Page 114 - DCOM204_AUDITING_THEORY

Auditing Theory

Notes when an entity may not satisfy any one of them and as a consequence shows results which may
not affect its liquidity, though theoretically there may be a possibility of technical insolvency.
The standard is not clear as to the manner of consideration of the same. For example, if a
company with a small capital base has been showing marginal profits after depreciation but
without accounting for gratuity. Gratuity is paid as and when liability arises on cash basis. If the
gratuity is provided, the company will come under the purview of potential sickness under
SICA. Such a policy is violative of the accrual concept. The company’s activities may not be
affected because gratuity is only a contingent liability and the liability to pay arises only when
all workers decide to retire on the same day. Hence, the auditor need not doubt the condition of
the company, as days to day activities are not affected.

6.8.2 Financial Indicators

There are a number of indicators which can help the Auditor in determining whether the status
of a company as a going concern is affected. These indicators can be categorized into three sets.
These are:
1. The financial indicators that indicate whether the company is a ‘going concern’ is as
follows:
Negative net worth or negative working capital;

fixed term borrowings approaching maturity without realistic prospects of renewal
or repayment or excessive reliance on short term borrowings to finance long term
assets;

Adverse key financial ratios; Substantial operating losses; Substantial negative cash
flows from operations;

Arrears or discontinuance of dividends;
Inability to pay creditors on due dates;
Difficulty in complying with terms of loan agreements;
Change from credit to cash on delivery transactions with suppliers;

Inability to obtain finance for essential new product development or other essential
investments;
Entering into a scheme of arrangement with creditors for reduction of liability.
2. Operating indicators: The operating indicators showing that the company is a ‘going
concern’ is as follows:
Loss of key management without replacement;

Loss of major market, franchise, license or principal supplier;
Labour difficulties or shortage of important supplies.
3. Other Indicator: The other indicators of the same are: Non-compliance with capital or
other statutory requirements; Pending legal proceedings against the entity that may, if
successful result in judgments that could not be met; Changes in Legislation or
Governmental policy Sickness of the company under any statutory definition. Thus, it can
be stated that the role of the Auditor has been made more proactive than ever before as far
as the ‘going concern’ is concerned. Any of the above factors if present or apprehended
will entail detailed enquiry by the Auditors. While looking at the above mentioned
criteria the AS-3 which is regarding cash flow has to be kept in mind. The moment a cash
flow statement is prepared, normally it would show the true colors of the company.

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