ARMGT402 – DECEMBER 2023

Going Concern Question 1

Medimade Ltd is an established pharmaceutical company that has, for many years, generated 90%
of its revenue through the sale of two specific cold and flu remedies. Medimade has lately seen a
real growth in the level of competition and demand for its products has significantly declined. To
make matters worse, the company has not invested sufficiently in new product development and
so has been trying to remedy this by recruiting suitably trained scientific staff, but this has proved
more difficult than anticipated.
Medimade also needed to invest $2 million in plant and machinery. It wanted to borrow this sum
but was unable to agree suitable terms with the bank; therefore, it used its overdraft facility, which
carried a higher interest rate. Consequently, some of Medimade’s suppliers have been paid much
later than usual and hence some of them have withdrawn credit terms meaning the company must
pay cash on delivery. As a result of the above, Medimade’s overdraft balance has grown
substantially.
The directors have produced a cash flow forecast and this shows a significantly worsening position
over the coming 12 months.
The directors have informed you that the bank overdraft facility is due for renewal next month, but
they are confident that it will be renewed. They also strongly believe that the new products which
are being developed will be ready to market soon and hence trading levels will improve and
therefore that the company is a going concern. Therefore, they do not intend to make any
disclosures in the accounts regarding going concern.
Required:
a. Define the going concern basis of accounting (2 marks)
b. Identify any potential indicators that the company is not a going concern and
describe why these could affect the ability of the company to continue trading on
a going concern basis. (8 marks)
c. Explain the audit procedures that the auditor of Medimade should perform in
assessing whether the company is a going concern. (6 marks)
d. Describe the impact on the auditor’s report of Medimade if the auditor believes
the company is a going concern but a material uncertainty exists. (4 marks)
Suggested Solution

a. The going concern basis of accounting is appropriate when management believes the company
will continue in business for the foreseeable future. IAS 1 Presentation of Financial Statements
requires that management automatically prepare financial statements on a going concern basis
unless they believe that the company will soon cease trading.

(b) Indicators Why going concern may be affected

Medimade has seen a If the company is not able to increase demand for its products, it will
significant decline in struggle to generate sufficient operating cash flows leading to going
demand for its products. concern difficulties.
Medimade generates 90%
As the market is very competitive and Medimade has only two
of its revenue through sales
products, it is very dependent on these and must ensure that it makes
of just two products, and
sufficient sales as otherwise it may face difficulties in meeting all
this market has now become
expenses.
very competitive.
As current products reach the end of their life-cycle, they will bring
Lack of investment in future
in diminishing cash flows. Without new products to generate future
product development
income, operating cash flows will be strained.
The company has decided that it needs to develop new products,
The company is struggling
however, this is a highly specialised area and therefore it needs
to recruit suitably trained
sufficiently trained staff. If it cannot recruit enough staff, it could
scientific staff to develop
hold up product development and stop the company from increasing
new products.
revenue.
Medimade was unable to If Medimade was unable to obtain finance for its investment, this
obtain suitable funding for could indicate that the banks deem the company to be too risky to
its $2m investment in plant lend money to. They may be concerned that Medimade is unable to
and machinery. meet its loan payments, suggesting cash flow problems.
Failing to make payments to suppliers on time could ultimately lead
Some trade payables have to some of them refusing to supply Medimade. Therefore the
been paid much later than company may need to find alternative suppliers and they could be
their due dates. more expensive which will decrease operating cash flows and
profits.
That Medimade must now make cash on delivery payments puts
Some suppliers have
additional pressure on the company’s overdraft, which has already
withdrawn credit terms
grown substantially. This is because the company has to pay for
from Medimade resulting in
goods in advance but it may not receive cash from its receivables
cash on delivery payments.
for some time later.
The overdraft facility has Medimade’s overdraft has grown significantly and it is heavily
increased substantially and dependent on it to pay its expenses. If the bank does not renew the
is due for renewal next overdraft and the company is unable to obtain alternative finance, it
month. may not be able to continue to trade.
(c) Procedures
 Obtain the company’s cash flow forecast and review the cash in and out flows. Assess the
assumptions for reasonableness and discuss the findings with management to understand if the
company will have sufficient cash flows.
 Inspect any current agreements with the bank to determine whether any key ratios have been
breached.
 Inspect any bank correspondence to assess the likelihood of the bank renewing the overdraft
facility.
 Inquire and discuss with the directors whether they have contacted any alternative banks for
finance or whether they have any other means of repaying the bank overdraft.
 Inspect the company’s post year-end sales and order book to assess if the levels of trade are
likely to increase and if the revenue figures in the cash flow forecast are reasonable.
 Review post year-end correspondence with suppliers to identify if any further restrictions in
credit have arisen, and if so ensure that the cash flow forecast reflects an immediate payment
for trade payables.
 Inquire of the lawyers of Medimade as to the existence of litigation and claims; if any exist,
consider their materiality and impact on the appropriateness of the going concern basis.
 Perform audit tests in relation to subsequent events to identify any items that might indicate
or mitigate the risk that the going concern basis may not be appropriate.
 Inspect the post year-end board minutes to identify any other issues that might indicate
financial difficulties for the company.
 Inspect post year-end management accounts to assess if in line with cash flow forecast.
 Consider whether any additional disclosures as required by IAS 1 Presentation of Financial
Statements in relation to material uncertainties over going concern should be made in the
financial statements.
 Obtain a written representation confirming the director’s view that Medimade is a going
concern.

(d) Impact on auditor’s report

 The directors of Medimade have agreed to make going concern disclosures. The implications
for the auditor’s report depend on the adequacy of these disclosures.
 If adequate, the audit opinion will be unmodified. However, a Material Uncertainty Related to
Going Concern section would be included in the report. This will state that there is a material
uncertainty and reference the disclosure note in the financial statement for details. It will also
state that the audit opinion is not modified in respect of this matter. This section would be
included after the basis for opinion section.
 If the disclosures made by management are not adequate, the audit opinion will need to be
modified. A disagreement modification will be required. This will usually be a qualified
“except for” opinion but could be an adverse opinion if the matter is pervasive.
 A basis for opinion section describing the matter giving rise to the modification will be
included after the opinion section and this will clearly identify the going concern uncertainty.
The opinion section will be amended to state “except for” or the financial statements are not
fairly presented.