Vellick Fabrication: Covenant Waiver, Customer Loss and a Going Concern Dispute
Vellick Fabrication Ltd is a private manufacturer with revenue of $58 million and a 31 December 20X5 year-end. The audit partner records the following. First, Vellick breached a covenant on its $12 million term loan on 30 November 20X5; the bank has given a waiver that expires on 31 March 20X6. Second, Vellick's largest customer, 31% of revenue, announced in February 20X6 that it will move sourcing to a competitor from April 20X6. Third, the directors' twelve-month cash flow forecast shows headroom of $1.2 million, but it assumes a $3 million revolving facility will be renewed in June 20X6 and a 15% improvement in gross margin that has not been achieved in any of the last three years. Fourth, materiality is $1.1 million. The directors refuse to disclose a material uncertainty, arguing the covenant waiver resolves the loan issue. The audit report is due 20 March 20X6 and the financial statements are approved the same day.
1. Evaluate whether a material uncertainty over going concern exists and whether the going concern basis remains appropriate.
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Assessment period. Going concern is assessed for at least twelve months from 20 March 20X6, i.e. to March 20X7.
Indicators pointing to material uncertainty
- The covenant breach at 30 November 20X5 means the $12 million loan is repayable on demand unless waived. The waiver expires 31 March 20X6 - only days after the financial statements are approved and well within the assessment period. The loan must be classified as current at 31 December 20X5 unless a longer waiver or refinancing is obtained.
- Forecast headroom of $1.2 million is thin relative to materiality of $1.1 million and to the size of the loan. A small adverse variance wipes it out.
- Two key assumptions are unsupported: renewal of the $3 million facility is not agreed, and a 15% gross margin improvement has not been achieved in three years.
- The February 20X6 loss of a customer representing 31% of revenue is a major cash inflow risk, even though it is a non-adjusting event for the 20X5 numbers.
Conclusion. A material uncertainty exists. The going concern basis may still be appropriate if the directors have credible plans - an extended waiver, a committed facility and a credible cost response - but that is not yet demonstrated. The auditor should not accept the assertion that the waiver resolves the issue.
2. If the directors continue to refuse disclosure, what audit opinion should be issued and why?
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If disclosure is adequate - an unmodified opinion with a separate Material Uncertainty Related to Going Concern section, placed immediately after the opinion, referring to the note and stating that the auditor's opinion is not modified.
If the directors refuse disclosure - the financial statements are materially misstated because a material uncertainty that users need in order to understand the financial statements is omitted. The auditor then chooses between qualified and adverse by reference to pervasiveness:
- Qualified opinion (except for) if the effects are material but not pervasive - for example, where the going concern basis remains appropriate, the numbers are fairly stated, and only the note is missing.
- Adverse opinion if the omission is pervasive because it goes to the heart of users' understanding of the financial statements as a whole. Given that the uncertainty concerns the entity's ability to continue, and the loan is classified as current, an adverse opinion is often the better fit.
- If the going concern basis is itself inappropriate (liquidation basis required), the misstatement is pervasive and the opinion is adverse.
The auditor cannot issue a disclaimer to avoid the dispute; a disclaimer is for an inability to obtain evidence, not for a known misstatement caused by management's refusal.
3. What should the auditor do before signing the 20 March 20X6 report, and how should the February customer announcement be treated?
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Procedures before signing
- Obtain the extended or renewed covenant waiver and confirm it directly with the bank; a waiver to 31 March 20X6 does not cover the assessment period.
- Confirm in writing the status of the $3 million revolving facility, including any term sheet, conditions precedent and expiry.
- Test the forecast: challenge the 15% margin improvement against historical data, sensitise for the loss of the 31% customer, and model a reasonable downside.
- Review board minutes, post year-end management accounts, cash balances and aged receivables for the period to March 20X6.
- Obtain written representations on the forecasts, the covenant position and the completeness of known uncertainties.
- Consider whether the loan should be reclassified as current at 31 December 20X5; this is a year-end measurement issue, not only a disclosure issue.
- Communicate with those charged with governance and document the rationale; consider legal advice if the bank's position is unclear.
February announcement
It is a non-adjusting subsequent event for the 20X5 financial statements unless it evidences a condition existing at 31 December 20X5. It is, however, highly relevant to going concern and to the forecast. If the loss is material, consider whether a disclosure note is needed; if the going concern assessment changes, the audit opinion follows. The auditor should also consider whether the announcement should be reflected in the cash flow forecast used for the going concern conclusion.