Going-Concern Evidence and the Auditor's Response
A distributor being audited for the year ended 31 December has a bank overdraft of BDT 120 million repayable on demand, a term loan of BDT 200 million with a covenant requiring a current ratio of at least 1.5, and cash of BDT 15 million. Current assets are BDT 300 million and current liabilities BDT 260 million, giving a current ratio of 1.15. The company breached the covenant on 30 November; the bank has issued a waiver valid only until 31 March next year. The directors prepared the financial statements on a going-concern basis. The auditor's cash-flow forecast review shows a funding gap of BDT 45 million in the second quarter unless a new facility is agreed. Negotiations with a second bank are at an early stage and no term sheet exists. The audit partner is under pressure to sign before the annual general meeting.
1. Evaluate whether a material uncertainty exists and how it should be reported.
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A material uncertainty exists when events or conditions cast significant doubt on the entity's ability to continue as a going concern and the entity has not disclosed it adequately. Indicators here: net current liabilities position is not present, but the current ratio of 1.15 is below the 1.5 covenant, the overdraft is repayable on demand, the covenant breach occurred, the waiver expires 31 March, and the forecast shows a BDT 45 million gap with no committed facility.
The breach and demand feature mean the overdraft and term loan may become repayable within twelve months, which would reclassify liabilities as current and worsen the position. The waiver removes the breach only until 31 March; after that the bank can demand repayment.
The auditor should obtain written representations, review the bank's waiver and correspondence, challenge the forecast, and assess whether the second-bank negotiations are sufficiently advanced. If the auditor concludes the going-concern basis is appropriate but a material uncertainty exists, the report includes an Emphasis of Matter-type paragraph headed 'Material Uncertainty Related to Going Concern', placed after the opinion, referring to the disclosure. The opinion itself remains unmodified if disclosure is adequate. If disclosure is inadequate, the opinion should be qualified or adverse.
2. Advise on the auditor's response if the directors refuse to disclose the uncertainty or if the auditor concludes the going-concern basis is inappropriate.
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If the auditor concludes a material uncertainty exists but the directors omit or misstate the disclosure, the financial statements are materially misstated. The auditor should express a qualified opinion if the effect is material but not pervasive, or an adverse opinion if pervasive. The basis for opinion paragraph must describe the matter.
If the auditor concludes the going-concern basis is not appropriate, the financial statements should be prepared on a break-up basis. If the directors refuse, the auditor expresses an adverse opinion because the financial statements as a whole are misleading.
If the auditor cannot obtain sufficient evidence to conclude - for example, the second-bank negotiations are opaque - the auditor issues a disclaimer of opinion where the possible effects are material and pervasive.
Practical steps: escalate to those charged with governance, document the assessment, consider whether the auditor should resign or whether law requires reporting to a regulator, and resist signing before the evidence is obtained. The AGM timetable is not a valid reason to accept inadequate evidence.
3. Identify the ethical and professional pressures in this scenario and how they should be managed.
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Pressures include: time pressure from the AGM, possible client pressure to avoid a modified report, and the risk that the partner's judgement is influenced by fee dependence. These threaten objectivity and professional scepticism.
The safeguards are: engagement quality control review by an independent partner; escalation to the firm's risk committee; documentation of the evidence obtained and the reasoning; a clear written communication to those charged with governance about the uncertainty; and consideration of the firm's policies on accepting or continuing the engagement if management obstructs.
Independence issues also arise if the firm has provided services that create a self-review threat, such as preparing the cash-flow forecast used as audit evidence. The auditor should ensure the forecast is management's responsibility, test the assumptions, and avoid taking on management's decision-making.
The examiner rewards identifying the specific threat, the safeguard, and the conclusion that professional judgement must not be subordinated to the timetable.