The reliability of management forecasts is a key consideration for auditors. Andrew Paul shares reminders on requirements and tips for times of uncertainty.
A financial statement audit is often seen only as a comment on historical performance, despite a clear and explicit requirement on auditors to also look forward and be satisfied that a robust assessment of the audited entity’s going concern status has been undertaken. Predicting the future is not an exact science and assessing the reliability of a forecast is often tricky. But what should it look like during periods of economic uncertainty? What are the issues that should be considered to demonstrate that the entity ‘will continue its operations for the foreseeable future’? These are important questions for auditors and directors, but before answering them, let’s consider some basics.
Whose job is it to assess going concern?
First, a reminder of where the responsibilities sit in respect of going concern.
Most financial reporting frameworks contain explicit requirements for management to assess the going concern status of their entity. It is management who decide the basis of accounting and therefore they should have evidence to support that decision.
The role of the auditor is to obtain sufficient appropriate audit evidence regarding, and to conclude upon, the appropriateness of management’s use of the going concern basis and whether any material uncertainty exists about the entity’s ability to continue as a going concern.
This is an often-misunderstood area. It is not the auditor’s job to carry out the going concern assessment. They should not be generating budgets, cash flows and forecasts to enable them to discern whether their clients are a going concern or not. Auditors should be looking at what management have prepared and assessed and considering if they have reached a reasonable conclusion.
What is a forecast?
While this may seem obvious, I am sure that – as auditors – we have received a variety of documents that have been described by management as a forecast.
Forecasts should be grounded and based on evidence available at the time they are produced. They should not be optimistic, but should be realistic and based on as many relevant known factors as possible. There is often confusion between a forecast and a model. Modelling is focused on ‘what ifs’, usually considering a number of possible options and can become very theoretical, whereas a forecast should be much more about what is actually expected to happen based, for example, on orders, agreed contract pricing, agreed wage rates and so on.
As auditors, we should be prepared to be professionally sceptical about forecasts and challenge their underlying assumptions, considering not just corroboratory but also contradictory evidence wherever possible. While the entity may have many reasons for setting high targets (such as motivation of staff or pressure from investors), the auditor’s job is to see through any froth and assess the underlying fundamentals.
What are the issues to focus on in the coming year?
Assessing the reliability of a forecast has always been difficult as we are looking forward into the unknown but, in times of heightened economic and political uncertainty and volatility, it is likely to be even more difficult. So what are some of the key issues to focus on during the year ahead?
Finance costs: with interest rates rising, but with some commentators suggesting they may start to fall again later this or early next year, the cost of capital will be something to watch out for in forecasts. Has the entity got a fixed rate or variable rate loan? Are they applying a reasonable cost of capital across the forecast period?
Inflation rates: a number of entities would traditionally increase prices for inflation each year, but are they going to be able to do that? Will passing through a 10% price rise affect sales volumes, or does the forecast just assume volumes will be stable? What about increased input costs? Have these been considered? A well-written forecast will take account of both price and volume changes on both outputs and inputs.
Both finance costs and inflation will impact on discount rates used in present value calculations for items such as intangible assets and financial instruments. Be mindful that management may try to simply roll forward historical discount rates on these calculations.
Employment costs: as has been seen across the media, wage demands are increasing and so, again, forecasts will need to be realistic in including changes in pay rates during the course of the forecast. Management may be reluctant to include in their forecasts high percentage increases, but auditors need to be satisfied that these costs appear to be reasonably estimated.
Energy costs: while not always the largest expense for an entity, energy costs have increased significantly during the past 18 months – although some of this increase may have been masked by government support or previously agreed fixed-rate deals with energy suppliers. As these arrangements start to unwind during 2023, it is important that any forecasts are realistic about the costs of energy and the timings of changes in these costs.
Exchange rates: where an entity has significant sales or purchases overseas, foreign exchange rates will play a part in the forecasts. Where the entity has managed their risk with forward contracts these rates should be used, but where there is exposure to volatile market rates, caution should be exercised.
These are just a few of the many factors for auditors to be discussing and challenging management on when reviewing forecasts this audit season. It is certainly a time to be sharpening up the professional scepticism pencil.
Andrew Paul, Audit Software and Technical Manager, Baker Tilly International
Further reading