Going Concern Assessment for a Distressed Entity
Your client, 'Sevan Hotels' CJSC, has experienced declining occupancy rates and cash flow problems. As of 31 December 2023, the company has a net loss of 200 million AMD, negative operating cash flow of 150 million AMD, and a current ratio of 0.8. The company has a bank loan of 500 million AMD due in June 2024. Management has prepared a cash flow forecast for 12 months from the date of approval of the financial statements (expected 30 April 2024). The forecast assumes a 20% increase in revenue due to a new marketing campaign and a renegotiation of the loan terms. However, the bank has not yet agreed to extend the loan, and the marketing campaign is not yet launched. Management believes the going concern assumption is appropriate. The auditor has obtained the forecast but is skeptical about the assumptions.
1. Evaluate management's going concern assessment and identify the key factors that may cast doubt on the entity's ability to continue as a going concern.
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Under ISA 570, the auditor must evaluate management's assessment of the entity's ability to continue as a going concern. Key factors: (1) Net loss of 200 million and negative operating cash flow indicate financial distress. (2) Current ratio of 0.8 shows liquidity problems. (3) The bank loan of 500 million due in June 2024 is a significant near-term obligation; without renewal, the company may not be able to pay. (4) The forecast relies on a 20% revenue increase from an unlaunched marketing campaign, which is speculative and not supported by historical performance. (5) Loan renegotiation is not confirmed; there is no written agreement from the bank. These factors raise substantial doubt about the going concern assumption. Management's assumption may not be supportable unless they can provide convincing evidence of the loan extension and the effectiveness of the marketing campaign. The auditor should challenge the assumptions, obtain corroborating evidence (e.g., bank correspondence, marketing plans), and consider whether the forecast is realistic.
2. What additional audit procedures should the auditor perform to assess going concern? If the auditor concludes that a material uncertainty exists, how should it be reflected in the auditor's report?
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Additional procedures: (1) Obtain and review the bank loan agreement and any correspondence with the bank regarding renewal; confirm the status directly with the bank. (2) Evaluate the feasibility of the marketing campaign: review the plan, budget, and any market research; compare to historical revenue increases. (3) Perform sensitivity analysis on the cash flow forecast to assess the impact of not achieving the revenue increase. (4) Review subsequent events after year-end to see if the loan was renewed or new financing obtained. (5) Inquire of management about other sources of financing or cost-cutting measures. (6) Obtain written representations from management regarding their plans and intentions. If the auditor concludes that a material uncertainty exists but management has adequately disclosed it, the auditor should include an Emphasis of Matter paragraph in the auditor's report (or a separate section under ISA 570) drawing attention to the disclosure. If the auditor concludes that the going concern assumption is inappropriate, the auditor should issue an adverse opinion. If management refuses to make adequate disclosures, the auditor should issue a qualified or adverse opinion. Given the facts, if the loan is not renewed and the campaign is uncertain, a material uncertainty likely exists; the auditor should ensure the financial statements include clear disclosure of the uncertainty and the basis for management's assessment.