Going concern indicators
There are a range of matters which cast doubt on Daley Co’s ability to continue as a going concern. In particular, the company appears to be exhibiting many of the indicators of a business which is overtrading.
Revenue and profitability
Daley Co has experienced a significant increase in revenue of 28·4% which may not be sustainable in the short to medium term without additional external sources of finance. The company is also experiencing a significant decline in its operating profit margin and net profit margin. It is notable that even after taking account of the provision, other operating expenses have increased by more than 4·3 times ((9·1 – 3·5)/1·3) resulting in an overall loss of $3·4 million in the current reporting period. It is possible that the company has had to reduce its selling prices in order to achieve the high level of sales growth and that this has resulted in a negative net profit margin this year of (30·1%).
Liquidity and working capital​​​​​​​
Daley Co has also suffered a decline in liquidity as evidenced by a fall in its current ratio from 2·4 to 1·6 and in its acid test ratio from 1·1 to 0·6. A review of the company’s working capital ratios indicates long and worsening inventory holding periods (481 days in 20X8 compared to 466 days in 20X7) and overall inventory has increased by 57% which may be indicative of problems in relation to the saleability of inventory which is in breach of domestic regulations. The company is currently taking on average 120 days to collect its trade debts (108 days in 20X7) and requires an average of 348 days in 20X8 (365 days in 20X7) to pay its trade payables. Although this is a fall in the average payment period compared to the prior year, it still appears to be a long period which may be related to ongoing payment disputes in relation to the regulatory breaches noted previously. Overall, trade payables have increased by 44·8% on the prior year and the company may struggle to settle this liability given its worsening cash position, which may in turn result in a loss of goodwill with its suppliers and a refusal to supply or to withdraw credit in the future which would severely restrict the company’s operations. The poor working capital management and declining liquidity have resulted in Daley Co’s cash position deteriorating from a positive position of $0·6 million in 20X7 to an overdraft of $1·8 million in 20X8 which is significant at 7·8% of total assets.
Gearing and finance
In addition to problems with short-term finance and liquidity, Daley Co is also exhibiting a significant increase in gearing as evidenced by the increase in debt to equity from 2·3 in 20X7 to 6·4 in 20X8 and a fall in interest cover from 6·6 times to (1·5) times over the same period, indicating that the business is unable to service its current levels of finance. The company’s finance costs as a percentage of long-term borrowings have increased from 5·6% in 20X7 to 13·4% in 20X8. This may be due at least in part to the interest on the overdraft proving to be an expensive way of financing the entity’s operations and if the overdraft has not been agreed with the bank, the company may be incurring additional penalties and charges thereby putting additional strain on the company’s cash flows. The increasing finance costs may also reflect lenders already perceiving Daley Co to be a high credit risk. It is also notable that non-current assets have decreased by 7·5% this year which suggests that the business is also struggling to replace and renew its existing capital expenditure levels. If this is the case, it may cast further doubt on the feasibility of the planned expansion of its operations.
Legal claim​​​​​​​
Given Daley Co’s current financial position, it seems unlikely that the business will be able to settle the legal claim of $3·5 million which threatens to place severe demands on the company’s cash flow. Indeed, if there is a prospect of more claims arising in the future, the problems with the saleability of inventory and management of working capital as a result of the regulatory breaches discussed earlier may worsen further leading to a greater deterioration in the company’s cash flow position.
Cash flow forecast​​​​​​​
Overall, Daley Co’s ability to continue to trade appears to be dependent on obtaining the new bank finance which it has assumed in its cash flow forecast. The bank financing is needed to meet existing liabilities and it is doubtful whether sufficient funding will be available in order to finance the proposed expansion. Moreover, the forecast itself appears to be unrealistic in its other assumptions. In particular, the assumption that the business’s revenue will grow by 25% seems optimistic given the arrival of a major competitor in its market place and the projected trade receivable collection period of 60 days may well be unachievable on the basis of the historic ratios identified above. A return to a positive cash position is dependent on these assumptions and obtaining the new bank finance which may not be forthcoming based on the bank’s assessment of the business’s current financial position and performance.

Audit evidence on the cash flow forecast
The audit working papers should include sufficient evidence that appropriate audit procedures have been conducted in relation to the assumption that Daley Co is a going concern at the reporting date, including the following:
– Evidence of agreement of the opening cash position to the cash book and bank reconciliation.
– Reperformance by the audit team of the client’s calculations in preparing the forecast in order to check its arithmetic accuracy.
– Details of a review of the results of any market research which has been conducted by Daley Co for the next 12 months in order to assess the potential impact of the new competitor
– Notes from meetings with management detailing discussion of the key assumptions made by management in the preparation of the forecast (including the growth rate and receivables days) and an assessment of the consistency of the assumptions with the auditor’s knowledge of the business and with management’s intentions regarding the future of the company and corroborating evidence of assumptions.
– Evaluation by the audit team of previous profit and other financial forecasts and their outcome in order to assess the consistency of the cash flow forecast with other prospective information prepared by management.
– A comparison of the cash flow forecast for the period October to November 20X8 with management accounts for the same period in order to assess the accuracy of the forecast compared to actual data to date.
– Results of analytical review of the items included in the cash flow forecast including, for example, a detailed review of the breakdown of different categories of expenses in order to identify any items which may have been omitted.
– A review of correspondence with Daley Co’s lawyers in relation to the legal claims in order to assess the likelihood of losing the actions, the likely cost and the possibility of further claims arising in the future.
– Based on the review of legal correspondence, confirmation that the settlement of the legal claims has been appropriately included in the cash flow forecast.
– A review of correspondence with Daley Co’s bankers and supporting documentation for both the company’s existing loan facilities and the proposed new loan.
– Minutes of discussions with management in relation to the likelihood of obtaining the new loan.
– Based on these reviews and discussions, a recalculation by the auditor of the finance cost and confirmation that the finance cost and the receipt of the loan have been accurately reflected in the cash flow forecast.
– Working paper detailing the review of the documentation in relation to the new warehousing agreeing the cost and checking that the cash outflow is included in the forecast at the correct amount and at the correct date.
– A review of board minutes in relation to the company’s current trading position and the ongoing negotiations for the proposed new bank finance.
– A consideration of the impact on cash flows and liquidity when the company is incurring the additional costs of compliance with all laws and regulations.
– Obtain written representations from management confirming the reasonableness of the cash flow forecast.

Reasons for non-disclosure and implications for the auditor’s report
Motives for directors not wishing to make going concern disclosures
The directors’ motives for non-disclosure of uncertainties in relation to going concern seem likely to reflect a desire to present the company in a positive light to investors and other third parties. This is a particularly sensitive issue at a time when the company is planning a major expansion and is seeking to raise significant new finance while struggling to manage its liquidity and working capital.
The disclosure of uncertainties in relation to going concern may well deter the bank from lending the new finance and may lead to a loss of confidence and goodwill with key suppliers and customers. Operational difficulties with suppliers and customers may prove to be particularly problematic with the arrival of the major new competitor in Daley Co’s market in October 20X8.
Implications for the auditor’s report
ISA 705 Modifications to the Opinion in the Independent Auditor’s Report requires the auditor to modify the opinion in the auditor’s report when they conclude that, based on the audit evidence obtained, the financial statements as a whole are not free from material misstatement. The failure to include disclosures regarding material uncertainties in relation to going concern in Daley Co’s financial statements represents a material omission which will therefore require a modification of the auditor’s opinion. In this case, the auditor must exercise professional judgement and assess whether the absence of this disclosure is material but not pervasive to the financial statements or whether it is material and pervasive to the financial statements.
Material but not pervasive​​​​​​​
If the auditor concludes that the omission of the required disclosures, such as the uncertainty over the bank loan and the possible outcome of the legal case, is material but not pervasive to the financial statements, a qualified audit opinion on the grounds of material misstatement is appropriate, as the directors have failed to include required disclosures. The auditor will include a ‘Qualified Opinion’ paragraph at the start of the auditor’s report which will state that the financial statements are presented fairly in all material respects ‘except for’ the absence of this disclosure. The qualified opinion paragraph will be followed immediately by a ‘Basis for Qualified Opinion’ paragraph which will give details of the going concern uncertainties in relation to Daley Co and explain that the financial statements do not adequately disclose these uncertainties.
Material and pervasive​​​​​​​
The auditor may conclude that the omission of the required disclosures as discussed above is material and pervasive to the financial statements, as in the auditor’s opinion the lack of these disclosures will have a fundamental impact on the users’ understanding of the financial statements. On this basis, an adverse audit opinion on the grounds of material misstatement is appropriate. The auditor will include an ‘Adverse Opinion’ paragraph at the start of the auditor’s report which will state that the financial statements are not presented fairly in all material respects. The adverse opinion paragraph will be followed immediately by a ‘Basis for Adverse Opinion’ paragraph which will give details of the going concern uncertainties in relation to Daley Co and explain that in the opinion of the auditor, the omission of key disclosures in this respect are fundamental and pervasive to the financial statements and therefore require an adverse opinion.
Tutorial note: Key audit matters (KAM) disclosures are not relevant for Daley Co as a result of its unlisted status.​​​​​​​