Going concern in a Hong Kong SME audit: what directors must consider

Going Concern Assessment for Hong Kong SME Audits

Every set of financial statements prepared under Hong Kong Financial Reporting Standards (HKFRS) or the SME-FRF and SME-FRS rests on the going concern assumption. When an auditor signs a statutory audit report for a Hong Kong company, they must evaluate whether the directors’ use of that basis is appropriate. For small and medium enterprises, this assessment demands more judgement than for larger entities. SMEs have fewer resources to weather financial difficulty.

The Going Concern Assumption and the Auditor’s Responsibility

The directors of every Hong Kong company must prepare financial statements on the going concern basis unless they intend to liquidate the company or cease trading. The Companies Ordinance (Cap. 622) does not define going concern directly. HKICPA standards require management to assess the entity’s ability to continue as a going concern for at least twelve months from the end of the reporting period.

The auditor’s responsibility is to obtain sufficient audit evidence about the appropriateness of the directors’ use of the going concern assumption. If events or conditions cast significant doubt on the entity’s ability to continue, the auditor must determine whether the financial statements disclose that material uncertainty adequately. This evaluation is part of every statutory audit, regardless of company size.

Hong Kong Going Concern Assessment

A Hong Kong going concern assessment begins with the directors’ own evaluation. The auditor challenges that evaluation by reviewing the company’s forecasts, cash flow projections, and available financing. For an SME, the assessment often relies on a simple cash flow forecast covering the next twelve months, supported by evidence of committed funding from shareholders or banks.

The auditor looks for indicators that the company may not be a going concern. Common red flags include:

• Net liability position: total liabilities exceed total assets on the balance sheet.
• Liquidity problems: the current ratio (current assets divided by current liabilities) is below 1.0, or the company relies on short-term borrowing to meet operating expenses.
• Loan covenant breaches: the company has defaulted on a loan agreement and the lender has not waived the default.
• Loss of a key customer or supplier: a single customer accounts for most revenue and has terminated the relationship.
• Legal proceedings: a significant claim against the company that could result in a large cash outflow.

If any of these indicators exist, the auditor will ask for a detailed management assessment and supporting documentation. The directors must provide a written forecast and explain how they intend to address the risk.

Going Concern Disclosure Hong Kong

When a material uncertainty exists, the directors must disclose it in the financial statements. The disclosure should describe the events or conditions that give rise to the uncertainty, management’s plans to address them, and a statement that the financial statements are prepared on a going concern basis despite that uncertainty.

Under HKICPA standards, the disclosure is placed in a note to the financial statements, often titled “Going Concern” or “Material Uncertainty Related to Going Concern”. The directors’ report must also address the company’s business review and principal risks, which may include going concern risks.

If the directors conclude that the going concern basis is no longer appropriate, the financial statements must be prepared on a break-up basis. This is rare for an SME that intends to continue trading. It can occur where liquidation is inevitable.

Hong Kong Auditor Going Concern

The Hong Kong auditor going concern evaluation follows HKSA 570 (Revised), “Going Concern”. The standard requires the auditor to perform procedures that include:

• Reviewing management’s assessment of the entity’s ability to continue as a going concern.
• Evaluating the reliability of the underlying data used in the forecast.
• Considering whether any subsequent events have occurred that affect the going concern assumption.
• Obtaining written representations from management about their plans and the feasibility of those plans.

If the auditor concludes that a material uncertainty exists and the financial statements disclose it adequately, the auditor’s report will include an Emphasis of Matter paragraph. This paragraph draws the reader’s attention to the disclosure in the financial statements but does not modify the audit opinion. The opinion remains unmodified.

If the financial statements do not disclose the material uncertainty adequately, the auditor must express a qualified opinion or an adverse opinion, depending on the pervasiveness of the matter. A qualified opinion states that the financial statements are fairly presented except for the effect of the undisclosed uncertainty. An adverse opinion states that the financial statements are not fairly presented.

Distinguishing Emphasis of Matter From Modified Opinion

Many directors confuse an emphasis of matter with a modified opinion. The distinction matters for the company’s reputation and for third parties such as banks and trade creditors.

• Emphasis of matter: the auditor draws attention to a matter that is properly disclosed in the financial statements. The audit opinion is unmodified. The company can still present its financial statements as clean.
• Modified opinion: the auditor concludes that the financial statements are not fairly presented (qualified or adverse) or that the auditor was unable to obtain sufficient evidence (disclaimer). The opinion is modified. The company must explain the modification to lenders and other stakeholders.

For an SME with a going concern problem, the auditor will issue an emphasis of matter if the directors have made full disclosure. A modified opinion arises only where the directors have failed to disclose the uncertainty or where the auditor cannot obtain enough evidence about the directors’ plans.

Example: Hong Kong SME with Negative Equity

Consider a Hong Kong trading company with net liabilities of HK$500,000. The company has been trading for five years but has accumulated losses. The directors have obtained a letter of support from the sole shareholder, who has agreed to provide a loan of HK$300,000 if needed. The company’s cash flow forecast shows that it can meet its obligations for the next twelve months with that support.

The directors should disclose the net liability position and the shareholder’s support in a note to the financial statements. The auditor will review the forecast and the shareholder’s commitment. If the auditor is satisfied that the support is genuine and the forecast is reasonable, the auditor will issue an unmodified opinion with an emphasis of matter paragraph that refers to the going concern disclosure.

If the shareholder had not provided a letter of support and the company had no other source of funding, the auditor would conclude that a material uncertainty exists and that the financial statements cannot be prepared on a going concern basis. The auditor would then require the directors to prepare the financial statements on a break-up basis, or the auditor would issue a qualified or adverse opinion.

Directors’ Report and Accounting Records

The directors’ report must contain a business review that includes a description of the principal risks and uncertainties facing the company. For an SME with going concern issues, this section should address the risk of continued trading and the directors’ plans to mitigate that risk.

The Companies Ordinance (Cap. 622) requires directors to keep accounting records that are sufficient to show and explain the company’s transactions and to disclose its financial position with reasonable accuracy. If the company is in financial difficulty, the accounting records must be maintained to a standard that allows the auditor to assess the going concern assumption. Records must be kept for seven years.

Practical Steps for Directors

Directors of a Hong Kong SME should take the following steps when preparing for an audit that may involve a going concern assessment:

1. Prepare a cash flow forecast for at least twelve months from the balance sheet date.
2. Document any assumptions used in the forecast, such as revenue growth, cost reductions, or new financing.
3. Obtain written commitments from shareholders or lenders who have agreed to provide financial support.
4. Disclose any material uncertainty in the financial statements, including the nature of the uncertainty and the directors’ plans to address it.
5. Ensure the directors’ report includes a discussion of the going concern risk.

If the company qualifies for the reporting exemption under section 359 of the Companies Ordinance, the disclosure requirements are reduced. The going concern assessment remains the same. The auditor must still evaluate the directors’ use of the going concern basis, regardless of the financial reporting framework applied.