Introduction
A popular idiom says: “You can’t see the forest for the trees.”
That phrase might apply to those interested in the financial information of Venezuelan entities, but particularly shareholders, managers, controllers, accountants and especially auditors and sole practitioners CPAs.
I mean the fact that watching what is happening in Venezuela from abroad, some observers and researchers of economic activity and country´s businesses, see "a forest of problems" affecting nearly all business entities, but undoubtedly many who live in the country do not detect it or lose sight of the problems, and surrounded by the problems as they are, fail to perceive and evaluate them accurate and timely.
Situations such as the shortage of foreign exchange needed for most activities; continuing increases in prices, labor and general expenses; controls established by government authorities to keep prices at levels they want; the absence of a real market where products and goods are traded freely; and many other uncertainties generally affecting all entrepreneurs, are part of the "forest of problems". But many who observe and assess concerned, focusing on finding solutions, can’t see the whole situation because they are looking too closely at the details.
Most probably, many actors in the business activities that have been or are being affected by these problems, individually or jointly, are dedicated to finding solutions and often are confronted with the reality that these solutions neither do not exist nor are possible in the current non-viable environment. Then, they have no choice but to wait a while and see if it resolves itself, someday, because they have no way to afford a solution.
As this lack of activity occurs, the actors don’t see the forest and as a consequence they don’t realize that exists a fundamental problem affecting many organizations, but the fact is that some are coming to the conclusion (or have reach, in many cases) that the reality seems to be indicating that their businesses are no longer viable; that they are no longer feasible; that no longer have continuity because there are no short-term solutions and much less medium or long-term solutions. Those who come to this conclusion suddenly realize that their business is no longer financially feasible; that theirs is not “a going concern business"; that there is a strong likelihood that the “Going Concern Assumption”, as outlined in accounting principles, must be evaluated urgently. Is in this moment when those actors begin to see "the forest" and no longer see just the trees.
This work is not to explore or provide solutions to the "forest of problems". Instead, it is intended to guide all of who are potentially involved in the assessment of this severe problem and how to approach it from the accounting point of view. That is the purpose of this single contribution to the Venezuelan CPA profession.
Many times, the preparation of financial statements in accordance with International Financial Reporting Standards (IFRS) is an automated process which is completed almost without taking into account that there are certain rules that must be evaluated every time when the reporting entity submit its financial statements to stakeholders. When preparing financial statements in accordance with IFRS (and US-GAAP), management must assess the ability of the entity to continue as a going concern. IAS 1 Presentation of Financial Statements and Section 3 of IFRS for SMEs contain provisions in regard to this matter.
Accounting Assesment
Financial statements are always prepared under the going concern assumption unless management has decided to put the entity in liquidation or stop business operations. It is presumed that an entity is always in operation and will remain so until management, shareholders, a government entity, or an unforeseen event determine the cessation of its business. That's what normally happens. But on occasions, internal or external factors may evidence, whether managers or owners have raised it, that the entity could not continue in operation because it does not meet all the needed conditions to accomplish its business objective.
Under IFRS, when assessing whether the going concern assumption is appropriate, management must take into account all available information about the future, which must cover at least twelve (12) months from the end of the current reporting period. An entity closing in December should consider this information for the next twelve months, i.e. until December of the following year. The degree of detail of the future considerations depends on the facts in each case.
If an entity has a history of profitable operations and ready access to financial resources, it can be concluded that the application of the going concern assumption is appropriate, without having to perform a detailed analysis. However, the standard does not define what “financial resources” are. The same concept is used in International Standard on Auditing (ISA) No. 570, "Going Concern" without further explanation.
IAS 1 requires that an entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. This is a very important concept, because if an entity is not a going concern business, it should present its assets and liabilities on the liquidation basis.
The Standard states that the determination of the carrying amount of assets and liabilities requires estimation, at the end of the reporting period, about the effects of uncertain future events on these amounts. For example, in the absence of recently observed fair market prices, it would be necessary to make estimates about the future to measure the recoverable amount of classes of property, plant and equipment; the effect of technological obsolescence or other issues on inventories; provisions subject to the future outcome of litigation in progress; liabilities and employee benefits in the long term, such as pension obligations, if present.
In US GAAP similar standards are in Subtopic 205-40 Going Concern. In this regard, FASB recently issued ASU No. 2014-15 Bulletin containing the accounting principles on this matter which are very similar to those set out in IFRS.
Audit Assesment
As mentioned, ISA 570 contains the rules for the work to be performed by the external auditor when reviewing the financial statements of an entity to render an opinion on these financial statements based on International Standards on Auditing.
In Venezuela auditors must apply those rules in accordance with that approved by the Federation of Public Accountants of Venezuela (FCCPV). See the relevant information, in Spanish: https://sites.google.com/site/fccpvauditoria/noticias/basesyfundamentos.
ISA 570 includes similar accounting standards and provisions already mentioned and specifically states in paragraph 7 that:
"Evaluating management going concern assumption involves making a judgment, at a particular point in time, about the future outcome of events or conditions that are inherently uncertain. The following factors are relevant:
• In general, the degree of uncertainty associated with the outcome of an event or condition increases significantly the more I advance into the future is the judgment made on the outcome of an event or condition. For that reason, most financial reporting frameworks requiring an explicit management assessment specify the period for which management is required to take into account all available information.
• Any judgment about the future is based on information available at the time the judgment is made. Subsequent events can contradict a judgment which was reasonable at the time it was made.
• The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors, all this affects judgment regarding the outcome of events or conditions."
A non-exhaustive list of examples of events or conditions that individually or collectively may cast significant doubt about the going concern assumption is included in paragraph 8 of ISA 570. See the next section.
Assesment of the Venezuelan Circumstances
To assess the situation in Venezuela, managers and/or shareholders must take into consideration the concepts of IAS 1 and the disclosures required in this regard (or Section 3 of IFRS for SMEs if it is a medium or small entity).
In order to guide readers on the factors that may indicate a going concern in their businesses, following is the contents of paragraph 8 of ISA 570:
“The following are examples of events or conditions that, individually or collectively, may cast significant doubt about the going concern assumption. This listing is not all-inclusive nor does the existence of one or more of the items always signify that a material uncertainty exists.
Financial
• Net liability or net current liability position.
• Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment; or excessive reliance on short-term borrowings to finance long-term assets.
• Indications of withdrawal of financial support by creditors.
• Negative operating cash flows indicated by historical or prospective financial statements.
• Adverse key financial ratios.
• Substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
• Arrears or discontinuance of dividends.
• Inability to pay creditors on due dates.
• Inability to comply with the terms of loan agreements.
• Change from credit to cash-on-delivery transactions with suppliers.
• Inability to obtain financing for essential new product development or other essential investments.
Operating
• Management intentions to liquidate the entity or to cease operations.
• Loss of key management without replacement.
• Loss of a major market, key customer(s), franchise, license, or principal supplier(s).
• Labor difficulties.
• Shortages of important supplies.
• Emergence of a highly successful competitor.
Other
• Non-compliance with capital or other statutory requirements.
• Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that the entity is unlikely to be able to satisfy.
• Changes in law or regulation or government policy expected to adversely affect the entity.
• Uninsured or underinsured catastrophes when they occur.
The significance of such events or conditions often can be mitigated by other factors. For example, the effect of an entity being unable to make its normal debt repayments may be counter-balanced by management’s plans to maintain adequate cash flows by alternative means, such as by disposing of assets, rescheduling loan repayments, or obtaining additional capital. Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable alternative source of supply.”
Additionally, as mentioned earlier, IAS 1 states that if an entity has a history of profitable operations and ready access to financial resources, it can be concluded that the application of the going concern assumption is appropriate without having to perform a detailed analysis.
Therefore, an analysis of what the term "financial resources" would mean, apply. A broad definition of “financial resources” includes the net financial assets of an entity that have some degree of liquidity. Cash, accounts and notes receivable, deposits with financial institutions, foreign exchange and equity and bond holdings are part of the financial resources, net of financial liabilities.
Within the Venezuelan business environment, it is my opinion that foreign currency are, per se, the main financial resource of many entities and comprise its principal financial objective, because these entities are facing a continued difficulty to get foreign currency in a country that maintains a tight exchange control since 2003. Financial resources in local currency seem to abound at relatively low interest rates (compared to current rates of inflation) and this issue could be considered a mitigating internal factor.
Perhaps, many entities, especially large entities exploiting high revenue businesses, have big levels of cash in banks and accounts receivable in local currency, but with many are in trouble to convert it into foreign currency. It is known that many large multinationals have failed to pay dividends to its shareholders from abroad due to the difficulty in obtaining foreign exchange, although they have reported large amounts of net earnings in local currency. Working on a business model based only in local transactions, these entities would have no difficulty in continuing to operate without foreign currency. However, managers of these entities are struggling to get foreign currency to accomplish the process for assets replacement; payment of royalties and dividends; or for other purposes, which is not guaranteed by national government.
Other not so large entities may own financial resources in local currency but as they cannot be converted into foreign exchange for imports of goods and services or for payment of outstanding debt in foreign currency, are prevented from continuing its regular operations, perhaps for long periods during which they have to continue paying salaries, social charges and expenses of any kind, without the possibility of generating revenue because they don’t have inventory or because certain equipment or machinery for the production have being halted waiting for inputs or parts from abroad.
In addition to the issue of foreign currency, which is the main issue in Venezuela today, a set of situations require management entities and their auditors to review for evaluating the going concern assumption, such as:
1. Inflexible government controls on prices that undermine the ability of the entity to decide on the pricing of their products or services, with the consequent possibility of incurring losses from continuing operations.
2. Risk of devaluation of the national currency which permanently boost local price increases. New exchange rates signify increases in price of products and services. In an unending process to justify prices within the framework of price control´s law, entities would incur in more operating losses while new prices are approved by governmental authorities.
3. Exacerbated inflation causing similar effects to the above, because increases in costs are not easy translated to prices of goods and services because of the price controls.
4. Excessive and complicated legal framework that requires entities to disburse amounts for the payment of employee benefits, taxes and legal contributions of all kinds, without any connection with the operation of the entity. That is, entities must make those payments, whether they are not producing at full capacity or are not recovering the costs of its goods and services.
5. Risk of prolonged closures of plants and warehouses if government authorities decide that the entity has violated certain laws, for example the mentioned Law of Fair Prices.
6. Difficult to import essential supplies and goods and services for own production due to the inability to obtain foreign currency for imports.
7. Difficulty obtaining local goods and supplies necessary for the production itself, because other producers or importers in the country face the same problems of production and/or importation, all contributing to high level of shortages of many goods and supplies.
8. Risk of recording continued losses for the buildup of financial and production problems; untimely labor strikes without reason or justification; arbitrary plant and warehouses occupations by workers with or without justified reasons; sales diminished with excessive costs and expenses increased for the reasons previously discussed.
9. Inability to pay debts in foreign currency due to the failure to obtain foreign exchange through legal mechanisms of exchange and risk of incurring in violations of laws created to prohibit acquisition of foreign currency out of these mechanisms.
10. Risk (although not as significant) of expropriation of all kinds of assets due to unforeseen or unanticipated government decisions.
11. Loss of key management, production and marketing personnel as a result of emigration of qualified professionals to other countries.
12. Seizure of products by actions of governmental authorities based on the framework of laws such as the Law of Fair Prices.
13. Risk of losses in accounts receivable from entities that, in turn, would be having trouble going concern assumption.
14. Depressed real estate prices caused by the atmosphere of general uncertainty about the assets in the country; and
15. Other minor.
Analyzing these factors and others discussed above in an individualized context, it could be concluded that an entity would not face problems on its status as a going concern, but if somebody combine several of them and the test results are negative, he could reach to a different conclusion.
Therefore, permanently and full evaluations must be completed by management and shareholders (and external auditors, if applicable). In case an entity concludes negatively in its analysis, the going concern assumption could be impaired.
Consequences of the Analysis
The accumulation of some of the matters discussed in the previous section doesn’t necessarily determine that an institution faces difficulties to ensure compliance with the Going Concern Assumption. New business decisions; changes in government policies and laws; improved economic outlook; change of line of business; change of management approach; etc., can be used as a mean to justify that the entity must, yet, be considered as a going concern, even though financial reports could show severe financial problems. In such cases, the disclosures required by IFRS would help users of financial statements of these entities to understand the situation, which imply a good preparation of management to properly develop such disclosures.
However, if the conclusions from the analysis are that the entity is facing severe business problems that would build up in the immediate future; i.e. the continuity of the entity would be under a certain level of uncertainty about their future, management must obtain specialized audit and legal advice to properly proceed before reporting.
IFRS does not contain any provision for the presentation of financial statements under a basis for liquidation of a company with going concern problems. A guide for those interested in improving their knowledge on such an accounting basis, can found it in the Subtopic 205.30 US GAAP Presentation of Financial Statements - Liquidation Basis of Accounting.
Conclusion
We can only see the forest when we get out of the trees!
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This is a translation of the original work in the Spanish language titled "Hipótesis de Negocio en Marcha" published in this Blog in September 26, 2014.
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