Going concern assessment in the Covid-19 environment

The going concern concept requires that the financial statements of a company must normally be prepared under the assumption that the business will continue to operate and will not be liquidated. Therefore, the going concern value of a business is typically much higher than the breakup or liquidation value. However, this assumption has to be abandoned if there is significant doubt about the entity’s ability to continue as a going concern.

Management must make the going concern assessment based not only on information that exists on the balance-sheet date but events occurring after the balance-sheet date for conditions existing at the balance-sheet date (Ind AS 4). As Covid-19 was declared as a global pandemic by the WHO before March 31, 2020, the financial reports prepared for the financial year 2019-20 should reflect a post-Covid going concern assumption.

While the management is primarily responsible for the going concern assessment, the auditors are required to provide their opinion by applying professional judgment and professional scepticism based on the management’s representations and their independent assessment. A modified opinion is warranted if the management fails to recognise the financial impact of Covid-19 appropriately.

While assessing the going concern assumption, the management (and the auditor) will have to consider all available information and make reasonable estimates and judgments about current and future profitability and cash flows, liquidity and solvency issues like debt repayment schedules, borrowing and refinancing capabilities, asset valuation, financial conditions of key customers and suppliers, etc. (Ind AS 1).

Some of the factors are internal to the organisation, and the management is probably better placed than anybody else to assess these. However, neither the management nor the auditors have any particular expertise in making judgments about macroeconomic and public health factors like the lingering impact of Covid-19.

We believe that it would be dysfunctional to leave the post-Covid going concern assessment to the management and auditors. First, different companies (and auditors) will make different assumptions about the future evolution of the pandemic, and produce completely different financial assessments for companies whose economic position might be quite similar. Comparability of financial statement across companies would be fatally compromised.

Second, the preparation of financial statements and the conduct of the audit under the current environment is already quite challenging. There is no merit in wasting precious resources of both the management and the auditors on a useless debate regarding macro assumptions about which neither has any expertise.

Default assumptions

Investors and other users of financial reports would benefit from all companies making going concern assessments based on a common template of assumptions laid down by the regulators (including Ministry of Company Affairs, National Financial Reporting Authority, Reserve Bank of India, and Securities and Exchange Board of India).

Neither the management nor the auditors would be allowed to deviate from these default assumptions unless there is compelling evidence to the contrary. The management and the auditors would be shielded from liability for a wrong going concern assessment so long as this assessment was based on the default assumptions.

It might appear that we are asking the regulators to perform an impossible task of laying down default assumptions for the entire Indian business sector in an environment where the regulators themselves are overburdened and struggling to perform their normal functions. However, there are simple ways of setting the default assumptions: for example, the default assumption might be that while the first quarter of 2020-21 (April-June) has been more or less wiped out, there will be a V-shaped recovery and revenues for the remaining three quarters (July-March) will be similar to the corresponding period of 2019-20 with a possible adjustment for the historical annual growth rate.

If the regulators have enough time and information, they might lay down different recovery assumptions for certain sectors. For example, the tourism and travel industry may be subjected to a more pessimistic assumption.

Standard practices

Some analysts might think that our assumptions are too crude, simplistic and optimistic, but practices similar to what we recommend are, in fact, quite standard globally. Central banks performing a stress test of all banks under a common set of assumptions about macroeconomic shocks is standard practice across the world. On Covid-19 itself, we have already seen private contracts using an approach similar to what we recommend. For example, Live Nation Entertainment renegotiated its debt covenant so that the actual EBITDA of certain quarters of 2020-21 would be replaced by that of corresponding quarters of 2019-20.

Second, in times of crisis where financial stress is widespread, some degree of regulatory forbearance is a well-established policy response, and that principle justifies a lenient assumption. Finally, nobody knows for sure what will happen, and we have to just get on with life.

Moreover, if regulators are not satisfied with a simple assumption about a common recovery curve for the entire economy or different sectors, regulators can instead specify assumptions about macroeconomic factors like GDP growth, inflation rates, interest rates, unemployment, foreign exchange rates, industrial production, crude oil prices, household consumptions and savings rates, tax rates, economic reliefs, import policy, labour laws, government grants and concessions, and require each company to turn these macro forecasts into forecasts about its revenues and cash flows.

Another issue with the going concern test is that even if a company is balance-sheet solvent, it may be cash-flow insolvent because of lack of liquidity and access to financing. The regulators must also require companies to assume that the current accommodative monetary policy and central bank liquidity support policies would continue during the forecast horizon.

The central bank may also lay down additional assumptions to be used by financial institutions to deal with issues related to collateral valuation, debt covenant requirements, and initiation of bankruptcy proceedings.

The writers are on the faculty of IIM Ahmedabad