By David Lineen
During these times, when forecasts and models are guiding our lives like never before, much uncertainty looms over their accuracy and basic efficacy. This is definitely true for going concern – usually the largest judgement that management has to make when preparing annual financial statements.
The accounting regulator, the Financial Reporting Council (FRC), has placed growing pressure on auditors’ shoulders to make sure they challenge and interrogate the going concern judgements made by businesses. Therefore, to ensure your assessment of your company’s prospects makes it through this interrogation, it is worth considering some key best practice advice.
Making your case
Demonstrating credible forecasts, which show the ability of your business to survive a variety of severe but plausible scenarios, is of critical importance. These do not need to include ‘worst-case’ scenarios that are outside the realm of realistic possibility (i.e. implausible) but must address head on the main uncertainties facing the business and explore how it could cope if these took a turn for the worse (i.e. severe).
It is important that these forecasts cover a period of at least a year from the projected date of signing the financial statements and should model the impact on your cash and liquidity. On the basis of these forecasts, you can then make your assessment of going concern to present to the auditor. This assessment should display all the measures taken by the business to safeguard cash, including cost-cutting and accessing CBILS loans for example, and your reasons for confidence in the business’s near future, such as revenue growth, new products and access to new sources of funding.
Additionally, it is essential that you set out concisely all the key assumptions that underpin your forecasts and then consider what evidence you can obtain to support each assumption. Wherever possible, you should seek to use publicly available reputable information, as this is what your auditor will find persuasive. For example, you could point to IHS Markit or Tech Nation sector forecasts to support the revenue growth you are projecting over the next few years. Importantly however, you are not required to slavishly fit your forecasts to the sector-wide projections. The key is to use the publicly available projections as a benchmark to contextualise your forecasts, carefully setting out how and why your business will diverge from the sector as a whole.
If you are projecting various cost-cutting measures, you will need a coherent argument as to how those measures are feasible and will avoid unintended consequences, such as leaving the business unable to deliver on its commitments to its customers.
Finally, it is important to consider whether you can win your auditor’s confidence by pointing to previous examples of your forecasting accuracy. For example, if your budget for the previous year turned out to be broadly in line with actual results (perhaps barring any unforeseeable events), it would be worthwhile including evidence of this in your going concern assessment.
Pull the lever
Ultimately, you want to convince your auditor that as management of the business, there are many different mitigating actions you can take to preserve the business through challenging times. There are few more challenging times than the present, with KPMG’s UK Tech Monitor Index finding that Q1 of 2020 saw the steepest fall in UK tech sector output since the global financial crisis (albeit there were signs of recovery in Q3), therefore the ability of management to adapt and pull various transformative levers is crucial. Whether it is postponing a capital investment project or new software development to reduce costs, moving to a new business model where more of your software development is outsourced to locations with lower labour costs, or accessing an invoice discounting facility, demonstrating that these actions are feasible and effective could be absolutely critical in persuading your auditor that your business is a going concern.
Amending your cashflow models to depict the impact of these measures, either individually or acting in concert, will also be important so that resulting liquidity can be assessed. Monthly cash burn is always a particularly important metric, so illustrating how these measures reduce that sustainably so that cash can be conserved could well be vital. Ultimately, your auditor will want to see that you have sufficient cash to operate throughout the 12-month period.
Reverse stress testing has come to the fore recently in the auditing profession as an effective tool to gauge the resilience of a business. Building on the cashflow forecasts you have already prepared, you could model various scenarios to ascertain the point at which the business fails; for example, what level of revenues would the forecast have to sink to until the business runs out of cash? Although slightly morbid, the advantage of this process is that it demonstrates the level of headroom in the forecasts. If you can demonstrate that, in this example, your revenue is likely to be well in excess of the reverse stress test curve then you have bolstered your case that the business is a going concern, especially if you can support this with details of your current order book or correspondence with potential new customers.
Money in the bank
Financing is key. If your forecasts rely on overdraft and loan facilities, you will need to know whether these extend for the full year after signing the financial statements or if they require renewing in that time. If renewal is required, you will need to consider what evidence you can provide to the auditor, which demonstrate that the facilities are highly likely to be renewed (i.e. correspondence with bank on chances of renewal, track record of consistent renewal in the past, etc).
Additionally, if your loan financing has covenants attached, your cashflow forecasts will also need to model compliance with these covenants. If they indicate a covenant will be breached, it would be wise to initiate discussions with your lender to see if a waiver can be obtained well in advance. Although we have seen an increased willingness from banks to waive covenants in these straitened economic times, this cannot be taken for granted.
Timing it right
Auditing standards require management of a business to consider at least 12 months after issuing the financial statements when making a judgement on going concern. In practice, most businesses consider only 12 months, but there is a requirement to look beyond that 12 month period if circumstances demand it. For example, if the businesses’ loans expire in 13 months’ time, then you should factor that in to your assessment and show how you will respond to that circumstance. Equally, if the cashflow forecasts show the business running out of cash in 54 weeks’ time, again, you will need to show how you can mitigate this.
Does it work?
The technical and commercial feasibility of your product is key, particularly if your business is earlier in its life-cycle and hasn’t yet broken even. Demonstrating the progress you have made in developing the product, i.e. the obstacles you have overcome, as well as interest from customers and distributors is vital, as well as any track record of bringing similar products to market. As you are likely to be met with scepticism if your business is perennially expecting a breakthrough in terms of proving the technology works or that a market exists for it, it is essential you can point to some kind of tangible progress being made on these fronts. A frank assessment of the remaining challenges you face in achieving that breakthrough coupled with incremental, practical steps to overcome them – be it through recruitment of specialist talent, acquisition of a business with the tech solution you lack or even a more focussed marketing strategy – will be what your auditor is looking for.
If you have been successful in securing investment from knowledgeable investors, experienced in investing in tech companies, this will provide further comfort for your auditor that your product is technically feasible and commercially viable.
There is increasing pressure on companies to include more meaningful, specific information in their financial statements in order to allow users of the accounts to make more informed decisions, rather than the generic ‘boiler-plate’ narrative which you often find bulking out financial statements. Nowhere is this more apparent than in the going concern section of the financial statements where the FRC is calling for detailed disclosure of any specific events or conditions which threaten the going concern status of the business. Obviously, there is no compulsion to disclose anything that is commercially sensitive to the business, but a certain level of transparency is required. It is important that you also balance this disclosure with your plans to deal with these ‘events or conditions’ and by setting out the efficacy of the levers available to you.
Ultimately, updating your business plan to include a comprehensive and well-evidenced going concern assessment is key. Businesses often find that undertaking this process in a rigorous and thoughtful manner actually strengthens management’s appreciation of the various risks and uncertainties the business faces, facilitating better strategic leadership and giving you more confidence when speaking to lenders, investors, customers and suppliers about the prospects of the business. Moreover, you will give yourself every chance of convincing your auditor and other stakeholders of the going concern status of your tech business.
About the Author
David Lineen is a Director and haysmacintyre. He has over 13 years’ experience auditing businesses in a wide variety of sectors, from telecommunications to manufacturing to fintech, with a particular specialism in working with growing tech businesses. He has spent a large portion of his career at KPMG, where he enjoyed delivering technical audit training and promoting best practice in audit quality throughout the firm, as well as providing technical accounting advice to clients. David worked with a number of premium listed clients with global operations, as well as start-up and owner-managed businesses in early stages of their growth journey and was adept at adding value to his clients beyond issuing an audit opinion.