Going concern, covenant breach and post year-end forbearance
You are the audit senior on the audit of Calderside Engineering Ltd, a UK manufacturer with revenue £38m and a bank loan of £10m. The loan covenants require interest cover of at least 3.0x and net debt/EBITDA below 2.5x. At 31 December 20X5 the company reported interest cover of 3.1x and net debt/EBITDA of 2.4x. In February 20X6 the company lost its largest customer, representing 22% of revenue, and the directors' 12-month cash flow forecast shows a covenant breach in nine months unless a new contract with a prospective customer is signed. That contract is at heads of terms only. The overseas parent has offered a letter of support, but it is not a guarantee and the parent has no obligation to fund. In March 20X6, before the audit report is signed, the bank issued a six-month forbearance letter. The directors propose to use the going concern basis and include a material uncertainty disclosure.
1. Assess whether the going concern basis remains appropriate and whether the evidence is sufficient. What further procedures would you perform?
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Framework. ISA (UK) 570 requires me to evaluate management's assessment over at least 12 months from the approval of the financial statements. The loss of 22% of revenue is a significant indicator, and the forecast breach in nine months means the assessment period is critical.
Evidence. The heads of terms are not a signed contract and may not be enforceable. I would inspect the terms, assess the counterparty and obtain evidence of creditworthiness. The parent support letter is not a guarantee; I need to assess whether the parent has the ability and legal obligation to fund. The six-month forbearance helps, but it covers only part of the 12-month period. I would obtain direct confirmation from the bank, review board minutes and the cash flow model, and perform sensitivity analysis on the new contract.
Conclusion. The going concern basis may still be appropriate if the bank forbearance and realistic cash flow headroom support trading for at least 12 months. However, a material uncertainty is likely unless the contract is signed and the parent support is enforceable. I would obtain written representations and consider whether disclosure is adequate.
2. Draft the key disclosures and explain the impact on the audit report if the directors include adequate disclosure, and if they do not.
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Adequate disclosure. If the directors disclose the principal events, the nature of the uncertainty, the plans and the bank forbearance, the audit report can be unmodified but must include a separate 'Material Uncertainty Related to Going Concern' section under ISA (UK) 570. The section must refer to the relevant note and state that the auditor's opinion is not modified.
Inadequate disclosure. If the note is missing or misleading, ISA (UK) 705 requires a modified opinion. If the effect is material but not pervasive, qualify ('except for'); if the going concern issue is fundamental and pervasive, or the basis is inappropriate, an adverse opinion may be needed. The auditor should also consider whether the matter is a key audit matter and communicate it to those charged with governance.
3. How does the March forbearance letter affect your conclusion, given it was received after the year-end but before the audit report date?
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Subsequent event. The forbearance letter is received after the year-end but before the audit report date, so ISA (UK) 560 applies. It provides evidence about the bank's position at the year-end and about the conditions that existed at that date. It is not a cure-all because it lasts six months and the going concern assessment covers at least 12 months.
Audit response. Obtain the letter directly from the bank, check its terms and any conditions, and update the cash flow forecast. Consider whether it is an adjusting event (it may confirm the loan was not in default at year-end) or a non-adjusting event requiring disclosure. If it materially affects the going concern conclusion, update the disclosure and the audit report. Document the date the evidence was obtained and the effect on the report.