The assessment of going concern is more important than ever due to the current economic climate. This makes it a crucial part of the annual audit process.
High levels of inflation and increasing interest rates make it more likely that a parent entity, director, shareholder, lender or other party may write a letter to a company or group entity, declaring their willingness to provide financial support if this should become necessary. Letters of support have therefore become a key consideration in the assessment of going concern and can be used as vital audit evidence.
A letter of support, also sometimes known as a letter of comfort, is commonly provided by a parent entity, director or shareholder, in respect of a company’s financial obligations to a lender, or to help the directors of the company to meet their responsibilities with respect to going concern.
Although usually not legally binding, letters of support are commonly used where the parent entity, director or shareholder, is unable or unwilling to give a legal guarantee but wishes to give some comfort in respect of the company’s ability to meet its obligations. They are especially common where the company is loss-making, has net liabilities, or has high levels of intercompany creditors which the company may not be readily able to repay were they to be called in. They are also often used where a parent has previously provided loans and agrees to defer collection.
The following are situations where a company may commonly require letters of support:
- Where the company is short of cash, or not in charge of its cash function, to confirm that the parent, or director or shareholder will provide sufficient cash to enable the company to meet its obligations as they fall due.
- Where a subsidiary company has a high proportion of the group cash, to give comfort that this will not be removed by the parent to provide funding elsewhere in the group.
- The company has one contract, or reliance on one customer.
- To provide comfort around policies and methodology with respect to transfer pricing arrangements between two group entities.
- The UK subsidiary entity conducts UK sales for an international group.
- The company acts as the sole supplier of a good or service to the group companies or otherwise only exists because of group structure, and there is perceived to be a risk that the group might decide to source elsewhere.
- The subsidiary is set up to provide pensions services to other group entities.
On its own, a letter of support may not provide sufficient appropriate audit evidence of the entity’s ability to continue as a going concern, which may mean that there is a material uncertainty related to going concern. While a legally binding agreement will generally provide more persuasive audit evidence than one which is not legally binding, it should not be regarded as sufficient appropriate audit evidence on its own. For example, the auditor still needs to evaluate the ability of the entity or individual to actually be able to provide the support.
Other factors which should be considered when using a letter of support are as follows:
- Is the support letter being obtained from the right entity in the group?
- Do the company’s financial statements disclose that its ability to continue as a going concern is dependent on the support of its parent, or director or shareholder, and that the support is not legally binding?
- Is the support to the subsidiary disclosed in the financial statements of the parent entity?
- Does the parent entity have sufficient funds to cover the support?
- Is the parent entity or individual providing the support to any other entities?
- Is there a cap on the letter of support?
- Is the robustness of the letter qualified further by inclusion of certain wording?
- What time period does the support letter cover?
- Was a support letter requested by the directors of the company?
Letter of support can, and do, provide good audit evidence but the ever- changing implications of the current level of inflation and interest rates mean that detailed assessments of going concern are of increasing importance for all businesses.
If you have any questions regarding the use of letters of support and going concern assessments, then please do get in touch with our Head of Audit, Grahame Maughan, who would be delighted to help.
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