect is also inherently subjective but again would require, among other things, evaluation of future plans and/or events (even if there are multiple possible scenarios) to reflect whether there is a possibility of returning the company to solvency. In this case, a rescued entity is able to continue as a going concern. However, as described below, the forecasts underlying the assessment need to be carefully assessed.
Forecast Information
Forecast information is, by its nature, derived using future (and sometimes subjective) assumptions. Robust forecasts may also include various scenarios reflecting, for example, a base case, a “best case” and a “worst case” (which reflect permutations of the assumptions). This adds further intricacy to the going concern assessment. Furthermore, forecasts need to be prepared with a focus on both financial factors and operational circumstances. Poorly considered and inadequately tested assumptions, as well as assumptions that do not factor in the consequences of the entity’s financial distress and the root causes thereof, may lead to inappropriate conclusions and further consequences for the entity and its management.
Key Considerations for Making the Assessment for Distressed Companies
Despite the complexity, management of a distressed company can still use the factors listed by IAS1.26 (IASB, 2022) and similar factors to make this assessment but must take into account essential aspects of their current position. Some of these are outlined below. (Management should also, at the time of making its assessment, document its considerations.)
Updated Cash Flow Forecast
The forecasts on which management bases its assessment should be up-to-date for all relevant circumstances — forecasts that have been prepared some time ago may no longer be reliably used if the plans for the entity have since changed or recent performance has differed significantly. While many forecasts are built using income statement and balance sheet data, a detailed cash flow forecast is critical. In particular, a monthly (or even weekly) short-term cash flow forecast will aid an assessment of the ability to pay debts as due (and thereby avoid cessation of trading) and guide management decision making.
Operations and Impacts of New Projects or Strategies
Various turnaround plans may be expected (or already in place) and may include new strategies, new projects or even the possible disposal/closure of certain non-core or non-performing segments. In this context, such plans should be subject to detailed review, which should include, among other things, the following pertinent factors.
- Revenue: In relation to income expected to be derived from these new activities, management must evaluate how any distress may have altered the business. In a business that operates a subscription model, for example, management should gauge if the distress caused poor service delivery and possibly led to long-term customer loss. Management should also identify any once-off factors that may have affected the most recent periods but will not continue into perpetuity (e.g., a sale discounting merchandise significantly to generate cash inflows but which is not reflective of future pricing of goods). Where an entity enters a new segment of the market, it is important that, in assessing the forecast, a market leader is not used as a comparative benchmark. The entity should reflect its relative position as a new entrant, as well as the possible reputational impact of its financial distress if public or known to certain stakeholders (e.g. trade creditors).
- Expenses: Corresponding costs for any new initiatives should be properly considered. Ideally, all critical costs for any new projects should be modeled from a granular level. Similarly, management should, as far as practically possible for ongoing costs, evaluate each major cost individually and apply an appropriate increase rather than a blanket inflationary increase across all costs. In addition, management should assess whether suppliers (in the context of distress and any possible missed payments) will be willing to provide any discounts and then consider how to maximise those discounts. Also, where any non-core operations will cease, any related costs of such cessation should be included (e.g. costs of decommissioning a site).
- Market Factors: Current market dynamics and the wider macroeconomic environment should also be incorporated. For example, if products are obsolete due to technological advancements in competitor products or if there is new regulation that will limit the use of the entity’s products, this impact should also be accounted for when forecasting demand (and, in turn, revenue and costs). In addition, any new levies or taxes that have been announced should be inserted as additional costs. Where credit lines have been reduced or withdrawn by suppliers due to non-payment and/or the financial distress, this must also be factored into the cash flow forecast.
Available Creditor Stretch or Deferrals
Where the forecast reflects periods of illiquidity followed by periods of growth, management should assess whether “stretching” creditors (i.e. paying slightly later than the due date per the payment terms) may be a temporary option. It is important that this is done only for a short period and after negotiation and agreement with the relevant creditor/s. Similarly, if loan repayments fall due during critical points in the turnaround period and it seems unlikely that the business could sustain itself while making these payments, a temporary deferral (or alternative sources of finance) may be a solution. Again, this can only be done with the support of the relevant lender/s and through a process of engagement and negotiation. Research shows that companies are generally raising the flag of distress and entering into restructuring processes too late (Levenstein, 2022), which often limits support for their restructuring options. Thus, timely and robust management forecasts prepared with appropriate challenge and testing are crucial, as is swift management action when the warning signs first become evident.
Conclusion
Robust going concern assessments are becoming increasingly important and increasingly relied upon. While the process of assessing the ability of a distressed company to continue as a going concern can be complex, applying critical principles and robust challenge, while having regard for the intricate and difficult circumstances in which the entity finds itself, can help management (and, where relevant, auditors) reach the appropriate conclusion.
Note: This article was first published in SAICA’s Accountancy SA magazine.
References:
Companies Act. (2008). Companies Act 71 of 2008.
IASB. (2022). IAS 1 Presentation of Financial Statements. Retrieved April 10, 2024, from ifrs.org: https://www.ifrs.org/issued-standards/list-of-standards/ias-1-presentation-of-financial-statements/#standard,
Levenstein, E. (2022, November 14). The Status of Business Rescue in South Africa – October 2022. Retrieved April 8, 2024, from https://www.werksmans.com/legal-updates-and-opinions/the-status-of-business-rescue-in-south-africa-october-2022/
